EQUITIES COMMENT - Inequality

There have been numerous reports about the pandemic exacerbating inequality. The following graph shows job losses in the U.S. during the past six months. The losses have been concentrated in Services industries such as restaurants and hospitality. Job losses in Goods industries such as manufacturing have been much lower. Inequality has not been confined to the labour market; there is also evidence of it in the stock market.

During the third quarter, global equity markets continued to recover from the COVID-19 induced February/March meltdown with the U.S. market actually reaching a new record high. The TSX was up 5%, the U.S. S&P 500 gained 7% and international stocks (MSCI EAFE) rose 3% (all returns in Canadian dollars). These numbers only tell part of the story…

When looking at graphs of the major market indices, it is evident that a lot of the ground lost early in the year has been recaptured. The S&P 500 is actually up 9% this year, while the TSX and EAFE are now only down 3% and 4%, respectively. However, when we look at individual sectors, there is evidence of inequality in rates of return.

At one extreme, we have Technology which is ahead 68% in Canada and 28% in the U.S. At the other end of the spectrum, we have Energy which is down 39% in Canada and 50% in the U.S. Financials have also performed poorly in both regions. These two sectors along with Real Estate (and Health Care in Canada) have been left behind during the recovery. The remaining sectors have mixed results, generally in the range of +10% or -10%. The outliers are Golds in Canada and Consumer Discretionary (includes Amazon) in the U.S. The pandemic has had a positive impact on many companies in the Technology sector due to increased demand for computers and internet related services. An already growing sector has accelerated. Contrast this with Energy and Financials. Energy is suffering from reduced demand for oil due to the collapse in travel along with depressed prices. Financials have been hurt by record low interest rates. As well, banks have had to set aside substantial reserves for potential loan losses due to high unemployment.

The graphs beside highlight the unequal performance of individual stocks this year-- Microsoft and Apple, two leaders and TD Bank and Enbridge, two laggards.

We believe that the inequality we are seeing in the stock market will diminish over the next 1-3 years. During this time frame, COVID-19 should become a much smaller influence on the economy due to the combination of more effective treatments and/or a vaccine as well as increasing immunity. This will allow more people to get back to work and greater movement of people around the globe. Banks and energy firms would benefit. A reduced COVID threat could also slow the growth in demand for technology services and components.

Another reason for expecting increased equality rests on valuation. We use a number of valuation measures when analyzing stocks. Probably the most well-known is the price to earnings multiple (p/e) – the ratio of the stock price to the earnings per share a company generates. When a stock has a high p/e, investors expect that earnings will grow quickly. If growth does not materialize as expected, there is a risk the stock will fall hard as the p/e multiple declines. Stocks with a low p/e ratio generally have lower growth potential. When growth turns out to be better than forecast, these stocks can benefit from an increased p/e multiple; disappointing earnings mean less downside risk in a low p/e stock. Currently, a lot of the laggards have low p/e multiples while the leaders have high p/e’s. We think valuations for laggards could improve over the next 1-3 years as earnings recover while valuations have limited upside, perhaps even some downside, for the leaders.

Another key valuation measure is dividend yield. This is the ratio of the annual cash companies pay out to their stockholders for each share they hold divided by the price of the stock. A lot of laggards have higher than average dividend yields while the leaders have low yields. We believe there is room for dividend yields of laggards to come down which would mean higher stock prices.

Given the very low interest rate environment we are in, dividend yields on laggards look especially compelling compared to bond yields. This could result in investors increasing the proportion of high quality dividend paying stocks in their portfolios at the expense of bonds and cash.

In the short term, investors need to keep their eye on two U.S. political developments: the timing and approval of a fiscal spending package to support the economy and the outcome of the presidential election. Both issues are expected to contribute to market volatility between now and the end of the year. Longer term, over the next 1-3 years, our outlook for stocks is positive. Our 2021 targets for the TSX and S&P 500 are 17,500 and 3,600, respectively. This assumes earnings continue to recover and valuations remain about the same overall. As we have discussed, we expect to see less extreme inequality among stock and sector returns during this time. In the meantime, patient investors holding high quality dividend paying stocks are earning an attractive level of income while waiting for capital appreciation. MSFT

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