The UK Stock Market
In the year to 30 June, the UK stock market has not made significant overall gains or losses but there has been continued volatility in both individual share prices and the key UK indices. The level of investor optimism rose quickly in January only to be undermined by geopolitical events. We believe that there remains a strong undercurrent of optimism overlaid with a sense of nervousness, the combined effect of which can be seen as investors over-react to both positive and negative news. However, this on-going volatility does not change our view that markets (in both the UK and the US) will end the year higher than their current levels.
Aside from underlying company performance, the major driver influencing the level of stock markets is human psychology. We believe that many companies are showing signs of recovery and we anticipate a pick up in corporate spending in the short to medium term. We have heard evidence of this from managers of early cycle companies whom we have visited who now feel brave enough to voice cautious optimism.
However, many later cycle companies have stated that they do not yet feel this optimism, something which continues to feed investor nervousness. Consequently, whilst investor sentiment has certainly improved over the last 12-18 months, it is reassuring to note that few people are talking about the beginnings of a bull market. As strong believers in contrarian investing and the market cycle, we are confident that this presents real investment opportunities.
We follow, and have invested in, those companies that we believe will benefit from the anticipated additional corporate expenditure. Our focus is to identify quality companies that, in our opinion, have a depressed valuation because investors have turned their attention elsewhere or sat on the sidelines. We strongly believe that it is these companies, which have concentrated their efforts on cost reduction and restructuring, which are best placed to increase earnings in the next stage of the market cycle. We are confident that timely investment in these companies, which we think will report earnings ahead of expectations, will reap significant investment returns.
We have visited many companies in recent months and have found that many of those best placed to benefit from the next stage of the market cycle can be found in the media, information technology, telecoms and electronics sectors. We also believe that these sectors will appeal to changing investor sentiment. Consequently, we will watch the developments in both company earnings and investor sentiment very carefully. Although excited by such prospects, we are confident that we are some way off the peak of this market cycle.
The US Stock Market
The S&P 500 has risen in every presidential election year between 1964 and 1996. Indeed, history shows that company share prices perform well in presidential election years regardless of the strength of the economy or whether the incumbent or opposition party win.
However, in our opinion, the re-election of George Bush is an important factor for the US economy. Not only will his re-election provide a degree of stability but there are already clear indications that he will initiate a comprehensive series of business friendly legislative changes.
We believe Bush will address issues of corporate concern and employee benefits. The Republicans recently put forward a bill to limit class-action lawsuits against corporations and there have been clear indications that they will look to undertake a reform of US patent and copyright laws and review the responsibilities imposed on US companies for environmental protection. In addition, the recent high profile appointment of Dr Mark McClellan, following a successful tenure as Commissioner of the Food and Drug Administration, as head of the Centres for Medicare and Medicaid Services (agencies that provide healthcare reimbursement costs) indicates Bush’s readiness to address employee benefits at the same time as dealing with the concerns of the rising costs of the provision of healthcare by employers.
In addition to the hoped for rally in the US market on the back of the election, we expect the rise to be supported by strong corporate earnings. The recovery in the US economy is slightly ahead of the UK and corporate earnings are already strengthening: analysts have revised their estimates upwards for the second time in as many quarterly earnings releases. However, as in the UK market, a key factor influencing company share prices, no matter how compelling the earnings story, is investor sentiment. We believe that the time lag between early indications of stronger company performance and the recognition by the market of such positive trends provides a window of opportunity for the nimble investor.
Speculation about interest rates is another factor concerning investors and this pessimism has been factored into company share prices. We feel, however, that investors are being overly pessimistic as we believe that interest rate rises are unlikely to occur as quickly and steeply as in 1994. This time round the Federal Reserve has acted quickly to align interest rates with the economic recovery.
We must also consider the impact of the price of oil on interest rates. At U$40 a barrel, oil is acting as a major drag on the US economy and will be an important factor when it comes to setting interest rates.
We are perhaps more positive than many commentators on the US economy. Our main concern is that the levels of optimism may become too high once the full extent of the positive corporate earnings outlook is realised.
Asia
The Asian markets also offer interesting investment opportunities. Following significant gains in 2003, there has been a degree of consolidation, primarily due to concerns about the continued pace of growth in China. Despite these fears, we continue to believe in the potential that Asia’s fast developing economies and increasingly affluent populations offer and we will exploit this through investment in carefully selected investment trusts and unit trusts.
30 June 2004
