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News, Events and Research
February, 2011

Do we have too much of a run up in US equities already?

US investors continue to like what they see in the US economy. The US equity market has rallied to a two and a half year high. Is there any room left for US equity to continue to go up? Is the US equity market lofty?

We believe that US equity may have more upside potential. The US economy avoided a “second dip” in 2010, and recent economic indicators suggest that the market will continue to pick up steam in 2011. The US consumer started to spend again, as was demonstrated by the strong holiday retail sales reported. US business increased their spending and industrial production is appearing to be ramping up.  Although the unemployment rate still very high, we believe the unemployment rate will start to decline in 2011. In addition, gains in productivity will help to increase personal income and boost personal spending.  US exports also starting to increase.  Couple all the above with the current low interest rate environment, extension of the Bush-era tax cuts, and strong government expansion policies, we anticipate the US GDP will grow at 3% to 3.5% in 2011.

Under such an US economic backdrop, US corporate profits are likely to continue to improve after cutting their expenses. US corporate profits should reach a new high level which in turn will bolster US equity along with it. In addition, US equities market when evaluated by PE (Price to Earnings ratio) is still a bargain. It is currently evaluated, as measured by PE, at only 13, still below its historical average PE of 15, as showed in the chart.  The chart shows S&P 500’s peak PE, through PE, average PE (red line) and the current PE (star) during a few US major recessions.  If S&P 500’s PE just moves from its current 13 to its historical average of 15, it will register an impressive 15% return from current level. We see US equities having not only more upside potential, but a major upside run in US equities may lie ahead helped by the two engines of profits and PE expansion.


Of course, given that we have just emerged from the Great Recession, investors understandably remain cautious about the current rally. The unemployment rate is still very high, the troubled housing market is still languishing at recession levels, the European sovereign debt crisis remains a threat to market stability, moves by China to slow China’s growth could slow down global economy growth, US budget deficit is at a historical high and finally, the fear that inflation may pick up. All of these weaknesses may lead to a 5% to 10% correction in US equity market, which is normal during rallies. 

In conclusion, we believe that the US equity rally will continue. In fact, the major part of the rally may lie ahead. We anticipate a normal correction in the equity market over the coming months that will bring buying opportunities. 

Li Liu, CFA
CEO and Chief investment Officer

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© 2011 Highlands Asset Management