To The Moon

Summary

• I view it as an understatement to say that the current overall market, approximated by the SPDR S&P 500 Trust ETF (SPY), is expensive.

• It is more expensive, much more, than what appears on the surface.

• Benchmarked against risk-free rates, my estimate is that the current SPY valuation is among the top 4% percentile.

• The valuation gap between SPY and value stocks, approximated by the Schwab U.S. Dividend Equity ETF (SCHD) is off the chart.

• I see overwhelming odds for SCHD to outperform in the years to come.

Identify the risk assessment matrix at "High" level.

Thesis

$E-mini S&P 500 - main 2306(ESmain)$ Back in July 2021, Fortune published an article to caution investors about the valuation bubble. The article has a pretty sensational title - "Bubble warning: The S&P 500 has only been this expensive for 4% of the past 140 years". At that time, the S&P 500 index just hit an all-time high of 4,385 and the P/E stood at 26.5x. Their analyses were a bit more complicated and involved the Shiller cyclically adjusted P/E ("CAPE"). However, I can easily believe their conclusion just by eyeballing the data shown in the chart below.

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Today, the S&P 500 index has retreated a bit (4,146 as I am typing this line) and the P/E has shrunk a bit too (to 24.06x as shown above). However, bear in mind that risk-free rates have changed/risen a lot since July 2021. Therefore, as I am going to argue next, the valuation of the overall market has actually become even more expensive than in July 2021 when adjusted for risk-free rates.

To facilitate the rest of the discussion, I will use the SPDR S&P 500 Trust ETF (NYSEARCA:SPY) to approximate the S&P 500 index. The considerations are mainly twofold. The first reason is that it is much easier for me (and I assume for the readers too) to pull SPY data than the S&P 500 data. This advantage will become clear when I benchmark the dividend yield against risk-free rates and also other ETFs.

And secondly, historical data has shown that SPY tracks the index closely, and as such, the error involved in this approximation is negligible. Finally, as a side benefit, by anchoring the discussion with a specific ETF, the discussion can be a bit more concrete and actionable. After all, many more investors express their view on the "market" via specific ETFs rather than trading the index itself.

After discussing the valuation risks associated with SPY, I will then offer an alternative idea. I will explain why I see the value sector as a much more attractive alternative to the overall market. For the same considerations above, I will use the Schwab U.S. Dividend Equity ETF (NYSEARCA:SCHD) to approximate the value sector.

SCHD and SPY: basic information

Let me start off with a quick introduction to both ETF funds just in case there are readers new to them. Key envelope information for both funds is summarized below.

SPY probably needs no introduction. It is the most popular ETF that tracks the S&P 500 index (and therefore is categorized as a large-cap blend fund). SCHD tracks the Dow Jones U.S. Dividend 100™ Index. The following description is directly quoted from its Fund description and it is categorized as a large-cap value fund. Note that SCHD charges a slightly lower expense ratio of 0.06% compared to SPY's 0.09%.

The fund's goal is to track as closely as possible, before fees and expenses, the total return of the Dow Jones U.S. Dividend 100™ Index… The fund tracks an index focused on the quality and sustainability of dividends and invests in stocks selected for fundamental strength relative to their peers, based on financial ratios.

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Source: Vanguard.com

Excess CAPE yield

Now, let's get back to SPY's valuation risks and why I view SCHD as a much better alternative. As aforementioned, on the surface, SPY's price and P/E have both become lower than compared to July 2021. However, my view is any discussion about valuation is incomplete without comparing it to risk-free rates.

And risk-free rates have risen by A LOT since July 2021. As an example, here I will use the ECY (excess CAPE yield), which is defined as ECY = (1 / CAPE) - U.S. 10-year treasury bond real yield. As seen from the chart below, back in July 2021, the ECY of SPY (read the blue line and the left axis) was around 3.2%. And today, the increase in treasury rates has more than offset the decrease in SPY price and valuation. As a result, SPY's ECY has become lower, only at 2.68% now.

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Fortunately, the valuation risk is not evenly distributed across market sectors. And investors can therefore still find places to hide amid an elevated overall market. In particular, the valuation gap between SCHD and SPY's growth sector has widened in recent years as shown in the next two charts. To wit, SPY's growth sector is currently trading at an FWD P/E of 20.4x, while the value sector is only at 16.8x. The gap is almost 20%.

To better contextualize and quantify the valuation gap, the next chart shows the yield spread between SCHD and SPY. The computation of the YS has been detailed in our earlier article and you are welcome to download our Google sheet here. As aforementioned, this is a key motivation for us to use these ETFs to approximate their underlying indices. The data are just much more accessible and easier for other individual investors to verify or replicate. As seen, the YS has sharply risen since 2020 and currently hovers around 2.2%, the highest level in more than a decade.

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Historical performances and volatility risks

Such a large valuation premium is completely unjustifiable in my view. And historical data does not suggest that including the growth sector can actually translate to higher returns. As you can see from the following charts, SCHD has delivered essentially the same (and sometimes even superior performance over some periods) as SPY. To cite a few numbers, SCHD's 3-year total return has been 20.2%, outperforming SPY's 17.7% by 2.5%. Its 5-year and 10-year returns are within 0.5% of SPY's returns.

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While in terms of volatility risks, SCHD's investors historically have suffered much lower volatility than SPY's as seen in the next chart. To wit, SCHD's price standard deviation has been 12.7% compared to SPY's 14.3%. The comparison is even more vivid and tangible in terms of worst-year performance and maximum drawdown. As seen, SCHD's worst-year performance thus far has been 5.5%, compared to SPY's 18.2%. And its maximum drawdown has been 21.5%, compared to SPY's 23.9%.

These advantages - comparable performance at lower risks - are not historical accidents in my view. I believe these advantages are fundamental and are therefore very likely to be repeatable in the future due to SCHD's emphasis on quality and sustainability as you can tell from the comparison of their top 10 holdings.

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Other risks and final thoughts

I not only believe the above advantages will continue into the future, but I also see the current valuation gap further tilting the odds toward SCHD, as evidenced by the historical data shown below.

The chart below depicts the 2-year total return (that is, it includes both price appreciation and dividend payouts) from SCHD minus that from SPY regressed on YS. Put another way, it shows SCHD's alpha as a function of the YS analyzed above. There is a clear positive correlation (and the Pearson coefficient is a positive 0.56). Historically, when the YS was above 1.2% (which only occurred a few times as seen), SCHD always outperformed SPY in the next two years. And the current YS spread of 2.2% is just off the chart.

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I have been talking about SPY's issues so far. And I want to point out a few issues with SCHD to provide a more balanced view. As an index fund, SCHD may offer lower valuation risks, but it is exposed to the same macroeconomic risks as SPY. Also, SCHD has higher turnover rates (14%) than SPY (2%). As a result, if you are (or plan to) hold SCHD in an account that is not tax-sheltered, its higher turnover rates could cause tax headwinds.

Finally, as a fund indexed by market cap, SCHD is even more top-heavy than SPY, which is already quite top-heavy given the dominance of the tech giants in the index. The top 10 holdings represent almost 30% of SPY's total assets, and they represent more than 40% of SCHD. Such a top-heavy portion may cause concentration risks.

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To summarize, I see the valuation risks in the overall market represented by SPY to be even higher than on the surface once adjusted for risk-free rates. Fortunately, the valuation risk is not evenly distributed across all market sectors. My view is that the valuation risks are concentrated in the growth sector judging by the record valuation gap and YS between SCHD and SPY. Historically, SCHD has outperformed SPY (especially with risks adjusted) even when the valuation gap is not as large. As such, I see overwhelming odds for SCHD to outperform SPY in the years to come.

Source: seeking alpha