To my clients:

It was an up week for North American stock markets with the Canadian TSX finishing up 2.6%; the U.S. Dow Jones Index finishing up 1.1%; and the U.S. S&P 500 finishing up 1.6%.

This week, let’s keep the update short and spin a metaphorical analogy to explain the dynamic playing out in the markets right now. Let’s imagine a tug-of-war…

While volatility in markets remains uncomfortably high, it nonetheless has moderated from last week’s extreme levels. Simply put, there has been a tug of war playing out in markets with rising interest rates pulling at one end of the “rope”, and earnings expectations pulling from the other.

So, at one end of this metaphorical “rope”, in an inflationary environment necessitating higher interest rates from central banks, the resultant impact on stocks is that investors are willing to pay less for every dollar of profit earned by the shares they own. This is known as the price-to-earnings ratio (aka: P/E ratio), and it is the most widely used metric in evaluating stock valuations. All else equal, lesser P/E ratios imply lower stock prices.

BUT, all else is NOT equal because, at the other end of the rope, there is an expectation that earnings themselves will increase. Unsurprisingly, higher earnings drive higher stock prices.

So, which of these two competing forces will win the tug-of-war? Given no recession is in sight, I and RBC decisively support the side pulling for higher earnings. In due course, we believe that the earnings power of high quality companies – the kind held in my client portfolios – will overwhelm the competing force of lower P/E ratios. Like any good competition though, this may take some time to play out, and there may be stretches of time where our favoured team appears to be losing. So far in 2022, this is what has played out. Team “Lower P/E Ratio” has pulled its rope harder than team “Higher Earnings”. But we are only 1/12th through 2022. There is much competition yet to be waged, and we believe the strength of better earnings delivered by high quality companies will regain the lead by the second half of our tug-of-war competition (in other words, sometime in the July to December timeframe of 2022).

I’m not sure how well this analogy may have worked for clients, but there you have it. Oh, and by the way, all of the “Big 3” economic indicators – the ISM Manufacturing and Services Indices as well as the Monthly Employment Report came in ahead of expectations. In the case of the Employment Report, massively so. These metrics are the "fans" cheering on and supporting Team Higher Earnings.

That’s it for this week. All the best,

Nick

Nick Scholte, CIM, FCSI

Senior Portfolio Manager

Scholte Wealth Management
RBC Dominion Securities Inc. │ Tel: 604.257.7569 │ Fax: 604.235.9950
3200-1055 West Georgia │ Vancouver, BC │ V6E 3P3
Toll Free: 1.844.665.9900 │Email: nick.scholte@rbc.com

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