Global Investment Strategy

Weekly market insights and possible impacts on investors from the Wells Fargo Investment Institute Global Investment Strategy team.

February 13, 2017

Chris Haverland, CFA, Global Asset Allocation Strategist

Are the Capital Markets Priced for Perfection?

  • Many equity indices have reached record highs, while fixed-income credit yield spreads have declined further in 2017.
  • Given recent moves in the capital markets, some investors may be wondering if valuations are stretched. Our view is that valuations generally remain reasonable, but there are areas of concern.

What it may mean for investors

  • In this environment, we favor maintaining a neutral (to slightly defensive) posture by overweighting Intermediate Term Fixed Income and Public Real Estate, while underweighting High Yield Fixed Income and Small Cap Equities.

Despite policy uncertainty, the capital markets have carried much of the momentum from 2016 into the early part of 2017. Many equity indices have reached record highs, while fixed-income credit yield spreads have compressed further. Although the markets were showing some positive signs prior to the U.S. election, much of the recent movement is likely a reflection of optimism around future fiscal, tax and regulatory policy. Given the recent rally, are the capital markets priced for perfection? In our view, most market metrics remain in fair-value territory, keeping us in a neutral (to slightly defensive) posture.

Our framework for analyzing capital-market conditions includes four primary components (our view is in parentheses):

  • Macroeconomic environment (neutral) —The current macro environment is mixed, with expectations for modest improvement in economic growth.
  • Fundamentals (neutral) —Fundamentals appear balanced, with expectations for some upside in high-quality earnings, but potential downside in low-quality credit trends.
  • Valuations (neutral) —Valuations are reasonable in most asset classes, but there are some areas of concern.
  • Market environment (neutral) —The market environment remains favorable for riskier asset classes, but some trends have cooled lately.

With equity markets reaching all-time highs, some investors may be wondering if valuations are stretched. For equities, a key measure of valuation is the price-to-earnings (P/E) ratio, or the number of dollars that an investor is willing to pay for one dollar of earnings. Since the equity markets are typically priced based on future earnings, we evaluate value using “forward” (or our forecasted) earnings per share (EPS). At the end of January, the P/E ratio for the S&P 500 Index was 17.9x based on our 2017 EPS estimate of $127. This is slightly above the 20-year average of 17.1x and not unusual given the current inflation environment (average P/E ratios have historically been higher when inflation rates were in the 0-4 percent range). We remain tactically evenweight on large-cap equities.

Chart 1. Key Equity-Market ValuationsChart 1. Key Equity-Market ValuationsSource: Bloomberg, FactSet; 2/9/17. Average is calculated from 1/97-1/17; except for the MSCI Emerging Markets Index, for which it is calculated from 10/99-1/17.

Mid- and small-cap equity indices are currently trading above their historical P/E ratios. However, with heightened volatility in these asset classes, we consider the historical median P/E—for which mid-caps are trading in line, while small caps remain above this P/E level. We expect little upside in mid-cap equities (tactically evenweight) this year, and see the potential for downside in small caps (tactically underweight), given the current fundamental and valuation backdrop. International developed-market equities (tactically evenweight) are trading in line with historical averages, while emerging-market equities (tactically evenweight) are slightly above. Similar to U.S. equity markets, we are not expecting significant gains in international equity markets in 2017.

A key valuation measure within the fixed-income credit markets is yield spreads to comparable U.S. Treasury securities. In this case, the lower the spread, the more expensive a credit investment may be. As Chart 2 shows, credit spreads have compressed to levels below long-term averages in U.S. investment-grade corporate bonds, high-yield fixed income, and emerging-market debt (EMD). We prefer higher-quality credit in the intermediate portion of the yield curve and remain tactically overweight in this area. Valuations and leverage trends are a concern in the high-yield fixed income (below investment grade) asset class, and this keeps us tactically underweight. Although EMD spreads are below long-term averages, we see fundamentals as neutral and the market environment showing positive trends, which leads us to a tactical evenweight rating.

Chart 2. Key Fixed-Income Credit Market ValuationsChart 2. Key Fixed-Income Credit Market ValuationsSource: Bloomberg, FactSet; 2/9/17. Average is calculated from 1/97-1/17; except for Emerging Market spreads, for which it is calculated from 8/00-1/17.

Although they provide valuable information, P/E ratios and credit spreads are just two of the metrics that can be used in valuation analysis. Furthermore, valuations are just one of the factors we examine to determine whether an asset class deserves a tactical shift. We also explore valuation trends relative to other asset classes. When valuation extremes exist, it often prompts a tactical shift discussion, but this is not considered in isolation and doesn’t always result in a move. Even in this relatively neutral valuation environment, investors must remain agile and be ready to capitalize upon opportunities as they present themselves.

Risk Factors

All investing involves some degree of risk, whether it is associated with market volatility, purchasing power or a specific security. Stocks offer long-term growth potential, but may fluctuate more and provide less current income than other investments.

The prices of small and mid-cap company stocks are generally more volatile than large company stocks. They often involve higher risks because smaller companies may lack the management expertise, financial resources, product diversification and competitive strengths to endure adverse economic conditions.

Investments in fixed-income securities are subject to interest rate and credit 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. 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.

Investing in foreign securities presents certain risks not associated with domestic investments, such as currency fluctuation, political and economic instability, and different accounting standards. This may result in greater share price volatility. These risks are heightened in emerging markets.

There are special risks associated with an investment in real estate, including the possible illiquidity of the underlying properties, credit risk, interest rate fluctuations and the impact of varied economic conditions.

Definitions

S&P 500 Index is a market capitalization-weighted index composed of 500 widely held common stocks that is generally considered representative of the US stock market.

The Russell Midcap® Index measures the performance of the 800 smallest companies in the Russell 1000 Index, which represent approximately 25% of the total market capitalization of the Russell 1000® Index. 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. 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 2000® Index measures the performance of the 2,000 smallest companies in the Russell 3000® Index, which represents approximately 8% of the total market capitalization of the Russell 3000 Index.

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 US & 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.

An index is unmanaged and not available for direct investment.

Global Investment Strategy is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly-owned subsidiary of Wells Fargo & Company and provides investment advice to Wells Fargo Bank, N.A., Wells Fargo Advisors and other Wells Fargo affiliates. Wells Fargo Bank, N.A. is a bank affiliate of Wells Fargo & Company.

The information in this report was prepared by the Global Investment Strategy division of WFII. Opinions represent GIS’ opinion as of the date of this report and are for general information 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.

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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