US stocks: no trade is an island

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“Be fearful when others are greedy, and be greedy when others are fearful.” So said a famous proponent of big US companies in 2008, after the shares of those companies lost a third of their value. And very right Warren Buffett was, too. Is his pithy slogan true in both directions, though? Because the only thing investors seem fearful of now is not owning US large capitalisation stocks.

The case for owning US stocks is strong. It has several parts. One: they are not European or Japanese stocks, which face deflation. Two: they are not stocks from commodity-dependent emerging countries. Three: they are not bonds with most of the yield forcibly extracted by central bankers. Four: the US, except for the bit where Sarah Palin’s house sits, is really quite far from Russia.

That US stocks have become a safety trade is reflected in the fact that bigger capitalisation equities have easily outperformed smaller ones this year. This is a reversal of 2013, and of the longer-term trend. Further, defensive sectors — healthcare and utilities — have led gains in the S&P 500. Cyclicals and consumer discretionary shares have lagged behind.

So what could make the safety trade unsafe? The elephant in the room is rates. If they rise faster than expected, stocks will tremble, says conventional wisdom. Well, maybe. The relationship between rates and stocks is far from linear. And one nice thing about this risk is that lots of people have been thinking a lot about it. It may be partly priced in.

Suppose instead that 2015 is a good year globally. Commodity prices stabilise, Russia behaves itself and growth is just a shade better than expected in Europe, Japan, and China. Suddenly, then, a US-centred asset allocation makes much less sense. In the ensuing rotation, toppy US valuations contract.

Frightened investors are not, it should be noted, the most important buyers of US companies. That honour goes to the companies themselves. Share buybacks and the market have risen in lockstep. There is no particular reason to think buybacks will slow. Executives love them. All the same, this is the risk to watch.

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