The major US indices—the S&P 500 and the Dow Jones Industrials—are up over 20% year to date and hit all-time highs over the past week. Many investors are surprised by the market’s resilience, given fears of slowing global growth and possible recession.
Are markets getting too expensive? Are investors too optimistic?
In this market snapshot, we provide our quick take on current market dynamics. To summarize:
- On the surface, US stock prices are not out of line, given current inflation trends and low bond yields.
- That said, beneath the surface, risk and opportunity within US markets have diverged meaningfully over the past 18 months, as investors have pursued excessive defense and passive investment solutions, leaving the rest of the market behind.
- Since September, we have started seeing a notable change in direction, away from over-priced defense and narrowly defined growth, and toward more favorably priced opportunities. For portfolios with a long-term view, we have positioned investments to favor these opportunities.
Market Peaks and All-Time Highs?
- Noting that stocks are at a peak is not a meaningful metric, in our view. It grabs headlines, but is not indicative of opportunity or risk, on the surface.
- With low inflation and very low bond yields, US stocks are not expensive as a group, relative to history. They aren’t cheap either, but our tempered view runs counter to much of what we read in the popular press—that valuations are stretched or unappealing.
- We would need to see inflation heading toward 4% or 5%, or yields on 10-year Treasury bonds exceeding 3% or 4%, to consider whether stocks as a group are overpriced.
Looking Beneath the Surface: Recession Already Here?
- For much of the past 12-18 months, investors have already been acting as if recession were imminent, judging from short-term price movements.
- Consider that defensive investments like utilities, real estate trusts, and long-term government bonds were up over 20%, vs. the S&P 500’s return of only 4%, between September 2018 and September of this year. We have allocations to these important sectors, but we are not chasing them during this run-up. They are getting very expensive, by our research system.
- In contrast, more economically-sensitive investments like small stocks, emerging markets, and commodities, as well as stocks in sectors like transportation, capital goods, banks, and energy were actually down, some as much as -5% or more, during this period. Relative to their fundamental outlooks, we see better long-term potential from stocks in these segments.
Why This Divergence?
- This divergence is occurring, in our view, because 1) investors are responding to macro events like tariff wars, Central Bank monetary policy, and fears of recession; and 2) investors have pursued passive investing strategies (“indexation”) that disproportionately favor the biggest stocks.
- In both cases, investors are making investment decisions regardless of the price being paid, which increases risk over the long-term, in our view.
- For reference, we highlighted the risk from indexation in a report last week (see “Making Bubbles” LINK). To summarize, as billions of dollars have flowed from active investment strategies to passively managed (“indexed”) strategies, mispricing can naturally occur—increasing the risk to a narrow set of winning stocks, and creating unintended opportunity in the process.
Signs of Change?
In October and so far in November, we have seen a shift in investor sentiment, from excessive fear to potential optimism.
We attribute this shift to several interrelated events:
- A recently improving yield curve (which helps banks’ profitability and lending activity);
- Signs that rate cuts and stimulus measures by central banks are beginning to help spur growth (especially in important markets like the US, Germany, and China);
- Better earnings reports from large US companies in October (encouraging investors to perhaps “see a bottom” in negative earnings trends);
- Prospects that the US and China may find at least interim progress on tariff negotiations, ahead of elections next year.
Investors are believing that collectively these developments will lift economic forecasts, which could fuel a further rally in stocks.
In our view, it would be premature to call an “all clear” signal yet.
- We expect the tariff negotiations to be a multi-year process, with many ebbs and flows (see our comment here).
- Likewise, earnings expectations for next year may not meet rising expectations—we note that many companies have actually lowered their guidance for earnings growth next year.
- Finally, we believe excessively low rates are a double-edged sword—helping governments stimulate economies in the short term, but posing long-term risks to managing debt levels should rates rise meaningfully over time.
Nevertheless, this improved sentiment has begun to favor stocks and investments that should benefit from better economic growth or that trade at more compelling valuations.
Conclusion: Investment Strategy and Positioning
The secret to long-term investing is moving to where the better opportunity is—and away from what is popular (and potentially overpriced) today. The challenge is that success often means being early, because it is impossible to know when the turn in sentiment occurs. By design, our research system moves us away from what we consider to carry excess risk and toward those segments presenting better long-term opportunity.
- In US markets, our research indicates an overweight to the Value style (since December 2018) and an emphasis on small- and mid-sized stocks (since Spring 2019).
- Outside the US, we believe emerging markets and international small cap have appeal as well, although a strong US dollar and global economic challenges present meaningful headwinds. Large international markets also offer good value but face weak earnings trends.
- In fixed income, historically low yields and tight spreads encourage us to favor investment grade credits, with medium duration.
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