The Bull Run
The average American household’s net worth soared to $885,000 last year, 65% higher than a decade ago, according to data from the Federal Reserve and Census Bureau1. Much of the gain came from financial markets where both stocks and bonds surged. Conditions seem supportive for further gains, but valuations are looking full. Even though fundamentals look good, returns in the future should be lower because stock and bond yields sit at historic lows and because markets are already expecting good news.
Rise of Liquidity
Other than a small decline last week on coronavirus concerns, stocks have been quiet. When central banks turned more accommodative a year ago, stock and bond markets began a tear. The Federal Reserve cut interest rates and began to expand its balance sheet, providing support to the market. Facing low or negative interest rates, global investors sought returns elsewhere. Stocks and bonds in the United States proved to be beneficiaries of the worldwide appetite for return.
Another example that shows that liquidity is abundant is the lack of nervousness in interbank markets. A measure of interbank risk, called the St. Louis Financial Stress Index, hit a post-recession low a week ago. All-in-all, markets have been supported by a rising tide of liquidity. As it now stands, markets expect central banks to remain accommodative through the balance of the year.
Record Low Yields
Even though liquidity is abundant, returns in the future should be lower because stock and bond yields sit at historic lows. The dividend yield on the S&P 500, an index of large-capitalization U.S. stocks, is now at a fresh cycle low, below 1.8%. Similarly, 10-year U.S. Treasury yields are at 1.7%, and credit spreads are below average (the Moody’s Baa / 10-year Treasury spread is 2.2% versus a post-2009 average of 2.7%. No matter how you look at this, valuations across-the-board, from stocks to bonds, are elevated. Therefore, we think it is essential to keep return expectations from here reasonable.
Markets have been generous over the past decade. The average annualized return on a simple 60% stock (S&P 500) and 40% bond (Barclays Aggregate Bond Index, a proxy for the broad U.S. bond market) is 9.3% through this writing. This performance is not quite as high as the 1990s bull market, but it is getting close. It is also higher than our forecast range for returns going forward (chart, below). Rational and mean-reverting markets are basic tenants of investing and we factor this into our forecasts.
The most basic reason returns in the future should be lower is because markets might be pricing perfection. The last year’s rally, plunge in volatility, and elevated valuations point to bullish expectations. Market cooperation, along with easing trade tensions and accommodative central banks, could lead to a global growth pickup ahead. Analysts expect a 9.5% gain in S&P 500 profits this year, far better than the 2% decline in 2019. Given that earnings forecasts tend to fall throughout the year, we expect today’s expectations to fade some.
So it is clear that although liquidity is abundant and profits are high, returns in the future should be lower for two main reasons. First, stock and bond yields sit at historic lows. But most importantly, markets are already expecting positive developments ahead as central banks remain accommodative, and earnings gains are already in most analyst forecasts.
Indeed, the rise in household wealth to records is unprecedented and extraordinary. Extrapolating these returns into the future, however, is probably not such a good idea now.
What to do from here?
1) Look for consistent businesses with low debt.
2) Prefer companies with steady dividend increases.
3) Avoid the temptation to chase yield.
In short, focus on quality.
Kevin Caron, CFA, Senior Portfolio Manager
Chad Morganlander, Senior Portfolio Manager
Matthew Battipaglia, Portfolio Manager
Steve Lerit, CFA, Client Portfolio Manager
Suzanne Ashley, Analyst
1 This should not be confused with median net worth which was recently reported as being near $97,000 per household.
WCA Fundamental Conditions Barometer Description: We regularly assess changes in fundamental conditions to help guide near-term asset allocation decisions. The analysis incorporates approximately 30 forward-looking indicators in categories ranging from Credit and Capital Markets to U.S. Economic Conditions and Foreign Conditions. From each category of data, we create three diffusion-style sub-indices that measure the trends in the underlying data. Sustained improvement that is spread across a wide variety of observations will produce index readings above 50 (potentially favoring stocks), while readings below 50 would indicate potential deterioration (potentially favoring bonds). The WCA Fundamental Conditions Index combines the three underlying categories into a single summary measure. This measure can be thought of as a “barometer” for changes in fundamental conditions.
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