2022 Outlook: Why Stretched Valuations Might Not Matter
Summary
- Increasing passive investment inflows support higher multiples in the stock market.
- Real 10Y Treasury yields approaching negative territory translate into a bullish signal.
- Traditional alternatives to stocks still fail to capture investors' attention.
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Thesis
Over the past few years, the stock market has been experiencing an impressive run-up, recording a 5-year 110% growth. Despite a massive pullback after the Covid-19 pandemic hit in early 2020, recovery has been swift, with all major indices making new all-time high since. While earnings growth has been strong, valuations have also expanded. According to many analysts, valuations that widely exceed long-term averages have historically forecasted major drops in the stock market and are therefore a strong bearish sign.
Well, I personally place a lot of attention on multiples and relative performance, especially when it comes to analyzing individual companies, there are a few key factors that indicate stretched valuations might be here to stay for a while. In this analysis, I will examine a couple of these factors, after looking into how and if a strong performing year like 2021 could have an impact on this year's S&P 500's returns. Some counterarguments/risks to my thesis are also provided.
Previous Year Influence
For the Year 2020, the S&P 500 closed at 4766.18 points, recording a 26.89% growth. With the S&P 500 beating most analysts' expectations, 2021 was arguably a year of impressive stock market performance. While high-performing years are not at all uncommon throughout the stock market's long-standing history, some analysts have expressed a concern that after a strong run, pullback is bound to occur. The question is whether S&P 500 performance in a given year carries any statistical influence on the next year. The answer is no. As the chart provided below shows, given the R-squared of 0.0001, there is no statistical correlation between the returns of the trailing year and the year that follows. The chart is based on 90+ years of data, dating back to 1929.
Source: MacroTrends, Author's Research
Passive Investment Inflows
Passive Investing is on the rise and in 2021, U.S. ETF inflows have surpassed $1 trillion according to recent data provided by Schwab. Accessibility and low expense ratios are key driving factors. More than 60% of these flows are concentrated on ETFs with expense ratios of 10 basis points (0.10%) or less. At the same time with Government, Investment Grade and even High yield (junk) bonds offering unappealing yields, especially in real terms after inflation is considered, more investors turn to dividend and income-oriented funds. Even in the bond realm, ETFs have become the most popular investment vehicle for investors looking to move some risk away from their portfolios.
One area of the market where analysts identify significantly higher valuation multiples is the FAANG and Mega Cap Technology field. Blue-chip stocks like Apple (AAPL), Microsoft (MSFT), and even a Fintech Giant like Visa (V) currently trade at P/E ratios of 31.1x, 36.5x, and 30.8x respectively. While someone could argue that impressive Revenue growth and Profitability margins drive the raised valuations, ETF inflows are also a catalyst, especially, for these stocks in my view. Market cap concentration at the largest S&P 500 stocks stands at all-time highs, with the S&P 500's Top 10 holdings accounting for 31.4% of total market capitalization. Nasdaq and Technology-oriented funds, like Invesco's QQQ, exhibit even higher concentrations. Investors' savings flowing into most major ETFs are essentially translated into stock Buy orders for most large U.S. companies.
As millennials enter their prime financial years, accelerating their investing, the popularity of passive investing is unlikely to fade. As long as it doesn't, stock market leaders will have a lot of fuel available to propel stock prices higher.
In 2021, low-cost, passively managed ETFs run by Vanguard, BlackRock, and State Street together control more than 75% of all U.S. ETF assets and have been investors' favorite savings destination. Given that more than $1.1 trillion was directed at ETFs in 2021, we could perform some quick and rather simplistic math. At 75% for passively managed mainstream funds, more than $770 billion flowed towards the largest U.S. stock indices. For a company like Apple that maintains approximately a 6.6% weight, that translates into $55 billion directed towards buying Apple stock in one year, just by considering the majority of ETF inflows. When Mutual funds are also considered, the case could easily be made that the inflows towards the stock reach $100 billion.
It is important to note that mutual fund and ETF inflows are more often than not part of a retirement or long-term investing strategy, in other words, long-term buy positions. With an ample supply of this type of positions, that are initiated without regard for valuations, we could see a stock market where valuations stay elevated for years. Unless a fundamental shift in investor behavior takes place, passive investing will continue to support stock market growth for the foreseeable future, reinforcing a bullish, long-term thesis.
Interest Rate Environment
According to world-famous investor Warren Buffett: "Interest rates are to the value of assets what gravity is to matter". It should come as no surprise then that depressed rates have driven stock market returns over the last few years.
With the 10-year US Treasury Note yielding around 1.5%, we are looking at a historically low interest environment. Even after the Fed announces the rate hikes that most analysts anticipate, yields would still linger below historical averages. A low-rate environment coupled with elevated inflation makes bonds arguably unattractive compared to equities.
In fact, according to Fundstrat, as inflation increases (measured by the CPI) and nominal rates remain low, we are about to enter a negative real rate market. The research firm shows in the graph provided below that the US has only experienced such a market three times in the last 120+ years, and we are just about to enter the fourth. Every negative real rate market recorded coincided with a strong bull market in stocks, delivering parabolic returns. In Fundstrat's view, this is another important signal that today's stock market has still a lot of room to expand.
Risks to the Bullish Case
After expanding on some bullish signals the stock market is transmitting, it is only fair to offer some brief insight on potential risk factors. Any way someone looks at history in the financial markets points to the fact that uncertainty looms and projections often fall short.
The Covid-19 pandemic has introduced a wide range of challenges and the way it progresses from here is unpredictable. More variants could once again sabotage everyday life and present more disruptions to the supply chain, which could, in turn, hurt business growth.
Monetary policy currently occupies a lot of investor attention, with inflation climbing to levels unseen since the '70s. How the Fed responds to the situation is crucial, since large rate increases could ignite some rotation away from stocks. Higher interest rates usually mean less borrowing in the economy as well, hurting GDP and economic growth. Failure to control inflation on the other hand could also be damaging, with investors' purchasing power decreasing and sentiment deteriorating. A potentially weaker and more volatile dollar also invites larger allocations towards cryptocurrencies, gold, and other alternative asset classes.
Finally, trade and business relationships, especially when it comes to China are one more key factor. Conflict invites disruptions and with a significant portion of American manufacturing depending on the Chinese economy, policy changes could have a strong impact on the U.S. equities.
Final Thoughts
When all things are considered, future stock market returns are uncertain and difficult to forecast. Based on the two prevailing trends examined in this analysis, however, and assuming economic growth does not come to a halt over some dramatic, unforeseen event, I maintain a bullish mid-term outlook on the market. Given the lack of better alternatives, the growth of passive investing, and monetary influence, we might come to admit that stocks, at current valuation multiples, might not be in fact expensive, stocks have rather traded on a discount for a long time.
This article was written by
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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Comments (3)
And why do you think Mr. Buffett is sitting on ~150B dollars?