Let’s start by addressing the event that the whole world has been talking about for several months: the American elections. Despite tighter results than many expected, the market did not experience any drastic movement following Joe Biden’s victory. Some feared that a Democratic victory could have caused the market to fall due to their intention to raise corporate taxes, while others believed the stock market would rise due to their more generous stimulus package. Regardless, the market recovered from the losses it had suffered in the weeks leading up to the election. As for the House of Representatives, it retained a majority of Democratic seats and we are still awaiting the official result of the Senate. We will be keeping an eye on this outcome and the impact it will have on the markets.
In recent weeks, apart from the US elections, the stock market has experienced a period of rise following the announcements of potential vaccines from Pfizer and Moderna. The markets have also experienced a transition from "growth" stocks, which have had enormous success in recent years, to "value" stocks which have been more neglected during the same period. Indeed, the announcement of potential vaccines seems to have given investors hope for the industries that had been particularly affected by COVID-19. However, this recent increase has been reversed in recent days as despite the hope of a vaccine, the number of cases and hospitalizations worldwide remains worrying and many companies are still suffering serious consequences.
We believe that despite the potential increase in the market that a of a vaccine could generate in the short term, such a high market valuation cannot be sustained in the medium or long term. We therefore believe that the divergence between the price of financial assets and their fundamental values cannot be eternal. One day or another, profits will have to rise to justify current prices or, conversely, the stock market will have to experience a sharp correction. This is why we prioritize fundamental analysis and the selection of individual stocks, well positioned to face the many challenges posed by COVID-19.
Below are our findings for the month of November regarding the returns to be expected from fixed income investments and stocks.
Fixed-income investments
Here is a graph that shows the evolution of long-term interest rates over the years. It can easily be seen that interest rates are currently at a level well below their all-time high of 15.32% in the early 1980s. Long-term interest rates now stand at 0.79%, which represents a certain increase compared to 0.69% for the month of October 2020.
Interest rates – Long-term government bonds
Source : http://www.econ.yale.edu/~shiller/data.htm as of November 6, 2020
Now let's move on to provincial bonds. Here are the returns for a 1 to 10-year laddered bond portfolio. The yield increased slightly from last month, from 0.88% to 0.97%.
| Provincial bonds yield-to-maturity | ||
|---|---|---|
| 1 year | 0.22% | Alberta 1.35% - September 1, 2021 |
| 2 years | 0.37% | Alberta 1.60% - September 1, 2022 |
| 3 years | 0.62% | Ontario 1.50% - September 8, 2023 |
| 4 years | 0.91% | Newfoundland 2.00% - April 17, 2024 |
| 5 years | 0.97% | Saskatchewan 1.80% - May 30, 2025 |
| 6 years | 0.96% | Ontario 0.00% - June 2, 2026 |
| 7 years | 1.22% | Quebec 1.00% - September 21, 2027 |
| 8 years | 1.31% | Quebec 1.40% - June 1,2028 |
| 9 years | 1.46% | Quebec 1.70% - June 1, 2029 |
| 10 years | 1.66% | Manitoba 1.70% - September 5, 2030 |
| Average: | 0.97% | |
Source : Factset as of November 18, 2020
So, again, we should expect a return of roughly 1% for the next several years from secure fixed income...
Stock market investments
The price paid for publicly traded companies, according to the Shiller ratio, is currently at 31.96 times their profits. The ratio has increased since last month, when it stood at 30.79. This increase can be explained by the rise of the S&P 500 index on the stock market without seeing the profits of the companies that compose the index following the same trend .The market was only as expensive as it was in 1929 and 1999, two periods followed by a sharp correction.
Price paid per one dollar of profit (Shiller PE ratio)
Source : http://www.econ.yale.edu/~shiller/data.htm as of November 6, 2020
Let’s now take a look at the return achieved by investors during the 15 years that followed such a high valuation of the stock market in the past.
Shiller PE ratio vs. Average annual return in the following 15 years
Source : Factset as of November 6, 2020
So here are the results. On the horizontal axis, you can see different levels of Shiller's price-earnings ratio. It should be remembered that the higher the ratio, the more expensive the market is. The vertical axis represents the average annual return for the next 15 years. The blue dots represent all observed data and, finally, the black dotted line is the trendline of the graph. So, it is easy to see that the cheaper the market is considered, the higher the returns of the next 15 years, and vice versa.
If we take the current Shiller ratio which is currently at 31.96, we can see that the worst annual return for the next 15 years was negative and very close to zero, while the best was around 6%. Based on the trendline, at the current ratio, we can expect an average annual return of 4-5% over the next 15 years.
The following graph compares the price movement of the S&P 500 index with the earnings per share of the companies that make it up. Normally, it makes sense to observe a positive correlation between profit growth and market price. The more companies' profits increase, the more these companies increase in value and the more investors are willing to pay for them.
Price of S&P 500 index vs. Profits of S&P 500 companies
Source : http://www.econ.yale.edu/~shiller/data.htm as of November 6, 2020
We can observe that in each of the previous major crises, a decrease in profits (orange line) resulted in a decrease in the index price (blue line). During the tech bubble of the 2000s, the profits of the S&P 500 returned to their initial value after four years, while the index price took seven years before returning to the same level. As for the 2008 financial crisis, both profits and the price of the S&P 500 returned to their original values after about four years. In the current situation, we have seen a significant drop in profits since the start of the pandemic and the stock market experienced a marked drop in March in line with this decrease. However, unlike the last two crises, the S&P 500 has regained its value in just a few months and is now priced higher than before the decline! And this time around, this recovery is not accompanied by an equivalent rise in profits, far from it. It is likely that corporate profits will start to rise again, but it is unlikely that this rise will be fast enough to justify the increase in the stock market prices in recent months.
Disclaimer
Information in this article is from sources believed to be reliable; however, we cannot represent that it is accurate or complete. It is provided as a general source of information and should not be considered personal investment advice or solicitation to buy or sell securities. The views are those of the author, Marc-André Turcot, and not necessarily those of Raymond James Investment Counsel Ltd. Investors considering any investment strategy should consult with their investment advisor to ensure that it is suitable for the investor’s circumstances and risk tolerance before making any investment decision.
