- Increasing interest rates make earnings growth unlikely and increase the probability for a decline of the S&P 500.
- To beat the S&P 500, you have to invest in sectors that offer a better risk reward ratio than the S&P 500.
Don’t Go For 10 To 20 Percent Returns In 2017
With the S&P 500 yielding 3.85% going into 2017, stocks in general are currently an investment vehicle that gives you a small and limited upside with a potentially large downside.
We know that the FED plans to raise interest rates another three times in 2017. If that happens, the investments people consider most secure—like treasuries, dividend paying blue-chips or REITs—will be hit the hardest because as required yields go up, their asset prices will go down. Therefore, the best way to prepare for 2017 is to position yourself so that if the FED raises rates, your upside is far bigger than 3.85% and your downside far smaller than the potential downside of the currently overvalued stock market.
The Stock Market Carries The Risk Of A 40% Decline
The S&P 500 currently yields 3.85%, which would translate into 86.9 S&P 500 points of earnings per year. If we add an extremely positive 10% earnings growth expectation to the equation, we get 2017 earnings of 95.62, giving a 2017 PE ratio of 23.61 or an earnings yield of 4.23%. Such an earnings yield is excellent if investors get 0.25% for their bank deposits or 1.4% on their treasuries. However, as the FED increases interest rates, so will yields on deposits and treasuries increase.
Figure 1: 10-year treasury yield. Source: FRED.
This increase in risk-free yields should push required S&P 500 yields higher. When this will happen is anyone’s guess, but if it happens, a sharp decline for stocks is inevitable.
As stocks yielded around 4% while the federal funds rate was close to zero, a federal funds rate close to the target of 3% could require stocks to yield 7% or more. Increasing debt costs would weigh on earnings on top of the higher required yield. If a stock yields 7%, the S&P 500 would be at a level of 1366, a potential 40% decline. The downside may look extreme, but add a recession and we’re there in the blink of an eye.
I’m not saying this will happen the way I described above, I’m just mentioning it as a risk because investing is about properly measuring the risks for the estimated rewards. My standing is that there are much better risk reward opportunities out there than the 40% downside and 10-15% upside the S&P 500 offers. Let’s dig into those.
Sectors That Beat 40% Downside For 15% Upside
A sector to follow in 2017 is definitely energy. The slump in oil prices has brought the sector to lows not seen since the great recession, but as oil reverts to its historical mean, there is still plenty of upside for the sector. A good play could be the iShares Global Energy ETF (IXC) as energy earnings are expected to be the biggest growth story of 2017.
Figure 2: Earnings growth per sector. Source: FACTSET.
If the earnings expectations are met, we could see the energy ETF reach new multi-year highs in 2017.
Figure 3: iShares Global Energy ETF. Source: iShares.
If the ETF reaches $45 from the current $35, it’ll represent growth of 28%. This isn’t impossible if oil reaches $60 or $70. However, if oil stumbles again and the ETF reaches a low of $25, it’ll represent a 28% potential decline, which is still better than the 40% decline and 15% return the S&P 500 offers.
A Sector That Benefits From Both Higher Interest Rates & Economic Growth
A sector that is going to benefit from economic growth and higher interest rates is the insurance industry. This is clear not only to me, but to the general investment environment and is the reason why the U.S. insurance ETF (IAK) has outperformed the S&P 500 in 2016.
Figure 4: U.S. insurance ETF in the last 12 months. Source: iShares.
However, the sector still seems cheap with an average PE ratio of 14.83 and a price to book ratio of 1.36. The relative cheapness, improving economic conditions, and increased earnings through higher yields on assets should limit the downside of the sector and increase the upside in 2017 giving it a better risk reward ratio than the S&P 500.
Emerging Markets Hold Short Term Risks, But High Long Term Upside
The third sector that I think gives a better risk reward situation than the S&P 500 is emerging markets. The dollar has much more purchasing power globally than it had two years ago, therefore now it is a good time to start thinking about international diversification.
The strong dollar makes the U.S. economy less competitive and this will inevitably have an impact on economic growth in the future. When that happens, the currency will weaken and international investments will do well. On top of that, emerging markets have a PE ratio of only 11.55 and they are expected to grow much faster than developed economies.
Figure 5: Emerging markets ETF (EEM). Source: iShares.
However, emerging markets have a much larger downside than the S&P 500. An increase in negative sentiment can send the index down 40% very easily. But the upside potential, especially for the long term, is much larger than what the S&P 500 has to offer.
Most investors know the S&P 500 is overvalued from an historical perspective, but not from a current perspective where interest rates are close to zero. As interest rates are about to rise, it’s wise to adjust your holdings accordingly.
There is still plenty of time to analyze the best risk reward options going into the new environment of higher interest rates as most are invested in passive funds, and those are very slow to change. We hope to have given you some ideas.