October 16, 2017
Gains continued across most asset classes in the 3rd quarter as the S&P 500 rose 4.5% and US Treasurys rose 0.4%. Interestingly, emerging markets stocks rose 8.1%. Some of these gains in stocks could probably be attributed to a dollar decline of about 3%, which pushed gold prices up by about 3%.
Broad gains have at least partly resulted from a continuation of the tide of complacency that has swept most investment markets since 2011. This complacency is due in large part to the US Federal Reserve holding interest rates at microscopic levels for ten years, and the likelihood that it will continue to be “accommodative”. Fed policy has created a virtuous cycle for asset prices because cheap debt leads to rising debt levels, which exerts deflationary pressure on the economy, further lowering borrowing costs and necessitating an accommodative Fed to prevent recession. Market participants know this. And combined with a more business-friendly government and rising asset prices, investor confidence has increased.
If one looks at the chart above, however, periods of high and rising investor confidence (e.g. leading up to 2000 and 2007) have not been the best time to be aggressive in equity investing over the last twenty years. It is for this reason that we have remained conservative in our approach. Yet since the future direction of markets is entirely unpredictable stock prices can also continue much higher. Therefore, as prices and risk both rise, our focus must be on identifying attractive investments within the market itself.
One of the more reliable phenomena of finance is the concept of mean-reversion, where if values become too high or too low they tend to revert to an average level. Over long periods of time, this occurs in many measurements such as profit margins, valuations, returns on investment and even in human behavior such as fear, greed and investor confidence.
Because of mean-reversion and the strong recent performance of the S&P 500 (and attendant high median valuations per the chart below) we now want to significantly underweight the S&P 500’s top members. Because valuation tends to be a reliable indicator of future long-term returns, there is now more risk and less opportunity in the S&P 500 itself than in other investments that earn high returns on equity but have been out of favor for various reasons.
This begs the question of whether one should avoid equities altogether. After all, if the S&P 500 is expensively valued, isn’t everything? The answer is no. This is because the top 10 stocks of the S&P 500 drive 20% of its return and the top 30 stocks drive 45% of the return. So while the index itself is expensive, it will be the largest S&P companies that carry the most risk in an overall decline. They have carried the index to the upside. There are lots of reasons why the S&P 500 has outperformed that are also beyond the scope of this letter, but the belief in the infallibility of passive investing is a big one. This outperformance will not continue forever.
In deciding how to put long-term capital to work, what matters for future returns is beginning valuations. And valuation attractiveness is typically created by past underperformance. In the last few years, foreign and emerging market stocks have underperformed the S&P significantly -- to the point where the valuation differences are now stark (see chart on the next page which reflects the 10-year average price-to-earnings ratio of emerging, developed and US markets).
Very recently foreign and emerging market stocks, as well as many other out-of-favor investments, have shown signs of life. In 2017, emerging market equities have outperformed global equities by 13%, but still trade at a 22% discount to developed markets based on forward earnings. We can’t know if this represents a big change in the future investment environment, but we bring it up to support a case that foreign and emerging market stocks warrant inclusion in a long-term portfolio. Because the S&P 500 is arguably a bit stretched, it is important for us to look where the values are. And within the US, there are still many attractive long-term opportunities that offer plenty of upside.
If you would like to learn more about Highgate Securities Investments and its investment philosophy, company values and services, we would be eager to set up a no charge consultation. Our goal is to work with a select group of experienced and sophisticated clients, and to be the best advisor, not the biggest. Everything we do is guided by our objective of earning your trust through our experience, advocacy, diligence and care. Please visit our website at www.highgatesi.com or call our office at 303-968-1230 for more information.
John R. Goltermann, CFA, CPA, CGMA
 Source: Morgan Stanley