Is discretion the better part of valour | The Green Line

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16 June 2023

It’s been a tough year so far for investors who have a cautious view on markets.

Equity indices seem hellbent on restoring last year’s losses, but have relied on just a handful of stocks in the S&P 500 for all the gains, and safe havens have proved both elusive and costly. All this against a backdrop of high and persistent inflation, the highest interest rates this century and a growing threat of a recession.

For the moment, discretion is looking very much the worse part of valour. So can stockmarket valuations offer some guidance? Or has AI changed everything, immediately, including the relationship between risk-free returns on cash and the attractiveness of equities?

This month’s chart compares the earnings yield on US equities with the risk-free return available on cash. Not exactly the traditional bond equity ratio or the Fed model, which compares the earnings yield on the stockmarket with benchmark bond yields.

With the PE ratio on the S&P 500 around 18x, the earnings yield is currently 5.5%. This isn’t of course the actual cash yield you will get from owning equities; that is much lower, however you calculate it. Rather, it represents the profits potentially due to equity owners if companies paid out all of their profits without making any investments or capital expenditure or paying down debts.

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A 5.5% equity earnings yield is low. It has only been lower in 1999-2000 and 2020-2021. What is immediately striking, though, is how little yield premium equities are offering over the official interest rate of 5.25%. Good luck in getting that official rate from a bank savings account. But investors can get this rate, risk-free, directly from the Federal Reserve by buying US money market funds. Not surprisingly, money is flying into these accounts at record rates, though so far overwhelmingly out of bank deposits rather than the stockmarket.

We fear this flight to a safe return of over 5% could soon tempt equity investors to cash in too. Cash has only been such an attractive alternative to equities twice before during this century: in 2000 during the technology, media and telecoms (TMT) bubble, when the equity/cash premium actually went negative; and in 2007, just before the global financial crisis. Neither period ended well for equity investors, and we fear a similar outcome could be lying in wait for markets now.

Even more worrying is what happened after each of these previous crises. The market collapses in both 2000 and 2008 were immediately ‘medicated’ by dramatic interest rate cuts, supporting both equity markets and the real economy.

Today, no such rescue looks likely. With inflation proving more persistent than they promised, central bankers would have to choose between monetary stability (fighting inflation) and financial stability (supporting markets). Without a full-blown recession, there may be no room for rate cuts to bail out financial markets.

Add into this worrying picture a TMT-like boom concentrated in just a few US stocks (year to date, the unweighted S&P 500 is actually down in price terms).

For us, this certainly looks like a situation where discretion may still prove to be the better part of valour. So, whilst taking a cautious view so far this year has been painful, we think the evidence suggests that caution may win out.

#inflation

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Piers Wheeler

Director – Institutional

T +44 (0)20 7963 8258

Developing and executing asset management strategy for capital raising and strategic relationship management. Coverage includes EMEA, Asia and Australia. Piers joined Ruffer in 2021, having previously worked with asset management firms including Eastspring, AMP Capital and LEK as a strategic consultant. He holds a MA from the Bayes Business School and a BA (Hons) from the University of Oxford.

Annabel Paterson

Senior Associate – Institutional

T +44 (0)20 7963 8123

Joined Ruffer in 2021, having graduated with a first class honours degree in land economics from the University of Cambridge. After two years working with the UK Private Wealth team and completing her IMC and CFA Level I qualifications, she now supports Ruffer’s global business development and client servicing efforts.

Articles by Annabel

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Is discretion the better part of valour?