Market Reviews Archives - Aptus Capital Advisors

Valuations Matter

David Wagner — Fri, 10 Jun 2022 19:34:55 +0000

The returns witnessed by investors over the past few years have been an outlier. Entering the year, the 3-year annualized return for the S&P 500 was ~25% with the U.S. Barclays Agg. returning ~5%. In an environment where one has had strong returns, it makes one feel rich, naturally leading you to extrapolate further gains. More intriguingly, the highly valued, high growth stocks portion of the market has been hit the hardest.

Jason Zweig wrote about neuroeconomics in Your Money & Your Brain to show how financial decisions impact our brains. The brain scans have shown that the brain activity of a person that’s making money on their investments is indistinguishable from a test person – it literally makes people feel as if they are taking drugs. Investors need a bigger hit of adrenaline each time to get a bigger fix for the same emotional response.

It is our opinion that this is how leverage and speculation has the potential to cause financial ruin the market. That is why some of the most high-flying growth stocks have been hit the hardest this year – investors piled in at any valuation through FOMO. We have witnessed a valuation deleveraging event YTD.

As valuations quickly expanded over the recent years adding to returns, investors were just borrowing returns from the future. The more highly valued a holding is, the lower its return is likely to be down the road.

Perhaps this is a bit simplistic, but there is some truth to this line of thinking. The chart below shows the relationship between the S&P 500’s trailing 12-month operating PE ratio on the x-axis and the index’s annualized return over the ensuing 10 years on the y-axis. We entered 2022 at a valuation level that placed it in the 95% relative to a 50-year history, hence the title of our Aptus Annual Outlook this year – Investors May Need to Curb Their Enthusiasm in 2022.

Simply put, we feel higher valuations in the present generally coincide with lower returns over the following 10 years. The S&P’s P/E ratio began the year in the low 20s – historically this has coincided with annualized returns in the range of 2%-4% over the following 10 years. The S&P’s P/E ratio currently resides around 18.0x, which means that an investor can expect an annualized return closer to 6% over the following decade.

The return pain felt this year from the S&P 500 can be fully attributable to multiple compression. But the pain felt now, has helped create an environment which we think may be more fruitful in the future. Short-term pain for long-term gain.

This year could be deemed a “duration cleanse”, both on the equity and fixed income side.

As a note of caution, annualized returns have been as high as 11% and as low as -1% following similar valuations in the past. This is not meant to pinpoint exact returns moving forward but offer some expectation for the future based on current valuations.

My point here is that compounding capital can get messy in the short-term but tends to be a more consistent metric over longer periods of time. But, as we have seen, investors need to be prudent how the invest.

The relationship of valuation and return is much more random over the short-term. While the chart above shows annualized S&P 500 returns over the ensuing 10 years, the chart below simply shows returns over the following one year. Long-term investors might be able to set expectations based on current valuations, but short-term investors should not use this as a timing tool.

We understand that it has been a difficult beginning to the year, but sometimes, the best time to buy stocks is often when it feels the worst. This year has created an opportunity for long-term investors – there’s been a reset in valuations. Does that mean that a floor has been set in the markets? Absolutely not. But the valuations in this current environment are much more palatable than where they were to begin the year.

Let’s open that can of worms – is the market valuation at its bottom? Like I mentioned above, valuation is a poor tool on timing ST moves on sentiment. In fact, year-to-date, the market has seen its sharpest valuation decline in history. That begs the question – what all is priced into the market already?

As of today, there remains a lot of uncertainty in the P/E inputs. Many of y’all have heard me discuss that this market has been more macro-driven than fundamental: War in Ukraine, QE à QT, rising interest rates, a more hawkish Fed, a mid-term election, and John Luke’s favorite….inflation.

We do not have a crystal ball to call a market bottom. Looking over the last decade, stocks have been a great purchase ~16x multiple. Is that the case this time? We don’t know. But what we do know is that this “valuation cleanse” creates a more palatable environment for future returns.

Disclosures

Past performance is not indicative of future results. This material is not financial advice or an offer to sell any product. The information contained herein should not be considered a recommendation to purchase or sell any particular security. Forward looking statements cannot be guaranteed.

This commentary offers generalized research, not personalized investment advice. It is for informational purposes only and does not constitute a complete description of our investment services or performance. Nothing in this commentary should be interpreted to state or imply that past results are an indication of future investment returns. All investments involve risk and unless otherwise stated, are not guaranteed. Be sure to consult with an investment & tax professional before implementing any investment strategy. Investing involves risk. Principal loss is possible.

The S&P 500® Index is the Standard & Poor’s Composite Index and is widely regarded as a single gauge of large cap U.S. equities. It is market cap weighted and includes 500 leading companies, capturing approximately 80% coverage of available market capitalization.

The Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based benchmark that measures the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market. This includes Treasuries, government-related and corporate securities, mortgage-backed securities, asset-backed securities and collateralized mortgage-backed securities.

Advisory services are offered through Aptus Capital Advisors, LLC, a Registered Investment Adviser registered with the Securities and Exchange Commission. Registration does not imply a certain level or skill or training. More information about the advisor, its investment strategies and objectives, is included in the firm’s Form ADV Part 2, which can be obtained, at no charge, by calling (251) 517-7198. Aptus Capital Advisors, LLC is headquartered in Fairhope, Alabama. ACA- 2206-11.

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Rearview to Windshield, June 2022

David Wagner — Mon, 06 Jun 2022 21:40:18 +0000

Developments over the Past Month:

The Beatings Will Continue Until Morale Improves: Markets wrapped up a volatile month of May exactly where it began. We started May at 4,131 on the S&P and ended May at 4132. Along the way we had 9 of the 21 trading days see 2% moves or more. The S&P was down 6% for the month on the 19th but was able to claw those losses back last week. The Dow Jones Industrials closed out the month up 0.04%. The Nasdaq Composite slipped 0.4% to end the month down 2.1%. The index had larger daily moves on about half of May’s trading days than its full-month performance.

What is the Market Saying? – Both the Treasury and equity markets are clearly worried about the economic outlook. The only recent good news in the Treasury market is that inflation expectations have declined, but they still remain too high for comfort. Despite that, perceived inflation risk has increased. Expected growth has declined at all horizons but more so in the nearer term, and safe-haven flows indicate nervousness about the outlook. In the equity market, three- to five-years ahead earnings expectations have declined markedly and are well below trend, which in the past has been associated with serious economic slowdowns or recessions. Despite these concerning signs, a Fed reverse pivot does not appear close; the political environment is an important obstacle.
How Far Can Stocks Rally? – Medium-term risks remain heavily tilted to the downside, in our view, but positioning, softer Fedspeak, and a history of vicious bear market rallies raise the risk of a continued near-term equity bounce. After all, not being close to the Fed put strike doesn’t mean markets are close to the (short) Fed call strike either, the point at which the Fed starts pushing back on equity strength to fight inflation.
The Beginning of Quantitative Tightening – We are beginning a new regime as the Fed moves to reduce the size of its balance sheet which has grown to nearly $9 Trillion. Since March 2020, the Fed has made more than $4T in bond purchases. Now, to fight inflation, the Fed will begin to let some of their bonds mature (without replacing them). According to the central bank, roll offs will ramp up to $95 billion in September including a $60 billion reduction in U.S. Treasuries (“UST”) and a $35 billion reduction in Mortgage-Backed Securities (“MBS”). The first three months, however, will begin at half that pace, $47.5 billion, comprised of $30 billion UST and $17.5 billion MBS. That compares to a peak roll off $50 billion a month when the Fed performed the exercise starting back in 2017.
Where is The Fed Put? – We continue to believe that the Fed Put is much lower right now, as FOMC Chairman Jerome Powell has stated that the Fed is going to keep raising until we have a recession unless inflation meaningfully improves. The cause of the decline is equally important. The Fed has a long history of easing policy in response to earnings drops, but there isn’t much evidence that it responds to multiple compression. The fact that inflation is higher than at any time since the genesis of the Fed Put and that stocks have appreciated a lot over the past two years suggest the strike is well below current prices. Similarly, the recent decline in stock prices owes exclusively to lower multiples; it would take another leg down induced by a drop in earnings to impress the Fed.
Rate Hikes: The Fed is expected to hike another 50-bps hike in June, and now, the market is pricing in a 50 basis point hike in September. But after that the outlook is bit cloudier. The market has fully priced-in 10 rates hikes in 2022 (to the 2.50-2.75% range) and one more in 2023 which would be the fasted pace of hikes since 1989. We expect Powell’s tone to remain hawkish at future press conference. Finally, financial conditions have already tightened significantly, for example the pop in mortgage rates is harming housing affordability and with further Fed tightening there will be more casualties to slow the economy further.
Earnings Highlights – Overall, 2022 consensus EPS are up modestly, but what is most noteworthy is how this earnings trend has skewed between indexes with small cap and value indexes seeing much more significant positive earnings revisions, while growth and larger cap indexes, more negative. While consensus 2022 EPS rose 1% since April 1, it was entirely driven by Energy (-0.2% ex-Energy). Over this past retail earnings season in middle May, we started to see a shift if spending habits by the consumer, spooking the market.
Yield Curve Flattening & What It’s Telling Investors: The yield curve’s flattening is a sign of growing concern that the Fed is going to hike too much and break something. The curve inverted at the end of the last quarter, which would signal the market believes things are already breaking. As the short end of the curve rises, so too do the odds of rate hikes. The market is now pricing in a 50 basis point rate hike in Sep.
Earnings: 2022 S&P 500 operating earnings = $223. 2023 = $235. 2021 = $209. 2020 = $142. 2019 = $165.
Valuations: S&P 500 Fwd. P/E: 18.0x, EAFE: 12.7x, EM: 11.2x, R1V: 14.6x, R1G: 23.3x, and R2K: 12.1x.

Client Talking Points – June 2022

Yield Curve: The yield curve officially inverted at the end of March. An inversion of the 10/2 spread does not mean a recession is imminent. Historically speaking, stocks rally for about a year after a 10s-2s inversion, with an average return around 15% (heads up, this is a different range than shown in a below chart). So, a curve inversion is not a reason to sell—it’s a signal that the time on the bull market and economic expansion is now limited, and to prepare for both to end.
Build Back Better: Though it wasn’t passed in 2021, President Biden outlined the biggest expansion of the federal government matched with the largest tax increase since 1968. Biden senses the post-COVID era is a once-in-a-generation opportunity to massively restructure US fiscal, monetary, and social policy. In our opinion, this is a big experiment. We’ll wait to see how the Build Back Better plan and taxes pan out. It appears that this dramatic change in societal direction has proved to be difficult for some moderate Democrats to get on board, i.e., Manchin.
We continue to watch forward EPS expectations fort he market as it starts to grapple with higher-than-expected inflation curtailing margins.
Longer-term, we believe valuations and bond yields will eventually matter, and both will lower expected returns for balanced portfolios.

Disclosures:

Aptus Capital Advisors, LLC is a Registered Investment Advisor (RIA) registered with the Securities and Exchange Commission and is headquartered in Fairhope, Alabama. Registration does not imply a certain level of skill or training. For more information about our firm, or to receive a copy of our disclosure Form ADV and Privacy Policy call (251) 517-7198 or contact us here. Information presented on this site is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any securities.

The S&P 500® is widely regarded as the best single gauge of large-cap U.S. equities. There is over USD 11.2 trillion indexed or benchmarked to the index, with indexed assets comprising approximately USD 4.6 trillion of this total. The index includes 500 leading companies and covers approximately 80% of available market capitalization.

The Nasdaq Composite Index measures all Nasdaq domestic and international based common type stocks listed on The Nasdaq Stock Market. To be eligible for inclusion in the Index, the security’s U.S. listing must be exclusively on The Nasdaq Stock Market (unless the security was dually listed on another U.S. market prior to January 1, 2004 and has continuously maintained such listing). The security types eligible for the Index include common stocks, ordinary shares, ADRs, shares of beneficial interest or limited partnership interests and tracking stocks. Security types not included in the Index are closed-end funds, convertible debentures, exchange traded funds, preferred stocks, rights, warrants, units and other derivative securities.

The Dow Jones Industrial Average® (The Dow®), is a price-weighted measure of 30 U.S. blue-chip companies. The index covers all industries except transportation and utilities.

The Russell 2000® Index measures the performance of the small-cap segment of the US equity universe. The Russell 2000® Index is a subset of the Russell 3000® Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership. The Russell 2000® is constructed to provide a comprehensive and unbiased small-cap barometer and is completely reconstituted annually to ensure larger stocks do not distort the performance and characteristics of the true small-cap opportunity set.

The MSCI EAFE Index is an equity index which captures large and mid-cap representation across 21 Developed Markets countries*around the world, excluding the US and Canada. With 902 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.

The MSCI Emerging Markets Index captures large and mid-cap representation across 26 Emerging Markets (EM) countries*. With 1,387 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.

Investment-grade Bond (or High-grade Bond) are believed to have a lower risk of default and receive higher ratings by the credit rating agencies. These bonds tend to be issued at lower yields than less creditworthy bonds.

Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities.

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Aptus Musings: Q1 2022 Earnings Expectations

David Wagner — Wed, 20 Apr 2022 21:09:05 +0000

Q1 2022 Earnings Preview

Earnings season started last week with JP Morgan (“JPM”) and a slew of other banks, and given the early tone, this earnings season could be underwhelming as we did not witness the outsized beats we have become accustomed to over the last year. Year-over-year, sales growth is still expected to be double-digits (10.9%) with earnings growth in the mid-single digits (6.3%). Excluding Energy these figures look less robust.

Anecdotally, heading into earnings season, it feels as if sentiment will ultimately drive the direction of the market – the latest bull/bear figures showed another retreat by the bulls. That shouldn’t be too surprising, given JPMorgan’s commentary last week, as it really stood out to us – they ‘re raising their credit reserves. Banks typically do that when they think that default rates, which are currently low, will start to rise. JPMorgan admitted to such during the call, saying it was a “preemptive move” if the economy slowed. JPM put their money where their mouth is, and the stock paid for it – down almost 4%. In our opinion the banks are clearly concerned about the economy going forward.

Second, we believe that inflation is no longer a net positive for earnings growth. While we appreciate how inflation can be good for nominal GDP and therefore revenue growth, we think inflation is no longer a net positive for earnings growth given the impact on costs that are now showing up in margins. With S&P 500 costs growth peaking at 13.4% in January, it should come as welcomed news that the current reading is 11.7%. This may look like a relief for companies on the surface, much of this is simply base effects.

Lastly, from a broader level perspective, we’re watching next year’s earnings guidance. If this ’23 earnings number comes down, don’t be surprised if stocks drop on earnings disappointments – as that will only raise anxiety for corporate profits if the economy slows (see above). Conversely, if the 2023 S&P 500 earnings do stay at current levels, that again could set up a near-term rally, as investors will begin to value the S&P 500 on 2023 earnings in June or July. And if you plug a 19.5x handle on the projected $243 EPS – that would equate to an S&P price of around 4750 – a rally of 7%.

During this earnings season, we are following sentiment, which is very low right now, and secondly, we’ll be following next year’s guidance commentary because we do expect this to be a more volatile earnings season relative to last quarter.

Why Focus on Growth Expectations?

Why are we following next year’s guidance commentary so closely? Simple – falling earnings revisions matter because price is correlated with revisions – there is a strong relationship between prices and revision breadth over time. We believe that this quarter’s earnings season may finally bring down NTM earnings revisions, which has been very elusive since the March 2020 bottom.

Historically, P/Es tend to de-rate when the market no longer believes the forecasts – you tend to see this with some cheap cyclical stocks. While P/Es have de-rated this year as we expected, they remain stubbornly high when taking into account the historically sharp rise in 10-year yields. In short, P/Es are down about 11% since we published our year ahead outlook (Investors May Need to Curb Their Enthusiasm), but that de-rating has come from higher rates, as the equity risk premium (”ERP”) has plummeted. This would suggest that the equity market has not yet worried about growth – only higher rates.

As shown above, P/Es have contracted, and NTM earnings expectations have continued to increase all year – bucking the trend of what has historically happened – stocks tend to go higher so long as forward estimates are rising. In our view, there is information in this price pattern because stocks lead revisions historically by about 3-5 months. We’ll see if this time is different, as stocks tend to not lie. We remain cognizant on watching management’s commentary, as this will be our best way to put our ear to the ground on EPS revisions.

Luckily, our funds tend to utilize volatility as an exposure, which we believe helps us remain convicted that we are properly positioned given the current climate.

Disclosures

This document may contain certain information that constitutes “forward-looking statements” which can be identified by the use of forward-looking terminology such as “may,” “expect,” “will,” “if,” “forecast,” “intend,” “target,” “believe,” and/or comparable terminology. No assurance, representation, or warranty is made by any person that any of Aptus’s assumptions, expectations, objectives, and/or goals will be achieved. Nothing contained in this document may be relied upon as a guarantee, promise, assurance, or representation as to the future.

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Rearview to Windshield, April 2022

David Wagner — Tue, 05 Apr 2022 01:02:02 +0000

Developments over the Past Month

Monthly Recap: March was a tale of two different periods (see below). The first quarter was one of the worst on record for the collective performance of stocks and bonds, with the latter worse than the former. This makes sense given investor concern focused more on the “Fire” (inflation and the Fed) than the “Ice” (growth slowdown).

Late March: This Rebound Has Not Been Normal – Heading into the end of the month, the S&P has produced one of its sharpest rallies in history, larger than the biggest 10-day rallies in 7 of the S&P’s 11 bear markets since 1927. It has done so despite clearly weaker fundamentals (more hikes, higher inflation, and curve inversion) and the Fed leaning against equity market strength to hike faster (akin to the Fed writing a call on the market). Rates markets are reflecting this gloomier picture and short “Fed call”, in the largest divergence between equities and rates in the pricing of risk since the GFC.
Early March – Corrections are Normal: The current correction in stocks earlier this month was overdue. Investors have not had a 10%+ S&P 500 correction since the quick bear market of March 2020. A 10%+ correction has occurred once per year on average since 1930, and have lasted on average 54 trading days before lifting more than 10% from the trough. Bear markets of 20%+ or more occur once every 3-4 years, but 9 of the last 12 since the 1950s have occurred around economic recessions.
What Drove This Month’s Performance: The S&P 500 outperformed small caps this month. At the end of the month, investors saw a substantial rally in growth broadly in the last two weeks, and it is still unclear if this is just a reversion to the mean after severe value outperformance YTD, fear amongst investors that a recession is getting closer, and thus a move from cyclicals/value and into growth, a growing chorus of stimulus around the world in reaction to commodity price rises in the last month, or perhaps Chinese government comments around supporting the economy has created rolling short squeezes/risk-on breeze across the globe. Probably some combination of all these is the cause.
America Always Exports Recessions, It Never Imports Them: While tensions between Russia and Ukraine have been rising for years, the current military action is creating concerns about the potential impact on financial markets and the global economy. Fortunately, however, history shows that while geopolitical crises such as the one between Russia and Ukraine can temporarily roil markets, they don’t typically have long-term consequences for investors- look at March’s end of month rally. In general, these types of crises tend to only have a significant and lasting impact on global financial markets if they have a sustained macroeconomic impact on major economies. While Russia’s economy ranks as the world’s 11th largest, according to the IMF, at only 1/20th the size of the US and 1/15th the size of China, it is likely not big enough by itself to affect global markets or economic growth, even if it were to suffer significant economic damage as a result of sanctions or other measures taken against it by the US and Europe.
Bonds Not Hedging Stocks – We believe that fixed income has offered no hedge to the equity drawdown this year – in fact, the S&P 500 has outperformed during the volatile environment. This was the first ever market correction in the QE regime where bond yields have gone up, not down. There’s been 6 major drawdowns over the last 13 years, in every one of them, yields have roughly declined by 100bps on average during the drawdown – that has not been the case this time.
Rate Hikes: Market participants are pricing in the potential for as many as eight rate hikes by the Federal reserve this year, with the first hike occurring this past month. Furthermore, the market continues to price in what would be the first-rate hike above 25bps since May 2000. We continue to think that the hawkish estimates will prove to be overblown. The current Federal Reserve has been both hyper transparent, and steadfastly deliberate in their actions. The potential for them to do anything that surprises the markets seems unlikely.
Yield Curve Flattening & What It’s Telling Investors: The yield curve’s flattening is a sign of growing concern that the Fed is going to hike too much and break something. The curve inverted this past month, which would signal the market believes things are already breaking. As the short end of the curve rises, so too do the odds of rate hikes. The market has seven (8) rate hikes priced in by the end of 2022.
Earnings: 2021 S&P 500 operating earnings = $209. 2022 = $228 (up from $225 in Mar. 2022). 2023 = $234. 2020 = $142. 2019 = $165.
Valuations: S&P 500 Fwd. P/E is at 20.1x. EAFE is 14.0x forward P/E, while EM is at 12.4x. R1V is 15.9x v. R1G at 27.7x.

Talking Points Ahead

Yield Curve: The yield curve officially inverted at the end of March. an inversion of the 10/2 spread does not mean a recession is imminent. Historically speaking, stocks rally for about a year after a 10s-2s inversion, with an average return around 15% (heads up, this is a different range than shown in a below chart). So, a curve inversion is not a reason to sell—it’s a signal that the time on the bull market and economic expansion is now limited, and to prepare for both to end.
Build Back Better: Though it wasn’t passed in 2021, President Biden outlined the biggest expansion of the federal government matched with the largest tax increase since 1968. Biden senses the post-COVID era is a once-in-a-generation opportunity to massively restructure US fiscal, monetary, and social policy. In our opinion, this is a big experiment. We’ll wait to see how the Build Back Better plan and taxes pan out. It appears that this dramatic change in societal direction has proved to be difficult for some moderate Democrats to get on board, i.e., Manchin.
We feel it will be worth watching the general trend of economic and fundamental data, and when it will begin to decelerate.
Longer-term, we believe valuations and bond yields will eventually matter, and both will lower expected returns for balanced portfolios.

Disclosures:

The Dow Jones Industrial Average® (The Dow®), is a price-weighted measure of 30 U.S. blue-chip companies. The index covers all industries except transportation and utilities.

Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities.

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Rearview to Windshield, March 2022

David Wagner — Tue, 01 Mar 2022 20:26:39 +0000

The market, measured by the S&P 500, officially entered a “correction” phase, as investors continue to disseminate the latest news on the Russia/Ukraine front. Markets have been attempting to price in worst case scenarios as it pertains to Russia and Ukraine over the last several weeks. While there has been significant multiple contraction and risk off action over that time frame. One of the hardest things to do when faced with a major global event – whether it’s weather: e.g., hurricanes, floods, tornadoes, etc., or a military conflict, as we are facing today – is to separate the emotional response from the economic implications. Through February the S&P finds itself off a little more than -8% for the year – since 1950, only 2020 (-9%), 2009 (-19%), 2008 (-9%), and 1978 (-9%) have been worse.

February Notables

Russia/Ukraine Geopolitical Volatility

While tensions between Russia and Ukraine have been rising for years, the current military action is creating concerns about the potential impact on financial markets and the global economy. Fortunately, however, history shows that while geopolitical crises such as the one between Russia and Ukraine can temporarily roil markets, they don’t typically have long-term consequences for investors. In general, these types of crises tend to only have a significant and lasting impact on global financial markets if they have a sustained macroeconomic impact on major economies. While Russia’s economy ranks as the world’s 11th largest, according to the IMF, at only 1/20th the size of the US and 1/15th the size of China, it is likely not big enough by itself to affect global markets or economic growth, even if it were to suffer significant economic damage as a result of sanctions or other measures taken against it by the US and Europe.

Equity Fundamentals are Normalizing

As equity valuations come under scrutiny amid the rapid rise in real rates, investor focus will increasingly assess whether earnings growth can continue to lead the market higher. The fourth quarter reporting season wrapped up at the end of February for the S&P 500 and all things considered, we believe it turned out to be a strong quarter. Earnings growth came in north of 30% and revenue growth approached 15%. 2022 is going to be a much different strong as companies deal with various macro events.

Bonds Not Hedging Stocks

Fixed Income has offered no hedge to the equity drawdown this year. This was the first ever market correction in the QE regime where bond yields have gone up, not down. There’s been 6 major drawdowns over the last 13 years, in every one of them, yields have roughly declined by 100bps on average during the drawdown – that has not been the case this time.

The Fed Update

Russia’s invasion of Ukraine has injected new uncertainty into the economic outlook but is unlikely to derail the Federal Reserve’s plans to begin raising interest rates from March, as it seeks to combat the highest inflation in 40 years…the first rate rise is only expected to be a quarter of a percentage point as opposed to a supersized half-point increase as some have speculated, given concerns about how Russia’s assault on Ukraine could temper economic growth, and earlier resistance from many Fed officials…There are concerns about the Fed moving too gradually.

Rate Hikes

Market participants are pricing in the potential for as many as seven rate hikes by the Federal reserve this year, with some looking for the first hike in March to be 50 basis points – this would be the first rate hike above 25bps since May 2000. We continue to think that the hawkish estimates will prove to be overblown. The current Federal Reserve has been both hyper transparent, and steadfastly deliberate in their actions. The potential for them to do anything that surprises the markets seems unlikely.

Yield Curve Flattening & What It’s Telling Investors

The yield curve’s flattening is a sign of growing concern that the Fed is going to hike too much and break something. The curve is not yet inverted, which would signal the market believes things are already breaking, but it is rapidly moving toward that level. As the short end of the curve rises, so too do the odds of rate hikes. The market has seven (7) rate hikes priced in by the end of 2022. The market still sees the terminal rate settling in around 1.75% or 2.00%.

Earnings

2021 S&P 500 operating earnings = $209. 2022 = $225. 2019 = $165. Bottoms-up for 2020 = $142.

Valuations

S&P 500 Fwd. P/E is at 19.3x. EAFE is 13.7x forward P/E, while EM is at 11.4x. Russell 1000 Value is 15.3x v. Russell 1000 Growth at 25.4x.

Talking Points – March 2022

We have expected bond yields to reflate as the pandemic improves and economic activity begins to normalize. The spread on the 2s and 10s has historically expanded as wide as 300 bps (~41bps as of February month-end). Last year’s peak was in March 2021 at ~160bps. Real Rates have never been negative outside some sort of Quantitative Easing environment.

Though it wasn’t passed in 2021, President Biden outlined the biggest expansion of the federal government matched with the largest tax increase since 1968. Biden senses the post-COVID era is a once-in-a-generation opportunity to massively restructure US fiscal, monetary, and social policy. In our opinion, this is a big experiment. We’ll wait to see how the Build Back Better plan and taxes pan out. It appears that this dramatic change in societal direction has proved to be difficult for some moderate Democrats to get on board, i.e., Manchin.

This past year was led by a bunch of one-hit wonders, i.e., most likely not repeatable – a very dovish Fed, a successful economic reopening, and $8T of stimulus. None of which are expected to sustainably pump liquidity into the market next year. In 2022, the market may have to navigate a slew of negative headlines – increased taxes, higher-than-expected inflation, continued supply bottlenecks, and the possibility of more variants. All in all, we believe that this can create an environment of increased volatility.
We feel it will be worth watching the general trend of economic and fundamental data, and when it will begin to decelerate.

Longer-term, we believe valuations and bond yields will eventually matter, and both will lower expected returns for balanced portfolios.

Disclosures

The Dow Jones Industrial Average® (The Dow®), is a price-weighted measure of 30 U.S. blue-chip companies. The index covers all industries except transportation and utilities.

Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities.

Nasdaq-100® includes 100 of the largest domestic and international non-financial companies listed on the Nasdaq Stock Market based on market capitalization.

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Rearview to Windshield, February 2022

Aptus PM Team — Wed, 02 Feb 2022 21:46:51 +0000

Developments over the Past Month:

Monthly Recap:
We’ve seen big moves in equities to start the year. This has been the worst January for the S&P 500 since 2009 while at the same time it’s been the best start to the year for Value stocks in decades. We expect market volatility to remain high and headline-driven for a while longer.

Enter Volatility:
The new year is certainly off to a volatile start. The huge month-end rallies continued a trend of big swings that has defined markets since the Federal Reserve signaled its intention to tamp down inflation that had swelled to the fastest since the early 1980s. In one session, the Nasdaq 100 erased a loss of almost 5%, while the S&P 500 staged three straight days with swings that topped 3%. Markets are finding themselves in a tug of war between strong earnings and economic growth, and the specter of the Fed raising rates. And not to mention a normalization of egregious valuations.

Equity Fundamentals are Normalizing:
As equity valuations come under scrutiny amid the rapid rise in real rates, investor focus will increasingly assess whether earnings growth can continue to lead the market higher. We are focusing on Q4 2021 earnings, which has had a strong start from MSFT and AAPL. As of year-end, the consensus estimates expect S&P 500 EPS to increase +9% in 2022. We believe there is upside to consensus estimates but expect the frequency and magnitude of EPS beats will moderate from 1H 2022. There remain a few key risks to watch: (1) Supply chains, (2) oil, (3) labor costs, (4) Fed tapering cadence, (5) Omicron variant effects, and (6) China growth.

The Fed Update:
During the January meeting, the Fed did nothing to contain market expectations to four (4) rate hikes this year, effectively inviting the market to price in even more, hence why the market saw a swift move. Furthermore, Powell also hinted that he will be revising up his 2022 inflation forecast, which will pressure the dots higher. Thus, the March SEP is likely to show four (4) hikes at a minimum, and possibly more (up from three in December). Fortunately, the FOMC’s balance sheet guidance was a bit more dovish, i.e., helpful in cutting the tail risks. The Fed intends to shrink the balance sheet in a “predictable manner” and “primarily” through runoff, which makes asset sales very unlikely in the first year.

Rate Hikes:
At the same time, market participants are pricing in the potential for as many as five rate hikes by the Federal reserve this year, with some looking for the first hike in March to be 50 basis points. We continue to think that the hawkish estimates will prove to be overblown. The current Federal Reserve has been both hyper transparent, and steadfastly deliberate in their actions. The potential for them to do anything that surprises the markets seems unlikely.

Yield Curve Flattening & What It’s Telling Investors:
The yield curve’s flattening is a sign of growing concern that the Fed is going to hike too much and break something. The curve is not inverted, which would signal the market believes things are already breaking, but it is rapidly moving toward that level. As the short end of the curve rises, so too do the odds of rate hikes. The market has five (5) rate hikes priced in by the end of 2022. A sixth hike is priced in by March 2023. The market still sees the terminal rate settling in around 1.75% or 2.00%.

Fourth Quarter Earnings Season Has Begun:
Fourth-quarter earnings season has been constructive. So far, earnings growth is coming in at 25.3% year over year, with companies in aggregate reporting earnings 4.1% above expectations. That’s in line with the long-term average beat rate, but well below the 16% average beat in the previous four quarters. Companies that have reported growing profit margins in the quarter have seen their stocks rise about 1% the next day, on average, with those that beat earnings climbing 1.4% and those that missed slipping 1.6%.

Earnings:
2021 S&P 500 operating earnings = $209. 2022 = $224. 2019 = $165. Bottoms-up for 2020 = $142.

Valuations:
S&P 500 Fwd. P/E is at 20.3x. EAFE is 14.3x forward P/E, while EM is at 11.7x. R1V is 15.9x v. R1G at 27.1x.

Client Talking Points – February 2022:

Though it wasn’t passed in 2021, President Biden outlined the biggest expansion of the federal government matched with the largest tax increase since 1968. Biden senses the post-COVID era is a once-in-a-generation opportunity to massively restructure US fiscal, monetary, and social policy. In our opinion, this is a big experiment. We’ll wait to see how the Build Back Better plan and taxes pan out. It appears that this dramatic change in societal direction has proved to be difficult for some moderate Democrats to get on board, i.e., Manchin.
We have expected bond yields to reflate as the pandemic improves and economic activity begins to normalize. The spread on the 2s and 10s has historically expanded as wide as 300 bps (~73bps as of January month-end). This year’s peak was in March at ~160bps. Real Rates have never been negative outside some sort of Quantitative Easing environment.
This past year was led by a bunch of one-hit wonders, i.e., most likely not repeatable – a very dovish Fed, a successful economic reopening, and $8T of stimulus. None of which are expected to sustainably pump liquidity into the market next year. In 2022, the market may have to navigate a slew of negative headlines – increased taxes, higher-than-expected inflation, continued supply bottlenecks, and the possibility of more variants. All in all, we believe that this can create an environment of increased volatility.
We feel it will be worth watching the general trend of economic and fundamental data, and when it will begin to decelerate.
Longer-term, we believe valuations and bond yields will eventually matter, and both will lower expected returns for balanced portfolios.

Disclosures
Aptus Capital Advisors, LLC is a Registered Investment Advisor (RIA) registered with the Securities and Exchange Commission and is headquartered in Fairhope, Alabama. Registration does not imply a certain level of skill or training. For more information about our firm, or to receive a copy of our disclosure Form ADV and Privacy Policy call (251) 517-7198 or contact us here. Information presented on this site is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any securities.

The Dow Jones Industrial Average® (The Dow®), is a price-weighted measure of 30 U.S. blue-chip companies. The index covers all industries except transportation and utilities.

Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities.

Nasdaq-100® includes 100 of the largest domestic and international non-financial companies listed on the Nasdaq Stock Market based on market capitalization.

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Is Value Trading at a Value?

David Wagner — Sat, 29 Jan 2022 02:39:23 +0000

The recent market volatility has been keeping us busy, or maybe the fact that I’m still celebrating a Cincinnati Bengals playoff victory against the first-seeded Tennessee Titans last week – WHY NOT US? Speaking of Value, at the beginning of the year, the Cincinnati Bengals were not projected to come close to winning the AFC North, let alone making it to the AFC Championship. One could say, in Vegas terminology, that the Bengals have been trading at a Value all season – Value that has proven to be victorious. Yet, the Bengals weren’t the only Value trade winning – in fact, to begin 2022, the Value-style of investing has been all of the rage across all market cap spectrums.

After the recent deleveraging event to start the year in the market, which statement is correct? Please feel free to respond:

Value Continues to Trade at a Value!
After the recent rout, Growth is on sale!

Over the next few weeks, I’m going to put out a series of analysis on 2021, hitting some of the bigger relative opportunity sets within the equity market:

Week 1: Domestic v. International
Week 2: Small v. Large
Week 3: Value v. Growth

Value v. Growth Performance Recap:
To be quite honest, doing a 2021 performance recap on Value vs. Growth is stale, especially given how the market has performed to begin the year. So let’s break out the performance periods and do a recap on both:

2021 Performance Recap, and
YTD 2022.Performance Recap

2021 Performance Recap:
The big thing that stood out to us, from a performance standpoint, is that within U.S. Large, Growth outperformed Value – led by the larger tech names, i.e., NVDA, etc. This has definitely been the microcosm for performance over the past few years, as to why Growth has been all the rave – it’s easy – just own the mega-cap companies, which tend to skew towards the Growth-style bias. It’s no secret the likes of AAPL, GOOGL, MSFT, NVDA, etc. have been the darlings of the market for quite some time. But Growth outperforming Value was not the case if you went lower in the market cap spectrum. The Russell 2000 Value (“R2KV”) had quite the comeback vs. the Russell 2000 Growth (“R2KG”) with the difference of 25.5% for the year – being the second-widest in history with only ’00 being bigger. Jefferies went back and looked at periods when U.S. Small Value beat Growth by more than 10%, looking for the next year’s return and we found it still looks good. The R2KV beats the R2KG by an average of 4.7% and did so 9 of 12 periods.

The reason for the underperformance was the fact that the R2KG is littered with non-earners and biotech stocks, which underperformed last year, while the R2KV is heavily weighted in banks, which outperformed. It truly shows that one needs to understand the underlying composition of an index before investing.

YTD 2022 Performance Recap:
Much of the cyclical areas of the market that rallied last year have extended their dominance in 2022. Year to date, this Value rotation is beating Growth by a staggering 11.53%. This is in the 99th percentile of monthly Value returns over the past 44 years.

Firstly, if real yields continue to normalize as inflation moderates, we believe Value is likely to outperform further. Secondly, the earnings momentum which Value had all throughout 2021 is still in place for 2022. Cheap stocks earnings are still being net upgraded more than expensive stocks. The earnings revisions, on balance, for Energy, Materials, Financials is still in positive territory – meaning these stocks are being upgraded faster than Growth stocks. Valuation multiples for the Value sectors have not yet recovered to pre-pandemic levels, despite the rotation- something that can’t be said for Growth. Thus, this is why we have seen this parabolic shift in relative performance YTD.

The Known: Yield
Indicated Yield:
           -U.S. Large Growth: 0.55%
           -U.S. Large Value: 2.18%
   -S&P 500: 1.30%

The Unknown: Growth
NTM Growth:
-U.S. Large Growth: +14.41%
-U.S. Large Value: +13.96%

Value stocks, which tend to be more cyclical than Growth stocks, are slated to grow faster than secular growth stocks this year. In fact, many Wall Street analysts are speculating that this trend should continue into 2023. Thus, I’m somewhat skeptical of Bloomberg’s growth rates above.

Market Sentiment: Valuation
NTM P/E:
           -U.S. Large Growth: 34.14x
           -U.S. Large Value: 15.34x
           -S&P 500: 19.98x

The forward p/e for the S&P 500 Value index relative to the S&P 500 Growth index shows that value still remains more attractive, albeit less so than it was just two short months ago. However, the valuation gap has closed rather quickly, with value holding up significantly better over the last four weeks. This is not too dissimilar to what occurred in 2000 when the tech bubble burst.

Source: Strategas, Data as of 1/26/2022

Source: Bernstein, Data as of 1/27/2021

Conclusion:
As of today, we prefer Value over Growth, even after the very strong comeback by the style last year. When we have seen big rebounds by Value, the momentum tends to continue, and the macro backdrop of above 4% GDP growth really supports the style. We also find that Value cycles do not end when their relative valuation trades in the 27th percentile versus history. Lastly, the earnings revision ratio is holding up slightly better for Value, and we suspect that it could potentially have more upside to its earnings thanks to low-expectations in Financials, and Energy.

Disclosures

The Dow Jones Industrial Average® (The Dow®), is a price-weighted measure of 30 U.S. blue-chip companies. The index covers all industries except transportation and utilities.

Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities.

Nasdaq-100® includes 100 of the largest domestic and international non-financial companies listed on the Nasdaq Stock Market based on market capitalization.

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Asset Style Review Part 2: Small vs. Large

David Wagner — Fri, 21 Jan 2022 16:54:05 +0000

Last week, we covered the age old question of “Domestic vs. International”. Let’s make this a bit more intimate with a more recently debated topic, given the rally in cyclicals –Small v. Large. Many of y’all have heard my spiel on this numerous times –get ready for it again.

Over the next few weeks, I’m going to put out a series of analysis on 2021, hitting some of the bigger relative opportunity sets within the equity market:

1. Week 1: Domestic v. International
2. Week 2: Small v. Large
3. Week 3: Value v. Growth

2021 Performance Recap

Both active and passive U.S. Small Cap funds may need to send their clients bumper stickers that say, “Have you Hugged your Small Cap Manager Today?” – U.S. Small Caps have underperformed U.S. Large Caps for five straight years. Even worse, this past year, 2021, U.S. Small Caps underperformed U.S. Large Caps by the largest spread since 1998 – ~14%. But, on the bright side, in years when GDP and inflation are above average (which is expected in 2022), even while the Fed is hiking, small tends to beat large by nearly 400bps. For the first time since ’95 to ’97, U.S. Small Caps delivered three consecutive years of double-digit gains. However, the performance was front-end loaded, as U.S. Small Caps were unable to break out of its 9-month range and only briefly surpassed its 3/15/21 high.

The big thing that stands out to us, from a performance standpoint, is that within U.S. Large, Growth outperformed Value – led by the larger tech names, i.e., NVDA, etc. But that was not the case if you went lower in the market cap spectrum. The Russell 2000 Value (“R2KV”) had quite the comeback vs. the Russell 2000 Growth (“R2KG”) with the difference of 25.5% for the year – being the second-widest in history with only ’00 being bigger. Jefferies went back and looked at periods when U.S. Small Value beat Growth by more than 10%, looking for the next year’s return and we found it still looks good. The R2KV beats the R2KG by an average of 4.7% and did so 9 of 12 periods.

h/t Jefferies for a lot of this historical data.

Framing the small-cap landscape:

The Top 5 names in the S&P 500 have a total market cap of $9.5T, over 3x larger than small caps, these stocks trade at 8.7x price-to-sales vs. <3x for the Russell 2000.
With record IPO activity, the number of publicly traded stocks rose to 3,384 names, and we will see this number head much higher. Increased IPO action tends to bode well for small cap performance.
The performance by the R1G was again very concentrated with the Top 10 contributors accounting for 61% of the index’s return. This is two years in a row in which this index was driven by the Top 10.

More importantly, when comparing performance, valuation metrics, and growth compositions for both U.S. Large and U.S. Small, it’s imperative to understand the sectors exposures underneath the hood of each asset class.

Know the Small Cap v. Large Cap Composition:

Simply put, depending on where you allocation, you have some substantial bets:
- U.S. Large: Investors are betting on Technology, specifically the mega-caps.
- U.S. Small Value: Investors are betting on cyclicals and Financials, i.e., banks and Energy.
- U.S. Small Growth: Betting on non-earners (close to 50% of the index) and biotech /pharmaceuticals.

Source: Bloomberg as of 1/17/2022

Yield + Growth Framework:

The Known: Yield
Indicated Yield:

-U.S. Large:1.27%
-U.S. Small: 0.98%

The Unknown: Growth
Next 12 Months Growth:

-U.S.Large:9.0%
-U.S. Small: 15.9%

Even though both the earnings and sales revision ratios fell, Q4 and ’22’s earnings growth has held up, at least for now. We see that Q4 numbers have been nudged upward from original estimates in September, with both size segments expected to see growth of 22% during Q4. As for ’22, we did see Small edge lower to 15.9% when it stood at 17.7% as of September 30, while large stayed static at 9.0% for Large.

Market Sentiment: Valuation
Next 12 Months P/E:

-U.S. Large: 21.54x
-U.S. Small: 15.31x

Given the substantial underperformance by small caps, we have seen our relative valuation model continue to fall back to ’20 levels. Historically, U.S. Small Caps have traded, on average, at a 4% premium to U.S. Large Caps. As of January 13, U.S. Small Caps trade at a 29% discount.

Fed tightening cycles have historically been accompanied by positive returns for both small and large caps, but multiple contraction in both size segments. Large cap multiples have typically contracted more: during both the first six months and first 12 months of the tightening cycle (where cycles have lasted 1.5 years on average).

Disclosures:

This document may contain certain information that constitutes “forward-looking statements” which can be identified by the use of forward-looking terminology such as “may,” “expect,” “will,” “hope,” “forecast,” “intend,” “target,” “believe,” and/or comparable terminology. No assurance, representation, or warranty is made by any person that any of Aptus’s assumptions, expectations, objectives, and/or goals will be achieved. Nothing contained in this document may be relied upon as a guarantee, promise, assurance, or representation as to the future. Forward looking statements cannot be guaranteed.

Economic and market forecasts presented herein reflect a series of assumptions and judgments as of the date of this presentation and are subject to change without notice. These forecasts do not take into account the specific investment objectives, restrictions, tax and financial situation or other needs of any specific client. Actual data will vary and may not be reflected here. These forecasts are subject to high levels of uncertainty that may affect actual performance. Accordingly, these forecasts should be viewed as merely representative of a broad range of possible outcomes. These forecasts are estimated, based on assumptions, and are subject to significant revision and may change materially as economic and market conditions change.

Material presented has been derived from sources considered to be reliable, but the accuracy and completeness cannot be guaranteed. They are based on certain assumptions and current market conditions, and although accurate at the time of writing, are subject to change without prior notice. This material does not constitute a general or personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual investors and should not be relied upon to evaluate the merits of investing in any security. Investors should ensure that they obtain all current available information before making any investment. Investors should also make an independent assessment of the relevant legal, regulatory, tax, credit, and accounting considerations and determine, together with their own professional advisers if investing is suitable to their personal financial goals.

The Dow Jones Industrial Average® (The Dow®), is a price-weighted measure of 30 U.S. blue-chip companies. The index covers all industries except transportation and utilities.

The Russell Midcap® Index measures the performance of the mid-cap segment of the US equity universe. The Russell Midcap® Index is a subset of the Russell 1000® Index. It includes approximately 800 of the smallest securities based on a combination of their market cap and current index membership. The Russell Midcap® Index represents approximately 31% of the total market capitalization of the Russell 1000® companies. The Russell Midcap® Index is constructed to provide a comprehensive and unbiased barometer for the mid-cap segment. The index is completely reconstituted annually to ensure larger stocks do not distort the performance and characteristics of the true mid-cap opportunity set.

Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities.

The Russell 1000® Index measures the performance of the large cap segment of the U.S. equity universe. The Russell 1000 Index is a subset of the Russell 3000® Index, representing approximately 90% of the total market capitalization of that index. It includes approximately 1,000 of the largest securities based on a combination of their market capitalization and current index membership.

The S&P SmallCap 600® seeks to measure the small-cap segment of the U.S. equity market. The index is designed to track companies that meet specific inclusion criteria to ensure that they are liquid and financially viable.

The Russell 2000® Growth Index measures the performance of the small cap growth segment of the US equity universe. It includes those Russell 2000® companies with higher price-to-value ratios and higher forecasted growth values. The Russell 2000® Growth Index is constructed to provide a comprehensive and unbiased barometer for the small-cap growth segment. The index is completely reconstituted annually to ensure larger stocks do not distort the performance and characteristics of the true small cap opportunity set and that the represented companies continue to reflect growth characteristics.

The Russell Midcap® Growth Index offers investors access to the mid cap growth segment of the U.S. equity universe. The Russell Midcap® Growth Index is constructed to provide a comprehensive and unbiased barometer of the mid cap growth market. Based on ongoing empirical research of investment manager behavior, the methodology used to determine growth probability approximates the aggregate mid cap growth manager’s opportunity set.

The Bloomberg US Mortgage-Backed Securities (MBS) Index tracks fixed-rate agency mortgage-backed pass-through securities guaranteed by Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac (FHLMC). The index is constructed by grouping individual TBA-deliverable MBS pools into aggregates or generics based on program, coupon and vintage.

Treasury Inflation-Protected Securities, or TIPS, provide protection against inflation. The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index.

Bloomberg Barclays Municipal 1-5 Yr TR USD includes all medium and larger issues of U.S. government, investment-grade corporate, and investment-grade international dollar-denominated bonds that have maturities of between 1 and 5 years and are publicly issued.

The Barclays Capital Intermediate U.S. Treasury Index includes all publicly issued, U.S. Treasury securities that have a remaining maturity of greater than or equal to 1 year and less than 10 years, are rated investment grade, and have $250 million or more of outstanding face value.

The Barclays Capital Long U.S. Treasury Index includes all publicly issued, U.S. Treasury securities that have a remaining maturity of 10 or more years, are rated investment grade, and have $250 million or more of outstanding face value.

Advisory services offered through Aptus Capital Advisors, LLC, a Registered Investment Adviser registered with the Securities and Exchange Commission. Registration does not imply a certain level or skill or training. More information about the advisor, its investment strategies and objectives, is included in the firm’s Form ADV Part 2, which can be obtained, at no charge, by calling (251) 517-7198. Aptus Capital Advisors, LLC is headquartered in Fairhope, Alabama. ACA-2201-22.

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Asset Style Review Part 1: Domestic vs. International

David Wagner — Wed, 05 Jan 2022 21:45:26 +0000

Over the next few weeks, I’m going to put out a series of analysis on 2021, hitting some of the bigger relative opportunity sets within the equity market:

Week 1: Domestic v. International

Week 2: Small v. Large

Week 3: Value v. Growth

Domestic v. International:

For most of the last decade, investors continue to be plagued with one of the most critical calls for an allocation – Domestic or International? Last year, the consensus amongst Wall Street was to realize U.S. profits and to re-allocate those gains into EAFE and EM – that was wrong. During the year, the S&P 500 almost returned 3x of the MSCI EAFE. If you believe that is painful, don’t even look at the relative performance between the former and Emerging Markets – over 30%! If you like putting salt in the wound, here’s another fact for you – Equities had their 21st best year ever – but even bonds outperformed EM last year – yikes.

From a longer-term perspective, the only period of prolonged underperformance of U.S. equities v. International was between 2002-2008.

Yield + Growth Framework:

The Known: Yield

Indicated Yield:

-International EAFE: 2.63%

-International EM: 2.40%

-S&P 500: 1.35%

The Unknown: Growth

Next 12 Months Growth:

-International EAFE: +7.8%

-International EM: +7.7%

-S&P 500: +9.0%

Market Sentiment: Valuation

Currently, the S&P 500 remains one of the most expensive global markets. The perceived economic resilience of the U.S. (as well as its significant Technology exposure) are likely contributors to this phenomenon. However, should we get a weaker U.S. dollar, investors may find attractive opportunities abroad to put money to work over the coming months as the jagged global economic recovery progresses.

Source: Strategas, Data as of 12/22/2021

Next Twelve Months (“NTM”) Price-to-Earnings Valuations:

International EAFE: 15.01x

International EM: 11.31x

S&P 500: 21.85x

Over the last 25 years, the S&P 500 has traded on average at an 8.0% premium to international stocks. As of today, the S&P 500 trades at a 45.6% premium – substantially higher than historical measures.

Why have International Stocks Underperformed U.S. Since the GFC / Why Do U.S. Stocks Trade at Such a Premium?

U.S. Has Higher Exposure to Growth – Given the significantly larger weight to Growth sectors, U.S. equities have consistently traded at a premium to their international counterparts. Last year’s outperformance by growth (in Large-Cap land), has taken the valuation premium to above 50%. With the Fed taper said to end in mid-March, and the dot plots signaling three hikes this year, rich valuations could pose as a headwind, especially for those stocks with weak or no earnings – growth tends to have more stocks that exhibit these characteristics.
Higher Profitability / Faster Earnings Growth – When it comes to profits, U.S. firms are in a different league compared to their international peers. Supported by superior margins and operating conditions, in our view U.S. firms have generated significantly better profits since the GFC, this is especially true of the more dominant Growth style. In fact, U.S. profit margins have exploded, while international has stayed stagnant over the past decade. The earnings backdrop is superior for U.S. equities v. International peers, even within the Value style. As such, the superior profitability for U.S. stocks is not only driven by the Tech heavy Growth style.
International Has More Industrial and Commodity Exposure – The International Indices have a heavier weight in manufacturing and commodity-producing markets. We believe stocks with these types of exposures tend to trade at lower multiples and have underperformed over the last decade. Not only have these areas of the market underperformed, but It’s been interesting to me that U.S. stocks have outperformed international peers, even within these more cyclical / Value areas of the market.
Consumers Have Changed their Spending Habits from Goods to Services – Another significant headwind for international has been the rotation of consumer spending to services from goods. All of the largest weights in the MSCI ACWI ex.-U.S. index have a tight relationship with the industrial cycle, i.e., goods not services. Moving forward, the continued slowdown in the manufacturing new orders PMI and elevated input costs could further worsen the prospects for all major international equity markets moving forward.

The Age-Old Question

We think it’s no secret to the market that international equities have had more headwinds than the U.S. over the past decade (and less growth). This is reflected in the relative valuation differentials between the two style classes. Everything that we have mentioned in this blog blast is information that should be in the rearview mirror – the market knows these problems, i.e., semi-efficient. Investors need to look through the windshield – what will drive relative returns in the future?

We are not here to make bets on which asset class will outperform over the next month, year, or decade. That’s why we rely on asset allocation diversification. Proper diversification is the first layer of portfolio protection. The idea that anyone is going to consistently overweight to next year’s leading styles could be considered crazy; we see building a structure that minimizes the drag of large losers as far more realistic. More importantly, on the international side, this is why our allocation includes guard rails while investing in this space – we like the asset class from a valuation perspective, but we also want to minimize the volatility in the space – an area which tends to exhibit more volatility than domestic stocks.

At Aptus, we believe in proper diversification, owning volatility as an asset class, the importance of sequence of returns, and owning areas of the market with actual return drivers.

Disclosures:

The Dow Jones Industrial Average® (The Dow®), is a price-weighted measure of 30 U.S. blue-chip companies. The index covers all industries except transportation and utilities.

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Rearview to Windshield, January 2022

David Wagner — Tue, 04 Jan 2022 13:50:24 +0000

Developments over the Past Month:

Monthly Recap: Do you believe in Santa Claus? The market obviously did, as December, which tends to be a seasonally strong month, saw the S&P 500 rally 4.5%. With the S&P 500 finishing the year up 28.71%, 2021 ranked as the 21^st best year for the index since 1926. It was also the 36th time that the total return was greater than 20%. With another year of superlatives, the market totaled 70 new all-time highs during the year – only trailing 1995 for most ever (77). Historically, when the number of new highs has been at elevated levels, the market has gone through a stretch in the following years of more new highs.
Yearly Recap: The S&P 500 posted a total return of 28.71%, just slightly ahead of the Nasdaq and the Russell 1000 Growth Index, followed by the Russell 1000 Value Index. Bitcoin –perhaps the ultimate risk asset –soared by 60%. However, the Russell 2000 small cap benchmark and the High Yield credit index, both often viewed as a proxies for risk, returned just 14.82% and 4.79%, respectively. Defensive assets such as Investment-Grade bonds, US Treasuries, and Gold, all posted negative returns at -1.84%, -4.65%, and -3.55%, respectively

Where Do We Stand? The path of least resistance has been higher in recent weeks, but there are a lot of moving pieces for the market to deal with – just look at the recent volatility. 1) Introduction of the Omicron variant 2) A potentially more hawkish Fed – Jerome Powell said that he would “consider” speeding up the pace of tapering and that it’s time to “retire” the word “transitory” when referring to inflation. Not to forget, the potential for increased political volatility – Congress did not pass the Build Back Better legislation in 2021, a mid-term election year.
Equity Fundamentals: As equity valuations come under scrutiny amid the rapid rise in real rates, investor focus will increasingly assess whether earnings growth can continue to lead the market higher. We are focusing on Q4 2021 earnings, which will begin in early February. As of year-end, the consensus estimates expect S&P 500 EPS to increase +9% in 2022. We believe there is upside to consensus estimates but expect the frequency and magnitude of EPS beats will moderate from 1H 2022. There remain a few key risks to watch: (1) Supply chains, (2) oil, (3) labor costs, (4) Fed tapering cadence, (5) Omicron variant, and (6) China growth.
The Fed Announced a Tapering Plan: As expected, the Federal Reserve officially announced the beginning of a tapering process to start last November at $15B/month. In December, Fed Chairman Jerome Powell announced that this cadence will double beginning in 2022 – ultimately concluding in late March ’22. This was somewhat expected by the market, as Fed Chair Powell continued to see strong economic data, alongside decade-high inflation readings. Even though the Fed increased their tapering cadence, they remain very dovish when it comes to interest rate hikes, i.e., liftoff. The market is currently pricing in three rate hikes next year and four in 2023.
Earnings: 2021 S&P 500 operating earnings = $209. 2022 = $224. 2019 = $165. Bottoms-up for 2020 = $142 (low of $125 in June 2020).
Valuations: S&P 500 Fwd. P/E is at 21.5x. EAFE is 14.7x forward P/E, while EM is at 11.9x. R1V is 15.7x v. R1G at 31.3x.

Talking Points – January 2022

Though it wasn’t passed in 2021, President Biden outlined the biggest expansion of the federal government matched with the largest tax increase since 1968. Biden senses the post-COVID era is a once-in-a-generation opportunity to massively restructure US fiscal, monetary, and social policy. In our opinion, this is a big experiment. We’ll wait to see how the Build Back Better plan and taxes pan out. It appears that this dramatic change in societal direction has proved to be difficult for some moderate Democrats to get on board, i.e., Manchin.
We have expected bond yields to reflate as the pandemic improves and economic activity begins to normalize. The spread on the 2s and 10s has historically expanded as wide as 300 bps (~84bps as of December month-end). This year’s peak was in March at ~160bps.
With the recent Merck /Pfizer Therapeutic news, we believe that this should create an environment of increased optimism surrounding the resumption of normal economic activity, our expectation is that rates will continue to rise, and market leadership will shift away from Tech Growth into more downtrodden components of the market.
This past year was led by a bunch of one-hit wonders, i.e., most likely not repeatable – a very dovish Fed, a successful economic reopening, and $8T of stimulus. None of which are expected to sustainably pump liquidity into the market next year. In 2022, the market may have to navigate a slew of negative headlines – increased taxes, higher-than-expected inflation, continued supply bottlenecks, and the possibility of more variants. All in all, we believe that this can create an environment of increased volatility.
We feel it will be worth watching the general trend of economic and fundamental data, and when it will begin to decelerate.
Longer-term, we believe valuations and bond yields will eventually matter, and both will lower expected returns for balanced portfolios.

Disclosures

The Dow Jones Industrial Average® (The Dow®), is a price-weighted measure of 30 U.S. blue-chip companies. The index covers all industries except transportation and utilities.

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