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Brian Tora: A cautious approach to developed markets

After last years strong returns from US and UK equities, there appears to be little cushion in current valuation if the recovery falters.

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It is remarkable how swiftly investor confidence can dissipate. Last month we saw the S&P 500 hit a new high, since when it has pulled back by around 5 per cent. The FTSE 100 Share index has suffered a similar fate. In Japan the fall has been double that of the Anglo-Saxon markets, but then it did deliver the largest rise last year.

The burning question must be, is the bull market over or is this merely a correction in a long term rerating of equities?

At the beginning of January, PSigma American fund manager James Abate distributed a most prescient paper, highlighting the risks associated with the seemingly unstoppable rise in American shares. As in our market, the running had been made by small and mid cap companies. His view was that their valuation levels now carried little cushion, should the economic recovery there falter.

And falter it did – or at least, appeared to. While initial investor nervousness can be laid at the door of the imminent ending of monetary easing and, in particular, the way in which excesses in some of those emerging markets that had sucked in liquidity were exposed, a poor set of numbers from manufacturing industry stateside sounded alarm bells. Could it be that the recovery was already running out of steam?

As it happens, the downturn could be attributed to the atrocious weather conditions that had brought much of the US to a standstill during December and January. Bulls of the US market were quick to point out that such a statistic could be happily ignored, given the exceptional circumstances. Abate was not so sure, though, as he made clear in one of his regular briefings to UK investors last week.

Drilling down into the detail of the American recovery does expose some worrying trends. Inventories have rebuilt significantly, so any downturn in consumption would inevitably impact upon future production. Capital expenditure remains at around recent trend levels, not necessarily a cause for concern, though it does remove one of the planks that support the argument for further strength in the economy there.

Putting his money where his mouth was, Abate had succeeded in elevating the American fund he manages that has much the same composition as the PSigma UK version into the top percentile of similar funds – 4th out of nearly 500. OK, that was just for a single month, but clearly his assessment of how the components of the US market might behave was on the button. But it is what might happen from here on that is of most importance to investors.

Overall he was not pessimistic – merely cautious. His expectation for modest growth over the next few years suggests that markets there might not race away, but should not collapse. Last year was a good year for investors and 2014 is likely to prove tougher, but then these are just the sort of conditions where disciplined active managers stand a chance of shining.

I certainly prefer his take on likely events to that of a technical analyst of my acquaintance. Pointing to lower lows in recent market movements, he is expecting further retrenchment, both here and in the US, with our own FTSE 100 Share index testing 6,000 – suggesting a fall that could amount to as much as that suffered by the Japanese market. Not that I feel investment strategy should necessarily be driven by technical considerations.

What both observers of the investment scene appear to be saying, though, is that market valuation levels are well up with events and have little margin for upsets. Here at home, smaller and mid cap companies have comprehensively out performed larger cap businesses, as it has in the US. For the time being there looks to be safety in size. Perhaps the Footsie is capable of breaking into new high ground after all.

Brian Tora is an associate with investment managers JM Finn & Co

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