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X October Newsletter – Are Equities Expensive?
Posted on October 6, 2020

October Newsletter – Are Equities Expensive?

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JP Morgan Market Insights: September 16, 2020 by Gabriela Santos

 

As suddenly and as sharply as the U.S. equity bear market began, so it ended. The rebound from the late-March lows was so quick and strong that it capped the shortest bear market in history (1 month) and marked the fastest round trip back to all-time highs (181 days). With such a rapid retracement, investors are left wondering: are equities expensive?

At the surface, the answer is yes: U.S. equities went from trading at valuations that were near one standard deviation cheap to over one standard deviation expensive relative to its 25-year average. However, the reality is that the answer to this question depends very much on where in the global equity market we look.

Beneath the surface, we have seen an incredibly uneven equity market recovery, with stark differences by sector, style and region. Given the constraints we are still facing in our normal lives, the market recovery has been led by sectors where consumers and businesses are able to spend: technology, communication services, and online retail – sectors that have a greater weighting in the growth style. On the other extreme, some sectors still remain in bear market territory, like airlines, energy, and banks – sectors that have a greater weighting in the value style.

Globally, this dispersion in sector and style performance has also played out. It is no surprise then that we have seen large regional differences in performance this year based on each region’s sector representation. U.S. equities and Asian equities have led, recouping most all of their COVID-related losses – regions in which the leading sectors have a greater weighting. Other regions, like Europe, Japan and Latin America have lagged, recouping about 65% of their losses (very similar to U.S. value) – given their heavier weighting towards value sectors.

As a result, a historic valuation gap has emerged between U.S. and international equities: Emerging market equities are now one standard deviation cheap relative to the U.S. A similar story exists for developed international equities which are more than one standard deviation cheap relative to the U.S. While we may be living in the COVID-world a bit longer, we will eventually emerge from it once a vaccine is distributed. Once we get greater visibility around this timing, the value style and international equities stand to potentially benefit the most. Investors who maintain discipline should have the chance to rebalance portfolios for a post-pandemic recovery – at very attractive valuations.

 

Comparing Traditional Mortgages vs. Variable-Rate Mortgages in the COVID-19 Economy

 

Do you remember what it was like to buy a house in 1982? You pulled up your Trans Am to the bank where the picture of President Regan hung on the lobby wall and got your checkbook out of your jean jacket. Then you signed up for a 30-year mortgage with a 17% interest rate!

The housing market, along with the rest of the world, has changed quite a bit since then. Now, you sit at home in your pajamas and compare interest rates across several lenders on high-speed internet – rates that are usually less than half of what you paid a generation ago.

COVID-19 tipped the gravity once again with this discussion and left us with historically low mortgage rates. The virus, quarantine and consequent economic depression caused the Federal Reserve to tank interest rates, leaving mortgage rates around or below 3.5% for most of the year. Compare this to a consistent rate of over 4% for several years running.

We’ve come a long way since mom and dad’s Trans Am scenario, which means a culture shift for housing finance and the need for new strategies, especially in an off-kilter year like 2020. Let’s look at some new cautions and opportunities in the housing markets.

 

Variable-Rate Mortgage versus 30-year Fixed Mortgage

Introduced in the 1980s, variable-rate mortgages – also called adjustable-rate mortgages – were a step toward helping the average American own a home. The variable rate could come in much lower than the going interest rate, which might make it more appealing to Joe and Jane Public as they scraped their pennies together.

Unlike generations before, who had to procure tens of thousands in cash and look down the barrel of a very high monthly payment for decades, the variable-rate put homeownership in reach. Joe and Jane could start homeownership with an interest rate at sometimes half of the 30-year fixed rates, which were nearly out of reach for most people in the middle of the bell curve in those days.

Today, the variable rate can be especially helpful if your life is set to change regularly. If you plan to move in five years, it can be advantageous to lock in that low interest rate for that limited initial period. You’ll also have a lower initial payment. The risk with variable rates is that they – guess what? – vary. Twenty years ago you may have been able to get a variable-rate mortgage at 3%, beating the market standard of 8%. This adjustable-rate was good for five years, and then you hit the going rate of 6.5%. It might stay there for a year before changing again – and change could mean going up! On the other hand, your rates could go down for certain periods over the life of your loan, depending on the markets.

If you were able to get a 30-year fixed-rate mortgage at 4%, then it would still be the same rate, no matter if the markets went up or down. Initially, you would have paid a bit more, but you don’t have to worry when the markets go up a few years later. Conversely, you don’t get to party when they go down, because your rate is locked in.

 

Current Rates

The debate between variable versus fixed-rate mortgages is a standard in financial circles, and both have pros and cons depending on your financial journey and goals. However, the current markets brought in a wild card because of the Fed’s efforts to shore up the economy.

With the lower federal rate, mortgages in early August are coming in at 3%. A popular variable-rate mortgage, the 5/1, is coming in at 2.5%.

 

Do the Math

Let’s look at the math. Yes, 3% is higher than 2.5% by half a percent. At the 2.5% rate, you would save $5,000 over five years on a $200,000 home loan. But after that, you’re subject to whatever interest rate benchmark your variable-rate loan is tied to. Five years from now, interest rates could spike. If the interest rate on your loan suddenly jumps to 6% for a year, that $5,000 you saved is going to disappear quickly.

Sticking with a 30-year fixed-rate, especially one you obtained in a low-interest market, will save you a lot in the long-run. Expand your vision from a few extra digits on the monthly bill to those few extra digits added up over the years. The variable-rate deal, which a bank or realtor might put in front of you, is similar to the maneuver often made by cell phone services. You sign on for a deal that shouts in loud, large-font letters: “PHONE FOR $29!!!” You don’t look closely enough to see that next to all those flashy words it says “per month.”

Well, you can cover 30 bucks a month, no problem. But after two years, you find you’ve paid $720 – plus a small horde of hidden fees – for the phone. That’s not unreasonable, but it’s not peanuts either, and it certainly feels different than the easy $29 you were promised on that first day. This is a small scale example of what could happen with a variable-rate mortgage, it looks smaller now, but you have to consider the life of the payment plan, not one installment.

 

Play 4D Chess

The slang term “4D chess” comes to mind when we think of variable versus fixed mortgage rates – which means you think and move in four dimensions, seeing beyond what’s right in front of you. We have to play 4D chess in an economic environment like 2020. We’re seeing counter-intuitive circumstances, like traditional and variable-rate mortgages at nearly the same rates, and it isn’t over yet.

In complex times like this, a meeting with your advisor can help you simplify and clarify. How can we help you? Get in touch today and we’ll help you plan out your next move.

 

 

Did You Know:

MOSTLY MORTGAGE DEBT

– Total household debt in the United States was $14.27 trillion as of 6/30/20, down slightly from the all-time record of $14.30 trillion set as of 3/31/20. 69% of the $14.27 trillion household debt total ($9.78 trillion) is mortgage debt (source: Federal Reserve Bank of New York).

AS LONG AS RATES STAY LOW

– The average interest rate that the US government pays on its interest-bearing debt as of 8/31/20 was 1.795%, down from 2.331% as of 12/31/15.  That means our government can borrow 29.9% more money today than it borrowed 5 years ago and still have the same out-of-pocket interest expense cost (source: Treasury Department).

 

Quotes:

“The greatest leader is not necessarily the one who does the greatest things. He is the one that gets the people to do the greatest things.”    – Ronald Reagan

“In matters of truth and justice, there is no difference between large and small problems, for issues concerning the treatment of people are all the same.” -Albert Einstein