“He who lives by the crystal ball will eat shattered glass.” – Legendary Investor Ray Dalio

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.

Friends & Partners,

Markets never seem to disappoint when it comes to causing confusion – hence the purpose of my monthly Partner Memo. I attempt to distill the noise down to the relevant issues and data points and give you a succinct summary and outlook.

Investors didn’t have to be geniuses over the past decade to make money – up until 2022. Central banks pumped money into the system making all asset prices increase. That trend is now reversing, and markets are coming to grips with this. As I have noted for some time, we are going to see a much different market environment moving forward than we have seen in the past decade, and that generational shift is occurring. There will be opportunities and pitfalls.

Source: Real Investment Advice

Interestingly, the market of late has proven very resilient in the face of multiple hazards so far this year. Very ‘glass half full’ in its reaction to things recently. Volatility measures are at multi-year lows, which is complacency we often see during weak market stretches. Don’t expect this complacency to last for too long.

It is worth noting that in the US, the main equity index (S&P500) is being driven by a small handful of companies (namely, the large tech companies). 80% of this year’s US stock market gains are attributable to 5 stocks. If we remove just 18 of the 500 companies in this index, the S&P 500's performance so far (up almost 8% at time of writing) would have been negative. The Russell 3000 index, which encompasses 98% of the investible names in the US, is up just over 5% YTD. But the average is down -1.5%, the median is down -2.44%, while 45% of the stocks are down -5%, 34% of them are down -10% and 26% of them are down -15%! The concentration in the indices is astounding, and being led by very few.

There has been some positive news supporting markets recently – so far. Firstly, the US banking issues appear to be fading. They may not be in the clear, but many deposits have moved into safer/large banks and money market vehicles.

Inflation has improved a bit of late as well. This was one of the market’s biggest issues last year, so continued improvement is positive news. Lower inflation has led to lower bond yields which fuels multiple expansions for the equity markets (i.e. higher stock prices).

All told, the number of mixed economic signals has increased recently. It’s almost as if the same data is looking at two different economies. Certain reports imply solid growth (Empire Manufacturing and Flash PMIs for example), while others signal a sharp slowdown is occurring (leading indicators). Some corporate earnings commentary talks about a resilient economy, while others warn of a looming intense slowdown. Headline inflation is falling, but core inflation is stable (if not rising). Fed officials are committed to hiking rates in May and are openly saying there will be no cuts this year, yet the market has two to three cuts priced in.

With markets pricing in a high probability that Central Banks lower interest rates significantly later in the year in response to a weakening economy and lower inflation, the question is “are the markets pricing in the lowering of rates correctly”? I’m not so sure - after having totally missed the inflation mark on the way up, central bankers on both sides of the border may well be willing to overdo it on the way down this time around. This means that there is likelihood of monetary overtightening than a premature pivot to lower rates, which is a significant risk to stocks and bonds as they’re currently priced. They may well pause on increasing rates, but may not lower rates as the market is currently expecting…

This level of divergence in the data and other reliable market indicators often comes at a “turn” in the economy (or markets). Some reports are looking at the current economy (fine growth) while others are looking at the coming economy (slowing growth). And since this economy is still solidly in growth mode, my concern remains the “turn” will be towards no growth or a contraction (i.e. recession). However, as I have written in recent Partner Memos, if ever there’s been a legitimate chance for a mild recession, it is now, and that is because of the pandemic stimulus and tight jobs market.

Bottom line, the conflicting signals from data, earnings, Fed speak, inflation, etc. only reinforce our concern the economy may be “turning,” and as such we continue to want to be positioned for slower growth ahead. The upcoming US debt ceiling impasse isn’t helping things either, this will likely become headline news soon and could cause a late-summer swoon (as it did in 2011). As well, I noted in last month’s Partner Memo that the next buried body may be commercial real estate which is now headline news (you can read that HERE). Legendary investor Howard Marks sums up this risk in his recent memo, noting that “no one knows whether banks will suffer losses on their commercial real estate loans, or what the magnitude will be. But we’re very likely to see mortgage defaults in the headlines, and at a minimum, this may spook lenders, throw sand into the gears of the financing and refinancing processes, and further contribute to a sense of heightened risk. Developments along these lines certainly have the potential to add to whatever additional distress materializes in the months ahead.” This all means it is still prudent to be playing defense and remaining conservative, well-hedged and “cashed up” in our portfolios.

The current market environment emphasizes the importance of active decision-making in investment allocations. The leaders of the next market environment will almost certainly not be the same as the last.

The approach and skill set in making money for most families is often quite different than the skill set in keeping it, and usually requires a different approach to risk management. In fact, the risk taken to build wealth needs to be reined in when it comes to the preservation of that acquired wealth. The traditional route to significant wealth creation requires risk tolerance and exposure, while paranoia and diversification are key to keeping it! True portfolio diversification includes multiple uncorrelated asset classes within a portfolio, meaning assets and strategies that may be negatively correlated with stocks. This means that they can make money when stocks go down, and add stability when markets are volatile.

A healthy cash allocation is also prudent at this point and can garner ~4-5% yield to boot. But this isn’t a long-term position either – remember, 5% inflation means that your money will lose 50% of its purchasing power in just 14 years. And even at 3% inflation, you lose 50% in 24 years. That’s a problem for most people.

 

A Few Other Interesting Things to Highlight + Upcoming Events

Financial literacy is lacking in our educational system, so it is an initiative that is important to me. I work with Junior Achievement to go into the classroom to try and make a bit of an impact on this front. On April 25th, we presented the ‘Dollars With Sense’ program at Mountain View Public School in Collingwood to the grade 7/8 class. The kids learned about currency, the cost of credit, saving, smart online shopping, budgets and investing basics. They enjoyed the program, learned a little and left inspired to keep learning more, which is the goal.

In concert with Women, Worth & Wellness, we will be hosting a catered ‘Spring Fling’ private event at Freda’s in Toronto on May 17th at 5-7:30pm. Let me know if you have interest in joining us, it should be fun!

Finally, we will be hosting an in-person Real Estate Investing & Outlook Event in Collingwood in early June as well, stay tuned for more detail. We have some bigtime speakers lined up for this one…

 

Corporate Earnings – So Far So Good, But What About The Outlook?*

Corporate earnings have come in reasonably well, but the outlook here has consistently been revised downward. Stocks don’t seem to mind so far though:

Bank of America’s strategist puts it well in noting that "peak-to-trough S&P 500 EPS declines during the dot com bust was -28%, financial crisis was -34%, and COVID was -15%, yet consensus forecasts a tiny -4% haircut ($224 to $216 EPS) in the meekest of recessions in '23…and thereafter renewed surge in EPS to $242 by 1Q25 (up 72% from the 1Q21 COVID low)." Realistic or fantasy?

And the disconnect between earnings and GDP projections remains a concern:

All this said, the S&P 500 tends to bottom 3-6 months before the rate of upward revisions for the stocks in the S&P 500 moves back into positive territory (in other words, the stock market tends to bottom well before estimates are done being cut):

 

The Pending Recession – What To Make Of It*

Many investors have been frustrated that the stock market seems to be ignoring an upcoming recession, but it’s happened once before. And if ever there has been a legitimate chance for a very mild recession, it is now, and it’s all because of the pandemic stimulus and tight jobs market. Let me explain.

To illustrate this, we need revisit the last two material economic slowdowns that have caused bear markets: the tech bubble of 2000 and the housing crisis of 2007. In both instances, there were asset bubbles that temporarily inflated people’s wealth, as the value of the stock market and home prices respectively created paper gains and gave birth to new industries to support these bubbles.

But when the bubbles burst, two things happened. First, the fledgling industries that were created to support the bubbles were destroyed, resulting in a large jump in unemployment (hurting economic growth). Second, the paper wealth that helped fuel consumer spending was erased, as the value of people’s stocks and home prices collapsed, essentially destroying a lot of their net worth and resulting in a drop in economic activity. However, none of that has happened this time around.

The post-pandemic economic expansion was not driven by an asset bubble that ultimately collapsed. It was driven by government directives that essentially prevented people from spending money on discretionary items, while at the same time literally unleashing a tidal wave of actual cash on the economy via direct stimulus payments. Note that:

• The S&P 500 is up 25% from January 2020
• The Case-Shiller National Home Price Index is up 38% from January 2020
• Wages have risen 54% since January 2020
• Pandemic stimulus in the US totaled more than $800bn in deposits into consumers accounts, and 90% of the $770 billion in stimulus loans have been completely or partially forgiven, injecting additional stimulus into the economy

What makes this so different is that the cash the government handed out won’t collapse in value like tech stocks did in 2000 or houses did in 2007. There’s no bubble burst (yet) that’s weighing on the economy, because in the end the “wealth creating event” in this cycle wasn’t asset appreciation, it was literally money mailed to the populous, and they don’t have to give it back.

Do you know anyone who is worse off financially today than they were before the pandemic? The vast majority of the answers to that question is “no.” Unlike the tech stock bubble or housing bubble, this stimulus didn’t lose value. It was money that’s either been saved or spent. That’s what makes this different from 2000 and 2007, and it’s why there’s a legitimate argument that even despite such aggressive Fed rate hikes, economic growth might not slow as much as one would expect.

Of course, there are caveats to these points. Inflation has particularly hurt the lower income and younger population. But from a macroeconomic standpoint, the most productive contributors to the economy (middle-aged people) are better off than before the pandemic, and that’s why there’s so much uncertainty regarding how bad the slowdown will be.

All this said, I am skeptical that we will avoid a healthy economic slowdown, partially because of signals in the bond market (yield curve inversions). The laws of economics, which say dramatic rate increases lead to real recessions, are still valid. However, the massive pandemic stimulus has succeeded in delaying that slowdown, simply because consumers have more money to work through before they change behavior. It’ll only be when that behavior changes that we’ll see unemployment rise, and that’s when the real slowdown will begin (I believe we have started that process). Until we get more compelling data that the economy is materially slowing, we can expect investors to remain optimistic about a “shallow” recession or soft landing.

Markets usually don’t bottom until a recession hits (see chart below). But to be fair, the 25% peak-to-trough decline in 2022 was in line with the median market decline during recessions, and we may have more progress on this front relative to historical trends:

But the last thing to note on this subject is that there actually is one period in history when the stock market appeared to ignore a recession – 1945. This was the recession that occurred as the US exited World War 2. It was short and lasted from February 1945 to October of 1945, and was driven by the pivot from a wartime economy to a peacetime economy in which government spending dried up quickly. Unemployment remained low despite the fact that soldiers returning home were competing with civilians for jobs. While there are clear differences between 1945 and today, one thing that both have in common is that unprecedented historical events caused dramatic shifts in the economy that required a tough transition back to more normal conditions. In the case of 1945, this resulted in a technical recession that the stock market was able to look past, perhaps due to all the pain it had already taken.

Source: RBC Capital Markets

 

 

There’s a Longer-Term Optimism To Be Had In All Of This*

While economic downturns aren’t ideal, the good news is that most recessions are short-lived, and earnings tend to recover quickly. Looking at the table in the chart below, we can see that during these past recessions, earnings have declined 24%, on average, over the course of 20 months.

It’s important to remember that markets are forward looking. Historically, stocks have had a habit of retreating in the months ahead of a recession. Markets then tend to put their worst fears behind them in the early stages of a recession, and when a recession does reach its end, corporate profits are still depressed but uncertainty is fading. Markets, being forward looking, have often rebounded strongly in these moments as they look towards a more clear and positive future.

Source: RBC GAM

The last curious data point that is supportive of equities is that market participants are so bearish, it can’t get materially worse and eventually this cash could flow into equities.