February 2023
2022 was a challenging year for investors. Stocks succumbed to what may prove to be the opening stages of a prolonged bear market. The S&P 500 Index peaked on January 3rd, 2022 and finished the year down -18%. Bond markets fared much worse, with U.S. Treasuries as measured by the ICE U.S. Treasury 20+ Year Bond Index falling -31%, registering their largest drop in 100 years. Commodities were the only major asset class to finish with a positive return in 2022.
Of course, it is impossible to know with any certainty when or if a bear market will materialize. However, looking back to the start of the year, stocks in general and especially growth stocks in particular were at record high valuations. There were clear signs of investor euphoria on display with the zeal associated with meme stocks, profitless tech companies, and SPAC issuers. Additionally, the monetary authorities were preparing to remove liquidity from the financial system by ending their quantitative easing programs and raising interest rates. We would not be surprised if the volatile markets we experienced last year continue into the first half of 2023 or potentially even longer.
In fact, from a fundamental perspective, we continue to see a clear disconnect between current stock valuations and interest rates. We can make this observation by using prevailing interest rates to arrive at an appropriate price-to-earnings (P/E) multiple for the S&P 500 Index and compare it to the actual reading. This is because the P/E multiple is effectively the reciprocal of the required return for equities. For example, a 10x and 20x P/E multiple represents a 10% and 5% required return on equities respectively. In practice, the required return for equities is usually calculated as the 10-year treasury yield plus an equity risk premium to compensate investors for the added risk of owning stocks.
Currently, the S&P 500 Index is at 4,100 points. According to Bloomberg, consensus estimates for 2023 earnings for the S&P 500 Index are $225 per share. Therefore, the prevailing forward P/E multiple is 18.2x (4,100 divided by $225). The reciprocal of an 18.2x multiple corresponds to a 5.50% required return for stocks. The current 10-year Treasury yield is 3.70%, which implies the equity risk premium is only 1.80% (5.50% minus 3.70%). This compares to a historical range of 3% to 4% for the equity risk premium.
If we apply the historical equity risk premium range of 3% to 4% to the current 3.7% 10-year Treasury yield, then the normalized range of the required return for stocks would be 6.7% to 7.7%. This would translate into a P/E multiple range of 13.0x-14.9x. Multiplying these multiples by consensus estimates of $225 per share would imply a fair value for the S&P 500 Index of 2,925-3,350. As of this writing, the S&P 500 currently trades for a considerably higher 4,100, which implies that growth stocks are still expensive relative to prevailing interest rates.
Given the uncertainty surrounding the sustainability of inflation, the elevated probability of a recession in the next twelve months, and a ground war in Europe; a paltry 1.80% equity risk premium doesn’t seem to be appropriately rewarding investors for the risk of owning stocks in general. If we dare to assume that interest rates stabilize near current levels of roughly 3.7% on the 10-year treasury, then there could be more pain ahead for the S&P 500 Index.
In our opinion, stocks appear to be pricing in a soft landing and return to the era of low interest rates that existed for the last decade. While this is certainly a potential outcome, we believe it is a low probability.
Importantly, when we reflect on the prior decade’s bull market, monetary authorities around the globe were solely concerned (some might say obsessed) with battling deflation and its negative influence on economic growth. The central banker’s arsenal to combat deflation consisted of negative interest rates and endless “emergency” quantitative tightening.
Today, we think it is reasonable to presume that deflation isn’t even on their radar screens. Central bankers are not concerned with deflation, and they no longer have a need or willingness to deploy the monetary tools to combat it. Until, the Fed Chairman begins delivering speeches on the risk of deflation, it is unlikely that we return to the “Free Money” era that embodied the investment environment of the last 12 years.
Conversely, the current macro-economic challenges facing central bankers include persistent levels of elevated inflation, shortages of both labor and major commodities, an overhaul of global supply chains, and declining confidence amongst corporate executives. We haven’t seen a similar combination of risks since the 1970’s.
We believe the market volatility over the prior year is a result of the increasing realization amongst investors that interest rates may not be headed back to zero. It is possible that the factors that drove above-average stock returns (particularly for growth stocks) in the prior decade could be undergoing a secular transition. These market regime transitions seem to unfold every other decade or so, and it isn’t uncommon for months or even years to transpire before it becomes obvious the landscape has shifted.
We think 2022 may have marked a new regime transition as inflation returned after a multi-decade absence and value stocks widely outpaced growth stocks after a decade of underperformance. The gap in valuation metrics between the two investment styles had widened to their largest divergence since the internet bubble of the late 1990’s. Between 2010 and 2021 the Russell 1000 Growth Index had a total return of 18% per year compared to a 12% annual total return for the Russell 1000 Value Index. In 2022, the value index dropped 7.6%, while the Russell 1000 Growth Index fell 29.1%.
We believe the rotation in market leadership towards value stocks could persist for the medium term. We see incredible opportunities in beaten-up value names that offer the potential for attractive future returns. These companies have above-average levels of profitability, strong balance sheets, shareholder friendly management teams, and in our estimation, stock prices that represent a discount to our estimates of their intrinsic values. Value stocks should outperform as real economic growth reaccelerates and interest rates remain near current levels.
Unfortunately, this outlook is not as favorable for more expensive growth stocks that relied on more accomidative monetary policies and sluggish economic growth. As the regime transition continues, we would expect that asset valuations could remain volatile and continue to decline in that environment. The bear market in stocks in general as measured by the broad S&P 500 Index and Nasdaq 100 Index may not yet have run their full course.
The silver lining of bear markets is that future long-run returns are getting better for investors, and they are certainly more attractive today than at the beginning of last year.
Tyler Hardt, CFA
Pelican Bay Capital Management
www.pelicanbaycap.com
