Knowing what you know now, if you had to relive it, would you buy stocks in January 1999? Sounds like a simple question. With perfect hindsight, how could you lose? But the answer isn’t quite so obvious. Two hallmarks characterized 1999: It was both a great year for stocks and the beginning of the end for stocks. That year, the S&P 500®,1 STOXX Europe 600,2 and MSCI Emerging Markets Index3 rallied 19.5%, 31.9%, and 63.7%, respectively (in price terms only). Global equities, as measured by the MSCI World Index,4 gained 25.9% from the end of 1998 through their peak in late March 2000. By February of 2001, all those gains had been wiped out. In the ensuing seven months, global equity prices collapsed another 25%. It all fell apart so fast.
Now, let’s return to reality. Perfect hindsight may exist, but perfect foresight does not. Market timing is a fool’s errand. I can’t do it (that’s confession #1) – and I’m pretty sure no one else can either. Stocks have had a fantastic run, and by most metrics, look rather expensive. So we return to 1999: Do you ride the rally for as long as it lasts or do you scale back equity risk now and leave the remaining upside – however much that may be – to braver souls? It’s a classic game of chicken. When do you swerve?
Riding the Bull
The bull case right now is fairly straightforward. First, major central banks are likely to keep interest rates low and to supply nearly unlimited liquidity for the rest of 2020, if not longer. This simplifies to the old adage, “Don’t fight the Fed” – or the European Central Bank (ECB), Bank of Japan, or Bank of England for that matter. Second, as a byproduct of central banks continuing to suppress rates, bond yields offer little competition for equity earnings and dividends. Say hello to TINA – “there is no alternative” – she is quite seductive. For many institutional investors, the low yields on high quality bonds simply won’t get it done, so the bid to equities (including private equity) is relentless. Third, the market has had a nice run, and momentum (“Big Mo”) can be powerful. This of course will revive investor FOMO – the “fear of missing out” on further gains. Fourth, the fundamentals appear solid. Recession fears have receded and the recent signing of both the US/China Phase One trade deal and the US/Mexico/Canada agreement should support global growth. On the back of this optimism, earnings growth is expected to be positive, if unspectacular – mid-to-high single digits for the S&P 500®, for example. We’ll decompose this later.
Finally, a great bull case always needs to overcome the best bear case, which for now is that stocks are both extremely expensive and “overbought.” Bulls will rightly point out that valuation is a poor timing tool. Confession #2: Even as a dyed-in-the-wool value proponent, this is hard to argue with. History shows that in the short run, cheap stocks can always get cheaper and expensive stocks can always get more expensive. Confession #3: For as much as I balk at current valuations, my guess is that stocks continue to move higher in the near term. (Remember that in the near term, we’re all guessing.)
Upside vs. Downside
So if the base case for global equities to move higher is so strong, why should investors remain cautious? Largely because the risk/return tradeoff is so poor. More specifically, the future return prospects appear significantly skewed. Current market dynamics show that the potential for outsized gains is somewhat limited, while the potential for outsized losses is not.
We can illustrate this by a simple decomposition of gain/loss where returns are derived from revenue growth, profit margins (which combine into earnings growth), and price-to-earnings (P/E) multiples.5 We are most optimistic on revenue growth. While bottom-up estimates vary, S&P 500® revenues are expected to grow around 5% to 6% in 2020. Given the International Monetary Fund’s 2020 outlook for global growth at 3.3% and adding back inflation (revenues are a nominal concept), this estimate for revenue growth seems reasonable. Most importantly, the upside vs. downside around that base estimate appears fairly symmetric if economic activity were to be stronger or weaker.
However, when we convert revenue growth to earnings growth via profit margins, the symmetry changes. Using monthly data for the S&P 500® going back 30 years, operating profit margins just under 13% would register in the 70th percentile. Gross margins near 33% would rank in the 84th percentile. Elevated, but not extreme. To be clear, we aren’t forecasting a decline in profit margins – although they have been deteriorating in the past year. We simply note that margins have much more room to shrink if the economy deteriorates than they have to expand if the economy gains more steam. So while our base case for earnings is mid-to-high single digits, the risk is skewed to the downside due to relatively high profit margins.
More worrisome are valuations. Again, using Bloomberg data since January 1990, the S&P 500® trades at 19.1x forward earnings. This metric ranks in the 81st percentile, meaning stocks have only been more expensive about 19% of the time over the last 30 years. Pricey to be sure, but not exorbitant.
However, this is a bit misleading. Most of the time the index spent above this valuation occurred in what we can now recognize as a massive market bubble, 1998 to 2001. Excluding those bubbly days, S&P 500® valuations have topped around 19x–20x, bottomed near 12x–13x, and averaged near 16x. Given the power of TINA, Big Mo, and FOMO, we have little doubt that multiples could continue to expand another 1x to 2x. However, a return to merely average valuations would cut three turns off the P/E ratio, while a real market panic could reduce the multiple by 6x. Using the forward multiple alone, we see that the ratio of downside risk to upside potential is somewhere between 2:1 and 3:1. Those ratios would be skewed even more to the downside if we included likely profit margin effects; that is, lower earnings combined with lower P/Es. In the end, the upside is modest and the margin of safety is thin.
S&P 500: Only More Expensive in the Bubble Years
Source: Bloomberg, Natixis Investment Strategies Group, January 1990 – January 2020 (monthly, latest as of 1/17/20).
Two final points about the asymmetry of risk today. First, we have focused on US stocks as measured by the S&P 500®. A quick review of other non-US developed and emerging markets also illustrates elevated valuations, but not to the same degree. We view stocks outside the US as considerably less vulnerable to this upside/downside math.
Second, the arithmetic in the credit markets is also challenging. We estimated the percentile rank of US and European investment grade and high yield debt along with hard-currency emerging markets using spread data going back nearly 20 years. In all cases, spreads rank between the 70th and 90th percentile. Expensive, but not absurd. To be clear, given that economic growth appears positive and reasonably stable, we do not expect credit spreads to widen significantly. They may even tighten a bit, given the alternative is punitive, super-low sovereign yields. (We’ve already introduced TINA.)
However, as with US equities, our concern lies in the outlier scenarios. At current levels, spreads have far more room to widen if growth falters or the credit cycle turns than they do to tighten if the economy picks up.
So to reiterate, our base case is that growth remains solid while TINA, Big Mo, and FOMO keep P/Es elevated and credit spreads tight. Party on.
But looking only at the most likely scenario doesn’t tell the whole story. Daily life is full of examples where we consider the consequences of an action and justifiably behave more cautiously than our base case would imply. On your walk home from work, you avoid a neighborhood known for criminal activity. You’d probably be fine (base case), but saving a few minutes getting home isn’t worth the (less likely) risk of being robbed. Perhaps your favorite football team is a bit better than their rival this week. At even money, that’s a good bet, but at odds of 3/1 on, the reward simply isn’t worth the risk, even though you believe your team will win. Yes, the base case is important, but the risks and the rewards of the tails matter too.
Like the everyday calculus above, I too am discounting my base case. While I see no obvious reason why the gains in risky assets shouldn’t continue, I must confess (#4), I am reluctant to bet on that view. Few if any of us can call the top, and buying expensive assets and betting that they will continue to get more expensive is a dangerous game. It may work for a while, as it did in the late 1990s, and then it won’t.
Every investor has unique circumstances and risk tolerance. Some investors will be happy to ride the bull for as long as it lasts, expecting, or hoping, they’ll know when to get out. For other investors, gradually scaling back risk may be more appropriate. Leaving some upside on the table may be a more forgivable sin than getting aggressive when there is too little margin of safety.
2 The STOXX® Europe 600 Index is derived from the STOXX® Europe Total Market Index (TMI) and is a subset of the STOXX® Global 1800 Index. With a fixed number of 600 components, the STOXX® Europe 600 Index represents large, mid and small capitalization companies across 18 countries of the European region: Austria, Belgium, Czech Republic, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the United Kingdom.
3 MSCI Emerging Markets Index is an unmanaged index that is designed to measure the equity market performance of emerging markets.
4 MSCI World Index (Net) is an unmanaged index that is designed to measure the equity market performance of developed markets. It is composed of common stocks of companies representative of the market structure of developed market countries in North America, Europe, and the Asia/Pacific Region. The index is calculated without dividends, with net or with gross dividends reinvested, in both US dollars and local currencies.
5 The price-earnings ratio (P/E) or price-earnings multiple is the current market price of a company share divided by the earnings per share of the company.
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