A few highlights to hit before we dig into "market stuff" over the following few paragraphs. This last Friday, the Whitaker-Myers Wealth Managers Team traveled from near and far to enjoy an evening of BBQ, swimming, and awards to celebrate our success over the last year. Despite the tough market cycle of 2022, the Lord has blessed our firm, and we wanted to celebrate that and thank Him! To that end, we make sure everyone gets a fun Whittie Award (to play off the Dundies from the popular TV show The Office) but receiving special recognition this year were Kelly Kranstuber, Andrew Young, and Shelly Sturts, along with Sandy Whittlesey, who won our award dedicated to kindness and caring, named after her late husband, Jim Whittlesey. Here are a few of your favorite Advisors receiving their Whittie Awards:
The past few years are proof that market sentiment can turn on a dime. This year's strong market rally, with the S&P 500 rising 13% and the Nasdaq gaining 29%, has been driven by technology stocks, improving inflation, and the absence of a recession. While it may be too early to tell, some investors believe we are in the midst of a new bull market. However, with the Fed and other central banks signaling further rate hikes to return inflation to 2%, others are questioning the sustainability of this year's rally. For long-term investors, who should be less concerned by day-to-day market swings, what matters more than what we call this market period is the level of valuations and interest rates. What are these factors signaling about achieving financial goals in the coming years?
Valuations are no longer cheap after this year's rally
It's important to start by discussing why valuation measures matter to long-term investors. Simply put, valuations are the best tools that investors have to gauge the attractiveness of the stock market over years and decades. This contrasts with much shorter time frames during which global headlines, industry news, and company-specific events can dominate market movements. These concerns eventually settle and fade, leaving only traces of their impacts on asset prices, underlying fundamentals, or both. In this way, valuations are not market timing tools for making all-or-nothing investment decisions. Instead, valuation levels are an important input in determining appropriate asset allocations based on financial goals.
Unlike stock prices on their own, valuations don't just tell you how much something costs, but what you get for your money in terms of earnings, book value, cash flow, dividends, and other measures. After all, holding shares of a company means you are entitled to a portion of its profitability, so paying an appropriate price can improve the odds of future growth. Valuations are correlated with long-term portfolio returns for this reason - i.e., buying when the market is cheap can improve the chances of success, and buying when the market is relatively expensive can reduce future returns.
To a large extent, the reason this pattern exists is exactly because it is difficult to stay invested when markets fall and valuations are the most attractive. Just think about how most investors felt at the start of this year, or back in March 2020, or during 2008. When it comes down to it, staying patient is much easier said than done.
What do valuations tell us today? On the surface, broad stock market valuations are above both their recent lows and historic averages. The price-to-earnings ratio for the S&P 500 (based on next-twelve-month earnings) is 18.9x, well above the average of 15.6x since the mid-1980s. This metric only briefly fell to 15.3x during last year's bear market crash before rebounding immediately. These numbers are highly dependent on the market and economic cycle and can therefore fluctuate over time. For example, the average over the past decade has been considerably higher at 17.6x, making it more difficult to interpret these valuation metrics.
Tom Lee at Fundstrat, one of my favorite buy side analysts recently pointed out the worn out agruement that valuations are too high at 18.9x is foolish because when removing FAANG from the calculation, where you land is a 16.4x valuation, not horribly higher than long term averages. And one must consider, if these FAANG names do infact deserve higher valuations. They've proven a repeatable model to drive higher than average earnings, hence the dominance of large cap growth over the last six years.
Earnings growth has flatlined but is expected to pick up
A related question many investors may be facing is around the impact of higher interest rates on the market, since there are many ways in which rates and stocks are linked. Higher interest rates tend to slow the economy which then impacts company sales and profitability. Higher rates also reduce the value of cash flows far into the future, making highly uncertain businesses or those reliant on future growth less valuable, at least in theory.
Interest rates also impact stock prices directly through financial markets and investor preferences. When rates are higher, bonds become more attractive relative to stocks since they can generate more income. The resulting headwind on stocks can be interpreted as investors shifting their portfolios toward bonds, or equivalently that stock prices should adjust so that their "yields" rise to new levels.
The first chart above highlights this relationship by focusing on the earnings yield of the S&P 500, which is just the inverse of the P/E ratio. This measure tells us how much in corporate earnings an investor is "yielding" for every dollar they invest, allowing us to think of stocks in a bond-like way. Specifically, the S&P 500 has an earnings yield of 5.3% compared to 10-year Treasury bonds yielding 3.7%. The gap between these two measures - a gauge of the relative attractiveness of stocks over bonds, has fallen as interest rates have risen. This difference is now 1.5% compared to a historical average of 1.9%. Of course, stocks are not like bonds in that earnings are not guaranteed, but this comparison is still helpful.
On the surface, these measures suggest the market is no longer cheap, which is to be expected after this year's significant rallies. However, there are big caveats to the preceding discussion. One reason this may be harder to interpret today is that the market's earnings yield has worsened not only because stock prices have risen, but also because earnings expectations have been flat.
However, if the economy does avoid a recession and begins to accelerate, corporate earnings could also recover. This would boost earnings yields, making stocks more attractive again. Given that even the most negative economic forecasts expect only a shallow and short-lived recession, it may be important to not focus too much on near-term earnings outlooks when interpreting valuation measures. Also, longer-term interest rates have been more stable this year despite the possibility of further Fed rate hikes. This could improve the comparison between stocks and bonds over time as well.
Many sectors are more attractive than the broader market
Additionally, valuations are only expensive when considering the broad market and certain sectors. Many parts of the market still look quite attractive, especially if earnings do rebound over the next year. The accompanying chart highlights both the forward-looking P/E ratios across sectors in addition to consensus earnings growth projections. It's easy to see that there are significant differences beneath the surface of the market. Diversifying across many of these sectors, with an eye toward growth and valuations, could be increasingly important as economic uncertainty continues.
The bottom line? While valuations are not short-term market timing tools, they are among the most important metrics for constructing long run portfolios that include both stocks and bonds. This is especially true as earnings growth recovers and interest rates stabilize. Investors should focus more on valuations than day-to-day headlines in order to stay focused on their financial goals.
2023 WHITTIE AWARDS & HOW THE MARKET RALLY AND INTEREST RATES IMPACT VALUATIONS
July 9, 2023
Whitaker-Myers Wealth Managers is an SEC-registered investment adviser firm. The information presented is for educational purposes only and intended for a broad audience. The information does not intend to make an offer or solicitation to sell or purchase any specific securities, investments, or investment strategies. Investments involve risk and are not guaranteed. Whitaker-Myers Wealth Managers reasonably believes that this marketing does not include any false or misleading statements or omissions of facts regarding services, investment, or client experience. Whitaker-Myers Wealth Managers has a reasonable belief that the content will not cause an untrue or misleading implication regarding the adviser’s services, investments, or client experiences. Please refer to the firm’s ADV Part 2A for material risks disclosures.
Past performance of specific investment advice should not be relied upon without knowledge of certain circumstances of market events, the nature and timing of the investments, and relevant constraints of the investment. Whitaker-Myers Wealth Managers has presented information in a fair and balanced manner.
Whitaker-Myers Wealth Managers is not giving tax, legal or accounting advice, consult a professional tax or legal representative if needed.
Copyright (c) 2023 Clearnomics, Inc. and Whitaker-Myers Wealth Managers, LTD. All rights reserved. The information contained herein has been obtained from sources believed to be reliable, but is not necessarily complete and its accuracy cannot be guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness, or correctness of the information and opinions contained herein. The views and the other information provided are subject to change without notice. All reports posted on or via www.clearnomics.com or any affiliated websites, applications, or services are issued without regard to the specific investment objectives, financial situation, or particular needs of any specific recipient and are not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results. Company fundamentals and earnings may be mentioned occasionally, but should not be construed as a recommendation to buy, sell, or hold the company's stock. Predictions, forecasts, and estimates for any and all markets should not be construed as recommendations to buy, sell, or hold any security--including mutual funds, futures contracts, and exchange traded funds, or any similar instruments. The text, images, and other materials contained or displayed in this report are proprietary to Clearnomics, Inc. and constitute valuable intellectual property. All unauthorized reproduction or other use of material from Clearnomics, Inc. shall be deemed willful infringement(s) of this copyright and other proprietary and intellectual property rights, including but not limited to, rights of privacy. Clearnomics, Inc. expressly reserves all rights in connection with its intellectual property, including without limitation the right to block the transfer of its products and services and/or to track usage thereof, through electronic tracking technology, and all other lawful means, now known or hereafter devised. Clearnomics, Inc. reserves the right, without further notice, to pursue to the fullest extent allowed by the law any and all criminal and civil remedies for the violation of its rights.