As investors, we naturally aim to understand what is and what is not discounted by financial markets. Of course, this is a difficult feat as it implies we know something about our stocks that others do not. Since the turn of the century, markets have become more informationally efficient and rapidly incorporate new information into stock prices.
Rather than just ask “what do we know that others do not?”, our Global Equity Growth Portfolio team likes to explore the deeper questions about investor beliefs. These determine how investors incorporate information into the investment problem itself and thus, how they arrive at their decisions.
We all bring all kinds of beliefs to the investment task. For example, some believe that value investing works and valuation inputs should be paramount. Others prefer to invest in growth stocks and dismiss the value of dividends. Some believe that technical analysis is superior to a fundamental approach and so forth. But how do investors arrive at these beliefs and what is the evidence for such?
One commonly held assumption is that today’s financial landscape is dangerously fragile. This is the outcome of the trauma of the Global Financial Crisis and its aftermath in particular. Are investors correct that unforeseen risks lurk around every corner? Only time will tell. But one sanguine perspective is illustrated below, the Overall Index of Systemic Vulnerability constructed by the Federal Reserve. This implies that the structural risks, which culminated in the Global Financial Crisis of 2008, are no longer present.
Figure 1. The Financial and Economic Landscape: Stronger than Many Believe?
Overall Index of Systemic Vulnerability
Another widespread belief is that the S&P 500 Index is “overvalued” and thus, lacks upside potential. As shown in Figure 2, the median
P/E for the S&P 500 is higher today than its average of the past 50 years. That said, stocks have been sustained near today’s valuations for long periods, including the bull market of the 1990’s.Figure 2. Is the S&P 500 Overvalued?
S&P 500 Index, Monthly data 3/31/1964 to 3/31/2016 (Log Scale)
Figure 3. P/E Multiples by Sector (x)
Quarterly Data, 3/31/1947 to 12/31/2015, Log Scale
What does all of this imply for what we should be thinking about?
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- If investors are “overpaying” for stability in sectors like consumer staples and utilities, how quickly could that sentiment reverse?
One insight may be the energy MLP stocks. These had been regarded as safe “bond proxies” when investors were reaching for yield. After peaking in 2014, these stocks lost more than half their value as their underlying business models proved far less defensive than investors had supposed.
- If investors are “overpaying” for stability in sectors like consumer staples and utilities, how quickly could that sentiment reverse?
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- Is overvaluation a headwind for the S&P 500, or is it more the pace of future earnings growth?
We think the resumption of the earnings cycle is the critical variable and will overcome investor concerns about valuation. This is why the debate over secular stagnation versus normalisation of global growth is worth monitoring.
- Is overvaluation a headwind for the S&P 500, or is it more the pace of future earnings growth?
- Treasury bonds are regarded as the ultimate safe asset. How vulnerable are fixed income markets to a modest return of confidence in the economic outlook?
If U.S. inflation drifts mildly higher, we see the potential for nominal GDP growth of 4%. As Treasury yields tend to equal growth in nominal GDP over the long term, the upside from current yields (1.78%) is significant.
Getting markets right is as much about formulating the right questions as knowing the right answers.
Happy investing,
The team at TAMIM.