Q3 2021: A Very Expensive Vintage Year

I’m very wary of making a big vintage year bet at this point in the cycle of equities broadly defined. In contrast, I was very happy to invest a huge amount in Q1-Q2 2020. The backdrop today is one where interest rates are historically low at a time of massive fiscal stimulus, economic recovery from a global pandemic, and rising inflation expectations. A higher interest rate will increase discount rates on equities and decrease equity multiples.

10-Year US Treasury Yields:

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

HY 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)

Credit Spreads (amount of extra yield one gets above treasuries) are near all time lows. The above chart highlights HY credit spreads less the yield above US Treasuries (Gov’t Option Adjusted Spread). At the moment, this is a historically unfavorable point in time for investments in HY loans. I, personally, sold all of my high yield holdings earlier this year.

Equities

Presently, valuation multiples (P/E) for equities are on the high end. The below chart depicts forward estimated earnings per share divided by price for the S&P 500 (Best P/E Ratio).

Source: Bloomberg, SPX Index P/E

There is “bubbly” behavior in certain sectors like meme stocks, crypto currencies, and SPACs (i.e., NKLA). Software multiples in particular have undergone a massive re-pricing in asset valuations.

Source: https://cloudedjudgement.substack.com/p/clouded-judgement-71621 - July 16, 2021

My concern is that a large vintage year bet on 2021 will create sustained losses in an environment where interest rates have any sort of moderation towards normalcy. I believe there are certain investments that can be made today that will perform well in that environment, but they represent a smaller part of the equity universe.

The strategy I’d recommend would be to build the equity allocation over 3 years split mostly between passive US equities and bets on individual positions where we underwrite strong returns (>10%) in a conservative environment. I think there should be a smaller amount (say 10% or so) which is dedicated to high convexity, paradigm shifting growth areas (early-stage companies, gene therapy, MRNA platforms, new frontiers in AI or computing) where the typical analytical tools make it difficult to underwrite to a particular return zip code. Backing winners in these areas have generally been a smart thing to do.

As you can see from the updated chart below - some companies screen well against this - while others do not.

Annualized 5-Year Returns (by metric)

Source: Analysis dated as of July 22 2021