Investment Strategy

Embrace the dip: Value is returning to markets

Global markets are down this year, but recent moves have solved a problem for investors.

Our Top Market Takeaways for April 29, 2022.

Market update

Testing the lows

Well, our bull case didn’t materialize, at least not this week. Global markets dropped since we last published on a confluence of risks that investors have been grappling with all year: Federal Reserve tightening (duh), China lockdowns (no off-ramp in sight), war in Ukraine (Russia cut off Poland and Bulgaria from gas exports), and the continued burst of the pandemic-era bubble (Teladoc plunged 40% after releasing earnings and is now down 90% (!) from February 2021 highs).

On Thursday, the U.S. GDP report showed a surprise contraction, but that was due to the notoriously volatile inventory and export data. Final sales to private domestic purchasers, which exclude government spending, trade and inventories, grew at a quite solid 3.67% real pace. 

This chart shows the S&P 500 forward 12 months P/E ratio, from May 15, 2015, until April 27, 2022. The first data point came in at 17.1x and declined to 15.1x by January 15, 2016. From there it rose to 18.4x by December 15, 2017. Then it declined to a trough of 13.9x by December 21, 2018. From there, it rose to 19x before dropping to an all-time low of 13.6 by March 20, 2020. Here, it rose to an all-time high of 22.8x by August 28, 2020. From there, it declined to 20.3x by October 1, 2021. Then it rose to 21.5x by November 5, 2021. From there until recently, it declined to 17.6x by April 27, 2022. The chart also shows the 7-year average of 18x.

One new-ish development is that currencies are starting to exhibit the volatility that has characterized equity and fixed income markets so far this year. The Broad Dollar Index is trading at 2016 highs, which is good news if you are an American booking a European vacation (or looking for another disinflationary impulse), but it is bad news for companies that sell goods abroad (because foreign profits are less valuable) or for dollar-reliant emerging markets (because your external debt service costs rise). A weaker euro (it’s trading at its lowest levels since 2016) could make the inflation problem worse on the continent. Finally, China’s renminbi had its sharpest fall since the trade war began, which is viewed by investors as a tacit admission from Chinese policymakers that domestic growth is slowing.   

Market volatility seems like it will be a feature for the rest of the year, but recent moves have actually solved a problem for long-term investors: Neither equity nor fixed income valuations are demanding. In fact, we haven’t seen an entry point like this for the two key components of balanced portfolios since 2018. Corporate earnings look solid, valuations are reasonable, and fixed income provides invaluable protection if we do end up seeing a recession over the medium term. This makes us constructive on markets for the remainder of the year. 

Spotlight

Solving the valuation problem

 

Since the middle of 2018, investors had to deal with a valuation problem. On the one hand, equity valuations (we will focus on the price-to-earnings ratio in this article) were historically elevated, and “risk-free” bond yields were historically low. Sure, there were parts of the equity market that looked cheap, and some areas of fixed income had value, but for the most part, asset valuations were high, and that meant investors expected lower future returns.

Now, the picture is very different.

Let’s start with equities. The last seven years offer a useful timeframe because they include several macroeconomic environments while also providing a consistent comparison of the types of companies that constitute the S&P 500. Ten years ago, financials and energy stocks (that naturally trade at lower price-to-earnings valuations because their earnings are more cyclical) made up a quarter of the S&P 500. Today, those two sectors make up just 15%. Right now, the S&P 500 is trading at a price-to-earnings ratio of 18x, which is exactly the average over that seven-year timeframe. We think corporate earnings (which drive stock prices over the long term) will continue to grow at a solid pace. But for the first time in a long time, we don’t think we are paying a premium for them.

This chart shows the S&P 500 forward 12 months P/E ratio, from May 15, 2015, until April 27, 2022. The first data point came in at 17.1x and declined to 15.1x by January 15, 2016. From there it rose to 18.4x by December 15, 2017. Then it declined to a trough of 13.9x by December 21, 2018. From there, it rose to 19x before dropping to an all-time low of 13.6 by March 20, 2020. Here, it rose to an all-time high of 22.8x by August 28, 2020. From there, it declined to 20.3x by October 1, 2021. Then it rose to 21.5x by November 5, 2021. From there until recently, it declined to 17.6x by April 27, 2022. The chart also shows the 7-year average of 18x.

On bonds, we had been unenthusiastic about most parts of core, investment-grade fixed income because we thought rates would rise (hurting prices), and the protection the asset class provides was eroded by the limited amount that rates could potentially fall. But the pivot from global central banks has changed that. Interest rates on longer-term, “risk-free” government securities are over 100 basis points higher than they were at the beginning of the year. This means that investment-grade fixed income securities such as municipal and corporate bonds actually offer a pretty attractive potential return. In the United States, municipal bond yields (which are tax-free) sport a yield of well over 3%. If interest rates fell back below 1% in a recession, a portfolio of those same securities could offer a 9–12% total return.

To get a holistic view of what this means for a multi-asset portfolio, we can consider the “earnings yield” of the equity portion (the inverse of the P/E ratio, which gives a sense of the implied yield of the equity market if every dollar of earnings was paid as interest to investors in order to compare to bonds) and the yield of the bond portion of the portfolio. This metric has averaged ~4.5% since the end of 2009 for a simple portfolio of the S&P 500 and U.S. investment-grade bonds. During the pandemic, this metric plunged down to just 2.5%. But now, the portfolio yield is back up to 4.62%, the highest since 2018.

This chart shows the earnings/coupon yield of a 60/40 portfolio from 2009 to 2022. It began at 4.7%, climbing to 6.4% in October 2011. It then fell to 4% in September 2016. It rose to 5.5% by January 2019, then fell to 3.9% by February 2020. It rose rapidly to 5.1% in March 2020 before plummeting to 2.7% by September 2020. It steadily rose to 4.62% as of the end of April 2022. The average since the end of 2009 is 4.55%.

While those who have been fully invested as part of a goals-based plan have had to endure lower asset prices and turbulence so far this year, those who are looking to start their own investment journeys are being provided with a compelling opportunity.  

Takeaway

Control what you can

 

Valuations for both stocks and bonds may be more reasonable now than they have been for several years, but that is by no means a guarantee of positive (or negative) near-term performance. Indeed, valuation is just one thing among many that can drive asset prices over a one-year time horizon. The chart below shows that over short spans, dramatic swings both higher and lower are possible in markets. Even though portfolio valuations seemed historically high at the end of 2020, 60/40 portfolios offered stellar gains in 2021.  

But history suggests that the longer the time horizon, the narrower the range of potential outcomes. This is one of the many reasons why we believe designing an investment portfolio with a clear intent and time horizon is the best way to increase the probability of investment success. Lower valuations just might make it feel a little bit better to get started now.

This chart shows the range of rolling annualized total returns, from 1950 to 2020, for stocks, bonds or a 50/50 portfolio. In 1-year, a portfolio of stocks annualized from -41% to 60%. For bonds, -6% to 33%. For a 50/50 portfolio, -20% to 42%. Annualized returns on a 5-year rolling basis for stocks are from -6% to 30%, for bonds, 0% to 19%, for a 50/50 portfolio, 0% to 22%. On a 10-year rolling basis, stocks returned from -4% to 21%, bonds ranged from 1% to 14%, and a 50/50 portfolio, 0% to 16%. And 20-year rolling annualized returns for stocks ranged from 5% to 18%, bonds, 2% to 11%, and a 50/50 portfolio, 5% to 14%.

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All market and economic data as of April 2022 and sourced from Bloomberg and FactSet unless otherwise stated.

We believe the information contained in this material to be reliable but do not warrant its accuracy or completeness. Opinions, estimates, and investment strategies and views expressed in this document constitute our judgment based on current market conditions and are subject to change without notice.

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