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.
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
- 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.
- 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.
- Meanwhile, we recently closed the long-held overweight position in gold and favor higher-yielding corporate bonds and REITs within the alternatives space.
- Among sectors, we now tilt toward consumer durables, healthcare, and staples and away from technology, energy, and utilities.
- 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.
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.
United States’ Market Capitalization to GDP
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.
Kevin R. Caron, CFA
Senior Portfolio Manager
Senior Portfolio Manager
Steve Lerit, CFA
Senior Risk Manager
Paul Clark, CFA
Senior Portfolio Manager
Municipal Fixed Income
Senior Portfolio Manager
Municipal Fixed Income
Internal Relationship Manager
Director, External Sales and Marketing
External Sales and Marketing
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