Markets serve up surprises and test our mettle
Much of the time, equity markets and many individual stocks appreciate in value and are pleasing to own. After 10 or more years of bull phases, we become conditioned for continued success – we extrapolate. At other times, uncertainty about the outlook for the economy or geo-politics cause investors to withdraw capital and markets to decline. If the downturn is severe and lasting, the biggest winners in epic bull phases often become the largest aggregate dollar losers in bear market periods. That’s because large valuation gains fuel price runups. In turn, a contraction in things like the PE (price to earnings) ratio can pave the way for sharp declines of 50% or more. In these instances, sharp reversals can be life changing but not in a good way.
A review of market environments of the past shows that once leading 'it' companies can falter as stocks and never regain their mojo. That’s because capitalism is dynamic and new entrants can catch up and surprise once formidable leaders in particular industries. Capitalism embodies change in direction, magnitude of growth etc. While hard to predict, we are wise to expect surprises and reversals. Adopting a longer-term horizon for our investments can help us mentally and financially prepare for the inevitable surprises that lie ahead.
Of late, there has been growing concern about a number of important factors including the potential for increased inflation, lower GDP growth here and abroad, deteriorating trade conditions and/or a diminished outlook for corporate profits. The challenges for investors are always acute during periods when it is unclear whether significant deterioration lies ahead or whether conditions will improve in the near term. During the early days of Covid-19, markets sold off sharply and then turned around relatively quickly and went on to close appreciably higher at the end of 2020 and higher still at the end of 2021. Then, we experienced significant spikes in inflation and an aggressive increase in the FED fund’s rate in 2022. Broad market indexes including the S&P 500 and U.S. aggregate bond index once again sold off sharply only to post strong gains after economic conditions improved and concerns abated. To the extent investors chose to sell equities and move to the safety of cash they likely experienced significant opportunity cost. The fact is, it is inherently difficult to effectively time in and out of things like broad based U.S. and international stock markets. Investors are well-served to adopt and adhere to a sensible plan to realize their short, intermediate and long-term objectives.
Stepping back from the here and now can be helpful
Bull phases are fueled by not only growth in sales, earnings and cash flow per share but also, the added boost of PE expansion. That math is simple. A 10x to 20x PE increase doubles the increase in EPS while 12x to 36x triples the increase in fundamentals. Investors love these periods and the heroes that power the rise in value. Of course, PE ratios also decline. Often, precipitously during times of economic and/or geopolitical stress and uncertainty. Valuation declines can partially and often fully offset growth in sales, earnings and other business fundamentals. Because increases in valuation can magnify gains in fundamentals while declines can partially or completely offset gains in sales, earnings and cash flow, valuation is a key input in our portfolio considerations.
Being pro-active as opposed to reactive can help
As you know, we allocate capital broadly across all major segments of the equity markets. Doing so reduces the risk associated with excess concentration of capital in the wrong place at the wrong time Beyond intentional diversification, a thoughtful consideration of valuation metrics (both absolute and relative to other market segments) can aid decision making over a multi-year period. That said, we know stocks and segments that are selling at all time high valuation metrics can continue to move higher. Nevertheless, it is reasonable to believe that a decline in valuation metrics is ultimately likely. The same is true for out-of-favor segments. They can get cheaper, but in time they will likely experience a positive re-rating when conditions improve.
Significant outperformance of the S&P 500 and Russell 3000 compared to other indexes and regions of the globe has enabled a very significant increase in the U.S. share of global stock market value. This winning streak has persisted for over 16 years (e.g., since the bottom of the market in March 2009). It is not always this way. In a recent letter, I shared that the U.S. share of global stock market value was in excess of 65% compared to our share of global population and GDP of roughly 5% and 25%, respectively. This was driven by good sales and earnings growth and a sharp increase in valuation. Other regions have experienced a decline in valuation metrics and their returns have been much lower. That said, ‘This has been a great investment’ is not sufficient. One needs to understand the drivers and then stress test the future. Huge moves up and down, show clearly that markets get out of kilter on the high and low side.
Significant increases in valuation by U.S. stocks on an absolute and relative to other regions enabled our markets to achieve this dominance over the rest of the world. However, if aggregate value of international markets increases relative to the U.S., returns from owning those market segments will be higher than those of the U.S. – potentially much higher. If that proves true, investors will benefit from owning more in international and less in U.S. securities. Research shows that most U.S. investors are highly concentrated in U.S. stocks and not positioned for a change in leadership. Well- diversified investors are always positioned for leadership changes.
In conclusion, the near-term direction of things like the S&P 500 is subject to change based upon things like a ratcheting up or a cooling in the rate of inflation or a significant change in expectations for GDP growth. Are these factors reliable determinants of investor confidence and do they foretell a change in markets? Sometimes they do, but markets have a long history of defying expectations. For our part, we are not prone to making wholesale changes in things like our equity and bond allocations or the composition of the equity allocation. We acknowledge that there will be lots of times where the ‘data exception’ occurs. That said, economic and market advances and sustained ‘bear market’ declines are certain to lie ahead. Of course, the timing is the tricky part. That said, we believe that awareness of things like valuation, investor positioning and other factors are worthy of thoughtful consideration. For example, when stocks are trading at or near valuation extremes (highs or lows) it is more likely that a reversal will occur and that the magnitude of change down or up that ultimately occurs will often be larger than most expect. Last but not least, I have included several of the many dozens of charts and tables we have seen from various firms that we rely upon for data and perspective in a lengthy end note with brief comments.
As always, please let us know if you have any questions or if we can otherwise be of help.
W. Richard Jones, CFA
Partner, Harmony Wealth Partners
Addendum
Below are some charts, tables and excerpts from recent research reports that caught my attention. Please find them below along with some brief commentary. First up an excerpt from a recent Goldman Sachs report.
The combination of larger tariffs, greater policy uncertainty, declining business and consumer confidence, and messaging from the administration indicating greater willingness to tolerate near-term economic weakness in pursuit of its policies increase downside risk.
Source: Goldman Sachs The Impact of Uncertainty on Investment, Hiring and Consumer Spending Aril 6, 2025
The good news to the chart to the left, is money managers are often complacent when risks appear to be low and vice versa. The fact that they are on alert now may mean a lot of uncertainty may already be reflected in markets. That said, if conditions do deteriorate, these concerns will likely lead to more impactful declines. Time will tell.
Over recent months and years, I have shared other tables and analyses that show that U.S. small cap stocks are priced attractively realtive to U.S. large caps. Historically, we have often seen reversals in performance by out of favor market segments that exceed those of the segments that were leading returns before the decline. Source: Research Affiliates
Generally speaking, profit margins along with valuation metrics like the PE ratio have expanded for U.S. large caps (e.g. the S&P 500). The increase in profit margins and valuations for mid and small caps have been far less pronounced. A decline in large cap margins would lower earnings growth and could in turn lead to lower valuation metrics. Source: FactSet on April 17, 2025
The good news (if there is any) is that economists are often wrong about a lot of things including the likelihood of near term economic or expansion. If they are right this time, we could experience some significant declines. On the other hand, if we avoid a recession in the near term, markets may recover. In any event, we are confident that we will continue to experience extremes across market cycles. Source: Reuters
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