In my year-end letter to clients, I talked about 2022 as a year of normalization. Interest rates moved back up to more sustainable levels, price-to-earnings (P/E) multiples came down and investor behaviour became more rational. The investment landscape is now more conducive to generating attractive investment returns.
Let’s look at the assumptions that underpin this view.
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Fixed-income fixing
Savers can once again generate an income by holding fixed-income securities and guaranteed investment certificates (GICs). To call yields more normal, however, assumes that inflation comes down significantly. If it doesn’t and was to stay at, say, eight per cent, then a bond yielding five per cent would have a real yield of minus three per cent. The holder would have significantly less purchasing power when the bond matured compared to when it was bought.
Negative real yields run counter to economic theory, but there were a few noteworthy periods when they persisted. Bond holders suffered in the 1970s when yields didn’t keep up with spiralling inflation. Interest rates rose, but real yields were still negative. That happened again in 2019, but for a different reason. Central banks pushed interest rates down near zero (below modest inflation) to stimulate the economy (and appease investors).
Real yields have stayed negative since then, but the reason has flipped back to the 1970’s scenario. Even though the stimulation pump was turned off, yields failed to keep up with the rapid rise in inflation.
Fortunately, recent data suggests inflation is starting to decline, although it will be months before we know if buying a five-per-cent bond was a good purchase or not. I’m betting it will be.
Better pricing
Prior to last year, P/E multiples were running well above their historical range. Starting from a peak in the summer of 2021, however, the broad market P/E dropped to its long-term average of 16x (as measured by the Value Line Investment Survey) from the low 20s.
P/Es have come down because of declines to the P (stock prices), but what about the E? Don’t earnings have to hold up for valuations to be considered reasonable? An economic slowdown will undoubtedly hinder profit growth and result in losses for some companies. Nonetheless, I’m now comfortable with valuations for two reasons.
First, I think profits will hold up better than the recession doomsayers suggest. Sales volumes are likely to fall, but some of the cost headwinds corporations are facing — labour shortages, supply chain challenges, high input prices and a strong United States dollar — will abate, too. And, whether we like it or not, many industries are highly concentrated and are more co-operative than competitive.
Second, an average P/E is a good measure for comparing a stock price to the company’s ongoing earnings power. But when earnings are depressed, investors look further out to the company’s longer-term potential. I have no doubt we’ll read about an economist applying an average multiple to trough earnings and declaring the market overvalued, but it doesn’t work that way. Indeed, the best time to buy a resource or other highly cyclical stock is when the P/E is sky high, or infinite (no profits).
I don’t deny that stocks are vulnerable to lower profit estimates, but I am happy to buy a great business at a good price. If that price goes from good to great, I’ll buy more.
Investor sentiment
The third thing to normalize is investor sentiment. Prior to the market decline, investor behaviour could only be described as speculative, euphoric and go-for-broke. We had it all. Meme stocks were hot, as were loss-making tech companies, cryptocurrencies and non-fungible tokens. Individual investors traded like bandits and there was an unprecedented level of options trading. I’ve never seen anything like it, and I was around during the dot.com boom in the late 1990s.
Since then, investor sentiment has come full circle, hitting extreme levels of fear last summer and early fall. The bearishness has moderated recently, but investors are still cautious, which makes it easier for companies to meet, or beat, expectations.
If yields are better, inflation is trending down, stocks are reasonably priced and investors are acting more rationally, what will drive returns from here?
Well, the answer isn’t very exciting, especially compared to the go-go days of 2021. It’s the same thing that always drives returns: corporate profits. No matter the hype around trends and macro issues, stock prices are ultimately linked to companies expanding, making a profit and paying dividends.
Boring, right? Well, maybe, but I like investors’ chances way more now than I did in the exciting new world of 2021.
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