Down Stocks Up
In our year-end newsletter, the main thing we said we were going to be looking at to figure out where 2023 was headed was whether inflation started to come down in the first half of the year, which would support the Federal Reserve slowing down or stopping interest rate increases. And more importantly, whether the Fed’s rate increases would push the economy into a recession or not.
So far, that Goldilocks scenario has been playing out. Inflation has been coming off its peak, which lead to the Fed’s decision to not increase interest rates at their most recent meeting for the first time in over a year. Despite the significant tightening in financial conditions, unemployment has remained under 4%, around where it was prior to the start of the pandemic.
The market has embraced this outcome, with a rally in stocks pushing the S&P 500 up 17% through the first half of the year. The top performers within the index were the same large tech companies whose performance last year was so miserable. Particularly, any companies which can claim to have anything to do with AI, saw their stockholders rewarded. I am reminded a bit of the dot-com era, when all a company needed to do to see their stock price soar was to announce they would now have a website for the business and adding a “dot com” to the end of their company’s name.
| Full Year 2022 | 1st Half 2023 | |
| International Stocks | -14.4% | +12.4% |
| Gold | -0.8% | +5.2% |
| US Stocks | -18.1% | +17.0% |
| US Corp Bonds | -15.7% | +3.1% |
| Real Estate | -26.2% | +4.5% |
| Cash | +1.6% | +2.4% |
While the strong performance of stocks over the past 9 months will be welcome for many investors who compare their portfolios to last September, when the markets bottomed, it has also brought back a level of froth to valuations, which gives us some pause over where equity markets could be headed in the second half of the year.
Unlike at the start of last year, when investment grade bonds were paying around 2%, bond investors are now being paid closer to 6% on those same bonds. For managed accounts, we have been re-allocating portfolios to take advantage of these higher interest rates and pushing out bond maturities. If the stock market does falter in the second half of the year, this should put portfolios in a good position to benefit from an increase in bond values that would typically occur during a falling equity market
The CAPE may be 31x, but the regular PE is 19x, much closer to average levels. If inflation continues to come down, earnings continue to grow, and we avoid any 2008-style recessions over the coming years, the CAPE will continue to drop further, even without a drop in stock prices. Remember: there are two numbers here: Price and Earnings. The ratio can decrease from either a decrease in price or an increase in earnings
Additionally, that 19x PE is for the S&P 500: the biggest public companies in the country (Large Blend on the graphic to the right), and heavily weighted towards tech companies, whose earnings tend to be much more volatile than the overall economy.
It is these growth-oriented companies whose valuations are so above historical levels. Many other parts of the stock market have valuations around 14x, suggesting prices of those stocks are close to fair value. Some parts of the market, like small cap value companies, are below their average valuations, suggesting they’re good buying opportunities. The same is true for most developed international markets, like Japan and European Countries, where PE valuations are also below 25-year average levels. This bifurcation in the market, with some parts being very expensive while others being cheap, is not usual, and makes asset allocation an even more important part of your current financial plan.
What we haven’t discussed yet, is where bonds fit into all of this. One thing your advisor may have told you in a recent meeting is that the increase in interest rates makes portfolio construction much easier. Look back to early 2021, when corporate bonds paid around 2% interest, and valuations were at a similar level as today. If an investor is targeting a 5% rate of return, the only way to achieve that would be having a high allocation to stocks or other more volatile types of investments.
Because we can now buy CDs paying over 5%, and high quality bonds paying 6-7%, it is much easier to build a portfolio to achieve a desired rate of return without as large a stock exposure. That unfortunate investor who invested in March 1999 and lost, on average, 5.9% per year over the next decade would have made a gain of 4.1% per year investing in bonds.
Applying that to today, we can easily see a similar scenario playing out of below average returns in the S&P 500 for the next decade that will reward investors who do not chase the teasingly high valuations and, instead, opt for tried and true approach of diversification across multiple asset classes.
Valuations Matter
Sometimes, in a review meeting with your advisor or watching the news, you may hear them say something like the stock market is “cheap” or “overvalued” at the moment. What does that mean?
The two most common metrics people use when talking about stock valuations are the Price-to-Earnings (PE) ratio, and it’s cousin, the Cyclically Adjusted Price-to-Earnings (CAPE) ratio. Both look at the current price of stocks versus the profits or earnings of the company. For instance, if a company’s share price were $10, and it’s profit was $1 per share, the PE ratio would be 10x. If the stock price doubled to $20, but profit stayed the same, the PE ratio would be 20x. The CAPE takes a similar approach exist using earnings over the past ten years to try and capture a full economic cycle.
When someone says “stocks are cheap”, what they mean is that the PE ratio is currently low, compared to it’s historical level. Over the past 100 years, the S&P 500 index has had an average CAPE ratio of 18x. At times, it has dipped as low as into the single digits, and three times has peaked above 30x. The first of those three times was in 1929, right before the start of the Great Depression. The second was April 2000, right at the peak of the dot-com bubble, and the third, was during the past few years, briefly at the start of 2020 before the pandemic started, and then again at the end of 2021.
We care about the CAPE ratio, because historically, whenever it gets very low or very high, it tends to slingshot back towards it’s long term average. It also helps set expectations, as there is a decent correlation between a starting CAPE ratio, and the subsequent returns in the stock market for the next ten years. Low CAPE ratios – such as the 13x one from March 2009 at the bottom of the 2008-2009 recession, have historically represented fantastic buying opportunities for long term investors. For someone who invested in the S&P 500 in March of 2009, they would have averaged 14.3% per year for the next ten years. Conversely, if you invested when the CAPE was very high, such as March 1999, when the ratio was at 41x, right before the dot-com bubble blew up, over the next ten years, your average annual return would have been -5.9% per year – ten years later you still would not have gotten back to where you started!
The stock market started 2022 at a CAPE of 38x, and with last year’s 18% drop, it ended at 27x, much lower, but still higher than the historical average of 18x. Does that mean we should be concerned about what stock market returns will look like over the next ten years? Fortunately, there is a lot to feel positive about, despite the elevated CAPE ratio on the S&P 500 index.
Plott and French Updates
Our May launch target for the new website turned out to be a bit ambitious, but the finishing touches are being put in place right now for a launch in the next few weeks. If you haven’t been following us on Facebook, we are starting some regular monthly articles and videos on a number of topics you might enjoy
If you live in the New River Valley, you’ll have received invitations in the mail at the end of June for our client appreciation event with the Pulaski River Turtles on July 16th. We’re thrilled at the response we have received so far, but if you’d still like to come, let us know by July 12th by calling the office.
Don’t worry if you live outside of the area, we’re exploring other events to host over the coming year that will include virtual events (online wine tastings anyone?).
We’ll be posting a link to a survey to our Facebook page in the next couple months asking for feedback and preferences on future client appreciation and education events, along with other questions on how we can continue to provide a great client experience. If you’re not following on Facebook yet, you can scan the QR code in the lower left part of the page.
Above: In May, Plott and French donated over 200 pounds of meat to Radford-Fairlawn Daily Bread, a non-profit which provides over 37,000 free meals per year to those experiencing food insecurity in our area. For more information on them, visit www.radfordfairlawndailybread.org
All data sourced from Ycharts.com as of 6/30/2023. Stocks refers to S&P 500 Index. International Stocks refers to the MSCI EAFE index. US Corp Bonds refers to the Bloomberg US Corporate Bond Index. Interest Rates are upper limit of Fed Funds Overnight Rate. Inflation is Year-over-Year Consumer Price Index. Indices are unmanaged and unavailable for direct investment. Past performance is not a guarantee of future results. Securities and Advisory Services offered through Geneos Wealth Management. Member FINRA/SIPC.
