DIARY OF A PORTFOLIO MANAGER
Here are some thoughts from our Global Strategy Group as we head into a short week on both sides of the border:
Rallies, recessions, and realistic thinking
While the S&P 500’s surge over the past nine months has rekindled investor optimism, it doesn’t feel to us much like the start of a new bull market, but rather much more like the last leg of the current rally. Whichever it is, the market is certainly in a different place today. While this advance should have further to go into the summer, the economy will likely set the market’s path for the coming 12 months.
Key points
- The market rally from the September lows has gone far enough to turn many skeptics into believers. Joining other major markets in new high ground this summer is not out of the question for North American averages.
- “Fear of missing out” has been propelling the North American averages higher and could go on doing so for some months yet. But the attractive valuations of last September are giving way to loftier price-to-earnings ratios that we believe will need the economy to cooperate to be justified.
- Reliable leading indicators of U.S. recession continue to worsen, suggesting to us that this latest advance in share prices will eventually give way to a more challenging period for equity investors.
A year ago, our 2022 Midyear Outlook was looking at an equity market landscape that was mostly the opposite of today’s:
Central banks, including the Fed, had started 2022 prepared to be somewhat tolerant of a pick-up in inflation but changed their tune as prices rose much faster than policymakers expected in the early months of the year. Mid-2022 would mark the opening stages of what would come to be the steepest series of rate hikes ever. Still to come for the Fed would be an unprecedented run of four successive 75 basis point (bps) jumps, followed by four more subdued increases totaling an additional 125 bps.
Also at this time last year, the stock market’s price-to-earnings (P/E) multiples had already been pressured lower by the sharp rise in bond yields that came with Fed tightening. The S&P 500 Index was down by 27 percent from its January 2022 peak while the Nasdaq was a whopping 38 percent off its high-water mark set in November 2021. Both had been heavily burdened by the big decline in P/E ratios among the previously high-flying mega-cap growth stocks. The six largest such stocks constituted more than 25 percent of the value of the S&P 500 at the peak of the market in early January last year.
Enter the rally
Most global equity indexes went on losing some more ground into last September before turning higher into a new up-leg. That rally from September has continued up to the present day. From September until May this was viewed by most as no better than a bear market rally that would eventually peter out. But as the S&P 500 moved convincingly above its trading range over past six weeks it has rekindled investor optimism. Market sentiment gauges have soared as “fear of missing out” (FOMO) has replaced caution.
For our part, we think this equity market up-leg has further to run. The UK’s FTSE All-Share Index, the EURO STOXX 50, and Japan’s TOPIX have all posted new highs for this cycle. Before the rally is over, we expect the S&P 500 and Canada’s S&P/TSX Composite will do the same.
New bull or last gasp
However, this doesn’t feel to us much like the start of a new bull market, but rather much more like the last leg of the current bull run. Whichever it is, the market is certainly in a different place than it was back at the September lows. At that point, most indexes had been falling steeply for nine months, some even longer. The P/E ratio for the S&P 500, an extravagantly overvalued 23.1x at the peak of the market in early January 2022, in our view, had fallen to a much more palatable, slightly undervalued 15.9x by September.
This downswing in the index and in valuations occurred even as reported earnings were rising—the running 12 months earnings per share had risen from $208 to $219. Meanwhile, over the same interval, investor sentiment followed the market lower, sinking all the way from unsustainably bullish readings at the top in January to equally unsustainable bearish ones at the bottom in late September. Since then, everything has been turned pretty much topsy-turvy. The U.S. equity market has gone up for nine months instead of down, and the S&P 500 is edging closer to new all-time highs. P/E multiples are back above a rich 20x. And, as noted above, sentiment readings have roared higher, getting closer to (but not yet at) the unsustainable levels that last prevailed at the top of the market a year-and-a-half ago.
Don’t fight the economy
This strong upswing in equity index values (mostly contributed once again by a handful of mega-cap Tech and tech-related stocks as well as by a wave of investor interest for anything even remotely related to artificial intelligence) is persuading some market watchers that the U.S. economy will avoid a deeper downturn. However, most reliable leading indicators of recession (see our U.S. Recession Scorecard) have been moving inexorably toward even more negative readings.
Of course, even leading indicators of U.S. recession that have been repeatedly and consistently right over the last 70 years or more could be wrong this time. Earnings and GDP growth could conceivably be pulling out of their funk starting right now. And if current consensus earnings estimates for $231 per share a year from now and $246 per share for all of 2024 prove to be correct, then that may be what is happening. That would put today’s index value at almost 19x year-ahead earnings—not cheap, but perhaps not overly risky either, in our view.
However, our Recession Scorecard tells us that the underlying economic assumptions needed to bring in those improved earnings are becoming more and more improbable by the week. We expect that a U.S. recession will arrive later this year, that actual earnings will come in lower than current consensus estimates, and that share prices will go through a challenging period during which unrealistic optimism on the part of investors gives way eventually to unrealistic pessimism.
Only resilient stocks need apply
We continue to recommend Market Weight equity exposure for a global balanced portfolio because we think this advance has further to go into the summer months. However, we increasingly think individual stock selections should be restricted to companies that an investor would be content to own through a recession. For us, that means high-quality businesses with resilient balance sheets, sustainable dividends, and business models that are not intensely sensitive to the economic cycle
Have yourself a great Canada Day weekend!
J. Todd Kennedy, CIM, FCSI
Senior Portfolio Manager
613-566-4582
This information is not investment advice and should be used only in conjunction with a discussion with your RBC Dominion Securities Inc. Investment Advisor. This will ensure that your own circumstances have been considered properly and that action is taken on the latest available information. The information contained herein has been obtained from sources believed to be reliable at the time obtained but neither RBC Dominion Securities Inc. nor its employees, agents, or information suppliers can guarantee its accuracy or completeness. This report is not and under no circumstances is to be construed as an offer to sell or the solicitation of an offer to buy any securities.