STA Weekly Report – Valuation Update Across Equity Markets
Written by Luke Patterson | Friday, August 16th, 2019
INSIDE THIS EDITION: Valuation Update Across Equity Markets Weekly Technical Comment| Weekly Snapshot of Global Asset Class Performance 401k Plan Manager
From a price perspective, equity markets are generally at similar levels as they were a year ago. Back then, we were on the verge of downward pressure on global equities as uncertainty about trade and interest rates drove markets lower in October and December.
Fast forward to today and we are largely in the same place with geopolitical concerns, Fed policy, and signs of a decelerating economy topping the list of investor concerns. While fourth quarter volatility helped cut forward price to earnings multiples, a domestic equity rally for most of this year, has helped reflate forward multiples.
As investors, we are always interested in understanding how
much we are paying for each dollar of future earnings and want to allocate to
areas of the market that are less expensive. This makes logical sense because
when valuations are low, the average expected returns on assets are higher than
they would be when valuations are high. Valuations however, can be hard to
gauge because they adjust on a continuous basis as new and disparate
information is priced into securities. This fact is one reason we employ a
multi-disciplinary approach to investment that combines the strengths of
fundamental valuation work with macroeconomic and technical disciplines.
Additionally, there are several different measures of valuation that can be
used depending on the sector, asset class, or nature of cash flows. In other
words, valuations and their measurement can be extremely complex. To make
things easy, many investors look to valuation multiples like the forward price
to earnings ratio to at least have a sense of whether assets are expensive or
For the sake of simplicity, we will focus our attention on
the forward price to earnings multiple because it tends to be widely used and
thus may be more familiar. The Price to Earnings ratio as it is also called, is
simply a calculation that divides price by the expected earnings a certain
business or index produces. As an example, if stock ABC traded for $15 per
share, and was expected to report earnings of $1.50, it would have a forward
P/E ratio of 10 ($15/$1.50 = 10). For the purpose of illustration if company
XYZ traded at a price of $15 per share also, but was instead expected to report
earnings of $3.00, it would have a forward P/E ratio of only 5. As such, the
lower forward P/E ratio offers in this case a more attractive return profile
where you get more earnings for the same share price.
While this is a very simplified illustration, it explains
how earnings multiples are arrived at and how they can be applied to compare
investment opportunities. Comparing
investments across a diverse set of valuation metrics is part of our
three-pronged investment management process and is only one factor we consider
when deciding which assets to overweight and underweight in a portfolio.
So where are
Domestic equity forward P/E’s briefly touched 23 at the
beginning of 2018. They then dropped throughout 2018 as prices came down and
corporate earnings reached peak levels. By December they were a more reasonable
16x. However, this year, despite more recent volatility, we have seen the
forward P/E multiple increase once again and currently sits close to 19x. By
historical standards this is not inexpensive.
Developed International Equities as measured by the MSCI
EAFE Index have seen a very similar forward P/E glide path. Although forward
P/E ratios for developed international equities peaked a bit earlier than
domestic equities (2016), they steadily declined forward recent lows of 14x.
This is largely attributed to many of the uncertainties that have plagued
international equities for the better part of 24 months including Brexit and
monetary policy shifts. Currently, developed international stocks have a
forward P/E of just above 16. While this is more attractive than domestic
equities on a relative basis, there are considerable risks that investors must
also factor in including trade impacts, negative interest rates, and continuing
uncertainty about the future of the European Union.
Where we see some more encouraging valuations are in
Emerging Market Equities. The MSCI Emerging Markets Index currently has a
forward P/E of just above 13x. Compared to domestic and developed international
equities, this is much more attractive. A valuation focused investor with a
long-term view may see this valuation level as attractive for allocating capital
for the long-term. We tend to agree with this view. However, investors must be aware of the
risks. For emerging market investors, risk comes in the form of politics,
trade, currency, and commodity risk. Recently, currency risk has been a
headwind that combined with trade concerns have had a negative impact on
emerging market equities.
However, we believe great opportunities require taking on
some of those risks. To manage for them, we favor selectivity in the context of
a globally diversified portfolio. Additionally,
we favor small exposures to countries that have catalysts in place that could
pay off over an intermediate-term time frame.
Bond Yields and Stocks
A lot of attention is being given to what falling bond yields mean for the U.S. economy and stock market. It’s important to understand that the relationship between bond yields and stocks underwent a major change after 2000.
Prior to 2000, bond yields and stock prices usually trended in opposite directions. As a result, falling bond yields were usually good for stocks. After 2000, however, that relationship changed. Since 2000, bond yields and stocks became more closely correlated. That change meant that falling bond yields since 2000 have usually been bad for stock prices. I believe that the emergence of deflationary pressures for the first time since the 1930s changed the bond-stock relationship. Interestingly, the absence of inflation is one of the reasons that global bond yields have been so weak this year, which suggests that deflationary forces are still in play. And why falling bond yields are still a negative sign for stocks.
Chart 1 compares the S&P 500 to
the 30-Year Treasury Bond yield between 1980 and 2000.
That period begins just after the hyper-inflationary decade of the 1970s when
surging commodity prices resulted in historically high interest rates and a
generally weak stock market. The two decades after 1980 saw a period of disinflation which
was marked by falling commodity prices and declining bond yields. That
disinflationary environment resulted in two decades of rising stock prices. The
main point of Chart 1 is to show that falling bond yields usually accompanied
rising stock prices. The green down arrows during 1982, 1985, 1991, 1995, and
1997 marked downturns in bond yields. Those downturns in yields were accompanied
by rising stock prices (rising black arrows).
The red circles, however, show three instances when
rising bond yields resulted in lower stock prices. They include the stock
meltdown during 1987, during 1990 in the months leading up to the first Iraq
war, and the so-called “stealth bear market” of 1994. In all three
instances, a downturn in bond yields helped resume the secular uptrend in stock
Bond/Stock Relationship Changes After 2000
Prior to 2000, bond yields and stocks
usually trended in the opposite direction. Chart 2 shows them trending in the same direction during
2000 and the two decades since then. A comparison of the first two red circles
shows a downturn in the 30-Year Yield during 2000 preceding a similar downturn in
the S&P 500 later that year. [Yields peaked during January;
the Nasdaq peaked during March; and the S&P 500 that August]. The second
set of circles show bond yields peaking earlier than stocks during 2007 (yields
peaked during June and the S&P that October). Another downturn in yields
during 2011 coincided with stock weakness. And again during 2015. The latest
downturn started late last year, and the 30-Year Treasury yield has fallen this week to the lowest in history (last red
circle). So far, that has had a mildly negative impact on stock prices. But if
recent history is any guide, falling bond yields aren’t a good sign for stocks.
The Deflation Scenario
Starting in 1998, the word deflation was
heard for the first time since the 1930s. That happened because of the Asian
currency crisis between 1997 and 1998 which contributed to a collapse in
commodity prices to the lowest level in 20 years (see Chart 3). That plunge in
commodity prices raised fears that a period of beneficial disinflation could
turn into a harmful deflation.
Falling Commodity Prices
Commodity prices began their decline in 1998 which
became a global deflationary trend. Chart 3 shows the Reuters/Jefferies
CRB Index of 19 commodity markets rising sharply between 2002 and mid-2008.
Since its 2008 peak, however, commodity prices have lost two-thirds of their
value. That’s pretty deflationary. That’s very different from what we’ve seen
in previous economic expansions. In previous expansions I’ve studied in the
postwar era, commodity prices have usually risen later in the business cycle as
inflationary pressures increased. That in turn forced the Fed to raise rates to
combat that inflation. And that usually led to stock market peaks and ensuing
recessions. It also usually led to an inverted yield curve first.
Although inverted yield curves in the past have usually led to recessions a
year or two down the road, this one has one big difference. It’s not being
caused by the inflationary impact of rising commodity prices.
Inverted Yield Curve and Commodity Prices
Everyone’s talking about inverted yield curves.
The 10 year – 3 month yield curve turned negative a few
months ago. The 10 year – 2 year spread turned negative
for a brief time yesterday but hasn’t officially inverted yet. For that to
happen, the 10-year yield needs to drop below the 2-year yield and stay there
for a while. But it’s getting close enough to get people worried. That’s
because inverted yield curves have a strong history of signaling economic
recessions. There is, however, something different about the current situation.
And that’s the direction of commodity prices.
The gray area in Chart 4 plots the ten year
– two-year yield curve. As of yesterday’s, close, the 10-year yield was
one basis point above the two-year. It’s still positive, but barely. The brown
bars plot the CRB Commodity Index. The last two yield curve
inversions took place during 2000 and 2006 (red circles). Both led to stock
market peaks and economic recessions within a year. Notice, however, that the
2000 inversion was accompanied by rising commodity prices (first box). In fact,
crude oil prices tripled during 1999 which forced the Fed to raise short-term
rates enough to push them above long term yields. Commodity prices also surged
during 2005 (second box) which again forced the Fed to tighten, which led to an
inverted yield the following year. Both of those yield curve inversions had bad
endings. And rising commodity prices had a lot to do with them. This time is
The brown bars show commodity prices in a steep
downtrend over the last decade. And they’re down again this year. That’s
especially true of agricultural commodities, industrial commodities (like
copper), and energy prices. Gold is the only commodity winner this year (along
with silver). But that has more to do with falling global interest rates than
rising inflation. [Gold is often incorrectly viewed as just an inflation hedge.
But it’s also a good hedge against deflation which is
its current role].
The problem in the present situation is that we have
very little history to go on regarding the meaning of the current inverted
yield curve (or impending one); or even the reasons for it. Falling commodity
prices at this late stage of an economic expansion are very unusual. So are
inverted yield curves that are not being caused by commodity inflation. The
absence of commodity inflation, however, also carries some risk. History shows
that deflation can be just as dangerous. And it’s a lot harder to fight. Just
ask central bankers.
STA Investment Committee Luke Patterson, CEO & Chief Investment Officer Mike Smith, President Andrei Costas, Senior Investment Analyst (Equity Strategies) Nan Lu, Senior Investment Analyst (Fixed Income Strategies)
Caring of Your Aging Parents
By Scott A. Bishop, MBA, CPA/PFS, CFP
Mom? Dad? We need to talk
Later this month I will be hosting a very important episode of the STA Money Hour with author and Journalist Cameron Huddleston. I have been interviewed by and hosted past STA Money Hour shows with Cameron in the past on “Money Worries”. This issue is near and dear to me as I have had to deal with this issue with many of my personal family members.
Caring for your aging parents is something you
hope you can handle when the time comes, but it’s the last thing you want to
think about. Whether the time is now or somewhere down the road, there are
steps that you can take to make your life (and theirs) a little easier. Some
people live their entire lives with little or no assistance from family and friends,
but today Americans are living longer than ever before. It’s always better to
The first step you need to take is talking to
your parents. Find out what their needs and wishes are. In some cases, however,
they may be unwilling or unable to talk about their future. This can happen for
a number of reasons, including:
Fear of becoming dependent
Resentment toward you for interfering
Reluctance to burden you with their problems
If such is the case with your parents, you may
need to do as much planning as you can without them. If their safety or health
is in danger, however, you may need to step in as caregiver. The bottom line is
that you need to have a plan. If you’re nervous about talking to your parents,
make a list of topics that you need to discuss. That way, you’ll be less likely
to forget anything. Here are some things that you may need to talk about:
Long-term care insurance: Do they have it? If not, should they buy it?
Living arrangements: Can they still live alone, or is it time to explore other options?
Medical care decisions: What are their wishes, and who will carry them out?
Financial planning: How can you protect their assets?
Estate planning: Do they have all of the necessary documents (e.g., wills, trusts)?
Expectations: What do you expect from your parents, and what do they expect from you?
Preparing a personal data record
Once you’ve opened the lines of communication,
your next step is to prepare a personal data record. This document lists
information that you might need in case your parents become incapacitated or
die. Here’s some information that should be included:
Financial information: Bank accounts, investment accounts, real estate holdings
Legal information: Wills, durable power of attorneys, health-care directives
Funeral and burial plans: Prepayment information, final wishes
Medical information: Health-care providers, medication, medical history
Insurance information: Policy numbers, company names
Advisor information: Names and phone numbers of any professional service providers
Location of other important records: Keys to safe-deposit boxes, real estate deeds
Be sure to write down the location of
documents and any relevant account numbers. It’s a good idea to make copies of
all of the documents you’ve gathered and keep them in a safe place. This is
especially important if you live far away, because you’ll want the information
readily available in the event of an emergency.
Where will your parents live?
If your parents are like many older folks,
where they live will depend on how healthy they are. As your parents grow
older, their health may deteriorate so much that they can no longer live on
their own. At this point, you may need to find them in-home health care or
health care within a retirement community or nursing home. Or, you may insist
that they come to live with you. If money is an issue, moving in with you may
be the best (or only) option, but you’ll want to give this decision serious
thought. This decision will impact your entire family, so talk about it as a
family first. A lot of help is out there, including friends and extended
family. Don’t be afraid to ask.
Evaluating your parents’ abilities
If you’re concerned about your parents’ mental
or physical capabilities, ask their doctor(s) to recommend a facility for a
geriatric assessment. These assessments can be done at hospitals or clinics.
The evaluation determines your parents’ capabilities for day-to-day activities
(e.g., cooking, housework, personal hygiene, taking medications, making phone
calls). The facility can then refer you and your parents to organizations that
If you can’t be there to care for your
parents, or if you just need some guidance to oversee your parents’ care, a
geriatric care manager (GCM) can also help. Typically, GCMs are nurses or
social workers with experience in geriatric care. They can assess your parents’
ability to live on their own, coordinate round-the-clock care if necessary, or
recommend home health care and other agencies that can help your parents remain
Get support and advice
Don’t try to care for your parents alone. Many
local and national caregiver support groups and community services are
available to help you cope with caring for your aging parents. If you don’t
know where to find help, contact your state’s department of eldercare services.
Or, call (800) 677-1116 to reach the Eldercare Locator, an information and
referral service sponsored by the federal government that can direct you to
resources available nationally or in your area. Some of the services available
in your community may include:
Caregiver support groups and training
Adult day care
Guidelines on how to choose a nursing home
Free or low-cost legal advice
Once you’ve gathered all of the necessary
information, you may find some gaps. Perhaps your mother doesn’t have a
health-care directive, or her will is outdated. You may wish to consult an
attorney or other financial professional whose advice both you and your parents
Important Disclosure: Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by STA Wealth Management, LLC), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from STA Wealth Management, LLC. Please remember to contact STA Wealth Management, LLC, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services. STA Wealth Management, LLC is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice. A copy of the STA Wealth Management, LLC’s current written disclosure statement discussing our advisory services and fees continues to remain available upon request.
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