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Magazine Issues » February 2011

US EQUITIES: bubble fears, fact or fiction?

bubblegum_machines_410The Federal Reserve's second quantitative easing exercise could lead to ramped up asset prices in the US equity market. But some experts think that this argument is not grounded in reality, as Angele Spiteri Paris reports.

Investors are edging back into equities, as US equities funds took in more than US$20bn (€14.7bn) during the final quarter of 2010, according to data provider EPFR Global. But as the second round of quantitative easing by the Federal Reserve feeds asset prices and contributes to a potential bubble - at least so some believe - investors would be wise to exercise some caution.

Andrew Beck is co-founder and president of Aviva-owned River Road Asset Management. “There is significant risk that we are facing another bubble, although exactly where that will be is still to be seen,” he says. “QE2 definitely runs the risk of inflating a bubble and you’d be foolhardy to dismiss that risk.”

Therefore, he advises investors to exercise caution in the face of a rising equity market that could be headed for a fall.
John Velis, is head of capital markets research at Russell Investments. He says: “The worry that QE will lead to the creation of a bubble is not an illegitimate concern.”

In January 2011, some financial blogs began to point the finger at QE2, claiming the Federal Reserve was helping to ramp up asset prices, and that the US stock market was ripe for a bubble to form.

“There is no question that the announcement of QE and QE2 led stocks to soar,” says Beck at River Road.

Fact or fiction?
However, some experts think that the threat of a bubble is more to do with scaremongering than fact.

John Carey is portfolio manager at Pioneer Investments. “The term ‘bubble’ connotes something way more extreme than what we’re currently seeing in the market,” he says.

“You will always have bulls and bears. In fact, a certain amount of tension is good – it creates opportunities.”

Jonathan Armitage, head of US large cap equities at Schroders, agrees. “The US equity market is certainly not over-extended. I’m not sure the suggestion of a bubble formation has much basis in fact,” he says.

Gerry Paul, US equities CIO at AllianceBernstein, goes further. “We’re complaining about the party before we’ve even been to it,” he says.

However, the party has been going on for some time now. Equity markets have seen relatively consistent good performance since March 2009.

Mark Stoeckle is head of US equities & global sector funds at BNP Paribas Investment Partners. “When you have such a strong period of performance, a portion of the investing public will inevitably try and see what’s wrong with it,” he says.
“There is always concern of a bubble forming in equity markets but I don’t think any of the current worry is well founded. They had said that QE was going to be bad for the dollar and bring rates down, and none of that has happened.”

“It’s true that the market isn’t as cheap as it was in 2009, but comparing the multiples seen in the market now with those observed in the mid- to late ’90s, they’re still way off,” says Carey. “Valuation levels are still reasonable and stand a good chance of yielding positive results for the year.”

Horacio Valeiras, CIO at Allianz Global Investors Capital, agrees. “Equity valuations are below the long term averages, so it is hard to make the case that we are in an equity bubble,” he says.

Those fearing a bubble, worry that by injecting money into the markets and encouraging the rise in asset values, the Federal Reserve will also be generating excess liquidity which can be defined as being “manufactured” rather than being a result of more activity in the market.

These views are not shared by Velis.  “We’re confident the Fed will hoover up any excess liquidity if it gets to that point,” he says.

Beck, however,  is not convinced. “We’d be hopeful that the Fed is able to contain any excess liquidity, but in reality, it doesn’t have a very good track record of doing that,” he says.

“That [the Fed containing excess liquidity] will be extremely difficult to do.  Inflationary pressures and evidence are already present and the Fed is making no attempt to address them,” says Valeiras. “Until we hear that inflation is a concern, we don’t expect policy changes and by then, it may be too late.”

Market correction
“There’s something to be said for QE2,” says Carey at Pioneer. “The market recovered more quickly than it otherwise might have done and although as a professional investor you may disagree with it, in principle, you cannot ignore the fact that it has helped.”

According to Carey, however, the recovery in the equity market was not solely fuelled by the quantitative easing exercise.

“Although some market advance was a result of QE, I think there is some natural momentum to the market recovery as people begin to come back to equities,” he says.

Carey believes that the interest in equity funds on behalf of investors will continue over the next few months, barring any catastrophe.

Other market observers are not so sure. “I don’t think the in-flows we saw in December 2010 are really sustainable, though the outflows we saw over the past 24 months should subside,” Valeiras says. “Demographics, diversification of portfolios and funding of benefits, etc for institutional investors will be a headwind for US equities for a while.”

Armitage says: “It’s probably too early to say this, but the flow into US equities is a definitive trend. It’s certainly encouraging.”

“I don’t think the commitment to equities is very firm,” says Paul at AllianceBernstein. “If we go through an anxiety-causing event, we’ll see investors leave equities.”

There are some who see a small-scale shake-up on the horizon. “We could see a correction at some point and we could have a significant one this year,” says Carey.

Beck agrees: “We haven’t reached a market peak in the current cycle but we think it could be a near-term peak and therefore could see a five to ten per cent  correction in the US market between now and mid-2011.”

Positive outlook
Velis believes the subdued performance outlook for the US equity market is positive. “I think there is going to be a limited upside to be had from equities. But in my opinion, this is a good thing – it reduces expectations and therefore you’re less likely to see irrational exuberance on behalf of investors,” he says.

However, despite the anticipated medium-term correction, there is still value to be found in US equities.

“The fundamental case for US equities remains very robust and company financial health is strong,” says Paul.

Velis agrees. “In 2011, US equities still look good as an asset class,” he says.

“There are some under-valued stocks which will benefit from additional investment. Some such companies can be found in the industrial sector, for example,” says Armitage.

Asked about his outlook for US equities, Valeiras, at Allianz Global Investors Capital, says: “We favour ... technology and companies exposed to the Asian consumer.”

Pioneer’s Carey gives some examples of names he thinks offer good value. “The Chevron stock appears to be still quite reasonably valued and was up 19% over the past twelve months. It’s selling at only ten times earnings. Norfolk Southern is also selling at a reasonable multiple compared with its growth potential,” he says.