Monthly Partner Memo – December 2022

November 29, 2022 | Paul Chapman


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“You get recessions, you have stock market declines. If you don't understand that's going to happen, then you're not ready. You won't do well in the markets. If you go to Minnesota in January, you should know it's gonna be cold. You don't panic when the thermometer falls below zero.” – Peter Lynch

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


Friends & Partners,

It seems that winter has come early this year, and whether that’s a good or bad thing depends on your perspective – for those of us who like to play in the snow it’s not all bad. The same goes for financial markets in a way. From volatility comes opportunity, and the challenge is finding that opportunity amid the storm.

There never seems to be a shortage of opinions and views, with most of the media airtime being taken by the most pessimistic talking heads – this can be seen across all forms of media, including the financial media. But that also doesn’t mean that the crowd is wrong, just that you may have to work harder to cut through the noise and find a balanced view. This is what I try to offer in my monthly commentary.

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No question markets have been bad in 2022, and may remain volatile for some time yet, but the world isn’t ending. There’s no Armageddon like 2008, or spring 2020, even though the media and financial newsletters might tell you to be stocking up on canned goods, firewood and candles.

We will see stresses in the system, and as the tide goes out, some will be caught swimming naked (think FTX the last few weeks, and there will likely be a few more before this is all over). Even though many are eager to see the advent of the next bull market, it can take some time to find the durable bottom.

Amidst the noise, and sometimes panic, everyone wants to desperately know “are we there yet”? Market bottoms only become obvious in hindsight, often occurring in the midst of max pessimism and calls for "lower lows" all across the media. And when the bear market does end, everyone will doubt the rally and claim it will be built on more hope than anything fundamental (recall that very few believed in the rally coming out of the Covid lows …). We are getting closer and seeing opportunities already in some asset classes (and close enough to begin positioning in some interesting strategies, which we have been doing).

One thing you can bet on is that when we see the next bull market, things will look very different than the last 10+ years. We are experiencing a generational shift in the markets as I have been touting since last fall, and it has certainly been playing out in spades.

As one peer recently stated, “nothing is forever in the capital markets”, and though sometimes markets can remain irrational for longer than we expect, inevitable shifts eventually occur. Growth stocks have outperformed value stocks for 15 years for example. Do you want to bet that continues? I wouldn’t.

Markets will have a lot more ‘normalcy’ to them moving forward I expect, much like the times prior to when central banks push all asset prices up which created a tailwind for lower quality asset classes. Who can remember the early 2000’s? ExxonMobil had the biggest market cap, which is almost hard to believe today when tech stocks have $2 trillion valuations. The future likely looks similar – big, boring, unsexy old industrial companies may well be the next ‘hot’ thing.

A close friend of mine who is a very large fund manager recently noted that 65% of portfolio managers weren’t in the business in 2008! So many investors have only ever really experienced a liquidity-fueled bull market, and a buy-the-dip mentality and approach has worked for well over a decade. Things are changing.

We will get there, but there remains much reason for continued caution. Central Banks (mainly the US Fed) may get off the brakes soon, but they won't necessarily get on the gas pedal for a while yet. The yield curve is highly inverted, and even though the economy has remained resilient thus far, headwinds continue to grow and a recession is still a significant possibility.

But a recession shouldn’t be as nasty as some others have been historically (fingers crossed) – the balance sheets of the U.S. (and Canadian) banking systems are strong. Further, corporate liquidity remains solid, as companies raised trillions of dollars of cheap debt during the past few years, with few maturities during the next few years. Finally, labor markets are tight and consumer balance sheets remain strong.

Regardless, as I have discussed at length for a few months now, earnings estimates are undoubtedly still too high. The process of normalizing these points could continue to make things a bit painful for investors as we normalize.

We are in a bear market which may take some time yet to play out, but one smart pundit noted that bear markets that happen as a result of rate hikes tend not to be the worst bear markets. We remain defensively positioned while nibbling at and adding to a number of strategies and positions that are attractive opportunities given the weakness that the markets have experienced so far this year.

A Few Other Interesting Things to Highlight

I am a huge proponent for Philanthropy, and how we can give more efficiently and effectively. Many don't know what they don't know around strategies to make your charitable giving go farther, and I wrote about one of the ways to do that HERE.

I am honoured to sit on the board of United Way Simcoe Muskoka – last month we celebrated National Philanthropy Day. In concert with Women Worth and Wellness, we hosted a wonderful event with United Way Simcoe Muskoka and their Women United program. A great summary video of the event is HERE.

On this topic, I am also proud to be able to be an active supporter and contributor to the Institute for Southern Georgian Bay, who is hosting an in-person event on Saturday December 3rd at 2-4pm at the Simcoe Street Theatre in Collingwood entitled “Multisector Partnerships and the Role of Philanthropy”. This initiative aims to gather businesses, nonprofits, government, and philanthropic leaders to explore how together we build our Local Sustainable Economies. See more detail and register HERE.

Finally, Financial Literacy is something I am also quite passionate about, and November has been Financial Literacy month. Our education system does a relatively poor job on this front, which is why I am active with Junior Achievement, an organization that focuses on financial literacy and entrepreneurship for youth. I will be going into some local schools in December to present and discuss with students.

You can promote financial literacy and build knowledge with your own family - here is a great way how, with no cost. Developed in collaboration with RBC Future Launch and The Globe and Mail, the McGill Personal Finance Essentials course helps young adults gain the knowledge and confidence around financial decisions. You and the family can learn finance essentials at your own pace for free from McGill professors. It’s certainly worth checking out.

Where Do The Issues Lie? Can We Go Lower From Here?*

There is always a case that we can go lower – as Howard Marks once quipped, ‘we can’t predict, but we can prepare’.

Every month since early summer, I’ve been noting that earnings forecasts are likely at risk to the downside. That is now headline news in the financial media, and one of the main reasons that many are calling for more caution. Earnings estimates surely need to adjust downward still – are stocks and bonds pricing in this forthcoming adjustment? That’s the million dollar question.

2023 expected earnings for the S&P 500 have so far declined ~10% from $245 to $223 in earnings per share (EPS). This would have to drop another $12 or 5% if this cycle’s decline in earnings was to match the average 14% reduction that the typical recession has on profits since WW2. So, analysts are likely still too optimistic. Every past recession has led to double-digit drops in earnings estimates:

However, the S&P 500 has historically bottomed ~12 months before EPS troughs. This occurred in 2009 and 2020, and since 1900, 13 of 16 major equity lows saw S&P 500 bottom well before EPS.  

On the other hand, earnings recessions tend to drag on, and take time to play out. If this is the case, things are still in early innings:

Source: Morgan Stanley

The following table shows max earnings drawdowns during the 4 most recent recessionary periods. If this one plays out like those did, only Health Care is fully pricing in a ‘hard landing’ recessionary scenario:

Source: Morgan Stanley, Bloomberg

There is also a case to be made that we can go lower in equities if this bear market plays out like some we’ve seen historically:

https://files.constantcontact.com/272ef070401/3db943ce-d890-443d-8b9f-54bf033d24b0.png

Bottom line is that conditions are not yet ideal for setting the foundation of a bottom, so we remain cautious, defensive and prudent. The economy is strong, the Fed is still committed to tightening policy (albeit at a slower pace), and long-term equity expected excess returns are low as equities have yet to experience a severe repricing – we haven’t likely seen the full washout quite yet.

Source: Bridgewater Associates

What Happened with FTX, And Are There Contagion Risks? Is There Hope for Crypto?*

I debated discussing this topic, but since FTX is dominating the headlines, I wanted to touch on it. Before I do, let me give you my take on crypto that I have told clients and friends many times over the past number of year – blockchain technology is real, and will change a number of businesses and products in our society, but crypto currency is far more opaque and impossible to value currently. It is still, and has been up until now, a purely speculative investment play.

In short, FTX is (was?) a cryptocurrency exchange. Trading crypto directly is somewhat cumbersome so exchanges became a solution, but many are offshore enterprises and lacked transparency.

Most of its users were hoping to escape a state-controlled financial system. In an ironic turn, they now hope a state-controlled bankruptcy system recovers some of their assets. Usually things don’t end well on this front.

For the broader economy, crypto firms like FTX have limited connections to the general banking system. Banks will barely touch crypto, as banks are very risk averse as you likely know. So this won’t be 2008 where major financial institutions get affected and/or dragged under by issues in that system. They also aren’t part of the government-backed protective schemes like FDIC and SIPC, making taxpayer risk minimal.

In the world (bubble) where central banks flooded the system with support and liquidity, driving up all assets, speculation ran rampant, and no environment flourished more than crypto on this front. With that environment always breeds bad actors and activity, so as things normalize, episodes like this aren’t surprising in the least – we’ve seen this movie before.

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We Are In A Brave New World – But Amidst This Market Pain, There Is An Alternative*

As I have noted before, I believe that we are experiencing a generational shift in the markets. These are the riskiest words to murmur in the world of finance but I will likely only state this phrase one time in my career - IT REALLY IS DIFFERENT THIS TIME. We have been in a bond bull market for decades, fueled by central banks, and equities have seen one of the biggest runs ever. This backdrop is shifting beneath our feet.

I would echo the great Howard Marks again when he noted that “we have to practice defensive investing, since many of the outcomes are likely to go against us. It’s more important to ensure survival under negative outcomes than it is to guarantee maximum returns under favorable ones.”

This year has been an ugly one for most, no question, the worst in a century for many:

Generally, we don’t need to shoot for the stars, we want solid risk-adjusted returns. We want to avoid fearful scenarios where we “sell to survive.” Sure, stocks provide solid long-term returns, but they come with jaw-dropping drawdowns along the way. Traditionally, bonds have usually provided the ballast, at least in the last few decades, but that fell apart this year as I had been very vocal about (see presentation on my website main page posted 2 years ago articulating this very risk).

We need to achieve enough returns to meet our long-term goals, with enough stability that we won’t puke along the way.

We implement a truly institutional approach to our portfolio construction for our clients – something that few do in the wealth management world. There is no reason your portfolio shouldn’t look a lot more like a pension fund or a global family office. The ride will prove to be a lot smoother and should help you achieve your objectives and sleep well at night.

Source: CPPIB 2019 annual report; UBS Evidence Lab, UBS Global Family Office Report 2021 covering 191 Family Office globally and US$225bn in total assets

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