EQUITIES COMMENT - Is The Glass Half Empty of Hal Full?
Excitement about opportunities in artificial intelligence (AI) caused Technology stocks to rise 17% in both Canada and the U.S. during the second quarter. Because Technology is a much larger component of the S&P 500 than the TSX, the return for the S&P was significantly higher than the TSX at 10% (Canadian dollar terms) versus 4%.
Stocks also benefited from stronger than projected economic activity which led to better than expected earnings. Declining inflation eased fears that interest rates would have to go much higher. The unemployment rate remained near record lows in both Canada and the U.S. As well, job openings remained high. The main source of strength in the economy was consumers. They continued to spend their wages and the savings they racked up during the pandemic. Sounds like the glass is half full!
As a lead in to the half empty glass, let’s review the S&P 500 sector performance for the first half of 2023 (graph next page). You can see the Technology sector (contains Apple, Microsoft, NVIDIA) is by far the winner. Discretionary (Amazon, Tesla) and Communications (Alphabet/Google, Meta-formerly Facebook) also had impressive gains. The remaining sectors had returns that were below 10% with three being negative. The seven Tech or Tech-like stocks mentioned accounted for close to 80% of the gain in U.S. stocks. Without them, U.S. stocks would have only been up about 2%. For the TSX Composite, Technology was also the leading sector during the first half with a 47% gain. Shopify was ahead 82%. Other sectors had modest or negative returns. Shopify alone accounted for over half of the increase in the TSX.
When a few stocks account for most of the gain in a stock index it is called “narrow breadth”. It is generally not a healthy signal for further stock advances. The recent gains in stocks could falter. “Broad leadership”, where many stocks in different sectors are making new high’s is a sign of a more enduring rise. Hmmm…recent gains in stocks might fall into the half empty glass.
What is holding back the stock market outside of Technology? The main problem is inflation which is still above central banks’ 2% targets. In order to bring down inflation, central banks in many countries are still raising interest rates. With the Bank of Canada rate now at 4.75%, GIC’s and many bonds are yielding close to 5%. This is a very competitive rate compared to the yield on stocks and is unlike recent years when interest rates were low and dividend yields were very attractive. The result has been downward pressure on stocks with high dividends such as utilities, communications and pipelines (part of Energy sector).
These developments have not changed our positive long term view on dividend paying stocks. We do not anticipate any dividend cuts among the stocks we favour. A big advantage of earning income from stocks as opposed to bonds is that dividends increase over time, thus providing a hedge against inflation. For taxable accounts, the after tax income from dividends is significantly higher than bonds. The rates on bonds are attractive now however, rates could move lower if we do enter a recession and/or inflation ebbs further. Therefore, when that bond or GIC comes due, it could be reinvested at a lower rate. Meanwhile, the dividend on the stock will most likely be higher than it is today.
The banks (part of Financials sector) also fall into the category of stocks with high dividend yields but, fear of a recession has been another factor explaining the banks’ recent weak performance. Energy and materials stocks have also been pressured by recession worries.
History tells us that in order to bring inflation down to target, central banks will have to slow economic growth enough to cause unemployment to rise. This typically results in a recession and is negative for stock prices. In support of this view, a number of “recession indicators” are flashing red. The graph below is a measure of U.S. manufacturing activity. When it falls below 50, this indicates manufacturing is contracting. Definitely the glass half empty view.
Now for the glass half full theory. The pandemic has had a huge disruptive effect on the economy. Could the continued COVID recovery prevent high interest rates from causing a recession in the next 12-18 months?
The low unemployment rate and high level of job openings could help to avert a recession or at least limit it to a very mild one. As you can see in the graph, job openings are declining but still remain well above pre-pandemic levels. Lower commodity prices such as oil and still high savings (although they are decreasing) could allow central bankers to engineer a slowdown in inflation without triggering a recession. This outcome would be positive for stocks.
Given the current level of uncertainty, what are stock prices reflecting? Investors are paying more for stocks, particularly Technology stocks. P/E multiples (the ratio of a stock price to earnings) have increased. Stocks in other sectors, particularly in Canada, seem reasonably valued assuming earnings do not experience a pronounced decline this year or next.
The quandary over whether the glass is half full or half empty for the stock market outlook will eventually be resolved. In this uncertain environment we are maintaining our targets of 21,600 for the TSX and 4,300 for the S&P 500 at year end 2023. We recognize that our target for the S&P is below the current level. Given the gains year to date, it would not be surprising to see a pullback in Technology during the next six months.
