North America: The US market on the road to recovery

What a year 2008 has been: the announced takeovers of Countrywide by Bank of America; Bear Stearns by JP Morgan Chase; Fannie Mae and Freddie Mac by the US government; the non-takeover and subsequent bankruptcy of Lehman Brothers; the shotgun merger of Merrill Lynch and Bank of America; the takeover of the insurance giant AIG; and the reorganisation of Goldman Sachs and Morgan Stanley as bank holding companies, thus marking the end of the independent investment bank business model. We also witnessed the collapse and subsequent FDIC-orchestrated takeover of the largest thrift in the US, Washington Mutual, by JP Morgan Chase. During the year, the US banking system underwent a very painful process of consolidation after over extending itself. This process has materially reduced the amount of credit which is available to fuel economic growth.

This will end, as all prior crises have ended, when visibility improves and value buyers show up and start spending. Movement began on two fronts late in 2008: by strategic buyers through mergers and acquisitions and by financial buyers through share repurchases. Perhaps we have witnessed the first positive steps in this direction with Warren Buffett's investments in Goldman Sachs and GE. These crises are ultimately alleviated when fiscal and monetary policies, and other policy responses, become significant enough to reverse the tide while possibly increasing the visibility of the downside and exposing a path to recovery from both the liquidity and economic problems.

We believe that US equity valuations are attractive at current levels, and that corporate earnings will clearly continue to be under pressure in 2009, but that implied consensus expectations are likely to be too conservative over the intermediate term. In our view, current investor sentiment is too negative. Given the massive amounts of policy stimulus in the system, we think the current fear filled markets are creating an opportunity for long-term investors to begin building equity allocations that will produce very attractive returns.

Today's market in perspective

As at the end of September, the system contained very high levels of liquidity, over 25% of the total market volume (source: Investment Company Institute). Additionally, assuming the year closes with large capitalisation US stocks down over 20% in 2008, the rolling 10-year average will be at return levels only reached four times previously in the last 160+ years. All of this confirms what Warren Buffett recently stated in a New York Times article: "Equities will almost certainly outperform cash over the next decade, probably by a substantial degree."

Sectors to watch

Stocks in the consumer sectors are benefiting from input cost reduction as commodity prices have come down substantially from earlier in the year. Additionally, consumers will benefit from the reduction in oil and heating costs.

Among the energy and utilities sectors, we continue to prefer companies exposed to natural gas, as the likelihood of a constricted supply is making companies with higher natural gas exposure more attractive.

Within the financials sector, we see the valuations in US banks as increasingly attractive. Why? While the severe credit issues continue, we have not, until recently, been interested in more highly credit sensitive banks. At this point, they remain inexpensive but even more importantly, the stocks are closer to discounting the credit problems and they are getting some relief as a result of the government led liquidity injection into the economy.

The future

Company balance sheets will continue to be a focus for investors because they hold a key to understanding systemic risks at companies. Those with stronger balance sheets are more likely to succeed in the near term and are also more likely to gain market share. The balance sheet has always been a 'leading indicator' to the income statement, but in these environments, their importance is even more evident.

We believe that the 'first-in, first-out' method used in inventory accounting is a good way to view the US market in terms of leading other markets in a recovery. While we know that 'decoupling' occurred with the US slowing first, we now think it's at least feasible that the US (with easier monetary policy for a longer period of time relative to most of Europe and Asia) will lead the global markets and economies out of this difficult period.

We don't expect a V-shaped recovery, but easy monetary policy and attractive valuations increase the likelihood that the US will lead the way out of this global mess at some point. We are not confident about the timing, but we do believe we are in the later stages of this crisis and that the market has discounted a fair amount of the downturn. We do not suggest that the US market will experience a quick recovery; however, we think the market is poised to reach a trough, and the combination of early signs of improving fundamentals and cheaper valuations will ultimately lead to strong returns.