Adapt and Thrive

We enter 2022 hoping that this letter finds you and your families healthy and well after another holiday, interrupted.  While our holiday cheer may have been dampened by the restrictions announced over the past few weeks amid the rising case counts of COVID-19, we can be comforted by the fact that we have been through this before and came out the other side.  We are resilient, we are adaptable.  We will get through this and move forward.

Think back to a year ago.  The global economy had just weathered arguably its greatest challenge since the great Depression, helped by overwhelming amounts of stimulus, rapid medical progress, and corporate and societal adjustments to the virus which likely surprised all of us. Most of Canada was still in lockdown as we waited patiently for the newly discovered vaccines to be distributed, while watching as other parts of the world re-opened and embarked upon the new normal.  Valuations across various asset classes were above-average, which was a less than ideal set-up for above-average returns for markets, especially when you consider that a new variant of the virus was exploding the case counts in India and threatening the nascent recovery.  What followed was objectively a very good year for most global markets.

The principal driver of these strong returns was a surge in corporate earnings, proof positive of how resilient and adaptable corporations were through the pandemic.  Consider this.  The benchmark U.S. market, the S&P 500, ended 2019 with $152.29 in earnings per share, and should end 2021 with $208.96 in earnings, or ~37% higher.  Global stocks, as tracked by the MSCI World Index, have also fared well, seeing their earnings grow from $114.13 at the end of 2019 to $158.88, a 39% increase (source: Bloomberg). This was largely driven by big U.S. companies like Microsoft, Google, Apple and Amazon, all of whom have seen their revenues grow at staggering rates, and their earnings roughly double.  In a rare turn, while most global stock markets enjoyed strong returns over the past year, they actually became cheaper as well.

Still, with the MSCI World currently trading for 20.4x earnings, and the S&P 500 at almost 23x earnings, stocks are by no means “cheap” in absolute terms.  For perspective, the S&P 500 has had an average valuation of 17.6x earnings since 1990.  This has drawn comparisons to the last time the stock market traded above 20x earnings for a sustained period in the late 1990s.  We hear the word “bubble” bandied about more than we used to.  Famed investor Charlie Munger of Berkshire Hathaway was bold enough to state a few weeks ago that the current environment was “crazier than the dot-com bubble.”*   

Stocks don’t trade in a vacuum; they operate in a relative world.  In late 1999, stocks peaked out at 26.6x earnings, or an earnings yield of only 3.75% (earnings yield is earnings divided by price), which, at the time, was just over half of the U.S. 10-year treasury yield (6.44%) and less than half than what one earned owning investment grade corporate bonds (8.2%).  Now, U.S. 10-year treasuries yield 1.5% and investment grade corporate bonds yield only 2.7%.  Relative to alternatives, the 4.3% earnings yield from the U.S. stock market, and the 4.9% earnings yield from global stocks looks attractive.  History is more likely to rhyme than repeat itself in this case.

In one important way, the world is very different than it was a year ago.  Inflation hit our radars again in 2021 after laying largely dormant for the last 30 years or so (the last time core CPI breached the 4.9% mark was in 1992).  Supply chain disruptions were the catalyst, as was a captive consumer sitting on record levels of cash.  And with unemployment levels approaching record lows again, wages have started to creep higher as well.  Central banks have a dual mandate, put in place during the runaway inflation of the late 1970s – price stability and low unemployment.  Having achieved the latter, central banks have started to focus on the former.  And they are taking it very seriously.  By April, the Federal Reserve is expected to reduce its monthly purchase of bonds from $90B to zero, and the European Central Bank will cut its monthly purchases from $80B to $40B. CIBC expects the Bank of Canada to raise rates 3 times in 2022. That’s a lot of liquidity to draw from the market.  To date, both the bond and stock markets have taken this news in stride, but we would anticipate that, all else equal, bond yields should start to move higher which may make stocks less attractive, following the logic above.  This bears close monitoring. 

Over the past year, the part of the market that have been most sensitive to rising interest rates has been stocks with very high valuations.  Not coincidentally, this group of stocks also tended to benefit from pandemic conditions (“Covid beneficiaries,” as we call them), and were driven to sky-high valuations when the pandemic was in its early days.  Many had little, or no, earnings to speak of, so were valued by discounting estimates of their future cash flows back at prevailing interest rates.  This made them very sensitive to both estimate earnings, which have fallen as the pandemic is becoming endemic, and rising interest rates: when rates move up, they go down, fast.  The air is being let out of a few bubbles while not disrupting the broader recovery. 

We would also be unsurprised if the current narrative of supply chain interruptions shifts to one of double orders, rising inventories and excess supply.  In 2020, we couldn’t find a piece of home gym equipment in the GTA.  Flash forward to a few weeks ago, and our local Canadian Tire had stocked an entire row with pallets stacked shoulder-high with free weights, kettlebells and skipping ropes.  We expect to see them on sale very soon.

As always, we will be looking for the best opportunities to grow your wealth in light of the current market environment. You are likely aware from our previous communications that our investment discipline is grounded in selecting well-managed companies with attractive free cash flow profiles and long sight-lines on growth, and to hire managers that share this philosophy. As we enter the new year, we’d ask you to focus on two other disciplines that are of equal importance in growing your wealth over the long term: updating your financial plan and contributing to your savings. We’ll be in touch in the weeks ahead to review performance and positioning to ensure they align with your long term plan. We’d ask that you consult with your tax advisor or myCRA to confirm your contribution limits, but here are the maximum amounts eligible to be contributed to registered plans and the RRSP contribution deadline so you can start planning your savings:

• TFSA: $6,000;
• RRSP: $29,210 (for 2022) and $27,830 (for 2021). The deadline for contributions to be applied against your 2021 earned income is March 1^st, 2022

 

Once again, we’d like to thank all of you for your support and commitment during this trying time. We continue to invest in growing our team and knowledge base so we can uphold our service commitment to you and your families while managing your wealth with the same prudent and thoughtful approach we have maintained for decades. Our practice continues to grow at a steady, sustainable pace thanks to you and the new clients you have steered in our direction.  For all of this, we are truly grateful.

 

*Not to fault Charlie Munger’s logic, but the market, with a few notable exceptions (meme stocks, for one), is actually acting much more rationally than it did in 1999.  Even the surge in cryptocurrency values and the proliferation of non fungible tokens over the past year make some sense in light of persistently negative real interest rates and the emergence of the metaverse. 

 

 

 

 

 

 

 

This information, including any opinion, is based on various sources believed to be reliable, but its accuracy cannot be guaranteed and is subject to change. CIBC and CIBC World Markets Inc., their affiliates, directors, officers and employees may buy, sell, or hold a position in securities of a company mentioned herein, its affiliates or subsidiaries, and may also perform financial advisory services, investment banking or other services for, or have lending or other credit relationships with the same. CIBC World Markets Inc. and its representatives will receive sales commissions and/or a spread between bid and ask prices if you purchase, sell or hold the securities referred to above. © CIBC World Markets Inc. 2022.

Clients are advised to seek advice regarding their particular circumstances from their personal tax and legal advisors.