By Deron T. McCoy, CFA®, CFP®, CAIA®
Chief Investment Officer
These three themes have been at the center of the investment landscape over the last nine months. And the beneficiaries of each turned out to be the same groups of stocks—Cyclicals, Value, and Small Caps. To help refresh your memory, let’s quickly recap our recent views;
- Late Summer 2020 (S&P 500® near 3500): Take profits in Growth sectors and rotate to Cyclicals/Value. Not only has the price action in Growth been extreme (with some charts looking like an Eiffel Tower), but we are also halfway through the dreaded 2020 (‘5 Down and 5 to Go’) so markets will soon move higher to a slowly reopening economy.
- Fall 2020 (near 3500): A renewed bout of COVID will resurface as ‘Winter is Coming’ but unlike Spring 2020, investors will look through the crisis and see the light at the end of the tunnel—as vaccine ‘hope,’ transitions to vaccine ‘approval,’ and eventually vaccine ‘rollout’. Furthermore, the election results are market friendly; stocks should move higher. And with the prospect of more stimulus and infrastructure plans, cyclical/value parts of the economy should respond favorably.
- Winter 2020 (3700): As society strives to get back to normal in 2021, assets should also start returning to more normal levels, with the one current outlier being interest rates. Therefore, expect rates to start moving higher over the upcoming year.
- Early 2021 (3800): Now that we’ve turned the page on the dreaded 2020, investors can take a deep collective breath. It ‘looks like we made it.’ While valuations are high, they’re not scary high as some would have you believe. Investors shouldn’t value the market amid a natural disaster (2020) nor the ensuing recovery (2021), but rather on more normal times (2022). Therefore, look to next year, and value the market on when the economy and corporate earnings will be back to normal.
While thus far things have certainly gone according to plan, savvy investors are always looking ahead and asking: “What’s next?” Vaccines have allowed society and the economy to slowly reopen. And the vision out of DC has provided unprecedented fiscal stimulus. Together, these two themes have propelled economic data higher—shattering some historic records. Fortunately, this is likely to continue in the months ahead; reminiscent of the catchy theme song from the Lego movie, ‘Everything is Awesome!’ But is it? Is everything really awesome?
Valuation clouds on the horizon
While collectively we all deserve some good news after the year we’ve endured, not everything is awesome from an investment standpoint. In revisiting that first “V” we need to be mindful of valuations now that the S&P 500 is hovering near 4200.
If you recall in our January 2021 commentary (when the S&P 500 was trading near 3800), we urged investors to look to valuation metrics based on when society and the economy returns to a more normal setting (perhaps in 2022) rather than using data from the middle of a natural disaster or the subsequent recovery. By doing so, the expensive Price-to-Earnings metric moved from an historically high 27x (using trailing 2020 earnings near $140) down to a more palatable 22x (using then 2021 estimated earnings of $170); and it moved even further down to a reasonable 19x (using estimated 2022 earnings). We call this valuation metric the ‘Future Forward Price-to-Earnings’ (FFPE) which measures the forward earnings, twelve months in the future.1
But now with the S&P 500 climbing to 4200 and 2022 earnings barely budging, the FFPE now stands near 21x (moving back into expensive territory). Can it move higher? The short answer is yes. Anything can happen—as investors witnessed just a year ago as oil prices traded in negative territory!
If multiples move to 25x (which was the height at the epic technology-media-telecom dotcom bubble high in the 2000 top), then the S&P 500 could conceivably approach 5000—equating to a 19% market rise from here to year end. Relying on a once-in-a-generation type of bubble, however, might be too aggressive. Conversely, if we use the 15x valuation at the peak before the Great Recession in 2008, then the S&P 500 would trade near 3000 (representing a 29% decline). Or, to offer one more plausible level, for the better part of the last bull market decade, markets traded between 16-18x, which would suggest an S&P 500 level near 3400 (a 19% decline).
Yikes! Should investors rely on a dotcom bubble, or should we prepare for a bear market? Perhaps more importantly, why are market multiples so high and can they stay there? Some argue that markets are elevated due to the powerful combination of low interest rates and unprecedented stimulus. So, lets tackle these issues one at a time.
Interest rates and stimulus
When interest rates are high, stock valuations tend to be low. Why? Consider the investment landscape 40 years ago. Back then, investors en mass reallocated portions of their portfolio away from stocks and towards a safe and secure investment (CDs or Treasury Bonds) that were yielding 10% or more. With demand for stocks low, valuations contracted.
Today’s environment is the polar opposite. With investors unable to generate positive real returns from safe investments, they’ve been forced to rotate towards riskier assets—pushing up prices and valuations. If you can make a strong case that interest rates will be lower in the future, then perhaps higher multiples (and rising stock prices) could be forecast on the horizon. Many, however, expect the exact opposite—with the path for interest rates rising. This would strengthen the case for stock valuations retreating.
Fiscal stimulus has similarly boosted economic activity and corporate earnings. It’s also put cash into investor’s hands—cash that’s been used to invest in stocks. Recent data suggests that $1.2 trillion in additional stimulus dollars should hit consumers by late summer2; again boosting activity which should in turn benefit stock prices. But then what? It’s hard to imagine this historic level of fiscal stimulus continuing indefinitely. At some point, this too shall pass as we return to a more normal environment.
At a minimum, the valuation tailwind seems to have run its course—or at least we’re far closer to the end than the beginning. Other tailwinds are waning as well. The previously mentioned fiscal stimulus and vision out of DC may switch to a headwind later this year, if recent chatter on tax hikes comes to pass. In fact, if corporate taxes are increased some estimate a 5% or $11 dollar hit to 2022 earnings3. Stock prices and multiples may then start to react negatively if corporate earnings decline—just as they reacted positively to the Trump tax cut a few years back.
The late summer timing on valuations and vision also coincides with the expiration of the recent vaccine tailwind. In other words, come August, the vaccine may become old news here in the U.S. and therefore not provide the same boost it once did. While new tailwinds can certainly emerge, the expiration (or possible reversal) of current tailwinds may cause some market choppiness in the second half of the year.
The exact timing of any bear market will prove difficult. Perhaps instead, we should take a step back and look at this from 30,000 feet. It was a decade ago (in our 2011 SEIA Report when the S&P 500 was near 1300) when we urged investors to buy stocks suggesting that “the time will soon be upon us when stocks again regain their status as king of the investment choices.” If GameStop proves anything, it proves that that time is now.
We’re not calling the top in stocks at this time, but wise investors must realize that anything can happen. Stocks certainly may push higher, further inflating this nascent bubble. But the risk-reward setup (or upside versus downside) is starting to skew to the downside. It may be wise to revisit that financial plan or at least take profits to prepare now for potential choppiness ahead.
While prudent investing is in no way on par with gambling, this negatively skewed payoff alongside certain pockets of froth brings to mind another ‘V’—Vegas. No gambler would stay solvent for too long by consistently betting red or black on the roulette wheel—the two green numbers skew the odds in favor of the house. If the casino added a few more green pockets, then gamblers would certainly adopt a new strategy or play a different game altogether. Sky high valuations may be the stock market equivalent of a roulette wheel with 10 green numbers—you can still win, but the odds move further against you. While we’re not quite there yet in terms of the current market, if this ‘Everything is Awesome’ euphoria does drive the market into a full-fledged bubble, it may be wise to take some chips off the table or play a different game completely.
But what game to play? As a reminder, Europe and Asia have measurably lower stock valuations and have not yet seen the full economic benefit of a successful vaccine rollout. Baccarat anyone?!
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