Valuations, Investment, and Growth
A Year of Churn
In the past year, forecast earnings for S&P 500 companies are up just about 9%, slightly above the S&P 500’s 5% year-on-year advance. The S&P 500 earnings yield, or inverse of the price-earnings-ratio, now stands near 6.25%, up from 5.9% a year ago. By comparison, the S&P 500 earnings yield is 385 basis points (or 3.85%) higher than the 2.4% yield on the 10-year U.S. Treasury bond. A year ago, the S&P 500 earnings yield spread over Treasuries was about 290 basis points (2.9%), so today’s 385 basis point spread points to somewhat better valuations for stocks versus bonds following a year of churn.
Watching Domestic Trends Closely
The United States generated 2.9% real growth in output last year — solidly above our 2.5% long-run growth assumption. Steady final demand, solid job gains, rising investment, and improving productivity all helped. But lately, worries over trade have raised concerns that some of these pillars of support may soon start to weaken. In the last few months, retail sales and overall final demand by purchasers in the United States have slipped some. Automobile sales and housing are a little soft, too. A key pillar in our tactical asset allocation work is that the United States will continue to provide global growth leadership. It is, therefore, important that we pay close attention to dynamics right here at home.
Business Investment Remains Key
To this end, we are going to pay close attention to this week’s durable goods report for clues about an important type of spending — business investment. The capital goods orders component (chart, below) is especially noteworthy since orders for these items are forward looking and reflect investment by business. Blast furnaces, tools, robotics, and other long-lived equipment used in the production process are expensive and are a good indicator of business investment confidence and production plans. When business investment spending is strong, growth in jobs and profits tend to follow. When such spending turns down, recessions often follow within 6-12 months (indicated by the grey areas in the chart below).
First quarter earnings reports, while good, revealed some information about capital spending plans. The Wall Street Journal reported on May 20, 2019 that the U.S. and China trade conflict was leading U.S. led company executives to curb investments. According to the article, capital spending was up just 3% in the first quarter for the 356 S&P 500 companies that had disclosed figures in quarterly regulatory filings through midday May 8. This was down from a 20% increase a year earlier. While 3% is still positive, further slippage in capital investment could undermine the growth outlook for the back half of this year and 2020.
Investments decisions made by firms are a very robust source of future economic growth. Such investments tend to trigger other investments by related firms and suppliers which, over time, tends to translate into higher worker productivity and growth. Over the long run, this dynamic is a powerful contributor to overall equity market returns and can also influence interest rates.
Given some improvement in our WCA Fundamental Conditions Barometer since the winter, we continue to maintain a slight tactical overweight to equities in CONQUEST portfolios. Slightly better relative equity valuations also raise slightly our expected long-run equity return.
For more on this, and other topics, we invite you to read our latest tactical asset allocation piece where we discuss how we are tactically allocating portfolios from both a long-run and short-term perspective.
Kevin Caron, CFA, Senior Portfolio Manager
Chad Morganlander, Senior Portfolio Manager
Matthew Battipaglia, Portfolio Manager
Steve Lerit, CFA, Client Portfolio Manager
Suzanne Ashley, Analyst
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.
The information contained herein has been prepared from sources believed to be reliable but is not guaranteed by us and is not a complete summary or statement of all available data, nor is it considered an offer to buy or sell any securities referred to herein. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation, or needs of individual investors. There is no guarantee that the figures or opinions forecasted in this report will be realized or achieved. Employees of Stifel, Nicolaus & Company, Incorporated or its affiliates may, at times, release written or oral commentary, technical analysis, or trading strategies that differ from the opinions expressed within. Past performance is no guarantee of future results. Indices are unmanaged, and you cannot invest directly in an index.
Asset allocation and diversification do not ensure a profit and may not protect against loss. There are special considerations associated with international investing, including the risk of currency fluctuations and political and economic events. Investing in emerging markets may involve greater risk and volatility than investing in more developed countries. Due to their narrow focus, sector-based investments typically exhibit greater volatility. Small company stocks are typically more volatile and carry additional risks, since smaller companies generally are not as well established as larger companies. Property values can fall due to environmental, economic, or other reasons, and changes in interest rates can negatively impact the performance of real estate companies. When investing in bonds, it is important to note that as interest rates rise, bond prices will fall. High-yield bonds have greater credit risk than higher-quality bonds. The risk of loss in trading commodities and futures can be substantial. You should therefore carefully consider whether such trading is suitable for you in light of your financial condition. The high degree of leverage that is often obtainable in commodity trading can work against you as well as for you. The use of leverage can lead to large losses as well as gains.
All investments involve risk, including loss of principal, and there is no guarantee that investment objectives will be met. It is important to review your investment objectives, risk tolerance and liquidity needs before choosing an investment style or manager. Equity investments are subject generally to market, market sector, market liquidity, issuer, and investment style risks, among other factors to varying degrees. Fixed Income investments are subject to market, market liquidity, issuer, investment style, interest rate, credit quality, and call risks, among other factors to varying degrees.
This commentary often expresses opinions about the direction of market, investment sector and other trends. The opinions should not be considered predictions of future results. The information contained in this report is based on sources believed to be reliable, but is not guaranteed and not necessarily complete.
Washington Crossing Advisors LLC is a wholly owned subsidiary and affiliated SEC Registered Investment Adviser of Stifel Financial Corp (NYSE: SF).