With Sophos Wealth Management’s first public post on the market environment I wanted to take a comprehensive look at the current investing climate. Future market reviews will be more concise as we catch up on recent developments and noteworthy items. However, I think it’s important to explain the big picture framework that guides our current asset allocation. Unfortunately, it’s not a pretty picture.
Recent Market Highlights:
| FY 2020 | Q1 2021 | |
| S&P 500 | 18.4% | 6.2% |
| Barclays US Agg Bond Index | 7.1% | -3.4% |
2020 was crazy for everyone and the stock market’s behaviour in some ways embodied the bizarre year. After a strong start to the year, the S&P 500 index fell precipitously on worries about the global pandemic, with the index falling 34% from highs. The index then roared back to life to finish the year with a total return of over 18%. That strength continued in the first quarter of 2021 with the S&P up over 6%. Bonds had a strong year in 2020 as well with the Barclays US aggregate bond index returning 7%. The recent rise in interest rates led to a negative 3.4% return in the bond index during the first quarter of 2021.
Stock Market Valuation
As much as I would rather not be in the gloom and doom camp, virtually every reliable historical indicator of stock market valuation screams that the US stock market is in a bubble.
The following chart shows an average of 4 valuation indicators strongly correlated with future stock returns. The 4 indicators are currently 196% higher than their historical average. That puts the measures substantially higher than both their 1929 peak before the great depression and the 1999 peak during the tech bubble. At its current valuation level, the market would have to fall nearly 70% to dip below its historical average.
The last two times markets went 83% above the average or higher investors saw negative returns over the following ten years. In getting those negative returns investors had to stomach drawdowns of 50% and nearly 90%.
And lest you think I’m cherry picking just one metric to make the market look expensive, a broad number of valuation indicators all paint the same picture. Here’s a look at various valuation metrics for the S&P 500 index, most of which show the market is the most expensive it has ever been (100th percentile).
So what do these extreme valuations tell us about the market? In the short run, not much. However, in the long run investors should expect low (or negative) returns out of the US stock market and should be aware that the odds of a crash are far higher than they would be if the market were trading at less expensive valuations.
The following chart looks at the valuation of the S&P 500 (measured by its enterprise value divided by its earnings before interest, taxes, depreciation, and amortization) and compares it with expected 10 year future returns. Historically the expected future return has tracked fairly closely to actual forward 10 year stock market returns.
At its current valuation level this metric predicts the S&P 500 will return -10% per year for the next decade. Similarly, GMO (the firm of investing icon Jeremy Grantham) predicts large cap US stock to return -6.2% per year over the next 7 years and small cap US stocks to return -7.9%. These types of negative returns would prove disastrous for most investors and ruin many retirements and financial plans.
Fortunately, I think there are pockets of value in the US market and more attractive opportunities in international markets, but that’s a topic for a different day. The important takeaway is that the broad US stock market is more expensive than it has ever been and is poised to deliver disappointing returns.
Qualitative Factors
Past bubbles have been characterized not only by their extreme overvaluation but also by rampant risk taking and speculative behavior. Today, it appears that signs of risk taking and speculation abound. I believe the proverbial shoe shine boy of the late 1920’s who gave everyone stock tips has morphed into the Uber driver trading crypto and the robinhood retail investor. Investing ‘advice’ is being peddled all over apps like TikTok and Instagram and websites like Reddit. That’s driven crazy price action in stocks like Gamestop and AMC.
Non Fungible Tokens (NFTs) have become the latest speculative asset du jour. There’s a proliferation of special purpose acquisition vehicles (SPACs), which are little more than blank checks to take over already expensive companies.
Corporations and governments have levered up. Investors margin debt is at a peak. Households allocations to equities are at or near highs (measured as stocks as a percentage of household financial assets). The list of speculative behavior goes on and on.
Interest Rates and Alternatives
Compounding the average investor’s problems, alternatives to stocks currently look unappealing. Despite a recent uptick in interest rates, interest rates are still extremely low by historical standards. Here’s a look at the 10 year treasury yield:
While the recent uptick in rates is helpful, you’re still getting paid less than 1.7% to lock your money up for 10 years. For those seeking a little more return, compensation for taking risks is currently near lows. The following chart shows the historical spread between treasuries and high yield bonds:
The takeaway from this chart is that investors are getting paid little to take additional risk in fixed income. Other alternatives that investors have turned to in the past (such as REITs and Utilities) show a similar pattern of paltry compensation for risk.
The positive news is that a US investor can at least get some positive return in treasuries, unlike our counterparts in Japan or Europe. By keeping maturities and duration short that will help an investor earn some positive return while waiting for better opportunities elsewhere.
What’s an investor to do?
“We have to practice defensive investing, since many of the outcomes are likely to go against us. It’s more important to ensure survival under negative outcomes than it is to guarantee maximum returns under favorable ones.” – Howard Marks
With a multitude of frothy warning signs and a market at or near all time high valuation levels, prudence dictates a defensive approach in the current environment. I think it’s particularly important to avoid the frothiest areas of the market such as tech and growth. Investors can take advantage of select individual values and tilt their portfolios towards more attractive international markets. However, the priority is to ensure your portfolio doesn’t take a massive hit if the bubble unwinds.
Being defensive gives the investor optionality as one can preserve purchasing power for better potential future opportunities. It was the defensive investor in 2007 that was able to take advantage of the values and opportunities in the market during 2008 and 2009. While we don’t know what will happen in the short run, history makes it clear that investors purchasing stocks at these levels are set up for poor future returns.
Scott Caufield, CFA, CPA