Smith & Williamson's Tana Focke, manager of the North American trust, wonders whether the US market rally can continue if government stimulus is withdrawn.
Dividends and share buybacks are both expected to increase this year, with dividends forecast to grow for the first time since 2007. In Q1, US companies were involved in $278bn of M&A, with about half in the form of all cash offers. M&A also enables companies to garner synergies and further cost reductions.
While companies have done a great job in maximising operating leverage and reaping the rewards of the cuts made in the previous two years, the key question is whether margins can continue to expand or whether they have peaked.
Adjusting for financials, S&P constituents have already surpassed the prior margin peak. The concern is, over the long run, margins revert to the mean and with a surge in input costs, corporations will find it hard to stave off margin compression over the course of the year. Adjusting the S&P P/E of 13.6x for peak operating margins, the valuation of the market looks expensive versus historical valuations.
QE3 a good assumption to avoid a double-dip
The market’s valuation has been supported by an unprecedented amount of liquidity, pumped into the markets by the Federal Open Market Committee. In fact, the market has returned over 25% since Ben Bernanke hinted at QE2. The asset purchases are due to come to an end in June, and the issue is, can the market sustain this rally without its support?
When the original QE ended in 2010, the market drifted lower by 14% until QE2 was announced. The market is described as being resilient in the face of the problems in Middle East and North Africa, the Japanese earthquake and the impending end of QE2. As we move into the summer, the question of whether resilience has been confused with complacency will be answered.
While the US economy seems to have gained momentum, there is concern it will dip once the infusion of liquidity is withdrawn. If this were to occur, it is reasonable to assume the Fed will hasten another phase of QE, as they would be keen to avoid a recurrence of double-dip fears that emerged this time last year. The coming months may see increased volatility that will create investment opportunities.
Tana Focke is manager of the Smith & Williamson North American Trust
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