January 6, 2020
Welcome to the first issue of 2020. I initially planned to publish a newsletter issue in late December, but decided to push it back until after the holidays.
This issue discusses relative valuation levels between various asset classes and my general expectations for the next decade, based on available data.
The Current Regime
Beginning 3-4 months ago, there have been several reversals in the market that continued over the full fourth quarter of 2019.
During the two weeks in early September leading up to the interest rate spike in overnight lending rates, bond yields increased sharply, and have generally continued that trend. The ten-year treasury note yield, for example, increased from 1.50% to 1.90% over the past several months, which is a very sizable move in percentage terms (a 25%+ higher interest rate), before backing down a bit recently, to just under 1.80%.
With a pivot in early October, the U.S. dollar broke its strengthening trend and turned into a weakening trend, represented here by the dollar index (DXY), which compares the dollar to a basket of currencies, especially the euro:
Chart Source: Marketwatch
A bullish trend of “higher highs and higher lows” turned into a bearish trend of “lower highs and lower lows”.
If you haven’t been following my work lately, my article The Most Crowded Trade and my November 2019 newsletter issue provide more background information on the probable causes and implications of the spike in overnight lending rates and subsequent reaction of the Federal Reserve to expand its balance sheet, and explains my expectation for a weaker dollar as one of the primary results.
The S&P 500 has performed very well in the fourth quarter, with an exceptionally strong December in particular. And emerging markets showed signs of life as well, with assistance from the weaker dollar. They have managed to outpace the S&P 500 since the start of the fourth quarter:
Commodities like oil and copper turned back up as well.
However, investors should be careful about complacency, and make sure that their portfolios have appropriate diversification for their particular age, goals, risk tolerance, and so forth. The million dollar question is whether these new trends will continue deep into 2020, or if they are setting up some big reversals yet again.
Growth-less Gains
The full year 2019 was all about equity valuation expansion rather than underlying earnings growth for the U.S. market. FactSet charts this well, showing that the strong tax-cut induced S&P 500 earnings growth that occurred in 2018 was followed by virtually flat analyst-consensus earnings growth for 2019 (with three of the four quarters already accounted for):
Chart Source: FactSet
These expectations for 0.3% earnings growth in 2019 are inclusive of buyback impacts, so company-wide net income has been negative on average this year, unless the fourth quarter comes in with a big upward surprise.
Consensus analyst expectations are for moderate earnings growth in 2020, but whether that will be accurate remains to be seen. Investors have bid up equity prices in anticipation that 2020 will be an economic rebound year, so there is certainly a risk to the downside if those earnings numbers fail to impress. That is always the case of course, but the gap is currently larger than normal.
Economic indicators show conflicting results. The ISM PMI continues to deteriorate, heavy truck sales are down, and initial jobless claims have been rising. Construction spending has shown a modest bounce, and industrial production is down year over year, but had a higher November figure than October. Retail sales growth has decelerated, but remains in positive growth territory.
Without strong conviction on the underlying economic fundamentals until a few more data points come in during this unclear inflection point, I’ll instead suggest the main thing to keep an eye on in the coming weeks and months: jobless claims and unemployment.
Annual spending on corporate buybacks already likely peaked for the cycle, hitting record dollar amounts spent in 2018, and lower-but-still-high amounts again in 2019. Corporate debt as a percentage of GDP is at all-time record levels, while GDP growth remains sluggish. The year 2019 saw the highest year-over-year hourly wage growth of this past decade, even as company-wide net income remained flat.
With corporate earnings growth at a potential standstill against a backdrop of rising labor costs and heavy balance sheets, the next step for many corporations if they want to further boost their earnings in the short term is to reduce their labor force.
And rising unemployment is typically the final nail on the coffin for a business cycle. We haven’t had that yet during this business cycle.
After a decade of declining weekly jobless claims, however, this is the first time that we have had flat initial jobless claims for almost two years, along with a small upward trend starting to form. We could very well be starting a bottoming process for unemployment, which is a case that is supported by both the corporate profit margin problem described above, and the chart itself:
Chart Source: St. Louis Fed
A bottoming job market has been roughly coincident with market peaks during the past few decades of business cycles, shown here by the Wilshire stock market index and the official unemployment rate:
Chart Source: St. Louis Fed
We still don’t have a confirmed unemployment bottom yet, but there are some potential early signs of one forming that we’ll need to confirm with ongoing data points. Plus, the coming decade could be messier for this equity performance vs unemployment chart than some of the previous cycles, if we see a return to higher inflation.
However, it’s a comparison to be aware of as we move onto the next section about expected forward returns.
Expected Returns for the 2020’s Decade
It is one of those unintuitive aspects of finance that it is easier for fundamental investors to predict long-term returns than short-term returns, although both exercises are quite challenging.
Especially with the process I use, which is a long-term (3-5 year) investment strategy based on fundamentals and valuations, data can give us useful insight for the long-term but gives us a lot of noise in the shorter term.
For example, forward P/E multiples have a decent inverse correlation to 5-year forward returns, and no correlation at all with 1-year forward returns:
Chart Source: J.P. Morgan Guide to the Markets
I don’t like to use standard P/E multiples for broad market valuation, though, because earnings can be so ephemeral. Back in 2009, because earnings had fallen off a cliff, the market’s P/E ratio was high, which was of course very misleading. Most other valuation metrics showed the market to be attractively priced, and it was a generational buying opportunity.
A better (but by no means perfect) measure is the cyclically-adjusted P/E (CAPE) ratio, which divides the current price by the average of the last ten years of inflation-adjusted earnings. The intent is to give us some insight on current stock prices relative to a full business cycle of earnings rather than just one year’s worth of fluctuating earnings.
Just like how the normal P/E ratio can be inverted into the E/P ratio (the “earnings yield”), the CAPE ratio can be inverted into the cyclically-adjusted earnings yield by dividing the average of the past ten years of inflation-adjusted earnings by the current price. In other words, if the CAPE ratio happens to be 31, the cyclically-adjusted earnings yield would be 1/31 or 3.22%. While a high CAPE means expensive stocks, the earnings yield is the inverse, so a low figure means expensive stocks.
Valuations and Stock Performance
This next chart shows the cyclically-adjusted earnings yield of the S&P 500 (blue line) during January of each year compared to forward 10-year annualized total returns of the S&P 500 starting from that year (orange bars):
Data Source: Robert Shiller, Yale University
As you can see, there is fairly strong correlation. Periods of high valuations are almost always followed by long-term periods of low returns, and vice versa. Based on the current high valuations, we should be prepared for the high likelihood of weak S&P 500 total returns during the 2020’s decade from today’s starting point.
Here is a similar chart that shows inflation-adjusted returns rather than nominal returns, which outlines just how bad the late 1960’s and early 1970’s starting points really were for investors:
Stocks vs Bonds
A big criticism of the CAPE ratio is that it is heavily influenced by interest rates. A low prevailing interest rate today means that the natural resting region of the CAPE should be elevated compared to its long-term historical average.
The equity risk premium, which can be measured in various ways, compares the expected returns of stocks vs bonds. Since stocks are more volatile than bonds, investors generally demand higher expected returns from them, and the equity risk premium tells us how big that gap currently is. Whether “risk free” 10-year treasury notes yield 2% or 7%, for example, sets a very different hurdle rate for what investors are willing to pay for equities.
A common way to measure the equity risk premium is to subtract the 10-year treasury yield from the S&P 500 earnings yield (the E/P ratio). However, because of my dislike for that 1-year ephemeral earnings measure, I use a different version of the equity risk premium. I take the cyclically-adjusted earnings yield of the S&P 500 instead of just the 1-year S&P 500 earnings yield, and subtract the 10-year treasury yield from that. We can call this the cyclically-adjusted equity risk premium.
For example, if the S&P 500 CAPE ratio is 31, then the cyclically-adjusted earnings yield is 3.22%. If the current 10-year treasury yield is 1.79%, then the cyclically-adjusted equity risk premium is 3.22% minus 1.79%, which equals 1.43%. The equity risk premium is therefore low but positive.
Here is the cyclically-adjusted equity risk premium (blue line) compared to the forward 10-year annualized excess returns of the S&P 500 index over 10-year treasury notes:
As you can see, this also has pretty good correlation, but nowhere near perfect. The higher the blue line, the bigger the equity risk premium is, and the better stocks typically do over bonds for the next decade. However, there were two notable exceptions during this near-century of data.
One brief exception was in the 1930’s, when the equity risk premium was extremely high, but stocks still performed only moderately well compared to bonds. This was due to the fact that it was an unusually unlucky decade, because even though stocks were very cheap in the early 1930’s, they were very cheap again in the early 1940’s during the heart of World War II. Stocks did have a big bounce from the early 1930’s, so the high equity risk premium actually was a nice multi-year buying signal, but the full 10-year period happened to land in a very unlucky spot.
The bigger exception was for a decade in the mid 1980’s to the mid 1990’s. The equity risk premium was negative, and yet stocks still outperformed bonds considerably. Both stocks and bonds did exceptionally well during that period, and it was one of the strongest bull markets in American history, leading up to the highest U.S. equity valuations of all time by the end of the period, and included the invention of the Internet. Stock valuations were low and the CAPE ratio was screaming “buy stocks!”, but because bond yields were also high, the equity risk premium was low. Investors did well buying both stocks and bonds, but especially stocks.
During all other times, the cyclically-adjusted equity risk premium has historically given a pretty good indicator of how stocks are likely to perform compared to bonds over a long stretch of time.
The lowest the equity risk premium ever reached was during the dotcom bubble in 2000. Equity valuations were extraordinarily high, and yet 10-year treasuries yielded over 5%, so buying bonds instead of stocks should have been a no-brainer.
That is not the case today, and is what makes asset allocation particularly hard for investors these days. Equity valuations are high, which indicates a high likelihood of poor forward equity returns. But bond yields are exceptionally low, meaning that the equity risk premium is still positive, which indicates that stocks have a high likelihood of outperforming bonds over the next decade, even if there will likely be some volatile years where stocks dramatically underperform.
In fact, a notable observation is that the S&P 500 has never provided good 10-year returns when the CAPE ratio was this high, and yet the S&P 500 has also never underperformed treasury notes on a forward 10-year basis when the equity risk premium was this positive. The conclusion based on historical data is that stock returns likely won’t be great, and 10-year treasury returns will likely be even worse.
Indeed, especially adjusting for inflation, treasuries performed very poorly during the previous period when interest rates were this low, which was a long time ago:
I noted this during the past summer, near the height of global negative interest rates, when I suggested in an article that bonds were in a bubble.
Overall, the current situation for stocks and bonds is reminiscent of the 1960’s, in my view. Investors generally have a recency bias, and often use the past business cycle or two as a likely model for how the next one will play out. However, I think some of the older periods, like the late 1960’s or late 1930’s, have more in common with today’s situation than the late 2000’s or late 1990’s.
Stocks vs Gold
Although U.S. stock returns and bond returns are both unlikely to be very attractive over the next decade, especially in real terms, there are a few more asset classes to look at.
This chart shows the outperformance or underperformance of the S&P 500 compared to gold over the subsequent 10-year period (orange bars) based on various levels of the cyclically-adjusted S&P 500 earnings yield (blue line):
As the chart shows, gold has historically outperformed stocks whenever stocks were this expensive.
Gold is somewhat volatile, and had periods where it was fixed at a dollar price, so it historically has been an “all or nothing, feast or famine” sort of differential compared to stocks, unlike the stock vs bonds chart above.
My primary article on precious metals explains my valuation process for gold and silver, and the various pros and cons of different ways to get exposure to them. The short version is that gold typically outperforms the S&P 500 when stock valuations are this high, and also outperforms bonds when interest rates are this low, and independent valuation methods suggest that gold is reasonably-priced at current levels and that silver is historically very cheap based on most comparative metrics.
I am more optimistic for precious metals at current levels than stocks or bonds, so I keep them as a defensive asset class within my various diversified portfolios.
U.S. vs International
Lastly, there are many international markets that we can consider to broaden our horizons and diversify our portfolios.
As this chart shows, decades tend to have alternating leaders for equity returns.
Chart Source: iShares
If we go back one decade further, the 1980’s were a time for developed international markets outperformance, thanks to the rise and bubble of Japan.
However, it’s not just based on chance. Markets with lower valuations unsurprisingly tend to outperform markets with higher valuations. They pay higher dividends, they have more potential for valuation expansion, and so forth. After this stellar decade for U.S. stock performance, the U.S. equity market is expensive compared to many other countries based on most metrics, even after adjusting for different sector exposure. And the dollar is strong.
Last spring, I wrote an article called “This Strategy Tripled the S&P 500 Over 25 Years” that cites research showing that a process of investing in the cheapest 25% of equity markets each year has historically outperformed investing in the S&P 500 alone, over a moderately large 25-year sample of time from 1993 to 2018. That’s not a strategy that most investors should necessarily follow, but it is instructive. Research by Star Capital has further supported this idea with valuation-vs-performance data from developed markets going back to 1979.
My base case is for international stocks, and in particular emerging markets, to likely outperform the S&P 500 over the next decade in U.S. dollar terms.
That doesn’t mean I go “all in” on them, but based on current levels of valuation, growth, and my expectations of a weaker dollar over the next few years, I certainly want to have some global exposure within my various diversified portfolios, and to rebalance into any weakness that one region may have compared to another.
Portfolio Updates
I have several investment accounts, and I provide updates on my asset allocation and investment selections in each newsletter issue every six weeks.
These portfolios include a primary passive/indexed retirement account, two actively-managed brokerage accounts at Fidelity and Charles Schwab, and the model portfolio account specifically for this newsletter at M1 Finance that I started last year.
I use a free account at Personal Capital to easily keep track of all my accounts and monitor my net worth.
M1 Finance Newsletter Portfolio
I started this account in September 2018 with $10k of new capital, and I put an additional $1k into it before each newsletter issue, totaling $21k so far.
It’s one of my smallest accounts, but the goal is for the portfolio to be accessible and to show newsletter readers my best representation of where I think value is in the market. It’s a low-turnover multi-asset globally diversified portfolio that focuses on liquid investments and is scalable to virtually any size.
I chose M1 Finance because their platform is commission-free and allows for a great combo of ETF and individual stock selection with automatic and/or manual rebalancing. It makes for a great model portfolio with high flexibility, and it’s the investment platform I recommend to most people. (See my disclosure policy here regarding my affiliation with M1.)
After adding $1,000 in fresh capital in late December, here’s the portfolio today:
Here is the full list of holdings within those various sections:
Changes since the previous issue:
- I sold Rockwell Automation (ROK) from the dividend section of the portfolio after a significant run-up in the stock price this year, and bought Carnival Corporation (CCL), which is doing well fundamentally but is trading at a historical inexpensive valuation.
- I bought Acuity Brands (AYI) in the growth section of the portfolio.
- I bought Canadian National Resources (CNQ) and Kirkland Lake Gold (KL) in the commodity section of the portfolio, and sold Agnico Eagle (AEM) for now.
Primary Retirement Portfolio
This next portfolio is my largest and least active. It purely consists of index funds that automatically rebalance themselves regularly, and I rarely make changes.
Here’s the allocation today:
From 2010 to 2016, this account was aggressively positioned with 90% in equities and enjoyed the long bull market.
Starting in 2017, in order to preserve capital, I dialed my equity allocation down to 60% (40% domestic, 20% foreign) and increased allocations to short-term bonds and cash. This was due to higher stock valuations and being later in the market cycle more generally. If the U.S. economy encounters a significant sell-off, I would likely increase equity allocations to upwards of 90% once again.
Related Guide: Tactical Asset Allocation
For my TSP readers, this is equivalent to the 2030 Lifecycle Fund. One reason this is so conservative for my age is that my active portfolios below are more concentrated and aggressive, so I consider them together when determining how to allocate assets.
This is an example of a portfolio strategy that takes a rather hands-off approach but that still makes a tactical adjustment every few years based on market conditions. This employer-based retirement account is limited to a very small number of funds to invest in, so my flexibility is limited compared to my other accounts. I would, for example, have some precious metal exposure in this one in place of some of the bonds if I had that option.
Active Portfolios
My accounts at Fidelity and Schwab are mainly for individual stock selection, single-country ETFs, and selling options, and helps to fill some of the gaps that my index retirement account has.
Changes since the previous issue:
- I bought shares of the Cheesecake Factory (CAKE), a casual-upscale restaurant that made a potentially lucrative acquisition this summer for brand diversification and growth, and whose stock has been declining over the past month.
Final Thoughts
To recap, the expected performance in dollar terms of various asset classes over the next decade based on current valuations and historical data is roughly as follows:
- High potential: Precious metals and international stocks
- Medium potential: Broad U.S. stock market indices
- Low potential: Bonds in the U.S. and other low-yielding regions
This comes with several caveats, though. Valuation data is useful for the long-term, unhelpful for the short-term, and imperfect over any length of time.
We could get a very unusual decade that pushes the historical boundaries to new levels, like the Dotcom Bubble or World War II did to the upside and downside ranges, respectively.
Even if the decade plays out as expected, traders can profit on the upside and downside in all of these asset classes along the way. There will be stock peaks, stock troughs, bond peaks, bond troughs, gold peaks, gold troughs, plenty of emerging markets volatility, and so forth.
I mostly position for multi-year outcomes, with a low turnover portfolio strategy. And as a long-term position investor, I’ll be keeping these valuation differentials and return expectations in mind when constructing and maintaining my portfolios.
Happy new year,
