Time to move out of overvalued sectors?

As rates rise, equity performance likely to disappoint

Over the past few weeks, many of the contributors to our Indepth Investing Podcast have been mentioning signs that certain sectors of the equity market might be getting overvalued. They have especially remarked on the near doubling of the long-term U.S. 10-year Treasury bond yield from under 1% at the end of 2020 to as high as 1.75% in March. The 10-year Treasury is regarded as the benchmark for asset prices, as it is seen as the default low-risk asset for investors. So when its yield moves in one direction or the other, it has major consequences for all other asset prices.

Thus, when 10-year Treasury yields briefly fell to 0.5% during the first wave of the Covid-19 pandemic last spring, equity prices shot up, as the competition from the risk-free rate of return on the Treasurys had fallen, allowing the long-term stream of income from equities to be more highly valued. This was especially true for the fast-growing technology sector, as most of the companies that comprise pay little or no dividends and therefore are valued on their long-term earnings potential.

Commodity prices, in contrast, fell sharply, as such a low bond yield indicated that investors were expecting a sharp recession, very slow growth, and hence very low demand for commodities. The price of a barrel of West Texas Intermediate (WTI) oil fell from $60 to actually being negative in May 2020, as demand had vanished and there was insufficient storage for all the oil that was being produced

Other commodities, such as iron ore, copper, and aluminium, which are regarded as bellwethers of global growth due to their inclusion in virtually every product and industry, also saw prices fall to decade lows.

Market leadership changing hands

With the arrival of a number of successful vaccines staring in November last year, and with the U.S. and the U.K. demonstrating that a rapid and effective rollout of the vaccines quickly reduces hospitalizations and deaths, equity markets moved away from technology stocks, which had benefited from the pandemic and the lockdowns. These were led by the so-called FAANG+ companies (Facebook, Amazon, Apple, Netflix, Alphabet (Google's parent), and Microsoft). But now the leadership has moved towards the more economically sensitive sectors like energy, materials, financials, and especially travel, leisure, and hospitality.

Meanwhile, 10-year Treasury yields began to rise, doubling to over 1% by early January and then rising another 75%, to 1.75%, by the end of the quarter. Over the last 12 months, U.S. 10 Treasury yields have risen 0.92%, to 1.58%. The first quarter was the worst for U.S. government bonds in terms of total return (price movement plus yield) in 40 years, with a loss of 5%.

Interest rates and equity markets do not rise together for long. If interest rates are rising because the market believes that the economy is strengthening, and that inflation and higher interest rates will result from increased demand, then the more attractive rate of return available from the supposedly risk-free 10-year government bond will make the earnings stream of equities less attractive. And that will be the case, ironically even if earnings are increasing too due higher economic growth.

In effect, equities are like runners on a treadmill, the speed of which is increasing (interest rates are rising). The equities have to run faster (increase their earnings) just to stand still. If they fail to increase them enough, or as much as optimistic forecasters expect, they will be hit by a double whammy. First, their earnings don’t go up as much as expected, and second, the price investors are willing to pay for those earnings, expressed as the price/earnings ratio (p/e ratio) will go down. Thus when market indexes, such as the S&P 500 Composite are selling at record high p/e ratios, as they are now (and were in 1999-2000 or 1987 or 1971-72 in the U.S., or 1989 in Japan), then there is a strong likelihood of disappointing price performance by equities.

Decade-long negative returns?

The very experienced value investor Jeremy Grantham, who correctly called the 1989 top in the Nikkei Dow Index in Japan, the 1999-2000 tech bubble, and the 2007-08 sub-prime mortgage crash, said in January that he believed the equity markets were once again in bubble territory and that the long-term returns from the major indexes would be negative for the next decade, even taking dividends into account. This is because all the research indicates that the price that an investor pays for equities, or indeed bonds or commodities, will dictate the returns that they receive over the next few years.

The fact that reports indicate more money has flowed into equity Exchange Traded Funds (ETFs) in the last five months than in the previous 12 years since the beginning of the bull market in 2009 shows that investors are buying without any concern for valuations. Investors seem confident that the enormous fiscal stimulus by governments and the promise from central banks to keep interest rates at generational lows for at least the next two years will support the markets, regardless of how overvalued they have become.

Here at Indepth Investing, we and our contributors have been advising investors to take some profits, especially in sectors such as the FAANG+ stocks that have done exceptionally well, but also in the major indexes like the S&P 500 to lock in their remarkable gains over the last year and five years. Taking profits now has never made more sense with capital gains taxes likely on the way up in the U.S.

Finding real value

We’ve also suggested looking at markets that are not as highly valued, such as the U.K., Japan, and the emerging markets, all of which have substantially underperformed the U.S. over the last five years. Finally, we’ve recommended looking at non-correlated asset classes, such as gold and precious metals, and perhaps cryptocurrencies, although the volatility of these makes them difficult to value.

Buying some of these ideas while selling large-capitalization U.S. stocks will likely prove to be a successful strategy in the next couple of years.

Gavin Graham is a veteran financial analyst and money manager and a specialist in international investing, with over 35 years’ experience in global investment management. He is the host of the Indepth Investing Podcast.

Notes and Disclaimer

The commentaries contained herein are provided as a general source of information based on information available as of 29, 2021, and should not be considered as investment advice or an offer or solicitations to buy and/or sell securities. Every effort has been made to ensure accuracy in these commentaries at the time of publication, however, accuracy cannot be guaranteed. Investors are expected to obtain professional investment advice.

The views expressed in this post are those of the author. Equity investments are subject to risk, including risk of loss. No guarantee of performance is made or implied. The foregoing is for general information purposes only. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice.