Global equities registered their seventh month in a row with gains in August, their longest stretch since 2018, and have now gone over 220 days without being in a 5% drawdown — the third-longest streak ever. In fact, the S&P 500® has notched 53 new all-time highs this year — the third-most of any year since 1991.1
Low rates, significant infusions of liquidity, and rebounding earnings have propelled these returns. As a result, investors have steadfastly favored equities relative to bonds. Equity ETFs have taken in $85 billion more than bond ETFs over the past three months, a figure that is in the 80th percentile and 158% above the typical three-month average.2
Yet, even with these returns and behavior, stocks are still cheap when compared to bonds3 — and that is likely to continue as the low rate environment has created a less than ideal future return scenario for bonds.4 Caution, however, has begun to creep into market sentiment. Three-month S&P® 500 put/call option skew as well as the put/call option interest ratio are elevated, with the latter sitting in the 92nd percentile over the last five years.5
Today’s complex environment has clients concerned with many variables that could alter the market’s trajectory: Policy normalization, tapering, low rates, fiscal spending impacts, inflationary pressures, expensive valuations, earnings growth stability, market gains concentrated around a few large stocks and the future path of an economy still dealing with the effects of the lingering COVID-19 pandemic. However, when grouped together, the through line of our client conversations centers on these two questions:
How can I continue participating in a policy-supported rally marked by elevated valuations given concerns about the sustainability of future growth?
Where can I source “real” levels of income within bond portfolios that can withstand rising rates?
The Key for Equities: Quality Not Quantity Stocks are expensive, and growth is projected to slow in 2022 — a cocktail that makes investors a bit squeamish about continuing to pile into stocks, even with TINA (“There is No Alternative”) and FOMO (“Fear of Missing Out”) tending bar.
The S&P 500’s 20%-plus gain so far this year has kept valuations elevated, even though earnings growth has been the driver.6 The market’s price-to-earnings ratio currently sits in the historical 90th percentile.7 This is not the only valuation ratio that is stretched, however. As shown below, four other common metrics are also elevated, with only one (next-twelve-months price-to-earnings ratio) not above the 90th percentile.
S&P 500 Valuations
Now, these metrics started 2021 near these levels and the market has still posted outsize gains. The difference for the road ahead is that growth is not expected to be as strong. Current figures project just single-digit growth in 2022 — revised lower over the past three months from 11.4% to 8.9%.8 In fact, 2022 figures have now been downgraded below the pre-pandemic 10-year average of 9.2%. As a result, the growth tailwinds enjoyed in 2021 may not be the driving force in future returns.
With concerns emerging over the quantity of growth, it is not surprising to see investors begin to place a preference on the “quality” of earnings growth. Over the past three months, stocks with more quality balance sheets and less volatile earnings patterns have outperformed the broader market by 2.8%. ranking in the top 88th percentile, historically, as shown below. In fact, momentum has been building for the quality factor over this period, and now leads all factors year-to-date in terms of returns. Valuations for quality stocks are elevated as well. But given these performance trends, it is apparent investors are comfortable paying a high multiple to access potentially more sustainable growth and less fundamental future volatility.
Quality Excess Returns to S&P 500 Index (Rolling Three-Months)
Targeting quality segments of the market can take different forms. You can target the factor outright or consider multi-factor exposures that have a quality bias. Strategies focused on dividend paying stocks with a track record of returning capital to shareholders are another option that can add an element of value, as dividend strategies tend to have a strong value bias and lower relative valuation metrics.9 Additionally, dividend funds may reduce broad market concentration issues, as they tend to have a low allocation to tech-related stocks (e.g., 3% for the S&P High Yield Dividend Aristocrats Index versus 28% for the S&P 500 Index).10
Thinking Small May Help Too While focusing on dividend strategies or the quality factor may help you tamp down exposure to expensive tech stocks and increase the sustainability of balance sheets, focusing on small caps can assist on three fronts: valuations, market concentration, and potential reactions to policy responses in the next leg of the rally.
Although small caps have outperformed large caps in 2021, small caps’ relative valuations have improved this year as a result of stable price-to-book ratios and declines in price-to-earnings ratios (both trailing and next-twelve-month). Based on a five-factor composite metric, as shown below, relative valuations for small caps sit in just the 7th percentile.
Average Percentile of Five Relative Valuation Metrics of Small Caps to Large Caps
Small caps may also allow you to diversify away from large cap/tech biases that have crept into portfolios this year. Currently, the largest 50 stocks in the S&P 500 make up more than 58% of the overall index, leading to concentration that we have not seen since the early 2000s.11 Including an exposure to small caps, with less skew between the largest and smallest holding (0.66% for the S&P 600 compared to 6% for the S&P 500), 12 may reduce the reliance on a few key stocks. Not to mention, small caps only have 15% in Technology and Communication Services sectors, versus 40% in large caps. 13
Small caps may also help you navigate any related market shifts stemming from the Federal Reserve (Fed) potentially tapering its asset purchases. At the Jackson Hole Symposium, Fed Chair Powell stated that the Fed will likely begin slowing down asset purchases this year. Yet, it is unlikely the taper announcement would come at the September meeting, given the softness in recent labor data and lingering concerns of how the Delta variant is impacting the recovery — a forecast supported by the options market implying a mundane move in equities around that date. Therefore, look for a taper announcement sometime in November when more economic data is known.
Past taper performance trends could help provide some clarity as to how asset classes may perform this time around — even if it is one single data point and subject to a small sample size bias.
For perspective, in May 2013, then Fed Chairman Bernanke first raised the possibility of a taper during his Congressional testimony, resulting in a "tantrum" in the rates market. Equities initially sold off as well. But by July, those losses were reversed. When the Fed did actually start to taper purchases at its December meeting, equities barely reacted and continued to rally throughout the year. Back then, as shown below, small caps led other major asset classes from tantrum to the actual taper.
Performance of Major Asset Classes Leading Up to First Taper (May 2013 to Dec 2013)
This time around, Fed Chair Powell telegraphed the taper extremely well and the market has taken the news in stride. I’d expect the same reaction when the taper announcement comes and the taper itself commences. And the strong performance by small-cap equities we witnessed back in 2013 could also repeat itself for three reasons:
A taper announcement signals confidence in the economy and more cyclical exposures have historically benefitted from an expansionary market environment.
Small caps have historically had a higher beta and correlation to interest rates than large caps.14
2022 earnings growth estimates for small caps have not been downgraded as much as large caps over the past three months, and are still in the double digits (13.8%)15 where the differential to large caps is actually larger now than at the start of the year (4.82% versus 3.73%).
Navigating Equities in the Fourth While the fourth quarter has historically brought increased levels of volatility — evidenced by all three months’ average CBOE VIX Index readings being at or above 20 since 1994,16 unlike any other quarter — there is an upward bias to the current market’s trajectory given supportive policies, slowing but still positive growth expectations and plenty of cash still on the sidelines.17
Overall, focusing on the exposures mentioned here (quality and size) may allow you to navigate some of these challenges facing both the stock markets right now.
Size bias/Small Caps: SPDR Portfolio S&P 600TM Small Cap ETF (SPSM)
And don’t forget to check out the second part of this blog series where I dig into fixed income positioning and question two, Where can I source “real” levels of income within bond portfolios that can withstand rising rates?
1. Bloomberg Finance, L.P. as of September 8, 2021 2. Bloomberg Finance, L.P. as of September 8, 2021, based on SPDR Americas Research calculations 3. Based on the Earnings Yield of the S&P 500 (3.71%) relative to the US 10 Year Yield (1.35%) 4. Bloomberg Finance, L.P. based on the 87% correlation between a current yield at time of purchase and the subsequent three-year return on the Bloomberg US Aggregate Bond Index per SPDR Research Calculations 5. Bloomberg Finance, L.P. as of September 8, 2021 based on the Put Call Open Interest Levels for S&P 500 Index Options 6. Based on a return attribution of the S&P 500 returns year-to-date, 100% has been from earnings growth as price-to-earnings ratios have slightly compressed based on FactSet data as of August 30, 2021 7. Bloomberg Finance, L.P. as of September 8, 2021 8. FactSet data as of August 30, 2021 9. Bloomberg Finance, L.P. as of September 8, 2021. The Price-to-Earnings Ratio for the S&P High Yield Dividend Aristocrats Index trades currently near its median 19.30 versus 19.62, as opposed to the S&P 500 Index which sits 43% above its 10-year median. 10. Bloomberg Finance, L.P. as of September 8, 2021 11. Bloomberg Finance, L.P. as of September 8, 2021 12. Bloomberg Finance, L.P. as of September 8, 2021 13. Bloomberg Finance, L.P. as of September 8, 2021 14. Bloomberg Finance, L.P. as of September 8, 2021 based on the beta sensitivity of the S&P 500 (.11) and correlation (0.34) to the US 10 Year Yield as well as the beta sensitivity of the S&P 600 (.25) and correlation (0.53) to the US 10 Year Yield from Sept 2016 to Sept 2021 based on monthly granularity. 15. FactSet data as of September 8, 2021 16. Bloomberg Finance, L.P. as of September 8, 2021 17. Mutual Fund Money Market Assets are in the 95th percentile, historically per Bloomberg Finance, L.P. as of September 8, 2021
Bloomberg Barclays US Aggregate Bond Index A broad-based flagship benchmark that measures the investment grade, US-dollar-denominated, fixed-rate taxable bond market.
CBOE VIX Index The VIX Index is a financial benchmark designed to be an up-to-the-minute market estimate of the expected volatility of the S&P 500® Index, and is calculated by using the midpoint of real-time S&P 500 Index (SPX) option bid/ask quotes.
Quality Characterized by firms with strong balance sheets and high profitablity.
S&P 500 Index A market-capitalization-weighted stock market index that measures the stock performance of the 500 largest publicly traded companies in the United States.
S&P High Yield Dividend Aristocrats Index The S&P High Yield Dividend Aristocrats index is designed to measure the performance of the 50 highest dividend yielding S&P Composite 1500 constituents which have followed a managed dividends policy of consistently increasing dividends every year for at least 20 years.
Smart Beta A term for rules-based investment strategies that don’t use conventional market-cap weightings.
Value Characterized by lower price levels relative to fundamentals, such as earnings.
Volatility Skew The difference in implied volatility (IV) between out-of-the-money options, at-the-money options, and in-the-money options. The volatility skew, which is affected by sentiment and the supply and demand relationship of particular options in the market, provides information on whether fund managers prefer to write calls or puts.
The views expressed in this material are the views of the SPDR Research and Strategy team and are subject to change based on market and other conditions. It should not be considered a solicitation to buy or an offer to sell any security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. There is no representation or warranty as to the current accuracy of such information, nor liability for decisions based on such information. Past performance is no guarantee of future results.
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