“If you only wished to be happy, this could be easily accomplished; but we wish to be happier than other people, and this is always difficult, for we believe others to be happier than they are.” – Montesquieu

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

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Friends & Partners,

I write this month’s Partner Note from a ship somewhere off the coast of Cuba – I was blessed and honoured to join a number of RBC partners and executives for a few days here. Beautiful weather, but choppy seas. Very fitting.

On the back of so many being in a rush to sell in Q4, 2022, we get a rally to kick off 2023 fueled by a set of positive surprises - resilient labour markets, a China reopening, and the mild Europe weather.

But the economy continues to slow, and it has become clear that a recession is coming. The debate rages around how bad it will be. It is consensus that a recession and an economic decline is in fact coming – and it may not have even started yet. And the market is clamouring for any evidence of a ‘soft landing’, aka a mild recession. And that optimism has fueled a rally in January.

But extrapolating this optimism to equate to a sustainable rebound in economic activity that drives significant earnings growth may be a stretch at this point.

Inflation is coming down no question, and so is economic activity. This is not the type of outlook where one should get overly aggressive and try to be ‘a hero’ and jump the gun. The mixed outlook remains at odds with the generous valuations with the S&P 500 above 4000 in my view. Weaker-than-forecast earnings and outlooks are now multiplying as well. You can also ignore any short-term call for either a rally or a sell-off as that is always difficult to impossible, and today there are more cross-currents than usual.

My friend and legend Bob Decker puts it colourfully in noting that “investors just entered the 'hopium den' of the soft landing story. The leadership of this rally has come from the most shorted or under-owned segments. The ARKK portfolio (my favourite reverse indicator) has just had its best start to a year ever. But strength from junk assets and speculative stocks is not a recipe for a sustainable new bull market.”

We know economic growth is slowing, and quickly. But as I noted in recent memos, the market is not the economy. Because employment remains so strong, it’s unclear how much slowing growth will 1) impact earnings, and 2) pressure the market valuation/multiple (it would have to be a clear and significant recession to push the multiple significantly lower). The point here is that “slowing growth” doesn’t automatically make stocks decline further. Rather, falling earnings and lower multiples make stocks decline, and because of still-strong employment, it’s not clear how much this slowing of growth will impact those factors yet. Second, we don’t know at what point the Fed pivots. In the nearly 25 years I’ve been in this business, I cannot remember a wider gap between what the Fed is saying and what the market thinks will happen.

So, what does this mean for us? First, don’t get too caught up in the hard vs. soft landing debate, or related market volatility. This issue won’t be settled for weeks or months, and in that time, the pendulum will likely continue to swing back and forth.

As we work thru the noise, we will be presented with a healthier and more sustainable buying opportunity as the market looks past the trough. And, as I’ve noted for months, the market moving forward will look nothing like where it came from. This is already happening as the 2022 market leaders have been underperforming, while the 2022 laggards have meaningfully outperformed. Expect more of that to continue.

And so we remain defensively and conservatively positioned, opportunistic and well-hedged, which continues to serve our clients well – just remember that insurance is very expensive if the house is already on fire. We continue to find attractive opportunities given the volatility across selected equities and credit – this is very different from a year ago where both of those asset classes were fraught with risk. Read on to see where we are finding opportunities today.

A Few Other Interesting Things to Highlight

I was honoured to have been invited on the RBC Partner Cruise to spend a few days with my executive peers. Getting to partake in intimate discussions with the firm’s leaders (like Dave McKay, RBC’s CEO pictured with me below) was very interesting, encouraging and time well spent. I am confident that RBC will remain the leader amongst its peers for the long term.

On January 19th, we were honoured to host a number of amazing women and were the presenting partner of “An Evening with Lisa LaFlamme” at the Winter Garden Theatre in Toronto; a perfect complement to our firm’s longstanding partnership with Dress for Success and our commitment to the economic empowerment of women. Lisa is Canada’s most beloved journalist, and certainly inspired ad engaged us.

I am excited to be able to be a sponsor of and host another great group at Women for Women’s 2023 Future Forward gala on March 8th. This is a gala connecting champions of women’s health and health equity across Canada in support of the mission and vision of Women’s College Hospital – a world leader in revolutionizing healthcare for women and for all.

And on this theme, Women Worth and Wellness kicked off 2023 with a free 4-part inspirational, impactful and informative weekly webinar series, Daring & Caring Women Leaders for Positive Impact. Each event boasted a superstar and accomplished line up of speakers. You can see the replays which will be posted on HERE. Our esteemed speakers included:

• Lisa Gable, Keynote Speaker, WSJ Best Selling Author, Presidential, Secretarial, and Gubernatorial Advisor - How to leverage the power of intentional actions and long-term relationships.

• Karen Cairney, Founder & CEO, Cairney & Company - Her story and leadership journey to help you dance in the moment authentically.

• Frances Wright, CEO, Famous5 Foundation - Why we need to reject complacency and stop accepting incremental change and the doors that the Famous 5 has opened for you.

• Shari Graydon, Speaker, Author, Facilitator, Catalyst of Informed Opinions - Why brilliance, without the capacity to communicate it effectively, is often overlooked.

• Carolynn Chalmers, CEO, Good Governance Academy and The ESG Exchange - The value of a purpose driven organization and Failing Forward.

• Desirée Bombenon, CEO & Chief Disruption Officer, SureCall B-Corp; Chair Calgary Chamber of Commerce - Respective professional relationships and the Mindful awareness of long-term impact.

• Deborah Rosati, Corporate Director, Entrepreneur, Advisor, Speaker, Author - How to be the hero of your own narrative.

• Inez Jabalpurwala, Global Director, VINEx, Executive Leader of Brain Health Nexus/Desautels Global Expert - Recognizing that wisdom comes from many different sources and the 3 traits to win in 2023.

Is Bad News Actually Bad News Again?*

Inflation was the biggest concern for markets in 2022 – how high would it go, how long would it last, how are central banks going to raise rates to fight it? As expected, inflation has started to come back down, and investors have a reasonable idea of how far central bankers will go in terms of rate hikes. The market thinks the Fed and other central banks will have to ease in the future as a slowing economy tightens its grip – in fact, the market is pricing in 6 rate cuts by the Fed in 2024!

Source: Bloomberg. Dec 23 – Dec 24 futures spread.

Interestingly, weak economic data was welcomed by the markets because it feared that inflation uncertainty was worse over economic recession uncertainty. So it rallied at times on the back of bad economic news, thinking that this would keep central bankers from raising rates too much as a slowing economy tackled inflation itself. This was the bad-news-is-good-news environment.

But that may be starting to change back to a more normal “bad-news-is-bad-news” again. Soft economic data is causing weak market reactions again.

This means we need the economy to hang in there somewhat, and good old fashioned results to be delivered by companies – i.e. decent earnings.

And expected earnings are likely still too high, something I’ve been discussing here for months. 2023 earnings-per-share consensus at $225 implies roughly a 4% earnings growth this year. In recessionary episodes, the average EPS decline is instead -30%.

3 good charts illustrating these points, with the last one showing there’s still room for downward revisions versus history:

But Decreasing Earnings and Even Recessions Don’t Mean the Market is Doomed*

Many expect a recession this year, but that doesn’t mean the stock is doomed over the long run. The S&P 500 delivered a positive return in 9 of the last 11 times we saw negative earnings growth year over year, and in those 9 positive years where earnings growth was negative, there was an average drawdown of -14% along the way. Sounds a bit familiar.

So, there have been many years where earnings have fallen while stocks have gone up. This isn’t a common occurrence, but there’s enough data to give this theory some legs. Do earnings revisions completely bottom out by Q1 setting the table for a 2023 rally? The theory definitely deserves consideration if you look at the chart below which tells us that there’s very little correlation in the short-term on 1 yr change for S&P earnings versus 1yr change in the S&P (price):

Source: Janus Henderson

As well, stocks sniff out the earnings low and look past the trough well ahead of time.

Source: Goldman Sachs.

There haven’t been many periods in recent history when forward earnings estimates for the S&P 500 Index have dropped significantly. But below I list the 4 primary examples. In all of these examples, forward earnings estimates bottomed out just a few months after the trough in the index price, and in all 4 periods the index rebounded strongly during that short time window. There are two primary conclusions to come out of this analysis: 1) over these 4 periods, the average time between the stock market bottom and earnings estimates bottoming is less than 3 months, and 2) over these 4 periods, the average market return from point to point is 28%.

Finally, it is consensus that because of higher structural inflation, P/E and valuations need to fall. This is arguably counter to history that shows the highest realized P/E occur when 10-yr yields are between 3.5% to 4.5% at ~19.5X, which is above where we are today…

Where Is There Opportunity and Value in the Markets Today?*

The investment landscape and market looks very different from a year ago. The outlook for both stocks and bonds at that time were fraught with risk as interest rates were coming off the floor, and I wrote on many occasions that the traditional 60/40 stock/bond portfolio mix was seriously threatened – that turned out to be the case in spades. It was the worst year for 60/40 portfolios in many decades.

But when the facts change, we need to change. And the facts have changed.

Simply put, dividend-paying stocks are relatively cheap as a group. The charts below are for the U.S. and Canada, contrasting dividend index valuations against their own history and the broader market. Valuations are low because yields have risen, and there is a higher degree of uncertainty about a potential recession. However, these low valuations provide a safety buffer in the cohort of equities that historically have a lower sensibility to market gyrations. If this bear is not over and we have a potential recession ahead, dividend companies, in general, should provide a better margin of safety.

If you recall, up until ~6 mos ago, I was screaming from the rooftops that bonds represented a significant risk in portfolios that many underestimated (eg – a ‘conservative’ asset mix consist of mostly bonds).

But things have changed there too. After a complete drubbing, bonds are the cheapest they have been to equities in 20+ years.

The historical relationship between bond yields and the earnings yield of equities is 2-3 standard deviations away from the average. That is to say, from an income perspective, bonds are positioned much more favorably than equities. This disconnect has been driven by the dramatic increase in short-term interest rates, which means bond yields fall in the short-term, but could set the stage for higher returns in the long-term.

As of Dec. 30th, 2022. Source: Absolute Strategy Research. US Bond Yield: Yield to maturity of 10-Year US government bond; Equity Yield = Dividend yield of S&P 500. Z-Score is calculated as the observed value at any certain time point minus the average of the dataset, divided by the dataset’s 10-year standard deviation.

Short-term US corporate bond yields are on par with the S&P 500’s earnings yield for the first time since the financial crisis.

Source: State Street.

Let’s Take A Step Back – What is Money To You?*

Money is emotional. Everyone's relationship with money is different - what many people think they want from money is the ability to stop thinking about money and be able to focus on other stuff. But this goal can break down when your relationship with money becomes an ingrained part of your personality. Many of us are guilty of that one.

I may go as far to say that this is the best article I have ever read, at least when it comes to the subject of money. It is certainly worth a few minutes of your time. I touched on the subject in an article about the meaning of money which you can also read HERE.

The article notes that the sacrifice that goes into making money drives some of the joy we derive in spending it. But this can be a problem for those who have a lot of it too - the struggle and sacrifice makes the payoff so much more rewarding.

And maybe the best point of all - "no one is impressed with your possessions as much as you are." When you see someone driving a nice car, you rarely think, "Wow, the guy driving that car is cool." Instead, you think, "Wow, if I had that car people would think I'm cool." He notes that subconsciously or not, this is how people think.

It is interesting to recognize that often spending money "on yourself" is done with the intent of influencing what other people think. This should spark three questions: Whose opinion are you trying to influence, why, and are those people even paying attention?

I will reiterate the quote at the start of this month’s memo that Montesquieu wrote 275 years ago: "If you only wished to be happy, this could be easily accomplished; but we wish to be happier than other people, and this is always difficult, for we believe others to be happier than they are."

And for some, spending money to make you happy is also hard if you're already happy. That’s a good place to be.