We here at HFG Trust believe in the philosophy of being globally diversified, value investors.
Built on an evidence-based approach, we advise our clients that when managing their equity allocations, to hold companies that fit into a particular criterion that will offer long term value to their portfolios and ultimately assist them in reaching their financial goals and objectives.
Since October 2007, we have experienced two dramatic “bear” markets. In spite of this, US stocks have done phenomenally well from the end of the 2007-2008 financial crisis, until the bottoming out of the market in 2020 in reaction to the Covid-19 pandemic. Since then, the US stock market has soared by nearly 100% since its most recent low in 2020. Although the economy has rebounded since the beginning of the pandemic, it has not kept up with the enthusiasm we have seen in the stock market.
Quarterly, Kevin Floyd, our Director of Investments, reports on the current investment climate, observing metrics that give us a sense of the price of the stock market – such as “is it cheap or expensive,” “undervalued or overvalued,” etc. He regularly reports on CAPE and the Price-to-Book metrics. The CAPE ratio metric is currently at a 20-year high – in fact it is at its second highest level in the past 100 years. At 40, it is less than the tech bubble’s lofty 45 in the year 2000, but much higher than the pre-Stock Market Crash of 1929’s value of 34. The average for the past 25 years has been a ratio of 27.86, so CAPE sits currently 44% above its average. As a reminder, CAPE compares stock price to average earnings, adjusted for inflation, over a 10-year period. Because it tends to smooth out the effects of a business cycle, it is considered a good metric to evaluate future performance of the stock market. Similarly, Price-to-Book values are 42% above their 25 year-average.
Aside from these enlightening metrics of CAPE and the Price-to-Book valuations, another popular market measurement is comparing the full US Stock Market Capitalization amount (the cost to buy every company in the US stock market) to the US Gross Domestic Product (GDP), currently about $21 trillion dollars (all the goods and services produced through US companies in a single year). By the way this is Warren Buffett’s favorite metric. Prior to the tech bubble crash in the early 2000’s, US companies were valued at 120% of that year’s GDP. Today that metric sits at an all-time high, a whopping 176% of the US GDP. Historically, 75% to 90% was considered a fair value for this metric.
Understandably, there are some very successful and expensive companies in the market today that can skew these figures. In fact, the top ten companies in market cap, make up 30% of the entire value of the S&P 500 stock index. Last year, Ty Haberling and Anthony Smith were quick to point out that with $10 trillion dollars, you could purchase only 10 “growth” companies. As of 11/29/21, that same $10 trillion will purchase only five of those companies!
Markets do ebb and flow over time – but there are periods in time when prices can get excessively high, particularly in the growth corner of the market, like we see today. We have made a conscious effort to tilt portfolios to value companies, the type of companies that have outperformed growth companies by roughly 20-30% over the past century. Notably, there are periods when growth companies outperform value companies, see 1929 just prior to the Great Depression and the early 2000’s just prior to the conclusion of the tech bubble.
However, as you can see on the chart below, most 10-year periods overwhelmingly support a “value” bias.
An area where there could be long-term opportunities are in the international markets. Most investors worldwide have a “home bias” tendency when it comes to investments, often overlooking opportunities outside their borders. For example, the US economy only makes up 25% of the world’s economy, but the average US investor’s portfolio holds 85% in domestic stocks. Meaning that the majority of US stock portfolios are not participating in the other 75% of the world’s economy. Fortunately for the American investor, US markets have outperformed international markets by 263% over the past 14 years. However, history tells us there will periods where international markets outperform US markets as well.
Long periods of outperformance tend to create future opportunities. Although international companies typically have a discounted price to US companies, today that discount has reached 34%! For every $100 we spend on a US business, an international company is only costing us $66.
We understand when dealing with markets, it is impossible to know where the next outperformer will rise from, or when. We know that some discrepancies can appear, but knowing that markets identify inefficiencies quickly, we don’t want to overcommit to what we may only perceive as a mispricing in the markets. Even if we are right, as John Maynard Keynes has been attributed to saying, “markets can remain irrational a lot longer than you and I can remain solvent.”
We do know that there are areas of the market that have historically proven to outperform others over long periods – for example, Value, Size, and Profitability factors. We want to continue to have a part of that. We also want to continue to emphasize a globally diversified portfolio that participates in the advantages of a growing economy, no matter where the reigning outperformer will come from in the future.
Until then, wishing you and your loved ones Happy Holidays and a blessed New Year!
Learn more about our investment philosophy and the investment management services we provide to our clients HERE.