EQUITIES COMMENT- Science to the Rescue

Vaccines a Game Changer - During the fourth quarter, an end to the pandemic came into sight. Three vaccines to fight COVID-19 received approval and effectiveness was above expectations. This news provided a tremendous boost to investor optimism. Canadian stocks rose 9%. U.S. and International stocks gained 7% and 11% respectively, in Canadian dollar terms. In fact, U.S. stocks reached new all-time highs. Good news on the vaccine front was supplemented by the Democrat win in the U.S. presidential election.

Pandemic Heightens Inequality With the onset of the COVID-19 pandemic and subsequent lockdowns, a chasm developed in the global economy and the stock market. Which sectors could still thrive in a world of limited social contact and which ones couldn’t? Manufacturing remained quite strong while service businesses such as airlines, restaurants and hotels suffered. Among stock market sectors, Technology was the big winner as consumers and businesses became ever more reliant on it. The losers included Financials and Energy. Banks faced potential losses on loans as unemployment in the service sector soared. Energy companies experienced a loss in demand as well as much lower prices because transportation ground to a halt. With the vaccine success, optimism about the chasm closing soared. Stocks that had been pummeled, began to recover.

Laggards Become Leaders In the following graph, we are highlighting the U.S. S&P 500 sectors with returns for the fourth quarter and 2020 as a whole. For the quarter, Energy and Financials were the leading sectors with returns over 20%.Technology still gained but, at a slower rate of 12%.For the year, Financials, Energy and Real Estate had negative returns and remained the laggards. The annual return for Technology was 44%, making it the leader. Discretionary, which includes Amazon, was ahead 33% while Communications (Facebook, Google and Netflix) gained 24%.

Results for the TSX are similar with Energy and Financials being strong performers during the quarter and laggards for the year and vice versa for Technology. During the quarter, Health Care(marijuana stocks) and Discretionary (retailers and auto parts) had the best returns. Gold stocks did well in 2020 but declined during the quarter.

What about 2021? Even after the sizeable gains in stocks over the last nine months, our research indicates they have further upside potential. We have increased our 2021 targets to 19,350 for the TSX Composite and 3,900 for the S&P 500.

Earnings Recovery Profit estimates have risen; for the TSX they are expected to grow over 25% this year and almost 20% for the S&P 500. However, this will only bring earnings back to the levels before the pandemic. Laggards during the pandemic are expected to have some of the strongest gains in earnings.

Low Bond Yields The valuation of the markets as measured by the p/e multiple (the ratio of the index value to the earnings generated by the stocks in the index) is forecast to decline but remain higher than average due to low bond yields. Historically, there has been an inverse relationship between p/e multiples and bond yields; the lower the bond yield, the higher the p/e and vice versa. Note: The p/e multiple for the TSX is lower than the S&P 500 due to a slower long term earnings growth rate. S&P 500 earnings have increased faster because of more exposure to Technology.

Dividend yields on stocks also look attractive due to low 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.

What Could Go Wrong? The primary risk we see is the vaccination process. It could take longer than anticipated to get people vaccinated for a whole host of reasons. This would mean a delay in the economic recovery and would likely have a negative impact on stocks.

Nations that are hostile towards the U.S. such as Iran could test the new president. Investors expect friction with foreign countries to diminish under Biden on both the trade and military fronts. Disappointment with U.S. foreign policy could cause markets to pause or decline.

Consumers and businesses have increased savings dramatically during the pandemic. Depending on how much and how quickly savings are spent could make our forecasts too conservative or too optimistic.

What to do? There has been a powerful rally in stocks since the end of March. We would not be surprised to see some consolidation or a pullback in the next six months. Selling in advance of such an occurrence and then trying to repurchase stocks at lower levels (market timing) has been proven to be a long run losing strategy. Missing out on a few days of 2% returns can destroy long term results. Our approach is to hold high quality dividend paying stocks that earn an attractive and growing level of income while waiting for capital appreciation.