“More money has been lost because of four words than at the point of a gun. Those words are ‘This time is different.’” – Harvard Professor Carmen Reinhart
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,
I think we would all agree that November could have gone any number of ways. “Probably 98% of the things Trump will do can’t be predicted, and even the consequences of the things we know he’ll do probably can’t be predicted. Anybody who tells me what they think the world’s going to look like two years from now, I’ll bet all my money that they’re wrong. The future is just too damn indeterminate to hang your hat on.” These are the words of US Ambassador John Kenneth Galbraith. Then comes the real beauty: “We have two kinds of forecasters, the ones who don’t know and the ones who don’t know they don’t know.”
Markets have run like a scolded cat in some respects, but be careful what you wish for. One of the smartest men ever to live was Sir Isaac Newton, and this is proof that markets confound even the best and brightest. Back in the 1700’s, Newton was an early investor in the South Sea Company – the rage of the time (a bit like Bitcoin and other names we see today??). Upon selling his shares at a handsome profit after he became convinced that the stock price had reached a level that was no longer justified, Newton became vocally annoyed as the stock continued to advance to illogical heights over the subsequent weeks. It was reported by John Robartes (the Earl of Radnor) that when Newton was asked about the continuance of the rising of South Sea stock, he bluntly answered, “I can calculate the movement of the stars, but not the madness of men.”
Source: gloomboomdoom.com
We are in the post-election honeymoon phase, as it did remove uncertainty from the market. But expect 2025 to be more volatile than in the past as the market becomes accustomed to headlines. The degree of dispersion in the range of forecasts is wider than usual, with some expecting that the effects of Trump tariffs could be relatively benign, while others like BCA Research (one of the most respected macro research shops on the Street) set the probability of a U.S. recession at 75% in response to Trump’s victory!
The S&P 500 is trading at a high valuation (forward P/E of 22x) relative to its own history and significantly higher than the level when Trump first took office in 2017. The positive is that the US economy remains strong so far showing limited signs of recession risk, and earnings estimates are rising. The negative is that earnings growth will have to be the driver of stock gains from here.
We must always remain vigilant – the last time we saw 1) an upward trending VIX (volatility measure) year to date, 2) the S&P 500 at all-time highs, and 3) an inverted yield curve (or in the process of reverting positive)… was October 2007. And we all know what happened next.
So, we need to focus on optimizing portfolios for the optimal balance of risk versus returns. The goal should be optimization, not return maximization. Many investors think about one goal – achieving the highest return. We all want solid returns of course. But the goal should be to achieve the optimal relationship between return and risk – we need to be compensated for the risk we take to achieve higher returns, so we aim to construct portfolios with the potential for an attractive risk-adjusted return.
A Few Interesting Events To Highlight
I was pleased to have been part of a panel discussion on private market alternative investments at the 23rd Annual World Alternatives & Investments Summit Canada. Thank you BMO Global Asset Management for hosting and inviting me on the panel. I have noted that I don't expect the next part of the cycle to look like the last, and there are a number of interesting strategies and opportunities in private equity, private credit, private infrastructure and private real estate to name a few to consider. Great managers are accessible for investors across the private alternatives front, and is an important part of an institutional portfolio construct.
It was a fun experience to be a Dragon as part of the 16th annual Meaford Dragons Den – we were able to help a number of new small businesses, all with wonderful ideas and plans. I was honoured to be a part of it and support the businesses at the event.
Finally, I hosted two real estate managers at a private and intimate gathering downtown Toronto last month. Elevate and Timbercreek presented on what they’re seeing in multi-family and commercial real estate, and ways they invest in the opportunities. Thanks again to those managers, it was a very informative event.
Trump – Is He Good Or Bad For Markets?*
It’s critical to understand that while many in the mainstream and financial media cover Trump through the lens of politics and the culture wars, the market is not political. It doesn’t care about draining swamps, political retribution, woke or anti-woke campaigns or DEI initiatives. The market only cares about policies that 1) increase (or decrease) earnings and 2) support growth (or hinder it). Any political movement or agenda that is viewed by the market as getting in the way of better earnings and growth will be viewed as negative and be a headwind on risk assets, regardless of whether those policies are from Republicans or Democrats.
To that point, while Republicans control Washington, many of President-elect Trump’s stated policies (most specifically massive tariffs but also possible large deportation initiatives) are not market friendly. Both, if executed to the fullest extent Trump has discussed, would likely be demonstrably negative for markets as they’d hurt earnings, possibly spike inflation and cause massive uncertainty (which the market hates). Because markets are not political, they want to see full implementation of all the pro-growth policies (tax cuts/ deregulation) and none of the policies that might interfere with the pro-growth agenda.
This much we know about Trump: he is pro-growth and anti-regulation, which are bullish for markets. The problem is that may largely be priced in already. He also likes tariffs, which are good for inflation, but that is a bit more slow-moving and hurts the economy generally.
In his first time in the oval office, Trump had the economy with global synchronized growth at his back. That will likely be the case for this term as well – policy matters but the economy trumps policy (no pun intended). As well, in 2016, the S&P 500 was trading 17x forward earnings, with the expected earnings growth being really low. Today, the market is trading 22x forward earnings, which is already priced at 12% earnings growth. And yields are very different today, much higher than at that time.
So, investors will have to weigh the balance of risks. Upside potential can be found in corporate tax cuts and deregulation. The sources of downside risk are trade wars and the negative effects of deportations on short run economic growth. One thing is for sure – volatility should rise. The number of geopolitical conflicts remains high, and Trumps responses to those is unknowable. Tariffs are now uncertain and likely to change quickly, as will tax policy. The debt ceiling could return as an uncertainty in 2025. Given the sweep of all three branches of government, that, too, adds to uncertainty as markets actually prefer a divided government because that limits policy changes, which means fewer surprises and greater certainty. Get ready for lots of noise and tweets…
The chart below explains why incumbent parties are losing office worldwide (and likely coming soon to Canada too...). While central banks may declare victory in the war against inflation, the average person feels otherwise, as prices remain permanently elevated.
Do We Need To Be Worried Here? Here Are The Reasons That Argue ‘YES’*
Many are still expecting a ‘soft landing’ or ‘no landing’ in the economy. A downshift in growth, with some inflation and employment slowly pulling back. To those who have not studied the history of economic cycles, this condition appears to resemble the prelude to a soft landing, but the issue with this is that there are few instances of such an outcome (precisely one 1 of 14 since 1945). So a recession risk is certainly still lurking.
The stock market in the US ain’t cheap. The Magnificent 7 (big tech names in the US that we all know) make up 36% of the S&P 500. NVIDIA alone is now larger than the total market caps of Canada, UK, France, Germany, and Italy combined! ‘Passive’ investing has taken over the world, and is creating ‘buying at any price’ – I would argue this may give at some point.
When comparing P/E multiples, at 22x earnings (1 full standard deviation higher than the 30 year avg. of 16.7x), 5 year forward returns fell between 0-3% annualized:
Source: Purpose
The S&P 500 risk premium (forward earnings yield minus the 10-year Treasury yield) has turned negative for the first time since 2002, indicating frothy valuations in the US stock market.
On a price-to-sales basis, the stock market is very close to the record set in the post-Covid boom in 2021. On a price-to-book value basis, it's almost taken out the all-time high from the dot-com bubble in 2000.
The S&P 500 being up >20% for two consecutive years has only happened four times in the past 150 years. The most important question is what happens next. US equity market valuations are high, but they are not reliable indicators of short-term performance. Valuation based investors have been burned having reduced exposure to US equities during the recent rally.
The cyclically adjusted price earnings ratio (CAPE) at 38 is near all-time highs, significantly above its long-term average at 17. Historically, when valuations have hit these levels (1929,1999, 2021), the market has been on the doorstep of a pullback:
Source: Apollo
We have also hit the 4th highest trailing P/E in 125 years. Again, high multiples tend to coincide with/near market peaks.
In credit markets, spreads are TIGHT. In fact, the tightest on record. This means that the premium that investors demand in corporate bonds over risk-free treasuries is small, so likely only one way to go there…
Source: Bloomberg
Sentiment has been unabashedly bullish as of late. That’s usually a bad sign. So we need to watch how that can shift in certain parts of the market.
Source: Apollo
Source: Jared Dillian
Investor sentiment towards the stock market is more euphoric than ever before.
Source: Sentix
Some of the recent strength can be attributed to the election, but history suggests that it may not work out so well. There was an especially strong post-election bounce in November 1980. But the celebration of Reagan's victory didn't last long and stocks fell into a long grinding bear market during all of 1981 and into the summer of 1982.
Recent gains are typically linked to increasing earnings revisions; however, expectations for earnings have not risen significantly, raising questions about the sustainability of this rally.
Corporate insider trading activity has never been more bearish than it is right now. The ratio of insider sales-to-insider buys has hit a record high for any quarter in two decades:
This should be especially concerning given the fact that aggregate insider activity is one of the best predictors of future earnings trends and earnings quality has deteriorated significantly of late:
Technology Wins Ultimately – Investors Lose*
Artificial Intelligence. It’s all the rage, and may well improve productivity and profits. But you have to choose the winners well and time it right. New technologies tend to be winner-takes-most: look no further than Google’s 90 per cent share of online search. Money will be incinerated in pursuit of this goal…
Technological revolutions don’t always produce spectacular investment returns. The classic example is British railways in the 1800s:
Do We Need To Be Worried Here? Here Are The Reasons That Argue NO*
Stock prices are up a lot but fundamentals have largely kept pace. In fact, the stock market has actually gotten less expensive over the past couple of years because of earnings growth:
Source: Ritzholtz
And earnings are expected to keep growing too, which should do the heavy lifting moving forward as I noted in the opening section:
Source: Ritzholtz
The economy remains strong for now in the US, with GDP growth doing better than expected (3Q24: 2.8% QoQ), essentially full employment (October unemployment rate: 4.1%), and low inflation (September CPI: 2.4% YoY).
Source: Morgan Stanley
With defaults still tame:
Source: Apollo
Earnings for the S&P 500 are projected to grow 13% in 2024, 13% in 2025 and 12% in 2026. You can see in the below chart that earnings growth is expected to converge between the broader S&P 500 index and the Magnificent 7 by 2025. These double-digit growth rates are impressive and could support a higher price-to-earnings for U.S. large-cap stocks beyond just the Magnificent 7.
Expected earnings growth converges
Source: RBC GAM, Bloomberg. As of November 22, 2024. S&P 500 consensus EPS estimates
Most central banks are cutting rates, including the Federal Reserve. Rate cuts generally help spur economic growth, as lower rates make it less expensive for businesses and households to borrow, encouraging people to spend more and save less. This is one of the reasons why RBC Economics has a base case scenario that assumes a 75% probability of a soft-landing – which means that the U.S. economy, and therefore businesses, could keep chugging along.
From an economic lens, U.S. data remains fairly positive.
- The unemployment rate of 4.1% sits near the lowest readings over the past 70 years.
- Retail sales for October reported an above-consensus increase.
- Consumers appear to be spending, and overall consumer confidence is rising.
- Business expectations are improving, and the Institute for Supply Management (ISM) Services Index hit a two-year high in the month of October.
Overall, the U.S. economy is doing quite well at this juncture. Investors are primarily keeping an eye on future employment levels to help gauge the state of the economy, which currently remains strong.
Note: New orders for non-defense capital goods excluding aircraft (NDCGXA) is the best metric we have for national business spending and investment.