Investing in Uncertain Times
What happened last week?
- The S&P 500 shed -2.39%
- The Dow Jones declined by -1.61%
- The Nasdaq plunged by -3.16%
This week investors will digest 3Q earnings reports from 32% of the S&P 500’s constituents, including some big tech, auto and energy names. This comes on top of the 17% of S&P 500 firms that have already reported.
Historically, stocks have performed well in the fourth quarter. Returns have been positive in four of five years with higher median and mean returns than in any other quarter since 1950.
3 Things to Know
Investing Now Makes Sense Despite the Geopolitical Risks
The war in the Middle East and the Russia-Ukraine war makes investing difficult. However, such events are most often not a long-term driver of world financial markets.
The key is whether these events catalyze a turning point in regional economies or the global economy.
More than 90% of history’s shocking geopolitical events did not reach the critical threshold, collapsing the world economy. As of October 20, 2023, the oil price has dropped 8% despite the greater risks to regional oil producers.
Having cash on hand to “provide liquidity” when markets dislocate is a potentially beneficial, opportunistic strategy.
That said, maintaining and growing core portfolios remains central to building and preserving wealth over time. Though risks are higher than average today, we are entering a period when adding to core portfolios, including equities, bonds, and alternatives, may simply make sense.
US EPS Could Reach a Record High in 2025
When we look at possible equity returns over 12–18 months (the Global Investment Committee’s tactical return window) we expect US EPS to reach a new record high by 2025, even as we are skeptical of analyst estimates for 2024.
In the near term, seasonal trends might help broad equity markets reset before year end. At our most recent Global Investment Committee (GIC) meeting, we elected to make a significant portfolio allocation within equities.
Small and medium sized growth companies in the US have outgrown their large counterparts. These small and mid-cap growth firms trade at a record 32% valuation discount based on current year earnings estimates.
Profitable US SMID also trades at a lower-than-average historical valuation (15.2x trailing earnings vs 21.3x).
These portfolio additions were represented by overweights to the S&P 400 and S&P 600 growth firms. Taken together, the SMID growth indices trade at 15.2x trailing EPS, 29% below their 25-year average absolute valuation. Very few asset classes trade below their long-term averages now.
The discount in profitable SMID growth shares is not the result of poor EPS performance. Their EPS growth has been nearly 12% per annum over the past 10 years, faster than the 9% for large cap US growth companies. It turns out that smaller firms have more room to grow before they dominate their industries.
We foresee a time in 2024 when rate pressures recede and the US dollar declines. This could help set the stage for stronger global growth in 2025.
Current Bond Yields in Rare Air
Investment grade corporate debt yields, even those with low durations, now sit at 6%. This is two times the Fed’s own estimate of its five-year policy rate during the next five years.
And if inflation were to end 2024 at 2.5%, real corporate bond yields will be 3.5% or so. Such real yields are rare, last seen in the late 1990s.
Furthermore, the risk of entering new bond positions is materially less now than it was just 18 months ago. Treasury coupons have moved from near zero to almost 5% today and their price sensitivity (effective duration) has been sharply reduced. And the bond yields across the range of securities have more than doubled since 2021.
While no one can predict the absolute peak for rates, we are likely at the top of the range. High rates, quantitative tightening of more than US$1 trillion, and restrictive bank lending will act as “gravity”, slowing the economy. Lags in the impact of monetary policy are common, but this post-COVID period has delayed their cumulative impact.
See our weekly CIO Strategy Bulletin for more details