The Winner Takes It All: An Argument For Equities

This week we’re sharing a blog post written by TEAM Executive Chairman Mark Clubb, on investment options and why he remains positive about equities.

“I don’t wanna talk
About things we’ve gone through.
Though it’s hurting me,
Now it’s history.

I’ve played all my cards
And that’s what you’ve done too.
Nothing more to say,
No more ace to play.

The winner takes it all,
The loser’s standing small…”

(Songwriters: Andersson Benny Goran Bror / Ulvaeus Bjoern K)

The Swedish late 70s and early 80s pop sensations Abba this week announced the release of their first album in 39 years. For the younger readers amongst you, the band’s last major hit was “Super Trouper” in 1980.

Interestingly, one could argue that the stock market’s great 1980s bull run started around then. It ended in spectacular fashion in 1987.

Had one had the foresight, and a healthy degree of patience, and invested in the U.S. S&P 500 in 1980, that individual would be sitting here today on a gain of approximately 9,500% or 11.5% per year.

Of late, I am constantly being asked why I remain positive for equities.

The arguments for those investors that hold a negative view are:

1. Inflation means interest rates are going up, which means bad news for equities.

2. Equity valuations are uncomfortably high. The price earnings (P/E) ratio is typically deployed at this point as the weapon of choice.

Let’s keep this as simple as we can.

Investors and savers have choice. Shares, or equities, are not the only game in town. You can also invest in bonds, property, private equity, commodities, bitcoin and a plethora of other asset classes.

At the end of the day, investors are looking for the highest return within their tolerance of risk. In investment parlance: “risk adjusted returns”. The lowest risk being cash (currently yielding zero, or worse, across swathes of Europe, meaning you pay the bank for the privilege of keeping your money with the institution), followed by a bond issued by a government, because the coupon is paid by the trusted government, be it the American, British, Japanese, Australian etc.

I tend to use the 10 Year U.S. Treasury as my “risk free” base return or yield. In other words, if I buy a U.S. 10 Year bond today, what would be my annual return. That is my ultra-safe, ‘almost guaranteed’ return.

These returns or yields fluctuate as inflation, interest rate, government policy and economic growth expectations change.

Currently, the U.S. 10 year is yielding approximately 1.3%.

Another way of looking at this is it would take nearly 77 years ($100 divided by $1.3) to get your investment paid back in full. This perspective should be viewed as analogous to the P/E for an equity security. But this is a 10 Year bond that matures before I can earn it. Caveat: should I wish to I can sell the bond before its maturity date.

The U.S. S&P 500 share index currently has an average P/E multiple of an historically high circa 35.3 times. But one should consider this high number against forecast total S&P 500 earnings in Q3 2021 up +26.2% on +13.3% higher revenues. That is an astonishing level of growth.

In addition, a record number of companies have been guiding earnings higher, indicating that corporate management is feeling confident of continued growth over the balance of the year.

In context, equities appear expensive but are reasonably cheap versus bonds at 77 times.

Another way to look at things would be the “earnings yield”, or the earnings the stock market generates, compared to the price you are paying for those stocks (i.e., the E/P ratio). 

It’s the inverse of the P/E ratio which we know is currently 35.3.

Today that means the S&P’s earnings yield is 2.8% (1 / 35.28 = 0.02834). 

So, we have treasury yield of 1.3% and we have the S&P’s earnings yield of 2.8%. But that’s not it.

Let’s not forget dividends.

Dividends play a massive role in your overall reward for investing in equities or shares.

Today, the S&P 500 dividend yield is 1.3%.

So, we have the earnings yield (2.8%) and the dividend yield (1.3%) to get a total yield of 4.1%.

Is that attractive or not?

One final step before we reach our conclusion.

Clearly, there is a higher risk for investing in equities. They are inherently more volatile given the nature of business cycles and the prospect of frequent – and sometimes sharp – economic downturns. Furthermore, equities may also carry an additional health warning in the form of company -specific problems.

Therefore, it is only reasonable that we should expect something more for assuming an additional degree of risk. We should demand a premium, known as the “risk premium”.

We can calculate this “risk premium” by taking the total yield (earnings + dividends) we can earn from the S&P 500 and subtracting the 10 Year U.S. Treasury yield. Today, that equals 2.8% (4.1% – 1.3%).

The risk premium can vary quite a bit depending on market conditions, but the S&P 500 average during the past 20 years has been 3.1%. Today’s 2.8% is a little below average but pretty close.

So, are equities too high?

For the U.S. market the historical numbers suggest no. Yes, they’re high, but as we’ve just calculated, not massively out of line on a historical basis.

We will continue to experience volatility. As an example, September is traditionally a poor month for equity returns, Given the strong performance of the equity market so far in 2021, a correction would not be a surprise, and is, in fact, long overdue. Were a sell-off to materialise, we simply have no way of knowing it’s magnitude.

Corrections, or draw downs, are by definition unpredictable, both in size and timing.

Regarding September, I would write that share prices do not follow calendars. No individual month or period of year is better for long term investors. What matters is future earnings and so far, so good.

I believe the current risk premium offered by the S&P 500 is still attractive, which leave share prices plenty of room to appreciate. This base case remains in play so long as the economic and earnings news remains positive, and the bond market behaves itself.

In other news...


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