DIARY OF A PORTFOLIO MANAGER
April 5, 2024
“I know it's up for me
(If you steal my sunshine)
Making sure I'm not in too deep
(If you steal my sunshine)”
Keeping versed and on my feet
–Steal My Sunshine, Len
Good day,
ECLIPSE MUSIC
Two interesting things about the song referenced above. When it comes on the radio in the car, 1) I turn it up and 2) my wife, Sue, turns it off.
Maybe an interesting song to play during the eclipse on Monday? Total Eclipse of the Heart and Black Hole Sun would round out my Top 3.
What is going on today?
Investors are digesting recent jobs reports in Canada and the U.S. Meanwhile, the consensus view remains that rate cuts are looming in the second half of the year. The exact timing and degree of cuts are topics of debate given recent comments from a few officials at the U.S. Federal Reserve. Given the strong global equity market gains over the past year, market valuations and return expectations going forward seem worthy of focus.
We have and continue to be guided by a simple but intuitive framework for longer-term investing. In essence, it suggests that long-term returns can be particularly rewarding when investments are made at inexpensive valuations. Likewise, investing results have proven to be less satisfying, over time, when investments were made at elevated valuation levels. Importantly, this guideline has no real bearing on investment returns from one year to the next. Rather, it has proven particularly useful for investors to use this over longer time frames to help assess the long-term return potential of various asset classes. Reflecting on this basic rule recently has led to me to ask the question: where are valuations today? And importantly, what expectations should one have for longer-term returns from equities?
VALUATIONS IN THE U.S.
On the surface, the large cap U.S. stock market (the S&P 500 index is my proxy) appears expensive. That’s not that surprising given how well it has performed since the lows reached in the fall of 2022. Its forward Price to Earnings ratio, which reflects the current price divided by the earnings expected from the companies within the index over the next twelve months, currently sits at about 21. That compares to its average of 16 over the past twenty to thirty years. But, as has been well documented in recent months, the gains of the U.S. market over the past year have been heavily influenced by the performance of the “Magnificent 7”, a group of seven large technology stocks. If we strip out these seven stocks, the market’s P/E ratio falls to a more reasonable range of 17-18. In other words, the U.S. market is not cheap but may not necessarily be as expensive as one would think. This is why you may have noticed more than usual cash holdings in the US side of your account as we have taken profits from the names that have done well and are overweight in the portfolio.
VALUATIONS IN CANADA
The forward P/E ratio for the Canadian equity market is just below 15, which is around its long-term average. The same ratio for overseas developed markets is also just below 15, which is slightly higher than its long-term average. In emerging markets, the ratio is nearly 12 which is also just above its longer-term average.
My key takeaway is that despite the fact equity markets have done well since the lows reached in 2022, the valuation levels, outside of some of the largest technology stocks in the world, are not necessarily at the kind of elevated levels that would suggest investors need to meaningfully recalibrate their long-term return expectations.
Nevertheless, should markets continue to march forward without a meaningful pick-up in earnings, I will have to revisit this exercise as it could be indicative that markets have got ahead of themselves in the short term.
Have yourself a great weekend,
