The first topic that investors need to assess when forecasting a market outlook is determining what fundamental issues are going to remain steady as opposed to changing. Macro or other crises will be important as the year unfolds but exogenous events are difficult to predict in terms of actuality and, just as important when it comes to market impact, in terms of timing.
In the US, profits are likely to continue to move higher as the economic recovery continues to gain momentum. The recent Institute of Supply Management manufacturing and services indexes as well as corporate profit forecasts indicate that the trend should continue.
However, unlike a year ago, consensus expectations have shifted to embracing the sustainable rise in US corporate profits and margin gains. The one positive surprise may come from a realisation that peak profit margins are still far off in this economic expansion, given efficiency gains of the past couple of years.
Where our optimism might be misplaced is if we see a double-dip recession, a likelihood that we put very low odds on.
Similar to expectations heading into last year, it seems that consensus opinion expects interest rates to rise – both long-term rates due to inflation and short-term rates as the Federal Reserve starts to shift from accommodative to neutral/restrictive in its interest rate policy. We do not expect either event to unfold as inflation remains contained and the unemployment rate grudgingly declines during the year, pushing action by the Federal Reserve out further than most expect.
Despite our natural bias as a big-capitalisation-style fund, given our profit and interest rate forecast, we do not expect bigger companies to outperform mid and smaller-cap ones but expect the differential to decrease.
From a sector standpoint, it is likely that 2010’s winners will do well in 2011, with the possible addition of the finan-cial sector, as it will be rewarded from a valuation perspec-tive for all the efforts in putt-ing its problems behind it. With many regional banks still trading near book value, big upside potential exists.
One positive driver we expect is a strong resurgence of mergers and acquisitions as well as high-profile initial public offerings. As with prior cycles, M&A and IPO activity plunged during the financial crisis as the availability of funding dried up and risk aversion spiked.
In 2010, both the number and value of M&A deals in North America exceeded 2009 levels and are following the trend of the 2002/4 period. In addition to the M&A turn-round, the number of announced IPOs from a year ago has almost doubled.
It signals not only that confidence among corporations and investors is rising but also productive growth capital formation with plans for its use is under way.
In 2011, M&A volume is likely to boom as companies search for top-line growth as well as cost-cutting synergies from acquired assets. In addition, several companies such as LinkedIn, Skype, Facebook, etc, will prepare to go public, contributing positively to sentiment.
Both of these factors are likely to lead to a rise in the overall stockmarket valuation multiple. Even a small change from a price/earnings multiple of 14 times to 16 will drive the market higher by roughly 14 per cent, assuming all else remains constant.
Lower economic and interest rate volatility plus lower risk aversion illustrated best through record M&A will provide the fuel for a third consecutive year of strong US equity returns.
James Abate is fund manager of the PSigma American growth fund