Skip to content

Daniel Tolomay in The Wall Street Journal: Should Investors Allocate Overseas?

With inflation skyrocketing and a potential recession looming as the world continues to grapple with the impacts of Russia’s invasion of Ukraine, 2022 has been a year of persistent volatility in global markets. To help combat this turbulence, investors are pouring capital into U.S. stocks to avoid seemingly darker seas abroad. In fact, according to Refinitive Lipper Data, investors have added money to U.S. equity-focused stock and mutual funds for four out of the past six weeks – the longest streak since 2019.

While many remain optimistic about the U.S. economy and the S&P 500 has outpaced major indexes in Europe and Asia since hitting its low for the year in mid-June, is piling into U.S. stocks truly the right path for investors? Or, should investors still consider allocating overseas? The Wall Street Journal recently turned to Daniel Tolomay, chief investment officer at Trust Company of the South, to find out.

According to Tolomay, if stock valuations in the U.S. continue to rise, investors may want to consider increasing their exposure to international equities where valuations are cheaper after years of outperformance by the U.S. The Stoxx Europe 600, for example, recently traded at 11.61 times its projected earnings over the next 12 months, according to FactSet, compared with 16.70 for the S&P 500.

“International being more attractively priced, we would expect better returns from the international market going forward,” Tolomay explains.

Click here to read the entire article in The Wall Street Journal

Monthly Market Dashboard: August

by M. Burke Koonce, III

31 August 2022

Current Conditions

After a buoyant July, markets turned lower in August, spooked by signals from the Federal Reserve that the specter of inflation would justify further monetary tightening. Markets darkened leading up to Fed Chairman Jay Powell’s remarks in Jackson Hole, WY last week, where the chairman made clear that the fight against inflation was far from over and basically acknowledged that Fed tightening was already causing the economy to slow.

While U.S. markets ended the month with just low-single-digit losses, the pain seemed worse because the month has started out strong. While the S&P 500 finished 4 percent lower for the month (total return), it was down 8 percent from its intra-month high on August 16. Bond yields, which move in the opposite direction of bond prices, rose steadily all month.

It would be an easy narrative to write that fears about persistent inflation caused stocks to move lower during the month, but it wouldn’t really be that accurate. While yields moved up, which one might expect as the market’s expectations for additional rate increases rose, the fear in the market seems to be more about the economy, which shows signs of slowing. Powell’s remarks seemed to drive home the reality that the Fed’s actions are already causing the economy to cool, and he sought to convince everyone that the central bank would continue to tighten as warranted, on which he seemed completely credible. But Powell seemed slightly less confident that the Fed is even winning the inflation fight at the moment, which was a little nettlesome, and his speech indicated he was girding for economic trouble. The gist of the message was as follows:

Restoring price stability will take some time and requires using our tools forcefully to bring demand and supply into better balance. Reducing inflation is likely to require a sustained period of below-trend growth. Moreover, there will very likely be some softening of labor market conditions. While higher interest rates, slower growth and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses. These are the unfortunate costs of reducing inflation. But a failure to restore price stability would mean far greater pain.

Pain? Did someone say pain? The VIX Index, which measures market volatility—a kind of risk proxy—spiked hard in the back half of the month, as traders reassessed risk. Of course, counterintuitively, a more volatile market is a more attractive market for long-term investors, though it can cause a little pain in the near term.

But meanwhile, what does near-term economic pain mean for markets? Well, as always, it’s complicated, and it seems especially complicated at the moment. Many of the world’s most successful hedge funds, staffed by “the best and the brightest,” are experiencing historically bad performance years, as economic signals collide and old models prove insufficient to predict the future amid a backdrop in which central banks are no longer pouring punch into the punch bowl. For years, central banks around the world were tasked to stimulate sufficient demand to meet the seemingly infinite supply curve, as globalization drove input costs further and further down. It’s a different deal entirely for a central bank to tamp down demand to rightsize it for constrained supply.

Globalization appears to be taking a breather at the moment, as companies focus more on building redundant systems and finding strangely scarce workers in the post-pandemic world. Rising rates tend to be a headwind for all asset classes, and a slower economy likely means lower corporate earnings. In equities, slower growth would tend to favor growth-centric strategies over value-centric strategies all else equal. Growth beat value for the third month in a row (Russell 2000 Growth (-0.9%) vs. Russell 2000 Value (-3.1%), but all else isn’t equal. With rates rising and receding liquidity, growth has its own challenges and trails value by almost 1000 basis points year to date. And when growth stocks miss earnings estimates and fall, well, that’s not pretty to watch either.

The thing about inflation is that the longer it lasts, the longer it lasts. Former Fed Chairman Paul Volker rightly observed back in 1979 that “inflation feeds partly on itself.” The Fed is absolutely going to rein inflation in, but the collateral damage on the housing market, corporate earnings and corporate credit is likely to be significant—in fact, that’s really the point. Does that mean long-term investors should sell stocks? No.

Markets are unpredictable in the near-term, even if they are rather predictable in the long-term—they do tend to go up. In an environment with no shortage of crosscurrents, it continues to be a good idea to resist the temptation to react to daily news flow and let the power of compounding continue to work to one’s advantage. That’s a force more persistent than inflation and it only grows stronger over time.

Monthly Market Dashboard: June

by M. Burke Koonce, III

June 30 2022

“If you are shopping for common stocks, choose them the way you would buy groceries, not the way you would buy perfume.”  — Benjamin Graham

Financial markets just turned in the worst first-half performance in decades, with the S&P 500 now down 20 percent for the year on a total return basis. That’s the worst performance to start the year since 1970. For the month of June, the S&P 500 was down 8.3 percent, the Dow Jones Industrial Average was down 6.5 percent and the growth-heavy NASDAQ fell 8.7 percent.

The six-month report card was grim. Joining the S&P 500 in remedial math this summer will be the Dow, down 14.4 percent, and the NASDAQ, down 29.2 percent. After several flirtations this year, the S&P 500 officially entered a bear market on June 13, closing more than 20 percent down from its January peak, the first time the U.S. stock index closed in bear market territory since the COVID-19 abyss of March 2020.

While markets have long since ceased being fixated by C           OVID-19 cases and death tolls, markets are still very much wrestling with the aftereffects of the pandemic. Supply chains continue to be disrupted by shutdowns in China, while government stimulus around the world, combined with strong employment, has helped keep demand elevated. Finally, the war in Ukraine’s impact on energy prices has been real, contributing to higher price expectations throughout the global economy. Ten-year interest rates in the U.S. have more than doubled since the start of the year.

There’s been a lot of ink spilled about the effect that interest rates have on asset prices, but it’s perhaps worth repeating anyway. As interest rates rise, the biggest price impact is on long duration assets such as long-dated bonds and expensive growth stocks—both are assets that are expected to pay back investors in the distant future. Those future returns are worth relatively less in a higher interest rate environment because they’re discounted back to the present at those higher rates. This is why growth stocks and long bonds have seen such significant price declines in the market this year, far more than short-term bonds and short-duration stocks such as big dividend payers and high earners. (The Russell 2000 Growth Index is now down 29.5 percent year to date, while the Russell 2000 Value is down 17.4 percent.)

However, while market prices continued to slide in June, the nature of the price action seemed to change. Not only had value beaten growth by almost 1600 basis points year to date, but value had outpaced growth every individual month also. That reversed in June, with growth outstripping value by 358 basis points. Of course, one month does not necessarily a trend make, but it did end value’s winning streak. What does this mean? It might be nothing at all, but it might be some evidence that tighter financial conditions are beginning to slow the actual economy, not just the financial markets, which often bodes well for growth stocks, which become more sought-after. Just like that, ten-year yields have come back in from almost 3.5 percent to below 3 percent. Consumer spending actually fell in May, the first time this year, and, according to the Commerce Department, consumer price increases last month were below expectations. Meanwhile, the University of Michigan’s long-running index of consumer sentiment is now at the lowest levels ever recorded. Counterintuitively, these are generally reasons to be bullish.

The market’s decline has been so swift and severe so far this year that one could be forgiven for overlooking how favorable some measures have become. After several years of gaudy valuations, the markets are not even historically expensive anymore. The S&P 500’s price/earnings ratio has fallen below 16.3x—that’s below the 25-year average of 16.9x and a far cry from the low 20s the market was sporting late last year. Granted, earnings numbers could come down as inflation eats away at corporate profits, but the market generally does a pretty good job at discounting information such as that.

We all know the market is quite efficient over the long-term. What’s less obvious sometimes during a period of elevated volatility such as this one is the opportunity it represents to rebalance portfolios to take advantage of favorable short-term price changes. For long-term investors, developments such as rising interest rates are a godsend—as long as one’s time horizon exceeds the duration of a given portfolio, higher rates are going to add to investment returns. That’s because higher rates mean better yields on bonds and lower multiples to pay for stocks.

The market is already pricing in lower rates by the end of 2024 than 2023. In other words, all else equal for long-term investors, these grocery prices might not last.

Monthly Market Dashboard: May

by M. Burke Koonce, III

25 May 2022

Current Conditions

“Rough winds do shake the darling buds of May” — William Shakespeare, Sonnet 18

Shakespeare could have just as well been describing financial markets this month when he wrote his most famous sonnet more than four centuries ago. A more apt description does not readily present itself, let alone one less laden with financial jargon. But alas, Bards are hard to come by these days, so here we are. Elevated volatility, rising interest rates, persistent inflation, and economic uncertainty do shake the darling buds of May… Miss him yet?

The market declines that began almost immediately back in January continue as we near Memorial Day. Through yesterday, the S&P 500 Index was down about 17 percent YTD on a total return basis, while the NASDAQ was down about 28 percent. The Dow Jones Industrial Average has held up somewhat better, off about 11 percent. For the month, the S&P 500 was down about 4.5 percent, the NASDAQ about 8.5 percent and the DJIA about 3 percent. The tech-heavy NASDAQ is well into a bear market (defined by a 20 percent decline from its peak), while the S&P 500 has flirted with bear market territory on numerous occasions.

Interestingly, for all the sturm and drang surrounding markets this year, the DJIA, with its less tech-heavy constituency, has held up remarkably well. That’s because it’s the technology sector that has so far been the primary target of the market’s “slings and arrows of outrageous fortune.” Value has beaten growth in every month this year, and to date, May’s value outperformance is the largest since January. Using the Russell 2000 Value Index and the Russell 2000 Growth Index as proxies, value is now outperforming growth by more than 1600 basis points for the year. Moreover, value is now well ahead of the growth for the trailing one-year period and is now poised to overtake growth on a five-year basis also. It’s a stunning reversal in both scale and speed for financial markets, which have been led higher by technology and growth-oriented issues for years, only to have 100 percent of that outperformance “vanish into air.”

Since the COVID-19 panic and recovery of March 2020, market valuations, particularly in the US, had been elevated, buoyed by oceans of fiscal support, ultra-low interest rates, and of course, an economy that proved far more robust than many thought possible amid the global pandemic. Fully all of that premium valuation has been extinguished during the last five months. As of now, the forward price/earnings ratio of the S&P 500, at 16.7x, has fallen below its 25-year average of 16.9x. Of course, this measure could continue to fall, and as earnings estimates come down due to persistent inflation, the index could continue to drop even if this ratio stabilizes, but this is no longer an expensive market, at least by this one closely-watched yardstick.

The terrible war in Ukraine and COVID-19’s continued burden on the global economy through supply chain disruptions and labor scarcity have dominated headlines, but the true ghost on the platform in Elsinore Castle this year has been rising interest rates. Of course, rates are rising in response to inflationary forces unleashed and exacerbated by Ukraine, COVID-19 and the world’s responses to them, but the receding liquidity that accompanies rising rates is what we are seeing play out in changes in market prices. Ten-year Treasury yields more than doubled between year-end and May 6th, creating a huge repricing in fixed income markets in addition to the equity markets. To the dismay of 60/40 portfolio holders everywhere, bonds did not provide the desired protection from equity market volatility.

“Oh fortune, fortune! All men call thee fickle!” Romeo and Juliet

Then again, if this market has taught us anything this year, it is that circumstances change quickly. On December 31, the market was pricing in just three 25-basis-point rate increases for the year. Fast forward to April 30 and the market was expecting 10 such rate hikes, plus another in February 2023. It is worth noting then that markets have in recent weeks taken on a slightly but distinctly more dovish view, with the current curve pricing in just seven hikes in 2022. Bond markets have stabilized. Five-year inflation expectations, which had jumped to 3.5 percent back in March, are back down to 2.9 percent—not far from where we were at the start of the year. Consumer sentiment is shockingly low, housing starts and building permits have crept lower, and jobless claims have recently been slightly higher than expected. If the economy is cooling a bit, inflation will eventually follow, and interest rates are starting to react.

None of this means we are advocating buying growth stocks with both hands; we never have and almost certainly never will. Markets are fickle, after all. But what we think all of this means is that the areas of the market where the historical evidence suggests that premium returns exist—value, small cap, and international, is where the future premiums do in fact exist.

For the vast majority of investors, bear markets are no fun. Growth is in a bear market at this moment, and it is during bear markets when people rediscover the meaning of margin of safety—the ability to point to an estimated stream of future cash flows generated by a company and say something other than “we are such stuff as dreams are made on.” In a bull market, it’s easy to find someone whose dreams are even more optimistic than your own who will pay you a premium for what you own. In a bear market, stocks return to their rightful owners. And it wasn’t Shakespeare who said that—it was J.P. Morgan.