In my experience as an investment advisor, I find that most people are either too conservative or too aggressive. People come to conclusions based on a few data points but then fail to see the larger concern or investment opportunity without guidance or input from someone more experienced.
This week, let’s consider whether fixed income (aka bonds) or stocks (aka equities) are over-valued, undervalued, or priced just right.
Are Bonds Overvalued?
The short answer is ‘yes’. The 10-year Treasury is 1.5% with inflation above 5%. If the costs are increasing at a 5% rate, borrowing should be be higher. This inversion is because the Federal Reserve and Central Banks around the world are keeping rates low to help businesses harmed by the pandemic as well as consumers with historically low loan rates. When interest rates are lower than the inflation rate, we have negative real rates. This is meant to stimulate consumption while helping borrowers. The policy hurts investors as debt held earns less than the implied devaluation of the underlying currency aka inflation. Negative real rates erode purchasing power to those owning the bonds. This rate phenomena causes assets like real estate and equities to increase in value at the expense of debtholders.
Governments around the world are subsidizing borrowing rates. Through September, the U.S. government was buying $120 billion in Treasuries and mortgage-backed bonds per month. Since the start of the pandemic, the Fed has grown its balance sheet by roughly $8 trillion. While some of these funds are borrowed from investors and other governments, the largest creditor to the U.S government is the American people as most of debt issued to pay for the asset purchases is simply an I.O.U. from the Federal Reserve to the U.S. Treasury.
With debt levels at historic highs during a period of negative real rates, monetary policy is extremely accommodative. Well-run companies that use debt to grow income face a Goldilocks economic environment. This interest rate environment also helps to keep zombie companies alive while helping municipalities to afford increased borrowing needs.
If you are worried a decline in your buying power over time, greater reliance on equities with an emphasis on financially strong dividend paying companies is necessary to recoup the inflation gap.
Are Equities Overvalued?
Some are for sure. Meme stocks like AMC or Gamestop continue to retain market values that make little sense. The interesting part that many overlook is that half of all S&P 500 stocks are down more than 20% since hitting record highs in March.
Despite this, the S&P 500 is up nearly 15% on the year. This discrepancy is because the index is driven by the valuations 10-20 mega-cap companies led by Amazon, Apple, Microsoft, Google, Netflix, Tesla, and Facebook. Looking at the Price/Earnings ratio, this index was expensive at 35.6x this time last year and is 31.1x at present. If we look at projections for 2022 (termed the forward P/E ratio), this index looks much healthier at 22.0x.
The Dow 30 is up a bit more than 10% with relatively modest P/E ratio of 22.4x, down from 27.3x one year ago. If we look at Dows’ forward P/E here, we get a reasonable 18.9 P/E ratio.
The tech heavy NASDAQ 100 appears overvalued with a P/E of 36x and forward P/E of 29x.
With interest rates expected to stay low for years, the valuations of most large and mid-cap companies appear fair with many looking undervalued due to negative real interest rates as well as businesses and consumers flush with cash.
Current market conditions are nearly ideal for well-run and profitable companies. When investing in equities, choose best-in-class companies with defensible market niches, strong cash flow, low debt and proven management teams.
When looking at your portfolio, be concerned about long-dated and low quality bonds. In both cases, risks currently exceed returns significantly. When it comes to stocks, be careful but market conditions and valuations suggest that prices are more likely to go up than down over the next 15 months.
Haddon Libby is the Founder and Managing Partner of Winslow Drake Investment Management. This article should not be construed as a recommendation to buy or sell any stock or bond. Please see your investment professional for advice. If you do not have one, come see us and see why an Investment Advisor that operates as a Fiduciary is preferential to a Broker Advisor. www.WinslowDrake.com
