Navigating Risks Amid High Prices and High Hopes

Navigating Risks Amid High Prices and High Hopes

Recognizing market trends, understanding their impact and knowing what to do next. That’s the purpose behind our semi-annual resource, Investment Themes. In a quick-dive format, our investment professionals sum up the current market environment into key themes, examine their potential effects on investments and provide considerations for clients’ portfolios to address those issues.

In the first of our three-part series, we explore how market expectations are stretching stock valuations, pushing U.S. stocks to record highs. Despite the momentum, hope is not a viable investment strategy. Here, we provide ideas for navigating the risks inherent in a stretched-valuation environment.

What to Know

EQUITY VALUATIONS IN THE U.S. ARE CLIMBING

U.S. stock indices reached new highs following the U.S. presidential election. The S&P 500® Index has reached its third highest CAPE ratio peak since 1920, surpassed only by the dot-com bubble of 1999 and Black Tuesday in 1929. This indicates that its price (driven by investor expectations) is elevated relative to its actual historical earnings.

Are Investors Driving Up Valuations?

S&P 500 Index Cyclically Adjusted Price-Earnings (CAPE) Ratio

Are Investors Driving Up Valuations?
Source: FactSet. Data from 1/1/1920 to 6/30/2017. Cyclically Adjusted Price-to-Earnings (CAPE) Ratio measures the valuation of the U.S. equity market, usually the S&P 500® Index, calculated by dividing the price by the average inflation-adjusted earnings for the past 10 years.

While the overall market’s valuations are stretched, we see pockets of opportunity. More importantly, however, we will avoid overexposure to stocks “priced to perfection,” as they tend to have much more downside potential during corrections.

OVERVALUED STOCKS ARE VULNERABLE TO ADDITIONAL RISKS

While expectations that a Trump presidency will be pro-growth seem reasonable, the actual impact will not crystallize until policies move forward. These uncertain policy outcomes, coupled with higher interest rates, inflation and trade restrictions, could create headwinds.

What to Consider

IN THE U.S., BE SELECTIVE

For investors seeking to maintain U.S equity allocations, in-depth, company-level research is critical. Look to company fundamentals, such as quality, valuation or accelerating earnings growth. In recent years, macroeconomic trends and global bank policies pushed stock prices higher, regardless of fundamentals. But this changed after the U.S. presidential election, with more dispersion in stock performance and clear winners and losers. We believe in-depth, company level research is critical as stocks should be purchased on their own merits.

CONSIDER UNCORRELATED SOURCES OF RETURN

Since traditional equities may not always drive portfolio returns in a given market cycle, we believe alternative strategies deserve strong consideration. Long/short equity and equity market neutral strategies may help mitigate the impact of market declines and improve risk-adjusted return potential. Historically, these investments have had lower or negative correlation to the S&P 500 Index. In addition, we believe they’ll benefit from rising rates and the increased performance dispersion among stocks.

  • Long/Short Strategies – Participate in positive market environments and seek to outperform during periods of negative stock market returns.
  • Equity Market Neutral Strategies – Designed to seek positive returns regardless of equity market performance.

What’s Correlated (Or Not) with U.S. Large Caps?

In the chart below, one equals a perfect correlation, where the investments moved in tandem; -1 equals opposite movement; and zero equals no relationship.

20-Year Correlation of Various Asset Classes with S&P 500 Index
Foreign Large Caps 0.85
Foreign Small/Mid Caps 0.77
Emerging Markets Equity 0.77
Long/Short Equity 0.74
Global Real Estate 0.67
Emerging Markets Bond 0.60
Commodities 0.25
Intermediate-Term Bond 0.17
Inflation-Protected Bond 0.08
Market Neutral  -0.16

Source: Morningstar Direct. Data as of 6/30/2017. Correlations represented by Morningstar categories.

For our full discussion of stretched valuation and other themes, review our 2017 Mid-Year Investment Themes.

Alternative mutual funds often hold a variety of non-traditional investments and often employ more complex trading strategies than traditional mutual funds. Each of these alternative asset classes and investment strategies have unique risks, typically making them more suitable for investors with an above average tolerance for risk. Investors should fully understand the asset classes, investment strategies and their risks before investing.

The opinions expressed are those of Matt Oldroyd and are no guarantee of the future performance of any American Century Investments fund.

This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.