Why These Global Asset-Allocation Experts Are Making the Case for US Equities

On this episode of The Long View, Omar Aguilar, CEO and chief investment officer for Charles Schwab Asset Management, and Sébastien Page, Global Multi-Asset Investing at T. Rowe Price, discuss the potential interest-rate cuts, the economy, recession risk, and the state of equities today.

Here are a few excerpts from Aguilar and Page’s conversation with Morningstar’s Christine Benz and Amy Arnott.

Why T. Rowe Price’s Target-Date Funds Have Had a Persistent Overweighting in Stocks

Amy Arnott: We wanted to shift to the equity side, and Sébastien, T. Rowe Price’s Target Date series have had a persistent overweighting in stocks compared with some other target-date fund offerings. Can you talk about the thinking behind that positioning and at what life stage does your team start meaningfully ratcheting down that equity exposure within the target-date funds?

Sébastien Page: That’s a great question. We have two series—one that’s higher equities, one that’s lower equities. So, we’re a solutions provider in target-date strategies and we have a wide range of capabilities blending active and passive, active only, and so on. But our flagship has a fairly healthy allocation to stocks, and I talk about this in my book. It has to do with the time horizon. And when you ask people how much stocks do you think you should own depending on how far you are from retirement? Well, the first answer is every situation is unique. But if you bear with me and think about broad averages or very simple guidance or modeling, the answer is often more than you think. I’m 47 years old and for me it’s 80%-plus in stocks because Omar hinted at this, once you retire, nowadays you can live another 30-plus years—hopefully, if all goes well, if you stay healthy.

So, when you have a long time horizon like this and you want the power of compounding to work for you, the definition of risk is very different. It’s not month-to-month volatility. It’s longevity risk. How many years will my savings last? It’s the level of payments you can generate once you’re in retirement to Omar’s point. The income component. It’s the liquidity component. It’s a combination of these different factors. And when you put them all together, the empirical research shows that a fairly healthy allocation to stocks is more likely to lead to better retirement outcomes if you’re willing to take the month-to-month volatility, which I would argue if you’re far enough from retirement or even in retirement, you should be willing to take some of that because it’s one of the trade-offs that you can get paid for.

It decreases once you’re close to retirement. We now have an innovation in our target-date strategies where we add some tail-risk hedging component to the equity part of the portfolio when you get close to retirement to protect the downside a bit more directly as you start converting your savings into income. And I’ll just leave it at that and say that you know this whole lifecycle investing, it is, as Bill Sharpe said, the thorniest, hardest problem in finance. How do you generate income from your savings? And it’s fascinating how it’s evolving in many different directions into really—well, one thing I want to convey to you all and to your audience is there is no single solution for lifecycle investing and especially for drawing income from your savings. It’s really about where you are. It’s about personalization ultimately.

Do US Stocks Currently Look Attractive After Market Volatility?

Christine Benz: Omar, I wanted to follow up on the current time period for equities. US stocks have had quite strong gains for the year to date in 2024. The question is, do you think that US stocks are expensive currently or do valuations look more attractive to you now that we’ve had a little bit of volatility in the equity market?

Omar Aguilar: Well, a great question, and one that I think we have discussed extensively throughout this year. And I’ll mention a few things. One is, when you look at equities as an asset class and you look historically and you look at the traditional metrics that people look for evaluating whether equities are expensive or not, they look above average in terms of valuation. In other words, if you just close your eyes, look at what the indexes have and say, hey, based on history, where we are relative to the distribution of either multiples or valuation metrics, whatever is your best one that you want, definitely they look more expensive than what history may suggest for their own history.

When we tend to advise our clients and discuss with our clients, and we would like to discuss this with advisors as well, is to say, well, but equities are just one asset class that you need to put into context with the rest. And that’s when we start discussing the concept of equity risk premium. And what that means is, are the valuations or equities relative to bonds something that is still attractive for you for the risk you’re going to take? And when you look at historically, the equity risk premium is not at the level of being above average of what you would expect. What that suggests is that given—especially over the course of the last couple of months—that fixed-income assets actually tend to be a little more expensive than equities at the moment when you compare one versus the other. In other words, what that suggests is that there is still a good opportunity for you to have that diversification by providing and have a healthy allocation to equities. That doesn’t necessarily mean that you need to just be completely overweight or doesn’t necessarily mean that you need to be underweight because your concept is that valuations are above average.

The other component that I want to mention—which is critical for this—is that is if you look at the indexes and the challenge with the indexes, especially as we know this year is that the heavy concentration in the top 20% of stocks has actually created the illusion that equities are expensive. Not too long ago, and actually after the events of the unwinding of the current rate is actually more extreme, there were 70% of the stocks in the S&P 500 that had negative returns for the year. Even though the indexes overall were very positive and close to 15%-20%, not all individual securities and individual sectors ended up having the same level of performance for the year. So, what that means is that overall, because of the heavy concentration in a few stocks, that actually creates the illusion that equities have become expensive.

What we tend to emphasize for our advisors and our clients is to say, well, what that means is that you need to look beyond just the mega-caps and the large cap and the traditional definition of equities, which tends to be linked to one or two indexes, and basically look at what do you do with your value exposure? What do you do with your growth exposure? What do you do with your small cap? What do you do with your international? What do you do with emerging markets so that you can actually have an allocation that is robust at all times so that you don’t necessarily look expensive in your equity allocation related to bonds?

So, to answer your question specifically, we don’t necessarily think that equities are expensive at the moment. We actually think that equity risk premium allows you to be more thorough about allocating, but we also don’t think that it’s a good time now to take excessive risk because we expect more volatility in the second half of the year.

Why Small Caps, Mid-Caps, and International Stocks Look Attractive Today

Arnott: You mentioned a variety of equity sectors beyond the large mega-cap tech names that are still dominating broad equity indexes. So small-cap stocks, value stocks, international stocks, emerging markets—are any of those areas particularly attractive to you now in terms of valuations?

Aguilar: Our work continues to suggest that having an allocation to small caps, mid-caps, and international, it is a good amount of strategic allocation that needs to happen. And yes, in many cases, theoretical research suggests that when you have lower levels of interest rates that tend to be a positive catalyst for small caps to outperform. We saw that a little bit at the beginning of the summer when we started to see that rotation away from those mega-caps into small caps and mid-caps. And we do expect that overall, that should be a healthy way to suggest that we’re starting to just get into the next phase of the cycle. The same thing goes with the growth and value.

It is interesting because when you take out those Mag Seven securities, the performance of growth and value becomes almost identical. And in other words, there is a significant amount still of impact of those Mag Seven and those mega-caps in that definition of growth and value, which suggests that there is still a good opportunity for that cyclical diversification that allows you to prepare for the next part of the cycle, which suggests to invest in financials and industrials, in materials that usually tend to do better in the early part of the recovery.

Should Stock Investors Consider Diversifying Internationally?

Benz: Sébastien, I wanted to ask about international equities, which look attractive relative to US on many measures—valuation, dividend yield. Do you think that many US investors are overly concentrated in US stocks and should think about diversifying internationally? And if you’re making the case to investors about that, what are your talking points there?

Page: The US has an advantage in terms of the dynamism of its economy and innovation and AI and technology that’s not to be underestimated. It also now, because it’s performed so well relative to the rest of the world, represents about 70% of the total size of world stock markets. So, you would expect investors, especially if they’re in the US, but just generally, to have a large allocation to US stocks.

The valuation case has been made before and it’s been a little bit of a value trap. So, you need to ask what would be the catalysts for this rotation? Omar talked about the rotation into small caps. Currently, tactically, we’re neutral between large and small caps. He hinted at the rotation between growth and value. Currently, we’re long value relative to growth. And that also dovetails with we’re actually neutral in international. But if you force me to make the case or push me to make the case, I would say that the valuations just generally for value and Europe is more value-oriented. You have to think about it in terms of sector differences as well. Has some upside as the world economies slow down and we get eventually to the other side. Non-US central banks have been even more aggressive in lowering rates. That could be the catalyst to unlock the valuation advantage. Some emerging markets have been beaten down substantially. And so, the sentiment is so negative that it becomes attractive to take the other side.

Again, that’s if you force me to make the case. I think it’s good to have a strategic allocation that’s closer to say the relative size of the markets, which is where we’re at. But I think it could be part of the whole rotation picture as the massive spend on AI, which by the way, we think is real and is going to lead to productivity gains, but still, it leads to margin compressions. And the market, now investors starting to ask, well, where are the AI application revenues? And as we go through that transition, just generally, whether it’s international, small or value, you’re looking at a situation where the comparables are so high for growth stocks that by the end of 2024, the consensus forecast is that you’ll see for value stocks, including abroad, a year-over-year earnings-growth rate that should outpace the growth stocks. And I don’t think a lot of market participants are really positioned for an improvement in fundamentals, a passing of the baton in the fundamentals.

I’ll say one more thing on valuation. And this applies to international stocks, but also value versus growth stocks. Omar mentioned the market concentration makes the market look expensive. 2021 price/earnings ratio is very expensive by historical standards. I like to tell that story of the statistician who had their head in the freezer and their feet in the oven, but was very comfortable saying, “Oh, I’m feeling great. On average, I’m feeling great.” And this kind of, the 21 is an average of 15 price/earnings ratio for value stocks, which is basically historical average and 30 for growth stocks. So, when you look at market valuation, you’re looking at head in the freezer, feet in the oven kind of bifurcation, which is very, very, very stretched by historical standards. When we were that stretched, in no way do I think we’re in a tech bubble, by the way, because the price/cash flows are much better now for tech companies than they were in the tech bubble. But nonetheless, when you were that stretched between value and growth, in the early 2000, value outperformed by 45% in less than a year. Even in 2022, you had a big snapback of the relative valuation and value outperformed by over 20%. And so, these things can happen pretty quickly when the valuation band is stretched like that.