Monthly Partner Memo – October 2022

September 28, 2022 | Paul Chapman


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Take comfort in the knowledge that your capital is being managed the way your friends complain they wish theirs was managed.

“All the adversity I've had in my life, all my troubles and obstacles, have strengthened me... You may not realize it when it happens, but a kick in the teeth may be the best thing in the world for you.” – Walt Disney

Note that the contents of this memo are all my thoughts, and not the views of RBC Dominion Securities.


Friends & Partners,

Markets have certainly been facing their fair share of adversity of late – September has served us its ugliest month in some time. The central banks have given up the pretense of a soft landing for the developed economies, and markets are facing the harsh realities of a global economic slowdown. Fed Chairman Jerome Powell put it plainly when he said “I wish there were a painless way to [bring inflation back down to 2%]; there isn’t.”

The markets now acknowledge that curing inflation might require poisoning the economy too. With interest rates going up more than the market initially thought (called the ‘terminal rate’), inflation still stubbornly high (though has certainly peaked), and earnings expectations for companies now at further risk to the downside, all throws into question what is the right ‘value’ that stocks should trade at. Price/earnings multiples tend to move depending on the attractiveness of other investments, and bonds finally look more interesting at today’s higher coupon rates, so stock valuations have had to come down until they can attract buyers.

If we multiply the long-term average P/E ratio for the S&P500 of around 16.5x by the current consensus estimate for S&P 500 earnings of $242, we get an implied year-end target of around 4,000. But given the general outlook, including the US Dollar strength, current estimates are almost certainly still too high. So, the markets need to deal with the next threat being negative earnings revisions. Will a series of earnings resets to the downside be enough of a 'bad news' to be 'good news'?

To put in an ultimate bottom and validate real capitulation (which we likely need as part of the bottoming cycle), we need to see real volume trade – this hasn’t happened yet. Bottoms are usually met with a semblance of panic and/or forced selling (which we have not seen much of yet either, but it is starting).

On the positive side, sentiment is terrible and the worst since the 2008 financial crisis (usually a positive counter-indicator), and the consumer appears to be in a relatively solid position in terms of savings and employment. But indicators like the VIX (volatility) haven’t hit anywhere near extreme levels – I’m afraid we need to wash out some players before we see full ‘capitulation’ and see a long-term bottom and set a base for a solid market footing moving forward.

I noted in last month’s memo that “markets are still weaning themselves off of the central banks stimulus and low interest rates, and I suspect it to continue to be a bit of a rough ride while the patient remains in withdrawal for the next while. Though there are pockets of opportunity that I am seeing, I continue to urge prudence and caution as we move into the end of the year, and maintain that a well-constructed and defensive portfolio should continue to preserve and grow capital.” This view hasn’t changed.

I have also noted multiple times in the last 2 years that we are undergoing a generational change in markets and portfolio construction, and your old 60/40 ‘balanced’ portfolio is likely to be broken for some time. That is certainly the case – the typical 60/40 balanced fund has now had its worst performance since 1937, down 15-20% this year so far. Major global markets are down between 25-35% this year. Having gotten even more defensive in our positioning this summer, our portfolios are managing to come out with minimal volatility in very difficult markets thankfully – capital preservation is job #1 when things get testy. But, how one positions thru these types of market are the time you make your money for the next 5+ years.

On a personal note, I am humbled and honoured to have received an RBC Performance award in recognition of partnership with my peers. It was certainly unexpected, and is a testament to my wonderful colleagues across the platform and the truly collaborative culture at RBC - this is one of the many reasons I chose RBC; they walk the walk.

Optimistic Earnings Estimates STILL Remain a Risk, Part 3!*

I wrote about earnings estimates being a risk in the summer HERE, and again last month HERE. This still remains the case. Consensus growth forecast revisions for 2022 and 2023 are actively falling, and likely aren’t done quite yet:

Source: BCG

And you may want to ask the smartest guys in the room on this subject:

Source: Bloomberg

BUT, there’s always the ‘glass half full’ argument however – earnings revisions have been tracking the pattern seen in previous recessions, so on this basis one could argue that markets have priced this in and that there are signs of bottoming out in the earnings revisions metric:

Source: JP Morgan Cross Asset

Is There Any Good News or Hope? Believe It Or Not, There Is*

In most bear market cases, the bottom is many months or even a few quarters before economic activity bottoms and many months before earnings growth bottoms. While the high risk of recession ahead isn't great news, the market is already pricing in some of that risk, and markets put in a bottom when it sniffs out an improving environment well ahead of time. In today’s case inflation and interest rates have been the real thorn in the market’s side. If inflation starts to show a few months of improvement, and the timing and depth of a potential recession becomes clearer, that may be enough to kick start a market recovery.

Inflation has likely peaked as I wrote about in August HERE. The question is, how long will it remain stubbornly high for? One positive indicator we heard last week from Costco management on their conference call was:

“We are seeing just a little light at the end of the tunnel….We're seeing commodities -- some commodities prices coming down, such as gas, steel, beef, relative to a year ago, even some small cost changes in plastics. We're seeing some relief on container pricing. Wages are still the higher thing when we talk to our suppliers. And as we all know, wages still seem to be the one thing that's still relatively higher. But overall, some beginnings, some light at the end of that tunnel.”

Investor sentiment is also the worst it has been since the financial crisis – this is a very good counter-indicator, though isn’t a great timing indicator admittedly. It is now showing the most bearish 61% since the 70% reading on March 5, 2009 (note the S&P bottomed on March 6, 2009). The chart below is the four-week average bulls minus the bears, which currently sits at -32. Readings at these levels usually imply a strong market advance during the subsequent 12 months. However, during 2008 there were many signals this bearish before the market ever bottomed. It just goes to show things work most of the time but not all of the time.

Consumers have massive amounts of cash stashed as well, which can help through trying times and markets. Over the course of the pandemic, U.S. households built out US$2.1 trillion in excess savings (see chart below), and with U.S. GDP around a total of US $24.9 trillion, excess savings offer the potential to lift nominal GDP growth meaningfully. If only a quarter of excess savings were spent over the next year, that lift would account for 2.1 percentage points of nominal GDP growth going forward. This elevated level of deployable cash is likely to continue supporting consumption. The US consumer also has little debt (unlike us Canadians unfortunately), unlike prior to the 2008 financial crisis. All this means that households in aggregate are in a better financial position than previous economic slowdowns.

Source: BCA Research

Things Can Turn Quickly*

It seems that everything is happening in hyperspeed today – perhaps it is the seamless flow of information, or the prevalence of electronic and computer trading. In terms of markets, if you wait for the 'all clear,' you will likely have missed a lot already. Things can change quickly – does anyone remember (or study) the early 80’s? You don’t have to be a hero and time the market perfectly either, you should already be there in part. On the valuation side of things, remember ~70% of S&P 500 stocks currently have P/E multiples below their historical averages

And on a shorter term note, seasonals suggest that Q4 is traditionally the strongest quarter for equities: