Everything is Relative...
February 24, 2020
By Mike Moreland
VP - Investments
With the tremendous results of 2019 still fresh, and prices reaching new highs in early 2020, the investment world’s parlor game of ‘calling the top’ is back in vogue. The argument for this is valuation – stocks are expensive, and they can’t go any higher.
The first part is true. The data below, from Goldman Sachs Global Investment Research, illustrate this. The S&P 500 sells at metrics averaging in the top decile reaching back to the mid-1970s. And, as we regularly discuss, probably the best predictor of long-term performance is valuation at the starting point. The cheaper the market, the brighter the future, and vice versa.
Source: Goldman Sachs Global Investment Research
Clearly, stocks are expensive today. Are we nearing the end of the 11-year bull market? Compared to the market’s own history, yes. Valuations are near the late 1990s tech bubble peak, and no one around then wants to experience that aftermath again. The 2000s were called ‘The Lost Decade’ for good reason.
But there’s a difference that puts today’s prospects in a better light. Stocks, in a vacuum, are walk-away-from expensive. Relative to alternative investments, not so much. In fact, the last item in the table – the earnings yield on the S&P 500 versus interest rates on 10-year US Treasury notes – is in the bottom quartile of similar measures over the last four decades.
What does this tell us? The dramatic decline in global yields over the last decade is providing support for the stock market. As long as interest rates stay low – and they should – markets will likely be well-behaved. The normal gyrations from the news of the day will always be there, but the end of the bull market is not here yet.
The lesson is to make decisions in a broad context. Financial markets are cheap or dear not just by their own metrics, but in comparison to all options available. To paraphrase our corporate slogan, everything matters – not just the price.
P.S. It's a Coronavirus Market Now
On Monday, the Dow Jones Industrial Average dropped 1,031 points, its worst one-day decline in just over two years. The spread of coronavirus beyond China appears to be accelerating, calling into question the ability of world economies to advance when contagion risks are rising.
You will see a lot of analysis comparing today’s environment to similar episodes in the past – SARS, Ebola, Swine Flu and the like. In those, economies and markets recovered fairly quickly; activity was delayed, not cancelled.
How might things be different this time? Just a few items to keep in mind:
- China’s importance to the world economy (about 17% of global GDP) is multiples of its impact just a decade or two ago;
- Globalization of trade in the last generation drove significant manufacturing capacity to the Far East over the same period; and
- Cost-effective inventory management in all business areas demands efficient, fully functioning manufacturing and transportation capabilities.
These facts suggest near term market risks might be higher than previously thought – and today is evidence of a renewed ‘risk-off’ positioning. Still, assuming the general path is similar, and the epidemic is successfully addressed, global growth should resume.
That said, keep in mind one HUGE caveat: No one has sufficient data to make informed investment decisions about the near term course of coronavirus or its ultimate impact on the economy and markets. Be safe, be diversified, and focus on those aspects of investing within your control. Let us know how we can help you navigate the challenging times.
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