Resilient Equities, Attractive Cash

March 2, 2023

Source: Bloomberg Source: Bloomberg

With January being unseasonably warm, perhaps this had a positive correlation with the strong economic data we witnessed for the month. In addition, the bond market repriced sharply. As you can see in this week’s chart, the market was pricing in recession risk and two rate cuts during the second half of 2023, but only 12 basis points (bps) of rate cuts are priced in currently. The terminal rate was also priced higher by 40 bps, to the 5.3% range. The only item that didn’t change is the forecasted rate cuts in 2024. The market moved recession risk from late 2023 to 2024, and is pricing in 139 bps of rate cuts.

In 2022, a stronger labor market and higher inflation were negative catalysts for financial markets. However, in 2023, the risk market is showing surprising resilience. U.S. equities sold off recently but are still up nicely year-to-date. The S&P 500 Index is trading at 18x forward P/E, and the Nasdaq 100 Index is trading at 22x forward P/E. None of this is cheap.1

There are several technical reasons for this equity strength. Risk positioning was light, while sentiment was and still is very bearish. A revival of retail trading is also contributing to the recent rally of many technology stocks and cryptocurrencies.

One of the major drivers of longer-term equity valuation is the interest rate. The support for high equity valuation includes the fact that the market is pricing in a 139 bps rate cut in 2024, and that the 2-year forward 10-year rate is currently priced at 3.3%.2 The market views recent inflation as transitory, which is reflected in the inflation breakeven market as well. The 10-year breakeven rate is currently not far from the last 10-year average.

Is the market correct to anticipate that the economy will return to the disinflationary environment we saw pre-pandemic? The answer to that will essentially determine the valuation for all financial assets. And at this point, it is extremely difficult to draw a conclusion.

The good news is treasury bills are currently yielding 5%, so it may be attractive to park money there and wait for more data.3

There is a lot of research demonstrating that equity returns could suffer significantly if the best days of the year are missed. However, not enough research is conducted to show how much returns could improve if the worst days of the year are missed.

Here is one interesting result according to Occam Investing: Between 1963 and 2004, the equity index return for the weighted composite of stocks traded on the New York Stock Exchange (NYSE), American Stock Exchange (ASE) and the National Association of Securities Dealers Automated Quotation system (NASDAQ) averaged 10.6% per year. By missing the best 90 days, the annual return declines to 3.2%. However, by missing the worst 90 days, the annual return goes up to 19.6%.4 Some investors turn to cash; however, it may be more in a panic rather than using cash as a strategic tool to dial down portfolio risk when the market is strong.

Key Takeaway           

While it can be difficult to determine what the “best” and “worst” days are, data showing that missing the worst days of the market can potentially be even more impactful than missing the best days, don’t be afraid of utilizing cash to manage portfolio risk — particularly in light of the attractive cash yield and resilience currently seen in the equity market.



1Source: Wall Street Journal- P/Es & Yields on Major Indexes; as of 2/24/23

2Source: CNBC- U.S. Treasuries; as of 3/1/23

3Source: CNBC- U.S. Treasuries; as of 3/1/23

4Source: Occam Investing- Problems with the “X Best Days” Argument; 5/28/22


Tags: Equities | Bond markets | Inflation | Risk management | Disinflation

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This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.  This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.

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