Research Note - September 2016

August 29, 2016 | Market Commentary

Once again equity markets have demonstrated their ability to bounce back from a flare up in volatility. The market shock from the unexpected victory for the “Leave” camp in the United Kingdom’s referendum on membership in the European Union has faded, and the VIX is once again near multi-year lows. At the same time, another key financial variable stands at all-time lows for the modern era: it should not come as a surprise that the identity of the variable in question is the yield on the 10-year U.S. Treasury bond.

Much has been written on the state of bond yields around the world today—yields have moved lower and lower, even negative in some of the world’s largest bond markets. Long bond returns in 2016 have been nothing short of impressive. However, in this research note we focus our attention away from yields themselves and onto the distortions they have created in equity markets.

It is no secret that falling bond yields have forced income oriented investors to expand their search for yield, both in the form of greater credit risk and, in some cases, wading into equity markets in search of yield. Over the past several years, this has resulted in a dramatic increase in the value the market has assigned to high dividend yielding companies. The chart below compares the median next 12-month price to earnings ratio (NTM P/E) of the median stock among the highest yielding 20% of companies in the Russell 1000 Index to that of the median stock in the index overall. Prior to 2011, high dividend yielding companies consistently traded at a discount to their index peers. However, by 2011 the gap had closed, and high yielders now trade on par with the broader market. In fact, as of the end of July, the top dividend yielding cohort traded at a median NTM P/E of just over 18—a new 20+ year high!

Admittedly, a lot can happen over the course of 20 years. Perhaps the fundamental backdrop of these high yielders has improved sufficiently to warrant relatively lofty valuations versus history? As we will see, that is not the case. Historically, the market’s growth expectation for high yielding companies has been several percentage points below that of the broader market. This is due in no small part to the fact that companies with high dividend yields often are paying out a material portion of their earnings, leaving fewer funds in the business for future growth opportunities. The chart below shows that while overall growth expectations have come down in recent years, the market still expects meaningfully less growth from the high yielders—scarcely a justification for the valuation the market has bestowed on these stocks.

The same story can be seen looking at profitability measures such as return on assets (ROA) and return on equity (ROE). Historically, high dividend payers have also generally produced lower ROAs and ROEs than the typical stock. This remains the case today. Fundamental improvements clearly have not driven the absolute and relative valuation expansion of high dividend yielders, suggesting other forces are at work.

Of course, many investors own bonds for more than just yield. Bonds for many serve as a diversifier and buffer to equities within a balanced portfolio. And what a great buffer they have been. A long bond bull market, which has seen yields drop from double digit highs to below 2%, has also provided investors with an important source of total return over time. Today, however, the prospects for another sustained period of strong contribution to portfolio returns is unlikely. This has led some investors to consider allocations to lower volatility and/or low beta equities as a way to achieve some of the buffering of bonds with the potential for more meaningful gains along the way. Low volatility themed ETFs have been among the most aggressive asset gatherers in the ETF space in recent years. The growing popularity of such strategies and a broader quest for perceived safety at any price have propelled the absolute and relative valuations of these investment themes (i.e., factor portfolios) toward 20+ year highs.

Though these strategies are based on the idea of safety, they carry unique risks. From a practical standpoint, a portfolio based on a strategy such as low beta or realized volatility comes with the potential challenge of an ever shifting portfolio composition. Moreover, the construction of these portfolios is inherently backward looking. The phrase “past performance does not guarantee future results” is not just an important disclaimer, it is also sound advice. Just because a stock has exhibited lower volatility in its returns versus others or lower sensitivity (i.e., beta) to the broader market does not mean it will necessarily do so in the future. Finally, the surge in valuations in these themes introduces an important new risk to be considered—buying an entire portfolio of overvalued companies. The chart below tracks the median ROE for the least volatile and lowest beta quintiles of the Russell 1000 over time. Based on history, there is little evidence of something fundamentally superior about these “bond proxies” that warrants their current above-market valuations.

Low bond yields have also given rise to the notion that owning more equities is the ONLY option for investors seeking to meet long-term objectives. This theme has even been afforded its own acronym by its proponents: TINA—There Is No Alternative (to stocks). The TINA hypothesis focuses on stock market valuations relative to bond yields. To be clear, when compared to bonds, stocks still look like a bargain (at least at first glance). For example, as of the end of July, the dividend yield on the S&P 500 exceeded that of the 10-year U.S. Treasury bond. This has indeed been a rare occurrence over the past 50 years—it even marked the market lows in 2009! However, if one goes further back into history, it is not a rare occurrence at all. We plot the spread of dividend yields versus bond yields below, utilizing Robert Shiller’s excellent dataset of historical market data. In the last 50 years, it seems the relationship has had a lot more to do with the bond market than the equity market.

The merit of looking back at over 140 years of market history can be debated; however, it is worth noting that the pre-1960 average spread between dividend yields and bond yields was 1.74%, suggesting that today’s current spread of around 0.54% may not be as compelling as some may argue.

The idea of any asset class as a one-decision, buy-and-hold forever asset is troubling. It is particularly concerning when it comes seven years removed from the last bear market’s bottom and at a time when stocks are trading at valuations that look full or even somewhat overvalued. To add to the concern, margins look to have peaked several quarters ago. While low rates may be able to support the TINA trade for some time, eventually the market may require greater compensation to go from owning the most senior asset in a company’s capital structure (bonds) to the most junior (equities).

What are investors to do?

First and foremost, investors need to evaluate their long-term goals and the risk/reward tradeoff associated with pursuing those goals. History has shown there is generally an inherent tradeoff between safety and returns. Ultimately, if safe investments consistently achieved both objectives of capital preservation and longer-term growth, investors would not invest in risky ones. Although government bonds have arguably provided both safety and attractive returns over the past several decades, today’s historically low interest rates should leave serious doubts regarding the continuation of this trend.

Investors in search of income and return have been pushed further and further out the risk spectrum. In some cases, this has meant purchasing equities as bond proxies on the basis of yield and/or perceived stability or market sensitivity, as discussed above. As low bond yields have distorted investment decision making, valuations have risen among so-called bond proxies as well as the broad equity market.

In looking for safety outside the bond markets, we believe investors should have two main considerations:

  • Does a given investment provide actual safety or merely the illusion of safety?
  • Can a safe investment still be considered safe if it’s overvalued?

Even though higher dividend yielding and lower beta stocks have proven less volatile than broad equity markets over the past several years, investors should remember the distinction between absolute and relative volatility. Most notably, we remain in the midst of one of the longest bull markets on record, and are many years removed from the market downturn of 2008. Since even the least volatile stock could be significantly more volatile than high quality bonds, investors replacing actual bonds with bond proxies ignore the distinction between absolute and relative volatility at their own peril.

Likewise, purchasing a supposedly safe investment at elevated valuations, by definition, makes it risky. If an investor overpays for an investment, their prospect of future returns is more reliant on the willingness of other investors to pay an even higher price. When this concept is applied to a universe of safe investments, they only continue to remain safe if enough investors believe in their supposed safety and are willing to pay an even higher price than the current price for that safety. In this respect, these investments become similar to technology stocks prior to the tech bubble or financials prior to the credit crisis.

Undoubtedly, the current market environment has created greater challenges for all equity investors, whether they are focused on the entire market or some of the more distorted areas such as dividend paying stocks. The good news is we believe that opportunities remain for those willing to adopt a flexible approach to investing. For income investors, this could mean a willingness to trade some yield for better valued investments. The top 20% of dividend payers, as a group, look relatively expensive versus history, but the next 20% of dividend payers look more reasonably valued. By casting a wider net and taking an active approach to selecting companies among the higher yielders based on valuation and fundamentals, investors may be able to construct an income portfolio without overpaying for yield.

We continue to advocate an opportunistic and selective approach to investing in today’s market environment. Recurring episodes of market volatility are likely in today’s low-growth world that is laden with uncertainty and lacks compelling equity market valuations. We believe that as long as underlying economic conditions remain supportive, these periods of volatility can and should be taken advantage of. Similarly, periods of relative calm such as what we have experienced in August should be used to trim exposure at the margin.


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