Is the S&P 500 rally overdone?

Emerging Markets EBRD editions, May 10 2013

With the S&P 500 at record highs and the FTSE All-World equity index at its highest level since June 2008, fund managers and analysts face a challenging question: is the rally over-done, or sustainable?

Frances Hudson, global thematic strategist at Standard Life in Edinburgh, which had GBP218 billion under management at the end of 2012, told Emerging Markets there were reasons for continued confidence in global equities. “If you were to take a macro perspective, it’s supported by things stabilising, and by continued liquidity support from the various quantitative easing initiatives.”

But in terms of underlying fundamentals, she said “earnings are not doing quite so well as they have been, partly because you had a period of several years where the macro environment was so uncertain that companies haven’t wanted to make commitments to taking people on or investing, and so have not been growing. If you don’t grow, you don’t grow earnings.” On that basis, “valuations on fundamental grounds are looking a little more stretched than before.”

But investor confidence shows a different picture. “I think what’s happened is that we’ve survived,” she said when asked about resilience to external shocks such as Cyprus. “We understand better how that type of event would have an impact. Many companies in Europe are not particularly domestically oriented and so not that vulnerable to the domestic situation: so you can still have a Spanish or Portuguese company that prospers irrespective of what’s happening in the government.”

Christopher Beachamp, market analyst at IG in London, said: “It’s safe to say this rally has been one of the least liked for global markets: people say it’s based on central bank activity, not fundamentals, and is getting ahead of itself.” But he said there were reasons to be “cautiously optimistic” because of improvements in US data, such as last week’s non-farm payroll numbers. “It’s not to say we won’t see short-lived sell-offs with lots of people sitting on hefty gains from the last four months, but it won’t disrupt the upward trend.”

He agreed European stability had helped sentiment. “We’ve stopped expecting Spain or Italy to ask for a bailout every day now, which was the perception at the end of last year.” The lack of impact of the fiscal cliff and sequester issues in the US economy have also helped.

Hudson said Standard Life was overweight the US, because of better economic fundamentals and signs of recovery in the housing market and consumer spending; and Japan, with the momentum of the Abe administration. It is neutral on the UK and emerging market equities – “if what you’re trying to get is emerging market growth, you’re better off investing in the currencies or bonds” – and underweight continental Europe and developed Asia. “In Europe valuations and competitiveness are improving, but the fiscal programs are still fairly seriously constrained and there is ongoing political uncertainty,” she said. “The German elections in September will be another benchmark.”

In terms of sectors, Hudson said Standard Life was starting to favour cyclicals over defensives; Beachamp said discretionary spending stocks were coming back into favour, with retail and housing worth watching closely. “US housing has been a long-absent story,” he said. “If it shows sustained improvement, that feeds through in a big way, and has a multiplier effect on the US economy.”