We Don’t Need No Stinkin’ Valuation Metrics
2020 was a remarkable year, to say the least. As we begin 2021, we are faced with as many questions as we have answers. While the global pandemic caused economies to come to an abrupt halt in early 2020, we are now seeing some recovery, albeit tempered by recent spikes in infections. Financial markets, however, have recovered to new highs and are arguably at very rich valuation levels. Interest rates around the world have declined to where extracting income is nearly impossible. Central banks have provided nearly unlimited amounts of liquidity and that has found its way into propelling asset prices to record levels, such as we have recently seen with Bitcoin. The question on our minds is whether or not the markets are untethered from the economy to such a degree that investors should more actively seek shelter.
GDP growth for the first three quarters of 2020 was -5.0%, -31.4%, and 33.4%, respectively. Clearly, we are now in a recovery from the very sharp but short-lived recession. Simple arithmetic will tell you that we’re still a bit below where we began 2020, but we have recouped most of the losses. Also, given the magnitude of the recovery, it is almost impossible to forecast GDP growth with any accuracy, so investors are focused on direction, which is decidedly up. The markets, however, seem to be discounting not only a return to where we were but meaningful growth beyond that. No one knows how much pent-up demand there is in the economy and how much growth beyond what we should reasonably expect there will be. Are we entering our own version of the roaring ’20s? Time will tell.
Traditional measures show equity, Treasury, and some commodity markets are at levels where one could reasonably expect a meaningful correction, allowing valuations to better reflect expected economic growth. The equity market, in particular, is at valuation levels not seen since 2000 at the peak of the Internet bubble. Since hitting the low of 1.08% in late July, yields on investment grade bonds have consistently hovered near that level, so they too are at all-time lows. Non-investment grade bonds, on the other hand, have only recently reached record lows in yields but spreads are still well above where the market has peaked in the past. In fact, on a global basis both domestic and emerging market non-investment grade bonds have the highest spreads relative to other fixed income markets. Given what the alternatives are yielding, this is one of the few major asset classes offering a modicum of yield support, which could set the stage for continued inflows into the sector. This is why we still consider U.S. dollar-denominated high yield relatively attractive. In addition, in November there were more rising stars (bonds upgraded to investment grade) than fallen angels (bonds downgraded to non-investment grade) for the first time this year, showing that fundamentals are improving and lending some support to the market.
The Fed, along with other central banks, has provided massive liquidity injections, and while that raised confidence during the initial heat of the pandemic-induced selloff, it has also distorted yield curves and has made it very difficult for investors to determine the natural interest rate, especially at the short end of the curve. According to a recent Bloomberg article, aggregate money supply has increased by $14 trillion in 2020, a staggering amount. In the U.S. alone, money supply has grown by almost $4 trillion since March. This may explain why asset prices seem to have almost inexhaustible, albeit somewhat artificial demand.
Given that interest rates are an important input in determining equity valuations, if they are distorted by artificial means, does it follow that equity valuations are equally distorted? In a recent “Thoughts from the Frontline,” John Mauldin examines what he calls “fundamental madness” in a series of tables and charts showing that on almost every metric we are at peak valuations. While we may not have a sharp correction in our future given that the Fed and other central banks remain very constructive, we very likely may go through a period of stagnant returns until fundamentals catch up with the markets. This is especially true for high-quality fixed income as yields there are very low and effective durations very high. That said, the amount of bonds around the world yielding less than zero has risen to new highs so we may see flows into the U.S. market that could act as a buffer to any rising inflation or growth-induced selloffs.
Anecdotally, earnings seem to be on much more solid footing, especially for companies not directly affected by the pandemic. One important element of both GDP growth and earnings growth is productivity. After declining 0.3% in the first quarter, productivity has rebounded sharply since then, increasing 10.6% in the second quarter and 4.6% in the third quarter. We have not seen growth like this since 2009 and it should allow profit margins and earnings to continue growing for the foreseeable future. Household debt as a percentage of GDP stood at 77.5% on September 30. This is well below 97.7% reading in early 2008. Household net worth is at a record high now, but keep in mind that a good portion of this increase in wealth is due to the rise in financial asset prices. As you can see, the U.S. consumer is in pretty good shape “on average,” and we stress “on average.” There are sadly still large numbers who are not in great shape and those are the ones targeted by government relief bills, like the one recently signed. We should expect continued government and Fed support for both economic and corporate earnings growth. More widespread distribution of effective vaccines globally should also help free up pent-up demand especially for services that were hard-hit due to the pandemic.
Where does this leave us as investors in fixed income? We believe that a healthy dose of caution is not unreasonable here but also see encouraging signs of a more fulsome recovery ahead. With possible near-term headwinds, we feel it makes sense to de-risk portfolios a bit now and wait for better entry points. However, we feel there are still pockets of value in the fixed income markets where one can garner reasonable income from companies whose earnings are rising and whose balance sheets are improving. Convertible bonds have had a great year on balance. We feel it is prudent to take some money off the table there and look for better buying opportunities. This will come as no surprise to many of you, but we also feel having a healthy cash and short-term bond reserve is appropriate at this time.
We thank you for your continued support and welcome your comments and questions. Here’s to a much calmer and more measured 2021!
Carl Kaufman, Bradley Kane, Craig Manchuck
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Earnings growth is the actual or expected increase in profits over two comparable periods of time.
A basis point (bp) is a unit that is equal to 1/100th of 1%.
The S&P 500 Index is an unmanaged index that is widely regarded as the standard for measuring large-cap U.S. stock market
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The Bloomberg Barclays U.S. Corporate High Yield Bond Index measures the USD-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody’s, Fitch and S&P is Ba1/BB+/BB+ or below. Bonds from issuers with an emerging markets country of risk, based on Barclays EM country definition, are excluded.
Duration measures the sensitivity of a fixed income security’s price (or the aggregate market value of a portfolio of fixed income securities) to changes in interest rates. Fixed income securities with longer durations generally have more volatile prices than those of comparable quality with shorter durations.
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