The Past, Present, and Future
I am afraid I cannot convey the peculiar sensations of time traveling. They are excessively unpleasant.
- H.G. Wells
In H.G. Wells’ classic “The Time Traveler,” readers are taken along a fantastical journey by the Time Traveler. As he spins his tale of a perplexing journey into the future, the Time Traveler struggles to reconcile the future and the changes man will face. Likewise, investors in 2020 have felt somewhat fast forwarded into a new reality. In a year where social restrictions have dislocated our seasonal normality, most of us can sympathize with the disorientation expressed by the Time Traveler. In our strange world, we encounter unexpected sources of volatility such as COVID curves and economic lockdowns. We are even evaluating companies on their social distancing characteristics. How well we assess and react to very real social and economic changes will ultimately determine our outcome. Even so, it is the long-term trends that will most impact the patient investor. As the Time Traveler adapted to his new world, the patient investor must keep an eye on the time tested methods of managing volatility while acknowledging current risks and opportunities. Like the Time Traveler, our way forward requires a clear understanding of the past, present and likely future.
As we entered into 2020, expectations for a robust year economically, a fairly certain electoral outcome and a strong market were almost givens. If you were to travel in a time machine back to December 31, 2019 and tell investors all that had happened in 2020 and ask them to guess where the stock market would be today, our guess is that their speculation would be fairly pessimistic.
As we enter into the fourth quarter 2020, the market is hovering near all- time highs with extended valuations. On September 2, the S&P 500 closed up 61.4% since the market bottom on March 23rd. Since then, the rally stalled as COVID uncertainty and the pending election came into focus. The quarter ended with a Forward P/E of 21.5x, well above the 25-year average of 16.5x. Market valuations are always tricky. While the market price is known, the path of future earnings is always uncertain. As time travelers, before we can develop an assessment of the future, we must first ground ourselves in an understanding of the present.
With concerns and anticipation building around COVID this winter, the upcoming earnings season is likely to be especially meaningful to market outcomes. We are already seeing a record low number of companies releasing guidance making it especially difficult to assess the direction of earnings. It is very understandable for companies to stop issuing forward earnings guidance in a time of COVID but it also leaves investors with less visibility thus making earnings season particularly unsettling. One positive outcome of this dynamic is that earnings expectations tend to be quite conservative and easier to beat than usual. As a result, the second quarter, and likely the third, saw corporate results come in significantly better than expected. With valuations on the high end, stronger-than-expected earnings growth has helped keep markets at current levels.
Should we see a significant uptick in COVID cases, and more importantly, a corresponding increase in governmental mandated lockdowns, the underlying “V” shaped recovery hopes would fade quickly. For investors, this is even more important. While pessimism for corporate earnings has understated results, a bad winter would likely cause markets to slump in response.
What is often lost in the P/E discussion is the impact of accommodative Fed policy. Companies, at the most basic level, are valued based on the net-present value of future cashflows. Low inflation expectations and low interest rates mean a low discount rate. A low discount rate means that those future cash flows are worth more today than an otherwise “normal” (ie. higher) interest rate environment. Correspondingly, this also means investors should naturally be willing to pay a higher valuation multiple for equities. With interest rates at these historic lows, the question becomes how high valuations should go. We are still below tech-bubble extremes, but not far off of them.
The other major trend is that a handful of companies continue to dominate returns. Most investors measure the market according to the S&P 500. This index is market-cap weighted, therefore, the biggest companies have a disproportionately large impact on returns. These names include Facebook, Apple, Netflix, Microsoft, Amazon, and Google (often referred to by the acronym FANMAG). Much of this group is associated with the technology space – which brings back concerns that we are in a bubble like we were in 2000.
While Fed policy might have put us in an asset bubble across the board, the similarities between today’s market and the late 1990s is fairly different. In our current low-growth environment, these technology companies are the ones who are not only producing earnings, but tend to grow faster than the broader market. In contrast, the 2000 Tech Bubble was characterized by scarce earnings and speculation on unprofitable start-ups.
The distinction between the past, present and future is only a stubbornly persistent illusion.
- Albert Einstein
Einstein changed the way the world looked at physics and opened the door to the possibility of time travel. He accomplished his work by simply trying to view the world from a different perspective. He was famous for what he called “thought experiments,” where he would imagine the world and seek to understand why things happened. When people talk of a new paradigm, often it is the same old situation packaged in a new wrapper. In the market of 2020, investors are tempted to focus too heavily on COVID curves and election uncertainty for guidance. But the patient investor will be most interested in long-run market fundamentals, including the link between current valuations and expected returns.
Regardless of current fears and risks, what we know is that there is a strong inverse correlation between current P/E ratios and expected real returns over the long-run. Often investors look at company or market earnings yield as a proxy for expected real returns. Essentially, this measure is the inverse of the P/E ratio. As of the end of the third quarter of 2020, that number hit 4.6%. The earnings yield tells us that investors buying into the market today should expect returns on stocks as low as they’ve been in the past 20 years. This situation begs the question, “is there someplace better to turn?” The natural alternative is bonds. Investors often use the spread between the earnings yield and Baa bonds as way to answer this question. Despite exceptionally high valuations, the historic low yields on bonds means that spread is still tilting toward stocks. Unfortunately, barring a new pro-growth environment, investors are looking at historically-low expected returns across the board.
(when) you’ve pushed Einstein’s theory to the very limits… you really need a theory of everything… And the only candidate is string theory.
- Micho Kaku
Navigating our current investment environment is difficult. Like physicists looking toward string theory to find answers when the rules of physics break down, investors need to look deeper for solutions. Diversification is the deeper solution of investing. Under this umbrella, investors need to specifically consider a variety of asset classes for potential returns and to offset valuation risks. International stocks offer better valuations and could garner tailwinds from more stimulus post-election. Small and mid-cap stocks offer more domestic based exposure should global lockdowns re-emerge. Other assets such as MLPs, high-yield bonds, convertible bonds, and preferred shares have their own set of drivers (and risks) which tend to have lower correlations to bond and stock markets, but have seen higher correlations to equity sectors and markets during downturns. Alternative trading strategies, such as managed futures may also reduce risk and help as shock absorbers should the road get bumpy over the next few months.
While COVID is likely to have the greatest impact to the economy and markets over the next six months, the upcoming election could also result in short-term volatility. A change in regime would also likely impact economic and market trends. From a policy standpoint, 2018’s tax-cuts were extremely meaningful to earnings. Any increase to corporate taxes would go directly to the bottom- line. In a market already dealing with historically high valuations, this might be a catalyst for a correction. At the same time a required fiscal stimulus and or government spending plan on infrastructure and/or health care could also serve as a tailwind for the markets. A high-quality diversified portfolio should be well positioned to manage these near- term risks.
If the Universe came to an end every time there was some uncertainty about what had happened in it, it would never have got beyond the first picosecond.
- Douglas Adams
Sometimes we get caught up in the latest crisis. Uncertainty in markets is always pitched as unique and the way forward as a new paradigm. However, we find that the path to success is almost always rooted in the same fundamental approaches - diversification, quality investments, rebalancing and sticking with the investment process. In our world, where we are constantly inundated by stimuli designed to cause a reaction, those concepts can easily get lost. The uncertainty we face today feels different and unique, but so has every other crisis that we have faced. Now is the time for sticking to the process and making sound decisions while everyone else panics and takes missteps.
Details you need to make a smart decision
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This material contains forward looking statements and projections. There are no guarantees that these results will be achieved.
Investing involves risk including the potential loss of principal. There is no guarantee that a diversified portfolio will outperform a non-diversified portfolio in any given market environment. No investment strategy, such as asset allocation, can guarantee a profit or protect against loss in periods of declining values. Past performance is no guarantee of future results. Please note that individual situations can vary. Therefore, the information presented here should only be relied upon when coordinated with individual professional advice.
Indexes are unmanaged and investors are not able to invest directly into any index.
International investing involves special risks not present with U.S. investments due to factors such as increased volatility, currency fluctuation, and differences in auditing and other financial standards. These risks can be accentuated in emerging markets.
Investments in stocks of small companies involve additional risks. Smaller companies typically have a higher risk of failure, and are not as well established as larger blue-chip companies. Historically, smaller-company stocks have experienced a greater degree of market volatility than the overall market average.
Equity investments tend to be volatile and do not involve the guarantees associated with holding a bond to maturity.
In general, the bond market is volatile as prices rise when interest rates fall and vice versa. This effect is usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.
Fixed income investments are subject to various risks including changes in interest rates, credit quality, inflation risk, market valuations, prepayments, corporate events, tax ramifications and other factors.
The investor should note that vehicles that invest in lower-rated debt securities (commonly referred to as junk bonds) involve additional risks because of the lower credit quality of the securities in the portfolio. The investor should be aware of the possible higher level of volatility, and increased risk of default.
Municipal bond offerings are subject to availability and change in price. If sold prior to maturity, municipal bonds may be subject to market and interest risk. An issuer may default on payment of the principal or interest of a bond. Bond values will decline as interest rates rise. Depending upon the municipal bond offered, alternative minimum tax and state/local taxes could apply.
The price of commodities is subject to substantial price fluctuations of short periods of time and may be affected by unpredictable international monetary and political policies. The market for commodities is widely unregulated and concentrated investing may lead to higher price volatility.
Investments in real estate have various risks including possible lack of liquidity and devaluation based on adverse economic and regulatory changes.
Other Sources: Bloomberg; California.gov; Russell.com; First page index returns are calculated on a total return basis using the following indexes: S&P 500 (SPX), MSCI World (MXWO), MSCI Emerging Markets (MXEF), BofA Merrill Lynch U.S. Treasuries 1-10 years, BofA Merrill Lynch U.S. Agencies 1-10 years, BofA Merrill Lynch U.S. Corporates 1-10 years A-AAA, BofA Merrill Lynch U.S. Municipals 1-10 years A-AAA, Russell Top 200 Index, Russell 1000 Index, Russell Midcap Index, Russell 2500 Index, Russell 2000 Index, Credit Suisse High Yield Index (CSHY), MSCI U.S. REIT Index (RMZ Index).