Don't give up on the tried and trusted

There is a considerable degree of trepidation as we head into the Q2 company earnings reporting season. It is obvious that earnings will have taken a huge hit as consumer demand collapsed across the board. However, the main focus will be on guidance as investors treat the last three months as bygones. Dow Jones reported at the start of July that 157 S&P500 companies had reduced their outlook as of end-June with just 23 providing upgrades, whilst 180 have pulled them altogether which suggests that markets will be flying blind for a while to come.

Current consensus estimates point to a fall of around 30% in S&P500 Q2 earnings relative to Q1, which follows a 15% decline in Q1. If realised, this will put Q2 earnings around 45% below year-ago levels. Even assuming a rebound in the second half, the consensus suggests we are set for a 25% decline in 2020, which would be close to the 28% decline registered in 2008. It would not take a huge miss on the numbers to record the worst year for US corporate earnings since the 1930s (chart 1).  Moreover the concern is that the consensus is overstating expectations for an earnings rebound. In the wake of the 2008 crash it took more than three years for earnings to get within 10% of the previous cyclical high. This time around, the consensus view is that it can be achieved within 18 months.

 

Valuation metrics also look elevated as markets are priced for perfection. The one-year forward P/E ratio on the S&P500 is trading above a multiple of 25 and the price-to-book ratio is at 3.65 versus a long-term average of 2.65. Under normal circumstances such indicators would set the alarm bells ringing but as we are all too well aware, times are not normal. Discounted future cash flows have been boosted by central bank actions to cut rates to zero, and on the expectation they will not rise anytime soon it is logical that equity prices should rise. The lack of returns in other asset classes further raises the attractiveness of equities. Even sectors which have performed strongly over the past decade, such as property, are struggling. Whilst stocks may look over-bought and there are clearly risks associated with both the earnings and economic outlook, investors cannot bring themselves to bet against a strategy which has worked so well in the post-2008 world.

This impact of low interest rates and their effects on equity markets has once again raised questions of whether the traditional 60/40 portfolio rule is fit for purpose. This famous investment rule of thumb suggests investors should hold 60% of their portfolio in stocks and 40% in lower risk securities such as bonds. In theory this should produce long-term average returns which match equities but by allocating a sizeable chunk to bonds it smooths out the extreme highs and lows associated with an equity-only portfolio. The evidence suggests that this strategy has outperformed over the past 20 years. Using a portfolio in which the available assets are global equities, US Treasuries, the GSCI commodity returns index and an estimate of cash returns in the industrialised world, the 60/40 portfolio generated an average annual return of 4.9% between September 2000 and June 2020.

It has not always been the optimal portfolio. Immediately prior to the Lehman’s crash, the 60/40 portfolio was one of the poorer performers largely because it took no account of the commodity boom that was building at the time. Indeed, I well remember being told in 2006-07 that no self-respecting portfolio manager could afford to ignore commodities because returns were uncorrelated with other financial assets and consequently they enhanced portfolio risk diversification. How times change: Commodities are down 84% from their peak achieved in summer 2008 and they have proven poisonous to investor returns. The 60/40 portfolio has outperformed both safe and risky structures which assign varying non-zero weights to commodities and cash. Moreover, as the Credit Suisse hedge fund returns index shows, this simple strategy has matched hedge fund strategies in recent years which – given what investors pay hedge funds to manage their money – is a poor show on their part (chart 2). All told, on a 20 year horizon the 60/40 strategy has generated higher returns once hedge fund fees are taken into account.

This is not the first time the 60/40 strategy has been called into question – it seems to arise every time one or other of the markets appears out of whack. On this occasion low interest rates mean that the returns from bonds are likely to look very poor for years to come. But investors tempted to overweight equities, which are likely to benefit as a consequence, run the risk of getting caught out by volatility as markets continue to question whether current price valuations are justified (we can expect quite a lot of that in the months ahead). Since the intention of 60/40 is to offset the extreme highs and lows of equities, it may be worthwhile sticking with it for a bit longer. It is after all, a tried and trusted method and that is not a bad thing in our new, uncertain investment world.