"As the old saying goes, there are only two types of investor: those who can’t time the markets, and those who don’t know they can’t time the markets.” – Terry Smith

Note that the contents of this memo are all my thoughts, and not the views of RBC Dominion Securities. As well, no part of this content was AI-assisted or created.

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Friends & Partners,

Managing money for our clients is a privilege and an honor. This responsibility fuels me every day to work my heart out, and I can’t imagine doing anything else. I will always obsess over my clients, and labour to make sense of the markets, economy, and ultimately – your wealth. These are complicated with countless variables, but at the end of the day should and can be simplified. We work in an industry where everyone is supposed to be an expert and have an opinion on everything. Few can admit that at some points there is significant uncertainty – and we are experiencing one of those points.

There is no better market environment than the last few months to underscore the importance of the quote at the top of this month’s Partner Memo relating to trying and time markets. I would add another one on the same theme from the father of value investing Benjamin Graham: "In the financial markets, hindsight is forever 20/20, but foresight is legally blind. And thus, for most investors, market timing is a practical and emotional impossibility."

Uncertainty reigns as it often seems to, and recent strong economic data has confused pundits even further. Remember, when it comes to the economy and the financial markets, the two may be related, but they aren’t the same. Good news for one can be bad news for the other.

When it comes to the market, people love analogies, and the latest analogy to define trading has been likening the economy to a plane the central banks (mainly the US Federal Reserve) is piloting, with rate hikes forcing the economic plane onto the ground via a “soft landing” (the most positive outcome) or a “hard landing” (the most negative). But, in light of recent strong economic data, there’s another landing that we must consider and has started to get more attention: “No landing.” Essentially, what “no landing” means is that the economy does not come in for a landing, that it stays strong and we do not see growth meaningfully slow. What this would look like is data rebounding: job adds staying strong, service measures of the economy staying in expansion territory, and manufacturing and housing bouncing back in the coming months.

What would a “no landing” mean for markets? The most important takeaway from this scenario is that numerous additional Fed rate hikes would come back on the table (viewed by markets as a negative headwind). That would then bring us back to a 2022 situation, where markets again begin to price in an ever-higher terminal (i.e. peak) fed funds interest rate, which would weigh on stocks and bonds. Additionally and importantly, a ‘no landing’ simply delays, but likely does not avoid, the hard vs. soft landing debate. The reason why is that the Fed will keep raising rates until it feels confident that growth is slowing enough that it won’t put upward pressure on inflation.

A ‘no landing’ scenario would not be a sustainable positive because it just ultimately delays that point where the market can reasonably expect the Fed to pivot to a more supportive stance for the economy (meaning rates stabilize and the outlook for eventual rate cuts is on the horizon).

Hopes for even a ‘soft landing’ have led to a thud in prior episodes (i.e. the ‘tech wreck’ and the 2008 financial crisis)…

Source: Trahan Macro

There are positives however, and a number of material improvements that have occurred over the past few months: economic activity remains resilient, earnings have held up better than investors feared (at least so far), disinflation is occurring and the peak in inflation is behind us, and, the Fed is much closer to an end to rate hikes than the beginning. But investors seemingly remain far too eager to extrapolate one data point to imply an imminent end to Fed rate hikes and an economic soft landing.

So, there are still a number of reasons to remain skeptical that the bull market in stocks has resumed. First and foremost, equities have never put in a bottom before a recession has begun in modern market history. And with a deeply inverted yield curve (across all duration spreads), bond markets telling a much different story from stocks currently, and strong economic data reigniting inflation fears, it is prudent to remain conservative and defensive. However, there are pockets of value out there for active managers, and strategies that are very compelling with limited risk, so we have been allocating more heavily to those recently.

Finally, virtually all bear markets end with some form of ‘capitulation’, and it would be very difficult to make the case that October was a true retail capitulation moment. Capitulation is a behavior that has been a part of just about every major stock market bottom in history. Capitulation appears as an acceleration lower in prices due to the panicked nature of the selling, mostly by retail investors. It suggests that the market needs to experience some deeper pain before we can say with conviction that we are out of the woods. Things could be “different this time”, but it has rarely been profitable to bet on that concept...

 

A Few Other Interesting Things to Highlight

International Women’s Day is coming up in March, and in partnership with Women Worth and Wellness, we will present another webinar on March 6th as part of the Daring & Caring Women Leaders for Positive Impact – Embracing Gender Equity. Learn how to embrace and implement gender equity in your organization with expert strategies from 3 awesome women leaders in this field. You can sign up for the webinar HERE.

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.

 

Has the Bull Market Resumed Yet? I Wouldn’t Be So Sure*

Investors have been looking forward to the Fed cutting rates, which were expected to happen near the end of 2023 up until recent strong economic data pushed that timeline out. Yet in 1929, 2000, and 2007, the bulk of market declines occurred after the first rate cuts. These were after a significant bubble burst, so the question is are we in a bubble now?

The forward price-to-earnings ratio for the S&P 500 stands at ~18.5x for this year, just above the long-term average. This is a good proxy for how cheap or expensive the market is trading. But this assumes that the earnings side of the equation (the denominator) is correct, but is prone to error since it is a consensus earnings forecast. The issue is that they usually overstate expected earnings heading into a recession. If reported earnings for this year decline just 20% from 2022 levels (which is the average earnings drop during a recession), then the P/E ratio would be 22 – not exactly a bargain. So far, earnings estimates are only down 6% from their peak. Leading indicators suggest that things could slow further on the earnings front, and soon:

Forward earnings growth just went negative in early February – Morgan Stanley notes that this has only happened 4 times since 2000. In each prior instance (2001,2008,2015,2020), equities have faced significant price downside associated with the shift from positive to negative earnings growth, and the majority of the price downside in equities came after forward EPS growth went negative. This could argue that an earnings recession is not priced in quite yet.

We also have to consider a pillar of support in the markets, which is liquidity driven by the Central Banks. The Central Banks have been pumping liquidity into the system for over a decade, and is a major reason that virtually all asset prices screamed higher. This is no longer the case, and is certainly something to consider as they continue to drain liquidity from the banking system:

Source: Bloomberg Finance

One final pillar of support for equities and the economy has been the consumer – but their bloated balance sheet could be drawn down soon. Excess savings continue to dwindle, pointing to softer consumption ahead:

Source: JPMorgan

And don’t forget about ‘retail’ traders buying in droves – this is never a good sign because they’re always last to the party…

 

Are Stocks Expensive or Cheap? The Concept of ‘Equity Risk Premium’*

In my Monthly Partner Memo, I try to keep things consumable, understandable and enjoyably readable – at the end of the day, investing doesn’t have to be overly complicated. But it is a prudent time to revisit or learn about the concept of “equity risk premium”.

The equity risk premium equation is essentially a way to measure how expensive stocks are relative to bonds to quantify the excess return that can be expected for taking additional risk in the equity markets versus the risk-free Treasury bond market. Equity risk premium measures the current earnings yield of the broader stock market against a benchmark “risk-free” rate (typically the US 10-Year Treasury Note yield).

To calculate the earnings yield, we simply flip the Price/Earnings ratio equation upside down. Using the consensus earnings estimate of $225/share for 2023 S&P 500 earnings, and an S&P 500 level of ~4,000, we get an earnings yield of 5.5%.

Then to calculate the equity risk premium (aka the current additional return an investor can expect from broad equity market allocations versus bonds), we then subtract the 10-Year Treasury Note yield of ~3.8% from the earnings yield of 5.5% to get an equity risk premium of ~1.7%. That is the lowest reading since 2007.

So, even though stocks are over 15% below the all-time highs (reached in early 2022), the S&P 500 isn’t cheap when running this cross-asset analysis. In fact, the broad-based index is currently as expensive as it has been in 16 years relative to bond markets.

Morgan Stanley calls this the ‘death zone’, so they’re not overly bullish on US equities here!

Source: Morgan Stanley

 

What’s Really Going On With Inflation?*

There are many who believe that inflation will stay ‘sticky’, and not drop significantly like many are expecting and hoping for. Late February saw a hotter-than-expected Core PCE (personal consumption expenditure) release, which is the Fed’s traditionally preferred measure of inflation, and this took some wind out of the market’s sails as it has been expecting a steady decline in inflation measures.

The Fed is focused on ‘core service inflation’ excluding housing costs (rent). This figure was actually UP month over month in January, and if we also subtract airfares and health insurance (which are volatile and non-labour driven), core services in labour-intensive categories increased by even more (0.55% month over month). So, there is little indication that inflation is slowing at its core yet.

Many also believe that we will see inflation pick back up later in the year, or at some point in the future. This is the scenario that played out during the inflation of the 1970’s/80’s:

Source: Barron’s

The prospect of inflation roaring back again will be making the jobs of the Central Banks very difficult, and surely not letting them back off rate hikes if this scenario plays out. The Fed’s job may be more difficult than the market is currently discounting.

 

How Bad Could This Pending Recession Be?*

We discussed the ‘no landing’ scenario above, which arguably just kicks the can down the road to an eventual recession either way. Markets are being a little too sanguine about potential recession risks I would argue - broad asset classes across the U.S. and Europe are currently pricing in a relatively low probability of a recession within a range of 20% to 50% according to JP Morgan. However, there are arguments (many of which I have made for months in my memos) pointing to why an eventual recession may not be as bad as feared, though any recession never feels ‘good’.

 

There Is Always A Positive Take On Things*

There are a number of material improvements that we have seen in the past few months: economic activity remains resilient, earnings have held up better than investors feared (at least so far), disinflation is occurring and the peak in inflation is behind us, and, the Fed is much closer to an end to rate hikes than the beginning.

If the market is not in a bubble, equities have generally performed fairly well following the final rate hikes of the past. Stocks rose during the 11 other Fed hike periods in the past. That means 78% of the time, when Fed is hiking, stocks are rising. And this is what the market was anticipating as it ran hard in January of this year. We are close to the end of interest rate hikes either way you slice it.

The chart below plots the performance of the S&P 500 in the 12 months following the last Fed rate hike. On average after the last five hiking cycles, the S&P 500 has delivered nearly double its average annual return (of 10%).

In fact, the only time the S&P 500 performed poorly was after May 2000, when the market was grappling with the Enron scandal and the collapse of the Tech Bubble. So, the end of rate hikes historically hasn’t been a good time to avoid equities. However, often these changes in interest rate regimes are met with increased volatility – which is certainly what we’ve been experiencing over the last year.

Source: Bloomberg, RBC GAM. Analyzing index performance following central bank interest rate increases. U.S. index performance following Federal Reserve rate hikes represented by S&P 500 Index. Performance denoted in USD.

And note that compared to other interest rate hiking cycles, the S&P 500 is underperforming where it normally would be at this point in the cycle:

Source: Bloomberg