H/T Mebane Faber
Capital Markets Outlook
- Investors are faced with four primary issues in the near-term: 1) historically low bond yields, 2) the potential for a transition into a rising rate environment, 3) the potential for deteriorating corporate earnings, and 4) the possibility of much lower energy prices for a sustained period.
? The price of the U.S. stock market relative to ten-year average earnings has increased over the past year, remaining above its historical average (29.5x versus 21.6x).
- Small cap domestic stocks’ valuations remain expensive relative to large cap stocks.
? Developed international and emerging market stocks are trading at lower valuations than U.S. stocks.
- Sovereign debt issues and weak economic growth in Europe, and a cyclical slowdown in emerging economies, are weighing down valuations.
? Risk across markets measured by our Systemic Risk metric remains at a tolerable level.
- However, monetary policy changes by central banks and political upheaval could have a meaningful impact.
– At the end of March, spreads for high yield corporate and investment grade bonds (4.7% and 1.5% respectively) were back to near their long-term averages.
– At 1.9%, the yield on the ten-year Treasury remained far below its post-WWII average of 5.6%.
– Crude Oil prices have recently plunged which has had wide ranging effects across several markets.
- Systemic Risk which measures risk across markets is important because the more contagion of risk that exists between assets the more likely it is that markets will experience volatile periods.
- Despite the somewhat elevated level of market volatility from this time last year, overall Systemic Risk levels remain in a tolerable range.
- One of the most powerful predictors of long-term equity returns has been the Cyclically Adjusted Price to Earnings Ratio (CAPE).
- This fundamentally driven measure is highly correlated with future returns which are shown in the chart above using the CAPE metric on a reverse scale.
- The cyclically adjusted P/E ratio for the S&P 500 finished March at 29.5x, above its post-WWII average of 21.7x.
- Recent strong performance has driven this valuation measure one full standard deviation above the long-term average. Historically, a P/E ratio at this level has led to lower than average future returns over a 10 year horizon.