By Thierry J. D. Brunel
Director, Matter Family Office
One of the foundational principles of investing is the concept of valuation. As you can imagine, for such a broad concept, there are many tools available to help judge the value of an asset. In the equity markets, one of the more common metrics is the price–to-earnings multiple. Within fixed income markets, spreads are often a key indicator—they help define the additional yields investors are requiring for taking on an additional level of risk. Each valuation metric has its nuance, and alone should not dictate a binding decision—but together they do play an important role in putting together the mosaic that forms our outlook and projections.
Below are some summary points that we think are helpful to consider:
Source: ACG Research, Bloomberg
We believe that the two charts above illustrate the dilemma facing equity investors as we look at stock prices today. Looking solely at the chart on the left, which compares the current forward looking P/E levels (blue diamonds) to their 15–year historical averages (green circles), we could easily make the case that we are looking at a pretty attractive buying opportunity as the current multiples are below their historical averages.
On the other hand, one of the challenges we’ve discussed is the ability to reasonably forecast earnings in the coming 12 months, which leads to the chart on the right. We’ve seen earnings estimates range across the board, but if we assume that there will be some level of earnings declines as a result of the measures being taken to curtail the spread of COVID-19, the implications for valuations are important:
- If earnings drop by 10%, everything—with perhaps the exception of US Large Cap—looks attractive.
- If earnings drop by 20%, then US Large Cap seems a little expensive, while everything else looks to be at around fair value.
- If earnings drop by 30%, then every sector looks expensive.
The relative uncertainty regarding earnings trajectory is why we have been more measured in our perspective of whether now is the time to make any major moves in portfolios—we are not looking to go overweight equities at this time.
Fixed Income Markets
Source: ACG Research, Bloomberg
As we look to the bond markets, we have seen a material amount of supply and demand imbalance over the last week few weeks in certain segments of the market outside of US Treasuries. Yield levels remain extremely low—though that is to be expected, given the Fed’s decision to cut their target range to 0-0.25%.
The Term Spread, which tells us a little about how the market perceives near–term risk as compared to long-term risk, has actually widened from where it has been over the last year or so, as we are not near the yield curve inversion level (which would be a spread of less than 0). That said, much of that widening is a result of the Fed’s significant interest rate cuts.
Both the Investment Grade spread (which gives a measure of the perceived risk between the government and high-quality corporate bonds) and the High Yield Spread have widened significantly—though neither have reached the levels they reached back in 2008/2009. Anecdotally, Apollo, one of the managers we follow which runs a tactical high yield debt fund, not only called over half of their capital over the last 20 days, they are also launching another fund in the next three weeks to capitalize on what they see as a very attractive opportunity set in the high yield space.
Overall, Fixed Income remains a challenging market, as low absolute yield levels are balanced by the fact that high–quality fixed income tends to provide downside protection during market corrections. Higher–risk Fixed Income, like High Yield, may continue to face the same supply and demand issues that have impacted them over the last several weeks as investors pick safety over risk. That being said, we find the chart below to provide some important insights into the current spread levels as well the anticipatory nature of the markets. Across three of the largest credit dislocations in history, we can see how spreads began to tighten in advance of any amelioration in credit conditions.
Historical Credit Shocks
Source: J.P. Morgan Securities LLC.
The conclusions are by no means clear—they rarely are—and time horizon is key. As long–term investors, we would suggest that equities and higher–yielding fixed income represent reasonable value at this time, acknowledging that in the near term they could see some material pressure if the shutdowns last longer than anticipated. Conversely, Investment Grade Fixed Income, US Treasuries in particular, provide some valuable risk mitigation, but current yield levels imply underwhelming long-term returns. These conflicting signals reaffirm our perspective of remaining calm in the current environment, sticking to our strategic policies and avoiding making any major bets that could impact your portfolio’s ability to achieve its long-term goals.
This report is the confidential work product of Matter Family Office. Unauthorized distribution of this material is strictly prohibited. The information in this report is deemed to be reliable but has not been independently verified. Some of the conclusions in this report are intended to be generalizations. The specific circumstances of an individual’s situation may require advice that is different from that reflected in this report. Furthermore, the advice reflected in this report is based on our opinion, and our opinion may change as new information becomes available. Nothing in this presentation should be construed as an offer to sell or a solicitation of an offer to buy any securities. You should read the prospectus or offering memo before making any investment. You are solely responsible for any decision to invest in a private offering. The investment recommendations contained in this document may not prove to be profitable, and the actual performance of any investment may not be as favorable as the expectations that are expressed in this document. There is no guarantee that the past performance of any investment will continue in the future.