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Question of the day - market valuations

Scott Maxwell - Monday, August 19, 2013

Stock indexes continue to see new highs.  Is it too late to invest?  Aren’t things expensive?

Stock valuation is sometimes an imprecise science, but there accepted tools we can use to gauge a general ‘range’ for where we are in a valuation cycle.  Internally, we look at several different metrics, including a dividend discount model as well as relative PEG (‘price-to-earnings growth’) ratio analysis to help derive relative statistics between different equity market caps and regions (i.e. domestic vs. developed foreign vs. emerging markets, for example). 

When markets are at ‘fair value,’ which several roughly are now, based on a variety of measures—it doesn’t necessarily raise a red flag meaning ‘expensive’ or ‘sell now.’  It generally indicates that pricing conditions are close to average, relative to history—that current prices are reasonable given current earnings and dividends.  So, large-cap equities should be expected to perform at their ‘normal’ expected return levels looking forward.

Based on these same metrics, emerging market stocks are quite cheap—arguably the cheapest equity asset class—which falls right in line with the cash outflows from EM funds, negative sentiment and outright unpopularity/disgust.  Valuations tend to have an inverse relationship to an asset class’ general popularity with investors.

In fixed income, we look at things a little differently.  Over the long-term, bond attractiveness is based on the amount of ‘real’ yield being earned, which is the amount over and above that consumed by inflation.  In addition to this, we look at relative interest rate spreads in different assets, such as that of investment-grade corporate debt versus treasuries, high yield bonds versus treasuries, etc.  This helps us from both a long-term relative view of what ‘normal’ is, as well as a tactical standpoint, for nearer-term opportunities on the upside and risks on the downside.  In bonds, when spreads are ‘wide’ (or large) relative to history or relative to other assets, there exists a potential valuation opportunity.  Conversely, when spreads are ‘tight’ (or small), conditions are more expensive as you may not be compensated adequately for the amount of risk you’re taking.

We’ve moved from a time where spreads were extraordinarily wide in many non-treasury bonds (in 2008-09) to a point nearer to long-term normal, and even tighter in some cases.  This points to potentially slimmer return opportunities going forward on a relative basis.  But, an overriding theme in fixed income is the movement of general interest rate levels.  When rates move higher, it’s usually bad news in the shorter-term for bonds and bond funds.  While an oversimplification, the math implies you’re stuck with a fixed rate instrument while market rates are moving your lower fixed rate is no longer so attractive...and the price drops.  That’s the basic math of bonds.

From their last high point of the early 1980’s, interest rates are now at 30-year lows, which implies they have nowhere to move but upward (whenever that may be).  This doesn’t bode well for bonds, so avoiding bonds with the highest exposure to this trend (intermediate- and longer-term debt) would be a first step.  Holding interest rate exposure (duration) low is critical, which we have done in portfolios—a successful strategy thus far.  Moving ahead necessitates a careful balance between reducing the risk of these rising rates, while also taking advantage of opportunities where we can find them to earn a bit of return along the way.  Nevertheless, it may be a time for a stronger ‘defense’ than an overreaching ‘offense,’ if you don’t mind another sporting analogy.

Interestingly, from an asset allocation perspective, a recent survey noted that one in four Americans believe that cash investments are the best place for money not needed for the next decade.  This was followed by real estate in close second place, precious metals in third, and stocks and bonds in last place of the group.  Naturally, the first factor here is a behavioral one and response to the last crisis; but a significant issue with this sort of positioning is the likely inability to keep pace with inflation over time (however you define it, per comments above). 

Over rolling multi-year timeframes, a diversified asset allocation portfolio is a strong response to these types of questions from both an expected return and volatility standpoint. It’s not sexy and doesn’t make for great water cooler conversation but diversification coupled with an eye toward valuation provides a disciplined approach to the challenges of market cycles and asset positioning.

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