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Craig Jerusalim, senior portfolio manager at CIBC Asset Management.
The only thing worse than a portfolio being hit by a 37% drawdown like you saw in March, is an investor sitting on the sidelines and watching the market rise 50% like it just did. This entire year, which many would be happy to forget, has been a master’s class in the psychology, as the giant game of tug of war between fear and the fear of missing out has unfolded. One of the most prescient lessons has been that the economy is not the stock market and the stock market is not the economy. Even though the stock market has bounced back in a V shape, the economy is still significantly lagging pre-Covid levels. Covid-19 has disproportionately hit lower-income frontline workers, as well as minorities, women and single-parent families, while high-income white-collar workers who own a disproportionate amount of equities have largely been able to adapt to work-from-home changes.
Another interesting observation leading to the V-shape bounce back in the stock market has been the surge of day traders, seeking a reprieve from the boredom of staying home, fueled by the drastic reduction in trading fees, the introduction of fractional shares, and the lack of traditional sports and gaming gambling options. But when we look back at 2020, and I promise you, it will come to an end, there are a few sign posts that will be at the heart of this double debate. Some of the most obvious signposts of euphoria includes Kodak’s dizzying returns, Hertz’s worthless paper soaring in price, Tesla’s race for S&P inclusion, the SPAC [special-purpose acquisition companies] craze, and the overall market concentration and valuations. But we know that euphoria is never a good timer, and if you think about when valuations exceeded average levels at the end of the 1990s, well, the market didn’t correct for a number of years afterwards, leaving much money on the table if investors moved to the sidelines at that point.
So let’s look at valuations today and try and put them in an historical context. The S&P 500 is trading at a lofty five turns higher than its 30 year average, essentially higher than at any period outside of that technology bubble in the late 1990s. The TSX is slightly better at two to three turns higher than its long-term average, largely to the cyclical composite of the Canadian index. But are these levels justified? Oaktree’s Chairman Howard Marks addressed this issue in a recent memo, where he explicitly laid out the decomposition and outlined a great explanation of why stocks can be justified at current levels. The crux of the argument is that equity markets should trade at earnings yield, which is just the inverse of the price-to-earnings ratio, close to the Treasury yield or the risk-free rate, plus an equity risk premium in the 3% range, for a total earnings yield of 4%.
This reverses back into a PE closer to 25 times, and that’s not even the bull case. The bull case suggests the appropriate earnings yield should be the risk-free rate plus an equity risk premium, less some long-term growth rate roughly in the 2% range, and that leads to the conclusion that maybe multiples can expand much further than where they are today.
Over the next few quarters while we don’t know which direction the market will go, we do know that there’ll be a lot of volatility as economies try to reopen and potentially revert back, plus the upcoming U.S. election, tensions with China, and the overall economics earnings outlook. But we also know that over the long term, markets do move higher. So spending less time market timing and more time identifying quality businesses that compound returns over time is the more prudent strategy. [It] not only allows you to benefit from the magic of compounding, but also smoothes out the inevitable volatility that all cycles encounter.
On the topic of the U.S. election, many investors are asking what a Democratic win versus four more years of President Trump could mean for stocks. Based on the work that I did following Trump’s surprising first term win, the conclusion I came to was that the presidency is largely uncorrelated to stock market returns, and in fact, the results are often counterintuitive. Many people expected weak returns under Obama. Well, those eight years delivered an impressive cumulative return. The inverse was true under the Republican [George] W. Bush’s term. There will likely be overreactions in specific sectors, such as technology or healthcare post-election. But those overreactions are what create investment opportunities. Even if there are overreactions due to perceived higher corporate taxes, the TINA effect, or there is no alternative, would likely prevail in this lower-for-longer interest rate environment. One [sector] that will clearly benefit under Biden is the renewable sector, given communicated plans.
However, the renewable seam is bigger than any one person and the longterm investment case is strong under either candidate. Pipelines remain contentious and new pipelines will continue to be a challenge to install, but that likely inflates the value of existing infrastructure in place. Expenditures and debt levels are also biased higher under either candidate, which could pressure the greenback and keep a healthy bit on gold and other commodities, as well as construction and infrastructure stocks. But no matter who wins, the likely biggest beneficiary over the next term is going to continue to be Saturday Night Live comedy writers.