EQUITIES COMMENT – “SPECTACULAR RETURNS – CAN THEY CONTINUE?”

Stocks had spectacular returns over the past quarter and year with the S&P/TSX Composite ahead 12.5% during the quarter and 28.6% over the last year.  For these same periods, the S&P 500 has returned 10.3% and 21.1% in Canadian dollar terms.  These are excellent returns and beg the question “Can They Continue? “  We will attempt to answer this by the end of this report.

Gold stocks have been one of the main drivers of the TSX.  The price of gold is up 47% this year while TSX gold stocks have more than doubled.  U.S. policy uncertainty, a high U.S. budget deficit and debt to GDP along with ongoing central bank buying has contributed to the rise.  In addition, weakness in the U.S. dollar and the expectation for further declines in U.S. interest rates has also benefited gold.  Donald Trump is losing popularity.  Could this take some of the lustre off gold?

Huge capital investments in AI technologies have been powering the Nasdaq.  It is dominated by the giants of technology who are at the leading edge of AI.  There is a growing belief that the application of AI will result in a substantial improvement in productivity which will in turn boost economic growth.  It is being called the fourth industrial revolution.   

Like the internet bubble of the late 1990’s, are stocks getting ahead of themselves and will AI live up to the current expectations?

When we look at the sector returns for this year, we can see the influence of gold and AI.  The TSX Materials group, which contains gold miners, was up 78% to the end of September.  It was the only sector to earn a higher return than the TSX Composite.  If we were to exclude golds from the TSX Composite return, it would be up 13%, not 21%.  The S&P 500 benefited from returns greater than 20% for Technology and Communications which contains META and Alphabet (Google).  Outside of gold and AI, Canadian Financials, particularly banks, have done well as fears of a recession have subsided.  Among S&P 500 sectors, Industrials and Utilities have had higher returns than the overall index.  Industrials are being supported by increased activity among Aerospace and Defense companies. Utilities are experiencing more rapid growth as they provide power for the AI data centre buildout. 

Can spectacular returns continue?  Looking forward, trade policy will likely be a key factor influencing the returns for stocks.  In the U.S., tariffs are being implemented gradually.  As the year progresses, tariff rates will increase further.  So far, we have not seen serious damage to the overall economy or inflation.  In Canada, trade negotiations with the U.S. are underway and next year the USMCA will be revisited.  Due to the Canadian economy’s huge reliance on U.S. trade, we still have a cautious view on growth for next year.  In addition, the highly indebted consumer makes this country more vulnerable to a drop in exports.

Changes in fiscal spending are looming in both countries.  In the U.S., the government shutdown has now lasted a week.  Republicans and Democrats are disagreeing over spending issues such as Medicaid cuts and the extension of health care subsidies.   If these are restored without cutbacks elsewhere, the deficit will be even larger than originally planned.  The Canadian budget will be announced on November 4^th.  It is expected to increase the deficit to nearly $70 billion as investment in housing, defense and infrastructure are increased.  Meanwhile, cuts at the federal level, including jobs, are likely to continue.   Deficit spending in both countries is supporting economic growth.

During the last quarter, there was a significant increase in corporate profits estimates for 2025 and out to 2027.  For the TSX, the biggest increases have been for Materials (both gold and metal mining stocks), Technology and Financials.  Banks have been able to set aside less reserves for bad loans as the economy continues to expand.   Materials and Financials are cyclical businesses so if economic growth weakens, earnings expectations would likely be reduced.  Technology is the main contributor to earnings increases for the S&P 500. 

Stock valuations, as measured by the p/e multiple (ratio of price to earnings), have increased since the end of last year, particularly for the TSX.  The p/e for the TSX Composite is over 16 which is above the long term average.  The S&P 500 p/e is over 22 which is also above the long term average and at a significant premium to the TSX and other world equity indices.  We believe there is a good chance this gap will narrow over the next few years as Carney implements his plan to boost Canadian economic growth and U.S. government policies put downward pressure on the U.S. dollar.   P/E multiples are likely to receive further support from central bank rate cuts as long as tariffs do not cause a significant and lasting increase in inflation.

When we incorporate the increased earnings estimates and assume current p/e multiples are maintained, we can see the TSX reaching 32,300 over the next 6-12 months and the S&P touching 7,000.  This assumes gold stocks remain near current levels which could prove to be optimistic.  Disappointing developments in the field of AI could jeopardize these targets. Negative or positive surprises related to government policies could alter the trajectory of stocks at least in the short term. Overall, we expect returns of 5%-10%, including dividends, over the next six to twelve months--solid but unspectacular.

The chart below shows the superior performance of stocks relative to gold over the long term.   A large exposure to companies at the epicentre of the third industrial revolution (digital) and fourth (AI) explains the higher returns for the Nasdaq and S&P 500 versus the TSX.