Even though stocks should rise over time, we think the pace of the market rally is set to slow because extraordinary government supports for the economy are set to fade, and valuations have run ahead of fundamentals.

Changing Tack

It is hard to bet against stocks for the long-term. Since the 1920s, stocks have produced a positive return every 20 years based on S&P 500 annual returns. Stocks tend to beat bonds and cash over time, supporting the idea that markets tend to reward risk.

But this fact obscures the reality that stock investing also involves periodic drops. Not everyone has twenty years or more to ride out a demanding environment. Because of these facts, it can pay for some to take a more tactical investing approach. This means focusing some attention on changes in the economy, considering valuations, and attempting to spot trends as they develop.

To this end, we have adjusted our tactical positioning. Here is the CONQUEST tactical positioning in a nutshell.

CONQUEST Tactical Positioning

  1. Safe harbors, including gold and long-term Treasury bonds, seem expensive unless the economy turns for the worse. Since this is not our call presently, these assets offer little appeal at today’s prices and we are underweight these assets.
  2. Long under-performing areas, including foreign and value sectors, appear cheap and seem to be showing some signs of life, prompting small tactical over-weights.
  3. Meanwhile, we recently closed the long-held overweight position in gold and favor higher-yielding corporate bonds and REITs within the alternatives space.
  4. Among sectors, we now tilt toward consumer durables, healthcare, and staples and away from technology, energy, and utilities.
  5. Underlying these changes of tack remains the expectation that stocks should still outperform bonds longer-term, but elevated stock valuations and low bond yields could make generating returns harder from here for buy-and-hold investors.

This challenge is the main reason why we think a tactical approach to managing a portfolio could be especially sensible today.

Pace of Gains to Slow

Even though stocks should rise over time, the market’s recent ferocious rally appears set to slow because support for the economy is now ratcheting down. Consider that, since March 23, 2020, when the Federal Reserve announced a large-scale expansion of quantitative easing, the stock market began a 60% rally. Further, consider that Congress passed the CARES Act shortly after that, injecting trillions of dollars into the economy. The punch of full-throttle monetary and fiscal policy is mainly responsible for igniting this year’s spring-summer rally.

But Congress’ appetite for unlimited spending now seems to be fading. To finance jobless benefits, support businesses, and to fight the pandemic, borrowing soared. United States’ Treasury debt grew by $3.2 trillion from March through August 2020 — requiring an unprecedented borrowing pace. Negotiations over the next round of support payments are now dragging, and as jobs come back, appetite for another large stimulus round could fade further. As unemployment benefits start to roll off from here, and the rolls of permanently unemployed grow, some softening of economic data seems very likely.

After a sharp acceleration from spring through summer, our WCA Fundamental Conditions Barometer (Chart A, below) remains above 50 (signaling growth) but our forecast also calls for some moderation ahead. After many weeks of up-up-up in the market, the dynamism of our models suggest the pace of improvement is likely to slow. The forecast curve remains firmly on the ascent, but the pace of acceleration is set to fade as indicated by the dashed green, blue, and red lines in the chart below. We’ve trimmed the equity allocation from significantly overweight to moderately overweight equities in the satellite portion of tactical portfolios in anticipation of some moderation.

Chart A
WCA Conditions Barometer

The Valuation Challenge

The most important reason we think the market rally’s pace is set to slow is that valuations have run ahead of fundamentals. High valuations are not evident in all areas of the market but are apparent in sectors like technology. According to Bloomberg, the Dow Jones Internet index rose 32.7% year-to-date on a COVID-19 demand lift, pushing multiples to 21x enterprise value to cash flow, more than 30% higher than the 10-year average of 14-15x. If the pandemic passes, and remote work becomes less essential, the shine of the internet stock halo could start to fade, compressing multiples.

Another example that shows that valuations have run ahead of fundamentals is what we see when comparing the value of U.S. stocks to the economy. The chart below shows that U.S. stocks are now valued near twice the economy’s size, based on output. This is a somewhat flawed measure of value because it fails to adjust for debt or the economy’s proportion represented by public vs. private firms. Even with these shortcomings, the message is generally reasonable — stocks have become expensive.

Chart B
United States’ Market Capitalization to GDP

Conclusion

So it is clear that although stocks should beat bonds over the long haul, we think the pace of the equity market rally is now set to slow for two main reasons. First, the government’s supports for the economy are fading. But most importantly, valuations have run ahead of fundamentals in some key areas of the market. Neither of these issues damages the long-run view but could pose near-term challenges.

We continue to focus on evaluating the post-COVID environment, valuations, and trends across asset classes. From today’s starting point of low yields and elevated equity valuations, we feel that going-forward returns should be lower than in the past. In such an environment, investors seeking higher returns must look beyond buy-and-hold. A disciplined and tactical approach is one way to address today’s market challenges.

Disclosures:

WCA Barometer – We regularly assess changes in fundamental conditions to help guide near-term asset allocation decisions. 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.

Standard & Poor’s 500 Index (S&P 500) is a capitalization-weighted index that is generally considered representative of the U.S. large capitalization market.

The S&P 500 Equal Weight Index is the equal-weight version of the widely regarded Standard & Poor’s 500 Index, which is generally considered representative of the U.S. large capitalization market. The index has the same constituents as the capitalization-weighted S&P 500, but each company in the index is allocated a fixed weight of 0.20% at each quarterly rebalancing.

The Washington Crossing Advisors’ High Quality Index and Low Quality Index are objective, quantitative measures designed to identify quality in the top 1,000 U.S. companies. Ranked by fundamental factors, WCA grades companies from “A” (top quintile) to “F” (bottom quintile). Factors include debt relative to equity, asset profitability, and consistency in performance. Companies with lower debt, higher profitability, and greater consistency earn higher grades. These indices are reconstituted annually and rebalanced daily. For informational purposes only, and WCA Quality Grade indices do not reflect the performance of any WCA investment strategy.

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 forecast 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. Changes in market conditions or a company’s financial condition may impact a company’s ability to continue to pay dividends, and companies may also choose to discontinue dividend payments. 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. Bond laddering does not assure a profit or protect against loss in a declining market. 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. Changes in market conditions or a company’s financial condition may impact a company’s ability to continue to pay dividends, and companies may also choose to discontinue dividend payments.

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.

The securities discussed in this material were selected due to recent changes in the strategies. This selection criterion is not based on any measurement of performance of the underlying security.

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