Materially unloved

A decent start to the day for equity markets was slowly but surely eroded as the day wore on and as the Americans start defrosting their Turkeys. Having recovered well from the depths of mid October it may well be that equity markets are pausing for breath before the year-end.

As we discussed the other day strategists will be starting to focus on the year ahead, unlike the previous few years equity valuations should start the new year close to, if not slightly ahead of historic norms.

The positives for the coming year should see the fundamental backdrop remain supportive for equities, as governments continue to adopt pro growth policies and inflation remains in a range traditionally positive for equity returns. One also gets the sense that equity sentiment remains cautious as we come close to 2015. The recent Merrill Lynch fund manager survey continues to suggest fund manager cash levels are higher than the historic average. With their look at the next year, sentiments indicators Merrill Lynch believe remain one of the most compelling reasons to stay positive on equities.

The one area where equities do remain cheap is relative to bonds. According to Merrill Lynch more than 50% of the companies in the S&P 500 yield more than the 5-year US treasury. Those dividends should also grow over the next five years unlike the coupon on the 5-year treasury.

Merrill Lynch point out that the much vaunted switch from bonds to equities has not occurred in a meaningful way, as most of the investment into equities has come from cash deposits. Since 2009 almost twice as has been invested into bonds rather than equities.

A larger proportion of the cash that has gone into the equity markets has gone into bond proxy equities, those sectors that are far less geared to economic growth, for example consumer staples, pharma and utilities. These are the sectors that have seen valuations change the most markedly from multiple expansion.

Sector allocation is always important and how fund managers position themselves in the materials and energy sector will be interesting for 2015. The resurgence of the dollar, along with weaker than expected demand, particularly from China, has led to a fall in commodity prices this year. The Reuters CRB commodity index having been up almost 10% in the middle of the year is now down. Investor sentiment appears also to remain negative as fund managers remain cautious on the sector and underweight relative history.

Despite the fall in commodity prices, valuations are not unattractive, and the yields on both energy and material stocks are very supportive. A lot of investor focus remains on China, and one has seen recently its government remains pro growth, but one must not forget that India. This year India elected a new leader this year whose mandate is to reinvigorate their economy. Traditionally any asset when prices are down, sentiment is negative and valuations are undemanding being with the herd can be risky. 

Posted on November 26, 2014 .