Stocktake

European indices are ending the year on a high. Not only have the main bourses
surged 15 per cent since June , there have been 22 consecutive weeks of fund inflows from US investors – the longest streak since records began.

A raft of bank analysts are suggesting the flows into Europe will continue despite continued earnings stagnation.

Market gains have come almost entirely from an expansion in valuation multiples – Europeans equities now trade on over 13 times earnings, just above its 10-year average.

No longer a screaming bargain, then, but there is a case for continued gains.

Fund inflows have been a mere fraction of the cumulative outflows since 2007; the earnings recovery is in its infancy (European profits are 25 per cent below 2007 levels, while US earnings and profit margins are at all-time highs); and while Europe's one-year price-earnings ratio has risen steeply, its 10 cyclically adjusted ratio is at 12.3 – still much lower than its 30-year average of 17, says London–based Capital Economics, and allowing some breathing room for investors.


US outperforms rest of world
In contrast, the S&P 500 is the most expensive of the world's 44 developed and emerging markets, cautions investment manager Mebane Faber.

Faber's valuation derives from a 10-year cyclically adjusted price-earnings ratio (Cape). Cape has its critics – Prof Jeremy Siegel (pictured above) asserts the measure, once reliable, is now redundant due to accounting changes. Siegel, who correctly predicted this year's 25 per cent gain, says the market remains 10 to 15 per cent undervalued.

Barclays' Barry Knapp is somewhere in between, predicting the US – the "unambiguous leader in this current equity cycle" – will advance next year whilst advising investors to rotate into cheaper global markets.

A Barclays chart shows the US has outperformed the rest of the world throughout the 1995-2013 period, although the gap had shrunk to near irrelevance in 2008. Today, however, the spread is wider than ever – the US is now up over 450 per cent since 1995, compared to 200 per cent for the rest of the world. There is, as Knapp puts it, "a large gap to fill".


Bulls remain firmly in control
US markets may be over–valued and vulnerable to a pullback, but there is little evidence the bull market is tiring.

Take market breadth. In a healthy bull market most stocks advance, whereas tired bull runs become narrow, with a small number of large-cap stocks doing the heavy lifting.

One famous study of 14 major market tops found breadth declines months before market peaks.

This occurred in 2000, when just one-third of stocks traded above their 200–day moving average at the market peak.

Two-thirds of the S&P 500’s 1999 gains came from just 10 stocks, with the tech sector dragging the market higher. In 2007, the S&P 500 would have declined were it not for the outperformance of the 10 top performers.

Just over half of stocks traded above their long–term average at the October 2007 high.

In contrast, Strategas Research Partners notes the top 10 gainers in 2013 have contributed less than one-fifth of the S&P 500’s total gain. No sector has dominated, with around 90 per cent of stocks gaining this year – the highest number in a decade.

More than 80 per cent are above their 200

Hedge funds among the big losers of 2013
Hedge funds have been among the big losers of 2013, returning just 7 per cent compared to the S&P 500's near 30 per cent gain. Five successive years of underperformance mean they have trailed the S&P 500 by 97 percentage points since 2008. And yet, Bloomberg reports, $53 billion was added to their coffers in the first nine months of 2013, compared to $34 billion in all of 2012. Hedge funds can expect to earn some $50 billion in management fees this year.

Why? Impressionable investors may wrongly assume that complexity beats simplicity, or be seduced by the image of hot-shot managers making money in good times and bad. Those early days of hedge fund glory are gone, however.

The industry is worth over $2.5 trillion today, investment manager Barry Ritholtz (above) estimates, compared to just $100 billion in 1997. Once perceived as rare, almost exotic, there are around 10,000 hedge fund managers, all chasing a dwindling number of market inefficiencies. "Come for the high fees," jokes Ritholtz. "Stay for the underperformance."


Forecasters have a bad year
Yet again it's been another lousy year for market forecasters.

US investment adviser Robert Seawright compiled a list of 2013 forecasts by the major brokers.

Of the 14 S&P 500 forecasts, the best was off by 12 per cent, the worst by 30 per cent. On average, they missed by over 17 per cent, predicting the index, now over 1,800, would end the year at 1,534. “In other words”, says Seawright, “they all missed by miles”.