When low interest rates cause people to do dumb things
Noah Solomon: Investors would be well served to tilt their U.S. stock exposure in favour of value stocks
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By Noah Solomon
Investors can either accept lower returns and maintain their allocation to safe assets when cash and high-quality bonds offer little yield, or liquidate their safe assets and invest the proceeds in riskier assets such as equities, high-yield bonds, private equity, etc.
Many people choose the second option. This decision initially produces favourable results as the increase in demand for stocks pushes prices up. As this reallocation progresses, prices reach unreasonable valuations and the likely returns from risk assets do not compensate investors for their associated risk.
Following the global financial crisis, a prolonged period of near-zero rates pushed investors to shun safe assets and chase stocks even as their valuations became unsustainable. Had central banks not begun raising rates aggressively in 2022 to combat inflation, it is entirely possible (and perhaps even likely) that stocks would have continued their ascent, valuations be damned.
Instead, rising rates provided risk assets with some worthy competition, which in turn caused investors to rethink their asset mix and shed equity exposure.
A stock vs. bond beauty contest
The equity risk premium (ERP) can be defined as the enticement for investors to leave the safety of bonds and take their chances in the stock market. It is calculated by subtracting the 10-year Treasury yield from the earnings yield on stocks. For example, if the P/E of the S&P 500 is 20 (that is, an earnings yield of five per cent) and the yield on 10-year Treasuries is three per cent, the ERP would be two percentage points.
If stock valuations are cheap relative to the yields on safe assets, investors are getting well compensated for bearing risk, which tends to portend strong equity markets. Conversely, at times when stock valuations are expensive relative to yields on safe assets, investors are scantily compensated for bearing risk, which tends to foreshadow lower-than-average returns on stocks.
For example, at the end of 2020, the S&P 500 index’s PE ratio stood at 20, which by no means can be considered a bargain. However, stocks were attractive relative to the ultra-low rates on cash and high-quality bonds. It’s easy to look good when you have little competition.
By the end of 2021, the index’s PE ratio was above 24 (an earnings yield of 4.2 per cent). Stocks became far less attractive versus bonds given that 10-year Treasury yields had risen to 1.5 per cent from 0.9 per cent. This set the stage for a decline in both prices and valuations in 2022.
The contraction in multiples (an increase in earnings yield) was more than offset by a rise in bond yields, thereby causing the ERP to be lower at the end of 2022 than it was at the start of the year.
By the end of 2023, U.S. stock multiples had nearly regained the lofty levels of late 2021 even though Treasury yields had increased by more than two per cent.
In contrast, the relative valuation of Canadian stocks versus bonds currently lies at levels that are neither high nor low relative to recent history.
The growth stock amphetamine
Growth companies are projected to have rapidly growing earnings for many years. Whereas an “old economy” stock such as Clorox Co. or General Mills Inc. might be expected to grow its profits by two per cent to 10 per cent per year, a juggernaut such as Nvidia Corp. could be expected to double its profits every year for the foreseeable future.
Compared to other companies, the projected earnings of growth stocks are heavily back-end loaded. Their anticipated future profits dwarf their current earnings. Investors in growth stocks must wait longer to receive future cash flows than those who purchase value stocks.
All else being equal, growth companies become more attractive relative to value stocks when rates are low because the opportunity cost of the long wait is low — you’re not missing much by not having capital parked in safe assets. Conversely, growth companies become less enticing compared to value stocks when rates are high.
For example, central banks fuelled a tremendous rally in growth stocks when they cut rates to zero in response to COVID-19. From the end of March 2020 to the end of 2021, the S&P 500 growth index returned 106.1 per cent versus 69.6 per cent for the S&P 500 value index.
Growth stocks significantly underperformed when rates began to shoot higher in 2022, with the growth index falling 29.4 per cent compared to a 5.2 per cent decline in the value index.
In 2023, although 10-year Treasury yields ended the year largely unchanged, the growth index gained 30 per cent while its value counterpart gained 22.2 per cent.
The multiple on growth stocks relative to value stocks is currently higher than it has been at any point since the start of the tech wreck in early 2000.
Where things stand
Faced with near-zero yields on safe assets in late 2021, it is somewhat understandable why investors continued to pour money into stocks despite elevated valuations. However, it is difficult to explain why U.S. equities currently stand at similarly lofty multiples when yields on safe assets offer a reasonable alternative. By the same token, Canadian shares are far more attractively valued.
While I have no strong opinion regarding what will happen over the next six to 12 months, my sense is that U.S. stocks over the medium term will not continue their recent streak of outperformance and may even underperform.
Turning towards the Magnificent Seven phenomenon, I am of two minds. On one hand, these companies have delivered stupendous earnings growth. On the other, reversion to the mean is one of the most consistent forces in markets. This does not bode well for the relative performance of growth stocks given that the valuation difference between growth and value stocks is at its widest level since the start of the tech wreck in early 2000.
If forced to make a choice, my bet would be that mean reversion will win out over the medium term and investors would be well served to tilt their U.S. stock exposure in favour of value over growth stocks.
Noah Solomon is chief investment officer at Outcome Metric Asset Management LP.
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