November brought several large events that drove equity returns higher. The trailing one-month returns on stocks were large enough to push all year-to-date returns on the major stock categories positive for the year. The returns on out-of-favor stock categories like small-cap, value, and international saw their year-to-date losses reverse into gains by the end of November. Year-to-date returns on broad categories of stock investments are now positive, which seems fortunate in a year of so much uncertainty.
Positive developments around a COVID-19 vaccine were recently released which bolstered stocks and steepened the curve of government yields. A highly effective vaccine is expected to restore confidence and improve nominal growth. Valuations placed on stocks and bonds are reacting in accordance to an early-stage recovery.
Other indicators point to an expansion that is already underway. Demand is high for residential properties and durable good investments as a result of the low interest rates. These pockets of demand continue to sustain the construction and manufacturing segments of the economy. Furthermore, consumers are increasing expenditures on credit cards, which should eventually lead to a drop in the savings rate. Consumers appear to remain confident about spending their money. Interest-rate stimulus, as of late, has seemingly worked to encourage consumption and investment in this crisis.
Uncertainty challenges the economy and financial market system as a whole. The economy faces an upcoming personal income cliff if Congress does not complete a deal for taxpayers before the special unemployment benefits runout in December. Additionally, financial wealth has seen returns compress as asset valuations continue to climb. Interest-rate stimulus has done good things in the economy, but has lowered the rate that assets are required to pay.
The bond market is the most obvious place where the cost-of-capital has diminished. A corporate bond now pays an average of 1.0% less per year than it did a year ago. The same pattern is evident in US large-cap stocks. The cyclically adjusted price-to-earnings ratio produced by Professor Shiller (Yale) has had cumulative growth of 112% over five years and 150% over ten years. In either case, valuations set on a normalized proxy for equity returns are higher similar to how bond valuations can trade at a premium. The return on corporate equity is more valuable today because the market is willing to pay a larger price-multiple for it. As security prices move up, the internal rate-of-return for capital reinvestment goes down.
Stocks still seem to be on top in terms of the absolute returns that are available in the marketplace. However, they also carry more volatility and risk compared to other assets, such as bonds. US large-cap stocks appear to have solid value left at the current index price. Professor Damodaran (NYU) measures the risk-premium in US large-cap stocks on a monthly basis. The risk-premium is simply the difference between the expected stock return and treasury rate. His work shows that the risk-premium for stocks is right on pace with the five-year average. In other words, US large-cap stocks are priced well to deliver a fair premium on risk in this current climate. He estimates that the going absolute rate-of-return in US large-cap stocks is now 6% per year at the current index price.
Neglected stock categories, such as small-cap and value-style equities, may have more than 6% per year built into their index valuations over the long-term. This makes sense since their risk-premiums must be large enough to compensate investors for the increased volatility relative to other stocks. These particular stocks have all underperformed the US large-cap stock index in recent years. Their underperformance begs a question about the size of the risk-premiums held in their valuations. Will the premiums start to mean-revert and produce gains for the patient investor? With prospects of a recovering economy becoming more evident, the earnings in neglected stocks may be on their way to making a cyclical turnaround.