During times of uncertainty, we think that having a definable investment management process is especially important to help navigate economic and market crosscurrents. Our Three Layers of Risk Management process continues to prove valuable in helping us gain clarity and perspective among the noise. As a reminder, our Three Layers includes a strategic, longer-term view coupled with our near-term tactical outlook, and overlayed with our proprietary Cash Indicator.
Starting with our strategic, first layer of risk management, many of the best forecasting tools for long term U.S. equity and fixed income returns are based on current valuations. For broad equity market forecasting, we prefer to use the current earnings yield, which is the inverse of the price-to-earnings ratio (P/E ratio). Similarly, the yield-to-worst is very helpful in forecasting core fixed income returns over time. As of June 30, the earnings yield of the S&P 500 Index was 4.69% compared to the yield-to-worst of the Bloomberg US Aggregate Bond Index of 4.81%.
There is very little difference between these two valuation measures at this time. Historically, the earnings yield for equities has been significantly higher than the yield on core bonds as equity investors previously required greater compensation for taking on additional risk. Yet, higher interest rates have pushed bond prices down to the most attractive levels we have seen in over 15 years. It appears that the combination of this year’s equity market rally along with increases in yield on core fixed income have pushed the difference between the core bond yield and equity earnings yield to near parity, which makes equities look very expensive. However, we think that a deeper dive is useful due to the very narrow stock market rally this year.
For example, since the start of this year, the S&P 500 Index, which is weighted by the market capitalization of each of its constituent stocks, has returned roughly 16.88% with dividends reinvested. However, the equally weighted version of the S&P 500 Index is up only around 7.02%. This is a reflection of the narrow market rally since the market capitalization weighted version of the same 500 companies has outperformed the equally weighted version due to the significant price appreciation of only a handful of very large U.S. companies. The vast majority of S&P 500 Index companies have appreciated relatively little or are even down over the first six months of this year.
Due to the rally in a very few large company stocks, the S&P 500 Index is trading at almost 20x expected earnings, while the equally weighted version of the same Index is trading at less than 17x the expected 12 months earnings. In fact, relative to the valuation of the equally weight Index, the valuation premium of the capitalization weighted Index is near the upper end of its historical range (exhibit 1). In summary, by investing in the same companies on an equally weighted basis rather than a capitalization weighted basis, investors can go from paying an premium on expected earnings to a discount.
Turning to the second layer of our Three Layers of Risk Management, our near-term tactical view remains cautious. Our caution is the result of a tightening U.S. Federal Reserve (Fed) policy and slowing economic growth. In isolation, tighter Fed policy in response to stronger than preferred inflation makes sense. Also, slowing economic growth after the booming post-pandemic recovery would be expected and not a concern. However, because the Fed continues to tighten, and their policy shifts take time to impact the real economy, we are concerned that the Fed has already gone too far.
We note that our long lead time economic indicators, which typically lead turns in the economy by approximately a year or so, began signaling last summer that we could see some economic challenges in the middle of 2023. More recently, our near-term leading economic indicators, which tend to lead the economy only by a few months, have been flashing cautionary signals as well. These near-term indicators include the increasing pace of layoffs along with the decline in temporary work services. Finally, the strong pace of economic growth since the pandemic recovery and the historically fast rate of inflation means that nearly all the excess liquidity (money) provided by the massive amounts of government stimulus that created so much demand for goods and services has been absorbed. Adjusting for inflation, the amount of excess money in the economy, as measured by M2, grew to over $1.4 trillion above its previous trend and has fallen to less than $280 billion currently (exhibit 2). At the current pace of decline, we expect any excess liquidity and savings that resulted from stimulus to be wiped out sometime this fall.
The declining amount of excess money in the economy should reduce inflationary pressures further as well as likely create additional challenges for the economy.
Given the equity market distortions and opportunities for bonds discussed above, we think that investors can pick up discounted investments in the U.S. equity market and complement them with safe yields in U.S. Treasuries to create a very attractive portfolio that can be more resilient to economic and market shocks while investing in that portfolio at a discount to recent valuations.
With our near-term leading economic indicators flashing cautionary signals, we now focus on our coincident indicators to judge the current health of the U.S. economy. There are many ways to measure growth and challenges to that growth in an economy the size of ours. Inspired by the work of the National Bureau of Economic Research (NBER), the organization responsible for dating U.S. business cycles, we have developed our Four Dimensions of Economic Health. In general, the NBER measures economic activity across four broad areas: employment, real (inflation-adjusted) personal income, real consumer spending, and industrial production.
Our Four Dimensions of Economic Health consolidates these concepts into one graphic that is focused on the measures that we find the most relevant. Exhibit 3 shows the year-over-year change in each dimension relative to their historical ranges. As you can see, real income has improved since July of 2022 due to persistent wage growth and falling inflation. In addition, employment trends remain healthy, but have weakened since last July. Meanwhile, industrial production growth has stagnated, and real retail sales have declined.
INVESTMENT IMPLICATIONS
Looking across our Four Dimensions of Economic Health, it is apparent that the U.S. economy is weaker than it was last year. With the Fed continuing to tighten, we expect more economic challenges ahead. These types of challenges have historically caused equity market volatility and a rally in Treasury bonds. As a result, we remain defensively positioned including a relative underweight to equity risk and overweight to U.S. Treasuries.
While our economic views clearly remain cautious in the near term, we are exceedingly optimistic over the longer term. Investors may be well served utilizing a disciplined investment management process, such as our Three Layers of Risk Management, that can potentially participate in the markets’ upside while offering protection from significant downside risks. Our work suggests that we should expect a very strong business cycle after the near-term malaise.
We expect this new, high quality business cycle to be driven by the growing U.S. labor force, one of the few labor forces within the developed world that is expanding, and an industrial renaissance as more and more companies bring production to North America. We anticipate spending the next several years writing about an American industrial renaissance as global trade continues to fracture and the significantly positive attributes of the U.S. economy shine even brighter.
THE CASH INDICATOR
The Cash Indicator (CI) continues to meander near low levels that suggest financial markets are overly complacent. We think that riskier stocks and bonds, especially those trading at lofty valuations, may be subject to significant downside risk over the months ahead. At this level, the CI confirms our more cautious stance.
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DISCLOSURES
Any forecasts, figures, opinions or investment techniques and strategies explained are Stringer Asset Management, LLC’s as of the date of publication. They are considered to be accurate at the time of writing, but no warranty of accuracy is given and no liability in respect to error or omission is accepted. They are subject to change without reference or notification. The views contained herein are not to be taken as advice or a recommendation to buy or sell any investment and the material should not be relied upon as containing sufficient information to support an investment decision. It should be noted that the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested.
Past performance and yield may not be a reliable guide to future performance. Current performance may be higher or lower than the performance quoted.
The securities identified and described may not represent all of the securities purchased, sold or recommended for client accounts. The reader should not assume that an investment in the securities identified was or will be profitable.
Data is provided by various sources and prepared by Stringer Asset Management, LLC and has not been verified or audited by an independent accountant.
Index Definitions:
S&P 500 Index – This Index is a capitalization-weighted index of 500 stocks. The Index is designed to measure performance of a broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
S&P 500 Equal-Weight Index – This Index is a capitalization-weighted index of 500 stocks. The Index includes the same constituents as the capitalization weighted S&P 500 Index, but each company in the S&P 500 EW is allocated a fixed weight + or -0.2% of the Index total at each quarterly rebalance.