Market Overview | April 2023
A good asset allocation decision first analyzes the relative attractiveness of various investments and then determines their appropriate weightings within a portfolio. Aligning investments with an investor's time horizon is important in determining successful outcomes. Portfolios should always have a long-term asset allocation plan and model based on an investor's specific needs and goals. That allocation strategy can be tilted from time to time toward safety or growth based on current market conditions. When seeking to capture a higher return opportunity, prudence dictates that the weighting of the proposed investment should be appropriate for risk tolerance, and the time horizon should be long enough to provide a higher probability of success.
Based on our analysis of risks and rewards as of April 2023, most portfolios should be somewhat underweight equities relative to long-term asset allocation models. Those monies should be invested into short and intermediate-term fixed-income securities. The duration of the current allocation decisions will be evidence-based as we watch for progress in reducing inflation, monitor stock prices and valuations relative to other investment opportunities, and closely monitor several other macro/global factors.
It has been 16 months since the stock market peaked and 13 months since the first rate hike by the Federal Reserve. The S&P 500's most recent low came in October 2022, down approximately 27% from the peak. The Fed continues to raise rates in their fight against inflation, and stocks have shrugged off several events, including a bank run, and have staged a partial rally over the last six months. While no one can know with certainty whether the October low will prove to be the bottom of this market cycle there are a few things that we can know with a high level of conviction. First, there are several significant challenges and headwinds facing "risky" investments in the short run, and in the long run, the stock market should ultimately rise above the Dec 2021 highs. One is a short-term set of risks stemming from current dislocations, imbalances, war, and inflation. The other is a highly probable long-term outcome based on historic observations - every bear market decline in history has then been followed by a new all-time high in equity markets. The new highs can often take a very long time, but ultimately every single market plunge has been erased over time.
Risk Avoidance and Loss Aversion
It can be tempting to want to hurry things along and move away from tough conditions. It is deeply ingrained into us as human beings. We want to be done with tough times and move into better times. And nearly everyone has an opinion on whether to be buying or selling stocks. It is impossible to know the short-term future outcomes for any investment asset, and it is a waste of time to argue opinions. Instead, some facts can help make an informed decision that is mathematically correct and good for the investor's psyche.
Numerous studies have shown that humans have a stronger aversion to losses than the emotion felt related to gains. In fact, the aversion is so strong that some studies suggest that loss aversion is 2.5x more powerful than the emotion felt toward gains of the same magnitude. More recently, more nuanced studies have also shown that, much like many other facets of human life, not all humans feel the same level of aversion as others. Researchers have found that among other things, age, knowledge, and magnitude (of loss) can also dictate just how averse a person might be toward loss.
If the average person is 2.5x more averse to a loss than to a gain, then how much extra profit is required for an investor to choose a stock over a safe investment return? Today the 1-Year US Treasury Bill yields 4.7%. So what would be the required expected return on stocks in order for a typical investor to move from the safety of a 4.7% yield to an uncertain possible higher return in another asset?
A prudent investor would require a premium for choosing a risky position over a safe return. This is called the "equity risk premium." The exact "required" risk premium for any investor is dependent on factors that are specific to the investor. Historically, for a typical investor, a 2.75% equity risk premium could be considered a meaningful and actionable level where stocks can be purchased with confidence within a longer-term portfolio seeking growth.
Current Relative Yields Across Major Asset Classes
The 1 Year US T-bill offers a yield of 4.7% and has always paid investors back at maturity. It is considered "risk-free" and a very safe investment choice. Corporate bonds issued by "investment grade" quality companies are offering yields over 5.0%. The stock market's earning yield (earnings for the most recent year divided by the current price) can provide an apples-to-apples comparison to other yield-based assets. The S&P 500's earnings yield is currently 4.6% (earnings of $187 for the S&P 500 vs. a price of 4100). And while real estate is extremely diverse and harder to track, investment-grade tenants with long-term leases are offering investors yields (called "cap rates") of 5.25% to 6.0%. Ignoring the long-term appreciation potential of both real estate and stocks, and focusing on the relative yields, it is apparent that riskier assets are not yet priced to be attractive (in the short run) relative to safer assets.
Stocks currently offer no risk premiums over bonds. Safe bond yields are 4.7% and the stock market's earnings yield is 4.6%, a -0.1% risk premium. For context, during the Global Financial Crisis in March of 2009, stocks offered a 7.8% risk premium over bonds. After the Covid crash in 2020, the stock equity risk premium was 5.1%.
Since the relative attractiveness of any investment is based on the changing nature of all assets, it is not as simple as calculating the stock market decline necessary for stocks to offer a risk premium of 2.75% over a safe asset. A stock market decline of 37% would be required to make stocks that attractive. However, the Fed will likely respond to a recession or major bear market decline by reducing rates. So, if a recession resulted in a stock market decline and the Fed reduced rates by 1.5% (this presumes that the Fed has no desire to return to its zero-interest rate policy, and instead move toward an "accommodative" stance), then stocks would become quite attractive around the S&P 500 level of 3200, a decline of around 19% from current levels.
Again, real estate has its own set of rules but based on financing rates today, it would be reasonable to expect yields on real estate (cap rates) to rise over 6.0% and toward 7.0% for many types of property. This would suggest that many areas of the real estate market might need to drop by 10-15% to become significantly more attractive than bonds or stocks.
This is not an abandonment of stocks or long-term asset allocation strategies; there is no evidence or historic precedent that suggests a total abandonment of a long-term allocation plan. Quite the contrary. There is significant evidence that a long-term allocation strategy should be followed to have long-term investing success. This is simply an exercise to determine when we might be able to add to our stocks and have a very good chance for long-term growth well above the returns we can receive from bonds.
For now, bonds are offering very good yields with a low risk of loss. Today's relative yields across assets do suggest that portfolios can be tilted toward bonds in the short term until global and domestic risks are resolved, or stocks decline enough to become more attractive on a relative basis.
*The foregoing content reflects the opinions of Van Hulzen Asset Management DBA "Van Hulzen Financial Advisors" and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.