The October 7th-13th cover of The Economist led with the phrases “The bull market in everything” and “Are asset prices too high?” The main article mentioned potential bubbles in equities (at an all-time high), fixed income (boosted by easy monetary policy), real estate (see the 2007 Financial Crisis), and cryptocurrencies (Bitcoin, Etherium, etc.). I will focus my attention on equities since they tend to be the most important, and largest, component of a client’s long-term growth.
What I would like to share today are some of the counter-arguments I have come across in my research regarding high equity valuations. I will then finish up with investment themes, risks, and how we are currently positioning client accounts.
Valuation Counter-Arguments
- Not all valuation metrics have reached extreme levels – Though above their long-term averages, none of the main valuation measures are stretched by more than 1 standard deviation.
- Higher valuations are warranted given fiscal stimulus reform – Deregulation, tax reform, and infrastructure spending add to economic growth thus boosting the E in P/E. It is worth keeping an eye on tax reform as it is appearing difficult to please both the moderate and budget hawk factions in the Republican Party.
- Removal of the FANG stocks reduces the S&P 500 P/E by approximately 1 point – Facebook, Amazon, Netflix, and Alphabet (Google) make up approximately 7% of the S&P 500. The removal of these four companies alone would bring the P/E ratio down closer to its 25-year average. Many supporters of tech-oriented growth stocks dismiss the importance of the P/E ratio altogether for valuing these types of companies because profits are foregone now and money is reinvested in pursuit of longer-term growth.
- There is a lack of excessive optimism – There is still a record number of idle cash sitting on the sideline with many skeptics still unsure of putting money to work.
- Not all equity markets have lofty valuations – Of all the major markets, the U.S. currently has the highest P/E ratio of 17.8 while Japan, whose valuations actually became more attractive in 2016, has the lowest at 13.8. These cheap valuations, along with a weakening yen and continued monetary stimulus, all point to the potential for strong performance for Japanese equities in the short to mid-term.
To this last point, there are three stages to a secular bull market. The first stage was led by accommodative monetary policy and occurred from October 2008 – May 2015. The second stage, and current stage, began in early 2016 and is being driven by earnings growth. The last stage tends to consist of a speculative top led by excessive optimism and idle cash being invested as investors begin to fear missing out. There is no saying when this will occur but it is important to remember that bull markets do not die of old age.
Investment Themes
- We continue to favor equities over fixed income in part to rising growth expectations and the continuation of gradual monetary tightening
- We favor international over domestic due to more attractive valuations, stabilizing commodity prices, and a weaker dollar
- We favor shorter to intermediate-term duration given a potential flattening of the yield curve. Prefer EM debt and Credit strategies over Mortgage-Backed securities and treasuries.
- We maintain strategic allocations to cash and alternative strategies to weather short-term volatility and provide liquidity. We view any market pullback (5% or more) as a buying opportunity and would look to add to equities
Risks
- Geopolitical risk – any increased escalation with North Korea or Iran poses significant short-term risk. Also, trade disputes with China and NAFTA would have broader ramifications impacting global trade.
- Monetary risk – any swift and unexpected Fed tightening would create turmoil for fixed income and emerging markets. Big decision forthcoming for President Trump. Will he reappoint Janet Yellen as Fed chair or replace her with someone potentially more hawkish?
ASSET ALLOCATION VIEWS
| EQUITIES | ||
| Large Cap Growth | Overweight | |
| Large Cap Value | Neutral | |
| Large Cap Dividend Growth | Neutral | |
| Mid Cap | Neutral | |
| 1 | Small Cap | Neutral |
| Europe | Overweight | |
| Asia Pacific | Slightly Overweight | |
| Canada | Neutral | |
| 2 | Developed Small Cap | Overweight |
| Emerging Markets | Slightly Overweight | |
| FIXED INCOME | ||
| U.S. Treasuries | Underweight | |
| Investment Grade Corporate Debt | Slightly Overweight | |
| Mortgage-Backed Securities | Slightly Underweight | |
| High Yield Debt | Slightly Overweight | |
| 3 | Emerging Market Debt | Overweight |
| 1 | Poised for an upgrade if there is substantial tax reform | |
| 2 | highly cyclical; benefits the most from a pickup in global trade | |
| 3 | benefits the most from commodity stabilization and a weak dollar |
Written by: Antonio Belmonte
These are the opinions of Antonio Belmonte and not necessarily those of Cambridge, are for informational purposes only, and should not be construed or acted upon as individualized investment advice. Investing involves risk. Depending on the types of investments, there may be varying degrees of risk. Investors should be prepared to bear loss, including total loss of principal. The strategies discussed herein are not designed based on the individual needs of any one specific client or investor. In other words, it is not a customized strategy designed on the specific financial circumstances of the client. However, prior to opening an account Cambridge will consult with you to determine if your financial objectives are appropriate for investing in the model. You are also provided the opportunity to place reasonable restrictions on the securities held in your account