Valuations in a Low Interest Rate Environment
At the height of the COVID-19-induced panic in March, few would have thought the market would recoup all its losses within five months. But that’s what happened—and then some. The S&P 500 Index hit a new all-time high on August 18 and has continued to trend higher until September 3rd when valuations and the growth focused nature of this rally came back into focus. While it is normal for the market to recover before the economy, the market’s more than 50% increase since its trough in March raises questions about valuations. Has the market got ahead of its fundamentals?
These questions are particularly relevant with the economic recovery still so uncertain. However, with interest rates close to 0%, future earnings are just about as good as current earnings—provided future earnings have some degree of certainty. This has boosted demand for investments that were less impacted by the pandemic – pushing the valuations on growth relative to value to its highest levels in almost 20 years. While cheap relative to bonds, equities appear expensive relative to historic valuation levels. However, the market’s changing composition, in part due to COVID-19, is another important consideration in our conclusion that, while high, current valuation levels on aggregate are not yet overly concerning.
- While highly valued, U.S. equity markets remain attractive relative to fixed income. From a portfolio management perspective, this is supportive for equities.
- The narrow growth-focused rally accentuated the market’s already changing composition. This in turn has the potential to raise valuations with high-growth segments becoming a larger share of the broader market. The market’s changing composition should hasten the earnings recovery for a market-cap weighted index.
- Valuations on certain companies may have run ahead of fundamentals; but, overall, we do not currently believe that the market is at alarming levels, especially considering the supportive interest rate environment. However, investors should remain mindful of fundamentals and assess the extent to which a company’s operations benefitted from COVID-disruptions and if these benefits are likely to have a longer-term impact on the company’s future growth prospects.
Divergent Yields Favor Equities
Prior to 2008, the correlation between the earnings yield on the S&P 500 Index and the yield on 10-year Treasuries was 72.2%. Since then, the sharp decline in interest rates following the Global Financial Crisis has almost completely removed this relationship. If this relationship still held, equity market valuations would be far higher than they are today.
Typically, Wall Street compares the earnings yield on the stock market with the long-term Treasury yield to get a broad sense of if equities are cheap or expensive relative to Treasuries. Chart 1 tracks the premium or discount of the earnings yield relative to the yield on the 10-year Treasury since 1960. Generally, the market would expect the earnings yield to be higher than that of Treasuries because it also needs to reflect an equity risk premium. Conversely, the market would expect earnings to grow over time, so this higher growth rate has the potential to partially or even fully offset the equity risk premium.
Given the exceptionally low yields on Treasuries today, the stock market looks attractive relative to the bond market. This has the potential to be a tailwind for equities due to stocks and bonds being the largest asset classes.
Low Interest Rates Have a Major Impact on Valuations
Discounted cash flow analysis typically looks at expected future dividends or cash flows in terms of their current value to investors. It does this by discounting future cash flows based on a company’s cost of capital. With interest rates close to 0%, this makes future cash flows more valuable currently, all else equal.
The table below presents four scenarios in which the Federal Reserve (Fed) lowers interest rates in response to macroeconomic weakness. In Scenarios C and D, the Fed provides support for corporate debt markets. In Scenarios A and B, the Fed does not.
Scenario A looks at a company that was unaffected by an economic downturn. This reflects the “all else equal” idea; that is, the only major impact on a company’s valuation should be the lower discount rate. Conversely, the company in Scenario B reflects segments of the market that were seriously impacted by a downturn.
In the COVID-19 era, it’s easy to identify companies, industries or sectors that naturally fall into Scenario A or, the worst case, Scenario B. Fortunately, Fed support for corporate debt markets helped restore a normal functioning debt market; however, that support skewed the risk-reward dynamics in favor of higher risk.
In Scenarios C and D, Fed support has the potential to lower the equity risk premium and reduce the spread between corporate debt yields and Treasuries. This is highly favorable for valuations due to the potentially large impact on the weighted average cost of capital.
Investors Put a Premium on the Ability to Grow
Typically, when the economy contracts, so does the equity market. And that trend continued in 2020. However, this year’s market decline was not of the same magnitude as the decline in GDP. In addition, the current market recovery has been far more rapid than any prior market recovery. Support from the Fed and Congress played a large role in helping the market weather the weak economic environment. Notwithstanding this assistance, the ability to grow despite the weak economy has continued to favor the growthier segments of the market.
The resulting premium on growth is not unique to the COVID era. Subdued GDP growth from the last five years favored growth over value investing. However, the current economic uncertainty accentuates the premium. Chart 2 shows that the current Price/earnings premium for the Russell 1000 Growth Index relative to the Russell 1000 Value Index is at its largest since 2000.
The growth focused NASDAQ Index led markets higher during the pandemic rally, but it has also borne the brunt of the selloff in early September. Our recent Snap Chart: Flying vs Just Recouped Losses illustrates the scale of the NASDAQ’s growth driven outperformance relative to both the S&P 500 and the Dow Jones Industrial Average. This is something that could reverse in time, especially given how highly valued growth is currently relative to value. This is the big question facing the market currently, is the premium valuation justified and can growth deliver on its promises? If not, the concentrated nature of the pandemic rally could potentially leave the market vulnerable.
Concentrated Rally Favored Mega Cap Growth
Although the S&P 500 Index set new all-time highs in August, less than 50% of the listings on the NYSE are trading above their 200-day moving average. It is encouraging that this percentage increased from only 37% to 49% in August, but Chart 3 shows that it remains below its long-term average and reflects a far narrower market recovery relative to the Global Financial Crisis. When focusing on just the S&P 500 Index, the percentage of companies trading above their 200-day moving average only improves to 61%.
Chart 4 shows just how concentrated this rally has been. Currently, only three sectors are outperforming the market on a year-to-date basis: Information Technology, Consumer Discretionary and Communication Services. As discussed in Q2 Earnings Review – One for the Record Books, Information Technology was one of only two sectors to increase revenue during the quarter, with the other being Healthcare. Additionally, Information Technology was responsible for the largest percentage of positive EPS surprises in Q2, with 93% of companies out-earning their estimates.1 This was an impressive feat given the macroeconomic headwinds of Q2. It also reflects the sector’s current resilience and illustrates the favorable scenarios discussed in the interest rates table above.
Drilling down further, this rally is concentrated in the S&P 500 Index’s five largest holdings, which currently comprise roughly 19% of the index while providing nearly 100% of its year-to-date returns. Not surprisingly, the five largest holdings come from Information Technology, Consumer Discretionary and Communication Services. Information Technology has the two largest holdings, comprising almost 11% of the S&P 500 Index. The other three holdings come from Consumer Discretionary and Communication Services with each sector comprising roughly 4% of the index.
Beyond the sector concentration, this rally is also extremely large and mega-cap focused, which was especially true in Q1. And as Chart 6 shows, the Russell 1000 Index’s performance relative to the Russell 2000 Index in August suggests that the size element of this market concentration has yet to diminish.
Typical Valuation Metrics Appear Stretched, but Markets Have Changed
Valuations aren’t necessarily what they appear to be in this environment. U.S. equities are affordable relative to bonds, but they look rather pricey relative to historical multiples. With trailing price/earnings in the mid-30s and the forward multiple in the mid-20s, the market is certainly not cheap.2 We reach the same conclusion when looking at other valuation metrics, such as price/sales, price/book and price/free cash flow.
But the market has changed over the last decade. It has become increasingly growth focused with technology growing in prominence. Chart 7 illustrates the rise of the Information Technology sector from 16% of the S&P 500 Index a decade ago to almost 30% today. During this period, Financials declined from 14% to 10%, Industrials from 11% to 8% and Energy from 11% to 2%. Given the shifting nature of the S&P 500’s composition, we should expect some change in multiples, as sectors that historically traded at higher multiples now comprise a larger share of the market.
For example, historically, the Information Technology sector invested more in future growth, which kept current earnings at a lower level. Today, this strategy is starting to pay off with big tech becoming increasingly profitable while continuing to grow.
Valuations on Big Tech Raise Questions
The market becoming more tech focused explains some of the valuation uptick, but there’s also rising valuations within the more technology focused segments of the market. While the largest five companies contributed around 100% of the S&P 500’s rally from the start of year until the end of August, these same companies also contributed 38% of the market’s decline on 9/3/2020 – 9/4/2020.3 This reflects the market’s current concentration risk.
But how have valuations on these five key companies changed recently? The largest holding in the S&P 500 Index is currently trading at valuations significantly in excess of its longer-term average, after seeing a rapid increase in valuations since April. Conversely, the next four holdings are not too far from their historic averages, especially considering the favorable interest-rate environment. Thus, while there are questions regarding the valuations on segments that potentially benefitted from the pandemic, these concerns do not necessarily apply as a blanket statement. There are several factors to consider when assessing a company whose valuations surge during the pandemic rally.
- To what extent did their operations benefit from the COVID-disruptions?
- Are these benefits likely to have a longer-term impact on the company’s future growth prospects?
- Do these benefits justify the company’s current valuation level?
Valuations Not as Concerning When Normalized for Earning Shocks
The market is a great discounting machine. It is interested in the current value of future earnings and, most importantly, cash flows. A full discounted cash flow analysis has the potential to capture the current impact on earning while also looking forward to when earnings are expected to start growing again. Conversely, multiple analysis generally provides a much shorter horizon. Typically, it’s either a year trailing or an estimate for the next year. Following a major decline in earnings, such as what the market experienced in Q2, it could take more than a year to restore earnings to their pre-pandemic levels.
The cyclically-adjusted price/earnings (CAPE) ratio provides an indication of valuations when smoothing earnings over time. The ratio looks at the 10-year average inflation-adjusted earnings when calculating the PE. This helps to remove the impact of sudden earnings declines.
Chart 8 shows the CAPE ratio over an extended period. It is encouraging that the market is nowhere near the valuations reached during the dot-com bubble. It is also important to keep in mind that the interest rate environment has changed significantly over the last 140 years, and especially since the Global Financial Crisis. As discussed, lower interest rates are generally supportive of higher valuations. So, with yields close to 0%, it seems reasonably intuitive that the CAPE ratio should be reasonably elevated over the last decade.
Conclusion: A Different Type of Valuation Story Emerges
Valuations are elevated—and it’s right to question them right now—but we do not believe they are at concerning levels for three main reasons.
- U.S. equity markets remain attractive relative to fixed income. The low interest rate environment combined with Fed action has encouraged a risk-on environment while remaining supportive for equity valuations.
- A clear separation exists between companies, industries, and sectors that were less affected by the pandemic’s economic fallout and those that were directly in harm’s way. The result is a very narrow, growth-focused rally that has generally favored large and mega-cap companies. The market is increasingly dominated by the segments that are least affected by, and in some cases even benefitted from, the COVID-19 disruption. The market’s changing composition should hasten the earnings recovery for a market-cap weighted index.
- The market’s changing composition also has the potential to raise valuations with high-growth segments becoming a larger share of the broader market.
The market looked quite a bit different in March than it does today. Remember to be mindful of fundamentals, and the extent to which a company benefitted from the COVID disruption while assessing a company whose valuations surge during the pandemic rally. Valuations on certain companies may have run ahead of fundamentals; but, overall, we do not currently believe that the market is at concerning levels, especially considering the supportive interest rate environment.