SPY - ITOT: Earnings Revision Will Result In Another Round Of Decline

2023-03-30 03:07:41 ET

Summary

• ITOT has a portfolio of about 3,300 stocks, which is a good representation of the broader U.S. market.
• Despite the decline in the broader market since the beginning of 2022, valuation still appears expensive.
• Earnings may continue to be revised downward as the U.S. economy eventually enters a recession and ITOT’s fund price will be impacted negatively.

ETF Overview

The broader market suffered a significant decline in 2022 since reaching a cyclical high in late 2021. Now that the Federal Reserve announced that we are near the end of this rate hike cycle, is this a good time to invest? We will analyze iShares Core S&P Total U.S. Stock Market ETF ( ITOT ) and provide our insights and recommendations.

ITOT includes about 3,300 large-cap, mid-cap and small-cap stocks in its portfolio. The fund has comparable performance to the S&P 500 and appears to be a good replica of the broader market. Despite the significant decline last year, the broader stock market still looks expensive to us. Given a possible recession is on the horizon, we think investors should wait for a better entry point.

Fund Analysis

ITOT offers comparable performance to the S&P 500 but is much more diversified

Last year was a challenging year for the broader stock market as the Federal Reserve aggressively raise the rate to combat persistent inflation. ITOT also declined considerably. As can be seen from the chart below, the fund has declined by 18.27% since the beginning of 2022. This was slightly inferior to the S&P 500’s decline of 16.71%.

Despite the decline last year, the fund actually did very well over the long term. As the chart below shows, the fund delivered a total return of 393.5% since its inception in January 2004. This was only slightly inferior to the total return of 402.4% of the SPDR S&P 500 ETF ( SPY ), a fund that tracks the S&P 500 index. Given that large-cap stocks have generally outperformed the broader market in the past decade and that SPY consists solely of large-cap stocks, it is not surprising to see that ITOT trailed SPY’s performance slightly over the long run.

Despite its slightly inferior performance over the long run, ITOT appears much more diversified as it contains over 3,300 stocks. In contrast, S&P 500 index only include about 500 large-cap stocks. Although both funds’ top 10 stocks are identical, these stocks only represent about 23% of ITOT’s portfolio. On the other hand, the same top 10 stocks represent about 27% of SPY’s portfolio. Therefore, ITOT is much more diversified and is less impacted if any of these top 10 stocks decline significantly.

The revised Buffett Indicator tells us that the broader market is still expensive

One method to evaluate whether the broader market is expensive or not is to use the Buffett Indicator. In a Forbes interview in December 2001, Warren Buffett recommends using the ratio of total market capitalization to GDP to evaluate whether the broader stock market is overvalued or not. According to Warren Buffett, if the total market capitalization to GDP ratio is in the range between 75% and 90%, the market’s valuation is considered fair. If this ratio is above 90%, the stock market is somewhat expensive. If this ratio is above 120%, the broader stock market is very expensive.

This method to evaluate the valuation is very appropriate, as ITOT’s portfolio of 3,300 stocks in the U.S. stock market appears to be a good representation of the broader U.S. market. However, given that the Federal Reserve has significantly expanded its balance sheet over the past 20 years, the denominator of the equation needs to be revised to include total assets of the Federal Reserve. Taking this into consideration, the revised ratio is equal to the total market capitalization divide by GDP plus Fed Assets. Using this equation, the ratio is derived to be about 113.9%. As can be seen from the chart below, while this ratio has declined significantly from nearly 150% during the peak of the pandemic, it is still quite elevated compared to the period between 2010 and 2017. In addition, this ratio of 113.9% is still way above the fairly valued range of 75%~90%. Therefore, we think the broader market is still quite expensive despite the decline in 2022.

A recession will lead to earnings revision and compress the fund price

Looking forward to the rest of 2023, the Federal Reserve has indicated that they will not lower the rate this year, as inflation is still quite high. We believe the Federal Reserve is walking a tightrope between fighting against persistent inflation and keeping the economy afloat. The longer they keep the rate elevated, the more likely a recession will occur. Our base case is that the Federal Reserve’s tightening policy will eventually lead the economy into a recession. As can be seen from the chart below, in past recessions, earnings estimate of stocks in the S&P 500 (large-cap), 400 (small-cap), or 600 (mid-cap) indexes got significantly revised downward. In fact, we are beginning to see earnings estimate being revised downward in the past few months. The problem is that then earnings revision usually reach a bottom in a recession, not before a recession. Since we are not yet into a recession, we think there is still more room for earnings to be revised downward. This will lead to more declines in ITOT’s fund price.

Investor Takeaway

Although ITOT’s valuation has declined considerably last year, it is still quite expensive based on the Buffett Indicator. Given that earnings revision of the broader market is just starting, downside risk remains quite high. Hence, we recommend investors to wait on the sidelines.

Additional Disclosure : This is not financial advice and that all financial investments carry risks. Investors are expected to seek financial advice from professionals before making any investment.

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