Moody Market
January 22, 2024
Markets certainly move around a lot.
Last summer, the stock market rallied over a number of months into the end of July before going on a three-month decline due to rising bond yields. Then, from what were oversold levels, the market rallied for the last two months of the year. This put a cherry on top of 2023, which saw the S&P 500 gain 26% – a very impressive year.
So, where did those returns come from? The chart below decomposes the U.S. equity market performance into different components: dividends, earnings growth and multiple expansion/contraction. Of that 26% last year, 2.1% was thanks to dividends, 6.1% from earnings growth and the rest, 18.1%, was due to a rising market multiple. The price-to-earnings (PE) ratio for the S&P 500 rose from 16.8 to 19.7, about three points of multiple expansion. Hence, the red bar in 2023 is rather large, actually close to the same size in the opposite direction compared to 2022.
So, where did those returns come from? The chart below decomposes the U.S. equity market performance into different components: dividends, earnings growth and multiple expansion/contraction. Of that 26% last year, 2.1% was thanks to dividends, 6.1% from earnings growth and the rest, 18.1%, was due to a rising market multiple. The price-to-earnings (PE) ratio for the S&P 500 rose from 16.8 to 19.7, about three points of multiple expansion. Hence, the red bar in 2023 is rather large, actually close to the same size in the opposite direction compared to 2022.
However, if you look longer term, the changing market valuation multiple quickly fades in importance and earnings growth becomes the key driver of performance, plus a bit from dividends. This makes sense as the market multiple fluctuates, given investor optimism or pessimism about everything from the economy, rates, profits, war, elections, etc. It fluctuates in both directions and clearly exhibits mean-reversion tendencies. Or, in simpler words, a PE of 20 does have a greater likelihood of declining than expanding in 2024… but of course, either direction is possible.
In 2024, there are a few things we can know with a decent amount of certainty. The total dividends paid by the index constituents do change over time, but usually very gradually. So, we are probably safe in expecting a little less than 2% returns from dividends in 2024. Earnings growth does tend to be more volatile and uncertain, but if we go with consensus bottom-up analyst predictions, that is 10-12% earnings growth. Add those two together, leaning on the lower end of the range for earnings growth totals about 12%. That sounds pretty darn good; of course, that implies a stable market multiple… in a metric that is anything but stable. How unstable? Well, the previous chart looked at annual return decomposition; the next one breaks it down to monthly performance. You can’t even see dividends anymore, and earnings growth is still there, but the changing market multiple dominates. Some months giving, some months taking.
In 2024, there are a few things we can know with a decent amount of certainty. The total dividends paid by the index constituents do change over time, but usually very gradually. So, we are probably safe in expecting a little less than 2% returns from dividends in 2024. Earnings growth does tend to be more volatile and uncertain, but if we go with consensus bottom-up analyst predictions, that is 10-12% earnings growth. Add those two together, leaning on the lower end of the range for earnings growth totals about 12%. That sounds pretty darn good; of course, that implies a stable market multiple… in a metric that is anything but stable. How unstable? Well, the previous chart looked at annual return decomposition; the next one breaks it down to monthly performance. You can’t even see dividends anymore, and earnings growth is still there, but the changing market multiple dominates. Some months giving, some months taking.
If you can figure out where the market multiple is going next, ring us, and we will create a fund/ETF for you. It is really trying to gauge the mood of the market, or more specifically, the direction in which the mood is changing. From pessimism to optimism, you get multiple expansion. From optimist to pessimism, you get multiple contraction.
There are some fundamental drivers. Higher bond yields are historically associated with a lower market multiple. The chart below uses valuation data for the S&P 500 going back to the 1960s. While there are clearly outliers, there does appear to be a long-term relationship between bond yields and stock market valuations. This is logical; everything is a competing asset class, so if bonds are paying more, equities, to remain competitive, must offer more compelling valuations. The big red dot in the chart below marks “today,” which appears to have only slightly elevated valuations.
What will the market mood be next?
There are some fundamental drivers. Higher bond yields are historically associated with a lower market multiple. The chart below uses valuation data for the S&P 500 going back to the 1960s. While there are clearly outliers, there does appear to be a long-term relationship between bond yields and stock market valuations. This is logical; everything is a competing asset class, so if bonds are paying more, equities, to remain competitive, must offer more compelling valuations. The big red dot in the chart below marks “today,” which appears to have only slightly elevated valuations.
Yet, as we demonstrated from our monthly return decomposition chart, it is more about changing moods. In November and December, the vast majority of the market’s move higher was due to an improving mood among investors, given the multiple changes added over 10% of gains. Worth noting, during that period, bond yields, as measured by the 10-year Treasury, fell from 4.9% to 3.9%. So yields do matter a lot, but so do so many other things.
If we suddenly had peace in the world’s major current conflicts, we would probably lift the multiple. If inflation continues to decline, that would be good news. If the economic data weakens, it likely lowers the multiple. Then again, if the economic data weakens (bad), bond yields would likely fall more (good). All these things and many more are happening at the same time, making it rather challenging to guess the next directional move of the market multiple.
Not fundamentals but sentiment and positioning can provide some clues as to the more likely next move in the market multiple. For instance, if everyone is bearish due to lots of bad news, what happens next? Well, if everyone is bearish, then there is nobody left to move from being bullish to bearish, as they are all already there. So, the more likely next step would be for one of those bearish folks to become bullish. This is why sentiment is a contrarian indicator. You are supposed to buy when everyone is bearish and be a seller when all are bullish.
 Gauging investor sentiment is challenging. One of the longest data sources is the AAII investor sentiment survey, which asks respondents whether they believe the stock market will be higher or lower in the next year. When this is near an extreme level, either overly bullish or overly bearish, there is, on average, a strong determinant of stock market performance. When very bearish, the average future performance is well above average, and when everyone is bullish, future performance tends to be lower than usual.
If we suddenly had peace in the world’s major current conflicts, we would probably lift the multiple. If inflation continues to decline, that would be good news. If the economic data weakens, it likely lowers the multiple. Then again, if the economic data weakens (bad), bond yields would likely fall more (good). All these things and many more are happening at the same time, making it rather challenging to guess the next directional move of the market multiple.
Not fundamentals but sentiment and positioning can provide some clues as to the more likely next move in the market multiple. For instance, if everyone is bearish due to lots of bad news, what happens next? Well, if everyone is bearish, then there is nobody left to move from being bullish to bearish, as they are all already there. So, the more likely next step would be for one of those bearish folks to become bullish. This is why sentiment is a contrarian indicator. You are supposed to buy when everyone is bearish and be a seller when all are bullish.
 Gauging investor sentiment is challenging. One of the longest data sources is the AAII investor sentiment survey, which asks respondents whether they believe the stock market will be higher or lower in the next year. When this is near an extreme level, either overly bullish or overly bearish, there is, on average, a strong determinant of stock market performance. When very bearish, the average future performance is well above average, and when everyone is bullish, future performance tends to be lower than usual.
While far from perfect, when the bulls vastly outnumber the bears (above the red line), the S&P 500 has typically seen weakness ahead. When most are bearish, the future returns are much better. So, while the S&P 500 may be somewhat euphoric, trading up to over 4,800, sentiment certainly should cause investors some pause as to what may be coming next in the near term. In addition to this, valuations are certainly extended after the strong market returns of late 2023 and the lack of earnings improvement.
 Despite investors being rather bullish (which is bearish), portfolio positioning doesn’t exactly match this. Using CFTC non-commercial futures positioning in S&P 500 futures contracts still has more betting the market will decline than rise. But just mildly below neutral. Future market returns tend to be more strongly positive when positioning is very negative. And vice versa. Today, there are a few more positioned bearish, based on e-mini S&P 500 futures. We would not characterize this as extreme, though, which certainly means the market could continue to improve, especially if more start placing positions on the bullish side. It is certainly something to keep an eye on. Worth noting small cap futures, based on the Russell 2000, are actually very bullishly positioned (which should be bearish).
 Despite investors being rather bullish (which is bearish), portfolio positioning doesn’t exactly match this. Using CFTC non-commercial futures positioning in S&P 500 futures contracts still has more betting the market will decline than rise. But just mildly below neutral. Future market returns tend to be more strongly positive when positioning is very negative. And vice versa. Today, there are a few more positioned bearish, based on e-mini S&P 500 futures. We would not characterize this as extreme, though, which certainly means the market could continue to improve, especially if more start placing positions on the bullish side. It is certainly something to keep an eye on. Worth noting small cap futures, based on the Russell 2000, are actually very bullishly positioned (which should be bearish).
Finally, there is momentum. Momentum measures of the market don’t differentiate between economic news, changing yields, changes in geopolitical risk, valuations or ever explain why the market is moving. But when momentum gets overly strong or overly weak, it usually mean reverts. As a result, extremes in momentum can also highlight good times to reduce and good times to put money to work when very low.
While this is only a few years, the table below does look similar over longer time periods. Simply put, the average forward return of the S&P 500 is much higher when RSI is low. And it is lower when RSI is higher. It’s worth noting RSI was well over 70 in late December.
Final Thoughts
We are big fans of long cycles, positioning based on return expectations, valuations, and where we are in the cycle. Again, earnings growth, which is determined by the economy, is the longer-term driver of market returns. But when you look at shorter periods, the importance of earnings growth fades, and the mood of the market dominates. Or more specifically, the changing market multiple caused by the changing mood of the market. Today, with RSI over 70 a few weeks back, investor sentiment is rather bullish. We would say the short-term risks are likely higher than the short-term potential gains. But you never know; the market is always moody.
— Craig Basinger is the Chief Market Strategist at Purpose Investments
Source: Charts are sourced to Bloomberg L.P. and Purpose Investments Inc.
The contents of this publication were researched, written and produced by Purpose Investments Inc. and are used by Echelon Wealth Partners Inc. for information purposes only.
This report is authored by Craig Basinger, Chief Market Strategist, Purpose Investments Inc.
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It seems like just yesterday that you could buy a pint of Stella for $7 or so. Now, more often than not, it is closer to $10. Yep, inflation. It is kind of like a tax on doing things, as just about everything has cost more over the past few years. Hop on a flight, eat at a nice restaurant, refinance your mortgage, the list goes on. With the benefit of hindsight, the current higher inflationary environment can be blamed on a few pretty big factors. Changes in behaviour during and coming out of the pandemic blew up supply changes, as capacity was unable to keep pace with demand. Then, of course, unprecedented money printing magnified the situation, as it made everyone wealthier and more willing to pay $10 for a pint. Of course, the textbook solution is to raise interest rates, which is clearly occurring around the world. These monetary policy shifts are effective but do work with variable lags. Making those lags longer, or even temporally offsetting them, was fiscal policy. It doesn’t take an economist to understand if the monetary policy is trying to slow the economy to tame inflation; materially elevated fiscal spending in an economy that is still growing at a decent pace is counterproductive for the inflation fight.
If the wealth advice service were in the manufacturing industry, the portfolio would be akin to what we make. Sure, there are many value-added services in addition to the portfolio, but it’s the portfolio that has to succeed for the client to reach their long-term goals. So, the more we can think about portfolio construction, the better. One challenge is that while portfolio construction is often based on as long a historical time period as possible, things never remain static. Markets evolve and change over time, relationships change, and the available tools in the portfolio construction toolbox also change over time. One recent change that has been a challenge is the bond/stock correlation. After a couple of decades of very low or even negative correlations between these two core building blocks, correlations are back to being positive. The following chart shows the 2-year monthly correlation between Canadian equities and bonds. It looks rather similar for the U.S. and global markets, but we just thought some Canadian content would be nice. The higher correlation means that, more often, equities and bonds are moving in the same direction. Nobody complains when both are moving higher, like in the past 12 months, but when they move lower together, everyone starts getting grumpy, like in 2022. The 2nd line, beta, measures not just the direction of the two asset classes but the magnitude of the relative move.
The US market is up a little over 10% this year, Canada +6%, Europe +10%, and Japan +15%, while bonds are down about -1%. Huh, that sure does look like asset allocation is working well again after the car crash of 2022. Even better news is that the market is moving higher thanks to good fundamental news, not simply because central bankers are jamming more money into the financial system. Recession risk has continued to fade, as evidenced by the survey of economists. For the UK, Canada, US, Eurozone, China & Japan, the average probability of a recession hit a high in late 2022 at about 60% and has fallen down to a mere 25% of late. The UK, which was as high as 90% and suffered two negative quarters of GDP growth, is now down to 30%, winning the most improved ribbon. Even Canada, which is clearly struggling with higher rates, has improved from over 60% to 30%. Most are clustered around the 30% zone.
Should it be any surprise how calm markets have become? Global equities are up 9.2% year to date. Apart from a 2% decline in January and a 5% drop in April, the trend has been steadily up to the right on the chart. We can easily slap a financial narrative on this, such as improving economic growth globally, a decent Q1 earnings season, or maybe it's just the AI frenzy. More than a third of the advances in global equities are attributed to Nvidia, Microsoft, Amazon, Meta, and Alphabet. Whatever the cause, equity volatility has been very calm so far in 2024. But it is more than this, as it isn’t just equities.  The volatility in the bond market has gone super low (2nd panel in chart). The MOVE index measures volatility in U.S. Treasury Bonds [actually at-the-money options on interest rate swaps, but let’s not go down that rabbit hole]. Even though bond yields moved higher this year, the 10-year started at 4%, gradually up to 4.75%, then back down to 4.5%; these moves pale in comparison to the last couple of years. In case you forgot, the same bond in 2022 went from 1.5% to 4.0% and in 2023, yields oscillated between 3.5 to 5.0%. Looking beyond Treasuries, credit spreads are back down to or close to historical lows. Investment Grade spreads in the U.S. are 50bps. Lows in past mini-credit cycles have been 40-60bps.
I think we might be in that very unique market mood when bad news is good news. The equity market weakness in April can probably be attributed to bond yields moving higher, so any economic data on the weaker growth side is welcome news at the moment. The S&P started to recover on May 3rd, rising 1.3% when the ever-important non-farm payroll labour report came in softer than expected, helping 10-year yields fall back down to 4.5%. Then, over the past few weeks, we have seen generally weaker economic data for the ever-important U.S. economy; bond yields have continued to come down, and equity prices have moved up. Of course, all eyes were on the U.S. inflation print for April, which was marginally softer than expected (soft CPI is truly good news), helping bond yields fall and pushing the S&P 500 to a new all-time high. But really, 0.3% vs. expectations of 0.4% is not huge, especially given that the core reading was in line at 0.3%. This still has the annualized 3-month change running a hot 4.5%. To be fair, there was some good news beneath the surface on the CPI print. But on that day, helping, and less talked about, was a really weak Empire manufacturing survey and weak retail sales.
The normal narrative for encouraging investors to look at emerging markets typically goes like this: The valuations are cheap, the demographics/rising incomes are supportive of growth, and they offer diversification. Perhaps this is more the marketing narrative. Kind of how, like for infrastructure strategies, they always talk about how many bridges need repairing. We are not refuting any of the above reasons, as they have been rather perennial for many, many years. And yet, for those who know us, we have been rather negative or at least cool on emerging markets for a long time. How long? Well, this negative view persisted for well over a decade. This is us giving ourselves a pat on the back since Emerging Markets (EM) have done roughly nothing for the past 12 years as Developed Markets (DM) have charged higher (chart).
Take your pick. There is no shortage of both good and bad news floating about the financial markets. To be fair, this is always the case. The hard part is understanding which side is stronger today and which side will be stronger tomorrow. With markets up low to mid-single digits following a very strong Q4 finish to 2023, most would agree the optimists are carrying the day at the moment. It is not just rose-coloured glasses; there is good news out there. Economic growth signs or momentum appear to be improving year-to-date. Dial back a few quarters, and the U.S. economy remained resilient while other economies softened or were rather lacklustre, including Canada, Europe, Japan, and China, to highlight some of the biggies. Today, while Canada is struggling, momentum in the U.S. has moved even higher, and there are signs of improvement in most jurisdictions.
There are three things you should rarely ever bet against: the Leaf’s opposing team in the playoffs, the American consumer’s ability to spend, and corporate profits. As we are now about halfway through U.S. earnings season, once again, positive surprises remain the norm; 81% have beaten. It's a bit better than the 20-year average of 75%. The fact is that companies are good at managing analysts’ expectations. At least enough to beat them when the numbers hit the tape. The size of the positive surprises have been encouraging as well, at just under 10%. The highest surprise magnitude in some time.  One of our reservations on the sustainability of this market rally over the past couple of quarters has been the flat earnings revisions. In other words, global markets are up over 20% but earnings estimates have remained flat or tilted down slightly. More often than not, markets trend in the same direction as earnings revisions. Earnings get revised up when companies raise guidance and/or analysts become more encouraged about growth prospects. That is a good thing for markets. Obviously, downward revisions are bad. Yet estimates have remained very flat as markets marched higher, a challenging combination.
The oil market has been interesting lately and, to the surprise of many, has been the biggest silent outperformer this year. There is no shortage of geopolitical events to choose from that’s leading to a higher risk premium in oil with Brent breaking $90, whether it’s the Houthis missile attacks in the Red Sea leading to a massive re-route of trade, Ukraine’s drone strikes on Russian refineries, and the latest escalation between Israel and Iran leading to some news outlets using WWIII as click bait-y headlines. Given the run-up in oil prices, Canadian oil equities have clearly benefitted from the much higher torque. But there is a layer of even better news: The Transmountain Expansion (TMX) continues to look to be in operation by May, which would lead to much better pricing on the Western Canadian Select (WCS). With the current setup for the oil markets, some key questions that we often get from investors are: How sustainable is the rally in Canadian energy names? To determine if the oil equities are overstretched, we can look at the debt-adjusted cash flow (DACF) multiples of the major integrated oil names and see how the valuation has shifted in light of the recent oil move. From Exhibit 1, the DACF multiples for the Canadian integrated have been fairly range-bound over the last year, also in line with WTI, which has been in the $70 - $85 range. As a starting point, we can infer that the valuations of the companies have been commensurate with the movements in the underlying oil price deck and in line with where the equities should trade in the cycle historically over the last couple of years. Typically, in the commodities cycle, higher prices are usually coupled with lower multiples as market participants will usually price in lower normalized prices and vice versa, so a cause of concern would be if valuation starts trending towards the 6.5x – 7.0x+ area if oil prices continue to stay in the upper bounds of the $70 - $90 range or higher.
As part of your wealth planning, have you considered your wealth’s longevity? Many of us have heard of the “shirtsleeves curse”: Family wealth is often built up and lost within three generations. You may not be surprised to learn that recipients often make “big” purchases within the first few weeks of receiving their inheritance. This is because many heirs are not focused on the longevity of new-found wealth. What are high-net-worth families doing to help prevent this loss? There has been an increasing focus on intergenerational wealth planning, with the objective of supporting wealth longevity. This involves getting existing generations to meet about their finances and form shared financial goals and values to help encourage lasting wealth. Here are some steps that can be taken as part of this planning process: Start with a plan and document it Start by thinking about your vision for your wealth for the generations to come. The plan should set out goals and provisions for how you wish funds to be used, accessed and replenished. For instance, you may wish for family members to invest in themselves to gain the experience needed to create and grow wealth, using funds for higher education or a business start-up or expansion. Others may wish to leave endowments to a charity. Once you determine your goals and provisions, it is important to formally record them as this document will be passed along to future generations. Communicate your plan Once the plan has been documented, it should be communicated to family members. Often, parents keep their finances and related values to themselves, missing the opportunity to pass along their ideals to children. While specific financial details need not be disclosed, sharing your vision is intended to be a catalyst for meaningful discussions. Some families use this plan to form a family constitution to help future generations carry forward their intentions. Engage in regular meetings Regular family meetings are intended to help cultivate family values based on your vision for your wealth. If wealth has been carefully built up through the generations, it may involve exploring family history. Or, you may use this time to educate children about finances and managing money or introduce high-level strategies to carry out the intergenerational plan relating to running a family business or a family giving strategy. Consider protection tools You may determine through family meetings that beneficiaries will need support. Certain tools can support beneficiaries to meet your goals, or protect future wealth in situations in which beneficiaries may not be capable. For example, a trust can put assets under the control of a responsible trustee, with the terms of the trust specifying the conditions, timing and amount of distributions to be made to heirs. Other tools, such as life insurance, can protect and grow assets while also providing access to cash. Setting up a support system of trusted professionals may help to ensure a successful wealth transfer, especially if heirs do not have the skills to manage funds independently. Monitor the plan’s success By having an ongoing dialogue with family members, you will be able to identify and address any gaps or concerns as they arise. You can also continue to define and refine family roles to ensure that your plan has a greater chance of success. Here to Provide Support While intergenerational wealth planning may not be for everyone, consider that creating a lasting legacy can be one of the greatest gifts you leave behind. If you need assistance with family discussions or educational tools to support children, please contact your Echelon Advisor.
