Piloting Through: Why Investors Should Stay the Course

Episode Summary

Executive Summary: Sharmin Masavaramani argues investors should stay in U.S. equities despite expensive valuations, rising rates, and market volatility. She says valuation alone is a poor timing signal, the U.S. backdrop still supports earnings growth, and bonds look less attractive. She also downplays concentration fears, favors U.S. over non-U.S. stocks, and sees China and emerging markets as limited opportunities.

Main Topics: Why expensive valuations are not a sell signal (Priority: 5/5): Masavaramani argues U.S. equities are fully valued, but valuation alone has been a poor reason to exit because markets can remain expensive for years while still compounding strongly. Stay invested in U.S. equities (Priority: 5/5): She says the hurdle to underweight U.S. stocks should be very high because economic growth tends to translate into earnings growth and positive equity returns are more likely during expansions. Managing volatility and current pullbacks (Priority: 4/5): She frames the recent sell-off as consistent with normal equity volatility and suggests investors should use the decline as an opportunity to add incrementally, including via options. Market concentration concerns (Priority: 4/5): She rejects the idea that index concentration in a few large tech names predicts weak forward returns, citing evidence that equal-weight and median-stock returns have broadly matched market-cap-weighted indices. Inflation, Fed tightening, and recession risk (Priority: 5/5): She expects inflation to moderate gradually and the Fed to tighten slowly. While tightening can raise recession risk, she notes not all tightening cycles cause recessions and market peaks typically occur well after the first hike. U.S. equities vs. non-U.S. markets and China (Priority: 4/5): She remains underweight non-U.S. developed and emerging markets, including China, because U.S. companies have out-earned peers and foreign markets have delivered much weaker long-term equity returns.

Key Arguments: Valuations are expensive, but using valuation alone to time an exit has historically left investors out of major upside. The U.S. economy spends more than 80% of the time in growth, and earnings typically rise with it, supporting equity returns over time. In economic expansions, equities have produced positive returns 88% of the time, making a stay-invested stance favorable in the base case. Rising rates hurt bond prices, so equities remain relatively attractive versus fixed income even with elevated valuations. Index concentration is not a reliable predictor of next-12-month returns; equal-weight and median-stock performance show the rally has not been limited to a few names. Inflation should ease as goods prices normalize; shelter and wages are stickier but likely to trend down as affordability, labor supply, and COVID conditions improve. Fed tightening does not automatically cause recession; even if it does, the stock market usually peaks much later, so exiting too early is a bigger risk than staying invested. U.S. companies have out-earned non-U.S. peers across nearly every sector over a long period, supporting a strategic U.S. equity overweight. China and emerging markets face structural weaknesses, and recent performance gaps reinforce the case for only a small strategic allocation.

Data Points: Equity valuation decile: 10th decile - U.S. equities are described as expensive across several valuation measures. S&P 500 return since Dec. 2016 while valuations stayed in 10th decile: about 130% - Illustrates why valuation alone is a poor market-timing signal. U.S. equities total return after entering 10th decile in July 1995 through 2000: just under 200% - Historical example showing expensive valuations can persist while stocks keep rising. U.S. economic growth expectation for 2022: 3.5% to 4.0% - Base-case backdrop for earnings and equity returns. Midpoint U.S. growth forecast: 3.7% - Used as the representative growth assumption. Global growth expectation: about 4.5% - Supports earnings for multinational U.S. companies. Inflation expectation: high for the next few months, then moderating - Base case for price pressures. Unemployment expectation: as low as 3.1% - Signals continued labor market improvement. Fed hikes expected: 3 to 4 hikes - Assumed to be slow and steady tightening. S&P 500 earnings growth expectation: 12% - Forecast for 2022 earnings growth. Base-case annual total return for U.S. equities: about 6% including dividends - Whole-year forecast from the report. Return from current levels to base case: about 16% - Presenter notes upside from the time of the interview. Good-case annual total return: 12% for the year - Assigned 20% probability. Return from current levels in good case: 20%+ - Upside scenario from interview-date pricing. Probability of a 5% equity downdraft: 100% - Given expensive valuations, short-term pullbacks are treated as inevitable. Probability of a 10% equity downdraft: 79% - Rounded to 80% as a reminder of equity volatility. Probability of base case: 65% - Most likely market outcome in the outlook. 10-year Treasury yield outlook: about 2% - Expected to limit bond attractiveness. Average time from first Fed hike to recession: 30 months - Historical average across tightening cycles. Average time from first Fed hike to S&P 500 peak: 24 months - Shows markets often peak long after the first hike. Average S&P 500 return from first Fed hike: 36% - Supports the argument against exiting equities too early. Positive equity returns during expansions: 88% of the time - A key reason to remain invested. Tightening cycles since World War II leading to recession: 9 out of 15 - Used to show recession is possible but not certain. Performance of U.S. equities since GFC trough: just under 800% - Long-term outperformance versus other regions. Performance of non-U.S. developed markets since GFC trough: under 300% - Illustrates weaker long-term returns. Performance of emerging markets since GFC trough: under 300% - Shows similar underperformance to developed ex-U.S. Performance of China since GFC trough: about 230% - Highlights the gap versus U.S. equities. Moderate-risk diversified portfolio allocation to emerging markets: about 2% - Suggests only a small strategic weight to EM. China's equity return last year: down 21% - Used to underscore weak recent Chinese market performance. U.S. equities return last year: up 29% - Contrasts sharply with China. Return gap between U.S. equities and China last year: 50 percentage points - Shows how far Chinese equities lagged.

Pivotal Quotes: "valuations alone is not a good signal to go underweight equities" — Sharmin Masavaramani: Her core argument against using valuation as the main reason to exit stocks. "the hurdle to go underweight U.S. equities should be very high" — Sharmin Masavaramani: Summarizes her long-term stance in favor of staying invested. "the idea that it was just a handful of stocks that account for this return is actually factually not correct" — Sharmin Masavaramani: Her rebuttal to concentration concerns and index-narrowness fears.

Implications: For investors, the message is to stay selectively invested in U.S. equities, accept volatility, and avoid overreacting to valuation, concentration, or early Fed-tightening fears. Non-U.S. stocks and China remain small-weight, lower-conviction exposures.