As the economic recovery matures and investors contemplate the attenuation of government and monetary assistance, one topic that seems to produce the most agita amongst strategists, pundits and participants in markets is valuation. That is, how expensive is a dollar of earnings in the stock market or an interest coupon in the government bond and credit markets. The short answer is quite expensive. September’s almost 5% decline in the S&P 500 is a reminder of how the shift from ebullience to skepticism can temporarily roil markets.
By many long-term indicators, prices for stocks and bonds are dear enough to concern thoughtful investors. Starting at these elevated prices, how good can future returns be? We share these concerns but believe you must go underneath the stock indices and beyond the puny current yields of government bonds to chart a path forward.
With concerns about inflation and global growth rising, we respect the cautious message implied by today’s values. Thankfully, they are not the only measures that count. Beneath the hood of the vehicle we call the S&P 500 is a diverse collection of stocks. The index is indeed priced at a concerningly elevated level based on projected 2022 earnings of approximately 20 times.
But what if you removed the 10 largest members of the index and looked at the remaining shares? That collection of companies trades at a much more pedestrian (but still elevated) level of around 18 times earnings. Looking further below the surface, one can find good companies trading at prices that imply good future returns based on history.
That is not to say that in the event of a market sell off these firms will not decline in price, but that their current price is not an impediment to long-term shareholder returns, when the broad market recovers. The point here is that selectivity among stocks, emphasizing those with strong fundamentals and good prospects, along with an appropriate level of caution is a proven way to navigate through expensive and volatile markets.
The 10-year Treasury bond is currently trading with a yield of just over 1.5%. It normally trades with a yield at or above expected inflation. With inflation running at over 3% and expected to decline down towards 2.5%, bond prices (which move inversely to yields) may be as richly valued as the stock market. By under-emphasizing traditional bonds and incorporating inflation protected bonds in fixed income portfolios, we mute the risk associated with rising yields and maintain flexibility to adapt to changing interest rates.
The past six quarters have been rewarding ones for investors and the long-term outlook is good. Successful long-term investors know that opportunity waxes and wanes in both familiar and unexpected ways. The key to success during these times is fidelity to a well thought out investment policy and the flexibility to act as conditions change. As always, we are honored by the trust you have reposed in us look forward to talking with you soon.
The Altavista Investment Team – Fall 2021