Equity markets made up a lot of ground in the second quarter that was lost earlier this year. After being down 21% in the first quarter, the TSX Composite gained 17% in the second, the S&P 500 was down 12% and came back 15% while international stocks rose 10% after falling 15%.
On the surface, these numbers are encouraging. However, in Canada, the gains have been propelled by one sector—Technology. If we take out one Technology stock, Shopify, the TSX return for the first half of the year would be -11.3% not -7.5%. In the U.S., the FAANG stocks (Facebook, Amazon, Apple, Netflix and Google) have risen an average of 38% since the start of 2020 compared to the S&P 500 at up 2% (Canadian dollars).
In the following graph, you can see returns for most sectors are negative so far this year. Besides Technology, the only other sectors with positive gains are TSX Materials (gold stocks) and S&P Consumer Discretionary (Amazon). The remaining sectors all have negative returns with the worst being Energy. While there has been a strong rebound in the price of oil to $40US, demand remains weak. Canadian Health Care has been hard hit for two main reasons. Cannabis sales remain weak, companies are having trouble getting financing and they are unable to cover their costs.
Long term care homes are expected to experience higher costs going forward and this will dampen profitability. Financials (banks and insurance) are hurt by low interest rates and in the case of banks, high unemployment will result in defaults. Canadian Real Estate has also fared poorly due to the closure of malls and worries about the negative impact on office space due to more people working from home.
Shopify and Amazon are two of the small group of companies that are benefitting from the pandemic. Shopify sells software and services that businesses all over the world can use to manage online sales. The demand for this software has skyrocketed due to the lockdowns. As you know, Amazon is an online retailer that sells its own products plus those of other firms. It, too, has seen a spike in revenues as consumers and businesses ordered more goods online. While these companies are very well positioned to capitalize on the future growth in online sales, their stocks trade at such high valuations that much of this future growth is already reflected in the prices. For example, the ratio of the share price to earnings (p/e multiple) is 1500 for Shopify and 82 for Amazon. The TSX and S&P 500 currently trade at a p/e multiple of 20.
As you have seen, many sectors of the market are down this year. In some cases this seems justified due to potentially long term negative effects from the pandemic however, others appear overly discounted. Overall, we think many stocks offer good value when looking over 2-3 years (the estimated time for earnings to recover to the previous peak). Dividend yields are very attractive relative to bonds so investors are being paid to wait for capital appreciation.
The short term outlook for stocks remains uncertain. COVID-19 is a key risk however, it seems unlikely there will be another full lockdown. This means less damage to the economy with a second wave of infections. More testing and tracking is key to containing outbreaks. Development of an effective treatment or vaccine would give confidence a tremendous boost. The other main risk is the U.S. election outcome. Joe Biden is leading in the polls. If he wins, he plans to reverse Trump’s corporate tax cuts. This would be negative for corporate earnings.
The TSX Composite started the year at 17,063 and the S&P 500 at 3231. We could reach these levels, possibly surpass them, by the end of 2020 if the recovery is robust, technology related stocks hold their gains and/or there is success developing a vaccine. If another round of shutdowns is required we could see markets end the year closer to the March 31st levels of 13,379 (TSX) and 2585 (S&P).