October 20, 2024 – Over the long term, stock prices tend to revert to their intrinsic value, as determined by the present value of their future cash flows.
The problem with the long term is that it is… well, long.
Nevertheless, research by economists such as Robert Shiller (using the cyclically adjusted P/E ratio) has shown that the lower the valuation of the market at the time of investment, the higher the average returns over the following decade. Conversely, investing during periods of high valuations often results in lower returns.
If stocks are undervalued at the time of purchase, there’s the potential for above-average returns as securities appreciate to their fundamental fair value. Conversely, buying overvalued stocks can lead to subpar returns when prices adjust downward, in line with their historical valuations.
During market booms, such as the tech bubble in the late 1990s, stocks can become significantly overvalued, leading to poor returns once valuations normalize. After the tech bubble peaked in 2000, the S&P 500 generated a negative total return over the subsequent decade. Conversely, during bear markets, including the 2008-2009 financial crisis, low valuations can provide fertile ground for strong long-term returns as the market recovers.
Focusing on valuations also acts as a form of risk management. Buying overvalued stocks increases the risk of losses if market sentiment changes or fundamentals deteriorate.
Therefore, it is important for capital allocators to be aware of equity market valuations and what those valuations mean for expected future returns.
Since the great financial crisis, U.S. large cap equities have significantly outperformed international stock markets. While superior earnings growth has been one of the drivers, multiple expansion has also contributed. One result of the substantial relative outperformance of U.S. equities is its inflated valuation compared with other equity markets and its historical average.
Currently, the S&P 500 trades at 21.0x next year’s forecast earnings, which is 40% above its historical average valuation of 15.0x forward earnings (since 1990).
In comparison, both global (excluding the U.S.) and Canadian stocks are trading at a significant discount to the S&P 500 and closer to their historical average valuation.
Absolute and relative valuations are essential in asset allocation because of the implications for forward returns and risk.
Given the U.S. market’s current lofty stock market valuation, Goldman Sachs forecasts a below average baseline return of 3% annualized (within a forecast range of -1% to +7%) for the S&P 500 over the next ten years.
While it is impossible to pinpoint exactly how future returns will play out, it is unlikely that the next decade of U.S. equity returns will match those of the past ten years.
Nonetheless, a note of caution with respect to forecasts is warranted. It is often said forecasting is the art of saying what will happen and then explaining why it didn’t.
While valuation alone is not the sole determinant of returns (earnings growth, interest rates, and macroeconomic factors also play key roles), it is one of the most crucial drivers. Understanding valuations can help investors make informed decisions about when to increase or reduce allocations to stocks and manage expectations about future returns.
Essentially, the price you pay affects the return you get—so investing at attractive valuations is a fundamental principle of sound investing. Investing at above average valuations makes high returns unlikely while leading to increased downside risk.
While there has been a bear market in diversification, as investors flock to what has worked for so long (i.e. the S&P 500 or Nasdaq indexes), we still believe a diversified approach is prudent. Maintaining upside equity market potential, while hedging with short positions to mitigate downside risks, may help investors navigate the current environment of historically inflated U.S large cap growth stock market valuations.
Below, we highlight one top-decile stock expected to outperform and one bottom-decile stock expected to underperform in this month’s AlphaRank Top Stocks.
OUTPERFORM: NRG Energy, Inc. (NYSE: NRG) is a leading integrated energy company in the U.S., focused on producing and selling electricity, energy services, and sustainable energy solutions. NRG Energy offers a blend of growth, income, and exposure to the renewable energy transition, powering the infrastructure behind the AI revolution. NRG has a history of strong free cash flow generation, which supports both capital investments and shareholder returns through dividends and share buybacks. NRG’s 23% return on capital, in addition to its valuation of 9x EBITDA, offers an attractive mix of quality and value for investors. We believe its positive share price momentum will continue. Disclosure: Long NRG in the Accelerate Absolute Return Fund (TSX: HDGE, HDGE.U).
UNDERPERFORM: The Boeing Company (NYSE: BA) is one of the largest aerospace and defence companies in the world, known primarily for its commercial airplanes. BA manufactures and sells aircraft such as the 737, 747, 767, 777, and 787 Dreamliner. Boeing has faced significant production issues, particularly with the 737 MAX and the 787 Dreamliner. Persistent delays in deliveries, coupled with recurring quality control problems, have eroded trust among customers and regulators. The production challenges have also increased costs and delayed revenue recognition, creating downside risk for the stock if these issues persist or worsen. Boeing has a high debt load, with the company taking on significant debt to weather the COVID-19 pandemic and cover production costs for the 737 MAX grounding. As of mid-2024, Boeing’s total debt remains around $57 billion. BA’s persistent operating losses, along with its high debt load, make future equity issuance and shareholder dilution likely. In addition, the company’s high valuation, negative share price momentum, and recent quarterly miss (a signal of poor operating momentum) further support the case for continued underperformance. Disclosure: Short BA in the Accelerate Absolute Return Fund (TSX: HDGE, HDGE.U).
The AlphaRank Top and Bottom stock portfolios exhibited poor performance last month:
- In Canada, the top-ranked AlphaRank portfolio of stocks gained 0.8% compared to the benchmark’s 3.1% gain, while the bottom-ranked portfolio of Canadian stocks surged by 11.6%. The long-short portfolio (top – bottom ranked stocks) lost -10.8% in a challenging month. Over the past five years, the top decile AlphaRank portfolio has risen by 150%, while the bottom ranked portfolio has gained approximately 20%.
- In the U.S., the top-decile ranked equities rose by 1.5%, underperforming the S&P 500’s 2.1% gain. Meanwhile, the bottom-ranked stocks gained 2.8%%, leading to a 1.3% loss for the top decile minus the bottom decile long-short portfolio. Over the past five years, the top-ranked U.S. equities have gained more than 120%, while the bottom-ranked portfolio has fallen by more than -20%.
AlphaRank Top Stocks represents Accelerate’s predictive equity ranking powered by proven drivers of return. Stocks with the highest AlphaRank are expected to outperform, while stocks with the lowest AlphaRank are anticipated to underperform. AlphaRank assigns a numeric value to each security from zero (bottom-ranked) to 100 (top-ranked) based on selected predictive factors. All Canadian and U.S. stocks priced above $1.50 per share and $100 million in market capitalization are evaluated. In both the Accelerate Absolute Return Fund (TSX: HDGE) and the Accelerate Canadian Long Short Equity Fund (TSX: ATSX), Accelerate funds may be long many top-ranked stocks and short many bottom-ranked stocks. See AccelerateShares.com for more information.
