Meketa Investment Group's outlook for the capital market.
- Investors are faced with three primary issues in the near-term: 1) historically low bond yields, 2) the potential for a transition into a rising rate environment, and 3) the potential for deteriorating corporate earnings.
- The price of the U.S. stock market relative to ten-year average earnings increased slightly from the beginning of the year, remaining above its historical average (28.9x versus 21.6x).
- Small cap domestic stocks remain richly priced 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.
- Uncertainties around global demand (particularly from emerging markets), stimulative monetary policy, and geopolitical tensions could cause heightened volatility despite a recent lull in turbulence.
- In particular, the monetary policy changes by central banks are having a meaningful impact on most markets.
- At the end of June, the spreads for both high yield corporate bonds (3.4% versus 5.5%) and investment grade bonds (1.0% versus 1.5%) were below their long-term averages.
- At 2.5%, the yield on the ten-year Treasury remained far below its post-WWII average of 5.7%.
- Low yields on fixed income instruments are likely to push long-term investors further out on the risk spectrum as they seek to achieve their target returns, while short-term investors may look to cash for safety.
- The price of the U.S. stock market relative to ten-year average earnings increased slightly from the beginning of the year, remaining above its historical average (28.9x versus 21.6x).
The U.S. Cyclically Adjusted P/E and Long Term Equity Returns
- One of the most powerful predictors of long term equity returns has been the Cyclically Adjusted Price to Earnings Ratio (CAPE), which was originally proposed by Robert Shiller.
- This fundamentally driven measure is highly correlated with future returns which are shown in the chart above with seven year forward returns on a reverse scale.
U.S. Equity Cyclically Adjusted P/E
- The cyclically adjusted P/E ratio for the S&P 500 finished June at 28.9x, above its post-WWII average of 21.6x.
- Recent strong performance has driven this valuation measure well past its long-term average. While still not at extreme levels, it is not likely that this type of price appreciation can continue indefinitely.
Small Cap P/E vs. Large Cap P/E
The P/E ratio of small cap stocks (Russell 2000) relative to large cap stocks (Russell 1000) remains more than one standard deviation above its long-term average, signaling potential underperformance of small cap stocks relative to large cap stocks.
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