Back in a former life as Chief Canadian Equity Strategist for RBC CM, I used to describe the U.S. as a growth market and Canada as an income market. If one summed the combined weights of Financials, Utilities, Real Estate, Telecommunications, and Pipelines, the traditional “income-focused” sectors of the market, one would have found the following at the start of 2022:

In the face of too high inflation and the consequent need to sharply raise interest rates, pretty much all boats suffered in 2022, but in 2023, we have seen a sharp divergence as the “non-income” portions of the market have begun to recover, while income-oriented investments continue to lag:

Rather than dwell too much on what the past 18-months has wrought, we thought it would be interesting to take a look at where valuations for the TSX now lie. Generally speaking, when markets go through a prolonged rough patch, it is because earnings and earnings expectations collapse in the face of a slowing economy. However, we would note that at the beginning of 2022 reported and expected earnings for the TSX were lower than they are now. In other words, while the TSX is down ~7% since the start of 2022, this has not been because of some epic collapse in earnings or earnings expectations, but rather largely the result of a compression in valuations.

To get a good picture of value in the market, we will focus first on the Canadian banks and then look at the broader market.

 

The Banks – Partying Like it’s 1993

The Canadian banks are collectively down ~15% since the start of 2022. As with the broader market, this has not occurred because of some great collapse in earnings, but rather largely the result of severe multiple compression. Let’s look at a chart and then comment:

Here we are looking at a 30-year chart of the Canadian banks based on price-to-book value. While we will not get too deeply into the weeds on this, generally speaking, the Canadian banks have historically traded at close to 2x book value largely because they generate high teens return on equity (ROE) and a high teens ROE generally commands a valuation such as this.

However, as you can see in the chart above, the banks are currently well below this average (the red dotted line) and, in fact, are near the lows of the early 1990s, 2008/09 and the brief COVID selloff. To put the current valuations in perspective, the banks have spent 48 months below that lower grey line (one standard deviation below the average) over the past 30-years and the average 5-year return from those levels has been an annual compounded return of 21% with the worst return ~15%.

As a check, we might also take a look at earnings and it tells largely the same story:

Now, we would not be surprised to see the banks struggle for the next 6-months or so. The Bank of Canada seems hellbent on raising interest rates at least one more time (a decision that we disagree with) and it generally takes time for the banks to adjust their businesses to a dramatic change in interest rates (it typically takes 18-24 months for loans to reprice higher, so while the banks are paying significantly more for deposits than they were 18-months ago, their loan books have yet to reflect the current higher rate reality). But we believe that the day is approaching when investors will begin to look past the current valley and with valuations near historic lows, the set-up for 2024 and beyond is compelling.

 

The Broader Market: As cheap as it has ever been

While the Canadian banks are approaching historic lows on various valuation metrics, the broader TSX may already be there. Let’s start with a chart and then comment:

Here again valuation has been pushed to extremes, with the TSX only cheaper in the past 30-years during the Global Financial Crisis. While the economy has slowed over the past 18-months and the risks of recession remain, the economic backdrop today, especially as it relates to job creation and general animal spirits (restaurants remain full, as do airplanes and hotels), remains okay.

Bottom Line

If we had to make a call, it would be that the 0–6-month outlook remains muted, but the 6-60 outlook is much more favorable. The TSX and many of its component parts are very much like coiled springs with a catalyst of some sort waiting to unleash the pent-up energy. In our view, this is likely to be the point at which not only we have definitive evidence that the Bank of Canada (along with other global central bankers) are done with their rate hiking campaigns, but also some compelling evidence that interest rate relief will be forthcoming.

We are prepared for the 0-6 to get pushed back a bit (we are skeptical it will be pulled forward) as the BoC seems unlikely to pivot as soon as we think it should, but regardless, we think the set up for the next few years is becoming increasingly exciting. For now, we remain patient in waiting for opportunities, content to hold a bit more cash than we normally would – but capitalizing on opportunities when the valuation disconnect becomes too large to ignore.