Something a little different today...

Below are two pieces that I did not write. However, I felt that they were interesting and worth sharing. The first is from our Global Advisory Group and the second from the Globe and Mail.

1) THE FED INDUCED DOWNDRAFT

Author: Alan Robinson – RBC Global Portfolio Advisory Committee, Sept 26, 2022

The Fed’s actions have broadened the potential range of outcomes for stocks, and this added uncertainty has pressured markets. We examine the recent stock market weakness and what it implies for the market outlook over the next several quarters. U.S. and global stocks posted another week of severe losses during the week ended Sept. 23. The 4.6 percent weekly decline in the S&P 500 marked its fifth week of losses out of the last six weeks, and a 14.2 percent decline from its mid-August peak. The S&P 500 and NASDAQ Composite Index of technology stocks avoided posting new closing lows for the year, but only by a hair’s breadth, and other major indexes such as the Dow Jones Industrial Average ended the week at the low of the year. What happened?

The Federal Reserve raised interest rates by another 75 basis points (bps) at its Sept. 21 policy meeting. This move was widely anticipated, and, in fact, market-based interest rates leading up to the call implied that some traders were even looking for a 100 bps hike. But what really upset equity markets was commentary from Fed Chair Jerome Powell. He said, “I wish there were a painless way to [bring inflation back down to two percent]; there isn’t.” In combination with Fed officials’ views of much stickier inflation and a commitment to tighten policy beyond the perceived neutral rate of three percent, Powell’s statement was viewed by traders as an acknowledgment by the Fed that curing inflation might require poisoning the economy too. In sum, we believe the rate hikes enacted since the start of the cycle in March, together with their likely trajectory, means the odds are probably better than 50:50 that the U.S. economy is either in a recession now, or will be within the next year.

Aren’t stocks cheap now? They’re certainly cheaper than they were at the start of the year. At the all-time high on Jan. 3, the S&P 500 traded at a price-to-earnings (P/E) multiple of 21.5x the consensus earnings forecast of $223.46 for the year ahead. This was a high P/E multiple relative to the long-term average of 16x–17x, but it wasn’t unreasonable, in our view, given that the rates of return of other asset classes were so low. For example, the interest rates on 2-year and 10-year government bonds were 0.79 percent and 1.63 percent, respectively, and real inflation-adjusted interest rates implied by 10-year Treasury Inflation-Protected Securities (TIPS) were still negative at minus 0.97 percent. The same securities yielded 4.21 percent, 3.69 percent, and 1.32 percent at the Sept. 23 close. And there’s the rub. P/E multiples tend to move depending on the attractiveness of other investments. Bonds look a lot more interesting at today’s higher coupon rates, so stock P/E valuations have had to come down until they can attract buyers. If we multiply the long-term average P/E ratio of around 16.5x by the current consensus estimate for S&P 500 earnings of $242, we get an implied year-end target of around 4,000 for the index.

But we think the speed of Fed hikes together with the increased probability of a U.S. recession means current estimates are still too high. Earnings estimates rose steadily through the first half of the year as analysts looked toward the easing of both global COVID-19 restrictions and supply chain issues. But by the end of June, the suddenly hawkish Fed prompted more caution amongst analysts (see chart).

RBC Capital Markets, LLC Head of U.S. Equity Strategy Lori Calvasina thinks the consensus hasn’t gone far enough. Her models argue for an additional cut of 13 percent to 2023’s estimates, which would imply the broad markets may have further downside potential. The analyst community typically makes its most meaningful estimate changes around the time of the quarterly earnings reporting season. Given the increased economic uncertainty and wider range of potential outcomes, we expect these numbers to decline further after the Q3 2022 earnings season, which starts the first week of October. Are there any positive signs? Stock traders have had plenty of time to digest the restrictive rate hike regime from the Fed, so we believe a case could be made that most of the bad news is already reflected in stock prices.

And the extreme moves during the week pitched the widely watched CBOE Volatility Index, or VIX, up to levels that have historically been good times to buy stocks (see table). The VIX closed at 30 on Sept. 23; over the last 30 years, the subsequent six-month performance of stocks when the VIX closes at 30 or above is significantly better than average, and the “win” rate is higher too. Bottom line The Fed’s actions have broadened the potential range of outcomes for stocks, and this added uncertainty has pressured markets. Higher interest rates feed into lower valuation multiples, and although the consumer appears to be in a relatively solid position in terms of savings and employment, we believe a slowing economy means earnings estimates may have further to fall. But investors with a longer time horizon may want to use this pullback to create a shopping list of high-quality stocks that should benefit from an eventual stabilization and ultimately a reversal of this year’s market weakness.

2) THE TERRIFYING – AND HIGHLY PROFITABLE – JOURNEY OF A BANK STOCK

Author: John Heinzl, Globe and Mail, September 23, 2022

Last week, I discussed why the buy-and-hold approach is the best strategy for most investors. Today, I’ll provide a real-life example to illustrate my point.

The stock I’ll be discussing is Royal Bank of Canada

I chose Royal Bank because it’s Canada’s largest company by market value, and I didn’t want people to think I was cherry-picking some obscure business with fabulous returns just to prove my point.

The purpose of this exercise is to demonstrate that, when you own an excellent company, you are much better off holding the shares through thick and thin than trying to trade your way through the market’s gyrations. I don’t know anyone who can do that reliably, but I know plenty of people who try.

So let’s imagine you had $10,000 to invest on Sept. 21, 2002 – roughly 20 years ago. You had read that Royal Bank had paid dividends every year since 1870, so it sounded like a pretty safe bet. You also had the foresight to enroll your shares in the bank’s dividend reinvestment plan (DRIP) to get the full benefit of compound growth.

Then you crossed your fingers and hoped for the best.

For the first five years, you felt like a genius. By Sept. 21, 2007, Royal Bank’s share price soared 114 per cent. Including reinvested dividends, your $10,000 had grown to $24,937, for a total return of nearly 150 per cent. Easy peasy, right?

But then the financial crisis reared its head. As hedge funds blew up and the U.S. housing market unraveled, banks around the world scrambled to shore up their balance sheets. Over the next 17 months, Royal Bank’s stock plunged by more than half. Adding to your misery, the bank went nearly four years without increasing its dividend.

But being a good buy-and-hold dividend investor, you hung in there. As Royal Bank’s stock price languished, you comforted yourself with the knowledge that, thanks to your DRIP, you were acquiring additional shares at low prices.

Staying the course turned out to be the right move. As the global economy recovered, Royal Bank’s stock went on to produce several years of impressive gains. By 2011, the bank was raising its dividend again.

If you’d sold your shares during the 2008-09 meltdown, you would have been kicking yourself.

But there was another global crisis ahead. In 2020, the COVID-19 pandemic sent markets tumbling around the world. Once again, Royal Bank’s stock plunged, and Canadian banks put dividend increases on hold, this time under orders from the Office of the Superintendent of Financial Institutions.

But, just as it had done after the financial crisis, Royal Bank’s stock eventually recovered from the pandemic-induced setback and went on to reach new highs. When OSFI gave the green light to resume dividend increases last fall, Royal Bank obliged with an 11.1-per-cent hike in December, followed by a 6.7-per-cent dividend boost in May.

I mentioned the financial crisis and the pandemic for a reason. Both were highly unusual events that created massive disruptions to the global economy. Yet, in both cases, Royal Bank not only survived, but thrived. So did Canada’s other big banks, and plenty of other companies.

Now for the big question: What would your reward have been for buying and holding Royal Bank shares through a 20-year period that included two of the biggest crises in recent memory?

Well, Royal Bank’s total return over that time, including dividends, was 12.45 per cent on an annualized basis. To put that into dollars, your initial $10,000 investment would have grown to $104,618 – a gain of 946 per cent – before tax.

Not bad for doing nothing but buying and holding. Remember, that’s without contributing any additional cash along the way, apart from automatically reinvesting your dividends.

Well, that’s great, you say. But what about the next 20 years? Nobody knows what will happen, of course. An asteroid could strike the Earth. Climate change could render large swaths of the planet uninhabitable. A third world war could break out. But barring a global catastrophe of unprecedented scale, I expect that Royal Bank and its competitors will continue to do what they do best: make billions in profits each year and pay rising dividends to their shareholders.

As for the near-term risks, one concern is that central bank rate hikes to cool inflation could trigger a recession. Fears of an economic slowdown are one reason bank stocks have fallen across the board recently. But Canadian banks have extremely strong balance sheets to weather whatever is coming. What’s more, as a group, they are trading at very attractive valuations that average less than 10 times estimated fiscal 2023 earnings. Royal Bank’s P/E is currently about 10.4, implying that investors expect above-average earnings growth relative to peers.

As Royal Bank’s return history illustrates, you don’t need to trade your way to wealth. The simplest, and most effective, way to build your nest egg is to buy great companies and hold them through good times and bad.

That’s it for now! Next time, I will try to share something a little less about the markets.

Should you have any questions, please feel free to reach out.

J. Todd Kennedy, CIM, FCSI

Senior Portfolio Manager

613-566-4582

toddkennedy.ca