The financial crisis began in the US and many people believe in the “first in; first out” view that the US economy will lead the way to recovery. If this is to be believed, there are a number of signs that investors should be looking for as indicators of a return to growth, says Aris Vatis, portfolio manager of the Fidelity American Fund.

The financial crisis began in the US and many people believe in the “first in; first out” view that the US economy will lead the way to recovery. If this is to be believed, there are a number of signs that investors should be looking for as indicators of a return to growth, says Aris Vatis, portfolio manager of the Fidelity American Fund.

According to Mr Vatis, it is clear that the necessary political will for recovery exists in the US: President Obama is taking the restoration of stability and growth seriously, committing hundreds of billions of dollars to fiscal stimuli and bank stabilisation plans.

Although these plans are broadly welcomed, so far the market reaction to them has been at best muted and at worst, downright fierce. US treasury secretary Tim Geithner unveiled a $2 trillion bank rescue plan and in the ten minutes before Mr Geithner began his speech, shares fell 2.1 per cent and continued lower as a lack of detail disappointed investors who had hoped for more concrete plans.

In addition, in the month since President Obama's inauguration, the S&P 500 has slumped as much as 12 per cent and broken through the 2002 low that marked the bottom of the dot.com slump.

The absence of a euphoric bounce suggests investors are expecting more bad news, argues Mr Vatis, adding that the economic data points to a still worsening economic situation: jobless claims are still rising, house prices are still falling and with a zero-rate policy, the Fed has run out of conventional ammunition to fire. So even though the US economy has been in recession for more than a year, Mr Vatis thinks there is some way to travel before investors glimpse the light at the end of the tunnel.

However, Mr Vatis believes that the US market, with its unparalleled depth and breadth, will show signs of recovery before a turn in economic data or even general sentiment. He is therefore looking for signs of the bottom in places other than the conventional economic and market data and is selecting investments in these areas.

The credit crunch began in the housing sector and Mr Vatis finds it reasonable to expect stabilisation in the US housing market to be a prerequisite to a return to normality elsewhere. He is of the view that there are signs that we may be at the beginning of a bottoming process. Key indicators such as new home sales and housing starts are now approaching the trough levels of 1970, 1982 and 1990.

Additional liquidity provided by the US Treasury and Federal Reserve to stimulate credit for both the consumer and corporations has resulted in house refinancing activity accelerating. So while there remains a considerable inventory of homes for sale to work through before prices recover, he argues there is reason to believe the housing market has the worst behind it.

Across the equity market as a whole, Mr Vatis believes quality cyclical stocks offer better risk/reward when compared to defensive sectors. If the market continues to go down, Mr Vatis expects it will be the heavily owned sectors (defensives) which could see more selling pressure where those companies’ earnings estimates do not already account for a recession and a strong dollar.

Given investors’ current irrationality and the market’s consequent record high volatility, the risk/reward profile of certain individual shares has significantly improved in recent months. In particular, this applies to high quality, cyclical stocks with high free cash flow conversion of earnings and strong balance sheets. This should give good stock pickers an edge. This thought, combined with Mr Vatis’ belief that the housing market is displaying one or two early signs of a return to stability, translates into an attractive risk/reward for high quality home improvement stocks like, for example, Home Depot and Lowe’s.

As Mr Vatis points out, none of this evidence provides conclusive proof that the US economy will be the first to return to growth, but it should remind investors of two important facts that remain. First, that many investors are looking beyond the immediate daily fluctuations of the market and view this as a rarely paralleled opportunity to buy carefully selected shares at great value. And second, that whether the US economy is the first out of recession or not, it will return to growth and the world’s recovery is dependent upon that happening.