“Nothing in this world can take the place of persistence. Talent will not; nothing is more common than unsuccessful men with talent. Genius will not; unrewarded genius is almost a proverb. Education will not; the world is full of educated derelicts. Persistence and determination alone are omnipotent.” – Ray Kroc, Founder of McDonalds

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,

This business can be interesting and confusing, but in being in the capital markets for almost 25 years, I’m not sure I’ve seen anything quite like it. Views and the overall outlook are bifurcated unlike anything I’ve seen. There’s a dichotomy brewing.

The markets have been volatile this year so far, but indices are generally positive. The advent of functional Artificial Intelligence (AI) has become all the rage, and this theme as generally been the driver of most of the upside we’re seeing in US stocks. AI has the potential to disrupt the way we work, and it could be just as disruptive as the internet was in the 1990s no question. The outsized impact of these stocks on the S&P 500 has caused some to suggest that the index has begun a new bull market, and many investors have been sucked in out of fear of missing out on additional gains, noting that an upside breakout has been imminent, essentially based on the ‘technicals’. But we must respect that markets have been climbing the proverbial ‘wall of worry’ so far, though it also may be useful to keep in mind Bob Farrell’s Rule #7 of trading: “Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names”.

So far this year, the economy has remained resilient and the earnings revisions backdrop has marginally improved, and this has certainly helped backstop equities. The economy is being supported by households that added a colossal amount of savings last few years, much of which has yet to be spent down. Manufacturing activity has held up so far, as have labour markets. The market’s job is always to extract the most amount of pain from the most amount of people. In early 2022, that was via declines – recently, many investors have remained cautious and underinvested in the face of rising equities, so the ‘pain trade’ has been higher. Sentiment remains negative, a bullish sign for markets.

But there are reasons to remain cautious.

As I write this, the US ‘debt ceiling’ drama is in full swing, with a potential resolution imminent. Historical episodes on this front have pointed towards significant market volatility if the sides cannot agree. A good short update on the outlook of this can be found HERE. While this agreement is likely to pass, don’t be shocked if there’s some last-minute threats of lack of support and “horse trading” that injects some volatility into the markets. Regardless, the debt ceiling should soon be behind us, won’t be a material market influence, and will allow investor focus to turn to more important matters.

Valuations are by no means ‘cheap’, especially considering that the weakest economic quarters are likely still ahead, and core inflation isn’t likely coming down quite yet. Inflation will likely remain ‘sticky’ until the labour market weakens, which has yet to really happen. I’ve been noting for some time that Central Banks are not likely to start easing soon or provide the ~200bps of cuts over the next year as the market was predicting without something negative for markets occurring to force that pivot. Finally, consensus still expects double-digit earnings growth for the end of 2023 and into 2024, along with operating margins surging up towards their all-time highs – do we think this is likely as we enter a recession (no matter how ‘soft’ the landing may be)? The historical record shows that the stock market only bottomed after recessions have begun.

So, as I have been noting for months, we are slowly setting up for a generational opportunity for investors. But we aren’t there yet. As we know, equity markets offer the best long-term returns, but they come with the highest risk (volatility is the ‘price’ you pay for these high returns). Lower-risk assets such as bonds and cash are offering some of the most attractive returns in almost 20 years.

If there is one single tenet of investing to follow, it is “Don’t Fight the Fed” – the market has arguably been trying to, and not believing Central Bankers who are insisting they won’t be dropping rates ANY time soon. Finally, the US Dollar has been weakening since last fall, which is usually a general tailwind for stocks. But it has turned higher recently. The US Dollar Index peaked and turned lower about two weeks before stocks bottomed last October, so if that timing applies for stocks to react to current price action in the dollar, we could expect stocks to begin to feel the effects of a stronger dollar by the start of June – another near-term headwind.

We can position and hedge exposures for much of this, so how do you want to be positioned at this point? Investment Legend Stanley Druckenmiller puts this succinctly:

 

 

A Few Other Interesting Things to Highlight + Upcoming Events

On June 8th, I am hosting an in-person evening event entitled “Real Estate Investing and Market Outlook: An Intimate Discussion with Two Industry Thought Leaders” in Collingwood. Gain expert insights on the risks — and opportunities — to watch for in the real estate market (both locally and nationally) and mortgage investment products. We have Faheem Tejani who is President of Capital Asset Lending Inc., a mortgage underwriter and administrator with ~$1 billion in non-traditional single-family residential mortgage assets under management. We also have Peggy Hill, CEO & Broker of The Peggy Hill Team, the #1 Re/Max Team in Canada. If you can make it, come by, drinks and food will be complimentary of course. You can register HERE.

In concert with Women, Worth & Wellness, we hosted a catered ‘Spring Fling’ private event at Freda’s in Toronto on May 17th. It was a great group who joined, and Freda’s is an amazing store with great people who run it. More events on this front to come, stay tuned…

Our Global Portfolio Advisory Committee has written an excellent report on the longer-term implications on deglobalization for those who want to dig into the subject. With trade relations more fragmented and the potential for a great power rivalry between the U.S. and China, investors need to be ready for a new paradigm, which will affect portfolio management and structuring. See the report HERE.

 

 

One Dichotomy: Is A Recession Inevitable?*

Unless “things are different this time” (there are compelling arguments that they could be, but there always are), a recession will likely begin this year, and could already be underway – remember that recessions are typically identified in hindsight. (Minor amusing point: Many so-called “blue chip economists” continue to deny recession probabilities almost until we are completely through them. So much for their models.)

Many are still expecting that we can avoid a recession altogether, or achieve a ‘soft landing’ – I’m not sure it matters for investment positioning. The economy looks headed towards a shallow recession at best, and perhaps an extended period of sluggish growth. Time will tell. With a heavily indebted society, and the US regional banking crisis restricting lending (the ‘fuel’ for the economy), I’m not sure I’m going to be overly bullish either way:

Recent data continue to suggest the economic expansion is still occuring – so far. Job creation, wage growth, and consumer spending in major economies remain positive. Alongside this economic resilience, inflation has steadily trended downwards after hitting multi-decade highs last year.

But Home Depot recently showed us that cracks are beginnig to form. Smaller ticket items come under pressure as debt levels rise, which hit demand. The side effects from the rapid rate hikes by major central banks over the past 14 months will likely continue to permeate the economy beyond the most rate-sensitive sectors—such as real estate and banking—which have already come under duress.

Is this recession is going to be a ‘soft’ or ‘hard’ landing? Too much ink has been spilled on this subject, and there are compelling arguments for both sides. I’m torn as to whether it actually has significant implications for investing positioning – so let’s just assume the worst. If you know a recession is coming regardless, do you want to be aggressive in your positioning ahead of that?!

The Fed’s Senior Loan Officer Opinion Survey has a pretty good track record (100% historically) for determining soft and hard landings after a Fed tightening cycle by the way:

But we have to keep the long-term in context here: RBC’s analysis of the U.S. business cycles since 1945 shows there have been 13 recessions. This means investors should expect to experience a downturn once every six to seven years and lasting between two and 18 months, with a 10-month average. In contrast, U.S. expansions have endured 62 months on average. Growth is the regular state of the economy, and over the past eight decades the U.S. economy has spent nearly 90% of the time in expansion mode.

For markets, it is important to keep in mind that recessions are relatively brief and bring about a wide spectrum of market outcomes. Equity markets can recover quickly and powerfully out of economic downturns. Trying to be ‘all in’ or ‘all out’ trying to time a recession is a fruitless exercise – rather, we position accordingly. For example, if we do the math, 70% of rolling 1 year periods were positive, and 100% of rolling 10 year periods were positive! So don’t try to get too cute…

Source: RBC Capital Markets

 

 

Another Dichotomy: The Earnings Outlook*

Even though earnings expectations for the next 12 months have dropped 14% over the past 12 months, a rebound in EPS growth is expected, and predicated on pricing remaining sticky. But it's worth pointing out that falling inflation implies that pricing power is beginning to erode for corporates.

There is quite a dichotomy between economic and earnings forecasts. Many companies position 2023 growth recoveries as being contingent on a solid macro backdrop, so something doesn’t add up:

As well, leading macro economic indicators don’t bode well for a rosy earnings outlook:

Source: Morgan Stanley.

Margins are also looking challenged for many companies. Purpose notes that “interest costs are starting to weigh on companies’ income statements. Wages certainly are rising, as are other input costs. And while sales growth has been strong over the past couple of years, lifted in part by inflation, costs appear to be rising faster of late. The last two quarters for the S&P 500 have seen sales growth combined with negative earnings growth… that is the literal definition of margin compression. In simple terms, earnings growth is challenged.”

 

 

The Final Dichotomy: Valuations – A Tale of Two Markets*

Valuation is an interesting subject today – and speaks to the some of the bifurcation of things I’m seeing. Things ain’t cheap - if in fact a new bull market has begun, it would be the most expensive equity market starting point based on this indicator in the last 40-plus years – the value of the market to the country’s output:

There is a positive viewpoint here: Robert Schiller’s cyclically-adjusted price-earnings ratio (CAPE) is often used to estimate long term returns over 10-15 years. The good news is that current valuations on this metric suggest a ~9.5% annualized total return over the next 10 years.

Source: NBF

However, we may not want to be trying to group all stocks into an index given today’s market bifurcations. Let me explain.

The move higher in the S&P on the back of ‘good enough but not great’ earnings last quarter has pushed the forward price-to-earnings ratio of the S&P500 up to ~18.5x. By comparison, it was down to 15x during the lows of October. Unfortunately, this puts US valuations into the most expensive quartile grouping based on data back to the 1950s, and this bucket is followed by not-so-great returns for the index:

There is a big BUT here. As we know, the big US tech stocks are skewing the valuation of the index. BUT, not everything is expensive:

Souce: FundStrat.

So, for the S&P 500 to continue any rally, it’s going to take a broadening out of the leadership, because these five names likely won’t be able to push the market that much higher by themselves.