By Robert Serenbetz, Multi-Asset Solutions Team for New York Life Investments
Equity markets have steadily moved higher since January 2019, despite several headwinds. Even as economic and profit growth slow, neither the threat of war nor epidemics, have been able to dampen investor sentiment.
By our calculation, U.S. equity valuations are expensive. And, investors today are willing to pay around $22 for a dollar of corporate earnings — one of the highest prices of this expansion. Perhaps investors are optimistic that the future economic environment will be better than today; over time, accommodative monetary policy and reduced concern about coronavirus or trade wars could result in a real improvement in the economy and lead to a turnaround in corporate profits.
Or perhaps traditional equity valuation metrics no longer apply. For much of this economic expansion, and its accompanying bull market, traditional valuation metrics have not served as a useful signal for fundamental investors. Equity multiples, volatility signals, credit spreads, currency forwards, and risk premia metrics have effectively broken down. Instead of following those fundamentals, the market focuses on interest rates and liquidity conditions.
This valuation disconnect does not have to be feared in its entirety, but it does tend to obscure the valuation process. For instance, lower average interest rates mean that equity multiples can be higher on average and credit spreads lower. However, the disconnect in valuation introduces new risks. Lower rates and lower growth expectations have reduced return assumptions and pushed investors to buy riskier assets despite muted prospects for sustainable profit growth.
Signals from U.S. equity valuations differ
Sources: New York Life Investments Multi-Asset Solutions, IBES, S&P, Wilshire, U.S. Bureau of Economic Analysis, Schiller, Bloomberg, 11/18/19. Opinions of the Multi-Asset Solutions team.
Identifying value has become more challenging
For long-term investors, high valuations matter. Very few indicators have much luck predicting investor returns over the short term, but valuations are one of the single best indications for investor expectations over the next decade or so.
As a result, it is appropriate for most investors to focus on portfolio resiliency. There is more than one way to achieve a resilient portfolio. We recommend focusing on a combination of:
- Relying on more than just “prices going up” to add value: In equities, that means consistent dividend growth from companies with solid cash flows. And in fixed income, that means diligent credit research to avoid defaults. The combination offers a stable driver of long-term returns.
- Diversifying sources of exposure: Bouts of higher volatility and correlations between asset classes can make it particularly difficult to achieve investment objectives. Investors may benefit from expanding their portfolio into real assets, real estate, and municipal bonds
- Being creative in your review of valuations. Consider a more selective approach to allocating across risky assets, paying close attention to profits, factors, styles, and geographies.
A typical economic slowdown would favor removing risk exposure, included in equities. High absolute valuations would support that tactic, but relative valuations suggest that risk may still be better rewarded in equities than in corporate credit or government bonds. For the near term, investor sentiment and liquidity will drive markets. Still, today’s valuation levels suggest that downside risk is building.
For most investors, we believe it is appropriate to manage portfolio risk by gradually moving toward a more defensive posture—focusing on generating income across asset classes. Within equities, we like large caps and high-quality companies, as well as international and emerging equities should global growth accelerate in the next six months since they offer more upside potential given their cheaper relative valuations and leverage to international revenues.
|Asset Class vs. US Large Cap||Valuations||View|
|Small Caps||Small caps trade very expensive on absolute and relative basis. (Top decile)||Future profit growth for small caps is extremely optimistic. Heavy debt burden, low profitability levels, and less pricing power make these assets more vulnerable to late cycle dynamics.|
|International Developed Equity||Cheap on a relative and absolute basis||Differences in sector composition and growth differentials contribute to valuation premia – however a greater weight to cyclical industries could lead to temporary outperformance.|
|Emerging Market Equity||Neutral valuation||Emerging market company profits poised to rise on any improvement in Chinese growth prospects.|
|US Aggregate Bonds||Expensive||Investment grade bonds and sovereign debt is very expensive on a historical basis and relative to equity.|
|High Yield Bonds||Expensive||Despite some spread widening in the riskiest of credits, junk bonds do not reward investor risk.|
|Leveraged Loans||Expensive||Leveraged loans trade at within top 5% of historical valuation level.|
Opinions of NYLI Multi-Asset Solutions Team. As of 2/7/2020.
This material represents an assessment of the market environment as at a specific date; is subject to change; and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any issuer or security in particular.
The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective.
This material contains general information only and does not take into account an individual’s financial circumstances. This information should not be relied upon as a primary basis for an investment decision. Rather, an assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial advisor before making an investment decision.
“New York Life Investments” is both a service mark, and the common trade name, of the investment advisors affiliated with New York Life Insurance Company.