Welcome to our final edition for the year of The Markets in Three Charts.
To round out the year and (what a year it’s been) we’ve decided to temporarily shelve our social, economic, share price chart format and instead present three macro charts that are worth discussing given current markets.
Please note we are presenting general insights into our decision making, not investment advice.
CHART 1 – US public debt and stock market value as % of GDP
With the recent bout of volatility and the S&P 500 notching new all time highs, there are concerns about whether the staggering post-COVID market run is sustainable. But markets have been exhibiting fragility for some time. Rampant Crypto speculation, ‘Volmageddon’ events, substantial blow ups/defaults during the most buoyant of markets, and ETF/passive holders running for the narrow exits when the music has stopped, have been regular features of the last few years. In this context, how can we evaluate where the markets currently sit in terms of valuation metrics?
Chart 1 presents a good place to start. The orange line compares the value of US equities to GDP. In 2001 Warren Buffett remarked that this metric ”is probably the best single measure of where valuations stand at any given moment”. The red line, showing total public debt as a percentage of GDP, provides insight into the way that since the Dot Com Crash, public debt has been used as counter cyclical financial stimulus through periods of turmoil. As you can see both these measures now substantially exceed 100% of GDP, having increased substantially during the pandemic. The sustainability and affordability of public debt levels is a subject for another note, but the role of the Fed in underpinning the value of the equities market through low rates and quantitative easing, in perpetuity, is surely too good to be true.
The Fed has already signalled rate rises to tackle inflation and provide monetary headroom for the next crisis, and with private debt levels also at all time highs, surely this flows through to the business cycle.
Crucially for investors, in an environment of too much money chasing too few basis points, just how overvalued are markets if rates were to rise? Using Professor Aswath Damodaran’s intrinsic value calculator for the S&P 500, assuming a rise in long term US government bond rates of just 1% over the next 5 years and a reversion to the long-term S&P 500 annual return of 10.5%, the blue chip US index is almost 50% overvalued.
CHART 2 – Robert Shiller’s valuation metrics
What is a ‘CAPE’? The cyclically adjusted price-to-earnings (CAPE) ratio, commonly known as Shiller P/E, or P/E 10 ratio, is a valuation measure usually applied to the S&P 500 equity market. It is defined as price divided by the average of the previous ten years of earnings, adjusted for inflation. As such, it is principally used to assess likely future returns from equities over timescales of 10 to 20 years, with higher-than-average CAPE values implying lower than average long-term annual average returns. The current CAPE is 38 compared to an all time high of 43.5 just before the Dot Com Crash.
What is an ‘ECY’? Shiller's alternative metric, Excess CAPE Yield (ECY), is calculated by taking the regular CAPE earnings yield and subtracting the "real" or inflation-adjusted rate on the 10-year Treasury bond. What the Excess CAPE shows is how much the future returns on equities should exceed what you'd garner from the Treasury. This is currently 3.3% compared to an all-time low of -1.5% in 2000.
What does Chart 2 tell us? While the CAPE is at levels unseen since 2000, the ECY seems to suggest equities in the context of long-term bond rates are at a historically cheap levels. In short, markets are simultaneously very expensive and fairly cheap. While this does not strike us as particularly healthy, the key insight from these two metrics is how valuations are underpinned by low rates and the extreme reach for yield in equity markets as investors are forced out of low risk, low yield asset classes such as bonds.
While we don’t believe interest rates are returning to their historic levels soon, the recent flattening of the US yield curve is a bearish sign as it implies speculation the Fed will increase rates in the short term. Fresh investors unused to the look of a true bear market (especially those before the dawn of quantitative easing) may well respond with panic.
It is not just Shiller’s CAPE that suggests equity markets are on a serious sugar rush. Median price to sales ratios peaked at a 20 year high in November 2021. Price to Book ratios are well above 20-year averages, and the weight of the top ten stocks in the S&P 500 as a percentage of market capitalisation has also increased to record breaking levels, and so the concentration of markets and risk is at unprecedented altitudes.
While we can't say what the future holds, we can say that at these levels, simple index investing seems perilous to us.
But can't investors just hold through the storm of a market correction and wait it out?
CHART 3 – Number of years to get back to earning 6% in real terms
Why should we care if markets are overvalued?
Each line above measures the initial damage done when a financial bubble bursts, and then tracks how long it subsequently takes an investor to climb back to their “expected” 6% real return (accounting for inflation).
If annualised returns are the measure, then time is the medium through which investors must navigate. Decades of depressed returns can be catastrophic to long term wealth available in a person's lifetime, and it is therefore prudent to avoid huge drawdowns.
What does H&G IM do that sets it apart?
While we remain largely timing agnostic, periodically throughout H&G IM’s 14-year history (previously as Supervised Investments), when broader market returns are so excellent that they defy belief, the firm has taken hedging positions, trimmed risk, and increased our allocations to cash and gold, alongside our process of selecting largely uncorrelated equities (businesses) to hold for the long term.
In September, the H&G High Conviction Fund started allocating a modest budget toward cost effective risk mitigation in the form of out of the money S&P 500 put options. We have also built up a healthy cash holding.
As stewards of capital, it is our job to be experts on risk taking. The directors of the firm have spent years collectively taking risk without exposing themselves to the chance of ruin. They have also done this whilst maintaining benchmark outperformance over the long term.
The Fund’s inception in November 2007 coincided with the beginning of the GFC. Over the next 15 months (peak-to-trough), the ASX Small Ordinaries Accumulation index returned -59% compared to the Fund’s -10% net of fees. In the fourteen years since inception, the Fund has returned 8.5% p.a. net of fees compared to the Small Ordinaries’ 2.5% p.a.
Thank you for reading. If you'd like to know more about H&G High Conviction Fund, please contact Joseph Constable: +61 431 886 186.
Equity Trustees Limited (“Equity Trustees”) (ABN 46 004 031 298), AFSL 240975, is the Trustee for H&G High Conviction Fund. Equity Trustees is a subsidiary of EQT Holdings Limited (ABN 22 607 797 615), a publicly listed company on the Australian Securities Exchange (ASX: EQT).
This newsletter has been prepared by H&G Investment Management Ltd (ACN: 125 580 305; AFSL: 317155) to provide you with general information only. In preparing this report, we did not take into account the investment objectives, financial situation or particular needs of any particular person. It is not intended to take the place of professional advice and you should not take action on specific issues in reliance on this information. Neither H&G Investment Management Ltd, Equity Trustees nor any of its related parties, their employees or directors, provide and warranty of accuracy or reliability in relation to such information or accepts any liability to any person who relies on it. Past performance should not be taken as an indicator of future performance. You should obtain a copy of the Information Memorandum before making a decision about whether to invest in this product.