Making a case for both value and Canadian stocks
“Where there are no expectations, there is no disappointment.” ~ Charles Krauthammer
In the 1987 film Wall Street, Michael Douglas portrays Gordon Gekko, a Wall Street tycoon who is utterly devoid of morals. In 2003, the American Film Institute named Gekko No. 24 on its list of the top 50 movie villains of all time. His classic line, “Greed, for lack of a better word, is good,” is perhaps one of the most iconic lines in cinema history.
Notwithstanding that greed is generally frowned upon, there are times in markets when greed should be encouraged. There is little appetite for risk and sparse demand for stocks when investors suffer severe losses during bear markets. Equities become washed out and valuations reach levels where the risk of owning them is below average and their prospective returns are above average.
In contrast, there are times when greed and its close relative, the fear of missing out (FOMO), can have painful consequences. Greed tends to be in abundance when stocks have experienced a largely uninterrupted string of above-average returns, while FOMO is nowhere to be seen.
Such lopsided sentiment pushes valuations up to the point where stocks offer little (or negative) returns and pose elevated risk. Putting fresh money to work in such environments is akin to picking up pennies in front of a steamroller.
By the end of 1999, euphoric sentiment had pushed the S&P 500 to nearly 30 times forward earnings, which marked its highest valuation over the past 30 years and set the stage for a lost decade for investors. At the other end of the spectrum, the global financial crisis caused investors to sour on stocks to the point where the S&P 500 was valued at less than 12 times forward earnings, which placed it in the first percentile of its valuation range over the past 30 years. From this starting point, U.S. stocks subsequently rose at a breakneck pace.
One of the constants in markets is that human behaviour and emotions lead to unsustainable conditions. Losses tend to follow extremes of confidence, while outsized gains tend to follow extremes of despondency. Warren Buffett best summarized this cycle: “Be fearful when others are greedy and greedy when others are fearful.”
What can go wrong? Nothing and everything
As 2023 was drawing to a close, the prevailing narrative was that the United States economy would avoid a recession and expand at a healthy clip. Inflation would continue its downward trajectory, which would allow the U.S. Federal Reserve to enact six quarter-point rate cuts over the course of the following year.
Short of a future that entailed solid economic growth coupled with a return to zero interest rates, investors could not have hoped for a better environment than the one that was anticipated for 2024.
There were good reasons for this optimism, including the recent decline in inflation and a surprisingly resilient economy, but these sentiments were fully reflected (and perhaps over-reflected) in asset prices.
Whether things go right or wrong per se is not what moves markets. At least as important is what is embedded in asset prices at the time when things go right or wrong.
At the beginning of 2024, valuations were discounting a scenario in which pretty much everything would go the right way for equities. As such, when April’s inflation readings failed to register the anticipated improvement, stocks had an adverse reaction. Had markets (and, by extension, valuations) been less optimistic prior to this negative surprise, it is likely that April’s decline in prices would have either been less severe or nonexistent.
Goldilocks has left the building
Between 2008 and 2020, inflation remained extremely well-behaved, often running below two per cent. This gave the Fed little reason to tighten monetary policy, especially since markets tended to react adversely to any sign of rising rates.
Central bankers were in the enviable position of having their cake and eating it, too. They left rates at record low levels for an extended period and stimulated economic growth while simultaneously keeping the inflation genie safely contained in its bottle. This fostered a near-perfect backdrop for strong gains in asset prices.
Perhaps the single most important factor that enabled this Goldilocks environment was a dramatic increase in international trade and global integration. From the 1990s through mid-2016, total international trade rose from roughly 39 per cent to 56 per cent of global gross domestic product, propelled largely by the consistently rapid growth of the Chinese economy. This surge in trade led to an annualized reduction in U.S. inflation of between 0.1 per cent and 0.4 per cent between 1997 and 2018, according to the U.S. National Bureau of Economic Research.
This strong tailwind of globalization has stalled as anti-trade rhetoric has become increasingly prevalent. Populism and economic protectionism have intensified around the globe, most notably between the U.S. and China. The likelihood of greater global economic integration for the foreseeable future has also been reduced by a rash of geopolitical conflicts, which have caused companies to reevaluate supply chains and explore nearshoring opportunities.
These developments do not mean rates cannot decline from current levels, but they do suggest that the neutral setting for monetary policy (that is, the rate that is neither inflationary nor restrictive) may be higher than what markets have grown accustomed to.
Alternately stated, non-inflationary trend growth may be lower than has been the case over the past couple of decades. Barring a true catastrophe, I suspect that the world will have to tolerate some combination of higher rates, higher inflation and lower growth.
Goldilocks has left the building and she ain’t coming back anytime soon. This distinct possibility carries significant implications for markets and portfolio positioning.
The road ahead
It is not just what happens, but what happens relative to what markets are discounting when it happens. From this perspective, U.S. equities in particular are not priced for a higher-rate, lower-growth world.
As of the end of April, the PE ratio of the S&P 500 was in the 77th percentile of its historical range over the past 30 years. While not extreme, this level is more ominous when adjusting for the recent spike in rates.
From a valuation point of view, investors in U.S. stocks have less reason to leave the safety of Treasuries than at any point since the late 1990s tech bubble. Although this by no means assures that U.S. stocks are ripe for a bear market, it strongly suggests returns will be below average over the medium term.
In contrast, the PE ratio of the S&P/TSX composite index currently lies slightly below its long-term average, which places it in the bottom 10th percentile of its range of relative valuation to U.S. stocks over the past 20 years.
The valuation spread between U.S. and Canadian stocks has historically been a reasonable harbinger of the relative performance of the two markets. When the relative valuation of U.S. vs. Canadian stocks has been above average, the latter have tended to outperform, and vice versa.
From a style perspective, investors would be well-served to tilt their equity exposure in favour of value stocks, which are less dependent on low rates and high economic growth than their growth counterparts.
From a geographical perspective, it would also be prudent to increase allocations to Canadian versus U.S. stocks, given that the latter are poised to reverse their decade-long run of outperformance.
Noah Solomon is chief investment officer at Outcome Metric Asset Management LP.
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