The S&P 500 Index is continuously reaching new all-time highs. Will the rally continue?
Jeffrey Sherman: The S&P 500 is relatively expensive in historical terms. The good news is that the rally is driven by the technology sector, which has above-average earnings growth. The overall market is thus narrowly concentrated on a handful of stocks, making the valuation appear quite rich from a historical perspective.
An argument for the high valuation is the earnings yield compared to the yield on ten-year government bonds?
Both yields are roughly on par. Therefore, stocks are not really expensive compared to bonds. Rather, the US economy is robust, and earnings growth is appropriate for the cycle. Not only the real gross domestic product (GDP) but also the nominal GDP is relatively strong, pushing the stock market upwards.
Is persistent inflation not a problem?
A bit of inflation in small doses is quite good for the stock market because prices are obviously set in nominal dollars. From this standpoint, it is hardly possible to expect a decline in the short term, even if prices are not cheap in historical terms.
Can companies that meet earnings expectations expect further rising stock prices?
Certainly, as at this point everything is a function of corporate earnings. The future earnings prospects for the S&P 500 are still quite rosy, and we expect earnings growth of about seven percent for the current calendar year. However, we currently recommend investors not to invest directly in the S&P 500 Index but to consider two alternatives: the Fortune 500 Equal Weight ETF and the DoubleLine Shiller CAPE U.S. Equities ETF.
What is the reasoning behind this?
On one hand, with the DoubleLine Shiller CAPE U.S. Equities ETF, we have a sector rotation product based on the Case-Shiller Index's valuation of stocks. On a monthly basis, it screens for the five most attractively valued sectors of the 11 sectors comprising the S&P 500 Index. To avoid falling into so-called value traps, the strategy eliminates from those five value sectors the sector with the worst trailing 12-month return and invests with equal weightings in the remaining four. This seems to be a more reasonable strategy as certain sectors in the US have become quite expensive.
How does the Fortune 500 Equal Weight ETF differ, for example, from the SPDR S&P 500 ETF Trust?
The Fortune 500 list has been published for about 80 years. While the S&P 500 Index weights companies based on market capitalization, Forbes ranks companies based on their revenues. This identifies the largest revenue-generating companies in the US. We follow a process that equally weights the securities and adjusts them quarterly. As with the Case-Shiller Index, the multiplier measured by the price-to-earnings ratio is significantly lower than the S&P 500. These are two alternatives we offer to investors.
Is now the right time to invest more in value stocks instead of technology?
Technology stocks have been the leaders in price gains globally. Most of this is in the US, where earnings growth is very pronounced. This has generally lifted stock prices and broadened the rally. For the moment, however, the lack of interest rate cuts is putting some pressure on value stocks.
Are high interest rates problematic if they remain high for an extended period?
Higher interest rates are mainly a headwind for small companies, especially in the past year and a half. Blue-chip companies or higher-quality names have refinanced significant amounts of debt in the capital markets in 2020 and 2021 – and with very long maturities. This allowed them to secure financing at attractive terms for a longer period. In the small-cap sector, companies do not have as much access to the corporate bond market. These "riskier" companies have to dig deeper into their pockets for refinancing, and due to the high financing costs, it is a market with shorter maturities. Many smaller companies do not want to issue 30-year bonds at high interest rates. They try to improve the company and refinance later.
Will the Federal Reserve (Fed) stick to high interest rates?
In our base scenario, we expect a rate cut by the end of the year. Considering how volatile inflation data has been in recent months, the Fed is likely to keep the policy rate unchanged throughout the summer. It would probably take at least three positive improvements in the inflation rate for the Fed to attempt a rate cut this year. Therefore, there is a high risk that there will be no rate cuts this year, and we will see the first cut at the beginning of next year.
So there will be no new rally in the US bond markets soon?
At the moment, I believe the bond market is fairly valued. In the last three months, it has been a one-way street, and yields have risen significantly, especially at the long end. At the beginning of the year, more than six rate cuts were priced in. That was simply too much and too aggressive.
Are US government bonds attractive?
The best part of the yield curve is at the front end with shorter maturities. That makes sense today.
For investors with a long-term horizon, do 4.5 percent yields on a 10-year US Treasury bond seem attractive?
That’s right. When you look at it in terms of real yields, it is attractive. Investors should not lose sight of inflation, though. It is quite possible that inflation will hover around three percent over the next five years. I think the bond market will price in inflation again, and there will continue to be an attractive risk premium.
Do you see risks for the US economy and the stock market?
The biggest "risk" in the US is the labor market. We know its resilience thanks to falling quit rates, few applications for unemployment benefits, and the general labor shortage. Therefore, the labor market is the key variable. The bad news is that employment is usually the last thing to break in the economy. Companies do not lay off people because they believe managements think the economy might enter a recession. They do it because either the economy is already in a recession or their company is in trouble. That's usually what drives layoffs.
Labor market data has recently weakened slightly?
If you had asked me two years ago whether 175,000 new jobs per month in 2024 would be a good number, I would have cheered. Previously, we were simply spoiled with over 300,000 new jobs per month. An important factor is the slowdown in wage growth. This contributes to the Fed feeling more comfortable with its inflation targets. In general, this is positive.
Will there be a recession in the US?
At this point, I do not expect a recession in 2024. Of course, this is not a certainty, as things can change quickly. But given the strength of the US economy, a recession is hard to see.
Will the dollar continue to benefit from this?
In general, European markets are better positioned today, and of course, Switzerland is different – it goes its own way. From this standpoint, however, it is still hard to imagine the dollar weakening significantly in the near term.
Why is that?
One reason is the newfound resilience of the Fed to keep rates higher for longer. Personally, as a dollar investor, I do not want to own another currency today. I have the luxury of investing in dollars. The dollar is currently very strong, and it is really hard to imagine this changing – unless there is a radical shift at the Fed that accelerates possible rate cuts.
Jeffrey Sherman has been, along with Jeffrey Gundlach, Chief Investment Officer of the American investment company DoubleLine since 2009 and personally manages the DoubleLine Global Diversified Credit Fund. Previously, he was a portfolio manager and analyst in the Fixed Income division at the asset management firm TCW. Before that, he was a lecturer in statistics and mathematics at the University of the Pacific and Florida State University, and taught at the CFA Institute. Sherman, who lives in Los Angeles, also holds degrees in mathematics and financial engineering.
