What would it take to get the TSX to 20k by 2020? While I acknowledge there is no significance to 20k other than it’s a nice round number, as we have seen with Dow 10k or 20k, these things matter to investor psyche (not to mention the front page of the newspaper). With the S&P 500, such an exercise in prediction (what would it take to get the S&P 500 to 3k by 2020, for example) would in many ways be easier, as the S&P 500 is a broadly-diversified index both by sectors and stocks. This diversification allows one to make assumptions about earnings growth and the multiple that investors might be willing to put on earnings and come up with a simple answer. In other words, if S&P 500 earnings grow at 20% in 2018 (driven by tax cuts) and then by 6% in 2019 and 2020 (the historic average) and we assume a multiple of 18x these earnings (roughly around where we are right now), then we get to a value for the index slightly above 3K.

 

Conversely, the S&P/TSX does not fit so nicely into an analysis such as this. As I used to point out in institutional meetings (shameless plug by me as to my bona fides), the TSX is really two indices within an index. The first, a commodity index comprised of roughly 5,000 index points (and further sub-dividable into 3 other component parts). The other, an “ex-commodity” index (hereafter "ex") comprised of roughly 11,000 index points and split roughly equally between Financials and non-Financials.

 

The "ex"

In 2017, the “ex” index earned roughly $700 per share and our models suggested 2018 would likely see this EPS number rise to about $745. There was some variability to that number, but not much, barring a surprise recession or major credit event. In other words, it might be $740 or $750 of EPS, but it is unlikely it will be $700 or $800.

 

Historically, the “ex” has traded between 12 and 17x earnings (see chart) save for when Nortel or RIM might have pushed it higher. The Financials, which are about half the “ex”, tend to pull the multiple down, while everything else - the rails, Utilities, the grocers, etc. - tend to pull it up. We entered 2018 at about 14.8x 2018 earnings for the "ex" group - so not a table-pounding moment by any means, but reasonable in the context of expensive valuations in most jurisdictions.

Commodities

The commodity segment of the market can be further sub-divided into three roughly equal segments - Energy producers, mid-streams (pipelines) and metals (dominated by gold). The three subgroups account for ~5,000 TSX points and collectively earn between $100 and $200 per share; although the predictability of this earnings stream is much lower than it is for the "ex" group.

 

Further, earnings for this group probably do not matter all that much (except for putting a context around overall TSX valuation) as traditional price-to-earnings multiples are not going to be used by most investors in determining whether or not to take a position - but rather, the driving force is going to be their outlooks for the underlying commodities and the extent to which commodity stocks may or may not be pricing this in (ironically, the best time to buy them may be when they're the most expensive on a price-to-earnings basis as this usually corresponds to significant commodity downturns and maximum pessimism toward the group).

 

Collectively, the price-to-book multiple (the best, albeit flawed metric we have) for the group has tended to vary between about 1x and 1.9x (see chart); although the historic comparisons are somewhat sketchy as the nature of the index has shifted dramatically over the past two-decades (resources were once dominated by base metals and to a lesser extent energy producers, whereas producers, golds and mid-streams now make up the bulk of the TSX's resource exposure). Thus, for the sake of this piece, we will focus on the last decade, which will tend to give us the best representation of how the next few years might play out.

Getting to 20K

There are obviously a lot of moving parts to this, but I think the easiest stepping off point is to focus on the "ex" group and assume that over the next two-years we do not experience a recession. As mentioned, 2018 earnings should come in around $745 for the group. If we assume 6% earnings growth for the group (average for the past two decades), we get to a 2020 figure of about $840 per share.

 

At a 15x multiple, this would translate into ~12,500 TSX points. Every multiple point is worth about 800 TSX points, so one could imagine the "ex" group contributing closer to 13,000+ points in the right environment (especially closer to year-end 2020 when we pivot to 2021 earnings), but "betting" on multiple expansion is no better than a coin flip.

 

I would also add that the earnings growth for the "ex" group over the past two-decades has been fueled in large part by a massive leveraging of the Canadian consumer (see chart), not to mention a sharp downshift in operating ratios (costs as a percentage of revenues) for the Canadian rails and record low borrowing costs for consumers and businesses. Thus, getting to the historic average of 6% may be a bit of a stretch goal absent these same tailwinds.

The other 7k or so needed to get us to 20k likely would need to come from the commodity complex. Obviously, predicting the glide path of commodities is somewhat of a fool’s errand (although a fair bit of money is spent trying to figure it out), but the key here is going to be how quickly book values (net asset values (NAVs)) can compound and what multiple investors are willing to put on this.

 

Book values have largely stagnated over the past decade (compounding at an inflation-like 2% since the beginning of 2008), while multiples have hovered around 1.5x. If we assume that book values compounded at twice this rate (i.e. 4%) and that multiples converged toward the high-end of the range (i.e. 1.9x), we would get about a 40% return, which would provide the index with the needed 7,000 points to get to 20K.

 

How likely is this?

I think to get to 20k by 2020, one has to have a fairly sanguine view of things. Not only do you need to accept the premise that we do not have a recession between now and then, but you also need to accept the premise that the changes to mortgage rules, coupled with high consumer leverage and rising rates is not going to, at the very least, slow EPS growth (or worse should it trigger some credit problems). Further, one needs to accept that commodity prices will continue to rise (contributing to above-average compounding of NAVs) and that investors will attach a high multiple to this. Should one or more of these things fail to materialize (likely in my view), then the TSX is likely to fall short of the 20k mark.

 

Is this definitive? Of course not, but from my lens it illustrates how challenging it will be for a pure, broad Canadian mandate to perform over the next few years. 20K by year-end 2020 is ~8% per year, so granted one does not need 20K in order to get good returns out of Canada (especially when dividends are included), but if any of the above mentioned issues turns against us, 16k or 17k in 2020 may be more likely than 20k. Sure, oil could go to $100 or multiples for banks, rails, et al could vault toward the high end of the historic range (or even boldly go where they’ve never gone before), but banking on this would be a poor investment strategy in my view.

Bottom Line: You'll hear this a lot from me in the coming blog storm, but Canadian investors need to continue to think outside a pure Canada mandate. While the past 10-years have been a struggle in Canada, especially at the index level, the math does not suggest to me that this is about to change anytime soon. In my view, owning good core Canadian businesses is still key to any good strategy for Canadian investors (we'll have more on these core names in the blogs to come), but this should not be the only thing we own.