History says the market gains will continue … but valuation measurements tell us this isn’t an attractive market … riding the line between momentum and valuation … do you stay with Big Tech?
If history repeats, the S&P will climb 8% between now and the end of 2023.
Since 1945, when the S&P 500 rises at least 10% in the first half of a year (which it did, climbing 15.9%), it then adds another 8%, on average, in the second half.
So, is it time to push all your chips into this market?
Well, from a broad, valuation perspective, no – this is not an especially attractive market.
On the other hand, from a momentum perspective, yes – there are plenty of individual, surging stocks that appear very attractive.
But here’s where it gets complicated…
The Venn Diagram overlap of these two buckets – unattractive valuation and very attractive momentum – is enormous.
So, how do we handle this apparent contradiction?
Do we stay out of this market due to valuation concerns…but potentially miss big gains from surging stocks?
Or do we jump into the market while bullish spirits are here…but potentially suffer painful losses when expensive valuations mean-revert?
To answer, let’s begin by looking at the broad market valuation headwind.
Big picture, stock investors are getting less return potential for more risk exposure
Let’s look at the S&P’s valuation from a different angle.
Stocks aren’t the only game in town. There are bonds, real estate, cryptos, private equity deals, foreign assets, commodities, you name it. At the end of the day, what’s important is the highest risk-adjusted return, or yield.
For our purposes today, we can rephrase this as “after the blistering rally so far this year, how attractive are stocks as an asset class, relative to risk-free treasuries?”
We answer this by calculating the Equity Risk Premium (ERP). The ERP shows us how much extra return stock investors are demanding beyond the return they can get from risk-free investments (U.S. bonds).
Comparing the size of today’s ERP to its long-term average gives us a sense for whether stocks are offering us a good relative deal today.
To do this, we start with the yield of our risk-free asset, which is the 10-year Treasury note. As I write, the 10-year yields 3.86%.
Next, let’s figure out the overall yield from the S&P.
We start with the S&P’s earnings yield. This is just the inverse of its price-to-earnings (PE) ratio. According to Multpl.com, the S&P’s PE ratio is 25.79. So, when we divide “1” by “25.79” that gives us 3.88%.
Now, let’s factor in dividends. According to Multpl.com, the S&P’s current dividend yield is 1.53%.
Combining the S&P’s earnings yield and dividend yield gives us a total yield 5.41%.
So, we have two choices: treasuries yielding 3.86% or the S&P yielding 5.41%
But while the S&P is clearly offering a greater yield than treasuries, it’s not an apples-to-apples comparison because the risk levels aren’t the same.
As noted a moment ago, the way to analyze whether stocks are attractive on a risk-adjusted basis is by measuring our current ERP to the long-term average ERP.
So, we take our total S&P yield of 5.41% and subtract the risk-free rate of 3.86% to give us a current ERP of 1.55%.
For the long-term average figure, though it bounces around, its 20-year average ERP is roughly 3.68%.
This tells us that, at today’s prices, stock investors are demanding far less upside (less than half) in exchange for the added risk they’re taking relative to bonds.
Here’s Morgan Stanley:
Importantly, the equity risk premium—or the extra return an investor can expect for investing in the stock market instead of risk-free 10-year Treasuries—is at its lowest level in about 20 years.
So, from an average valuation perspective, this is not an attractive stock market.
But many of the specific stocks behind these “unattractive” valuations are actually incredibly attractive from a momentum perspective
As you’re aware, 2023 has been the year of Artificial Intelligence (AI) stocks. Their performance has dominated everything else.
And which stocks have investors flooded into more than just about any other in their attempt to get AI exposure?
Big Tech.
While we could think of them as “FANNGM Pt II,” investment talking head Jim Cramer has given them a new name: “The Magnificent Seven.”
We’re referencing Apple, Microsoft, Nvidia, Amazon, Meta, Tesla, and Alphabet.
These stocks have exploded on the year. Here’s their performance:
Apple: 48.6%
Microsoft: 41.6%
Nvidia: 190.3%
Amazon: 55.0%
Meta: 137.7%
Tesla: 127.2%
Alphabet: 35.9%
But this price surge has also sent their valuations into the stratosphere. And given the heavy weighting of the Magnificent Seven in the S&P, this is a huge reason why the Index’s Equity Risk Premium appears so unattractive by historical standards.
To illustrate, let’s look at the percentage change in the price-to-earnings ratio of the Magnificent Seven here in 2023
Below, we’ll show the January 1, 2023, PE ratio, the current PE ratio, and the resulting percentage change:
Apple: 22.06… 32.68… 48% more expensive
Microsoft: 26.65… 36.62… 37% more expensive
Nvidia: 62.19… 220.90… 255% more expensive
Amazon: it had a negative PE ratio until April, so let’s use its five-year average of 96.03 as our beginning point… 310.05… 223% more expensive
Meta: 14.03… 35.49… 153% more expensive
Tesla: 38.10… 82.30… 116% more expensive
Alphabet: 19.50… 26.85… 38% more expensive
It’s no wonder the S&P’s Equity Risk Premium is so low – during the first half of the year, investors have already gobbled up so much of that premium.
So, with the S&P and the Magnificent Seven attractive from a momentum perspective but unattractive from a valuation perspective, what do we do?
In short, we invest, but do so cautiously.
If we’re overly simplistic, we can break down investing into four broad categories:
- Cheap stocks with bullish action
- Expensive stocks with bullish action
- Expensive stocks with bearish action
- Cheap stocks with bearish action
Obviously, the best category is a cheap, bullish stock. The stock is moving in the right direction, and because of its valuation, there’s reason to believe it can continue in that direction for a long time to come.
But the second-best category is an expensive, bullish stock. After all, momentum is an incredibly powerful market force. And it can continue driving gains for far longer than valuations might justify.
That’s what we have today with the Magnificent Seven stocks.
Of course, as noted earlier, greater caution is warranted because the stage on the way is “expensive with bearish action.” And that’s the worst possible category, when losses can come fast and furious.
So, how do you respond to this tradeoff?
Well, being simplistic, a way to navigate the tension is by joining in the gains – yet with a trader’s mindset.
In other words, rather than buying stocks like the Magnificent Seven with the idea that they now have a permanent place in your portfolio, view them as short-term tools. They’re merely a means by which you’re making money. And the moment that they stop making you money, they’ll no longer have a place in your portfolio.
Now, that sounds easy, but what about the risk that they suddenly fall into the “expensive & bearish” bucket?
Well, in past Digests, we’ve recommending using a stock’s PE ratio as an inverse measure of your position size.
In other words, the larger the current PE ratio (relative to the stock’s average PE ratio), the smaller the position size you’ll take. This limits your downside risk.
To protect your wealth even more, you can pair a position-size with a thoughtful trailing stop level.
The idea is that you want this trailing stop to be wide enough to allow for the stock’s normal day-to-day volatility, but tight enough to protect your wealth from significant losses when momentum turns bearish.
Together, these risk mitigation tools help you walk a tight rope…
You get exposure to the surging Magnificent Seven (or whatever other AI stocks you like today) which might have a great deal more surging to do before the gains run out…but you do so with a hat-tip toward risk by exposing fewer of your dollars to the position.
Wrapping up, no, this is not a particularly attractive market from a broad, fundamental perspective
But if your definition of “attractive” skews more toward “making money,” then it remains a very attractive market thanks to momentum.
So, though we need to be cautious about the category of “expensive with bearish action,” we have no idea when it will arrive. And that means adopting a nimble trader’s mindset.
Be smart about your position sizes… be smart about your stop-losses… but with those risk mitigation tools in place, keep sucking the Equity Risk Premium out of this market for as long as bullish conditions are here.
Have a good evening,
Jeff Remsburg
