CIO Insights – A look at markets now and beyond
Commentary as of December 07, 2020
Over the course of 2020, you framed the recovery in the context of three pillars – the health impact, the economic impact, and the market impact. As we near year end, what are your main takeaways?
Dan: To be disarmingly simple, stock prices have followed fundamentals. Back in March, when markets were nearing their lows for the year, market uncertainty was reflecting fundamental uncertainty. We’d never seen that type of extreme uncertainty on a global scale. During this time, we experienced an abrupt shutdown to economic activity, and fundamentals were in freefall for the underlying businesses. As a result, stocks and risk assets were very challenged.
The recovery has been up and to the right because of coordinated fiscal and monetary support. Along the way, the U.S. economy has gradually reopened and global trade flows have gradually normalized. The U.S. is currently struggling through a very serious third wave of COVID-19 cases, which is quite daunting and having very serious impact. I believe the global economy is functioning well but not yet firing on all cylinders.
Markets have been led by durable growth business for most of 2020. Recently, we’ve seen a rotation into more cyclical and value-oriented companies. Do you think this is poised to continue into 2021?
Dan: In the short term, there has absolutely been a risk-on environment where lower-quality businesses have surged ahead. You can see this in the performance of the Russell 2000 Index and small-cap stocks in general. November was the strongest month for the Dow Jones Industrial Average since 1987. For the Russell 2000 Index, November marked the strongest month on record. We think there has been a bit of a catch-up trade on the heels of recent vaccine availability news and election outcomes. These events have helped to remove some uncertainty against the recovering economic backdrop.
Given this scenario, a balanced position currently makes the most sense to us. Investors who lean in to these riskier cyclical businesses are likely to experience a rocky ride as the fundamentals of those businesses tend to be less stable over time. At the same time, the path forward for secular growth businesses with high-quality business models continues to be favorable.
What are your observations around equity valuations? Do any pockets of the market seem stretched?
Dan: At the highest level, we like to look at the earnings yield from equities compared to U.S. Treasury yields. The S&P 500 Index’s forward price-to-earnings ratio is 21.91 , which translates into roughly a 4.6% earnings yield. That’s about a 4% advantage over the 10-year Treasury, which is currently yielding a little under 1%. We believe that’s an attractive valuation framework for U.S. stocks. Dividends of 1.6%2 alone generate more income than what investors can earn from the Treasury market. Long-term compounded returns for stocks against this framework could deliver mid- to high-single digits. Given the recent run – the S&P 500 Index has returned about 64% since March lows – it’s prudent to pull near-term expectations back a bit. And if we remove 2-3% from those long-term return expectations, that’s still a healthy mid-single digit return that’s very attractive compared to many alternatives. Interest rates globally are still very low, and real interest rates in many places are negative, with close to $17 trillion in global bonds with yields below 0%. To summarize, we think a balanced exposure to a mix of high-quality, sustainable models remains a good place to be.
We do believe some pockets of froth have emerged. Special Purpose Acquisition Companies (SPACs) and so-called “blank check” companies have raised around $70 billion. Bitcoin is hitting new highs and the chorus of financial voices has come in saying this is a real asset. While we agree that speculators have realized real returns, Bitcoin categorically is not a real asset. Activity like this seem like harbingers of speculative froth and investors should proceed with eyes wide open. These examples are really on the edges though. The S&P 500 Index has overwhelmingly been driven by stalwart fundamentals which have outweighed the challenged parts of the economy.
Emerging markets have performed well recent, even outperforming the S&P 500 Index over the past year. Developed international markets have lagged. What’s your perspective on the international landscape?
Dan: We’re in a global market. More than 40% of S&P 500 Index revenues are derived from activity outside U.S. borders. Broadly, emerging markets have not had to wait for a “reopening” trade because of their effective management of COVID-19, and particularly within technology companies that have been the powerhouse drivers of those markets. Many of these economies have been very proactive in dealing with COVID-19, so they haven’t had to deal with the rolling shutdowns that accompany spikes in new cases. These markets have been driven by incredibly strong growth businesses that continue to power forward with good fundamentals, similar to what we’ve seen in the U.S.
In other developed global markets, COVID-19 and inferior quality of business models have created more meaningful headwinds. Many of these companies tend to be more cyclical and asset intensive, without much visibility or value add. As a group, that appears less attractive from our perspective.
Are lower quality, more highly leveraged businesses poised to lead given low interest rates and the possibility of more fiscal stimulus?
Dan: The past month has been phenomenal for lower-quality businesses with greater capital intensity and leveraged balance sheets. Low price-to-sales stocks tend to be lower margin stocks. Companies with low margins often leverage up their balance sheets to amplify low return on equity and deliver higher return on assets. On a year-to-date basis, low price-to-sales stocks have returned -11%, significantly underperforming the broader market. On a one-month basis, it’s the exact opposite – they’ve returned a positive 11%. That’s consistent with what you’d expect in a cyclical rally. In our view, that doesn’t create a long-term sustainable advantage. Over the long term, lower price-to-sales businesses typically underperform the strongest return on asset companies. This is another reason we continue to prefer businesses with strong fundamentals.
1 Based on consensus bottom up 2021 earnings estimates
2 Trailing 12 months
Past performance is no guarantee of future results. This information is not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through Dec. 07, 2020, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This information is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor’s specific objectives, financial needs, risk tolerance and time horizon.
The Dow Jones Industrial Average is a stock market index that measures the stock performance of 30 large companies listed on stock exchanges in the U.S. The Russell 2000 Index is a float-adjusted market capitalization weighted index that measures the performance of the small-capitalization segment of the U.S. equity universe. The S&P 500 Index is a float-adjusted market capitalization weighted index that measures the large-capitalization of the U.S. equity market. It is not possible to invest directly in an index.
Risk factors: Investing involves risk and the potential to lose principal. Fixed-income securities are subject to interest rate risk and, as such, the value of such securities may fall as interest rates rise. International investing involves additional risks, including currency fluctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. These risks are magnified in emerging markets.
A Special Purpose Acquisition Company (SPAC) is a company created solely to merge or acquire another business and take it public — a cheaper, faster alternative to an initial public offering (IPO).
The impact of COVID-19, and other infectious illness outbreaks that may arise in the future, could adversely affect the economies of many nations or the entire global economy, individual issuers and capital markets in ways that cannot necessarily be foreseen. In addition, the impact of infectious illnesses in emerging market countries may be greater due to generally less established healthcare systems. Public health crises caused by the COVID-19 outbreak may exacerbate other pre-existing political, social and economic risks in certain countries or globally. The duration of the COVID-19 outbreak and its effects cannot be determined with certainty.