It’s Got Us Scratching Our Heads
BY: JIM McELROY, CFA
For those unfamiliar with even the most rudimentary elements of baseball, a “fat pitch” is a toss from a pitcher that crosses the precise middle of home plate at just below the batter’s waist. It should be slow enough to see, but fast enough to assure the batter of a trajectory well into the cheap seats behind centerfield. It’s an easy home run.
Baseball metaphors become commonplace during the third quarter of the year when the major league season draws to an end (on September 29th) with the playoffs following in October. In our investment strategy meetings over the summer, the lament has been that there are no fat pitches for investors, no clearly undervalued asset class begging for a swing of the bat.
To be honest, there never are easy wins in an efficiently calibrated investment market. The efficient market hypothesis, at least in its strongest version, states that asset prices fully reflect all known information and, very likely, the probability weighted value of much future information. Profits can be made by accurately predicting the future and by purchasing (or selling) assets at prices which do not fully reflect future information or events.
In other words, know the future and how much of the future is already in the price. From this perspective, a “fat pitch” may be a relative term: it implies that a potential investor has a moderate degree of certainty about the future and a high level of clarity about current values. The current investment environment, however, does not have this kind of clarity and seems even more opaque than usual: it’s not just that the future is cloudy and particularly resistant to predictability, but that the present as well seems abnormally confusing.
In the U.S., interest rates for cash equivalents and bonds are at levels that once would have appeared unimaginable for an economy in its eleventh year of expansion. At present, the yields on U.S. Treasuries are all under 2% for everything but the longest maturities: 90-day T-Bills at 1.82%, 5-year Treasury Notes at 1.55%, 10-year Treasury Bonds at 1.67% and 30-year Treasury Bonds at 2.12%. Taken as a whole and excluding the ten years since the last recession (June 2009 to the present), the yields on these securities appear to be range-bound at the lowest levels of the post WWII period.
During the last ten years we’ve witnessed near zero rates on T-Bills, persistently inverted yield curves (short term rates higher than long term rates), Fed purchases of bonds and mortgages … and through it all, the economy has chugged along at an average 2% annual rate, unemployment has hit record lows and inflation has stubbornly remained below the Fed’s target rate of 2%. Normally, after ten years of expansion with record low unemployment levels, inflation would be heating up, interest rates would be rising and the Fed would be aggressively tightening monetary policy, possibly creating an inverted yield curve. We do, in fact, have an inverted yield curve, which is ordinarily a harbinger and, in many cases, a producer of recessions.
In an ordinary environment, now would appear to be the time to buy longer term government bonds in order to capture higher yields before the economy heads south and rates plummet. But with rates at ridiculously low levels, who wants to commit to longer term bonds and run the risk of missing higher rates at some point in the future? And it’s not as if an investor is getting paid to wait for that point in the future. It’s definitely not a “fat pitch”.
On the large cap equity side, the S&P 500 has advanced 18.7% since the beginning of 2019 and stands about 1.7% from the all-time high set this past July. In terms of history, the current bull market, which has lasted ten and a half years and gained 347%, is the second longest bull market since the Great Depression. The longest (from December 4, 1987 to March 24, 2000) lasted 12.3 years and gained 582.1%.
At current prices, the index sports a Price/Earnings (P/E) ratio of 18.1 times expected earnings, 19.6 times trailing earnings and a dividend yield of 1.89%. These valuations, though by no means extreme, do represent historically elevated levels: from 1989 to the present, the P/E multiple on expected earnings has averaged 16 times; since 1926, the P/E multiple on trailing earnings has averaged 14 times and the dividend yield has averaged 4.41%.
P/E ratios and dividend yields can provide insights over and above historical comparisons. Another way of looking at P/E ratios is to think of them as the number of years of no growth earnings that an investor purchases when he buys a stock or an index. One could even consider the multiple a “payback” in years on one’s original investment. For example, the above history of S&P 500 multiples on expected earnings from 1989 to the present (16 times, on average), could mean that investors for the last twenty years have been willing to accept a 16-year payback on their investment.
But, of course, only an investor in utility stocks expects a zero-growth rate in earnings. With growth, the payback in years on a P/E multiple becomes less than the stated P/E. At 16 times forecasted earnings, assuming an average annual earnings growth rate of 7%, which was the actual rate over this period, the average payback over this tumultuous time was about eleven years. Applying this quasi-logic to today’s equity market, which is trading at about 18 times forecasted earnings, an eleven-year payback would imply an average earnings growth rate of a little over 9% over the next eleven years.
A 9% average growth in earnings over the next eleven years is not an unreasonable assumption: it happened 18% of the time over the last almost twenty years (13 of 74 trailing 44 quarter periods). But it’s not a fat pitch. Corporate earnings are vulnerable to slowdowns and declines in overall economic activity. Although the U.S. economy is still robust — GDP growth over 2% for the last eleven quarters, unemployment at its lowest rates since the 1950s, the Consumer Price Index at only 1.76% over the last twelve months — there are questions about the durability of the current expansion.
While the U.S. at eleven years is enjoying its longest uninterrupted expansion since at least the end of WWII, the rest of the world is slowing and, in many cases, already in recession. Such a stark contrast between the U.S. and the rest of the world would not have been unusual in the years following the end of WWII, but now, in this age of global trading interrelationships, it appears very unusual.
The current administration’s brinksmanship in negotiations with China certainly increases our uncertainty about future growth: no one benefits from a trade war between the first and second largest economies in the world. And when one adds the chaos of Brexit — will the U.K. remain in the European Union, will it leave and, if it leaves (likely), will it do so with moderating agreements or none — the future for corporate profits could be dim.
When there are no fat pitches — there rarely are — then it’s wise to rely on diversification and asset allocation to achieve desirable returns at acceptable levels of risk. The stock market has been volatile of late, but it’s still within striking distance of its all-time high. If equity positions have been pushed above desirable levels, then it’s an excellent time to look at trimming back stocks to fit long term goals. And despite the paltriness of yields in fixed income securities, they do provide protection from volatility, particularly when invested in intermediate term securities. We are still positive on stocks: over the long term, they will provide the highest long-term growth.
We are cautious, but far from worried. If we see a sudden and sustained deterioration in the employment numbers, our consumer-oriented economy could be in trouble and the bull market in stocks could come to an end. Until then, if you’ll pardon the extended metaphor, we think there’s a possibility for extra innings, but likely with singles and doubles instead of homeruns.