The Stock Market is Expensive: Where to Invest Now- By: Austin Crites
The US stock market looks expensive, but that is mainly driven by Large “Growth” stocks
US “Value”, “Small Cap” and “Foreign” stocks have relatively more attractive valuations
Value is a poor timing tool, but it can be a strong indicator of long-term forward returns
All data, charts, and tables in this article unless otherwise noted have been Powered by FactSet.
12/27/2021
“History doesn’t repeat itself, but it often rhymes” – Mark Twain
A common concern I hear from investors is that the stock market is expensive leaving people frustrated with a lack of attractive investment options. I believe those concerns to be valid, however, the headline valuation levels appear to be driven mainly by large US growth stocks. In my opinion, pockets of opportunity still exist. To find them, it is helpful to look beyond the aggregate and dissect the universe into different segments. It appears that opportunities exist within certain “value” style segments and smaller stocks both in the US and overseas and especially for companies with capital intensive business models which have been largely overlooked for much of the past decade. I will use a series of charts to help illustrate my point regarding valuation levels. It should be noted that valuation is a poor timing tool, however, it has been a strong indicator of future returns over longer periods of time (think 5-10 years or more). It is not my process to try to time the market, but to try to position client portfolios to achieve the best possible risk-adjusted returns on a forward-looking basis.
As an example of how valuation levels impact future returns, see the below study by JP Morgan which you can find in their “Guide to the Markets”
Source: FactSet, Standard & Poor’s, Thomson Reuters, J.P. Morgan Asset Management. Returns are 12-month and 60-month annualized total returns, measured monthly, beginning 8/31/96. R² represents the percent of total variation in total returns that can be explained by forward price-to-earnings ratios. Price-to-earnings is price divided by consensus analyst estimates of earnings per share for the next 12 months as provided by IBES since July 1996, and J.P. Morgan Asset Management for September 30, 2021. Guide to the Markets – U.S. Data are as of September 30, 2021.
The S&P 500 Looks Expensive Relative to Historical Observations
To illustrate my point, I use price to trailing earnings per share for the iShares Core S&P 500 ETF (IVV). If I use forward estimates the numbers change but the chart looks similar. By these measures, the S&P 500 is extremely expensive relative to the valuation levels it has traded at for most of the past 20+ years.
As Twain said, History often Rhymes
Students of market history should be feeling a bit of déjà vu. Two examples immediately come to mind. The most recent example is the tech/telecom bubble of the late 1990s which burst in the early 2000s. Stock market participants were enthralled by the emerging industries of everything dotcom as well as the telecom industry that would enable the internet revolution. As a proxy, the iShares Russell 1000 Growth ETF (IWF) indeed is trading at its most dear valuation since that period. Today’s darlings involve blockchain, artificial intelligence, electric vehicles, etc., along with many asset-light subscription businesses. These businesses tend to be technology stocks in the “growth” indices.
The prophecies told during the tech/telecom bubble of a transformed world were largely true, however, in aggregate the investments didn’t pan out very well because of the astronomical price paid. As you can see below, IWF suffered poor returns for over a decade that started with nose-bleed valuations.
Again, today the S&P 500 is extremely concentrated which bodes poorly for future returns. See this article by the Wall Street Journal for more information on why the biggest stocks in the index often have poor future returns. Gigantic Stocks Are a Reason to Worry - WSJ
Going back further, more seasoned investors may recall the “Nifty Fifty” of the 1970s. Lawrence Hamtil put together an insightful blog describing this period and the experience that followed. In a nutshell, about 50 stocks of mostly iconic companies traded at extremely expensive multiples. Most of the companies turned out to dominate their respective industries (Walt Disney, McDonalds, Coca Cola, etc.) but investors paid so much for them their returns for the ensuing decade were disappointing (though the 20 year and longer returns are much better).
“Value” Style Stocks May Be More Attractive
Investors may find more fertile ground in value stocks. While the valuation does not appear to be a huge bargain, it trades at only a slight premium to its typical valuation. Further, the value universe is more populated with the types of businesses that should benefit if inflation continues to run hot. Commodity producers, banks, life insurance companies, real estate investment trusts, heavy industry, and the like tend to do better when prices (including interest rates) go up because they own the assets that tend to appreciate. According to FactSet, as of November 30, 2021, the iShares Russell 1000 Value ETF comprises 24.06% Finance stocks, 17.39% healthcare stocks, and just 11.64% technology. By comparison, FactSet indicates that on the same date the iShares Russell 1000 Growth ETF contains by weight 52.96% technology stocks.
If we consider this on a relative basis (Value vs Growth), the opportunity becomes clearer. By this measure, value stocks are historically cheap. That doesn’t mean we should necessarily expect blockbuster returns from “Value”, but I believe they are likely to produce a better return than “Growth” stocks in the years ahead. For example, from 2001 through 2005 the iShares Russell 1000 Growth ETF lost a total of 18.22% while the iShares Russell 1000 Value ETF had total returns of 24.94% over the period. Given the wide dispersion in trailing P/E multiples, we may see something similar in the years ahead. “Value” should always trade at a discount to “Growth” because higher growth rates warrant a greater earnings multiple. However, when investors fall in love with an idea they tend to forget to ask “how much” creating pockets of overvaluation and relative opportunities in forgotten areas of the market. During the Dotcom bubble, value stocks were too cheap relative to the growthy technology stocks. That situation reversed prior to the financial crisis. Investors became enthralled by the profitability of the big banks and commodity producers pushing up value stocks. This created an opportunity in “Growth” as investors underpriced earnings growth. Now, we find ourselves back where we started as market participants are paying through the nose for growth and have largely forgotten the more cyclical and hard asset businesses that largely constitute “Value” stocks. I find this to be a useful lens through which you can cut through the noise to find better than average opportunities and put the odds in your favor.
Size Matters
Let’s look at the situation through another lens. Similar to the tech/telecom bubble, the stock market valuations are frothiest in the biggest companies. The chart below shows trailing price to earnings ratios for the S&P 500 ETF (IVV) representing large companies and the Russell 2000 ETF (IWM) representing smaller companies. While large stocks have outpaced smaller in recent years driving the valuation multiples higher, the last time we saw a starting valuation gap like this was in late 2000. Using the same timeframe as the previous study from 2001 through 2005, the iShares S&P 500 ETF (IVV) produced total returns of just 1.53% vs 43.08% for the iShares Russell 2000 ETF (IWM). With small cap stocks trading at levels today similar to 2001, it is conceivable that a similar opportunity exists in this space on both a relative and absolute basis.
What about International?
The S&P 500 tends to trade at a slight premium to international equity markets due to differences in quality, but the premium is historically quite small. The chart below shows trailing price to earnings ratios for the S&P 500 ETF (IVV) representing large companies and the iShares MSCI EAFE ETF (EFA) representing foreign companies. While large US stock returns have outpaced their foreign counterparts in recent years driving the valuation multiples higher, the last time we saw a starting valuation gap like this was in late 2001. From 2002 through 2005, the iShares S&P 500 ETF (IVV) produced total returns of just 15.49% vs 57.15% for the iShares MSCI EAFE ETF (EFA). Again, I believe this starting valuation difference is a strong indicator of future relative performance. US vs Foreign stock returns can be at least partially explained by the differences in sector exposure, similar to that of the growth & value dynamic. The US dominates global tech (outside of China). By contrast, technology stocks comprise just 10.89% of (EFA) as of 11/30/2021 according to FactSet. Foreign stocks appear to offer a greater return opportunity going forward than large US stocks.
In Summary
At Aurora, we are constantly looking for attractive investment opportunities for our clients. We look for businesses with economic moats, quality balance sheets and attractive upside potential. This blog represents our thinking at the time of publication. If you are a DIY investor, use this only as a starting point for your research and be sure to do your own due diligence. For questions regarding our asset allocation and individual stock strategies, please reach out to us!
Invest Curiously,
Austin Crites, CFA
Austin Crites is the Chief Investment Officer of Aurora Financial Strategies, a financial advisory firm based out of Kokomo, IN. He can be reached via email at austin@auroramgt.com. Investment Advisory Services are offered through BCGM Wealth Management, LLC, a SEC registered investment adviser. This blog does not constitute advice. This is not an offer to buy or sell securities. Advisor is not licensed in all states. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. BCGM Wealth Management, LLC manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results. Clients may own positions in the securities discussed.
