Equities fell as the three major indices each posted declines for the week. The losses came as investors began to assess whether stocks were overbought as a result of the post-election rally and weighed what Federal Reserve Chairman Jerome Powell’s comments about the pace of future rate cuts may mean for the economy. In our view, both concerns are best viewed in the context of the current state of the economy.
As we’ve noted over the past several months, the U.S. economy is out of balance with consumers and businesses who benefit from (or at least are not adversely affected by) higher interest rates thriving, while those who are feeling the pinch of elevated rates are lagging. Indeed, much of the rationale for a soft landing has been centered around the Fed cutting rates so that economic strength would broaden as consumers and businesses negatively impacted from elevated rates would feel relief. However, comments last week from Chair Powell cast some doubt as to how aggressively the Fed would cut rates going forward. In a speech in Dallas, Powell noted, “The economy is not sending any signals that we need to be in a hurry to lower rates.” While the comment shows the Fed views the economy as generally strong, it also suggests rates may remain elevated for longer and seep deeper into the economy. Indeed, the two cuts the Fed has already made have done little to aid those parts of the economy that are laboring due to higher borrowing costs. Since the Fed’s recent rate cuts that brought short-term rates down, interest rates on intermediate- and longer-term debt have risen, with the 10-year Treasury rising 0.83 percent from its recent post-rate-cut low. This has pushed up mortgage rates and has kept the housing market out of balance, as witnessed by existing home sales at a 14-year low.
Just as the economy is out of balance, so is the stock market. For example, the Shiller Cyclically Adjusted P/E (CAPE) ratio is at the second highest level since the dotcom years of 1999–2000. The appeal of using the CAPE ratio is that it measures valuations adjusted to strip out the temporary impacts of the business cycle. The adjustment allows investors to compare price multiples during various economic backdrops. Simply put, this measure indicates that, overall, large cap equity valuations may have already discounted future economic and profit growth.
Similarly, the earnings yield for the S&P 500 is now below that of the yield on the 10-year U.S. Treasury. Typically, comparing these two yields gives investors an idea of how much the market is compensating them for taking on the additional risk inherent in owning stocks that are not found in Treasurys. When the S&P 500 yield is lower than that of the 10-year Treasury, it means that investors are essentially “paying” for taking on the additional risk as opposed to being compensated for it.
Fortunately, not all equities are trading at elevated levels. Areas such as small and mid-caps, which we’ve highlighted in the past, are priced at relative discounts to their larger counterparts. These two groups, in our view, should provide investors with intermediate- to long-term investment horizons compelling returns in the coming years. Indeed, as expectations of broad economic strength spread through the market following the election, small and mid-cap equities outpaced large caps. Additionally, valuations for the S&P 500 are being distorted by a small sliver of stocks, and attractively valued large companies still offer opportunities for intermediate- and long-term investors.
While investors often overlook elevated valuations late in a business cycle based on hopes of an ever faster-growing economy, history has shown this approach entails risks. We believe the same holds true in the current market. As we’ve highlighted frequently over the past few months, the current economy is highly bifurcated, meaning it is largely divided into groups that have benefitted (or at least not been harmed) by high interest rates and those who have been negatively impacted by those rates.
None of this is to say that the markets don’t have room to move higher from here or that the economy is certain to falter. Earnings growth for companies could accelerate faster than even the most optimistic estimates. Likewise, core inflation readings and the still elevated pace of wage growth could decline enough that the Fed decides there is little risk in a steady pace of rate cuts. One way or another, the economy will eventually return to equilibrium. However, the return will likely have some bumps along the way, and investors should be positioned for potential volatility ahead.
Investors, in our view, should follow an investment plan for which an unexpected twist or turn doesn’t have an outsized impact on the long-term success of achieving their financial goals. We believe the best approach to an unknowable economic outcome is diversification. And while diversification is often viewed as a defensive tool, we believe it should be considered an all-weather approach that allows investors to have exposure to asset classes that typically perform well even as others lag.
About the Author:
Brent Schutte, CFA, is chief investment officer of the Northwestern Mutual Wealth Management Company.
