Market Outlook: Valuations Remain Stretched | Fourth Quarter 2017
In a Nut Shell: Stock and bond markets still aren’t cheap, but does anyone care? Valuations may be a great predictor of long-term returns, but even valuation-based investors admit and understand it’s not a good market timing tool (what is, of course?!). That was evident again during this past quarter, as well as for the last several years, as stocks in particular continued to move higher despite already lofty valuations. Valuations will matter at some point, but pinpointing when that will be is impossible. Typically, valuations begin to matter as the business cycle turns and fears of recession heat up. Fortunately not only is the global economy on solid footing, but in many areas it is accelerating. Predicting when that will change is the essence of market timing which is why we remain disciplined, diversified, and focused on long term success.
For an in-depth look at the big picture, read below.
The Big Picture
The big picture for Smith & Howard Wealth Management is always going to be framed by valuations (see our previous article “Why Valuation Matters”). As long-term investors, we recognize that while it is interesting to speculate and debate about near-term events and breaking news, ultimately, investment returns are driven by valuations. Shifting portfolios towards cheap assets and away from expensive ones “wins” over time. It not only generates a higher long-term return, but typically results in smaller drawdowns or losses along the way. Put more simply, it’s the amazingly simple, but difficult to execute philosophy of “buy low, sell high.”
The Market (Still) Isn’t Cheap
The last several quarters, we’ve shown a chart that showed valuations of bonds, stocks, and stocks relative to bonds. The chart, while busy, helps in understanding current market levels while providing some important historical perspective. With stocks continuing to move higher and bond yields relatively stable for the year the overall theme and message of that particular chart hasn’t changed, so we thought we’d show something slightly different this quarter.
In the following chart we are attempting to illustrate where current US bond and equity markets sit from a valuation standpoint relative to history. For example, the bar on the left related to the benchmark bond index shows that the current real yield (which is the quoted bond yield minus expected inflation) is roughly 0.75%. That point is denoted by the white diamond in the lower portion of the bar. The length or size of the bar reflects the range of observations of this real yield point over time going back to 1976. So this “real yield” has been as low as –0.8% and as high as 5.2%. As one can see we are on the lower (more expensive) end of that bar. The same can be said for U.S. equities (S&P 500) in the middle bar.
In this chart we are also showing what the “Yield” is of a portfolio of the two assets combined into a blended portfolio (40% bonds, 60% equities). While both bonds and stocks on their own are expensive they are also not at their most extreme levels (i.e. the diamond point for each is not at the lowest part of the bar). Interestingly though the portfolio combining both is at the lowest point which means a blended portfolio of US stocks and bonds has never been more expensive. The reason for that is that through history when stocks were cheap, bonds were expensive. Conversely, when stocks were expensive, bonds were cheap. Managing portfolios was about rebalancing and shifting between the two as one of them was typically still offering an attractive rate of return even if the other was not.
The most recent example of this shifting of valuations was at the height of the tech bubble in the late 90s. It seems crazy to think about now, but at the end of December 1999, investors could have invested in a diversified, investment grade bond portfolio with a yield exceeding 6% (nominal). Equities at that time traded at a cyclically adjusted price to earnings multiple of more than 44x or for ease of comparison a 2.3% earnings yield! Nobody thought at the time equities would return less than bonds going forward, but that is exactly what investors got over the course of the next 10 years with the Barclays US Aggregate bond index returning +6.3% and the S&P 500 a negative -1.0%.
Today we are faced with a very different dilemma as both stocks and bonds are expensive at the same time. Investors and wealth managers are not without options though. While markets generally are expensive across the globe, pockets of opportunity exist. International equities, both developed and emerging markets, as well as various alternative strategies provide opportunities to invest in areas that are more attractive on a valuation basis and/or have returns less determined by the general market direction. That has been and remains core to our strategy. While it is always more comfortable to invest closer to home (see our discussion on Home Country Bias) we must be willing and able to go where the returns are. Today that means less reliance on US markets and less on traditional stocks and bonds.
If you have questions about valuations of stock and bonds, please contact Brad Swinsburg 404-874-6244
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Unless stated otherwise, any estimates or projections (including performance and risk) given in this presentation are intended to be forward-looking statements. Such estimates are subject to actual known and unknown risks, uncertainties, and other factors that could cause actual results to differ materially from those projected. The securities described within this presentation do not represent all of the securities purchased, sold or recommended for client accounts. The reader should not assume that an investment in such securities was or will be profitable. Past performance does not indicate future results.