Asset Class Recap
During April, May and June, stock and bond prices were punished for a second consecutive quarter. Each of the asset classes we commonly include in our portfolios in the table below (with the exception of cash) had a negative total return for the first and second quarters of the year. We pulled quarterly return history for the last 40 years and found only two other quarters where all these asset classes were simultaneously negative; Q2 1984, in a sharply rising interest rate environment, and Q1 1990, when markets became worried about an Iraqi invasion of Kuwait.
Economists define a “bear market” as a market decline of at least 20% while a “correction” is a 10% pullback. All the asset classes in the table above have seen a year-to-date correction while some have crossed into bear market territory. Multiple factors have come together to bring the S&P 500 index sharply back down since it reached its all-time high on 1/3/2022, but rising interest rates have been the most significant factor.
Warren Buffett has said, “The most important item over time in valuation is obviously interest rates” and, “The bogey is always what government bonds yield.” This observation helps us understand a significant portion of the market’s 2022 pullback. Interest rates have increased more sharply than expected this year for multiple reasons. The Federal Reserve’s Quantitative Easing program that kicked off in November 2008 has intentionally kept interest rates artificially low for far longer than most economists expected and is finally starting to end. High inflation caused by; continuing COVID related shortages, energy supply constraints due to sanctions on Russia, commodity shortages from Ukraine, and federal limitations on “dirty” energy production, has prompted the Fed to take swift inflation fighting action.
To quantify the link between interest rates and stock valuations, we can lean on the Capital Asset Pricing Model’s concept that riskier investments deserve to earn higher returns to compensate you for accepting volatility. Over the last 25 years, the earnings yield for the S&P 500 index has exceeded the 10 year treasury note yield by an average of 1.89% each year. If we take the reciprocal of earnings yield, we have the commonly reported and analyzed valuation metric of Price-to-Earnings (P/E ratio). When we build a graph that plots the relationship between 10 year treasury note yields and expected stock P/E’s with the 1.89% equity premium baked in, we see the relationship below.
As rates rise, we should expect prevailing P/E’s to drop and stock prices should drop. This makes intuitive sense, because rising interest rates make bonds more attractive. Investors are enticed to pull some money out of stocks to invest in bonds, creating stock selling that puts downward pressure on stock prices. The yield on the 10 year treasury bond started the year at 1.51% and has nearly doubled to 2.97% at 6/30/22. The chart above suggests that fair P/E’s might move from 30 toward 20 with this type of change in treasury yields. Because there are many other factors that affect stock valuations in addition to treasury yields, we have not seen a move quite this strong, but this move in P/E’s is not too far off from what we have actually seen.
The blue numbers in the table below suggest a wide range of potentially fair values for the S&P 500 index, given various combinations of interest rates and weighted average corporate earnings, which were $198 for each unit of the S&P 500 index over the last year. The black circle shows where we are at today, with a 10 year treasury yield of 3% and earnings of about $200 and suggests a fair value for the S&P 500 of $4,090, which is a bit higher than where we are today. The black arrow shows the general direction of where we have come from over the last year – yields have increased while earnings have increased and the S&P 500 value has dropped sharply. The red arrow shows the general direction I expect we are headed – moderately higher interest rates, higher earnings and a slightly higher S&P 500 value. The four highlighted corner portfolios show outlier stock market values that are possible if we get extreme moves in earnings (due to a recession?) or interest rates (an additional surprise shock that pushes inflation higher?), but I believe any of these corner values are unlikely to happen within the next year.
The table below has returns for 23 non-traditional and alternative investments that we track. Although every one of the investments in the table has a 10 year return that is lower than the S&P 500 index, alternatives provide an attractive way to diversify a portfolio in various market environments. In high inflationary environments, Commodities traditionally perform well, which we see at the bottom of the table, as Invesco Optimum Yield Diversified Commodity Strategy ETF (ticker: PDBC) has returned 28.5% YTD and iPath® Pure Beta Crude Oil ETN (ticker: OIL) has returned 46.4% YTD. The average of the year-to-date returns in the table below is -9.0%, which is a terrible return, but is much higher than year-to-date returns for traditional stocks and bonds (in the first table of this writeup).
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