In the Gap Between the Two Trapezes

Clients of the Firm,

Midway through November 2023, the S&P 500 rallied to 4,500, within 6% of its highs set in early January 2022. The VIX sits at 13.96 and the 10-year Treasury yield is 4.47%, down from a recent high near 5%. A few large tech companies have led the equity charge boasting mid 20’s P/E ratios, strong profits and fortress balance sheets. Other sectors have fared less well, particularly banks which are experiencing unrealized losses associated with holding long duration bonds and the future specter of loan defaults in small business, credit card and commercial real estate.

Bond Valuation

We can review the impact of bond value mark downs for banks buried in the footnotes of the held to maturity (HTM) designated balance sheet assets. Due to accounting rules, these assets are not required to be marked to market on the balance sheet if they carry the HTM designation. Instead, they are held at amortized cost. Importantly, this accounting treatment does not necessarily reflect their liquidation value. We saw this acutely in the SVB bank run which forced the bank to liquidate their HTM portfolio at substantial losses destroying the equity of the firm.

Individual and institutional investors by contrast have their bonds marked to market by their custodian and therefore the unrealized losses on long-duration assets are more readily apparent. Similar to banks, individuals, as long as they don’t need liquidity, can also hold these bonds to maturity ensuring they don’t take losses. That said, the recovery period could be elongated depending on the price paid for the bond and the initial yield.

Inflation and Rate Expectations

Recent CPI and PPI data was less elevated than expectations which has led the market to price in an end to Fed rate hikes. Evidence for this pricing is in the Fed Funds Futures contracts. You can find the link to those here: https://www.cmegroup.com/markets/interest-rates/stirs/30-day-federal-fund.quotes.html#venue=globex

Rate expectations are calculated by taking the quoted Fed Funds Futures contract and subtracting it from 100. For example, the implied rate for April 2024 would be the contract price today of the Fed Funds Futures for that date which is 94.76 subtracted from a 100 resulting in an implied rate of 5.24%. Hence, we can imply that the market believes rates will remain unchanged at least through April 2024. By July 2024, current pricing is calling for a 25-basis point rate cut.

2024 Investing Outlook and Valuation

As we enter 2024, we can have a strong expectation that short duration assets (money markets and T-bills) will offer a close to a 5% initial return with very low risk. This is an important opportunity to take advantage of. In a soft-landing scenario (no recession and mild impact to the unemployment rate), earnings will likely be at the higher end of estimated ranges for the S&P 500 in 2024. Current Factset consensus earnings estimates for 2024 are $250 for the S&P 500. If a harder landing occurs (recession and spiked unemployment) earnings would likely be lower. Current valuation levels have the S&P 500 at 18 times those earnings.

As a reminder the earnings yield of an investment is the inverse P/E ratio. Therefore, an 18 times multiple is an initial rate of return of 5.55%. The earnings yield premium currently stands at 1.12% (the difference between the 10-year Treasury yield and the earnings yield). While the earnings yield is in the range of the long-term average, the premium is substantially lower than it was during the period of very low rates. This means that the differential between risk free assets and risk assets is much smaller than it has averaged in the last 15 years. Therefore, the hurdle for risk investments is by necessity higher, meaning our return expectations need to exceed what we can get in the less risky Treasury bond market.

Because the highest quality tech companies are market weighted in the S&P 500 and Nasdaq, their outperformance has contributed significantly to the rise of these major indices. These top holdings account for the lion’s share of this year’s stock market gains. While these assets are nearly fully priced, other components of the indices carry P/E ratios well below 18 times. Banks, energy, big pharma and telecom all offer expected initial rates of return that are over 10%. Dividends within these sectors comprise roughly half of the expected return, therefore these choices offer both income and valuation metrics that are favorable for investment.

Conclusion

Investors can choose between broad market investing and finding pockets of value within those markets. With the higher interest rate environment, we can afford to be even more discerning as our low-risk fixed income choices are plentiful to produce yield and thus contribute to overall returns.

In Coldplay’s Every Teardrop is a Waterfall, Chris Martin croons, “Maybe I’m in the black. Maybe I’m on my knees. Maybe I’m in the gap between the two trapezes.”. While the song opines on the human condition, it also applies to markets. Analytically, it appears we are currently in the gap between the two trapeze grips of market risk. Some may refer to this as fair value. Investment opportunity lies in finding outlier assets in this fair value paradigm, while earning low risk returns as we await the value pendulum to swing in our favor.

Sincerely,

Peter C. Wernau

President, CEO

Wernau Asset Management

http://www.wernauassetmanagement.com/

Office: 617.871.0029

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