Climate and Valuation Risks In Focus
Reading headlines over the last quarter sometimes felt like the beginning of the end of days. We’ve had five hurricanes make landfall in the region of North America, three of which set records: Harvey resulted in nearly 65 inches of rainfall, the highest-ever rainfall total for any tropical storm in the United States; Irma was the strongest Atlantic storm on record; Maria had the second-fastest intensification of any tropical depression to a hurricane since records have been kept. September 2017 was the most active month on record for Atlantic hurricanes. Mexico suffered two major earthquakes in a two-week period. There were widespread and damaging wildfires in the Pacific Northwest. Two nuclear powers, the U.S. and North Korea, are rattling sabers. What might all this mean for markets?
Momentum Stocks Fuel Equity Markets
Despite these headlines, the equity markets in the third quarter continued an unabated march upward with only very short periods of intermittent stumbling. Asset flows into passive investment vehicles have helped propel markets and valuations higher, indiscriminately directing capital to overvalued names. Such an environment is challenging for active managers as valuation, risk and fundamentals go largely ignored.
A deeper dive into what drove equity markets in third quarter reveals a market fueled by momentum and beta, confirming that investors are not focused on fundamentals. Momentum refers to the tendency of winning stocks to continue performing well in the near term, and that has been the dominant performance factor dating back to the 2016 presidential election.
The strong contribution of beta to performance suggests investors are ignoring risks, seemingly of any sort, natural disasters or otherwise. This is confirmed by the CBOE Volatility Index,ƒ commonly known as the VIX, which is used to gauge investor perception of risk. The VIX closed the quarter at a low not seen in over 10 years, further indicating that risk is taking a back seat, if not being buried in the trunk!
Trying to time when heightened volatility will creep back into the stock market is imprecise to say the least. However, investors who ignore the longer-term impacts of risk do so at their own peril. Two risks continue to remain a key element of our focus here at Pax — valuation in the near term and climate change over all time horizons.
How Much Room is Left to Run?
Historically, overvalued equity markets have tended to run and become more richly valued. That said, the length of the run, magnitude of returns and degree of over valuation varies before each correction. Equity markets, like today, can be sustained by positive sentiment from corporate earnings and economic data, but this is often quickly priced into the valuation. What may not be priced in are the risks that can bring the bull market to an abrupt and painful end.
This current bull market has run for 102 months, making it the second longest bull market in history. We believe valuations are stretched by many measures:
- Forward P/E on the S&P 500 Index† is currently at 18X, levels not seen since the Tech Bubble. And that valuation incorporates optimism on 2018 earnings.
- Small-cap stocks as represented by the Russell 2000 Index‡ are even more expensive at 24.5X 2018 earnings, also representing a multi-decade high.
- Total Market Cap of the U.S. Equity market as a percentage of U.S. gross domestic product (GDP) is now at 135%. A fairly-valued market historically has traded in 70%-90% range for this metric.
While it is often said that overvaluation alone does not end bull markets, these valuations are a warning that when the market becomes re-focused on risk, a sharp correction could be in order. The juxtaposition of the 10-year VIX chart with 10-year S&P 500 P/E chart (see Figure 1 below) presents the current environment succinctly and clearly — valuations are at multi-decade highs and concerns about risk are at a 10-year low. This should raise concern that any unforeseen risk — from an unexpected increase in the rise of interest rates to a geo political event — could cause a sharp reversion in stock prices.
Figure 1: Stock Market Valuations and Volatility: Volatility is near the lowest levels in decades, while valuations have ascended higher.
Time period 10/12/2007 through 10/11/2017.
Anticipating and Pricing Climate Risk
Historically, markets have tended to shrug at hurricanes, at least in the short term. The market reaction to many catastrophes follows this general pattern: great damage often crimps supplies of goods and services, which in turn raises prices, which, after all is said and done, may boost profits and therefore stock prices — at least for energy producers and insurance companies.
However, with the incidence of billion-dollar weather events increasing in recent decades, investors are learning to anticipate and price the risks of catastrophes and climate change with greater specificity. Some storms have affected fuel prices — through shutting down or damaging refineries (Katrina, Harvey) or damaging deepwater drilling platforms (Katrina, Rita) — and many represent heightened risk and financial outflows for reinsurance companies.
A recent report calculated that the economy is losing around $240 billion a year — 40% of U.S. economic growth — from weather events (whose impacts are significantly worsened by climate change) and air pollution from fossil fuel energy production. In the next decade, that is expected to increase to $360 billion per year — half of expected U.S. economic growth. Anything that affects the economy so profoundly will affect corporate financial performance and stock markets as well.
PriceWaterhouse does an annual survey of board directors, and according to the 2016 survey, 72% of directors see strategic/disruptive risks as the greatest oversight challenge to the board, the top vote-getter. But only 6% of directors saw social and environmental risks as the greatest oversight challenge. That raises an interesting question: do people — including directors, as well as investors — connect those categories?
According to the PwC survey, the answer for many directors is apparently no. But climate change is quite likely to be both strategic and disruptive if these risks are not anticipated and managed. If we see hurricanes as freaks of nature that occasionally happen, we’re more likely to be victims of increasingly violent weather, rather than taking steps to anticipate and plan for it. Some companies have heeded the wake-up call: after superstorm Sandy, Con Edison, the New York utility, spent $1 billion modernizing its infrastructure to cope with a future in which we can expect Sandy-like storms more often.
Investors are increasingly aware of the multiple risks that climate change poses, not just to the regulatory risk assumed by emitters but to any company whose facilities, customers, supply chains and infrastructures are vulnerable to the physical impacts of a warming globe.
That is why Pax has focused much of our company engagement on climate risk, urging companies to establish targets for emission reduction and publish reports on how they will adapt to a low-carbon economic future. And this year, for the first time, those proposals passed at several oil majors, including ExxonMobil, PPL and Occidental, where Pax cofiled the resolution asking the companies to report to shareholders on how limiting future warming to 2â°C would affect their operations.
This is a first: there have been several shareholder resolutions on climate change filed at major energy companies before, but none have passed — until now. This may be an inflection point on climate-change proposals, and it’s not a moment too soon. The greenhouse gases we emit today will be in the atmosphere for decades — and for some, millennia — so this isn’t a problem we can wait to solve. It’s good that investors are starting to really move the needle on this issue.
Real and Significant Risks
While the risks from overvaluation and climate change may not raise sufficient concern in the near-term, they are real and significant. A fully-priced equity market provides little room for error. In today’s euphoric market environment, we believe prudent long-term investors are best served not chasing the last dollar of a stretched bull market, but rather ensuring that the proper level of risk is maintained in their asset allocation. Similarly, just like Con Edison, investors can take steps to anticipate and plan for climate change by taking into account its potential impacts on sectors and companies.
Beta reflects the sensitivity of a Fund’s return to fluctuations in its benchmark; a beta for a benchmark is 1.00: a beta greater than 1.00 indicates above average volatility and risk.
Forward Price-Earnings (P/E) Ratio is a ratio for valuing a company that measures its current share price relative to its per-share earnings over the next 12 months.
ƒThe Chicago Board Options Exchange (CBOE) Volatility Index (VIX) is a measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. It is a widely-used measure of market risk and shows the market’s expectation of 30-day volatility.
†The S&P 500 Stock Index is an unmanaged index of large capitalization common stocks.
‡The Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 Index is a subset of the Russell 3000 Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership.
One cannot invest directly in an index.