Que será, será
The start of a new year brings with it a parade of economists, sell side analysts, and strategists of all kinds with projections for what the ensuing twelve months will deliver to investors. In our opinion, the idea that on January 1st someone would say, with any degree of certainty, that the S&P should finish the year at 5,138 (or pick your number) is either delusional, blatant pandering, or extreme hubris. And yet, turn on your favorite financial news network and that’s what you’ll hear, or pick up your favorite financial publication and that’s what you’ll read. The range of possible outcomes around such a prediction for a one-year period ultimately makes such a prediction of little value, but that doesn’t seem to affect the supply or demand for prognostications.
Regardless, we do know history. According to Ibbotson’s Stocks, Bonds, Bills & Inflation, from 1926 through 2020, U.S. large cap stocks have posted:
- An average annualized return of +10.3% (+7.2% real)
- A simple average return of +12.2%
- A maximum annual return of +53.9% in 1933
- A minimum annual return of -43.3% in 1931
- 70 calendar years of positive returns
- 25 calendar years of negative returns
With that as background, and peering into our Magic 8 Ball, our guess is that stocks will probably do better than -43% and worse than +54% in the coming year. Whatever will be, will be.
Sticking with the facts:
- The economy is, as of this pre-Omicron-impact moment, firing on all cylinders.
- Liquidity abounds, and the Fed’s tapering efforts won’t seemingly change that anytime soon.
- Many U.S. large cap companies are enjoying record margins.
- U.S. stock dominance continues, and as a result, we believe valuations are stretched.
- A small group of stocks exhibited undue influence on the performance of the S&P 500 in 2021.
- Our long term expected returns to essentially all major asset classes remain low by historical standards.
- At Frontier Asset Management, we will continue to employ time tested risk management measures (risk management being a quaint little notion from a different era), into everything we do, because alas, we don’t know what the market will do in 2022.
Much of the above is in flux however, so in keeping with the times, as everything must be “unpacked” these days, let’s begin.
Through November, the U.S. added 6.1 million jobs during the year, the largest increase on record. Further, the unemployment rate stands at 4.2%. Initial jobless claims recently hit a low not seen since 1969, and the number of job openings has eclipsed 11 million, which equates to about 1.5 job openings for each unemployed individual. The job market is quite strong and even with the potential impact of Omicron, most economists see continued gains throughout next year.
Likewise, overall growth has been solid, and while U.S. Real Gross Domestic Product (GDP) is expected to advance at a more modest pace next year, i.e., 3.9% vs. 5.6%, if expectations are met, that would still be well above average since the Great Financial Crisis. Beyond 2022 however, the growth picture appears as if it will settle back into its pre-pandemic low growth mode.
The G4 central bank balance sheets collectively stood at roughly $24.5 trillion as of late October, according to data from KKR, compared to about $15 trillion pre-COVID-19, and $6.7 trillion in 2009. The U.S. Federal Reserve has announced its intentions to quicken the pace of its tapering efforts, but remember, less bond buying is still bond buying; it is still stimulative. The liquidity picture remains a positive for asset prices, and while that won’t change quickly, the bathtub stopper has been pulled.
If supply chain problems, labor shortages, and rising inflation were supposed to put a dent in profits, someone didn’t get the memo. Operating margins reached an all-time high of 13.5% during the second quarter, as did both operating and as reported earnings per share for the S&P 500®. If pressed, we’d say that the aforementioned clouds gathering on the horizon, along with notable wins for labor amidst a hyperfocus on living wages, an ominous regulatory environment facing big tech, and the likely creep of rising debt service, all argue against further margin expansion.
Relative Performance & Valuations
It is understandable that investors’ perception of the benefits of diversification has taken a hit as we look back over the past decade. Through December 31, 2021, the S&P 500 has trounced every other asset class that we model, annualizing at 16.6%, versus 8.0% for MSCI EAFE, and 5.5% for MSCI Emerging Markets, to name a few. And that outperformance has been quite consistent as well, with the S&P 500 beating each of those major equity classes in 8 of the past 10 calendar years. Indeed, the chants of USA, USA have been justified of late, but with several caveats.
For one, as pointed out by GMO in their most recent quarterly letter, the difference between the S&P’s dismal performance for the decade ending in September of 2011, and its relative outstanding performance for the decade ending in September of 2021, was almost entirely due to valuation changes, not fundamentals. Valuation is impacted greatly by sentiment, and investors have been increasingly enthused and willing to pay up for a dollar of earnings.
Secondly, creative destruction and good old-fashioned competition on a global scale can swing the fortunes of market participants widely over time. Earlier this year we looked at the earnings growth picture for the decade ending in March, and found that while emerging market earnings growth at a mere 4.2% annually could certainly explain the underperformance to U.S. stocks, the same couldn’t be said for EAFE, where earnings grew at a respectable 10.2% annually versus 11.9% for the S&P. And in the decade ending in March of 2011, not only did emerging market earnings growth greatly eclipse that of the U.S. (10.4% vs. 5.1% annually), emerging market equities likewise crushed U.S. stocks, with a total return of 16.8% vs. 3.3% for the S&P 500. Point being, sometimes fundamentals are the driving force behind returns, and sometimes sentiment is in that driver seat, but over time it has paid to be diversified. Reflecting on performance in March of 2011, investors wondered why they hadn’t held a lot more emerging market equities and why they bothered with the S&P 500. Time has a way of changing perceptions.
Importantly, the love of U.S. stocks has pushed valuations to extreme levels by almost every measure, as seen in the following table. Granted, the yield gap and free cash flow yield can both be held up as reasons why stocks have room to run, but when everything else is flashing red, arguments favoring a “this time is different” rationale ring hollow to us.
Valuations in the more risky segments of the bond market, as measured by spreads over the last decade, are similarly unattractive, as pointed out by KKR’s Henry McVey.
The Undue Influence of a Few
One last point on the performance of markets this past year, according to Goldman Sachs, 35% of the S&P 500’s year-to-date return through December 9th came from just five stocks: Microsoft, Google, Apple, Nvidia and Tesla. And related (and also found in the report from KKR referenced above), it is quite hard to stay on top. The five largest stocks in the S&P 500 in 2000 accounted for 18% of the index, and now makeup just 8%. Whereas the five largest stocks in the S&P today accounted for less than 5% of the index in 2000, and now makeup a remarkable 23% of the index (as of November 12th).
As has been the case with the changing fortunes of equity asset classes at a macro level, that same pitched battle goes on between the constituents of the indices over time.
Expected Returns: Investors Should Temper Their Expectations
As we’ve hopefully impressed upon our readers, we don’t claim to know what will happen over the next year. We do know that all the macro factors that have contributed to the impressive run that we’ve witnessed in asset prices, especially U.S. stocks, are changing, and most likely, not for the better. The bar is quite high.
Our work, summarized in the table below, indicates that, in our opinion, investors should temper their expectations at this point. Decent returns can still be had, and we will endeavor to harvest as much as we can from what the markets make available, but it’s only getting harder based on our analysis*.
Happy New Year to all!
 U.S. Bureau of Labor Statistics
Past performance is no guarantee of future returns. Performance discussed represents total returns that include income, realized and unrealized gains and losses, but gross of advisory fees. Nothing presented herein is or is intended to constitute investment advice or recommendations to buy or sell any types of securities and no investment decision should be made based solely on information provided herein. There is a risk of loss from an investment in securities, including the risk of loss of principal. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable or suitable for an s investor’s financial situation or risk tolerance. Diversification and asset allocation do not ensure a profit or protect against a loss. All performance results should be considered in light of the market and economic conditions that prevailed at the time those results were generated. Before investing, consider investment objectives, risks, fees and expenses. Frontier may modify its process, opinions and assumptions at any time without notice as data is analyzed.
Information provided herein reflects Frontier’s views as of the date of this newsletter and can change at any time without notice. Frontier obtained some of the information provided herein from third party sources believed to be reliable, but it is not guaranteed, and Frontier does not warrant or guarantee the accuracy or completeness of such information. The use of such sources does not constitute an endorsement. Frontier’s use of external articles should in no way be considered a validation. The views and opinions of these authors are theirs alone. Reader accesses the links or websites at their own risk. Frontier is not responsible for any adverse outcomes from references provided and cannot guarantee their safety. Frontier does not have a position on the contents of these articles. Frontier does not have an affiliation with any author, company or security noted within. Frontier reserves the right to remove these links at any time without notice.
Exclusive reliance on the information herein is not advised. This information is not intended as a recommendation to invest in any particular asset class or strategy or as a promise of future performance. References to future returns are not promises or even estimates of actual returns a client portfolio may achieve. Assumptions, opinions and estimates are provided for illustrative purposes only. They should not be relied upon as recommendations to buy or sell any securities, commodities, treasuries or financial instruments of any kind. This material has been prepared for information purposes only and is not intended to provide, and should not be relied on for, accounting, legal, investment or tax advice. Frontier does not directly use economic data as a part of its investment process.
In reviewing the performance information presented here, we recommend that you consider both the returns generated and the level of risk that was assumed in generating those results. We believe that performance information cannot be properly assessed without understanding the amount of risk that was taken in delivering that performance.
Hypothetical expected returns have certain limitations, are shown for illustrative purposes only and it should not be assumed that actual results will match the hypothetical expected returns shown. Unlike actual performance, hypothetical expected returns do not represent actual trading and since trades have not been executed, the results shown may have under or overcompensated for the impact, if any, of certain unforeseen market factors. Hypothetical expected returns, whether back-tested or forecasted, have many inherent limitations and no representation is being made that any account will or is likely to achieve the results shown. In fact, there are frequently material differences between hypothetical expected results and actual results achieved. One of the limitations of hypothetical expected results in that they do not take into account that material market factors may have impacted the adviser’s decision-making process if the firm were actually trading clients’ accounts. Also, when calculating the hypothetical expected returns, the adviser has the ability to change certain assumptions and criteria in order to reflect better returns. There are numerous other factors related to the markets in general or to the implementation of any specific investment strategy that cannot be fully accounted for in the preparation of hypothetical expected results, all of which can adversely affect actual trading and performance. Importantly, it should not be assumed that investors who actually invest in this strategy will have positive returns or returns that equal either the hypothetical expected results reflected or any corresponding benchmark presented. In addition, performance can, and does, vary between individuals
Frontier provides model strategies to various investment advisory firms and does not manage those models on a discretionary basis. The performance and holdings of model strategies may vary from strategies managed by Frontier.
Any forward-looking statements or forecasts are based on assumptions and actual results are expected to vary from any such statements or forecasts. No reliance should be placed on any such statements or forecasts when making any investment decision. The estimates, including expected returns and downside risk, throughout are calculated monthly by Frontier and will change from month to month depending upon factors, including market movements, over which Frontier has no control. They are only one factor among many considered in Frontier’s investment process and are provided solely to offer insight into Frontier’s current views on long-term future asset class returns. They are not intended as guarantees of future returns and should not be relied upon in making investment decisions.
U.S. Market Cap to GDP measures the total value of all publicly-traded stocks in the U.S., divided by the U.S. Gross Domestic Product. The ratio in the chart above is calculated by dividing the S&P 500 Index by the US GDP.
The cyclically adjusted price-to-earnings ratio, commonly known as CAPE, Shiller P/E, or P/E 10 ratio, is a valuation measure usually applied to the US S&P 500 equity market. It is defined as price divided by the average of ten years of earnings, adjusted for inflation.
The enterprise value to sales (EV/Sales) ratio is similar to the price-to-sales ratio, but the price is adjusted for the company’s debt and cash levels.
The EV/EBITDA ratio measures a company’s valuation relative to its EBITDA, or Earnings Before Interest, Taxes, Depreciation, and Amortization.
The forward price-to-earnings (P/E) ratio is like the PE ratio, except that it uses the estimated earnings over the next year instead of historical earnings.
The price-to-book (P/B) ratio measures a stock’s price relative to book value. Book value is also called Shareholders’ equity.
The free cash flow (FCF) yield measures a company’s free cash flow relative to its price, shown as a percentage. It is the inverse of the P/FCF ratio.
U.S. Large Cap Equities
Represents US large company stocks. It is a market-value-weighted index of 500 stocks that are traded on the NYSE, AMEX, and NASDAQ.
International Developed Markets
Measures the equity market performance of developed markets outside of the U.S. & Canada.
MSCI Emerging Markets
Captures large and mid cap representation across 27 Emerging Markets (EM) countries.