Investment Strategy Brief:
Two Steps Forward, One Step Back

Below is a transcript of this week’s video.

Hi, this is Mike Reynolds with Investment Strategy at Glenmede.

Another quarter is in the books for 2023. It can be helpful to take stock of how markets behaved, some of the big drivers of that performance and how that sets the stage for the remainder of the year. To start, most major asset classes posted negative returns for Q3. Within equities, small caps underperformed their larger counterparts and international stocks were a bit of a mixed bag on a relative basis. In fixed income, investment grade bonds in both taxable and municipal variants suffered small losses and cash was the outlier, clipping a low single-digit gain.

Digging a little bit deeper under the hood in equities, while the decline in large cap equities bucked the trend so far this year of sequential quarterly gains, some of the underlying details remained intact. For instance, a handful of mega cap tech stocks have been big contributors to year-to-date gains. That outperformance continued in Q3, though it came in the form of less downside rather than more upside, especially when comparing the market capitalization weighted and equal weighted variants of the S&P 500.

In bond markets, the yield on 10-year U.S. Treasury bonds rose considerably, rising from 3.8% to 4.6% to end the quarter. September’s hawkish Fed dot-plot, coupled with political dysfunction in Washington, have resulted in investors demanding higher yields for Treasury bonds, which rippled through fixed income assets. While higher rates mean better returns for buy-and-hold fixed income investors stepping in with new purchases, the prices of outstanding bonds were forced to adjust downward. Those price declines more than offset the income returns for taxable investment-grade bonds.

Given that color on where markets have been, how does that set up the investment environment going forward? With one more quarter to go until year-end, bonds now offer one of the most compelling value propositions relative to equities than they have over the past two decades. For example, the difference between the 10-year U.S. Treasury yield and the dividend yield on the S&P 500 continues to widen. Rising yields are part of that story, but another is still-premium valuations for stocks. As a result, investors should underweight equity risk in favor of fixed income and cash for the time being.

With that said, not all equity asset classes are equally extended from a valuation perspective. U.S. large cap growth appears particularly expensive, currently sitting at the 81^st percentile of longer-term fair value by Glenmede’s estimates. In comparison, U.S. small caps and international equities appear more fairly valued, if not priced at modest discounts. Valuations tend to be important determinants of longer-term returns. But by themselves they are not great short-term timing indicators, so discounted valuations could certainly get cheaper if the macroeconomic environment continues to deteriorate.

Zooming in just a bit further, within U.S. large cap equities one can see even further disparity. The five largest companies in the S&P 500 Index still command a hefty valuation premium relative to the rest of the index. When measured by next-twelve-month price-to-earnings ratios, the top five sit at 27.9 vs. 16 for the rest of the index. This highlights the importance of a discerning valuation discipline in equity portfolios at this time.

So to summarize, most asset classes posted negative returns in Q3, with cash as the exception. Within equities, a top-heavy S&P 500 continued to outperform its equal-weighted variant as mega caps led the pack once again. Interest rates continued their climb higher throughout the summer, leading to negative returns in investment-grade bond markets. With one more quarter to go before year-end, bonds continue to look incrementally more attractive than equities, especially as the risk of recession looms. And while stocks continue to be priced at a premium, there’s some dispersion within with mega caps looking expensive. Altogether, investors should underweight equity risk in favor of fixed income and cash, with a discerning valuation discipline in their equity portfolios.

Thanks for listening! And please don’t hesitate to reach out with any questions.