Should investors care that stocks are expensive?

Ball

Coincident to the latest string of market records, another milestone was recently hit. The S&P 500 has recently been trading for more than 20x trailing price-to-earnings (P/E), according to Bloomberg data. The last time the market traded at these levels was 2009, when earnings were still depressed by the financial crisis and recession.

Before analyzing what it does mean, it is worth pointing out what it does not. There is no magical significance to crossing this particular threshold. Furthermore, as most investors realize, valuation is a poor short-term timing mechanism.

Don’t overemphasize stocks’ relative value to bonds

Bulls will also correctly point to the fact that stocks are cheap relative to bonds. While true, as I have argued in the past, in this case relative value may not support future returns. A large part of the reason bonds are expensive is because of extraordinary monetary policy, both here and abroad. To the extent policy reflects a dour outlook for both real and nominal global growth, corporate earnings are likely to remain in a rut, suggesting a lower not higher multiple. Additionally, while stocks look cheap relative to bonds, historically valuation multiples, rather than the equity risk premium, have been the better predictor of future stock returns.

A look back in history reveals some telling trends

Today’s elevated valuations do hold a warning for investors. Although value is not the primary determinant of returns, at times horizons of a year or longer it does matter. Looking back over the past 60 years of annual price returns, i.e. not including dividends, the level of the P/E at the start of the year explained roughly 6% of the variation in the following year’s returns, according to Bloomberg data. That does not sound like much, but historically there has been a material difference in returns following periods when the P/E was above average (roughly 16.5) versus below. In years following above average valuations, the average price return was roughly 5%. In years when the S&P 500 started the year on the cheap side, the average return was over 11%.

More interesting is what happened when valuations went from merely above average to truly expensive. In years when the trailing P/E ended the previous year above 20, returns were poor in the following year. The average annual price return was roughly 1%, with the S&P 500 advancing only 50% of the time. Downside risk was also accentuated; the bottom quartile of returns in those years was -11%, far worse than when stocks were cheaper.

No alarm bells will sound simply because multiples crossed the 20 threshold. Today the market is only marginally more overvalued than it has been for most of the past 18 months. Stocks have traded to far loftier levels, notably in 1987 and the late 1990s, before investors finally capitulated. Of course, in the late 1990s the market was benefiting from robust growth, soaring productivity, falling inflation and declining interest rates. Today, investors are primarily relying on one argument: bonds look worse.

Russ Koesterich, CFA, is Head of Asset Allocation for BlackRock’s Global Allocation team and is a regular contributor to The Blog.

 

Past performance is no guarantee of future results. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.

Investing involves risks, including possible loss of principal.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of July 2016 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader.

©2016 BlackRock, Inc. All rights reserved. iSHARES and BLACKROCK are registered trademarks of BlackRock, Inc., or its subsidiaries. All other marks are the property of their respective owners.

4 Reasons You Should Still Invest Abroad

Luggage

2016 has not been a stellar year for many markets, outside of gold. Indeed, a standard, plain vanilla, domestically oriented 60/40 blend of U.S. stocks and Treasury bonds has produced reasonably good returns. This, in turn, reinforces a nagging question: Is international investing still worth it?

After all, emerging market (EM) equities have trailed for most of the past five years, outperformance by Europe has been episodic, and despite some good years, Japan is once again frustrating investors. Given the risks, why bother?

But don’t be so quick to abandon investing outside the United States. Here are four reasons to consider why you should not throw in the towel on your overseas investments.

1. The U.S. may be safer, but at a cost.

The S&P 500 is currently trading at roughly 19.5x trailing earnings, the top quartile of historical observations, according to Bloomberg data. The good news is that this is still below the level associated with most recent market peaks (2008 was an exception). However, while not necessarily indicative of a market top, current levels have historically been associated with lower future returns. Longer-term valuation measures—notably cyclically adjusted earnings (CAPE)—are even more elevated and suggest low- to mid-single digit returns over the next five years. In contrast, most major markets outside the United States are trading at valuations at or below their historical average.

Valuations

2. EM is actually outperforming.

Emerging markets have started to recover, with stocks up roughly 6% in local currencies and more than 7% after adjusting for the rebound in EM currencies against the U.S. dollar, according to Bloomberg data. Although these stocks have started to stabilize, valuations still appear inexpensive, particularly on a relative basis. The MSCI EM equity index is trading at roughly 1.35x book value, more than 50% cheaper than the S&P 500, as Bloomberg data shows.

3. International investing is not just about stocks.

While U.S. stocks have led other developed equity markets this year, some of the best performing bond markets have been outside the United States. For example, emerging market debt is up over 10% year-to-date (Bloomberg data). With interest rates in the United States at record lows and rates in other developed markets increasingly in negative territory, investors may want to look beyond traditional markets in search of yield.

4. In a real bear market, U.S. stocks are not necessarily the safest place to hide.

If you’re really worried about a bear market, U.S. equities are still likely to suffer. Yes, given relatively high profitability and the dollar’s safe haven status, U.S. markets could probably hold up better than other stock markets, but not necessarily better than other asset classes. Investment grade bonds, preferred stocks or bank loans offer reasonable returns with arguably less volatility, in my opinion.

The lesson is not to abandon the United States. The domestic stock market still offers investors several desirable characteristics: a stable currency, high profit margins and world class companies. That said, it also comes with a high price tag. For long-term investors, this suggests looking beyond the comforts of home.

Russ Koesterich, CFA, is Head of Asset Allocation for BlackRock’s Global Allocation Fund and is a regular contributor to The Blog.

 

Past performance is no guarantee of future results. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.

Investing involves risks, including possible loss of principal. International investing involves special risks including, but not limited to political instability, currency fluctuations, illiquidity and volatility. These risks may be heightened for investments in emerging markets.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of July 2016 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader.

BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2016 BlackRock, Inc. All rights reserved. iSHARES and BLACKROCK are registered trademarks of BlackRock, Inc., or its subsidiaries. All other marks are the property of their respective owners.

A Cautiously Optimistic Outlook for U.S. Earnings

LIghthouse

The U.S. profits recession probably didn’t end last quarter, with S&P 500 earnings likely to post a fourth consecutive quarterly decline. We see company earnings improving in the second half, but the rebound may be smaller than many expect. This week’s chart helps explain why.

A second-half U.S. earnings recovery will be underpinned by three key factors, we believe: a slowdown in the U.S. dollar’s rise, stabilizing energy prices and solid consumption growth driven by rising wages. Yet a slowdown in capital expenditures (capex) may offset these positives. The amount companies plan to spend on capex in the coming 12 months has dropped to the lowest level since 2010, as the chart above shows.

006920A_BII_chart_web_V2

The energy sector has driven much of the recent capex weakness, and capex is a less important barometer of sentiment in service sectors and asset-lite businesses. But we believe many companies may be reluctant to invest in an uncertain political climate marked by an impending Brexit and the upcoming U.S. presidential election. As second-quarter earnings season moves into full swing, we will be paying close attention to any signs of reduced investment appetite in corporate guidance.

We will also be focused on earnings quality. The exclusion of asset write-downs in the energy and materials sectors and the use of aggressive accounting practices have inflated pro-forma earnings. We are watching for improvements in sales growth and cost controls — as well as the strength of demand that multinationals report seeing out of China and other emerging markets (EMs).

We see Brexit-related uncertainties weighing the most on already-depressed European earnings. Japanese and EM earnings estimates are also on a downswing. Bottom line: U.S. equities are the least dirty shirt of global equity markets, although high valuations keep our return expectations in check. We favor quality stocks and dividend growers. Read more market insights in my Weekly Commentary.

Richard Turnill is BlackRock’s global chief investment strategist. He is a regular contributor to The Blog.

Kate Moore, BlackRock’s chief equity strategist, contributed to this post.

 

Investing involves risks, including possible loss of principal. There is no guarantee that stocks will continue to pay dividends.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of July 2016 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader.

©2016 BlackRock, Inc. All rights reserved. iSHARES and BLACKROCK are registered trademarks of BlackRock, Inc., or its subsidiaries. All other marks are the property of their respective owners.

It’s Getting Late – In The Business Cycle

Corporate Profits

While the United Kingdom’s decision to leave the European Union (Brexit) has temporarily undermined market confidence, my confidence in equities was on the decline in advance of the vote. So let’s take a break from Brexit for a few minutes and look at some longer-term fundamentals.

I remain disenchanted with stocks and I need to see improvement in five key metrics before changing my view:

1) Improved pricing power for US based multi-national companies
2) Better consumer spend on goods and services
3) A weaker dollar relative to other currencies
4) Rising capital expenditures, especially in information technology
5) Moderating labor and health care costs

I’m focused on the behaviour of the private sector and its ability to generate free cash flows. During this business cycle, which began in July 2009, the US and many developed markets experienced record high profit margins, best-ever free cash flows relative to the size of the overall economy and high returns on equity. This surprised many cautious investors given that both the global and US growth rates had fallen below trend. The reasons for the high profit generation, which were complex, included gains in manufacturing sector efficiency, productive use of technology, rapid asset turnover, capital-light strategies, employment of global labor, use of operating leverage instead of financial leverage and low energy costs.

During the last three quarters most of these tailwinds for risk markets began to falter. Margins narrowed not just in the materials and mining sectors, but throughout much of the S & P 500, countering well-established trends that dated back to 2009. Now, selling, general and administrative (SG&A) expenses have been rising as a percentage of revenues. Financial leverage is replacing operating leverage, and both return on equity and margins continue to weaken into midyear.

All of these measures feed into a very important metric for me—the share of US gross domestic product going to the owners of capital. When the share of the economy going to the owners as profits begins to subside, a direct casualty is capital expenditure and durable goods spending.

Both are now weakening. Big ticket expenditures like purchases of machine tools by manufacturing firms and information technology spending by most firms, are a key to future growth of both jobs and profits and tend to perpetuate the cycle. These large expenditures by businesses have been weakening and the trend is downward.

The US consumer is doing better. Spending is increasing, but consumers have not spent the extra income afforded by the earlier oil price decline. And now, worryingly, energy prices are rebounding. The US dollar had been weak during much of this cycle, but now because of interest rate differentials and a flight to safety, the dollar has been heading back up. The strong company fundamentals that were the signature of this longer-than-usual cycle, have weakened in almost all categories.

Overall I am biased toward being underweight equities. Within equities I would favor US shares relative those of the UK, Eurozone and Japan.  Some emerging markets look attractive, particularly Latin America and Eastern Europe, but selectivity is very important, as always. In fixed income I prefer high yield because fundamentals in the US remain solid with odds favoring the US avoiding recession near-term, in my view.

History tells us a weakening of the profit cycle can herald recession. Usually a profits recession comes as rising interest rates hijack consumer and business spending. US recession risks are rising, but the risk of rates rising seems remote now. Rather than a recession unfolding soon, I see a continuing plague of profit disappointments but no economic collapse. A kind of investor’s limbo, if you will. I hope the five points above reverse, but unless they do, late cycle flags should be a caution to investors.

 

James T. Swanson, CFA is the chief investment strategist of MFS Investment Management.

The views expressed are those of James Swanson and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation or solicitation or as investment advice from the Advisor.