In a recent research publication on correlations, we stated:
“Simply put, if we combine the fact correlations are higher during periods with positive equity returns, and we add to this that positive correlations are also supported by inflation, asset allocation (as always) is driven by the outlook for asset class returns and inflation (as inflation influences asset class returns). If an investor believes that the economy will be inflationary, he or she can reasonably expect asset class returns to have similar returns – directionally. In other words, positive (negative) equity returns and positive (negative) bond returns. Historically speaking, an investor who believes that the outlook for equity returns is positive, and given that over time equities outperform bonds, the investor will overweight equities in order to capture higher returns. This does not mean, however, an investor will shun bonds, as doing so will create a significant tilt higher in risk.”
“That said, an investor can also see an inflationary environment, or a period where inflation is higher than desired, and believe that stocks will NOT outperform bonds near-term. In this case, the investor will tactically (near-term) reduce their allocation to equities and increase their allocation to bonds.”
As correlations are still positive (as the charts below show), an investor should review valuations for the various asset classes contained within (or being considered for) their portfolio.
From a rolling twelve-month perspective:
From a rolling 30-day perspective:
As the average investor’s portfolio has a larger equity weighting, a review of equity valuations is a good place to start.
First a look at a favored gauge of valuation, the price to earnings ratio (P/E). As the charts below show, P/E ratios are at or near their 10-year average. Importantly, the earnings multiples are lower than they were at their recent July 2023 highs.
The reduction in the P/E ratio is a result of the “re-pricing” that took place in October, where the “higher for longer” Fed regime was factored back in and took equity prices lower.
Importantly, forward earnings estimates were falling until the beginning of November until “higher for longer” was priced back out (notice the recurring theme – “higher for longer” in, out, in – until a clearer path is known, this volatility will persist) and we got further into the earnings season:
Looking at 12 month forward earnings, they are almost roughly in line with the general trend over the last 13 years or so:
Combining the current price and forward earnings estimates, we can see that the forward P/E is right around its historical level:
The bottom line on P/E charts: What concerns us about this chart is that the P/E ratio has fallen back to a historical level that took place in an “easy money” period. If the economy is slowing, and interest rates (and hence borrowing rates) are higher, a valuation consistent with easy money does not seem wholly appropriate.
Another way to look at valuation is the equity risk premium. While there are different ways to calculate and express this, we will use a comparison between the earnings yield of the market and the “risk free” interest rate. Using the Russell 1000 (large cap) earnings yield and the three-month and two-year Treasury rates results in the following:
This is not isolated to large cap stocks. The following chart shows the same data versus the Russell 3000 broad market index (approximately 98 percent of the investable U.S. market):
The bottom line on the equity risk premium charts: The drop in the earnings yield of the equity market(s) below the risk-free rate(s) implies over-valuation of equities and the attractiveness of rates. In other words, investors finally have an alternative to equities that has an attractive return potential.
Of course, investors have options aside from the domestic equity market – developed international and emerging market equities. Many investors will also either have a mandated equity exposure (as per their investment policy statement or financial plan) or prefer to have a portfolio that is diversified by asset class (which we highly recommend). Given this, investors cannot simply sell equities because they look fully (or over) valued and buy bonds and they must, therefore, determine where they will take their equity risk exposure. While equity risk exposure can be carved up in many ways (region, sector, capitalization, and currency to name a few), we will look at the United States by capitalization, developed international, emerging markets, and emerging markets ex-China. In order to facilitate an apples-to-apples comparison between these markets, we will look at the P/E ratio and the Z-score of the ratio (essentially the number of standard deviations the current P/E is from the mean, or average P/E ratio) over various time periods. In the following chart, the values are highlighted from green to red, with the values highlighted in green as those most attractive from a Z-score basis. (Please note that Russell 2000 data is available from 2004, MSCI EAFE data is available from 2006, and MSCI EM data is available from 2017, as a result, the ten and twenty year results have been impacted)
Bottom line on a “Z” analysis: The above table implies that US mid-caps are cheap to US small and large-cap stocks as well as other regions. As well, developed international equities look cheap relative to the majority of other options available. One might, therefore, consider taking a larger component of equity risk in these two areas. We are concerned, however that this might be reflective of “inexpensive” rather than “cheap”. The MSCI EAFE has looked attractive on this basis for some time, but we do not currently see a catalyst which would help investors realize the implied value in the space. We do find mid-caps attractive and believe an overweight is in order. Investing in small caps might be a bit premature, as they tend to perform well coming out of the down cycle, which seems to us to be a couple of months off. That said, if an investor is underweight small cap stocks, she may want to consider increasing exposure to a more neutral position.
Ultimately, we believe equities are fairly valued to a little rich at this juncture and are hesitant to add risk in the asset class as we believe there are other asset classes that are more attractive from a risk/return standpoint.
The views expressed in this publication are those of the author and do not necessarily reflect the views and opinions of Cetera Advisor LLC or Burrows Capital Advisors.
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