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Equity markets are enjoying a bounce-back recently, following a rough couple of weeks. The big question for investors is: will the rally continue? This episode, Stu Kedwell, Co-Head of North American Equities, discusses what’s behind the market shift and where they could go next, as earnings season gets underway. [14 minutes, 37 seconds] (Recorded: October 18, 2022)


Hello, and welcome to the Download. I'm your host, Dave Richardson and it is the ever-popular Stu’s days, actually being taped on a Tuesday. You know, Stu, my mom now, just in our general course of conversation, when she says she's got an appointment on Stu’s day, she actually says, I've got an appointment on Stu’s day. And I know it's going to your head; I can tell that's why you've been so hard to schedule lately. So that’s why we’ve been doing it Wednesdays and Thursdays.

Yeah, well, you know, I can share what would be my first autograph, Dave. I could probably arrange it, but it may not be worth very much. It may not be worth the paper it's written on.

You go sign an autograph for my mom and that is a four- or five-hour conversation you're getting into. You'll feel great at the end of it, but it will be a long conversation. She's the best. So Stu, just for the listeners coming on— actually, Stu is going to be surprised by this too— we had a little technical issue with the posting of the last five or six episodes of the podcast. We would like to say that this was all planned out, that we were thinking of it, that we were actually holding back episodes, that you could binge, listen to the recorded episodes while the weather was getting bad here in Canada. But actually, it was just a technical glitch between ourselves and some of the podcast services. So we have got that fixed up and that won't be an issue again. But just as a reminder, we got about five or six episodes, some really interesting stuff that we’ve piled up, including David Riley talking about the situation in the UK that's going on right now, and several episodes of Stu's days. So, go back and listen to those. But Stu, in the midst of all of that, the good news is that the market is rallying. And whenever we get into a period like this where it's been a down year, anytime we've rallied, it's just been a fake out to get investors to start to think confidently about the direction we're going, only to see the market drift back down and retest the lows, and in the case last week, actually even somewhat breakthrough the lows that we had in June. If we're looking at this rally and we're trying to decide whether this rally is real or if this is just another one of those bounces that we get in the midst of a bear market, what are the things we should be looking for on either side of that argument, particularly as we come into this very important earnings season and we'll talk a little bit at the end about the earnings we've seen, because there's some interesting stuff coming out of that?

Yeah, so that's a great question. There's lots of ingredients that go into a market bottom. Some of them we've seen, some of them we haven't. It is still a very unprecedented event. Having the market go up over 2%, down over 2% and then up over 2% has only happened four or five times in history. Interestingly, if you had to draw a conclusion, it was probably a bit of a positive, but nevertheless, I think in the last couple of days, some things maybe have stuck out. The new Minister of Finance in the UK, for sure, the idea of putting what had concerned the market, putting that genie back in the bottle, so to speak, seeing a big rally in the longer maturity Gilts. Maybe a bit of a message to governments in general around how that's going to take place. So that was a positive. The US banks have reported, and they've been quite positive. One of the largest banks, JPMorgan, interestingly, talked about if unemployment went to 6%— some people say that unemployment needs to go up to wrestle inflation down and we're around 3.5% in the United States— they, JPMorgan, would have to set aside provisions for credit of around $6 billion, which is a big number. But at the same time, in their quarter, their net-interest margins surprised people by $3 billion. So that is quite different than other periods of distress because banks are making more money as interest rates widen, which is creating the earnings that they could set aside for provisions for credit, if necessary, which leads to a bit of a healthier banking system than you often see during periods of decline. And then, probably a little bit of a divergence and often it's the reverse, but interest rates have levitated around 4% on a long-term ten-year bond and it hasn't seemed to bother the market the way it did earlier. And I read on Twitter somewhere last week, it kind of made me chuckle, an old trader’s line: if selling doesn't work, try buying. And that's kind of what we've seen. So is it possible that the equity market is looking through whether or not the high end of the ten year bond is 4 or 4.25? The equity market is saying that it is close, so we can take a bit of that. The interest rate can turn off the table. Earnings have been a little bit better. So the scenarios that you might envision on the downside to earnings may be not quite as negative. Against the backdrop of pessimism being quite high last week, a significant amount of puts were bought last week, which is people betting on the market going down and they were very short term in nature. So you had lots of ingredients that have presented themselves and created a little bit of an upswing. As for its duration, that's a great question. I think there's a couple of things that you didn't see. While you saw very strong up volume, you didn't see large swathes of stocks really surging to a high percentage change, which people like to see to help mark the bottom. You have seen leadership from financials and industrial sectors, which is good. So there's lots of things. I would say that the balance may be tilted a little bit in favor, but also, maybe a little bit too early to tell, from an intermediate term standpoint, we're trying to take advantage of weakness. We've talked over and over about dollar cost averaging, but in this environment, the two things are that earnings might come down, but trying to envision when the Fed might pivot, might stop tightening, in fact, might even loosen interest rates, that will change the illustration of how people think about earnings in a hurry. Having declining earnings when liquidity is still tightening, is not a great set of ingredients. But as soon as you think the Fed is done, then you stop paying attention to how bad earnings are today and you start thinking about how they can be better. So those are some of the things that we've been thinking about.

Yeah, and this is what we've talked a little bit about, because as you suggest there, you're looking forward, you're looking for where things are going to be, not where they are today. And at some point people are going to look forward and say, wow, what's over this hill is lower inflation, lower interest rates, better earnings. And at some point, I do want to buy. It is better than selling. And the market moves. And then as we've talked about how violently it moves off of a bottom and that's one of the reasons you want to be there. And then, of course, for everyone I know, who when they listen to the podcast, play the drinking game and they take a drink whenever you mentioned dollar cost averaging, you got that right in. So everyone knows that that is always a way that you can play a market, particularly one that you're uncertain about when you're seeing this rally, uncertain if that rally is going to continue or whether you're going to go the other way, because as your dollar cost averaging is in, you actually prefer the market to be down because you're buying more at a lower value. And then ultimately when it does turn around, you own more of that particular stock or mutual fund or whatever you're buying for when the rally sets in.

If you think about last week— and stocks don't stop going down just because the valuation is more reasonable—, but on a forward earnings basis, the market got to around 15 times earnings. Those earnings might need to be readjusted in the short term because of an economic slowdown, but over a long period of time, 15 times earnings has been a valuation that we've seen over and over again. So even if you were at 15 and you had to see 12, the odds of a long-term investor seeing 15 again are pretty good. And those earnings, maybe they would go down in a recession, but over time we know that they recover and earnings might grow in the long term around 7%. Dividend yields are pretty healthy. So for a longer term investor, you're sitting there saying the two most important dynamics to my long-term success are going to be the earnings and the dividend I get. And there are certain periods of time where the valuation is below average, which then accelerates my long-term returns. There are times when it's above average, which acts as the headwinds. And there are times when we're right near average and that starts to get people a lot more interested in saying, well, if earnings start to decline, people want to put money to work into that type of an environment because that long-term return potential starts presenting itself.

So just to come back to earnings, because ultimately it is all about earnings over the long haul— emotional swings back and forth and what you're willing to pay for those earnings changes, but over time, if those companies keep growing those earnings, those stocks are going to go higher down the road. Early on you mentioned JPMorgan, but other firms have reported— Goldman Sachs, this morning, and firms from other industries—, are you getting a sense at all of how much the higher interest rates and what we expect to be a slowdown in economic activity are having on the earnings that you've seen thus far anywhere in North America?

Yeah, I think it's going to bite in the near term and businesses will need to get reconfigured a little bit around this environment of slightly higher interest rates, although corporate balance sheets on the whole are in quite good shape, with higher wages. Those two things need to be digested. But companies have shown pretty good abilities to negotiate that over time. Your point around higher interest rates, maybe some higher wage costs— eventually we'll see another M&A cycle because business will restructure and recombine to gain efficiencies—, but in the near term, yeah, earnings probably need to drop a little bit. All the leading indicators suggest they're going to drop. So that is definitely in the cards. That's why the interest rate side becomes quite important, just as we discussed before, because declining interest rates with an ever-tightening Fed is a different set up than declining interest rates with maybe sight lines to the end. And as I say, it's only been a couple of days, but it is the first couple of days where the stock market hasn't worried about 4% on a US ten-year the same way it did a month ago.

Yes, and as you've said, again, for people who are going back and listening to some of the old episodes, which I find interesting— my mom does it almost obsessively—, you'll hear Stu talk about that idea that one of the sure signs of a turn in markets, as things are about to roll over to go down, is that the market is not satisfied by any news, as good as that news might be, and then at the bottom, the market is just so tired of hearing bad news, that next piece of bad news actually has it rallying. Because the assumption then is: it just can't get a whole lot worse than this. So as Stu says, or the trader he talked to: why not just go ahead and buy at this point? And when the bad news turns into good results, that's usually a time where you're starting to see things move in the right direction. Hopefully, this is the start of something good. Stu, thanks as always for another fantastic Stu’s days. Always insightful. Well, thank you and we will see when we come back next week whether this market continues to have legs or not.

100%. Thanks very much, Dave.

All right. Talk to you next week, Stu. Thanks everybody, and we'll talk to you soon.


Recorded: Oct 18, 2022

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