Image by Oto Godfrey and Justin Morton
INVESTMENT ENVIRONMENT1
Source: Orion Advisor Services, AlphaGlider
Global equity markets performed well for their fifth straight quarter, aiding by the accelerating rollout of COVID-19 vaccines in much of the developed world, and continued fiscal and monetary stimulus from central banks and governments around the world. The US equity market outpaced the 7.4% showing from our global equity market benchmark, the MSCI ACWI IMI,^d by one percentage point during the second quarter of 2021. Foreign equities markets, both developed and emerging, lagged the benchmark by a little over two percentage points. Bond yields fell during the quarter, driving our fixed income benchmark, the Bloomberg Barclays US Aggregate Bond Index,e up by 1.8%.
Picking up from last quarter’s deep dive into the topic of inflation, we are now seeing the tick up in prices that economists and investors were expecting. The Consumer Price Index (CPI) in June was 5.4% higher than during the year ago period, and 4.5% higher excluding volatile food and energy prices (core CPI). This was the highest CPI reading in 13 years.
The Fed continues to believe that any inflation we experience in 2021 is transitory, and will soon dissipate as the economy and all of its complicated supply chains come back online. A closer look into the drivers of today’s inflation seems to support the Fed’s assertion. Approximately three-fifths of the 5.4% CPI increase was due to used cars, new cars, auto parts, and car rentals, all categories that are likely seeing a temporary bottlenecks in supply. That said, the Fed did seem surprised by the magnitude of the strength of the US economy and the inflation that it caused when it met in mid-June meeting. It had expected to keep its zero interest rate policy in place until 2024, but now expects it will make two 25-basis point rate hikes during 2023. The market took this as a sign that the Fed will not let inflation get out of control, all but killing the reflation trade that had come to dominate this year. As a result, bond rates began to fall (sending bond prices up), and value stocks began to underperform growth stocks again.
US government fiscal stimulus continued to positively impact the economy, with $1,400 payouts to most adults. The next major piece of fiscal stimulus on the docket for the Biden administration, the infrastructure plan, was downscaled from an initially proposed $2.25 trillion to just under $1 trillion, in order to gain bipartisan support. As of the time of writing, the Senate negotiations appeared in their final intense days. Should negotiations fail, we could see US stocks fall along with bond yields and future inflation expectations.
Although the Biden administration’s proposed plan to raise taxes on corporations was put on the back burner to prioritize passage of its infrastructure plan, Treasury Secretary Janet Yellen was able to rally support among 130 nations for a US proposal to set a global minimum tax on corporations. Details will need to be ironed out at the upcoming G20 Summit in Rome this October, but the US has been pushing for a 15% global minimum tax rate. Large multinational technology and pharmaceutical companies, many of them American, would be among the most adversely affected if a final agreement can be struck by the global community, and passed by a heavily divided US Congress. We expect Biden will work hard to push it through Congress before the fall 2022 mid-term elections.
The widespread rollout of highly effective vaccines in North America and Europe has greatly reduced the mortality rate on those continents. A recent Yale study estimated that, by the end of June, the vaccines had prevented approximately 279,000 deaths in the US alone. However, the majority of the world’s population still has not been vaccinated, a situation that is likely to persist for several more years. In the meantime, COVID-19 continues to do what viruses do — evolve in order to better propagate. The Delta variant of COVID-19, which first appeared in India last October, is rapidly expanding throughout the world, including in countries with relatively high vaccination rates. A recent Israeli report indicates that the Pfizer/BioNTech vaccine provides excellent protection against severe illness and death from the Delta variant, but are only modest protection against infection (39% effectiveness).
We are starting to see increasing economic damage in the West caused by the emergence of the Delta variant, such as the recent shutdown of the travel bubble between Australia and New Zealand, and the Biden administration’s decision to postpone lifting of travel restrictions into the US from Europe, China, India, Brazil, Iran, and S Africa.
Source: The San Diego Union-Tribune
There is a real risk to the global economy that COVID-19 further evolves into a new variant that renders our current vaccines ineffective. The longer it takes to roll out vaccines in poorer nations, and the greater the number of individuals choosing not to be vaccinated in rich countries, the higher the risk that COVID-19 breaks through the effectiveness of our current vaccines, and the higher the risk of another economic recession.
PERFORMANCE DISCUSSION
AlphaGlider strategies were performing in line with their respective benchmarks throughout most of the second quarter, up until mid-June when the Fed signaled that it would likely need to raise rates earlier than it had previously expected. Still, our strategies experienced healthy absolute returns for the quarter, even though they fell 15-20% shy of their respective benchmarks.
The primary cause of our strategies’ relative underperformance was due to their mix of equities — underweight the strongly performing US stock market while overweight international stock markets. Our global equities benchmark, the MSCI All Country World Investable Market Index (ACWI IMI), was up 7.4% during the second quarter, whereas most of our international equity holdings came up short: developed international markets (SPDR Portfolio Dev World ex-US, SPDW,2 +5.5%; iShares ESG Aware MSCI EAFE, ESGD, +5.5%; iShares MSCI Singapore Capped, EWS, +0.4%), emerging international markets (Vanguard FTSE Emerging Markets, VWO, +4.9%; iShares ESG Aware MSCI EM, ESGE, +4.8%), and international real estate (Vanguard Global ex-US Real Estate, VNQI, +4.7%).
The mix within our US equity and fixed income investments also hurt our relative performance. Our US equity holdings skew more to value and stable/quality oriented stocks, which lagged the overall US equity market (S&P 500 +8.4%) during the quarter: value (Vanguard Value, VTV, +5.3%; Nuveen ESG Large-Cap Value, NULV, +4.3%) and quality (Vanguard Dividend Appreciation, VIG, +5.7%).
Longer duration bonds outperformed shorter ones during the quarter, and thus our strategies’ lower than benchmark duration held back performance: Vanguard ST Corporate Bond, VCSH, +0.7%; iShares ESG 1-5 Year USD Corp Bond, SUSB, +0.5%. This drag would have been worse had we not raised the duration of our fixed income investments back in February from approximately 4.7 years to 5.4 years. The duration of our fixed income benchmark (Bloomberg Barclays US Aggregate Bond Index) is 6.5 years. Another weak fixed income fund holding for our more conservative strategies was mortgage-backed securities (Vanguard Mortgage-Backed Securities, VMBS, +0.2%), which was weak in fear that the Fed would start to cut back on its purchases of these securities.
We did have several strong performers during the quarter. Our strategies outsized exposure to inflation-protected Treasury bonds continued to benefit our strategies: Schwab US TIPS, SCHP, +3.1%; Vanguard ST Inflation-Protected Securities, VTIP, +1.7%. Our physical gold (SPDR Gold MiniShares, GLDM, +3.6%), European equities (Vanguard FTSE Europe, VGK, +7.9%, and US technology equities (Fidelity MSCI Information Technology, FTEC, +11.5%) were also strong relative performers during the second quarter.
For the last 12 months, AlphaGlider strategies matched 85-95% of the returns posted by their respective benchmarks. The primary driver of this relative underperformance is due to their overexposure to developed international equity markets. Although collectively these markets performed fabulously well in absolute terms (MSCI EAFE, +32.4%), they were not able to keep up with US and emerging international markets which were both up over 40% during the last 12 months. Our developed international funds performed as follows: SPDW, +36.5%; ESGD, +33.3%; VGK, +37.5%; EWS +27.4%; VNQI +27.7%. Two other relative detractors for our strategies were our exposure to physical gold since late September 2020 (GLDM, -6%) and stable/quality US equities (VIG, +34.4%).
Unlike during the last quarter, interest rates increased over the last twelve months — which helped our relatively short duration fixed income investments outperform their benchmark (BB US Aggregate Bond, -0.3%): VCSH, +2.0%; SUSB, +1.6%. An even larger benefactor to our fixed income performance was our large exposure to inflation-protected Treasury bonds: SCHP, +6.3%; VTIP, +5.9%.
On the equity side, our strategies’ best performing equity funds were US value (VTV, +41.4%), US technology (FTEC, +44.3%), and emerging international (VWO, +40.5%; ESGE, +42.6%).
OUTLOOK & STRATEGY POSITIONING
Image courtesy of Universal City Studios, Inc.
If Marty McFly had pulled up in my driveway in mid-February 2020 and told me that we were on the verge of a pandemic that would dent global gross domestic product (GDP) by 5% over the coming year, I would have headed for the hills with our investment strategies (i.e. gone to cash). But with the S&P 500 closing out the first half of 2021 up nearly 27% over the pre-pandemic peak in February 2020, we’re fortunate that Marty took Doc Brown’s DeLorean to another place and time. As it turned out, we were bailed out by central banks and governments flooding the world with cash. Asset prices sky rocketed, not because their intrinsic value increased (i.e. our estimate of their future cash flows increased), but because all of this newly created cash didn’t have any other place to go (real bond rates have been in deeply negative territory). Now is a great time to review the valuations of US equities, as well for foreign equities, to see what long-term returns we should expect from them going forward.
As any regular reader of my quarterly pieces will know, US equities were expensive before the pandemic, both in absolute terms and relative to most other countries’ equities. This situation has only become more extreme during the pandemic, with US being among the world’s best performing markets. Although there are many reasons for this, among the most important was that the Fed and the US government were more aggressive in their stimulus programs than most other central banks and governments.
Source: AlphaGlider, JP Morgan Asset Management, FactSet, FRB, Robert Shiller, Standard & Poor’s, Thomson Reuters
The table on the left shows five valuation metrics for the S&P 500, a good proxy for the overall US equity market, as of the end of the second quarter. To give some perspective of the extreme nature of these values, I’ve listed where they land relative to values over the last 25 years. For example, the S&P 500’s current dividend yield of 1.44% is greater than 96.2% of the dividend yield values experienced over the last 25 years. Or said another way, there have only been 14.4 months over the last 25 years (i.e. 300 months) in which the S&P 500’s dividend has been higher than today’s.
Most of the months when the S&P 500 was more richly priced than it is today were immediately before and after the peak of the dot-com bubble. Most of my readers probably remember that time well, but in case you don’t, let me jog your memory. As you can see below, it was a frenzied 18 months leading up to the March 2000 bursting of the dot-com bubble, after which time the S&P 500 gave up 50% of its value over a period of two and a half years. During the months leading up to, and following, the peak, the S&P 500 sported higher valuations than we have today.
Source: AlphaGlider, Koyfin
At the peak of the bubble, six of the 10 largest components in the S&P 500 were technology related: Microsoft, Cisco, Intel, Lucent, IBM, and AOL. It was these technology stocks, and others like them, that drove the movement of the S&P 500. This can be clearly seen in the technology-heavy NASDAQ 100 indexf fell 80% from its March 2000 peak.
Source: AlphaGlider, Koyfin
I highlight technology companies’ central role in the dot-com bubble, including driving up US stock market valuations, because we are seeing something similar in 2021. Today the S&P 500 is even more dominated by technology companies, with seven of the largest 10 companies being technology-related (Apple, Microsoft, Amazon, Google, Facebook, Tesla, Nvidia). These seven companies are now collectively worth over $10 trillion (they were at $5 trillion in late 2019) and make up just over one-quarter of the value of the S&P 500 (thus the other 493 companies make up less than 75% of the S&P 500’s value).
Source: Holger Zschaepitz (@Schuldensuehner), Bloomberg
Just because the US stock market is extremely expensive, that doesn’t mean it must perform poorly going forward, especially over the short-term (1-3 years). But as one’s investment time horizon lengthens, the probability that an extremely expensive stock market performs well decreases. Like in early 2000, investors collectively are expecting great things from large US technology companies. They don’t believe Apple, Microsoft, Amazon, Google, Facebook, Tesla, and Nvidia will go the way of Cisco, Intel, Lucent, IBM, and AOL. I was a tech analyst back in 2000, and it sure felt to me that the technology sector in general, and these firms in particular, had a lock on the future. However, this lock was fully priced in, and then some.
You might have noticed that Microsoft was the sole technology survivor in the largest 10 companies of the S&P 500 between March 2000 and now. But it was hardly a smooth ride for the owners of Microsoft during this time — they would have seen their investment decline 80% over the next nine years, and would not have clawed back to neutral for another seven years. Quite a sobering thought that even though you may have bought what would become the best performing large (i.e. top 10) technology stock in the S&P 500 back in early 2000, you would have had to hold it for 17 years just for it to get back to the price you bought it.
Source: AlphaGlider, Koyfin
With our strategies’ underweight positions in US equities, we are acting on our belief that investors are once again overestimating the strength of US companies’ ability to grow cash flows much faster than foreign companies’, especially those of the largest US technology companies which dominate the S&P 500. We have no clue which companies will make up the largest 10 companies in the S&P 500 in a decade or two, but we suspect there will be fewer technology companies among them. We also suspect that US companies will make up a smaller proportion of the world’s total stock market value in 10 years time. Although the US makes up approximately 4.3% of the world’s population and just under 25% of its GDP, the US stock market makes a whopping 59% of the world’s total stock market value.
Investors as a whole are pricing in perfection for the US stock market even though there are numerous clouds on the horizon that could derail it. The ones that most concern us, in no particular order, are as follows:
- Earnings will be hurt by higher corporate tax rates as proposed by the Biden administration
- The trade war with China intensifies, causing US companies to lose access to its 1.4 billion consumers and its low cost and high quality manufacturing
- Earnings will be hurt by rising wage inflation as power shifts back to workers and unions
- Rising enforcement of antitrust laws by the US and foreign governments, particularly against the largest US technology companies
- The “Fed Put” (i.e. the Fed bailing out the market when it falls with liquidity/quantitative easing) may cease to exist sometime in the future, perhaps caused by unsustainably high US debt levels (resulting in higher borrowing rates and inflation, and a weaker US dollar)
With unattractive US equity valuations and low bond yields globally, we are pleased to still be able to find reasonable valuations in foreign equities. On a forward P/E basis, foreign equities are trading at a 27% discount to the S&P 500, 15.7x vs 21.6x. The valuation difference between foreign and US equities is even larger on most other valuation metrics. Foreign equities’ dividend yield is nearly double that of the S&P 500, 2.7% vs 1.4%. Foreign equities’ price to book ratio is less than half that of the S&P 500, 1.9x vs 4.2x. Foreign equities’ price to cash flow is only a little over half that of the S&P 500, 8.9x vs 16.1x. On a cyclically adjusted P/E basis (CAPE), foreign equities are trading at half the value of the S&P 500, ~18.5x vs 37.8x.
The only guaranteed investments that I’m aware of are US Treasuries, and right now they are guaranteed to give you a lackluster return (1.30% yield on the 10-Yr Treasury as I write this) and very likely a negative real (after inflation) return. Our use of fundamental analysis in conjunction with a long-term investment horizon definitely does not guarantee a successful return, but we believe it improves the probability of a successful one for our clients. And just as important, we believe that it also lowers the probability of a severe loss like those suffered by investors who were overexposed to technology stocks in early 2000.