Written by Nathan White, Chief Investment Officer
As the year has progressed, we’ve voiced concerns about both the bond and stock markets — and the need to stay flexible. We have moved our portfolios into a more defensive stance to protect against the current risks and to take advantage of any increases in volatility. While we are not outright bearish, we are seeing signs for caution.
Our investment strategy is a dual-model approach that uses various models to determine what assets to invest in and what our overall exposure to those assets should be. We analyze investments in a risk/reward framework that seeks to diversify by strategy in addition to traditional asset class diversification. Our focus on risk management is a crucial element in creating the robust portfolios our clients want.
The inputs we use on the models, which determine our overall exposure to the markets, cover a variety of factors. These include economic, valuation, monetary, market internals and sentiment factors.
The economic factors we use cover a wide range of measures that assess the current and future strength of the economy. They include measures such as the Leading Economic Indicators (LEI), which is comprised of 10 components designed to signal peaks and troughs in the business cycle. The U.S. LEI increased sharply in May after a somewhat weaker first quarter, indicating that the economy is returning back to a moderate growth trajectory for the second half of the year. The employment picture looks good as the economy has been enjoying full employment and climbing wages. Other key economic indicators have been weaker than expected, again confirming a rebound back to the range of 2.5 percent GDP growth. However, the continued pace of moderate economic growth should keep inflation below 2 percent. Overall, economic growth is mildly bullish as it is neither too strong nor too weak.
The valuation factors we follow are signaling caution. While valuation is not a favored timing method from our point of view, we do like to use it in context to help gauge risk. High valuations can be risky, as they indicate good news (which is then reflected in prices). Any disappointment can lead to painful readjustment, similar to what occurred after the tech boom in the late ‘90s. However, stocks can stay overvalued and undervalued for long periods of time, making valuations a difficult timing measure for stocks. The S&P 500 is currently trading with a price/earnings (P/E) multiple of about 19 times trailing earnings. Historically, this is on the high side, but not extremely so as the average is around 16 to 17. Low interest rates are also a boost to higher valuation levels as they support lower costs of capital for companies.
Going forward, with interest rates at rock-bottom levels, it can be difficult to support high valuation levels without an increase in economic growth and corporate profits. Since 1981, the median P/E for stocks has been 19.3 and the current reading is 24.9 (source: NDR as of 5/31/2015). This means that valuations are higher across the board today, relative to a narrower index such as the S&P 500. Profit margins are also at the high end, as companies have been become efficient at lowering costs to boost profits over the past six years. To grow from this point, companies will have to add capacity, which increases costs.
In fact, some of the most overvalued areas of the market are in areas usually thought of as the safest — the highest dividend yielders. High valuations are often associated with fast-growing companies like high-flying tech companies. While that’s probably true in the case of social media and biotech companies, it is interesting that what is generally a more conservative area is now an expensive one. The median forward P/E of the S&P 500 dividend high yielders is 17.33, compared to an average of about 12 since 1983. The cause for overvaluation in this area is the Federal Reserve’s unprecedented zero-interest-rate policy. With interest rates so low, investors have been driving up the prices of dividend yielding stocks. We have been very cautious of the risk of bonds and bond-like proxies such as these. With rates so low — and now set to rise — these areas have ironically become some of the riskiest areas for investors. Since the financial crisis, we have seen many investors in the search for safety and income buying stocks based upon the “stated” yield (i.e. yield chasers). At these valuations, it doesn’t take much movement to wipe out a 2 to 4 percent yearly dividend — something that could be realized in the next few years by holders of these stocks.
Monetary factors such as the level of nominal and real interest rates and overall Central Bank policy are also inputs of our models. Overall, the monetary factors we follow are neutral. While the Fed has ended its massive Quantitative Easing program and is set to raise interest rates as early as September, it is still accommodative overall. The Fed has made it clear that the path of interest rate increases will be low and slow. They have also not given a timetable for when they will start to unwind their massive balance sheet. The Fed says it will be data dependent, but every time the criteria has been met, they have come up with a new metric and put off increasing rates.
I have likened the current state of the markets to an adjustment period ahead of the Fed’s normalization of rates and the current stage of the economic cycle. Equities could continue to be range bound as markets price in the factors discussed above, in addition to the Greece/European issues. At this point, stocks are boxed in because if economic growth accelerates, it will aggravate cost pressures and interest rates, thereby capping profit growth. Conversely, if economic growth gets weaker and the Fed holds off on rate hikes, sales will be inadequate to drive earnings growth. At this point, easy choices are a thing of the past, so we are avoiding an all-in or all-out approach. We are prepared for more volatility and hope to take advantage of the coming opportunities.