Where to invest in 2023: 5 surprising strategies for beating the indexes this year

Where to invest in 2023: 5 surprising strategies for beating the indexes this year

During the opening week of January 2022, the S&P 500 hit its all-time high of 4794, and though investors were jubilant, the huge, pandemic-driven run-up brought a daunting downside. Valuations were so stretched that using the most reliable projections, the probable returns on both U.S. big-cap stocks and government bonds were likely to lag, or barely match inflation over the coming decade, even though the consumer price index sat at its most becalmed in recent history.

A year later, inflation’s roaring and will likely stay far more elevated in future than the fixed income markets were anticipating just after New Year’s of 2022. Yet the sweeping global selloff that has hammered the S&P and Nasdaq Composite by 20% and 34% respectively from the start of last year through Jan. 5, and even pummeled such out-of-favor choices as emerging markets and U.S. small-caps that lagged the big rally, has shrunk prices to the point where investors can garner returns that beat the long-term trajectory of consumer and producer prices by a decent to wide margin, depending on the category. In especially cheap areas such as emerging markets and European stocks, gains should exceed inflation by 7% or better.

By contrast, the 16% overall drop in U.S. bond prices still isn’t steep enough to provide yields that beat a rising CPI by a comfortable cushion. The fat returns will come in stocks, with some pretty good buys available in the U.S. but the best deals coming abroad. “The terrible returns in equities last year are highly disturbing to people who see their 401(k)s fall in double digits,” Chris Brightman, CEO of Research Affiliates, a firm that designs investment strategies for $132 billion in mutual funds and ETFs, told Fortune. “But for anybody saving for retirement or putting new money to work now, it’s great news. Dividend yields are much higher, and prices have dropped to the point where P/E multiples can stay steady instead of falling, or even rise in some beaten-down sectors.” By almost any metric, Brightman adds, the stock market’s now offering much better returns over inflation than at this time last year.

For this writer, Research Affiliates offers the most sophisticated forecasts on future returns in the business. On its website https://www.researchaffiliates.com/home, under “Asset Allocation,” RA displays a chart showing expected gains over the next 10 years for more than 50 investment vehicles, ranging from U.S. large-cap growth and value to global portfolios to a panoply of bond offerings to international REITs. For each category, RA projects average annual total returns over 10 years, and also provides estimates of volatility: Brightman often recommends safer sectors positing lower expected returns over those promising the biggest potential gains, since the high-fliers take investors on a rocky ride, and place bets in nations where political upheavals could endanger or erase the potential gains.

For stocks, RA calculates expected returns by making individual projections on the three principal building blocks: the dividend yield, growth in earnings, and increase or fall in the price-to-earnings multiple. For the valuation component, RA anticipates that the P/E will “revert to the mean” by shifting halfway to its long-term average over the next decade. That imposes a drag on U.S. growth stocks whose multiples exploded in recent years and remain unsustainably high, but provides a tailwind to the likes of emerging markets, whose multiples are slightly below their historical norms, and are therefore due for a modest snapback.

Let’s examine RA’s take on which investments will wax inflation by the smallest and widest margins through 2033. The best choices: those that provide strong “real” gains while offering a relatively smooth trajectory.

Bonds will offer poor returns over the next decade

RA’s negative view on most bonds contradicts what the fixed income markets are saying. The best deals, Brightman says, are in Treasury Inflation-Protected Securities or TIPS. The current yield on 10-year TIPS is a full 1.5%, meaning that investors are guaranteed to receive the inflation rate plus 1.5 points. “That would be a huge shift that makes TIPS far more attractive than a year ago,” says Brightman. “At the start of last year, the TIPS yield, or expected ‘real return’ was a negative 1.0%. So now, you’d be locking in a return of 1.5%, whereas last year, you’d be losing to inflation by 1%. So returns are sure to be 2.5 points higher on ten-year TIPS going forward than at the start of 2022.”

Unlike TIPS, 10-year Treasuries don’t offer a guaranteed real return. Brightman notes that the market-implied future inflation rate, called BEI (for breakeven inflation rate), is only a little over 2%. By definition, if that’s the inflation rate that really comes to pass, the 10-year Treasuries will give you the exact same 1.5% return as one-year TIPS. But the future inflation rate, he adds, is extremely uncertain right now. RA forecasts a 3.5% inflation rate over the next 10 years. Here’s his reasoning: “My conversations with policymakers and economists who study this subject in-depth suggests as the economy weakens, the Fed will cease tightening in order to keep unemployment from rising too high. Hence, inflation should only reach 3% by 2033 and average that 3.5% over the next 10 years. That’s much higher than the markets are anticipating.”

Higher than expected inflation is bad news for bonds. The 10-year Treasury started 2023 yielding 3.5%. If inflation averages 3.5% over the next decade as forecast by RA, the newly issued 10-year Treasuries will provide a 0% real return. RA, however, expects that other categories of bonds will deliver modestly positive real gains: 1.6% for investment-grade U.S. corporates and 2.5% for high-yield bonds. “The persistence of inflation that will likely be higher than the markets are predicting means government bonds aren’t a good place to be. But corporates are more attractive, and much more attractive than last year,” concludes Brightman.

Stocks are the place to be, but overweight overseas vs. the U.S.

For Brightman, last year’s big selloff has two main outcomes. First, it’s lowered valuations for most categories of overseas stocks to the point where they’ve gone from somewhat expensive to offering average deals by historical standards. And at those routine prices, future gains should exceed inflation by a wide margin. Second, though they’ve gotten much cheaper, U.S. stocks are still pricey overall, particularly the growth contingent that remains richly valued despite vastly underperforming big-caps. “Europe and the rest of the world outside the U.S. aren’t the outlier, they’ve just returned to more normal valuations; they’re neither cheap nor expensive,” explains Brightman. “It’s the U.S. that’s the outlier because despite last year’s awful performance, stocks stateside are selling at a big premium compared to overseas shares based on dividend yields, P/E ratios, and other fundamentals.”

Emerging markets promise the top returns, but beware the risks

To take the New Year’s prize in equities, says Brightman, overweight non-U.S. stocks in both developed and emerging markets, and underweight the U.S. The category promising the highest 10-year returns on the RA chart: emerging markets. The category promises average “nominal” annual gains of 11.9%, or 8.3% after inflation. (Unless otherwise noted, all numbers cited will be the “real” or adjusted for inflation.) Comprising the rich real returns are a trifecta of big boosters: a dividend yield of 3.4%; an EPS growth rate of 3.8%; and a rising P/E that adds 1.2% a year, not to mention a slight lift from the appreciation of their currencies measured in dollars. “Earnings in the big emerging markets such as China, India, and South Korea grew much faster than in the U.S. over the past decade, and we’ve extrapolated those trajectories over the next decade,” observes Brightman.

But betting on emerging markets has two potential drawbacks: First, it’s the most volatile class on the entire RA roster. Investors should expect price swings about one-third sharper than on a diversified portfolio of shares from developed nations. Second, a military or political shock in one or more major markets could cripple what would in routine times prove sumptuous gains. “Many of us keep fresh in our minds what happened in Q1 of last year,” recalls Brightman. “Russia was one of the cheapest and most promising markets. Yet the sanctions that Washington imposed on Russia when it waged war in Ukraine forced U.S. investors to write their Russian holdings to zero.” Brightman cautions that EM portfolios could suffer a similar blow if, for example, China invades Taiwan.

Big surprise: The most attractive market is Europe

Weighing likely returns against potential risks, Brightman ranks Europe as the world’s most promising market. Europe might seem an unlikely choice, given that the EU grew GDP at an annual rate of just 0.6% in the first three quarters of 2022; the U.K. economy is shrinking; and the bloc teeters on the brink of an energy cataclysm owing to Brussels-imposed restrictions on oil and gas imports from Russia, traditionally its biggest supplier, and Moscow’s slashing of exports in retaliation. “But companies are not countries,” says Brightman. “You might have higher GDP growth in the U.S. than in nations such as the Netherlands and Switzerland, but that doesn’t mean that Unilever or Royal Dutch Shell or Nestlé increase their earnings more slowly than comparable companies in the U.S.” Indeed, European companies by and large achieve real growth rates similar to those of their American rivals, says Brightman.

RA projects that EPS expansion in both Europe and the U.S. will hover in the 2.5% range over the next decade. The big difference in future returns arises from the gap in dividend yields. Though not a great bargain by historical standards, European stocks are much cheaper—measured by P/E ratios—than U.S. shares. Hence, Europe is offering a dividend yield of 3.4%, almost twice the U.S. figure of 1.8%. In fact, Europe’s fat dividends are comparable to those for emerging markets. All told, Europe offers 10-year real returns approaching 7%, among the world’s best but well shy of the EM projection of 8.3%. Although Brightman thinks that EM should be part of any well-diversified portfolio, he believes that European equities offer the best risk-adjusted returns going forward. 

The reason, he says, is safety. A portfolio of European stocks isn’t nearly as risky as an emerging markets fund. “You won’t see sanctions on U.S. investors imposed in the U.K. or the EU,” he says. “And Europe has strong protections for shareholders. It’s worth sacrificing the 1% potential extra return from emerging markets to limit the risk of buying stocks in potentially explosive locales such as China and India.”

The U.S. is generally unattractive, but two categories look good

As for the U.S., RA sees a portfolio of large-caps delivering real annual gains of just 2.3%, roughly one-quarter of the prospects for EM and about one-third the numbers expected from Europe. RA reckons that P/E multiples still loom well above historical norms in the U.S., and their retreat toward the long-term average will lower the S&P 500’s performance by about 2% per year.

Still, the dour outlook for large-caps as a whole obscures a gulf between the growth and value tranches. The former should take a heavy hit from the downward reversion of multiples, and return just 1.7% a year. “The problem is that prices for the Apples and Alphabets and Microsofts are still high compared to their earnings and dividends,” says Brightman. But value’s a pretty good deal. It’s offering 4% over inflation—chiefly because its yield at 2.3% is more than double large growth at 1.1%, and its P/E is much closer to the long-term average, whereas growth’s valuation is still inflated, and overdue for a fall.

Brightman recommends a modest allocation of U.S. value. But his favorite U.S. investment is small-caps. “They’re much cheaper than the large-caps, even than large-cap value,” he says. “Small-caps have lagged large since the Great Financial Crisis. All the money poured into the glamorous megacap stocks, especially the tech stars.” Since the start of 2016, the Russell 2000 small-company index has gained just 60%, compared with 110% for the S&P 500. As a result of their lowly valuation, small-caps should provide 5.5% real returns through 2033 as their P/Es trend back toward traditional levels, and their EPS growth rates greatly exceed those of large-caps. And, he adds, small-cap value is even more attractive than small-caps overall.

“Just because the U.S. overall isn’t attractive doesn’t mean parts of the U.S. aren’t attractive,” says Brightman. All told, Brightman advocates a portfolio that leans heavily toward stocks versus bonds, and parks the biggest proportions in Europe, U.S value, U.S. small-caps, and emerging markets. That blend promises inflation-adjusted returns in the 6% range. A year ago, even the smartest strategies struggled to beat what was then extremely low inflation. Today, though inflation’s back in our future, the big selloff launched a new era of strong real returns. It’s the New Year’s gift that only a big selloff could deliver.

Source link

Related post

Bitcoin pro traders warm up the $24K level, suggesting that the current BTC rally has legs

Bitcoin pro traders warm up the $24K level, suggesting…

On Feb. 1 and Feb 2. Bitcoin’s (BTC) price surpassed even the most bullish price projections after the U.S. Federal Reserve…
Troubled Crypto Miners Get Breathing Room as Bitcoin Rebounds

Troubled Crypto Miners Get Breathing Room as Bitcoin Rebounds

(Bloomberg) — Rising Bitcoin prices are buying some time for distressed crypto miners as they renegotiate debt with lenders to stay…
Financial Accounting Standards Board votes to release draft cryptocurrency in March

Financial Accounting Standards Board votes to release draft cryptocurrency…

The Financial Accounting Standards Board, in its Feb. 1 meeting, voted to advance its first standard on cryptocurrencies and digital assets.…

Leave a Reply

Your email address will not be published.