2023-03-30 05:47:02 ET
Summary
- VTI has a portfolio of about 3,945 stocks, and this provides a good representation of the broader U.S. market.
- Despite the decline last year, valuation still appears expensive based on the Buffett Indicator.
- The U.S. economy will eventually enter a recession in H2 2023 and the stock market will test another bottom as earnings continue to be revised downward.
ETF Overview
The broader market suffered significant decline in 2022 and reached a trough in October last year. However, it has since rebounded. Is a new bull market forming now? Is this a good time to invest? We will analyze Vanguard Total Stock Market ETF ( VTI ) and provide our insights and recommendations.
VTI invests in about 3,945 stocks and is much more diversified than the S&P 500 index which only include 500 stocks. Although VTI has declined by over 17% since early last year, its valuation is still expensive. Given a possible recession coming up in the second half of 2023 and earnings will continue to be revised downward, we think investors should patiently wait for the broader market to bottom before initiating a position.
YCharts
Fund Analysis
VTI has a much more diversified portfolio than the S&P 500
Last year was a difficult year for the broader market due to the Federal Reserve's aggressive rate hike to combat inflation. Like the S&P 500, VTI also delivered a negative return. In fact, its negative return of 17.17% was inferior than the S&P 500's negative return of 15.5%. This slightly inferior decline was primarily due to its much more diversified portfolio. Unlike the S&P 500 that includes about 500 large-cap stocks, VTI's portfolio has over 3,900 stocks. Although the top 500 stocks still represent roughly 85% of the total portfolio, the rest are mid-cap and small-cap stocks. These smaller stocks are not as established as large-cap stocks and are much more vulnerable in a rate rising environment. This was the primary reason behind VTI's underperformance last year.
VTI has underperformed the S&P 500 in the past 10 years, but outperformed since its inception in 2021
If we take a look at VTI's performance in the past 10 years, we will find that its total return of 191.6% slightly trails the S&P 500. Again, this was primarily due to S&P 500's higher exposure to large-cap stocks. More specifically, it was the large-cap growth stocks such as the FAANG stocks that contributed to the significant appreciation of the broader stock market in the past 10 years. Therefore, S&P 500's slightly higher exposure to these stocks than VTI was the primary reason.
YCharts
However, the story is a little bit different if we look at VTI's growth since its inception. As can be seen from the chart below, VTI delivered a total return of 411.3% since its inception in 2001. The fund has outperformed the S&P 500 by about 56 percentage points. This outperformance was because large-cap growth stocks was not favored by the market in the first decade after the internet-dot-com bubble in 2000. Looking forward, we do not know whether large-cap growth stocks will be favored by the market again or not, but we do know that diversification will help reduce the risk in the long run. Therefore, we still favor VTI over S&P 500 index.
YCharts
VTI is still expensive based on the revised Buffett Indicator
One method to evaluate whether the broader market is expensive or not is to use Warren Buffett's valuation metric, or the so-called Buffett Indicator. What exactly is 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 extremely overvalued.
This evaluation method is very appropriate as VTI's portfolio of 3,945 stocks is a good replica of the broader U.S. stock market. However, given that the Federal Reserve has significantly expanded its balance sheet over the past 20 years, we need to include the total assets of the Federal Reserve in the denominator. Therefore, the revised ratio is equal to the total market capitalization divide by GDP plus Fed Assets. As can be seen from the chart below, the ratio is currently about 115.5%. This is above the fairly valued range of 75% ~ 90% and is not far away from the extremely expensive range of 120% or above. Despite the stock market decline last year, the current ratio of 115.5% is still elevated when compared to the range between 2010 and 2015. Therefore, we think VTI is still very expensive.
Last year was about multiple compression, and this year is going to be about earnings revision
Our base case is that there will be a recession this year. The reason is simple, the longer the Federal Reserve decides to keep the rate elevated, the more likely it will tip the economy over to a recession. Since the Federal Reserve has indicated that they will not lower the rate any soon, we think this recession will eventually happen and it could be during the second half of 2023. Last year was about multiple compression as the Federal Reserve aggressively hike its rate, and this year will likely be about earnings revision especially if a recession is not far away. In fact, we are already seeing earnings being revised downward in different broader market indexes (see chart below). In previous two recessions, earnings were significantly revised. Since earnings revision usually ends during the recession and not before the recession, and that we have not yet even entered a recession, we think there is still more room for earnings to be revised downward. This will eventually lead to more decline in VTI's fund price.
Yardeni Research
Investor Takeaway
If last year's decline was due to multiple compression, the decline we project will happen later this year will be due to earnings revision. Given we think a recession will eventually arrive later this year, we think investors should patiently wait on the sidelines.
For further details see:
VTI: The Market Will Test Another Bottom As The Economy Heads Into A Recession