U.S. stocks are the world's priciest after this year's big rally. Many strategists predict a significant pullback, and Wall Street has been struggling in August. That should be a sell sign, shouldn't it?
Not yet, at least for lots of global large-cap fund managers who have stayed invested more heavily in the U.S. market than any other, according to recent Lipper data. Even after the big gains racked up in the first quarter of the year, a Bloomberg poll showed that global investors gave U.S. equities their highest rating in three-and-a-half years and expect them to be among the biggest gainers in the year ahead.
That marks a big difference from the recent past. Brazil, China and India were topping global investors' "favorites" lists in 2010 and 2011. This year, the so-called BRICs (those three nations plus Russia) are all struggling, The Standard & Poor's 500 index is up 20 percent, adding to last year's 13 percent gain.
Even with a pumped-up U.S. market valuation at 15.5 times projected earnings for 2013, global fund managers are sticking strongly with American stocks and adding to their holdings during market pullbacks.
So why do fund managers still say the U.S. market is the most attractive? Surprisingly, even at these levels, one answer is still-attractive valuations in parts of the market, says Timothy Hartch, who co-manages the BBH Global Core Select and BBH Core Select funds for Brown Brothers Harriman.
His global fund, which invests in stocks trading at 25 percent less than their fair value and offer steady earnings and solid balance sheets, is still largely holding domestic names.
"From that screening, we put together a wish list from the U.S. and around the world," he says. The U.S. market makes up 51 percent of the globe's "investible" equity, according to S&P Capital IQ. BBH Global Core Select has slightly more than that, 54 percent, in the U.S. market.
True "valuation" is more than just price. In looking at global markets, it's a mistake to boil valuations down to a single figure, says Alexander Young of S&P Capital IQ. To be sure, U.S. equities are the costlier than most, over 10 percent above the MSCI global average of 13 times earnings. But with risk factored in, emerging markets nearly always trade at a significant discount to developed markets, and Europe as well as the emerging markets face more earnings pressure this year. But Young says that could change soon. "Earnings momentum is expected to accelerate to 10 percent [profit] growth in 2014 [for emerging markets]," he says. "And this is one of the reasons we believe the [emerging markets] equity risk-reward is becoming more compelling. As for developed international [earnings per share] growth, it too is forecast to accelerate in 2014, to 11 percent."
Given that assessment, it hardly seems like Buy America time, especially when U.S. unemployment remains high in an economy so anemic it requires the Fed's monetary supplements to stay on track. But there are still opportunities, even in a lackluster U.S. landscape, Hartch says, alluding to the auto industry that has continued to grow globally despite Detroit's bankruptcy.
"There is no doubt the U.S. is facing some headwinds," Hartch says. "But we focus on the underlying businesses, identifying companies ... that provide certain attributes like essential products and services, and good financial structure with strong cash positions on their balance sheets."
[Read: How to Find Value in a Bull Market.]
After the United States, his fund's next-biggest investing destination is tiny Switzerland, which accounts for 12 percent of the portfolio's assets. The rest of the fund is largely invested in Western Europe and Canada. It has nothing invested directly in Asian countries. That helps at a time when China is weak.
Upside in Japan, Europe and emerging markets? Such a company-focused strategy carries a downside, however. "You can miss out on markets that are doing well," Young says. Investors may be unhappy with a global fund that misses a rally in a key market. In particular, he cites the recent strength of Japan. "Not having something in Japan seems like a risky strategy. You better get it right if you go that route," he says.
Japan does offer a pointed contrast between fundamental investors scouring balance sheets and macro-watchers divining buy signals from economic conditions and central bank policies (like those spurring Japan now). Hartch's BBH Global Core Select Fund launched in April, so there is no past performance to measure it against. But Hartch says he sticks to a disciplined investing pattern and says that "on balance, Japanese companies have very poor returns on capital, and they make weaker capital allocation decisions." It's "pretty rare," he says, to find companies that meet his criteria there, especially after Japan's market has risen 60 percent since the start of last year.
The investing strategy the new BBH fund follows is an extension of the one it followed for years with is large-cap funds, which have managed annual returns of 18 percent to 20 percent over the past three years and have consistently earned "low risk" ratings from fund tracker Morningstar. Morningstar analyst Russ Kinnel recently cited BBH as one of his favorite fund groups for its "good old-school focused, high-quality" investing style.
As part of BBH's disciplined approach, Hartch says he keeps a close watch for "when valuations get too high." Recently, he says the firm "trimmed some positions" because they were "getting stretched everywhere, including the U.S. market." The BBH large-cap funds are holding cash levels of between 7 percent to 10 percent, according to company data.
Global funds keeping high U.S. holdings. Overall, global large-cap funds have kept 45 percent of their investments in the U.S. market for the first half of the year, Lipper data shows. That's four times the level of the next biggest market, the United Kingdom. Despite the rise in U.S. stocks, the American market is still more attractive, given the slowdown in China and Europe's long struggle to show gains.
"The benefit of global funds is that when things get worse internationally, they can keep piling into the U.S. market," says Lipper research director Tom Roseen.
That strategy has worked over the past two years in terms of performance and fund flows, and is a big shift from the 2000-2010 decade when emerging markets, especially the BRICs, were lifted by China's powerful growth and helped by a weakening U.S. dollar. Those two key factors have flip-flopped this year. The dollar is strong. China is weak.
"The story now is that U.S. stocks are not overvalued after this year's really," Young says. "They are reasonably priced. The only place that's really cheap is emerging markets. But they're cheap for a reason. They face a lot of challenges."