So far this year, the S&P 500 bull market has notched 46 all-time highs (for comparison, there were 45 in 2013 and 53 in 2014), reaching 8.5 years old in the midst of elevated valuations (~18x forward earnings) and 100 basis points in Federal Reserve rate hikes. Although investor angst about future equity returns is building, we believe that (1) bull markets are likelier to die of poor health than old age, (2) elevated valuations may persist alongside earnings growth, and (3) Fed policy is a reflection of confidence in the economic outlook. In fact, despite the Fed’s rate hikes and announcement that balance sheet normalization would begin this month, financial conditions have reached their loosest (i.e. most supportive of economic growth) levels in almost three years. In other words, much like the wind’s direction and strength require adjusting an airplane’s thrust to maintain airspeed, current financial conditions permit the Fed more rate hikes than might have historically been the case. The equity bull market is ageing and valuations are elevated, but the macro backdrop is equally difficult to ignore: stable growth, stable inflation, stronger labor, and a steady data-dependent path higher for interest rates. Read More
Tax reform is starting to move forward and, in our view, the probability of enactment in 2018 is increasing. President Trump’s framework for reforming taxes, released in late-September, would cut the corporate tax rate from 35% to 20%, near the global average. Last month, we expressed the view that an increased likelihood of tax cuts – of almost any size – could be a net positive for US equities. We estimate that a cut to 20% could boost earnings on the S&P 500 by as much as 8%. In fact, the boost to small caps may be even more meaningful, given that on average they pay higher rates than their larger counterparts. Read More
We have previously discussed elevated valuation environments as having historically implied more about the magnitude of returns in subsequent years (mid-single digit returns, currently) than the onset of bear markets. Below, we now explore the use of valuations as a buy/sell indicator. We find that selling equities at elevated valuations in anticipation of more attractive entry points is a weak investment strategy. That is because those entry points have often taken years to materialize. In other words, the more you want, the less you get. Read More
Text Source: GSAM. Chart Source: Goldman Sachs Global Investment Research as of September 30, 2017. "US Financial Conditions" represents the Goldman Sachs Financial Conditions Index (GSFCI), a weighted average of several financial variables including riskless interest rates, spreads, equities, and FX (foreign exchange), based on their effects on future US GDP growth. The weights are meant to reflect the impact of changes on real GDP growth, holding all other components of the index constant. "Fed Balance Sheet Normalization Begins" in October 2017. FOMC stands for Federal Open Market Committee. Past performance does not guarantee future results, which may vary.
The old rule of thumb "buy low and sell high" only goes so far. Except in hindsight, investors cannot know when "high" or "low"has arrived. If an investor sells when equities are expensive, but the market moves higher still, significant gains may be foregone. Our historical analysis finds that when investors sell equities at elevated valuations, such as today's, the expectation of buying at lower valuations is usually disappointed. The result is meaningful underperformance relative to a much simpler approach: staying invested.
Elevated valuations can stay put for extended periods of time. An investor who employed a strategy of selling out of equities at high valuations (90th percentile) with the intention of buying back at "cheaper" levels would have exited the market in March of 1992 and February of 1998. Depending on the definition of "cheaper" (70th, 60th, or 50th percentile), it could have taken up to 100 months to get back into the market.
With the potential for valuations to remain elevated – using our historical analysis as a guide – investors may miss out on returns while waiting on the sidelines. Historically, a strategy that sells S&P 500 equities at the top decile of valuations and re-enters when stocks trade at their bottom half of valuations (50th percentile) underperformed a buy-and-hold strategy by 100bps on an annualized basis.
Top Section Notes: As of September 30, 2017. Analysis is from January 1954 to September 2017, earliest and latest available years for data, respectively. Chart shows the number of months an investor would have remained uninvested had they sold out of the S&P 500 after reaching the 90th percentile of valuations, waiting to buy back in at the 70th, 60th, and 50th percentiles, respectively. Valuation percentiles are based on the S&P 500's forward 12-month price-to-earnings (P/E) ratio. Past performance does not guarantee future results, which may vary.
Bottom Section Notes: As of September 30, 2017. Analysis is from January 1954 to September 2017, earliest and latest available years for data, respectively. Chart shows the underperformance on an annualized basis of a strategy that sells the S&P 500 index when valuations are above its 90th percentile, and repurchases at lower percentiles, when compared to a buy-and-hold strategy that stays invested for the same period of time. Underperformance is represented by S&P 500 total returns. These examples are for illustrative purposes only and are not actual results. If any assumptions used do not prove to be true, results may vary substantially.
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