Long-Term Strategic Insights: The High Hurdle for Underweighting US Equities

Exhibit 22: US Large-Cap Stocks’ Free Cash Flow Margins

Free cash flow margins have been rising since China joined the World Trade Organization in late 2001.

Margins (%) 14 Pre-Bretton Woods II Free Cash Flow Margins Bretton Woods II Free Cash Flow Margins

1957 1967 1977 1987 1997 2007 2017

Data through December 2021. Note: Excludes financials, REITs and utilities; data smoothed on a trailing three-month basis. Source: Investment Strategy Group, Corporate Reports, Empirical Research Partners.

Exhibit 23: S&P 500 Companies with Expanding Margins

A record number of S&P 500 corporations have margins at least one percentage point higher than 20 years ago.

% 80

70 % Companies with 1pp Higher Profit Margins vs. 20 Years Ago

75

60

50

40

30

20

10

0

1984 1988 1992 1996 2000 2004 2008 2012 2016 2020

Data through Q3 2021. Note: Shaded periods denote recessions. Source: Investment Strategy Group, S&P Global.

of 1981. Free cash flow margins currently stand at 11.1%.

The expansion in profit margins has been broad-based. Some 82%, a record high level, of S&P 500 corporations have higher profit margins than they did 20 years ago, and 75%, also a record high level, have increased their margins by at least one percentage point compared to 20 years ago (see Exhibit 23).

We also examined short-term indicators in search of evidence of froth. We found the opposite:

• The GIR Sentiment Indicator measures equity positioning across retail, institutional and foreign investors relative to the past 12 months. In the last several weeks of 2021, it stood between 0.7 and 1.0 standard deviations below the mean, indicating below-average positioning in equities. • The latest Global Fund Manager Survey from

Bank of America shows that fund managers have raised their cash allocations to 5.1%, which is the highest since May 2020 and stands in the 83rd percentile based on data since 2011— meaning cash allocations have been higher only 17% of the time in the past 11 years. • The American Association of Individual

Investors Sentiment Survey showed very low levels of bullish sentiment in December. • The ratio of put options to call options was more than two standard deviations above the mean of the last 12 months on December 29, indicating conservative investor sentiment and preference for put options. This indicator is volatile and changes daily.

In short, we do not see much evidence of widespread irrational exuberance. In our 2018 Outlook report, (Un)Steady as She Goes, we quoted Steve Einhorn, a former Goldman Sachs partner who led Global Investment Research, who said “This has been one of the most hated bull market advances.” Four years later, we believe that is still the case.

We conclude that our selection of short- and intermediate-term drivers does not warrant, at least not yet, an underweight to equities. These drivers do, however, propel us toward increasing vigilance and careful monitoring of triggers that would prompt us to underweight equities.

Long-Term Strategic Insights: The High Hurdle for Underweighting US Equities

While many of the readers of this report focus on our short-term financial market and economic outlook for 2022, we believe that our long-term strategic insights that establish a high hurdle for underweighting equities, if acted upon, will have the highest positive impact on our clients’ portfolios in the long run.