Is the Market Flashing Caution Signs? Three Observations
Investors in “balanced” portfolios just had their second-best start to a year since 2001. I am using the Vanguard Balanced Fund (VBIAX) as a proxy, which invests roughly 60% in U.S. stocks and 40% in bonds. The fund returned 10.5% from January 1 through June 30, 2023. This comes just one year after the worst start to a year EVER, when the balanced fund lost over 17% to start 2022.
At the same time, cash is cool again for millions of investors. After years of living with TINA, or There Is No Alternative [to stocks], rates on short-term savings, money markets, and certificates of deposit seem very attractive to many savers. MarketWatch reported high net worth individuals were keeping a whopping 34% of their wealth in cash in 2022!! Side note: here are some thoughts on how to keep your cash safe.
Considering the rebound in stock and bond prices this year, here are three observations for people considering moving from cash back into stocks and bonds.
The Equity Risk Premium Turned Negative, maybe
Buy low and sell high is a pretty good recipe for finding investment success. When comparing stocks to bonds, it might be easier to flip the equation and aim to buy high. Or, at least when the expected reward is high.
The equity risk premium (ERP), conceptually, is the “extra” return investors expect to earn above a risk-free rate for accepting equity risk. One way to measure the is by comparing the earnings yield on stocks, which is just the inverse of the price-to-earnings ratio, to the yield of a risk-free alternative like a U.S. Treasury security. While no investment is truly risk-free, U.S. Treasuries are widely used to represent this part of the equation.
Here is a quick example. XYZ stock’s price is $30 per share, and the company is expected to earn $2 in profit over the next year. The price-to-earnings ratio is $30 divided by $2, or 15x. The earnings yield simply inverts the equation so it can more easily be compared to bond yields. The same stock has an earnings yield of $2 divided by $30, or 6.7%. If a U.S. Treasury is yielding 5%, the stock would have a risk premium of 1.7%, which is its earnings yield (6.7%) minus the yield on the U.S. Treasury (5%). We wrote more about the ERP in April of this year – click here to read if interested.
Stock investors should aim to buy stocks when the ERP is high. The chart below shows two ways to think about the ERP.
The green line compares the S&P 500 earnings yield to a 3-month Treasury yield, while the orange line uses a 10-year Treasury as the risk-free rate. The earnings yield at the end of June using forward earnings estimates was 5.0%
Short-term rates are currently higher than long-term rates, and the ERP using a 3-month Treasury yield went negative for the first time since the early 2000s last month. Time will tell, but this does not seem like an ideal situation for stock buyers.
In our view, stocks should be considered long-term investments, so comparing the earnings yield to a longer-term Treasury may make more sense. Comparing the 5% earnings yield on stocks to the 3.8% 10-year U.S. Treasury yield, the ERP using this longer-term risk-free rate is still firmly positive, suggesting equity investors still expect to earn something extra for taking the equity risk.
Finally, these are just two ways to think about the ERP. Another method published by Aswath Damodaran suggests the implied equity risk premium from analyst forecasts is currently around 4.5-5.0%.
TAKEAWAY: Don’t place too much emphasis on any single data point. We can likely find evidence to support a variety of different narratives, good and bad.
Source: Divvi Wealth Management, Morningstar Direct. Equity Premium uses the forward earnings estimate for the S&P 500 index. The risk-free rate is represented by the 3-month U.S. Treasury Yield (green line) and the 10-year U.S. Treasury Yield (orange line).
strong Short-term returns don’t mean much
We know stocks produced good returns in the first half of 2023. Does that mean the next six months should also be good?
Not really. Since 1950, stock returns from the prior six months tell you essentially nothing about the next six months of stock returns. Look at the chart below.
The horizontal axis plots trailing 6-month returns for the S&P 500, and the vertical axis plots the future 6-month returns.
The dots are all over the place, seemingly without any organized pattern. The R2 attempts to measure how much future returns are explained by past returns. An R2 of 0.0003 implies no relationship between the two.
TAKEAWAY: Enjoy the strong returns from the last six months and try to resist thinking the second half should be more of the same based on those good results.
Long-term returns have improved with more attractive starting points (shocker!)
We talked about the Equity Risk Premium (ERP) and mentioned wanting to buy when the ERP is high. The chart below shows why.
Since late 1999, long-term real returns (meaning after inflation) generally improved when the ERP was higher at the beginning of the period.
The green line is the ERP at the beginning of the period, and the brown line shows the subsequent real total returns for the S&P 500. The dashed line shows the current ERP.
TAKEAWAY: When the earnings yield on stocks is high relative to the yield on bonds, good returns typically follow! Buy low and sell high – that’s the typical mantra. When using the ERP as your signal, invert. Buy high and sell low.
Final thoughts
Predicting short-term market returns is a practice we prefer to avoid. If we look hard enough, we can always find reasons to invest, as well as reasons to sit on the sidelines.
Consider using the market’s first half strength as an opportunity to revisit your broad asset allocation. For example, did the success of growth or cyclical stocks introduce unintended risk to your portfolio? Or did you take advantage of higher short-term rates in buckets of money intended to fund long-term goals? It could be a good time for a little realignment.
Interested in talking more? Email me at eric@divviwealth.com or set up time with the Divvi team to continue the conversations.
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