EQUITIES COMMENT - Is the clock about to Strike Midnight?
Some parallels can be drawn between the story of Cinderella and the stock market over the last two years. Let’s set the stage for where we are today in the story…
At the beginning of Cinderella, she is happily living with her father. Once he remarries, the true colours of her stepmother and stepsisters become apparent. The outlook for the stock market was positive at the end of 2019 and it reached record highs in February 2020. The initial appearance of COVID-19 was not taken too seriously. It was only when its true contagion and lethality became apparent, that a pandemic was declared. The stock market reacted in a violent sell off as governments started to shut down huge sectors of the economy and unemployment skyrocketed.
With her stepmother in charge, Cinderella was forced to work as a servant while her stepsisters led a life of leisure and privilege. However, when her fairy godmother appeared and waved her magic wand, she was given a chance to escape her life of drudgery. During the shutdown, unemployment rose dramatically and some businesses saw revenues evaporate, eg. cruise lines. Other companies thrived, such as Zoom. Among consumers, there was also a gap that opened with people in low paying jobs experiencing higher unemployment than those in white collar positions. Enter the fairy godmothers: central banks that lowered interest rates, governments that provided more generous unemployment benefits and later, scientists that speedily developed COVID vaccines.
Cinderella was given a beautiful dress and coach to take her to the ball. There she danced with the prince until the clock struck midnight. The stock market was given a huge boost in confidence by the fairy godmothers. This resulted in a rapid and persistent rise in stocks from the March 2020 low’s to today.
Both the TSX and S&P500 made new all-time high’s during the third quarter due to very strong corporate profit growth. However, a modest selloff at the end of the quarter meant the TSX had a gain of only .2% while the S&P was up 2.9% in Canadian dollars. Stocks came under pressure due to worries about the possible bankruptcy of the huge Chinese real estate company Evergrande, reduced bond buying by the U.S. Federal Reserve, failure to negotiate an increase in the U.S. debt ceiling and rising Delta variant cases.
Like the contrast between Cinderella and her stepsisters, there has been a discrepancy in performance among the sectors of the stock market. So far this year, Energy is the top performing sector after being the loser last year. Others that are doing noticeably better than last year are Financials and Real Estate. Technology has been a top performer throughout the pandemic. One of two losing sectors in 2021 is TSX Materials; gold stocks have fallen due to a decline in the price of gold.
Similar to the ball in Cinderella, the earnings recovery from the 2020 pandemic lows has been nothing short of spectacular. It has fuelled the gains in the stock market this year. Earnings for the TSX are forecast to rise over 90% this year and almost 50% for the S&P 500; this will put them well ahead of pre-pandemic levels. The outlook for earnings in 2022 is growth of between 7% and 11%.
Despite much higher stock prices, price to earnings multiples (the ratio of the stock price or index value to the earnings), a standard valuation measure, have actually come down due to the massive increase in earnings. Our research indicates stocks are generally not expensive outside of the Technology sector.
The fairy godmother warned Cinderella that at the stroke of midnight, the magic spell would end and her dress and coach would return to the former rags and pumpkin. Although Cinderella went back to her life as a servant, it was only temporary. Once she tried on the glass slipper, she married the prince and began a new life at the palace.
Stocks could experience a temporary correction as government and central bank fairy godmothers withdraw pandemic support measures. However, we do not expect the bull market to end. Policymakers want to ensure that unemployment will remain low and inflation stays contained so we expect a gradual reduction in stimulus. Increased vaccinations among younger children and in the developing world will allow greater movement of people and improved economic activity.
The strong growth we are seeing in earnings this year has a lot to do with the depressed levels of 2020. As the recovery continues, growth moving forward will moderate. Our year end 2021 targets remain at 21,200 for the TSX and 4,450 for the S&P 500. For 2022, we anticipate total returns of 7%-10% for stocks.
What could cause the clock to strike midnight and an end to the ball for the stock market? (in other words, a larger and more protracted decline)
Increased corporate tax rates
Higher than anticipated bond yields
Debt levels have increased during the pandemic; this could constrain future spending and dampen economic activity
Disappointing economic growth due to a China slowdown and/or high energy prices
More rapid spread of COVID or appearance of a new variant
The onslaught of the pandemic caused the global economy and stock market to go from riches to rags in early 2020. With the magic wands of central bank, government and vaccine scientist fairy godmothers, a spectacular ball ensued for the stock market which we do not expect to end soon. Gains in stocks have been driven by a massive increase in corporate profits. Although growth will slow, we still anticipate positive returns from stocks over the next twelve to eighteen months.