This was a fun exercise, hopefully the first of a monthly series. Given the popularity of our weekly Market in Pictures, we thought it made sense to pick out a few and go into more detail with our PMs. In this edition, Dave and John Luke will spend a few minutes on each of the following:
- The current anomaly between rising real yields and rising equity valuations
- The divergences for debtholders across consumers, corporations, and the Federal government
- Broad market valuations vs. those of the “Magnificent 7”
Not sure why, but halfway through our camera shots froze. But the pics and audio are there so we’ll run with this version, who needs our distracting animation anyway!
Hope you enjoy, and please send a note to [email protected] if there’s a particular chart/topic you’d like to see covered next month. Time to swing the ball around!
Transcript:
Derek:
Hello, Derek here from Aptus. It is Friday, September 1st going into Labor Day weekend and we’re doing a new little segment that we’re going to try to do every month where we just go through some of the charts that have been prevalent on some of the threads and discussions internally. Really just dig into them a little bit where we think they might have relevance to portfolios because ultimately that’s all that matters. There’s charts that are noisy and there’s charts that actually may have either a signal or a conflict inherent to them. I thought it’d be good to bring a couple of these guys in. They’re going to have some things where they sit on both sides of the debate.
I do need to read a disclosure. The opinions expressed during this call are those of the Aptus Capital Advisors Investment Committee and are subject to change without notice. This material is not financial advice or an offer to sell any product. Forward-looking statements are not guaranteed. Aptus reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs. More information about Aptus Investment Advisory services can be found in its form ADV part two, which is available upon request. If you’re a client, these guys, Dave Wagner, at least on the top of my screen, CFA, and really our equity guy. John Luke Tyner, who is also a CFA and really our fixed income guy, but they really cover all things macro. If you’re a client, you’ve talked to each of them probably multiple times and each have strong opinions and put in a lot of time on thinking through some of these topics and how it impacts allocations.
We all love football, but I think with the basketball pedigree in this firm, it made sense to go with three pointers where we’ll just go through three charts that are seem to be relevant right now and just hit them and see what these guys think. Part of this will be us teeing up the questions, but in the future there could be, we may pull in advisor ideas to say, “Hey, walk me through that chart, what does it mean?” If we get a couple of those requests, like those would be perfect for this format.
Anyway, I will start the first one that has been a pretty heavy discussion point. We all know there’s been a little bit of a change in the fixed-income correlation versus equities, but in particular what really doesn’t get discussed as much as real yields. Everybody sees what bonds yield, but we haven’t talked as much about real yields. Historically real yields at a higher level have been a little bit of a competition for stocks and would seem to put a little bit of a ceiling on valuations. We’ve not seen that all in the past year after having years of extremely low real yields or even negative real yields. We’ve seen real yields spike up quite a bit and become competition, but valuations haven’t come in much. Any thoughts there from either of you?
Dave:
Yeah, I’ll take that. This is a really cool idea walking through a few charts here. You’re going to get the raw thinking from John Luke and myself. We spend 10, 20 minutes a day on the phone with each other, just bantering back and forth with what we saw in the market, what we’re focusing on and what our takes are. We wanted to show that to everyone on this call listening what John Luke and I really do behind the scenes to really come together with some type of cohesive thinking.
This is a really interesting chart because given recency bias of 2022, we saw real rates continue to rise and valuations were hit. That’s the inverse correlation you would expect. Yet that hasn’t really been the story this year as real rates have continued to rise, but they have been positively correlated with the valuation. If you look at this chart on the left axis over there, it’s showing you the valuation on a forward basis over the next 12 months for the NASDAQ 100. What we’ve seen basically since the end of 2022 and early 23 via the red dotted line that valuations for the NASDAQ, well, it’s continued to go straight up into the right.
If you look at the blue line, and this is where the chart gets a little bit confusing, this is actually the inverted US 10 year real yield, and that’s showing on the right axis there. It’s actually going in a downward sloping fashion, but since it’s inverted, it’s actually showing that real rates are continuing to go up. That’s been pretty heavily correlated with the valuation and especially the higher value tech sector. You’ve seen this divergence [inaudible 00:04:37] and it’s really caught our eye, and I think it goes back to a lot of our commentary on has the market taken off that right tail risk of interest rates, allowing valuations to continue to increase given what happened back in March with all the banking aspects with the Fed stepping in, increasing their balance sheet to not bail out these banks but in a way bail out the banks.
Between that and the aspect of the market really not believing that rates are going to remain higher for longer basically has allowed valuations within the tech sector to continue to increase. When it comes back down to a portfolio allocation perspective, what we’ve been saying for quite some time is now that rates on the two year and ten year are back to where they were back in [inaudible 00:05:19], when is the market going to reintroduce this right tail of interest rate risk into the market? What that means is if rates stay higher for longer and the market starts to believe that, don’t you think valuations [inaudible 00:05:31] should really start to come down. We want to make sure that portfolios are positioned if that is the case moving forward.
John Luke:
Yeah, I think it’s a great point. When you think about real yields, it’s just the nominal treasury yield less inflation. There’s two ways that real yields can rise. Number one is just nominal yields rising and inflation staying flat, but then also it’s inflation going down and nominal yields staying flat. What we’ve seen this year has been really a mix of both where inflation’s come down significantly and nominal yields have risen, and so it’s artificially pushed real yields higher just due to the extent of how much inflation has come down. I think it’ll be interesting to see moving forward how real rates will react if we see inflation stay stickier in this 3% range.
Again, you would think that now that there’s an alternative where positive real yields are a great thing for savers because now they can actually put their money in something and have a safe return that’s positive in real terms. It will be interesting to see if the valuations can stay this elevated on a particular group of stocks that we’re very familiar with.
Dave:
Well, John Luke, what do you think about, people think in terms of nominal yield, but they eat real yield, you see that as a pretty big problem for overall portfolios if that mentality continues?
John Luke:
Yeah, and I think one of the interesting pieces is this move higher in real yields could be somewhat offset with just expectations of inflation being higher in the future so maybe the real yields aren’t necessarily as high as they look. I think that in an inflationary environment, the challenge for asset allocation is just making sure that you have enough things in the portfolio that are tied to real growth that can offset the inflation. Ultimately we can’t really affect whether inflation is low or high, you just have to flex your portfolio with what’s going on at the time.
Derek:
Awesome. Well, we are going to try to keep this moving along. That’s good though. I want to be able to cover each of these in a couple of minutes and make it something where once a month we can send this out. It might be less than 10 minutes, but provide a lot of punch for viewers. Another topic that pretty much anyone viewing this knows on the consumer side, if you have a mortgage and it’s pre-2022, you already know that you’re happy. You’ve got that two and a half, 3% mortgage, and if someone came to buy your house now, they would not get that mortgage. They’d be paying double, triple that number. It creates this massive disparity between current homeowners and prospective homeowners. We’ve seen it in really no homes for sale, especially in the existing home market.
I think what is less discussed is what are we seeing in the corporate world and what are we seeing at the government level? This chart’s pretty striking I thought that corporations they’re sitting pretty like consumers are. Feel free to walk through a little bit of what you see here.
John Luke:
Yeah, I think it goes back to 2020 and 2021 where just internally at Aptus, it seemed like every day that you were seeing companies issue debt 20, 30, even 40 years at rates that were just unbelievably low. I think what you’re seeing is the aftereffect where this chart specifically on the right-hand side just shows that more than or nearly half of the S and P 500 debt outstanding is due 2030 or later. A lot of that is well past 2030.So you’re talking 20 or 30 years out. Really if you think about an inflationary type of environment, the best thing that you can possibly have is cheap fixed debt and then inflate away the value of that debt over time.
Effectively that’s what you’re seeing at the company level or at the corporate level where these companies actually were very responsible, maybe seemed irresponsible at the time, but responsible in terms of stewarding shareholder value by extending the duration of the debt really long and locking in low borrowing cost. Really what you’ve seen is a less interest rate sensitive economy, especially for these large companies that could lock in long duration debt where a rise in rates it might affect people that have short-term borrowing where they have to refinance higher at higher rates. For the most part, many of these companies, they don’t have that problem frankly.
Dave:
It’s not something I think that’s just going to switch overnight. What this is showing here in the chart, like we said, John Luke, 46% of the outstanding debt is due after 2030. A Lot of these companies have weighted average cost of capital like 2%, and they’re sitting on a huge balance sheet worth of capital where they’re getting like 5% right now. It’s not arbitrage, they’re just clipping the spread. If you just look at Apple as a company as a whole, I just brought up a tear sheet on them. They have like $62.48 billion in cash right now, and that’s just not sitting [inaudible 00:10:45]. They’re obviously getting some type of yield here in that a quarter right now. I just think that the tailwinds just given the spread that I do believe that rates are going to remain higher for much longer. The fact how far out these maturities are in the debt, a lot of these companies, especially on the large cap side, are just going to be clipping money for quite some time.
John Luke:
They’re banks at this point.
Dave:
Oh yeah.
John Luke:
Right. Borrow low and lend high.
Dave:
I would love to try to figure out the interest. Sorry, John Luke, go ahead.
John Luke:
Yeah, it’s something that I think will drive earnings more than most folks realize is that these companies have so much interest income that they’re receiving in a positive sense that it can insulate a lot of volatility in the economy.
Dave:
Even if you look like Morgan Stanley’s Mike Wilson, this was a big thing that he was hitting against for quite some time, was that leverage is going to start hurting these companies substantially and that’s going to decrease margin, which should decrease the absolute valuation of the company and the market as a whole. We just haven’t seen that whatsoever. That was actually put out in [inaudible 00:11:48] that I did one or two weeks ago. The fact that the interest that’s coming in is substantially higher than the interest expense going out.
John Luke:
Yeah. It goes back to that last chart with NASDAQ valuations with the companies that are making up the bulk of the NASDAQ or the ones that have a lot of this debt after 2030. I think it doesn’t necessarily rationalize the multiples, but it makes them a little bit more tolerable when you put it in that context.
Derek:
Yeah. It probably breaks a lot of the textbooks that y’all studied back in the CFA that when you do go into a rising interest rate environment and companies that have short-term debt have to refinance, it hits their margins. I don’t know, it seems like a lot of US corporations milked it pretty good.
John Luke:
Yeah, well, it just gives you flexibility where they’ve got so much time to plan to pay off this debt. Now obviously the carry cost is low, but they’re going to be paying it off with massively inflated dollars and they’re going to have a whole lot of time to plan on how to extinguish it.
Dave:
I think that’s actually a huge positive for active stock pickers too, because exactly what you said there, D. Hern, what has history told you? It’s like I leverage on balance sheets, it’s binary, it’s bad. You want lower absolute leverage on your balances. Well, now you have to think about it from a qualitative aspect. What do these management teams do to look through that windshield of where they believe that rates are going to be moving forward to position their balance sheet for as much operating leverage as possible? That’s not something that could be computed by some type of computer or some type of tilted factor exposure through a passive smart beta type of ETF.
John Luke:
Yep. The last comment I’d make is the personal finance balance sheet of consumers is about in the same position as this. They’ve locked in a lot of long-term expenses with their mortgage payments being low and they’ve got pay increases and wage inflation that’s benefiting them and giving them more money to spend into the economy today. That’s what you’ve seen the last really year where everyone’s been so gung-ho that the recession was imminent and they just didn’t bake in the benefit of locked in low interest rates for the terms that we have in place right now. Obviously someone owns all of this debt, but it’s less sensitive because it’s locked up to banks and Fed balance sheets and things like that.
Dave:
I wouldn’t say that on the consumer side versus the corporate side that they’re on the same exact level. I think a lot of the data that we saw come out earlier this week on consumer spending, they continued to do, I forget who coined this term, it’s like YOLO spending this summer. I mean, it’s brought down their savings rate to three and a half percent right now. That’s substantially below long-term average savings rates. They are really dipping into their balance sheet, their war chest of capital a lot more I think than what corporations are. When you take that information and move it towards, what does that mean for the market?
Well, the S&P 500 tends to be more of a goods oriented type of exposure while GDP tends to be more heavily on the services side and the consumer side because two-thirds of GDP is made up of the consumer itself. That shows that you could continue to see some type of strength at the S&P 500 levels just because all those corporations tend to be more goods focused. That could be a pretty good investment of just owning some type of cheap beta in the S&P 500.
Derek:
Let’s talk about who did not take advantage of the low interest rates.
John Luke:
[inaudible 00:15:27] hundred year debt offerings?
Derek:
A huge missed opportunity it seems.
John Luke:
Yeah. I know that we looked at issuing some 50 and hundred year paper back at record lows and decided against it. Yeah, it’s certainly concerning in terms of where the Fed’s debt maturity profile is right now. Then also if you think about where they’ve been doing a huge bulk of the issuance lately has been at the front end of the curve, and that’s obviously been to protect the liquidity profile of markets. If you issue at the front end of the curve, that’s the least market impactful as far as draining liquidity from markets. It’s also the most expensive.
As governments and specifically the US government continues to refinance this debt from the low 2% level that we started at when we came into this rising interest rate mess to five and a half percent type of short end rates, it’s definitely having an impact on the fiscal situation of the US. Right now we’re running roughly a 9% deficit, and that’s with 3.8% unemployment. You’re running basically crisis or war level deficits with a “really healthy, strong economy”.
Dave:
I think one of the [inaudible 00:16:50] that when I look at this chart, John Luke, is there still going to be an arm’s length distance between the Fed and the government as all, or is the US government going to try to strong arm the Fed to decrease rates here? That’s why they’re obviously issuing the front end of the curve so they can reinvest once those roll off at lower rates because the government doesn’t think that rates can stay this higher for longer. All the data, I think to all the listeners who continue to listen to us, however far we are in here, all the data that John Luke and I always talk about is that rates should be higher for much, much longer. Is the government going to pressure Jerome Powell and the Fed, even though they’re not supposed to, into jawboning them into actually cutting rates sooner than expected so they can get this interest expense rate down, especially heading into an election year right now?
John Luke:
Yeah, I think that there’s certain ways that they can be a little bit more sneaky about it, like raising capital requirements for banks and doing other subtle forms of yield curve control where they hopefully keep rates to something sustainable. Ultimately, I think that unless the Fed is back involved in buying a lot of this issuance that they’re going to have to keep rates high in order to keep the demand there.
Dave:
If you think what happened back in March, I think everyone only thinks that the Fed, and maybe the US government thinks this too, they only have one lever to pull and that’s to decrease interest rates. That’s not the case. Look what happened back in March when all this banking crisis started to go on the Fed increased their balance sheet, they didn’t cut rates whatsoever. I think if you do see some type of crisis in the near future, I think the Fed is going to utilize a lever that they haven’t historically been able to do, and that’s to increase the size of the balance sheet without cutting some type of rates too. That definitely doesn’t help the US government whatsoever if something does happen.
John Luke:
Yeah, Fed’s balance sheets just creeped below 8 trillion, was a little over 9 trillion to start, so it’s certainly declining. The first trillion roll off of the balance sheet has been fairly smooth, but it’s going to be tough to see them really shred this thing down. If you look back at the FMC minute meetings from the last meeting, they’re pretty imminent that the balance sheet needs to continue to shrink. They’re certainly trying to go down that avenue. It’s just a question of will they be able to, and I guess last point is when you’re running a 9% deficit, that has to get funded somehow, and that means more debt issuance and someone’s got to buy all of it. I think that’s really what you’ve seen the last couple of weeks where rates have shot up higher.
Dave:
Correct me if I’m wrong with this number, John Luke, I’m probably just throwing out a random number. Every $100 billion worth of balance sheet reduction equates to 10 basis points or 20 basis points of interest rate hikes in a way, just from what it’s doing from a tightening perspective.
John Luke:
Yeah, that’s roughly the number that’s quoted. Just not sure the effectiveness because it’s the saying whenever you overuse one of the components of your tool that it dilutes the impact of it. I think we’ve probably seen some dilution.
Derek:
All right, I’m going to hop on one more chart, which has really been the story of this year in particular. Everyone talks about the market being expensive and maybe there’s a ceiling if we’re at 20 times earnings on the S&P index, but especially Dave as you know from studying individual stocks at all capitalizations, there’s a pretty wide range of where things sit. I thought we’ve seen this in a couple of different forms, but I thought this might be a good one for you to go through a little bit.
Dave:
Yeah, it felt like this year has just been a stock market, not a market of stocks. With that latter comment there, a market of stocks underneath the hood of whether it’s the S&P 500, Russell 2000, Russell 2000 value, our entire equity team is still finding opportunities and stuff that we think that there is value out there. Yes, 20 times future earnings on the S&P 500 does seem expensive. If you look at this chart here, it’s showing that the S&P 500, or basically the magnificent seven are trading at 32 point times [inaudible 00:21:16] forward earnings, but if you look at the average stock itself, it’s trading closer to 16.8 times.
That’s a lot more palatable in my mind. That’s why I think we’ve talked a lot about having more of an exposure to an equal weight S&P 500 over a market cap weight, or at least the introduction of some type of tilt to the average stock is pretty important right now. We’re finding a lot of opportunities out there on the individual stock basis and that gives me a lot of optimism I think for the equity markets into the future, even though we’re looking at the S&P 500 trading at 20 times. Like I said, it’s really a market of stocks instead of a stock market probably moving forward.
Derek:
Makes sense. I think a lot of what we’ve seen out of this is people have pinned their hopes on lower valuations. It’s almost, you could also put in the chart on the US versus Europe and versus the rest of the globe. The US has been at a premium multiple for years and people have been burned trying to buy those lower valuation international stocks. You wonder at some point if they’ve just given up and does that set up opportunity. I guess that’s where we sit now. Everyone certainly knows the story.
John Luke:
No, I think that some of these small caps and smaller market capitalization companies where they’re getting exposure to some of this infrastructure spending that’s in place and the re-shoring where maybe that’s being overlooked at the allocation level or where people are allocating dollars because as we move industry back to the US, we re-shore things. We have manufacturing and stuff that’s coming from China, not coming from China, but coming from the US or coming from Mexico, that these companies are going to have to be highly invested in in terms of actually making that happen. I think that is sort of a green shoot for small caps and I’m sure Dave agrees with that.
Dave:
A hundred percent. Here’s where my mind is. My biggest worry for the [inaudible 00:23:26], and I don’t want to open up a whole new can of worms here because we’re probably pressing up on time restraints right now, but it’s exactly what you’ve mentioned there, John Luke, that there is a lot of re-shoring going on in the United States, but it’s very concentrated to a very few [inaudible 00:23:40] state. It’s Tennessee, Ohio, Michigan, Indiana, Texas. You’re not going along the coastlines by any means. When we just spoke about the Fed and a lot of its monetary policy that they’re working on right now in this inflation environment, Fed policy is monolithic. The change that they make at the monetary level, whether it’s on interest rates or whatever they’re trying to pack from a labor situation, it’s broad based across the entire United States.
When I think that re-shoring aspect that we’re talking about here that will benefit small caps, it’s very centralized in a few areas. I think that there’s going to be a pretty big divergence in our country five, ten years from now that not everything is created equal. There’s going to be a disparity amongst geographical regions in the United States where Fed policy may not be as effective as they exactly want it to be because it’s only really affecting a small part of the company as a whole.
John Luke:
Yep. Great point.
Derek:
Awesome. All right, well as everyone knows, there’s a lot of gray, the markets are not as black and white as our services might be, so I’m going to give a plug for some of the work you guys do behind the scenes. Well, you guys and the rest of the CFAs. I think one thing that we’re really, really good at is helping advisors grow, helping them compete for and win and transition and manage high net worth accounts in particular, you guys have both been instrumental in helping someone who’s got a big individual bond portfolio or they bring over an SMA that’s got 200 stocks in it. That stuff’s a pain in the butt for an advisor to figure out from a tax standpoint and just the logistics of, “Okay, great, I can win this $3 million account, but what am I going to do with it? How am I ever going to get it into my models?”
I think I’m going to give a plug, less of a three pointer more of a slam dunk, I’m going to give a plug to if anyone has any of those accounts they’re trying to get or wants to learn more about how we can help with that stuff. I don’t know, I volunteer you guys all the time to help with that stuff and thankfully you take us up on it.
John Luke:
Yeah, thanks D. Hern. Great point.
Derek:
Well that’s good. I think we probably weren’t quite as quick as I would like, but that’s because you guys have good ideas and lots to talk about. It’s good though. I think we’ll do this every month and I would invite advisors to chime in and throw any questions our way that you might want to have discussed. I’ll thank you guys and hope y’all have a great weekend.
John Luke:
Thanks guys.
Dave:
Good day.
Disclosures
Past performance is not indicative of future results. This material is not financial advice or an offer to sell any product. The information contained herein should not be considered a recommendation to purchase or sell any particular security.
The opinions expressed are those of the Aptus Capital Advisors Investment Team. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Forward-looking statements cannot be guaranteed.
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