Discipline vs. FOMO

I’ve enjoyed watching our client’s portfolios grow significantly over the last 18 months as equity markets have reached new highs.  The S&P 500 has risen ~15% this year, on the back of a 26% gain in 2023, and is up an astonishing ~46% between Jan 2023 and June 2024. 

Source: Bloomberg

Note: Equity Indices - DJIA, S&P 500, NASDAQ; Fixed Income Indices - SPDR Bloomberg 1-3 Month T-Bill, BBG Municipal Bond Index, BBG US Corporate High Yield, BBG US Agg. Total Return, BBG US Gov.t 10 Year

It’s at times like these that it becomes more difficult to keep one’s discipline as an investor.  It’s very tempting to chase the market, and to invest more money in companies that have appreciated significantly (like Nvidia) over the last few quarters. 

I do not believe price momentum is a good reason to invest. We are investors, not speculators, and we are trying to buy companies at prices that undercount their value.  It’s at times like these when it’s important to remain disciplined, and to resist the FOMO (fear of missing out). 

It’s been a less fruitful experience for many fixed income investors over the last 18 months.  We’ve been wary of any fixed income exposure outside of T-Bills, and it’s interesting to see how T-Bills (+8%) have continued to outperform other fixed options, other than High Yield (+16%).   

Equities

Valuation: S&P 500 Price to Forward Earnings Ratio

Source: Bloomberg, SPX Index P/E

The market action has started to remind me a bit of 2021. 

• The S&P 500 is at a forward earnings multiple of ~23x, which is pretty much where it was when we wrote the Q3 2021 blog post about stocks being expensive.   

• In a reverse from last time, short term interest rates have been at a high point since the 2008 Great Financial Crisis, and the market expects short term interest rates to fall over the next year.  Lower interest rates could provide some support for profit multiples to increase in the short term.

• On the flip side, we believe lower interest rates will happen coincidentaly with lower growth and a possible recession.  A drop in earnings could counteract any positive change in multiples, and because multiples are highly sensitive to growth rates (the faster a company is growing, generally the higher a multiple it gets), a lower interest rate environment could be consistent with lower multiples as well. 

• We are still believers that it’s likely that interest rates will be substantially higher in the medium term (3-5 years from now), and if that comes to pass, we’d expect equity multiples to decline closer to their 50 year average of ~17x.

Trying to predict, and time, the direction of the stock market using these macro variables is very difficult.  So, while we keep an eye on the macro, we try to stay focused on the prospects of individual companies. 

We see very few obvious opportunities among the companies we follow.  Our large cap stocks are generally fully valued, or maybe more.  While some of small and mid-cap stocks we follow look interesting from a valuation perspective, those same companies are faced with significant threats to their existing moats from new technologies (generative AI) and disruptive companies (Shein/Temu). 

 More of our equity capital is being invested into broad-based indices rather than individual stocks. We believe that the convex nature of stock returns creates reasonable odds of decent performance in equity indices over long time periods, even when the overall indices have high prices.  In other words, only a few extraordinary companies need to have extraordinary performance for the overall index to do well.  Case in point, even if you had invested in the S&P 500 near the prior market peak (end of 2021), you would have made ~7% per annum between 2021 and Q2 2024. 

Public & Private Fixed Income

Source: Bloomberg, HY (High Yield ) Bond: LF98TRUU, IG (Investment Grade) Bond: LBUSTRUU, Municipal Bond: LMBITR, respectively. Income Tax Rate Assumptions: Federal (37%), State (10%)

US Treasuries

Expected Federal Effective Interest Rate

Source: Bloomberg, World Interest Rate Probability (WIRP) as of 7/8/2024

Cash vs. 10-Year US Treasury Yields

The Federal Reserve last raised interest rates at its July 2023 meeting, after having raised interest rates 11 times since March 2022, with the Federal effective rate currently at 5.3%.

At the beginning of this year, the market was pricing in six 0.25% rate cuts through the balance of the year, which would have brought interest rates down by ~1.5% to roughly 3.8%. Fast forward six months into the year, we have had zero rate cuts, the market anticipates one to three rate cuts through the balance of 2024, bringing interest rates down to ~4.8%.  

Inflation has been trending down closer to ~3%, meaning that treasury bills at a 3.2% after-tax yield will preserve your purchasing power. 

We see little reason to dump short duration treasury bills for longer duration treasury bonds at this point in time.

10-Year US Treasury Yields

Source: Bloomberg, 10-Yr US Treasury Yield (USGG10YR)

High Yield Credit Spreads: Additional yield received above US Treasuries for debt of riskier companies

Source: Bloomberg, BarCap US Corp HY YTW 10-Yr Spread (CSI BARC Index)

The above chart displays a modest credit spread for high-yield bonds issued by companies with riskier balance sheets. We think investing in high-yield bonds will make more sense once credit spreads breach 6%.

If the United States does enter a recession over the next few quarters, we believe that the 3.8% credit spread will provide poor compensation for defaults and losses in high yield bond portfolios. 

Investment Grade Bonds

Investment Grade Credit Spreads: AAA 10-Yr premium received above US Treasuries (in basis points; 1 basis point = 0.01%)

Source: Bloomberg, BASPCAAA Index

Investment Grade bonds are debt instruments issued by companies that rating agencies deem high quality and have a low risk of defaults.  An investor is receiving very minimal additional compensation to treasuries (0.81%) for investing in this asset class.   

On an after-tax basis, we see no additional yield for investment grade bonds compared to US Treasuries, despite US investment grade bonds having a higher risk of default and higher duration than that of US Treasuries. 

Municipal Bonds

Municipal Bond Index (YTW)

Source: Bloomberg, LMBIYW Index

Municipal bonds can be a tax-efficient way to generate yield and have recently reached levels that are more favorable. We recommend allocating exposure to the short end of the curve (maturities <1 year) as long-duration bonds still do not give adequate yield to compensate for interest rate and duration risk.

It’s important to understand one’s marginal tax rates and jurisdiction before investing in municipal bonds as those factors determine one’s after-tax yield and the attractiveness of the asset relative to treasuries or corporate bonds.  Recently, we haven’t seen many compelling opportunities in high quality municipal bonds. 

Concluding Thoughts

• We try to evaluate investments consistently.  Assumptions about growth, profitability, and valuations, should be done in a framework that allows one to flex those parameters and understand the implications.

• We try to use assumptions from very long historical contexts.  We look at interest rates and multiples over many decades and try to understand where we stand in the longer historical context.  I am over four decades old and still consider myself young, so our reference time series should at least be that long.  This is a useful way to avoid FOMO – long time series gives you a better sense of how markets gyrate over time. 

• We understand the role of luck – and try shaping our portfolios such that good luck matters more than bad luck. That means we focus on investments that have uncapped upside.

• We only recommend to our clients what we are buying.  You typically have a much higher bar when you are putting your own hard-earned money into something.  Having “skin in the game” creates greater discipline.