Are we entering a new bull market? The S&P 500 recently hit a high of 4,607 at the end of July, just 4% from its all-time high of 4,818 at the end of 2021. It currently trades at almost 23 times trailing earnings, which are in a modest decline, while the historic average multiple for the S&P 500 is between 18 and 22. However, those historic multiples are skewed higher by a steadily declining cost of capital over the last 20 years. At the end of 2021, the Fed’s discount rate was essentially zero, yet in the current environment, the risk-free cost of capital is almost 5.5%, approaching levels not seen by the current generation of advisors.
By most measures, the market is at least fairly valued based on earnings, if not meaningfully overvalued. Either the P or the E is not correct, or markets are thinking about valuations differently these days. Perhaps earnings are about to accelerate, which could be driven by a tight labor market as well as strong consumer and AI-driven productivity gains. We may be, as seems to be readily accepted on your business channel of choice, entering a new bull market.
But what if the P, not the E, is what needs to change? Given this backdrop, we have a few suggestions to help you and your clients navigate through what might be a turbulent time.
Diversification and Disciplined Rebalancing
Diversification is possibly the most underappreciated, yet most powerful strategy for return enhancement for any investor, be they institutional or individual, large or small. Diversification, over time, provides numerous benefits for advisors. First, it allows for a far more predictable investment outcome, especially over time. A concentrated portfolio of investments, either of asset class or individual investment, cannot be a strategic portfolio, because the unpredictability of outcomes makes it impossible to plan for growth, liquidity or income. Secondly, when coupled with disciplined rebalancing, diversification lends itself to the time-tested investment discipline of buying low and selling high. Over an investment cycle, disciplined rebalancing allows for better entrance and exit levels for all asset classes and allows the advisor to maintain the predictability of outcomes necessary for any thoughtful financial plan.
An Allocation to Cash and Liquidity
It’s always good to have a little extra gas in the tank, just in case of unexpected detours, traffic jams or sightseeing opportunities. The same is true for the investment journey, where liquidity (cash) is the fuel that allows you to survive or profit from the unexpected. The reality is that the more uncertainty there is in the route of the journey, the more gas or liquidity you need. As of writing this, uncertainty is pretty high. However, cash just like gas, comes at a cost. In the case of cash, it’s not price per gallon, but the foregone opportunity of higher returns in other investments where the risk inherent in the investment necessitates the expectation of a greater return. For more than a decade, the Federal Reserve has set the price (opportunity cost) of cash very high. Almost every other asset class has a positive expected return. Until the recent hiking cycle, the Fed intentionally set the return of cash near zero nominally, and negative in real (inflation-adjusted) terms. Hence the high price of cash relative to any other investment over the last decade or more. Conversely, the recent rate hikes from the Fed have massively increased the nominal rate of return of cash and dramatically reduced its opportunity cost (price) relative to other investment options. The level of cash advisors should hold as part of their strategic plan is very fact dependent. However, whatever that level is normally, it should be higher now to acknowledge the increased uncertainty in the returns of all other asset classes and cash’s much lower opportunity cost (price).
Tax-Optimized Direct Indexing
Exposure to the broader equity indices is a common way for advisors to expose themselves to an underlying asset class, often done with the use of broad-based ETFs. What an ETF doesn’t take advantage of is the potential to closely track the benchmark, while at the same time harvesting losses within the underlying asset class. Those losses can meaningfully strengthen the after-tax return, not only of the asset class but the broader investment strategy. Tax-optimized direct indexing is the ability to invest in a subset of an index that very closely tracks the overall performance of the index, while systematically or opportunistically recognizing losses in the underlying constituents and replacing them with new constituents that maintain the tight tracking of the index. Both an ETF and direct indexing strategy will yield the performance of the underlying index, however, only the direct indexing strategy will capture the economic value of the loss, increasing the after-tax return. A direct indexing strategy is even more valuable during volatile markets. When there is potential for greater volatility, the strategy provides an even greater advantage over the use of an ETF strategy.
Portfolio Insurance
It’s always better to buy car insurance before you wreck your car. When insurance is cheap relative to the value of what it protects, we should buy more of it. The same is true of your investment portfolio. Volatility, as measured by the VIX, is tame at the moment, bouncing between 12 and 16 over the last few months. It is the central argument for any strategy that attempts to hedge portfolio value. Specifically, we are employing protective puts on broad-based indexes like the S&P 500. We use this option strategy for a couple of reasons. First, they can provide a hedge against a broad market move and a simple hedge against a more diversified equity allocation. Secondly, indexes like the S&P 500 have very liquid ETFs associated with them and very efficient option markets against the ETF. With the S&P 500 currently around 4,500 and the VIX below 16, the cost of insuring against greater than a 10% drawdown on the S&P 500 through January 2024 is a little over 1% of the exposure to the S&P 500. Option strategies can be complex, and it is important for the advisor to understand the pros and cons of their use (as with any investment), but they can be a powerful hedging tool when used appropriately.
Perhaps the most valuable resource of any advisor is a meaningful level of humility. The more experience we have managing assets for families in an uncertain world, the greater level of humility is required, because we know more viscerally the uncertainties that we face. We offer these suggestions with an abundance of that often-scarce resource.
Neale Ellis and Matthew Michaels are founding partners, co-CIOs at Fidelis Capital
