How Investor Expectations Are Driving Stock Prices

This year, there has been more optimism in the stock market compared to 2022. For investors only looking at the returns of the S&P 500, it may seem like the economy is in a boom. This dynamic may be surprising, given the rising interest rates and forecasts for slower growth.

“Expectations are like a debt that must be repaid.” – Morgan Housel

To make sense of what’s happening with stock performance this year, let’s start with some basics about stock valuations. First, know that expectations are built into every company’s stock price. Valuation theory teaches us that a company’s stock price is based on a combination of the company’s current value and its expected future cash flows, or what investors expect the company will earn over time.

One of the more popular ways to measure investors’ expectations is the earnings yield, which is simply a company’s earnings expressed as a percentage of its market price. It’s the inverse of the price-to-earnings (P/E) ratio, and just like with bonds, a higher yield suggests that the stock may earn more over time.* With that background, here are three insights from the earnings yields we see around the world today, which show why chasing the biggest returns in equity markets may not be the wisest choice.

1. The Big Companies Are Expensive

We generally see large positive returns from a stock for one of two reasons: unexpected improvements in business fundamentals or improved expectations for the company.

With technology stocks, we’ve seen a lot of the second scenario playing out. Nvidia, a maker of computer components that help artificial intelligence applications run effectively, nearly tripled in value through the first six months of the year. As of the end of June, the top five stocks in the S&P 500 comprised nearly 24% of the index value. On average, these top five companies are worth 10 times as much as the rest of the index, but they only yield about half as much. Warren Buffett offered sound advice when he said: “A business with terrific economics can be a bad investment if it is bought for too high a price.”

Tech is Dominating the S&P 500

The Big Companies Are Expensive

2. The Price for Smaller, Less Expensive Companies Has Dropped

The optimism in U.S. stocks seems to be limited to large, established companies. Smaller companies in the U.S. are trading at significantly better yields. Specifically, companies that are inexpensive relative to their peers, what we call value companies, are seeing yields higher than during the 2008 financial crisis – they’re trading like we are already in a deep recession. Although that part might sound concerning, the higher yields show these stocks may be a great opportunity for investors who are focused on the long term.

Small Value Stocks Look Very Attractive

The Price for Smaller, Less Expensive Companies Has Dropped

3. Investors Agree That International Stocks Are Risky

The U.S. has had a great 15 years of stock market performance. However, the outperformance in the U.S. has been driven by multiples expansion – investors have been willing to pay more per dollar of earnings from U.S. companies, at least partially because they are perceived to be safer investments than companies overseas. Compared to the latest earnings, international stocks are about one-third less expensive than their U.S. counterparts, meaning the yields on international stocks look quite a bit more attractive.

Prices Reflect Higher Risk Internationally

Investors Agree That International Stocks Are Risky

Good Years Will Come at Different Times

The media portrays certain indexes, such as the Dow Jones and S&P 500, so frequently that they have become the de facto barometer for how stocks are performing. However, these indexes only represent a portion of investable companies, and as we have seen, the largest companies can represent an outsized portion of the index returns. The earnings yield is one way to measure how good of a deal different stocks or regions are compared to their peers, and right now, the evidence suggests that leaning toward both international companies and small, less expensive companies offers an attractive opportunity for evidence-driven investors.

*This is an imperfect measure: a stock with a low earnings yield could go on to outperform, assuming the company can exceed the current expectations or make unexpected innovations in its field. But comparing differences in yields can give an indication of how high investors have priced their expectations for different companies or segments of the market.

Sources: Returns data were retrieved from Morningstar. Earnings yield data are based on trailing 12-month earnings. U.S. stocks are represented by the Russell 3000 Index. International stocks are represented by the MSCI World ex USA IMI. Small Value stocks are represented by the Russell 2000 Value Index. Holdings and concentration calculations for the S&P 500 Index are based on the holdings of the Vanguard S&P 500 Index Fund ETF (ticker: VOO). All returns and valuation metrics presented are through June 30, 2023. In Chart 1, Tech is Dominating the S&P 500, four companies had an earnings yield greater than 25% and were excluded from the visual.

For informational and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is based on third-party data and may become outdated or otherwise superseded without notice. Third-party information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio nor do indices represent results of actual trading. Information from sources deemed reliable, but its accuracy cannot be guaranteed. Performance is historical and does not guarantee future results. All investments involve risk, including loss of principal. By clicking any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party websites. Buckingham is not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them. Neither the Securities and Exchange Commission (SEC) nor any other federal or state agency have approved, determined the accuracy, or confirmed the accuracy of this article. R-23-6175

Saving for College with a 529 Education Plan

Kevin Grogan: With it being back to school time, I wanted to spend today’s video talking about saving for college and specifically saving with 529 plans. So the agenda for today’s video is I’ll first talk about some of the basics related to 529 plans, and then I’ll cover a couple of the common questions that we often get related to saving in these plans.

529 Plan Basics

Kevin Grogan: So in terms of the 529 plan basics, the way these plans work is that you save into the accounts with after-tax money and then the amount that you save gets to grow tax free until you withdraw the money. And as long as you withdraw the money for educational purposes, then the money gets to come out tax free. And one additional benefit is that some states actually offer an income tax deduction at the state level for making the contributions in the year that you make the contributions. But to be clear, in all states, the investment gets to grow tax free and in all states the money gets to come out tax free if it’s used for education purposes. And the way 529 plans are structured is that they’re actually sponsored by individual states. So every state has its own 529 plan. You can kind of think of it as kind of analogous to how each company has its own 401K plan and the way these 529 plans work is each state’s plan will have its own set of investment options, will have its own set of costs associated with it. And again, it’s very analogous to how each company has a different set of investment options and costs associated with their 401k plans. And so that’s kind of an easy way to think about the structure of 529 plans.

What Happens to Unused Funds Left in a 529 Plan?

Kevin Grogan: So in terms of the common questions that we get, first, a most common question is what happens if I put money into a 529 plan and then I wind up not needing it for some reason, because again, my child winds up not going to college, gets a scholarship, things like that. And so the first thing to understand is that the penalty for pulling money out of a 529 plan for non-education related purposes is pretty steep. So you have to pay federal and state taxes on all of the earnings that were made in the account, plus a 10% penalty on all of the earnings in the account. So it is a pretty steep penalty to use 529 dollars for something other than educational purposes. But there are some workarounds that you can use if you wind up in a circumstance where you don’t need all the dollars that you’ve saved to the 529 plan. So the first and most common workaround is that you can change the beneficiary of the account. So let’s say, for example, you have three children. The first child winds up not going to college, second child winds up getting a full-ride scholarship that covers all of their education-related expenses and then the third child winds up going to an expensive college where they have to pay full freight. They don’t get any financial aid and no scholarships. What you can do in that circumstance is change the beneficiaries of the first two 529 plans assuming you’re saved into separate accounts for each beneficiary, you could change the beneficiaries of those first two 529 plans to your third child, and then that child could use all of those dollars. So that’s a very clear example where changing the beneficiary can be really helpful in using up all of the dollars that you’ve saved across all of your children. Beyond that, you can also change the beneficiary beyond just kind of your immediate family. You can change the beneficiary to a niece, nephew or if you really wanted to stretch things out over a longer period of time, you could change the beneficiary to a future grandchild if you wanted to do it that way as well. And then finally, there’s been a recent change in the law in that beginning in 2024, you can actually roll 529 dollars into a Roth IRA for that beneficiary. So there are a lot of limits and caveats associated with this Roth IRA provision. So be sure to look into that, check with an advisor before counting on the ability to roll things out into a Roth IRA.

Do I Have to Use My Own State’s 529 Plan?

Kevin Grogan: Second most common question is do I need to use my own state’s 529 plan? And the answer here is that it depends largely based on the tax provisions in your specific state. So if your state offers a tax deduction for using your home state’s plan, then in general it makes sense to go ahead and use that state’s plan to take advantage of that income tax deduction from making the contribution. So that would be the first piece of advice. But beyond that, there are groups of people in different categories that can use any state’s plan and they kind of fall into three different categories. So first category is the most straightforward. Those would be people who live in states that don’t have a state income tax. And so in that circumstance, it doesn’t really matter which state’s plan you use. Those examples of those states would be Florida, Nevada, Tennessee and Texas. The second category would be states that don’t offer any deduction regardless of which state’s plan that you use. So examples there would be California and North Carolina. Finally, there are a group of states that offer deductions, whether you use the home state plan or another state’s plan. And examples of those would be residents of Arizona, Missouri and Pennsylvania. So if you fall into one of those three categories where you can use any state’s plan, we would generally recommend using the Utah plan because it has very low costs and a good mix of investment options available for savers to use. If you do have any questions on anything I’ve covered in today’s video, please don’t hesitate to reach out to your advisor.

If you have any questions please feel free to drop us a note.

For informational and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is based on third party data and may become outdated or otherwise superseded without notice. Third party information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. The time frame chosen because of the dates of available data. The inception of the AIEQ ETF was 2017. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio nor do indices represent results of actual trading. Information from sources deemed reliable, but its accuracy cannot be guaranteed. Performance is historical and does not guarantee future results. All investments involve risk, including loss of principal. Neither the Securities and Exchange Commission (SEC) nor any other federal or state agency have approved, determined the accuracy, or confirmed the adequacy of this information.

Buckingham Connects Quarterly Webinar: September 2023

Buckingham thought leaders’ discuss U.S. and global market performance, tax planning considerations, and other financial planning topics.

During this recorded webinar, Chief Investment Officer Kevin Grogan, CFA, CFP®  gave an update on year-to-date market performance and shared why recession predictions for this year may be overblown. Chief Planning Officer Jeffrey Levine, CFP®, CPA, PFS, CWS, AIF, RICP, ChFC®, BFA touched on timely planning topics, including protecting yourself from cybersecurity risks, financial tips for teenagers who earned money in part-time jobs this summer, and an update on what taxpayers should know about state and local tax deductions. Buckingham Strategic Wealth President Wendy Hartman, CFP® covered what to know about the TD Ameritrade and Charles Schwab merger, changes affecting required minimum distributions (RMDs), and charitable giving strategies to consider before the year is over.

6 Steps to Plan for a Future Inheritance

Within the next 20 years, trillions of dollars are expected to be passed between generations. Whether you’re expecting a life-changing inheritance, a modest inheritance or maybe not anything, it’s an important situation to think about. Although everyone’s situation will be different, there are steps you can take to make sure the transfer of wealth goes smoothly.

1. Take care of yourself mentally and emotionally.

Coping with the loss of a loved one can be one of the hardest things to go through in life. Anticipating that can be equally as hard. Before you even get started on the financial aspect of an inheritance, it’s crucial to address the personal aspect, first and foremost. Make sure you are mentally and emotionally prepared to begin these conversations. Take care of yourself.

2. Communicate early on.

Whether you’re the one who will inherit wealth or will transfer wealth upon death, conversations about this topic can be uncomfortable. However, the loss of a loved one is something everyone experiences. Communicating in advance is a good way for everyone to get on the same page and know what to expect. It’s better to have answers to hard questions than to be left wondering when there’s no one around to answer them. Knowing what your predecessor’s estate plan consists of, for example, can help smooth uncertainty when the time comes to distribute their wealth.

In addition to communicating with your predecessors, if you are married, it’s equally important to communicate with your spouse. Often one spouse inherits wealth without having any prior conversations with the other spouse about how it will be used. Couples who haven’t planned may disagree on how to allocate these assets once received, leading to more uncertainty and stress during an already difficult time.

3. Make sure your own affairs are in order.

It’s always beneficial to revisit your own financial plan after a significant change, but it’s a better time before change happens. Take the time to make sure your financial affairs are in order. Try putting yourself in your predecessor’s shoes if you’re on the receiving end of the wealth transfer. How would you want the experience to go? What would you want your beneficiaries, heirs or legatees to know beforehand?

4. Know the legal and tax consequences in your respective state.

One should consider the tax and legal consequences of inheriting assets at both the federal and state level. Twelve states have an estate tax separate from the federal estate tax, and six states have an inheritance tax. These taxes can result in less being passed on.

Different assets and asset ownership types have different treatments. For example, investment accounts are typically more straightforward than real estate or ownership in private businesses. Another example is the nine states that have community property laws, which means that for married couples in these states, any assets acquired after marriage belong to both spouses equally. Such laws further complicate the potential distribution of assets and are another reason to plan for inheritance early.

5. Don’t count your eggs before they hatch.

No matter how likely the inheritance is, making major decisions based on anticipation of what’s to come is not a wise strategy. You don’t necessarily want to decide on retiring earlier than planned because of an inheritance that pushes you over the finish line. Depending on your situation, it may make sense to factor an inheritance into your retirement plan, but it’s best to be conservative with your expectations. If you make a decision based on possible outcomes, you could be in trouble if they don’t happen. If you wait to make a decision and the anticipated outcome happens, you still win.

A few reasons not to make a premature decision are:

  • Probate costs – probate costs can take a significant amount out of an estate before it reaches beneficiaries.
  • Creditors – creditors have a right to collect, and a good time for them may be upon passing of the debtor.
  • Taxes – there may be estate taxes, inheritance taxes or even unpaid taxes from prior years, all of which Uncle Sam has the right to collect.
  • Medical costs – medical costs can be incurred up until the last days of someone’s life. Although government programs like Medicare can cover certain end-of-life care expenses, these final medical costs can go unaccounted for or underestimated and can result in a lower estate value.
  • Owner may change their mind – even if someone promises to pass on wealth, they can choose to allocate the wealth elsewhere or spend it all without you knowing.
  • Value of assets decrease – if someone has their wealth tied up in capital markets, that wealth is subject to precipitous drops. Assets in the stock market can lose 10% in a day, and real estate assets can have their value cut in half in a matter of weeks. Although markets typically rebound after such declines, no one has a crystal ball to know when exactly these events will happen.

6. Seek help from a professional, wherever necessary.

If you don’t know how to prepare for or handle an inheritance when it comes, it may end up being worth little to nothing. Professionals in law, accounting and financial planning who specialize in this situation can offer their experience and knowledge. Even if you’re well versed in these areas, you may benefit from an outside party’s guidance as family wealth transfers can become complicated. Reach out to your advisor if you have questions about ensuring you are prepared to receive an inheritance.

If you are not currently working with an advisor, we would love to help answer your questions on inheritance planning. Please schedule a short phone call or virtual conversation with one of our advisors.