Back in May we wrote about how US equities had become extremely overstretched relative to European equities. If we leave the relative attractiveness discussion aside, US equities are in isolation not that expensive as they might look. As of July 2020, the 12-month trailing free cash flow (FCF) to enterprise value yield is 3.9% (the FCF yield on European equities is currently 12.5%) compared to only 0.5% for US 10Y Treasuries. Even if you only assume 0-2% growth in future free cash flows the future expected returns massively favour equities over bonds. The latter still plays a role though as a component to calibrate the portfolio to some desired risk profile.
If we compare the S&P 500 FCF yield against the US 10Y yield, then two things emerge. One, there is clearly two separate periods which we can call the pre-Lehman and post-Lehman periods. Second, equities are probably one of the few options investors have left for meaningful long-term return and especially in potentially inflationary environment. The pre-Lehman period was a period where financials, energy and other capital-intensive industries dominated the equity market. This period sees lower growth in free cash flows and a permanently lower free cash flow yield than the offered yield in US Treasuries.
As chart below shows the S&P 500 outperformed the US 10-year Treasuries, but with worse risk-adjusted statistics (see table below). The S&P 500 managed a 8.6% annualized return during this period compared to 7.1% annualized for the US 10-year Treasuries. Despite natural headwinds from valuation on the expected returns for equities during this period they managed to pull ahead of government bonds mostly due to growth in underlying free cash flow.
The post-Lehman period is interesting for two reasons. One, the technology eco-system (semiconductors, e-commerce, hardware (smartphones etc.), software, cloud etc.) compounded into becoming the most dominant segment in the equity market. Second, central banks have constantly pushed down interest rates despite the temporary period for the Fed in the years 2016-2019. Technology companies have lower capital expenditures requirements relative to revenue growth and the digitalization from a low penetration created a high growth environment for these companies with high operating margins and predictable cash flows.
As the interest rates have come down the valuation multiples on these types of businesses have increased dramatically and with long USD rates getting very close to zero the multiplication effect goes exponentially. On top of this the technology companies have delivered growth in free cash flows beyond the growth rate in the pre-Lehman period and the combination of the two has created a period (post-Lehman) where S&P 500 has delivered annualized return of 11.4% compared to only 5.3% annualized for US 10-year Treasuries. Despite this massive outperformance US equities still look attractive relative to US government bonds but relative to itself measured against the pre-Lehman period. The critical assumption behind this is the Fed will keep interest rates at these very low levels for a very long time. This assumption will come under massive pressure if inflation comes back but given our little understanding of forecasting inflation it will difficult to know when to change the mindset on equities. But our advice to investors is to closely monitor the US 10-year yield and inflation expectations.