In the early 1980s, the U.S. music scene was a bit of a black hole. Disco was dead (or on serious life support), the Eagles and Steely Dan had broken up, most of Lynyrd Skynyrd had died in a plane crash, most of Aerosmith wished it had died in a plane crash, and 80s stalwarts such as Michael Jackson, Prince, Lionel Ritchie, Whitney Houston, and Hall & Oates had yet to have their breakout albums. The UK, on the other hand, was becoming a burgeoning music hotspot. Bands such as the Police, U2 and the Pretenders were beginning to hit it big, fueled by a series of British programs that encouraged these acts to explore their more artistic side through a new-ish format called music videos. Now, music videos were not actually new, as artists such as the Beatles had popularized the format 15-years before. But in the UK in the late 1970s, music videos were no longer just the purview of a few established acts, but rather began to become a ubiquitous format used as a tool by even emerging artists to get their music out to the public.
On August 1st, 1981, Music Television or MTV was launched across cable stations in the U.S. MTV promised 24-hours of music videos hosted by Vee-jay’s. However, with the U.S. music scene stuck in a bit of black hole, MTV needed content to fill its rotation and with the UK scene rich in music videos, the marriage of the two was an easy one. Suddenly, acts such as the Police, Genesis, and Culture Club had an outlet to the U.S. music scene outside of traditional radio and a second British invasion (albeit a smaller one) was launched.
Amongst these “new invaders” was a new wave quintuplet out of Birmingham called Duran Duran. Duran Duran’s self-titled first album debuted in June of 1981 with their third single (and first hit) Girls on Film hitting the airwaves in July of 1981, just a few weeks before MTV’s launch. Now, Girls on Film is a really bad ear worm of a ditty, but as you might imagine given the title, the music video had some, umm, spice to it. In fact, the music video was so spicy that MTV would only agree to play it with some serious editing. But, no matter, even heavily edited, the video was a hit and Duran Duran was a global sensation.
The band’s second album – Rio – released a year later was a monster hit – leading to the moniker “the Fab Five” and the band launched a global tour that would make them among the most popular acts in the world (Princess Diana went as far as to call Duran Duran her favorite band, which is not nothing).
It is their third album, however, that provides our weekly segue – Seven and the Ragged Tiger. Somewhat despised by “Duran-istans”, Ragged Tiger was panned by critics, despite three huge hits, including the band’s only number one single – “The Reflex”, which is apparently in charge of finding treasure in the dark.
The Seven
2023 has been the year of the Seven. In our extended analogy, the Seven are Apple, Microsoft, Alphabet, Nvidia, Tesla, Amazon, and Meta. Let’s look at chart and then comment:
The rise of ChatGPT and Artificial Intelligence has helped to fuel a massive rally in these seven companies. This rise has also helped to drive the weighting in these seven names to nearly 30% of the index, which punches significantly above their weight (the chart below will help to explain what we mean by this):
While the Seven account for 28% of the market cap of the S&P 500 (they were about 20% at the start of the year), they account for only 11% of the revenue and 17% of the earnings of the index. This has helped to drive their valuations to heretofore unreached levels:
The Ragged Tiger
As you might have guessed, the Ragged Tiger in our bloated analogy is the rest of the stock market. While the S&P 500 has risen ~8% on the year, if one looks beneath the hood (or beyond the Seven), the picture is distinctly different:
Here, we are using the equal weighted S&P 500 but excluding the Seven. The average return year-to-date for the other 493 stocks in the S&P 500 is ~-7% or ~15% worse than the S&P 500 and ~85% worse than the average return for the Seven. Now, we would note that some of this is a reversal from 2022 when the average return for the Seven was -46%, while the Ragged Tiger only lost an average of 13% last year. In other words, if looked at over a 2-year basis, the relative returns look better (the Seven would be down ~10% since the start of 2022, whereas the Ragged Tiger would be ~17%).
Canada is the Ragged Tiger
For the most part, the Canadian market lacks exposure to stocks that resemble the Seven. That said – Energy has been a powerful driver of returns over the past two years:
Overall, the TSX is down ~12% since the beginning of 2022; although, if we strip out Energy, the remainder of the index is down ~20%. In other words, the TSX ex-Energy is a Ragged Tiger of its own. We have long harped on how the Canadian market is more of an income market, while the U.S. market is more of a growth market. This has become especially acute in the past few months as the sharp rise in longer-term interest rates has helped to fuel a sell-off in stocks that pay high dividends, regardless of the safety of these dividends. As a result, the TSX now has as many stocks with a dividend yield of greater than 6% as it does stocks with a dividend yield of between 2% and 4%:
When will the Ragged Tiger fix his/her stripes?
The easy answer to the above question is – when interest rates start to come down. This would have a dual effect for high dividend payers – 1) it would make their dividends look more attractive relative to bond yields; and 2) it would help to allay any concerns that investors might have regarding the balance sheets of these companies.
The first point is a straightforward one – dividend paying stocks compete with bonds for investor dollars. When bond yields are very low (as they were for more than a decade), dividend paying stocks look attractive on a relative basis, which helps to propel their stock prices, all else equal.
The second point is a bit more esoteric, but with the sharp rise in rates and many of the higher dividend paying sectors - Real Estate, Utilities, Pipelines, Telecom – carrying significant amounts of debt, the sharp rise in interest rates has stocked concerns about refinancing these debts at much higher rates, which would negatively impact earnings for these companies (through higher interest costs) and potentially their ability to pay high dividends. Add to this the negative impact that higher rates have on the broader economy (and Canadians are especially sensitive to this), and it’s not hard to envision these stocks responding very positively to rates coming back down.
So, when are we likely to see this?
While inflation has been far stickier than we or most others imagined, the Canadian economy has slowed markedly and is likely to get worse over the next couple of quarters. This has helped to bring inflation down; although, it remains well above the Bank of Canada’s 2% target (it remains between 3% and 4%). Our view remains that as we get toward the middle of 2024, rates are very likely to have peaked and will be heading lower in the face of a slowing economy. This is likely to first happen with long-term rates and then eventually short-term rates, so while the Bank of Canada may be on hold until late 2024 (or even 2025), this does not mean that there will not be some rate relief for the stock market.
One final note on the Ragged Tiger
We would add in closing that the damage done to stocks over the past 22-months has created a unique longer-term opportunity. Rarely do good businesses go on sale en masse, but with the “ready, fire, aim” approach of investors over the past few months, we have reached that point in our view. We remain patient in our approach to adding too much exposure at this point as we do not feel “the tiger is out of the woods, yet” (apologies for what has now become a tortured analogy), but when the time does come, we think the upside could be significant given where valuations have settled relative to historic norms.