US stock market returns in 2019 were unexpectedly high despite an economic slowdown with the S&P 500 Index yielding a YTD total return of 29.85% as of December 17, 2019. Global stock markets also rallied with the MSCI World Index, MSCI EAFE Index, and MSCI Emerging Markets Index, all yielding YTD total returns of 26.00%, 22.22%, and 17.20%, respectively. Markets appear to be pricing in a resolution to the US-China trade war along with expectations of no recession in the foreseeable future.
We use the cyclically adjusted price-earnings ratio (CAPE) as our primary valuation measure of the stock market where a high CAPE indicates stocks are expensive and vice versa. The S&P 500's CAPE currently stands at 28.78, which is about +1.08 standard deviations above the 22.31 average since 1994. 81.63% of all CAPE observations going back to 1994 were below current levels indicating the S&P 500's current valuation is somewhat high historically but not as high as 1999-2000. The S&P 500 is not cheap at current levels, but price-multiple expansion could continue as long as the economy does not enter into a recession.
We conducted a log-normal regression analysis of the S&P 500's CAPE ratio against real five-year forward returns to determine if today's CAPE can predict real returns over the next five years. We find that the CAPE does predict real five-year forward returns with high confidence. The CAPE ratio explains approximately 60% (R Square = 0.5996) of the variation of the real five-year forward return, with the other 40% explained by other factors not identified in this analysis.
Our statistical model predicts the five-year real forward return (December 2019-2024) for the S&P 500 will be 0.79% annualized with a 95% confidence interval of -5.28% to 6.85%. If we add the Federal Reserve's 2% inflation target rate to 0.79%, we get a nominal five-year forward return of 2.79% annualized, which contrasts markedly from 2019's high return as the index continues making record highs. This analysis implies that despite today's high returns, future returns (over the next five years) are unlikely to be as high.
Sophisticated investors may find it prudent to deviate from a passive allocation to the S&P 500 Index by being more selective in their investments. We think domestic value strategies and international diversification may outperform domestic growth strategies over the next five years, especially if US economic growth slows. However, domestic growth strategies may continue to outperform in the short-term as stocks maintain their positive price momentum.
We like high dividend and small-cap ETFs such as the iShares Select Dividend ETF (DVY), WisdomTree US SmallCap Fund (EES), WisdomTree US SmallCap Dividend Fund (DES), WisdomTree Emerging Markets SmallCap Dividend Fund (DGS) for their reasonable valuations and strong price momentum. We believe the energy sector has the lowest valuation of all sectors. Energy sector ETFs such as the Energy Select Sector SPDR Fund (XLE), iShares US Energy ETF (IYE), and iShares North American Natural Resources ETF (IGE) look relatively cheap. However, investors with environmental concerns may want to avoid the sector.
We like individual stocks that exhibit both low valuations relative to their forward estimates and smooth short-term price momentum. Names we believe exhibit these features include banks First Horizon National Corp (FHN), Pinnacle Financial Partners Inc (PNFP), and Sterling Bancorp/DE (STL) along with biopharmaceutical Jazz Pharmaceuticals PLC (JAZZ). Other names that we believe exhibit low relative valuation but less favorable price action include Amazon.com (AMZN), Biogen Inc (BIIB), PVH Corp (PVH), and Marathon Petroleum (MPC). We believe these stocks are cheap, but their stock price reflects either volatile or weak short-term price momentum, so investors buying now may need to have patience.
We believe gold is attractive for the commodity's strong momentum and fundamentals as the Federal Reserve engages in quantitative easing and the US federal government runs unsustainable trillion dollar deficits. We like the Aberdeen Standard Physical Gold Shares ETF (SGOL) for its low expense ratio and physical ownership of gold bullion bars stored in secure vaults. We also like the Goldman Sachs Access Treasury 0-1 Year ETF (GBIL) for its high yield-to-duration ratio at 4.64 (1.6% net yield / 0.32 modified duration), indicating highly efficient return per unit of risk. We also like the Xtrackers High Beta High Yield Bond ETF (HYUP) for its 7.19% net yield while still maintaining a low 3.09 modified duration; however, investors should be aware of its non-investment grade credit risk. By comparison, the Bloomberg Barclay's US Aggregate Bond Index (AGG) has a yield-to-duration ratio of just 0.43.
Disclosure: The published information does not constitute investment advice or recommendations. No responsibility is taken for the correctness of this information or actions taken based on this information. Source: NR Capital Management, Bloomberg.