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S&P 500: Why It’s Likely to Underperform and 5% Money Markets Aren’t the Answer

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Dear readers,

Throughout the year, I’ve received countless comments from investors, particularly regarding REIT stocks that I cover, asking why they shouldn’t invest in 5% money markets for a higher yield and capital safety compared to REITs. It’s a fair question, but today I want to explain why waiting in market money funds is not the solution. Instead, I will discuss two alternatives: the S&P 500 and REITs.

The S&P 500

Let’s start with my expectations for the S&P 500, which also apply to the Nasdaq 100. Both indexes have a significant weighting towards technology stocks, many of which are trading at high multiples despite rising interest rates. This raises concerns as technology stocks should be sensitive to interest rate changes due to their long duration.

Currently, growth stocks, especially in the technology sector, are overpriced. In fact, technology stocks are trading at a forward P/E 20% higher than the average between 1997 and today. This suggests that valuations have not adjusted to the higher rate environment.

Furthermore, JPMorgan’s study, which only considers data from 1997 onwards, indicates that a forward P/E of 17.8x historically results in average total returns of around 5% over the next five years. However, this analysis does not account for the period of near-zero interest rates, which could have artificially inflated the average P/E multiple. With rates currently above 5%, the actual future performance of the index may be worse than the predicted 5% return.

Considering the high inflation environment and the modest total return projections, a less-than-exciting sub-5% return over the next five years raises the question:

Isn’t it better to get 5% risk-free from money markets?

In the short-term, buying money market funds and fixed income instruments to generate yield for the next few years and immediate spending is a reasonable strategy. However, in the long-term, which is our focus when investing, this approach is not ideal. Yield from money markets tends to be short-lived, and when the money needs to be reinvested, interest rates will likely have dropped and stock prices will have risen significantly, resulting in substantial opportunity cost.

While there have been cases, such as 2000 and 2008, where waiting in money market funds at peak rates paid off, there have also been instances like the 1990s, 1995, and 2020, where money market investors missed out on substantial market rallies. Timing the market is nearly impossible, and settling for money market funds, which have historically failed to beat inflation, is not the solution.

A Possible Solution

Considering the current market conditions, the S&P 500 isn’t positioned to deliver the impressive annual returns we’ve seen in the past. However, waiting in treasuries isn’t foolproof either, as inflation is likely to erode most of our nominal returns, and there’s a risk of missing out on substantial upside in stocks over the long-term.

My strategy at the moment is to avoid overpriced stocks that have not adjusted for the high interest rate environment and instead invest in undervalued companies with strong balance sheets, growing cash flows, and high dividends. By doing so, I’m looking for opportunities where sentiment is low, despite favorable fundamentals.

Some may argue that it’s better to invest in recent winners and sell recent losers, but the name of the game is buying when others are fearful. Depending on your risk appetite, there are many stocks and sectors that have the potential for significant gains from current levels, which I cover here on Seeking Alpha.

Here are a few examples:

  • Brookfield Asset Management (BAM)
  • Blue Owl Capital (OWL)
  • Apollo Global Management (APO)
  • Blackstone (BX)

I also like selected consumer discretionary stocks, such as:

  • Starbucks (SBUX)
  • EssilorLuxottica (OTCPK:ESLOF)

Additionally, I believe equity REITs can outperform in a high interest rate environment. Some REITs worth considering are:

  • Agree Realty Corporation (ADC)
  • VICI Properties (VICI)
  • Alexandria Real Estate (ARE)
  • Crown Castle International (CCI)

For investors seeking safety and upside, a few preferred shares on REITs, utilities, and financials might be worth considering:

  • EPR Properties (EPR.PR.C)
  • Athene (ATH.PR.A)

The bottom line is that there are many attractive opportunities in the market today, and there’s no reason to invest in the overpriced S&P 500 or settle for money market funds. Conduct your own research and you’re likely to discover some bargains out there.

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