5-Minute Huddle: Overvalued or Overconcentrated?

May 18, 2020

By Justin Pawl, CFA, CAIA, CFP®


In this week’s edition:

  • Last Week Today.  Economic, market, and other events that moved markets.
  • Have and Have Nots.  Municipal bond markets are increasingly pricing in risks from the Great Lockdown.
  • Overvalued or Overconcentrated.  A different perspective on valuations of U.S. vs. international stocks.

Last Week Today.  The Fed waded into domestic equity markets, and further into uncharted territory, buying $305 million of corporate bond ETFs through its Secondary Market Corporate Credit Facility announced in late March.  |  Fed Chair Powell reiterated that rates will remain at the zero bound indefinitely and that his Fed will not take rates negative (of course, he could be replaced in 2022 when his term ends with someone who views negative interest rates as the “gift” that President Trump sees). | The House approved a new $3 trillion stimulus plan (matching the $3 trillion already approved), but the Senate is signaling the bill will be DOA.  |  U.S. tensions with China flared up as the Commerce Department limited Huawei Technologies’ access to U.S. semiconductor technology, the Trump administration ordered the federal employee retirement fund to avoid investing in an index that includes Chinese corporations, and President Trump said “The trade deal, I don’t know.  Somehow, I lost a little flavor for it.”

In contrast to prior weeks, financial markets were unable to shake-off more unprecedented bad economic data. A quick rundown:

  • April’s Core Consumer Price Index fell by 0.45%, the biggest one month decline on record.  Over the last two-months, year-on-year core inflation has tumbled as much as in the sharpest six-month drop in 2009.
  • Another 3 million people filed for unemployment last week, above the consensus estimate of 2.5 million.  Since the Great Lockdown began in earnest on March 15th, 36.5 million people have filed for unemployment insurance.
  • Retail sales posted the largest decline in history, falling 21.6% year-over-year, with apparel sales declining 89.3% (see chart below).  The only positive retail sales categories are grocery stores and online shopping.
  • During a speech on Wednesday in D.C., Fed Chair Powell communicated that the road to recovery will be long, irregular, and difficult.

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Source: FHN Financial and the Bureau of the Census.

The rhetoric with China in concert with the reality of the pandemic’s impact on the economy, cast a negative tone on investor sentiment.  The S&P 500 fell -2.3%, and the MSCI All Country World Index declined by -2.6%.  Commiserating with equities, bond investors continue to forecast low inflation and low growth, with the yield on 10-year US Treasury bonds falling to 0.64% and 30-year bonds to 1.33%.  For detailed weekly, month-to-date, and year-to-date asset class performance, please click on the table below.

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Have and Have Nots.  Pandemic risk is now increasingly pricing into municipal bonds, one of the safer asset classes, long favored by retirees.  Last week Utah, a state with the highest credit rating of AAA, issued bonds maturing it 2025 with an annual yield of just 0.75%.   Illinois, on the other hand, is a state whose credit quality is on the precipice of being downgraded to junk.  Illinois also issued 2025 maturity bonds last week but had to offer a 5.6% yield to get the deal done.  The nearly 7.5x difference in yield demanded by the market between a high-credit quality state and a low-credit quality state is indicative of investors’ increasingly pricing in different risks for states whose revenue has been slashed by the Great Lockdown.  Longer term, states forced to pay higher interest rates for today’s borrowing will drag on future growth locally.  Those states will need to levy higher taxes making the states less attractive to new businesses and even current residents, creating a vicious cycle with no easy solution.  In contrast, states with sturdy finances can benefit along with investors in their debt.  The Bloomberg Barclays indexes indicate that AAA credit muni bonds are poised to outperform high-yield debt by the most since 2008.

Overvalued or Overconcentrated?  Even as the market declined last week, or perhaps because of it, financial media fervently covered statements that U.S. equity markets are over-valued from investment legends Stanley Druckenmiller and David Tepper.  Thanks to some thoughtful work by Kevin O’Malley at Chatham Asset Management, perceptions of broad-based over-valuation are skewed by what he refers to as the Six Wonders of the world: Facebook, Apple, Amazon, Alphabet (aka Google), Netflix, and Microsoft.  The first chart below, grabbed my attention because earnings from these six stocks have handily outpaced that of the S&P 500, and when stripped out, earnings for U.S. companies is pretty similar to that of the rest of the world.

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Source: Chatham Asset Management

Investors have rewarded these companies for their faster earnings growth with higher stock prices.  Since equity indexes like the S&P 500 are capitalization weighted, companies with higher market capitalizations (= total number of stock outstanding multiplied by the stock price) have the most significant impact on the price of the index. Based on several measures, these companies comprise the highest percentage of S&P 500 capitalization than any six companies in history, leading some to believe a day of reckoning is coming.  That may be the case, but what is the appropriate price to pay for companies with high relative earnings capacity in normal times, and exceedingly higher relative earnings when the world is attempting to come back from a pandemic?  I can’t answer that question, but there are plenty of opinions on the topic.  Nonetheless, what happens if you exclude the Six Wonders from the S&P 500’s market valuation?

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Source: Chatham Asset Management

Ex-the Six Wonders, the S&P 500 isn’t cheap, especially when earnings forecasts are less reliable than at any point in recent history.  However, compared to a forward Price to Earnings (PE) multiple of 24.6, including the FAAANM stocks, the sub-20 PE multiple ex-FAAANM doesn’t look as lofty (although the variance between earnings levels and valuation levels argue that international stocks represent a better value than U.S. stocks).  Of course, this type of analysis is too nuanced for the financial media outlets to discuss.  Nor are they incentivized to do so.  It lacks the salacious, viewer-grabbing headline of quoting Mr. Tepper that the stock market is the “second-most overvalued” he’s ever seen. It’s also worth keeping in mind that investment luminaries who agree to television interviews aren’t necessarily doing the interviews out of the goodness of their hearts.  These individuals often have investment positions on in the market, and they are merely “talking their book.”  That is, it’s not unheard of (nor illegal) for investors to use the media megaphone to broadcast ideas that help their investment positions.

All of this is not to say that in the next decade U.S. equity markets will offer the same 13.5% annualized returns (including dividends) they generously provided last decade.  Likely, the returns will be lower due to demographic trends, high debt levels, reduced corporate stock buybacks, etc.  Heck, various parts of the country are just beginning to open for business, and the road to recovery is likely to be longer than most people expect — in China, restaurants have been open for a couple of months now, and sales are still only about half of what they were pre-COVID 19.  The U.S. economy will return to full-speed after a period of time, but over the next year (at least, unless an effective vaccine is discovered) investor sentiment will swing back and forth like people’s heads watching a tennis match.  Market volatility will remain a theme.  Hence, it’s essential to develop an investment plan and stick with it to take advantage of pockets of opportunity and not be shaken out of the market at inopportune times.

Be well,

Justin