Vanguard Mid Cap ETF: Cheap Valuations And High Quality (NYSEARCA:VO)


In this world nothing can be said to be certain, except death and taxes. – Benjamin Franklin

The Vanguard Mid Cap ETF (VO), a fund that is focused on mid-cap US stocks, has not been loved in recent years. It has had an impressive Covid-recovery, finally turning positive for the year, but remains below all-time highs made in February. Of course, this is not new for mid-cap investors. In the last three years, despite overwhelmingly positive equity markets and a risk-on sentiment, mid-caps have outperformed large caps, as measured by the Vanguard S&P 500 ETF (VOO). And by a significant amount, with a gain of 47.29% for the latter in the last 3 years to a gain of only 29.38% for the former.

Looking at the holdings of the ETF, the top 10 holdings account for only 8.1% of the portfolio, as much of the company-specific risk has been diversified away. Sector-wise, the holdings are balanced, with the top 3 sectors being Technology (21%) Financials (20.6%), and Industrials (15.3%). That gives a nice balance to the ETF in growth industries and value industries, which lets you hedge out the bet on which strategy will win out over the long term after more than a decade of growth stocks flourishing. Eventually, value investing can return, and you will have exposure to those types of companies with this holding.

Source: Vanguard

Thoughtful Selections

While the Covid crisis has many challenges for the mid-cap space, the portfolio has some excellent picks. For example, Lululemon Athletica Inc (LULU) is in a unique position, as their demand has likely increased with more consumers looking for comfort while working from home, a trend that the athleisurewear company has been excellent at capitalizing on. DexCom Inc. (DXCM) recently smashed earnings expectations in late July, with revenues gaining 34%, and earnings up a whopping 541%. SBA Communications (SBAC) managed to keep their dividend and beat FFO by $0.45, also beating on revenues, in their recent earnings report as more internet was used during the stay at home period. These, among other mid-cap plays, are extremely interesting in the ability to pivot and capitalize in a poor economy and should rebound stronger if the economy can continue its up leg.

Potential Risks

  1. If the economic recession is worse than thought, mid-caps may not have enough resources to weather the storm. Bankruptcies have been happening at an increased rate, especially when you go down the capitalization ladder, and could pose trouble throughout the rest of 2020 and into 2021, especially if government stimulus fails to gain traction in Congress. Many of these companies depend on a strong consumer.
  2. The dividend yield of VO could be under pressure here, especially if there is some movement on the political side to halt buybacks and shareholder payouts. While this remains a far-off risk, it is not implausible, and should be discounted as a risk when investing in these companies. With balance sheets that are inferior to larger-cap companies, there could be more pressure to keep free cash flow for future economic pullbacks and/or business pressure, lowering the dividend yield.
  3. This holding has 357 holdings currently, with a median market cap of $18.9 billion. While you are not going to be worried about diversification, you may suffer the effect of over-diversification with that many holdings. There have been studies done that say the proper amount of holdings for accurate diversification should be around 20-50 holdings only – at 357, the number is much higher.
  4. General market risk remains high after a Federal Reserve (Fed) fueled rally in 2020 off the March lows. If the Fed fails to stoke inflation, or they do not provide enough stimulus, stock markets are at risk of another major pullback. We saw some of this in the price action in early September, when tech stocks spurred a significant decline.

The ETF VO, and its underlying holdings, have shown a great ability to weather a downturn in the recent months. Although valuations remain elevated, at 25.3x P/E, the earnings growth rate of 13.7% should make up for that level over time. This is a great fund to get domestic exposure, as its foreign direct exposure remains 0%, and with a relatively low turnover of 15.2%, you should be comfortable holding this ETF long term.

While highly diversified, there are enough excellent ideas within the portfolio that can push the ETF to new highs, eventually. Whether the overall economy and markets remain in their uptrend is a huge question, but if you are looking for a 10- to 20-year investment, VO fits the bill. The nimbleness of mid-caps should allow them to adjust to the new normal economy, and if there is progress on a vaccine in late 2020 or early 2021, many will flourish.

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Rationalization: Low Rates Justify High Valuations


The “rationalization” that low rates justify high valuations is but one of several arguments used to justify overpaying for value in a late-stage bull market.

As discussed previously, one of the “bullish spins” for the market has been that “earnings are cheap” based on 2- and even 3-year forward estimates. As noted in “Justifiable Bullishness Or Is It Willful Blindness?“:

In 2020, investors are again chasing “growth at any price” and rationalizing overpaying for growth. Such makes the mantra of using 24-month estimates to justify paying exceedingly high valuations today, even riskier.”

Such is also why there is the most significant disparity between growth and value on record.

This Time Is Different

The belief that this time is different from the past has always been the most dangerous of phrases for investors. However, this is where participants exist today. While it is true the excessive monetary liquidity has certainly changed short-term market dynamics, there is no evidence that it has mitigated long-term consequences.

Moreover, investors are also relying on the belief that low interest rates justify overpaying for earnings and sales.

“Valuations don’t matter as much as they did in the past because ‘this time is different’ in that interest rates are so low.”

The basic premise of the interest rate/valuation argument has its roots in the “Fed Model” as promoted by Alan Greenspan during his tenure as Federal Reserve Chairman.

The Fed Model states that when the earnings yield on stocks (earnings divided by price) is higher than the Treasury yield, you invest in stocks, and vice-versa. In other words, disregard valuations and buy yield.

There is a critical disconnect that needs to be understood.

Earnings Yield

You receive the income from owning a Treasury bond. However, there is no tangible return from the earnings yield.

For example, if I own a Treasury bond with a 1% coupon and a stock with a 2% earnings yield, if the price of both assets doesn’t move for one year – my net return on the bond is 1%, while the net return on the stock is 0%.

Which one had the better return from 2000 to the present?

Yet, analysts keep trotting out this broken model to entice investors to chase an asset class with substantially higher volatility risk and lower returns.

Low Rates Don’t Justify High Valuations

An offshoot of the Fed Model to rationalize overpaying for assets is that low interest rates justify high valuations.

However, is the recent decline in interest rates, driven by massive global Central Bank interventions, really providing valuation support? The premise is that cheaper borrowing costs boost bottom line earnings. The problem is that over the last decade, low rates have led to a deterioration in economic growth and prosperity.

The chart below takes the interest rate argument from a little different angle. I have capped interest rates from their “low point” of each interest rate cycle to the next “high point” and then compared it to the S&P 500 index. (The vertical dashed lines mark the peaks in the S&P 500 Index.)

In the majority of cases, the market tends to peak between the low point interest rates for each cycle and the next high point. In other words, a period of steadily rising interest rates is not conducive to higher equity prices.

Discounting The Discount

The primary argument is that when inflation or interest rates fall, the present value of future cash flows from equities rises, and subsequently, so should their valuation. While true, assuming all else is equal, a falling discount rate does suggest a higher valuation. However, when inflation declines, future nominal cash flow from equities also falls, and this can offset the effect of lower discount rates. Lower discount rates are applied to lower expected cash flows.

In other words, without adjusting for inflation and, in no small degree, economic growth, suggesting low rates justify overpaying for cash flows is a very flawed premise.

“Instead of regarding stocks as a fixed-rate bond with known nominal coupons, one must think of stocks as a floating-rate bond whose coupons will float with nominal earnings growth. In this analogy, the stock market’s P/E is like the price of a floating-rate bond. In most cases, despite moves in interest rates, the price of a floating-rate bond changes little, and likewise the rational P/E for the stock market moves little.

– Cliff Asness

Historically, when interest rates or infla­tion are low, the stock market’s E/P is also low, as shown in the chart above.

But when isolating the times when interest rates were meager, that has occurred twice; in the 1940s and currently. In the 1940s, stock valuations were low, along with interest rates. Therefore, the statement that low interest rates cause high valuations is a .500 batting average, which is the equivalent of a coin-flip.

Analysis

  • Exceptionally high interest rates, which have occurred twice, coincided with low stock market valuations. This fact does not prove that high interest rates “cause” low stock valuations. But at least the historical record is consistent with such a statement.
  • Extremely low interest rates, which have occurred twice, have coincided with high stock market valuations only once: today. The historical record (1/2 probability) does not validate the highly confident mainstream narrative that low interest rates “cause” or extremely high stock market valuations.
  • Extremely high stock valuations have occurred three times. Only once (1/3 probability) did high stock valuations coincide with low interest rates: today.
  • If extremely low interest rates do not cause extremely high stock market valuations, then a rise in rates should not necessarily cause a decline in stocks. That is, the historical record does not support the near-certain mainstream narrative that an increase in rates will torpedo stock prices.
  • To demonstrate the ability of a consensus narrative to overwhelm analysis of historical facts and even current reality, consider that the Fed has hiked short-term interest rates five times since December 2015. Also, long-term rates bottomed in mid-2016 and have moved more than a full percent higher. Yet, the S&P 500 index has risen more than 30% since the lows in short-term and long-term rates.

As noted in “Why This Isn’t 1920. Valuations & Returns,” the highest correlation between stock prices and future returns comes from valuations.

Rationalization Low Rates, Rationalization: Low Rates Justify High Valuations

Forward Returns Suffer

There is little support for the statement that low rates support high valuations, as noted by Cliff Asness previously.

So, when pundits say it is a good time for long-term investors to buy stocks because interest rates are low, and then show you something like chart above to prove their point, please watch the tense of what they say, as what they often really mean is that it was a good time to buy stocks ten years ago, as investors are now paying a very high P/E for the stock market (perhaps fooled into doing so by low interest rates as I contend), and the story going forward may be painfully different.

– Cliff Asness

The last point is crucially important. The chart below compares earnings yield (inverted scale) to forward 5-year real returns. When E/Y has been near current levels, the performance over the next 5 years has been quite dismal.

Conclusion

It is imperative to remember valuations are very predictive of long-term returns from the investment process. However, they are horrible timing indicators.

Beware the investment advisor, pundit or superstar investor who is sure that extremely low rates cause incredibly high stock valuations. Or, that a rise in rates from extremely low levels will cause a decline in stock prices. Stocks may fall, and interest rates may rise, but the historical record disagrees that one causes the other.

There is much to debate about the current level of interest rates and future stock market returns. However, what is clear is the 40-year decline in rates did not mitigate two extremely nasty bear markets since 1998, just as falling rates did not mitigate the crash in 1929 and the subsequent depression.

Do low interest rates justify high valuations?

History suggests they don’t.

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Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.





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Wall Street advances as U.S. factory activity hits 19-month high By Reuters


© Reuters. The front facade of the of the NYSE is seen in New York

By Medha Singh and Devik Jain

(Reuters) – Wall Street climbed on Tuesday as a surge in Apple shares (NASDAQ:) propelled the tech-heavy Nasdaq to record highs, while better-than-expected U.S. manufacturing sector data fueled optimism around a post-pandemic economic recovery.

Apple Inc gained 1.7%, rising for the second straight day after its stock split took effect, as a report said the iPhone maker had asked suppliers to make at least 75 million 5G iPhones for later this year.

ISM data showed U.S. factory activity expanded for the third straight month to a reading of 56.0 in August, the highest since January 2019. The figures follow encouraging manufacturing surveys from China and Europe earlier in the day.

Investors will keep a close eye on the monthly U.S. jobs report due on Friday amid signs the labor market’s recovery is stalling.

Wall Street’s main indexes recorded their fifth straight monthly gain on Monday, riding massive central bank support, U.S. government aid and demand for tech-focused stocks.

While the Nasdaq and the S&P 500 have scaled all-time highs recently, the blue-chip Dow is still about 4% below its February peak.

“Investors are continuing to reward the ability to innovate and adapt … not just to the tech companies, but those companies that are in other industries that have been good users of technology,” said Stephen Lee, portfolio manager at Logan Capital Management in Newtown Square, Pennsylvania.

Technology, communication services and consumer discretionary stocks were leading gains among the major S&P sectors.

Treasury Secretary Steven Mnuchin’s comment that a new coronavirus relief bill will “hopefully” be unveiled next week also boosted sentiment.

U.S. politics will take center stage in the coming weeks. Republican president Donald Trump, who is running for re-election against Democratic presidential nominee Joe Biden, has seen his polling gap with the former vice president narrow recently.

At 10:11 a.m. ET, the was up 4.16 points, or 0.01%, at 28,434.21 and the S&P 500 was up 6.82 points, or 0.19%, at 3,507.13. The was up 98.94 points, or 0.84%, at 11,874.40.

Among other stocks, Zoom Video Communications (NASDAQ:) Inc surged 43.5% after the video-conferencing platform raised its annual revenue forecast by more than 30% as it converted more of its huge free user base to paid subscriptions.

Walmart (NYSE:) Inc rose 2.6% after the retail giant unveiled the perks of its new loyalty program, Walmart Plus, which will grant subscribers unlimited free delivery, fuel discounts and no checkout lines.

Tesla (NASDAQ:) Inc fell 4.3% after the electric-car maker announced plans to raise up to $5 billion through a share sale program a day after its 5-for-1 stock split.

Advancing issues outnumbered decliners for a 1.10-to-1 ratio on the NYSE. Declining issues outnumbered advancers for a 1.17-to-1 ratio on the Nasdaq.

The S&P index recorded 20 new 52-week highs and no new low, while the Nasdaq recorded 59 new highs and 22 new lows.





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Euro at two-year high vs. the dollar as European stocks and U.S. futures gain


A passenger wearing a face mask is seen at the main train station in Frankfurt, Germany, on Aug. 29, 2020.


Kevin Voigt/Zuma Press

The euro reached a two-year high on Tuesday and European stocks rose, as traders balanced growing signs the recovery is continuing with concerns governments are withdrawing aid.

The euro
EURUSD,
+0.25%

traded as high as $1.1999 vs. $1.1936 on Monday, as the shared currency reached the strongest level since May 2018. The gains for the euro come amid the backdrop of an aggressive U.S. Federal Reserve, which last week said it would begin an average inflation targeting program, though it left implementation vague.

The U.K. FTSE 100
UKX,
-1.12%

fell 1.2% after a three-day break. The German DAX
DAX,
+0.66%

and the French CAC 40
PX1,
+0.11%

each advanced, as did the Stoxx Europe 600
SXXP,
+0.14%
.

After a 223-point retreat for the Dow industrials
DJIA,
-0.78%

on Monday, U.S. stock futures
YM00,
+0.07%

pointed higher.

The German government upwardly revised its 2020 estimate of a contraction, now seeing a 5.8% fall versus the earlier projection for a 6.3% contraction in 2020. The final readings of the manufacturing purchasing managers index for August showed a second month of improving conditions, while consumer prices were negative.

U.S. Treasury Secretary Steven Mnuchin accused Democratic lawmakers of not wanting to negotiate in good faith, at a time when unemployed people in many U.S. states have lost federal unemployment benefits. The federal government is due to shut down on Oct. 1 in the absence of new funding agreements.

Reports over the weekend in the U.K. suggested the Treasury was looking to increase taxes to pay for coronavirus relief.

German commercial real estate company Aroundtown
AT1,
+3.49%

rose, after saying it would buy back up to €1 billion of its own stock as it is in talks to sell over €1 billion of assets.

Old Mutual
OMU,
-5.65%

slumped, as the Anglo-South African insurer reported a first-half loss and suspended its dividend.



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Asian stocks hit two-year high, Nikkei bounces as Berkshire buys in By Reuters


© Reuters.

By Wayne Cole

SYDNEY (Reuters) – Asian shares notched a fresh two-year high on Monday as investors wagered monetary and fiscal policies globally would stay super stimulatory for a protracted period, keeping the safe-haven dollar on the defensive.

MSCI’s broadest index of Asia-Pacific shares outside Japan added 0.2% to reach its highest since June 2018, extending a 2.8% rise last week.

Tokyo’s Nikkei () rallied 1.4% aided by news Warren Buffett’s Berkshire Hathaway (N:) had bought more than 5% stakes in each of the five leading Japanese trading companies.

The Nikkei had dipped on Friday after Prime Minister Shinzo Abe’s resignation stirred doubts about future fiscal and monetary stimulus policies.

Those concerns were eased somewhat by news Chief Cabinet Secretary Yoshihide Suga, and a close ally of Abe, would join the race to succeed his boss. A slimmed-down leadership contest is likely around Sept. 13 to 15.

The next event of note in Asia will be China’s official manufacturing PMI survey for August which is forecast to show a slight improvement to 51.2 as the recovery there continues.

The U.S. ISM manufacturing survey is also expected to show a continued pick up in activity in August, while August payrolls on Friday are forecast to rise 1.4 million with the unemployment rate dipping to a still painfully-high 9.8%.

A host of Federal Reserve officials are set to speak this week, kicking off with Vice Chair Richard Clarida later Monday as they put more flesh on the bank’s new policy framework

Fed Chair Jerome Powell boosted stock markets last week by committing to keep inflation at 2% on average, allowing prices to run hotter to balance periods when they undershot.

The risk of higher inflation in the future, assuming the Fed can get it there, was enough to push up longer-term Treasury yields and sharply steepen the yield curve.

Yields on 30-year bonds jumped almost 16 basis points last week to stand at 1.508%, 137 basis points above the two-year yield. The spread was now approaching the June gap of 146 basis points which was the largest since late 2017.

That shift was of little benefit to the U.S. dollar given the prospect of short rates staying super-low for longer, and the currency fell broadly.

Early Monday, the was down at 92.211 and just a whisker above the recent two-year low of 92.127. The euro edged higher to $1.1915 (), having climbed 0.9% last week.

Marshall Gittler, head of investment research at BDSwiss Group, noted speculators had already built up record levels of long positions in the euro which could work to limit further gains.

“A truly crowded trade that will take more news to push higher,” he argued.

The dollar did steady a little on the yen at 105.47 , after dropping 1.1% on Friday before finding support in the 105.10/20 zone.

In commodity markets, the drop in the dollar helped gold bounce to $1,974 an ounce.

Oil prices steadied, having dipped on Friday after Hurricane Laura passed the heart of the U.S. oil industry without causing any widespread damage.

futures rose 15 cents to $45.96 a barrel, while gained 6 cents to $43.03.

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