Investors looking to turn to cheaper stock valuations should consider allocating some US equity capital to select foreign equity markets. For those who are much more risk averse and conservative, i.e. seeking capital preservation, or simply strategically waiting for a bigger market decline, should consider owning gold, Treasury and/or Savings Bonds I in between. The two investment funnels are discussed below.
Here in 2022, US equity markets look vastly overvalued, even more so compared to my macro article from November 2020, in which I discussed how excessive valuations could be vulnerable to rising costs/inflation:
What is most concerning is that the government and the Fed are signaling that inflation remains weak, but that is not the case. The economy, in my view, has entered a period of low growth, high unemployment and high inflation, also known as “stagflation”. as well as the question of “High inflation. This one requires a reading between the lines, but inflation has certainly spiked in 2020 and will likely continue for years to come.”
Since then, the inflation rate in the United States has risen from around 1% to 7% currently.
Despite this painful situation which considerably penalizes consumers, in particular the modest and middle classes, savers, bondholders, as well as companies without adequate pricing power. Of course, some companies can handle cost inflation better than others. The US government continues to claim that inflation, although a problem, is under control, “which shows a significant reduction in headline inflation compared to last month, with gasoline prices and food prices falling, shows that we are making progress in slowing the rate of price increases.” Yet the current trend remains difficult.
I had also pointed out that if energy prices rose, it would also fuel food price inflation, and headline inflation would take off: “If fuel prices had risen significantly, food inflation would likely have topped 6%, which would have been the largest cost increase since the stagflation era of the 1970s and 1980s.”
On January 26, the Federal Reserve announced that it was keeping the federal funds rate at 0% despite inflation remaining at 7%, which is now the widest gap between inflation and the FFR. since the mid-1970s:
With unemployment well within the Fed’s target range, it is waiting to see if inflation starts to slow through 2022 before raising rates, although a hike is expected in March. It is difficult to determine whether inflation is entrenched or not. Real estate prices remain high due to lack of housing supply, auto prices are high due to a lack of semiconductor chips, energy prices tend to rise due from a severe lack of investment in oil and gas and general transportation, i.e. shipping and trucking rates, is still booming due to bottlenecks and the consumer demand resistance (so far). Rising energy prices also affect input costs of many things, including feed, packaging, other material costs, transportation, and more. There is also a labor shortage, which has also contributed to wage inflation. Arguably, inflation could remain persistent for one to three years before returning to the Fed’s 2% target range.
On the other hand, inflation could start to decelerate sooner, mainly due to slowing consumer demand. As U.S. consumers have spent massive amounts on reopening, including on a transactional basis, personal savings have plummeted. Sharp price increases have also outpaced wage gains and significantly weakened consumer sentiment, even worse than the jaw-dropping initial response to the pandemic, marking the lowest levels since 2011-2012.
If this translates into reduced spending, perhaps this decline in aggregate demand will at least allow product supply to catch up and thus bring inflation back to its longer-term trend. For now, my bias leans towards higher inflation given the massive M2 money supply expansion and supply chain disruptions continue unabated.
Despite my call on the overvaluation of US stock prices, namely the marking in the high 99th to 100th percentile on many valuation measures in November 2020, equity benchmarks have continued to rise. Since then, the S&P500 is up almost 37% from its peak in early January and about 26% so far. The macro picture has admittedly improved where S&P 500 (SPY) EPS estimates rebounded to $175/per share today and are expected to reach $209 eventually, putting the market at 21.2 times the earnings, in which case the market looks modestly expensive at an earnings yield of 4.7%. Some market players would call this slightly expensive compared to a typical P/E of 18x. Alternatively, the cyclically-adjusted earnings yield recently marked a new low at a P/E of 40x, or an earnings yield of 2.53%, which is the worst level in 100 years.
However, that’s only half the story, as interest rates are still at historic lows. If the Treasury yield curve were to rise towards, say, 2-4%, from 0-2% previously, stocks with an equity risk premium would reprice downwards. Currently, the total value of the US stock market is approximately $53 trillion and the gross national product of the United States is $23.5 trillion, a market capitalization to GNP ratio of 228%, which is also a record. There are several other metrics we can point to that stocks are overvalued, but as long as interest rates stay low, many will say this is the best game in town.
If there is concern that the US market is too expensive or too select, it may be worth looking abroad. Two countries with a relatively decent economy are Brazil (EWZ) and Norway (NORW), each with market caps to GDP of 68% and 72%, respectively. Until the dollar strengthens noticeably, investors would probably do well to hold these indices or look for undervalued companies in these markets. According to Yardeni Research, Brazil and Norway are also much more palatable with forward P/E ratios of 7.6x and 12.5x, respectively, against the US at 21.2x.
Again, if one is more concerned about an impending global market sell-off and/or looking primarily to preserve capital, owning gold and US government debt are the best safe havens. Gold (GLD) has risen more than 20% in value since the start of the pandemic, partly reflecting the depreciation of the dollar, and historically holds its value very well:
For government securities that are quickly redeemable and very liquid, I will stick to treasury bills. As an alternative to cash in the bank, this asset is mostly unaffected by rising interest rates, duration risk and/or credit risk, making it one of the safest places safe to park your capital. The main downside is inflation which currently offers a negative real return of 7%. However, should short-term rates rise, this will not only increase the yield on these assets, but will also likely reduce inflation, making it a better directional bet beyond 2022.
Finally, Series I Savings Bonds, which currently yield 7.12%, are calculated based on the estimated rate of inflation over a given period (last recorded at 3.56%). Assuming inflation is here to stay, this option will maintain your purchasing power and even has the risk-free attributes of Treasury bonds. The only downside is that investors must hold their investment in I Savings Bonds for at least one year before redeeming them and at least five years to avoid incurring a small interest penalty on their investment. If the inflation rate stays firm in the high numbers or spikes, the yield on that security will float higher with it. For example, if the estimated inflation rate maintains an average of 5%, Savings Bonds I would yield an annual coupon of 10%.
Maintaining exposure to US equities is not entirely irresponsible, but it is important to be aware of the enormous risks that record valuations present. Although a catalyst is often needed, markets could move into a significant correction or even a stock market crash simply due to a sense of risk aversion. For these reasons, I continue to remain invested in some US equities, while maintaining allocations to gold, treasuries and savings bonds I, and plan to diversify into more foreign equities soon. Although being fully invested in the stock market has historically generated the best returns, we have now entered a no mans land in 2022 with extremely high US equity valuations. If we add up the top 10 US stocks by market capitalization, they alone represent ~30% of GDP, which is abnormal. With that, investors should tread carefully in 2022 as volatility is to be expected. What do you think? Let me know in the comments section below. As always, thanks for reading.