Leon Mehl

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-offavor 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-ofcapital 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 priceto-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 riskpremium 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 riskpremiums 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.

US Stocks experienced large gains in November. Categories that have historically lagged performed best in the month. The small-cap category advanced 16% in the month and the large-cap category did 11%. As a whole, US stocks averaged better than 13% for the month, which turned the mid- and small-cap returns positive for the year. Small-caps have nearly captured a 3% return since the beginning of the year.

Foreign Bonds excelled as risk-buying resumed in emerging markets. The average return was around 3% for the entire category. Sentiment continued to improve for emerging market bond risk as the trailing one-month return rose above 4%. The year-to-date return on emerging bonds still lags behind the global bond return. The year-to-date return is approaching 3% for emerging bonds while, 6.5% has been earned on global bonds. 

Foreign Stocks, similar to the US equity markets, were just as effective at booking strong returns last month. The average category return grew above 12% on foreign stocks. The year-to-date returns in largeand small-cap improved considerably in November. Since the beginning of the year, large-cap was just short of a 4% return while emerging markets maintain their lead with a return near 9%.

Hard Assets largely improved in November. The only area of weakness was in the precious metal return. Despite precious metals losing value last month, they have a return of almost 23% year-to-date. Real estate and energy partnerships were the two hot segments in the hard asset category. Energy partnerships performed almost 19% in November. Real estate was around 11% for the same period. Both energy partnerships and real estate have yet to advance out of their year-to-date losses.

US Bond returns were modest in November as the attention was placed on stocks. Still, all of the bond categories delivered positive results in the month. Corporate bonds were a more popular investment in November. Monthly returns of investmentgrade and high-yield bonds performed better than the entire US Bond category. The monthly return flattened out on intermediate treasuries, but they were still able to end the month with a nominal gain.

Hybrids were strong in the month. The average return finished above 7% for the category. Convertibles led strongly in November with a return of 10%. Stock market strength helped lead the convertible category higher. The yearto-date return held in convertibles had expanded above 30%. Preferred stock experienced a one-month return in excess of 4%. Last month’s return took away the year-to-date losses that were previously being carried in the asset class.