Monthly Partner Memo - February 2022

January 31, 2022 | Paul Chapman


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

“If you can't fly then run, if you can't run then walk, if you can't walk then crawl, but whatever you do you have to keep moving forward.” - Martin Luther King Jr.

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

Friends & Partners,

“Past performance is not indicative of future results.”

It has certainly been a tumultuous start to 2022 in a number of ways – but let’s focus on the markets. I’m going to start off with the punch line from last month’s Partner Memo as I can’t put it any more succinctly today:

“…I would note that 2022 is truly unknown territory. Central Banks have signaled that they will begin to raise rates and tighten monetary conditions – they have essentially fueled all asset prices for years, and most of us have experienced this first hand through investment and real estate value gains, to name a few. 2022 onward will be a different investing environment than most have ever known.

The recent market noise is likely a very clear warning that 2022 will be more volatile than 2021… Given this inevitable volatility that I expect to continue in 2022, I would caution investors about being complacent since returns have come ‘easy’ for some time. I would encourage most to look at risk managed portfolios and solutions and think about how to minimize volatility – this is where I can help.”

Many stocks are already in bear markets, except for value stocks, some dividend stocks and the mega-cap tech stocks. A drop this sharp (only the ninth drop of 10% for a full month since 1950) causes many investors’ stomachs to roil, often leading to panicked selling (please don’t do this). Adding to investor angst might be the old adage that “as goes January, so goes the year” (though this is statistically untrue). And finally, we have a few notable pundits making doomsday headlines with predictions of an ‘epic crash’ on the horizon.

To keep things in perspective, remember that the S&P500 is still up almost 100% since the March 2020 lows. And a well-constructed portfolio is built to withstand much of the noise, and minimize the downside capture. Buying index funds is akin to taking a ‘shotgun approach’ to investing – there is value to be found out there, so expect active management to continue to outperform, and work with an Advisor that knows how to navigate on this front.

The economic outlook remains solid. All seven of our U.S. leading economic indicators of recession are giving readings consistent with the economic expansion having further to run despite the inflation headwinds and uncertainties surrounding central bank policies. If we avoid recession, history would suggest that a relatively rapid recovery is likely. Cash on personal balance sheets is significant, and personal income has been going up. Capital spending intentions have been pent-up, held back by Covid related shortages of materials and labour. As Omicron recedes, more people will also come back into the workforce and relieve the labour demand gap. Inflation could then subside somewhat as the supply chain issues wane.

The yield curve is a signal of impending recession when it becomes ‘inverted’ – and we aren’t there yet. This means that the market does not anticipate the Fed killing the recovery in the medium term, which offers some comfort that the bond market still thinks the economic expansion can continue.

Valuations are getting reasonable again. The S&P 500 is now trading at a much more reasonable ~19x 2022 earnings (though valuations are a poor predictor of near-term returns). And in Canada and internationally valuations are even lower. Companies with strong free cash flow generation and reasonable valuations, as opposed to momentum hype, are now starting to dominate market leadership which should continue.

This isn’t the first pullback we’ve had, nor will it be the last. It is part of the deal. We can’t predict, but we can prepare. Make a plan and stay the course. Bill  Miller,  one  of  the  great  investors  of  our  time,  notes in  his  3Q  2021 Market  Letter:

“In  the  post-war  period the  US  stock  market  has  gone  up  in around  70%  of  the  years… Odds much  less  favorable  than  that  have  made  casino  owners  very  rich,  yet  most investors  try  to  guess  the  30%  of  the  time  stocks  decline,  or  even  worse  spend  time  trying to surf,  to  no  avail,  the  quarterly up and down  waves  in the  market.   Most  of  the  returns  in stocks  are  concentrated  in sharp  bursts  beginning  in  periods  of  great  pessimism  or  fear, as we saw  most  recently  in  the  2020  pandemic  decline.   We  believe  time,  not  timing,  is  the key  to  building  wealth in  the  stock market.”*

Even Good Years Have Dark Days

Two thirds of years have 10%+ drawdowns, we have just been spoiled for some time without one until recently.


Key takeaway: Sizable corrections in equity markets are fairly common occurrences, even in years when markets produce strong gains.

This Pullback is Actually Uglier Than You Think

The reality is that this pullback is likely worse than the headlines suggest. The average stock in the Russell 3000 is down -35% and in the growth-heavy Nasdaq it is down almost -50%. More so, the average drawdown for the largest 10 U.S. stocks is -20%.


Source: JPMorgan

Are Valuations Almost Reasonable Again?

The S&P 500’s post-pandemic re-rating has almost been completely erased with forward P/E now only 0.5x higher (largely explained by TSLA addition) vs. pre-pandemic level when rates were more restrictive and fundamentals were less supportive. Even more extreme, small-caps have seen their valuation compress to levels last seen ~20 years ago to 14.6x forward P/E (-4.5x vs pre-pandemic).

Source: RBC GAM

Market valuations can provide us with some insights into the returns that we can expect over the next decade. When valuations are high, expected returns are lower, and vice versa. But valuations tell us next to nothing about what might happen in the next year, or the next three.

In fact, many single measures are a poor predictors of near term market direction. This chart from Vanguard does an excellent job making the point:

Source: Vanguard*

Interest Rates Are Going Higher – This is Actually a GOOD Thing

The market has been hooked on the QE (quantitative easing). And that’s being withdrawn now, and the patient is freaking a bit. BMO’s wonderful strategist Brian Belski reminds us that it is a GOOD thing that the Fed is moving toward normalcy, as it signals that the economy is improving and can stand on its own two feet. And we all knew this was coming, but the market is still having issues as it matures thru this early phase.

Here are two good charts to show that equity market returns are usually resilient as interest rates move higher:


Source: Goldman Sachs

"Friends don't let friends buy index funds.” – Part 2

Valuations don’t always signal tops or bottoms, but they are useful for projecting long-term returns. With where we are today, index fund returns will likely not be very good. “Rifle shots” will be key as I’ve been saying for some time now, and integrating alternative assets into the mix is paramount (as I noted many times, including “Friends Don’t Let Friends Buy Index Funds – Part 1”)

Over the last year or so, we have seen a rise in ‘dispersion’ within the S&P 500 – this means that more stocks are behaving independently of one another. When dispersion is low, it is harder for active management to outperform. Even if more winners are picked, or losers avoided, the magnitude of the benefit for the overall portfolio is less. Simply put, dispersion is good for active management, and dispersion continues to rise, bigtime.

There are a few drivers here. Rising yields and inflation tend to impact companies differently – some win and some lose. Fundamentals of companies start to matter more, which are seeing headwinds as we navigate a changing world. We continue to transition from a macro-driven market to one that is more micro, and that means higher dispersion between company performance. Good active managers can find these companies and take advantage of the opportunities that this presents.