The past year will arguably be viewed as the most unique year for equities in our lifetime. The year started as a promising one for equity markets. The global economy was improving, earnings were rising, valuations were tame, and management teams from many different industries were bullish on growth prospects. Then the global pandemic hit and equities plummeted 35% in the fastest bear market on record. In the U.S., at the March bottom, investors narrowed their investment focus to Growth companies (companies with high earnings growth). Specifically, investors focused on mega-cap consistent growth companies like Apple, Microsoft, Facebook, and Google, while simultaneously piling into “sheltered in place” growth beneficiaries like Peloton, Wayfair, Shopify, and Zoom, with no attention paid to valuation.
Later in the year, vaccine optimism and an improving economy, supported by the massive amount of monetary and fiscal stimulus, enabled the narrow equities rally (mega-cap and “sheltered in place”) to expand. Economically sensitive and value focused areas ranging from casino gaming to industrial metals began to outperform. Although many of the “sheltered in place” companies have sold off in an effort to correct egregious valuations, growth equities continue to perform well, and now trade at a 20-year record valuation premium over Value equities.
In reviewing the performance of foreign equities, it may be surprising to realize that foreign equities outperformed U.S. equities from the March low to the end of the year. Even with this outperformance, U.S. equities ended the year trading at a whopping 40% premium to the rest-of-the-world.
As we enter 2021, we feel there are three main questions investors should be asking about global equities: “Will Growth and Momentum companies continue to outperform Value and economically sensitive companies?”, “Will U.S. equities continue the 10-year theme of outperforming foreign equities?” and “Besides politics or a slow COVID-19 vaccine ramp, what can derail the U.S. stock market in 2021?”
Will Growth and Momentum companies continue to outperform Value and Economically Sensitive companies?
In reviewing history to see how this Growth outperformance started and progressed, the following chart shows the relative performance of Growth versus Value over the past ten years. Immediately, you will notice the two styles posted very similar returns from 2011 through the summer of 2015, then Growth inflects into a five-year period of consistent outperformance. What caused this sharp divergence?
After the global financial crisis that ended in 2009, the economy rebounded and earnings growth spiked, supporting both Growth and Value returns equally. However, in late 2015 to early 2016 the market experienced an earnings recession – economic growth decelerated and earnings temporarily contracted. By the second quarter of 2016, not only had interest rates fallen (the ten-year U.S. Treasury yield fell from over 3% to 1.5% in two years), but the valuation differential between Growth and Value, as measured by the forward price to earning ratio (P/E), had compressed – shown in the next chart. By the spring of 2016, Growth was trading at a scant 10% valuation premium to Value (versus a 25% long-term average). With relatively slow economic growth, and low interest rates increasing the present value of future earnings for Growth companies, it is relatively easy to see why Growth outperformed Value in 2017.
Then just as the global economy began to expand in the first half of 2018 and economically sensitive and Value companies had started to outperform, the U.S. began a trade war with China in the second half of 2018. The trade war once again caused earnings growth to cease, and by the time 18 months had passed, earnings growth was back to 0% in 2019. The lack of earnings growth, coupled with low interest rates caused investors to continue to pay up for increasingly expensive Growth stocks, and by the time 2019 ended, Growth was trading at a previously unimaginable 55% premium to Value. 2020 began as a very promising year for economically sensitive companies with rising earnings and low valuations. Then the pandemic hit, earnings dove, and investors rushed into Growth stocks. By mid-year, the premium to own Growth stocks reached a 20-year high of 80%. The slow U.S. economic growth which precipitated this Growth versus Value divergence was caused by the back-to-back-to-back trio just described. But what is the setup for U.S. equities in 2021?
Heading into 2021, economically sensitive companies have three probable tailwinds, each of which can be construed as negative at least for the high valuation (momentum) segment of the growth index. They are earnings growth, valuation, and interest rates. First, the four sectors with the highest estimated earnings growth in 2021 versus 2020 are energy, industrials, consumer discretionary, and materials – all economically sensitive sectors. The technology, communications, and healthcare sectors are expected to see slowing year-over-year earnings growth. This rotation in earnings growth begins as the growth index (Russell 1000 Growth® Index) is trading at a 74% premium to the Russell 1000 Value® Index – the highest premium since the internet bubble. Third, if interest rates rise over time due to improved post-pandemic economic growth, the present value of future earnings for growth companies falls. Additionally, in my career, I have only seen one other time when investors were so overloaded in growth stocks, and investment products that invest in momentum Growth companies were so obscenely popular…the year 2000.
Will U.S. equities continue the 10-year theme of outperforming foreign equities?
The outperformance of the U.S. versus the rest of the world’s equities followed a similar path as U.S. Growth versus Value. The reasons are similar and were further supported by a spike in the U.S. dollar that started in the second half of 2014 and potentially peaked in the summer of 2020.
For the market consensus, overweighting U.S. equities versus the rest of the world (ACWI ex U.S.) is an easy call. U.S. companies are “better,” they have the “tech leaders,” and the U.S. innovates like no other region. Although these are true, should investors be willing to pay a 40% premium to own U.S. equities relative to foreign equities? Unless earnings growth, interest rates changes, balance sheet strength, and currency fluctuations all move in a favorable fashion for the U.S., that answer should be a resounding ‘no’. As shown in the following chart, although the U.S. traded at a mere 6% premium to foreign equities in 2015, the premium has ballooned to 40% today versus a 20% average.
The big question entering 2021 is “what does the U.S. offer investors for the 40% premium?” The table below details a comparison of the U.S. versus foreign equities in valuation, earnings growth, dividend yield, and balance sheet leverage. On a valuation basis, the U.S. trades at a far higher P/E as previously mentioned, and over twice as expensive on a price-to-book (P/B) valuation. Earnings growth from 2020-2022 is estimated to be similar, while foreign equities pay a far higher dividend yield, with similar balance sheet leverage.
Besides politics or a slow COVID-19 vaccine ramp, what can derail the U.S. stock market in 2021?
Political and geopolitical related risks are always a concern but will likely be reduced in the coming four years versus the previous four years. The vaccine distribution ramp speed is certainly a risk, as is overspeculation in momentum equities, IPOs, SPACs, private equity, venture capital, and technology companies. However, the one hidden risk that could place a lid on valuations and further gains is rising interest rates.
With the consistent, stealth, methodical fall in interest rates over the past 30-years, most of us are simply used to interest rates being low. Most likely you are conditioned to see mortgage rates barely above long-term inflation, car loans at 3%, and money markets paying 0%. Besides helping to enable outsized gains in Growth equities, extremely low interest rates have helped the entire U.S. equity market rise in price and valuation. Below is a 30-year chart of the ten-year U.S. Treasury yield – stunning.
There is a calculation called the Equity Risk Premium (ERP). It is a measure of the excess premium an investor receives from investing in equities (higher risk) vs bonds (lower risk) by comparing the earnings yield of equities to the interest rate offered by bonds. An example of the ERP in 2016 versus today is helpful. In the summer of 2016, the S&P 500 was trading near $2,000. Earnings for 2016 were $118 per share, on their way to $130 in 2017. The ten-year Treasury yield had fallen to 1.40%. So the present and future ERP was (118/2000 minus 1.40%) and (130/2000 minus 1.40%) = 4.50% and 5.10%. Generally, equities outperform bonds when the ERP is above 5% and underperform when it is below 3% with extremes topping 7% and below 2%. In the summer of 2016, equities were certainly the superior investment. Note: the ERP was over 6% in March 2020. Compare this to today’s present and next year’s earnings to calculate ERP and interest rates at 1.00% = Present 2.50% and future 3.50%. Today’s figures essentially indicate U.S. equities can rise in 2021 if interest rates stay low and earnings are better than expected.
The table below shows a matrix of ERPs under different interest rates and S&P 500 levels, assuming earnings are slightly higher than expected in 2021.
Overall, if interest rates stay near 1.00%, and S&P 500 earnings beat estimates, upside is possible for equities. However, if the ten-year U.S. Treasury rate steadily rises, the upside for equities becomes capped, and the low ERP no longer points to equities being superior – which also increases the risk of equities underperforming versus other asset classes. This is why we believe it will be important to monitor interest rates with equities at these levels.
How these big questions for 2021 related to interest rates, foreign vs domestic equities, and Growth and Momentum vs Value and Economically Sensitive equities, are resolved will create opportunities and challenges this upcoming year. Osborne Partners’ diversified exposure across multiple asset classes, plus a disciplined focus on asset-specific risk-reward, positions us to take advantage of volatility that could arise as these questions are answered in 2021.