In 2022, rising rates, geopolitical conflict, and sluggish growth pushed global stocks and bonds into a bear market at the same time, for the first time ever.1 Within global equities, just one third of countries2 — and only one sector3 — posted a positive median stock return. Bonds fared even worse. Every country, sector, maturity bucket, and credit quality rating band in the 32,000 bond holdings within the Bloomberg Global Multiverse Bond Index suffered losses.4
Now, as a result of this pain, many markets trade well below their perceived fair value — some justifiably, given the confluence of risks. Unfortunately, the three factors inflicting pain at the close of 2022 are unlikely to change in 2023 — not immediately, at least. At some point, though, Fed policy may become less aggressive, and earnings sentiment could find a bottom.
If that happens, sentiment could shift to the healing phase of this cycle, given the market’s forward-looking nature. And some segments thrown out of balance in 2022 may be the first to mean revert in 2023, revealing the hidden value in today’s downtrodden and discarded areas.
Given the broad-based negative returns, some investors might think all markets present value opportunities. But that’s not the case.
For starters, even though US equities have fallen by 16%, they still trade at 17.9 times next year’s earnings.5 That’s still above the long-term average of 17.1 times,6 and doesn’t indicate broad-based value for contrarian investors looking to zig when everyone else zags.
Outside the US, the valuation case has more merit. Non-US equities now trade at 12.17 times next year’s earnings, 20% below their historical median average of 14.94.7 The same is true under a shorter horizon, as US stocks trade on par and at 7% above their 5- and 15-year median levels.8 Meanwhile, non-US stocks trade 11% and 12% below their 5- and-15-year median levels, respectively.9
This doesn’t mean every US market is rich and any country outside the US, cheap. Comparing multiple fundamental metrics rather than just one gives investors the needed nuance to rummage through the bargain bin.
We calculated percentile ranks using a five-factor ensemble valuation screen10 analyzing both absolute and relative valuations to the broader global market over the past 15 years. US small caps, followed by emerging markets (EM), screen as the most attractive. All US large caps are the most expensive, including large-cap value stocks — a reflection of their significant outperformance.
Valuation Screens for Markets Trading Above or Below Historical Levels
EM may be cheap for a reason, as earnings revisions have trended sideways and an 11% decline in 2022 earnings growth is currently projected.11 Not ready to signal a bottom in fundamental sentiment, analysts’ 2023 earnings estimates continue to decline. Next year’s growth rate for EM has dropped to 1.7% from 6.0% over the past three months.12
Small caps haven’t witnessed the same degree of negative earnings sentiment. In fact, 2022 earnings-per-share growth is estimated to be 14%, a full percentage point higher than forecasts at the start of the year.13 Additionally, 2023 estimates still call for 4% growth, with three of the four quarters expected to show positive growth (unlike EM, where growth is projected to be flat or negative every quarter).14
Risk aversion helps explain some of the negativity toward small caps from a price return perspective. Small caps are a volatile market segment, and investors dialed down risk in 2022 amid the multitude of macro factors impairing sentiment. This risk aversion rationale is reinforced by the fact that, in 2022, small caps registered their highest average 30-day correlation (93%) to high-beta stocks since 2011 (93.7%).15 Simply put, anything with a whiff of risk was seemingly discarded.
While risk is still likely to be elevated in the near term, if a policy pivot turns market pessimism to optimism and risk aversion declines, our view is that segments with decent fundamentals and attractive valuations may enter a repair phase more quickly than expensive areas. Domestically oriented US small caps represent one of these possibilities, given their cross-sectional valuation.
Within US equities, the semiconductor industry was one of the worst performers in 2022. Its high-growth, long-duration profile was impaired by the significant increase in rates. Semiconductors underperformed the S&P 500 Index by 9% after registering positive excess returns in eight of the past nine calendar years.16 This was the industry’s worst relative performance since 2012, when it fell 10% relative to the market.
Given this dour return backdrop, semiconductor stocks are trading at potentially attractive valuations. On an absolute basis, the current average percentile of the same five-factor-fundamental screen is 36% over the past ten years, as shown in the following chart. Meanwhile, valuations are, on average, in the lower 20th percentile relative to the broader US equity market.
But beneath the surface, three metrics are in the bottom 5th percentile:
These percentile rankings are much more attractive than broad-based tech, a sign that semiconductors carry a differentiated profile than the broader sector.
Semiconductors Screen Attractive
While valuations have re-rated, growth expectations remain elevated. Expected 3-5-year EPS growth has increased from 17.7% at the beginning of 2022 to 18.8%.17 Compared to the broader Tech sector, this seemingly minor one percentage increase is substantial, as the tech sector saw its longer-term forecasts ratcheted down to 12.9% from 14.6% over the same time frame.18
The growth also comes off a more profitable base. Of the six other sub-industries within the broader tech sector, the semiconductor industry has the largest percentage of firms (70%) with positive earnings-per-share figures over the past 12 months.19
Future semiconductor growth could be further supported by the recently passed CHIPS and Science Act, which provides $39 billion for construction of semiconductor plants and $11 billion for semiconductor research and development to be disbursed through 2026.20 The CHIPS and Science Act could add significantly to the momentum in capital expenditures and the ongoing trend of reshoring semiconductor capacity. Announced semiconductor plans have already surpassed $138 billion.21
Risks to the semiconductor sector include highly cyclical demand that is strongly correlated to global GDP and the fact that 80% of the industry’s revenue comes from outside the US.22 An upside surprise on growth stemming from a policy pivot and a weaker US dollar (USD) that mean reverts off 20-year peaks23 could counterbalance the headwinds for semiconductor sentiment and the recent trend of softer, but still positive, sales.
The dollar’s strength has hurt many markets this year, chief among them EM local debt. The segment is expected to have its worst calendar year return ever of -16%,24 which has pushed the yield on EM local debt to its highest level since the Global Financial Crisis, near 6.7%.25
While a shift higher in yields from central bank policy actions detracted from returns, currency effects were the main culprit as the dollar strengthened and EM currencies fell. Historically, EM local debt returns have had a 94% correlation to the returns on EM currencies, so this trend is no surprise.26
In fact, since 2008, EM local debt has had negative returns in 92% of the months when EM currencies fell (and the dollar strengthened), with an average monthly loss of -2.29%.27 As a result, an allocation into EM local debt is not so much a bullish view on the debt from developing nations, but rather a bearish view on the dollar.
High US inflation, rising US rates, and safe demand have kept the USD well-bid and trading at 20-year highs. Yet, given where we are from a valuation perspective, some near-term mean reversion could occur, particularly if a dip in inflation prompts a Fed pivot. That would be positive for risk-asset sentiment and could reduce the demand on the safe haven dollar.
The softening of the dollar would be net positive for EM local debt, as in the months when EM currencies rallied, EM local debt’s return was positive 86% of the time with an average monthly gain of +2.27%, as shown in the previous chart. And as a result of the demoralizing returns, a potential dollar bear allocation offers a generationally attractive yield that just may be worth the risk.
Preferred securities also have witnessed steep declines, returning -16% this year and pushing yields over 6% for the first time since 2013 (except for the brief interval during the COVID-19 crash).28 And not surprisingly, the average price on preferreds has dipped below 85,29 the first time that preferreds have traded at this large of a discount to par (except for the brief interval during the COVID-19 crash).
Part of the reason for the sizable drawdown is that preferreds carry a duration of over seven years.30 Preferreds are also equity sensitive, given that they are hybrid securities with features of both bonds and stocks. The underlying common equity on preferreds fell almost -8% in 2022, on average.31
The weakness, however, is not a result of any outsized credit risk, as the composite quality rating on preferreds is investment-grade.32 Primarily issued by banks and insurance companies, preferreds count toward regulatory capital requirements — and banks issue preferreds to help maintain their required capital ratios. And as of the latest stress tests, major financial institutions were given a clean bill of health, indicating that the underlying fundamentals for the largest sector of issuance are reasonably sound.33
Even with higher rates around the world, there is no sector, credit quality, or rating band in the Bloomberg Global Aggregate Bond Index that has a yield over 6%.34 Preferreds, therefore, offer a deeply discounted investment-grade yield opportunity and also may be able to participate in any risk aversion reversal in the equity market. The attractive entry point serves as a bit of a backstop and balances the risk that the Fed’s policy pivot doesn’t come soon or isn’t as benevolent as many expect.
For opportunities when the pendulum swings back to discarded market segments, consider:
1 Based on the MSCI ACWI IMI Index and MSCI Global Multiverse Index as of November 14, 2022 per Bloomberg Finance, L.P. data.
2 Based on the MSCI ACWI IMI Index as of November 14, 2022 per Bloomberg Finance, L.P. data.
3 Based on the MSCI ACWI IMI Index as of November 14, 2022 per Bloomberg Finance, L.P. data.
4 Based on the MSCI Global Multiverse Index as of November 14, 2022 per Bloomberg Finance, L.P. data.
5 Based on the S&P 500 Index as of November 14, 2022 per Bloomberg Finance, L.P. data.
6 Based on the S&P 500 Index as of November 14, 2022 per Bloomberg Finance, L.P. data from 1995-2022.
7 Based on the MSCI ACWI Ex-US Index as of November 14, 2022 per Bloomberg Finance, L.P. data from 1995-2022.
8 Based on the S&P 500 Index as of November 14, 2022 per Bloomberg Finance, L.P. data.
9 Based on the MSCI ACWI Ex-US Index as of November 14, 2022 per Bloomberg Finance, L.P. data.
10 Price-to-Earnings, Price-to-Earnings-Next-Twelve-Months, Enterprise Value-to-EBITDA, Price-to-Sales, and Price-to-Book.
11 Based on the MSCI Emerging Market Index as of November 14, 2022 per FactSet.
12 Based on the MSCI Emerging Market Index as of November 14, 2022 per FactSet.
13 Based on the S&P 600 Small Cap Index as of November 14, 2022 per FactSet.
14 Based on the S&P 600 Small Cap Index as of November 14, 2022 per FactSet.
15 Based on the S&P 600 Small Cap Index and S&P 500 High Beta Index as of November 14, 2022 per Bloomberg Finance L.P. data.
16 Based on the S&P Semiconductor Select Industry Index and the S&P 500 Index as of November 14, 2022 per Bloomberg Finance, L.P. data.
17 Based on the S&P Semiconductor Select Industry Index as of November 14, 2022 per Bloomberg Finance, L.P. data.
18 Based on the S&P 500 Information Technology Index as of November 14, 2022 per Bloomberg Finance, L.P. data.
19 Based on the S&P Total Market Information Technology sector as of November 14, 2022 per Bloomberg Finance, L.P. data.
20 “US semiconductor fabs coming faster than you think”, BofA Equity Research, November 4, 2022.
21 “US semiconductor fabs coming faster than you think”, BofA Equity Research, November 4, 2022.
22 Based on the S&P Semiconductor Select Industry Index as of November 14, 2022 per Bloomberg Finance L.P. data.
23 Based on the Citi Real Effective USD Rate as of November 14, 2022 per Bloomberg Finance L.P. data.
24 Based on the Bloomberg EM Local Currency Government Diversified Index as of November 14, 2022 per Bloomberg Finance, L.P. data.
25 Based on the Bloomberg EM Local Currency Government Diversified Index as of November 14, 2022 per Bloomberg Finance, L.P. data.
26 Based on the Bloomberg EM Local Currency Government Diversified Index and the MSCI Emerging Market Currency Index as of November 14, 2022 per Bloomberg Finance L.P. data from 2008-2022.
27 Based on the Bloomberg EM Local Currency Government Diversified Index as of November 14, 2022 per Bloomberg Finance, L.P. data from 2008-2022.
28 Based on the ICE Exchange-Listed Fixed & Adjustable Rate Preferred Securities Index as of November 14, 2022 per Bloomberg Finance L.P. data.
29 Based on the ICE Exchange-Listed Fixed & Adjustable Rate Preferred Securities Index as of November 14, 2022 per Bloomberg Finance L.P. data.
30 Based on the ICE Exchange-Listed Fixed & Adjustable Rate Preferred Securities Index as of November 14, 2022 per Bloomberg Finance L.P. data.
31 Based on the underlying common equity of the holdings in the ICE Exchange-Listed Fixed & Adjustable Rate Preferred Securities Index as of November 14, 2022 per Bloomberg Finance, L.P.
32 Based on the ICE Exchange-Listed Fixed & Adjustable Rate Preferred Securities Index as of November 14, 2022 per Bloomberg Finance, L.P. data.
33 “Federal Reserve Board releases results of annual bank stress test, which show that banks continue to have strong capital levels, allowing them to continue lending to households and businesses during a severe recession,” Federal Reserve, June 2022.
34 As of November 14, 2022 per Bloomberg Finance, L.P. data.
Bloomberg Global Aggregate Bond Index
A benchmark that provides a broad-based measure of the global investment-grade fixed income markets. The three major components of this index are the U.S. Aggregate, the Pan-European Aggregate, and the Asian-Pacific Aggregate Indices. The index also includes Eurodollar and Euro-Yen corporate bonds, Canadian government, agency and corporate securities, and USD investment-grade 144A securities.
Bloomberg Global Multiverse Bond Index
The index broadly tracks the global fixed-income bond market. It contains exposure to global investment grade and high yield fixed income securities as it is a union of the Bloomberg Global Aggregate and Global High-Yield indices.
Developing countries where the characteristics of mature economies, such as political stability, market liquidity and accounting transparency, are beginning to manifest. Emerging market investments are generally expected to achieve higher returns than developed markets but are also accompanied by greater risk, decreasing their correlation to investments in developed markets.
Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA)
An approximate measure of a corporation’s operating cash flow that is used to analyze and compare profitability between companies and industries because it eliminates the effects of financing and accounting decisions.
Earnings Per Share (EPS)
A profitability measure that is calculated by dividing a company’s net income by the number of shares outstanding.
Global Financial Crisis
The economic crisis that occurred from 2007-2009 that is generally considered biggest economic challenge since the Great Depression of the 1930s. The GFC was triggered largely by the sub-prime mortgage crisis that led to the collapse of systemically vital US investment banks such as Lehman Brothers. The crisis began with the collapse of two Bear Stearns hedge funds in June 2007, and the stabilization period began in late 2008 and continued until the end of 2009.
An overall increase in the price of an economy’s goods and services during a given period, translating to a loss in purchasing power per unit of currency. Inflation generally occurs when growth of the money supply outpaces growth of the economy. Central banks attempt to limit inflation, and avoid deflation, in order to keep the economy running smoothly.
A system of ranking scores that shows the percentage of results that are lower than the benchmark or fund in question for the most recent three-year period. Every year, each score is updated with the most recent year’s percentiles.
Price-to-Forward Earnings Ratio
The price of a security per share at a given time divided by its projected earnings per share over the coming year. A forward P/E ratio is a way to help determine a security’s stock valuation — that is, the fair value of a stock in a perfect market. It is also a measure of expected, but not realized, growth
An investor or portfolio that invests assets into one or more sector of the economy such as financials, energy, or health care.
Small Cap Stocks
Stocks with a relatively small market capitalizations— generally companies with market values of between $300 million and $2 billion. Small-cap stocks are more volatile than mid- or large-cap stocks, but tend to deliver higher returns over longer time periods.
S&P 500® Index
A popular benchmark for U.S. large-cap equities that includes 500 companies from leading industries and captures approximately 80% coverage of available market capitalization.
The process of determining the current worth of an asset or a company.
The views expressed in this material are the views of Michael Arone and Matthew Bartolini through the period ended November 17, 2022 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
The information provided does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your tax and financial advisor.
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Past performance is not a reliable indicator of future performance.
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Investing involves risk including the risk of loss of principal.
Diversification does not ensure a profit or guarantee against loss.
Frequent trading of ETFs could significantly increase commissions and other costs such that they may offset any savings from low fees or costs.
Non-diversified funds that focus on a relatively small number of [stocks, issuers, countries] tend to be more volatile than diversified funds and the market as a whole. While the Fund is expected to operate as a diversified fund, it may become non-diversified for periods of time solely as a result of changes in the composition of its benchmark index.
Companies with large market capitalizations go in and out of favor based on market and economic conditions. Larger companies tend to be less volatile than companies with smaller market capitalizations. In exchange for this potentially lower risk, the value of the security may not rise as much as companies with smaller market capitalizations.
Equity securities may fluctuate in value in response to the activities of individual companies and general market and economic conditions.
Because of their narrow focus, sector funds tend to be more volatile than broadly diversified funds and generally result in greater price fluctuations than the overall market.
Passively managed funds hold a range of securities that, in the aggregate, approximates the full Index in terms of key risk factors and other characteristics. This may cause the fund to experience tracking errors relative to performance of the index.
Preferred securities are subordinated to bonds and other debt instruments, and will be subject to greater credit risk. The fund may contain interest rate risk (as interest rates rise bond prices usually fall); the risk of issuer default; inflation risk; and issuer call risk. The fund may invest in US dollar-denominated securities of foreign issuers traded in the United States.