Global Equity Strategy

Weekly discussion of recent equity market action with equity sector highlights and what it may mean for investors.

May 24, 2017

Stuart Freeman, CFA, Co-Head of Global Equity Strategy
Scott Wren, Senior Global Equity Strategist

Large-Cap Stocks versus the 10-Year Treasury Yield

  • When compared with the yield on the 10-year Treasury note, the S&P 500 Index’s earnings yield now is more in line with historical averages than has been the case in recent years.
  • With U.S. interest rates expected to rise, the relative attractiveness of U.S. large-cap stocks versus Treasury bonds may deteriorate as we move through the balance of 2017.

What it may mean for investors

  • Domestic stocks are not nearly as attractively priced versus bonds as they were in 2011 and 2012. As a result, we moved our U.S. large-cap equity position to evenweight from overweight earlier this year.
  • We recommend that investors take this opportunity to rebalance portfolios to bring allocations more in line with their appropriate strategic guidance, based on their tolerance for risk. In our view, market pullbacks into our year-end target range represent buying opportunities in the more cyclical sectors of the equity market.
speedometer reading of equities: large cap, mid cap, developed markets, small cap, and emerging-market.

We regularly analyze the valuation of the S&P 500 Index versus the 10-year Treasury note yield. Stock valuations tend to be set in the marketplace—sometimes based upon forward growth rates, sometimes based upon changes in inflation expectations, and sometimes based upon current or expected changes in bond interest rates.

Stocks compete against other financial vehicles (like bonds) for investor interest. When the 10-year Treasury note yield was above 6 percent in 1999 and 2000 (in the technology-stock boom), S&P 500 Index price/earnings (P/E) valuations were near (or at) 30x. This represented a dramatic overvaluation for stocks (and, as we know, that overvaluation did not last for long).

Today, when compared with bonds, the S&P 500 Index has been less expensive 31 percent of the time (back to 1996). It had been less expensive relative to bonds only 1 percent of the time as of September 2011, when the 10-year Treasury yield and P/E valuations were low. It had been less expensive than the 10-year Treasury yield only 14 percent of the time as of February 2016. Since those two points in time, both S&P 500 Index P/E ratios and the 10-year Treasury note yield have increased, decreasing the relative attraction of U.S. stocks. As we suggested earlier, the S&P 500 Index has been less expensive (versus the 10-year Treasury note) 31 percent of the time back to 1996, and more expensive 69 percent of the time.

In Chart 1, we have plotted the relative valuation of the S&P 500 Index earnings yield (earnings divided by price) relative to the 10-year Treasury note yield. On the top portion of the graph, stocks appear attractive versus bonds. Note that the relative attractiveness of U.S. large-cap stocks versus bonds peaked in 2011 and 2012. These years represented excellent opportunities to acquire large-cap domestic stocks, and we had been recommending that investors overweight large-cap U.S. stocks for most of this cycle (until early this year). Now, as Chart 1 shows, relative valuation is approaching (but has not yet reached) a more average level. We have plotted the 20-year average relative valuation level with a dotted yellow line. We must point out that the very expensive relative valuation period, particularly in 1999 and 2000 (during the dot-com bubble), tends to overemphasize how expensive stocks can become. Both the absolute valuation of stocks and the relative valuation were extreme at that time, and the data tends to pull down the average valuation line. In other words, while we are not fans of pulling data out of historical data streams, valuations during several years in the 1990s were not at all in keeping with the true earnings growth that was taking place during that period. Instead, investors were paying for extreme levels of earnings (particularly technology earnings) that they hoped would result over the following few years.

Chart 1. S&P 500 Index Earnings Yield Relative to 10-Year Treasury Note YieldChart 1. S&P 500 Index Earnings Yield Relative to 10-Year Treasury Note YieldSources: Wells Fargo Investment Institute, Bloomberg. Data as of 5/22/17. Yields will fluctuate as market conditions change. Past performance is no guarantee of future results. An index is unmanaged and not available for direct investment. SPX = S&P 500 Index.

It also is important to keep in mind that we are most likely moving into a period during which Treasury yields will rise slowly. We anticipate a yet higher Treasury note yield in 2018. Thus, the markets are moving toward environments within which they will slowly face greater competition from other financial-vehicle returns. If we were dealing with today’s market valuations in an environment in which earnings were to continue to grow but rates were to soften, we would have a better case for high P/E valuations on stocks.

The Absolute Valuation of the S&P 500 Index

If one analyzes forward-looking earnings for the S&P 500 Index over time (not relative to other asset classes), the current data (from 1996 to today) would suggest that the S&P 500 Index P/E ratio has been cheaper 66 percent of the time and more expensive 34 percent of the time. If we remove the extreme data from the dot-com period (1999-2000, during which the S&P 500 Index registered a 30x P/E multiple and the Information Technology sector became an outsized portion of the index (with a P/E multiple of roughly 100x), we end up with what we would consider to be a better statistic for historical valuations over the past 20 years. When we remove those two years, the data suggests that the S&P 500 Index has been more attractively priced 80 percent of the time, and more expensively priced only 20 percent of the time.

Again, while we are not fans of removing historical market data points from our analyses, we do believe that an environment with rising yields (and Federal Reserve (Fed) tightening) —along with high absolute P/E multiples and below-historical-average economic growth—represents an environment likely to offer greater volatility than what we have observed over the past year. Also, for some reason, markets have been slow to consider seemingly building political risks. It seems that markets often tend to hope for the best from potential future policy. Until risk appears in reality (whether that risk is geopolitical, budget-related, or related to potentially favorable future policy), equity markets seem to be happy to go with the flow of the last backward-looking data point.

In any event, domestic valuations appear to suggest that above-average market risk, geopolitical risk and policy risk seems to be taking on more signs of concern, while Fed rate increases, even if slow and measured, clearly are in the offing. We are not projecting the end of the domestic economic cycle, but we do believe that complacency within the marketplace may be unreasonably high. Investors should remember that “the VIX” does not tend be a harbinger for future volatility levels.1 It tends to be a coincident indicator (although many take solace in its benign behavior over the past year). We recommend that investors reduce their exposure where they may be overweight versus the allocations of their chosen investment plan, and use any market pullbacks as opportunities to put capital back to work in cyclical sectors where they find that they are underexposed.

Weekly Wrap and Look Ahead

All major domestic and international indices were positive year-to date; most were negative last week.

Index Last Week’s Performance1 2017 YTD Performance
S&P 500 -0.4% +6.4%
DJIA -0.4% +5.3%
NASDAQ -0.6% +13.0%
Russell 2000 -1.1% +0.8%
MSCI EAFE +0.8% +11.8%
MSCI Emerging Markets -0.7% +15.5%

1. For the week of May 15 – May 19, 2017
Sources: Wells Fargo Investment Institute, Bloomberg, 5/22/17

Six of 11 S&P 500 Index sectors outperformed the index. Only four of 11 gained ground on the week.

Best-Performing Sectors
Sector Last Week’s Performance2
Real Estate +1.2%
Consumer Staples +0.6%
Utilities +0.5%
Worst-Performing Sectors
Sector Last Week’s Performance2
Financials -1.0%
Consumer Discretionary -0.8%
Information Technology -0.7%

2. For the week of May 15 – May 19, 2017
Source: Wells Fargo Investment Institute, 5/22/17
Past performance is no guarantee of future results

The S&P 500 Index feels like it wants to trade higher, but it has continued to be trapped in a 65-point range for more than three months. The recent, mild sell-off quickly reversed, and the index has spent the bulk of recent trading sessions toward the top end of that range.

In our opinion, investors are still holding out some hope that U.S. tax cuts would be implemented sooner, rather than later. We think it is more likely that any tax cut will actually be for the 2018 tax year. We have not been of the opinion that the new administration’s fiscal policies (tax cuts, infrastructure spending and meaningfully less regulation) would be debated, finalized or implemented smoothly or quickly. We stand by that long-held statement.

This week’s economic calendar is packed with reports, but the market likely will be paying the most attention to the segment of the durable goods report called “non-defense orders for capital goods excluding aircraft.” This portion of the report is a good gauge of business capital spending. We know that business confidence soared after the election. We also know that businesses want to see some concrete action from Washington before they open their wallets and boost their capital spending. For now, they appear to be sitting on the sidelines and waiting.

Our year-end target range for the S&P 500 Index remains at 2230-2330. In our opinion, second-half headwinds will be valuations and fears that wage pressures will erode profit margins in this modest-growth environment.

Sector S&P Weighting* Wells Fargo Investment Institute Guidance
Consumer Discretionary 12.4% Overweight 14.9%
Consumer Staples 9.3% Underweight 5.5%
Energy 6.3% Underweight 4.0%
Financials 13.9% Overweight 16.4%
Health Care 13.9% Overweight 17.2%
Industrials 10.1% Overweight 11.6%
Information Technoloy 23.0% Evenweight 21.8%
Materials 2.8% Evenweight 3.0%
Real Estate 2.9% Evenweight 3.1%
Telecom Services 2.2% Evenweight 2.5%
Utilities 3.2% Underweight 0.0%
S&P 500 Earnings Estimate for 2017 $127.00
S&P 500 Year-end 2017 Target Range 2230-2330

*Sector weightings may not add to 100 percent due to rounding. Weightings as of 5/22/17. Targets are not guaranteed and may change.
Sources: Wells Fargo Investment Institute, Bloomberg, 5/22/17

Valuations and Fundamentals for Five Primary Equity Asset Classes Valuations and Fundamentals for Five Primary Equity Asset Classes *Enterprise Value.
Source: Enterprise Value. Sources: Wells Fargo Investment Institute, Bloomberg, 5/22/17. Developed Markets: MSCI EAFE Index (Europe, Australasia, Far East). Emerging Markets: MSCI Emerging Markets Index.

1 The VIX is the Chicago Board Options Exchange (CBOE) Volatility Index.

Risk Factors

All investing involves risks including the possible loss of principal. Equity securities are subject to market risk which means their value may fluctuate in response to general economic and market conditions and the perception of individual issuers. Investments in equity securities are generally more volatile than other types of securities.

Investments in fixed-income securities are subject to market, interest rate, credit/default, liquidity, inflation and other risks. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline in the bond’s price. Credit risk is the risk that an issuer will default on payments of interest and principal. This risk is higher when investing in high yield bonds, also known as junk bonds, which have lower ratings and are subject to greater volatility. If sold prior to maturity, fixed income securities are subject to market risk. All fixed income investments may be worth less than their original cost upon redemption or maturity.


An index is unmanaged and not available for direct investment.

Chicago Board Options Exchange Volatility Index (VIX) is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices.

DJIA is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange and the Nasdaq.

MSCI EAFE Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. The Index consists of the following 21 developed market country indexes: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom.

MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. The MSCI Emerging Markets Index consists of the following 23 emerging market country indexes: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Peru, Philippines, Poland, Qatar, Russia, South Africa, Taiwan, Thailand, Turkey and United Arab Emirates.

NASDAQ is an unmanaged group of the 100 biggest companies listed on the NASDAQ Composite Index. The list is updated quarterly and companies on this Index are typically representative of technology-related industries, such as computer hardware and software products, telecommunications, biotechnology and retail/wholesale trade.

The Russell 1000® Index measures the performance of the 1,000 largest companies in the Russell 3000 Index, which represents approximately 92% of the total market capitalization of the Russell 3000 Index.

Russell 2000 Index measures the performance of the 2,000 smallest companies in the Russell 3000® Index, which represents approximately eight percent of the total market capitalization of the Russell 3000 Index.

The Russell 3000® Index measures the performance of the 3,000 largest U.S. companies based on total market capitalization, which represents approximately 98% of the investable U.S. equity market.

Russell Midcap® Index measures the performance of the 800 smallest companies in the Russell 1000 Index, which represent approximately 25 percent of the total market capitalization of the Russell 1000® Index.

S&P 500 Index is a market capitalization-weighted index composed of 500 widely held common stocks that is generally considered representative of the U.S. stock market. The Index is unmanaged and not available for direct investment.

Global Investment Strategy (“GIS”) is a division of Wells Fargo Investment Institute, Inc. (“WFII”). WFII is a registered investment adviser and wholly-owned subsidiary of Wells Fargo & Company.

The information in this report was prepared by the GIS division of WFII. Opinions represent GIS’ opinion as of the date of this report and are for general informational purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.

The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor. This report is not intended to be a client-specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon.

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