The Stock Market is Getting Greedy

Table of Contents

Equities

Fixed Income

US Treasuries

Investment Grade Bonds

Municipal Bonds

Since the start of the year and through the end of June, the equity markets have been red hot with the S&P 500 and the NASDAQ composite index up YTD +16.9% and +32.3%, respectively. There are many potential reasons for the rally in the stock market, including:

• Generative AI solutions enabling higher margins for companies. Companies may potentially replace white-collar employees with cheaper software.

• Declining inflation.

• Abated fears of a recession.

• The belief that we are near the peak in short-term interest rates.

• Corporate profits that are beating expectations.

• FX headwinds in 2022 becoming tailwinds in 2023 as the US dollar has weakened.

• A rebound from the 2022 decline in the S&P 500 and the NASDAQ composite index of -18.1% and -32.5%, respectively.

• Momentum carrying over from the rally earlier in the year.

We are not currently bullish on the equity markets. As Warren Buffett has often said, “be greedy when others are fearful, and fearful when others are greedy.”  Only a few companies we follow look attractive when compared to short-term treasuries with >5% yields.  We were quite bullish in the second half of 2022, when markets were much cheaper and there was more fear. 

Source: Bloomberg

Equities

Equity Performance by Indices

Source: Bloomberg

Valuation: S&P 500 P/E

Source: Bloomberg, SPX Index P/E

S&P 500 Price / Forward Earnings (P/E) multiple has increased to 20x, up from 18x in Q4, a decent bit above the 50-year average of 17x but below the recent market peak of 30x in April 2021.  We think the market is fully valued (and perhaps overvalued) in certain segments, though it’s possible this upward change in valuation is justified by the remarkable productivity gains that artificial intelligence has started to unlock.

That being said, there aren’t as many obvious opportunities to deploy capital into the equity markets compared to late 2022.  As a result, we are being more cautious about deploying client capital into stocks and are on the hunt for other opportunities that have strong long-term, tax-efficient, expected returns. 

Fixed Income

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

US Treasuries

Source: Bloomberg, World Interest Rate Probability (WIRP)

So far in 2023, the Fed has raised interest rates twice (March and May), while pausing in June as the Fed Funds rate hovers at ~5.1%.  Markets expect the Fed to raise rates by 0.25% in their next meeting on July 26th.  

We continue to favor investing in short-term treasuries above almost anything else in the fixed-income space.  Between the tax-efficiency, liquidity, low risk, and high yields, short-term treasuries are excellent investments right now. 

Based on market expectations, an investor should receive a pre-tax return on short-term treasuries of ~5% over the next year. One nice advantage of US Treasuries is that they are exempt from state and local income taxes, which can create a substantial after-tax yield advantage in certain jurisdictions vs. corporate debt. 

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

The 10-Year US Treasury ended the month at a 3.8% yield. This yield is lower than the short-term treasury yield of 5%, so 10-year Treasuries have lower yields than cash, and substantially more price risk. 

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 continued decrease in credit spreads since 2Q22 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%, levels last reached during the 2020 pandemic, Great Financial Crisis (GFC), and the dot .com bubble.

Investment Grade Bonds

Investment Grade Credit Spreads: AAA 10-Yr premium received above US Treasuries (in bps)

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. Compared to the end of 2022 and during 1Q23, these debt instruments were trading at lower spreads to underlying treasuries and are less compelling.

In addition, these instruments are fairly tax-inefficient and their absolute level of post-tax yield is still quite low. On an annual after-tax basis, 3-month treasuries yield 3.4% compared to 2.5% for the IG bond index, while also maintaining lower duration risk[1] (0.2 years vs. ~7 years).

[1] Duration is a measure of sensitivity to interest rates for a 1% move. A duration risk of 7 implies roughly a 7% drop in price if interest rates increase 1%.

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 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. 

Note: Header image sourced from CNN