The US stock markets have had an amazing run this year: equities jumped over 20 per cent, led by the NASDAQ 100’s nearly 32 per cent expansion. Yet earnings growth has been lackluster, increasing a tepid 2.6 per cent over the trailing 12 months through June. Not surprisingly, price/earnings expansion accounted for the bulk of equity markets’ return this year, a reversal of 2018. Naturally, investors are questioning valuations, given the apparent disconnect between the markets’ phenomenal returns and their unenthusiastic underpinnings.
Digging into valuation, however, unearths a mixed picture, particularly for the S&P 500. By most traditional measures – those that gauge forward earnings, cash flow, and book value relative to current market cap – the picture is grim. The S&P 500 valuation needle is near the top decile of its historical range dating back to 1999. Equally gloomy, the S&P 500’s market capitalization is now 1.2 times the size of the economy, placing it in the 99th percentile of its historical range. However, other measures – particularly those that view equity market valuations through the lens of bonds – paint a far more charitable picture.
Historically, the S&P 500’s earnings yield – the reciprocal of its price/earnings ratio – tracked the 10-year, BBB corporate bond yield; the logic was BBB is the average credit quality among S&P companies. The two series vacillated in tandem until Q4/09, about the time the Federal Reserve embarked on its quantitative easing program and sent intermediate interest rates toward the floor. Since then, the market’s earnings yield has been consistently more generous than its corporate bond yield equivalent. Currently, the S&P’s earnings yield is two percentage points higher than that of 10-year, BBB corporate bonds, making equities a more attractive investment alternative than equivalent-quality bonds.
Pursuing a goals-based investment strategy puts delivering predicted outcomes above all else. For that reason, valuation, while important, is of secondary importance to outcomes. Investing in diversified global equities, as part of Cresset’s Growth Strategy, is designed to deliver client cash flows between years seven and 15 in our clients’ future anticipated lifestyle. As a result, we require our Growth Strategy to achieve a 90 per cent success rate in delivering a positive return over any seven-year holding period. That means our investment team needs to have sufficiently high forward return assumptions along with sufficiently low volatility assumptions to achieve that statistical hurdle. As of the middle of 2019, our market return forecasts weighed against our volatility assumptions no longer assured a 90 per cent success rate from a diversified global equity allocation. For that reason, we added private equity secondaries to boost our expected return while cutting back our equity exposure to reduce the risk of our Growth Strategy. Our moves had little to do with whether we believe stocks are expensive or cheap, although we don’t believe they’re cheap. Our recent risk reallocation had everything to do with raising the certainty of our desired outcome in delivering cash flows to our clients. In a world where clients rely on the cooperation of the financial markets to fund their lifestyle, creating certainty in an uncertain world is paramount.