Transcript
Hello and welcome to The Download. I'm your host, Dave Richardson, and it is Stu's day in Toronto. A rainy day here, Stu, but it’s always sunny in podcast land when it's Stu's day. You had a good vacation?
A great vacation. It was amazing. Really good. It's always good to get away; always good to come back. And a lot happened. As we mentioned last time, vacation is not a set-and-forget-type of affair for me.
You mean, something actually happened in the last couple of weeks? I don't know what you're talking about. There's nothing going on. I'm just sitting here and staring out at my backyard, and it seems like it's the same as it was when I left three weeks ago. Anything in particular on your mind?
Yeah, it's been pretty quiet on the news front. What's happened? Well, we've had an assassination attempt. We've had a change in the Democrat leadership. You name it. We've had financial earnings. All sorts of things taking place. And yet markets, generally speaking, are right where they were before.
Wow. And did the Bank of Canada lower rates? Did that happen?
The Bank of Canada lowered rates. Yeah, that's another one to add to the list.
A modest inflation reports. Further progress on inflation. Yeah, nothing's happening. We go on vacation; the world stops just for us. That's nice. And then away we go. But I think the main point you just made is the key one, Stu, which is that markets are just absorbing everything.
Probably one of the more interesting things has been the two-year bond that dropped without the longer bonds moving a whole lot. You're always trying to see what is the bond market saying about the world? Lower shorter-term interest rates definitely would be helpful. But the lack of movement in the longer-dated interest rates while that takes place, is that a comment that it's going to be a soft landing and that growth is going to be good? Is it a comment around some concern on fiscal deficit? There are all sorts of conversations that take place when the yield curve moves in certain directions. That is definitely one thing. The slope of the yield curve, of course, given bank investments and things like that, always matters to that group, because a positively slope yield curve can be positive for bank stocks, generally speaking. All things considering, they've acted pretty well. It’s interesting as we make our way through the earnings season. Earnings have been okay, but the one area where revenue has been higher than expectation has been in the US financials. The rest of the revenue picture has been more muted relative to expectations as the economy slows and finds its footing, particularly in some of the consumer stocks where there's been some trouble. But the financial stocks are sitting at levels that are indicative of a soft landing, indicative of a better slope in the yield curve, so maybe some more net interest revenue, not significant jumps in provisions for credit. So it's interesting. It's always interesting, but it has been an interesting time.
Yeah. And we're tongue in cheek with the «nothing's going on» because certainly this has been one of those two-week periods where probably in 30 or 40 years from now, when I'm sitting with one of my grandchildren talking about what's going on in the current economy and something crazy is happening, I'll go, oh, it's nothing crazier than the two weeks in the middle of July with a US election up, which was crazy to begin with and then gets even crazier, and a period of unusually high inflation and the normalization coming out of that, not to mention a couple of years out of COVID. And by the way, one of the presidential candidates had COVID, too, as he was making his decision to drop out of the race. This is just one of those weeks that seems particularly significant in shaping what's going to be happening in terms of the discussion of the next three months and then years beyond that. That we've got to sit here and try and dissect what's happening and make some decisions around where things are going. If we take a look at the economic drop back — and I've been doing this as I've been out talking to advisors and investors — we keep coming back to this same idea: the inflation peaks, 12 months later, rates peak, 12 months later, earnings bottom out. And the softening you're talking about lines up with that. Now pretty much all around the world rates are moving down. Even China lowered rates last week. Canada lowers rates a second time today as we're taping this. And we're just waiting on the US, which is beginning to look more and more like September, or immediately following the election in November, that they're starting to lower rates. So rates are moving down. So again, you're starting to see as the anticipation of rates come down, that's going to help your revenues, your financial institutions. But as we're expecting the bottoming out of earnings, you're seeing that softness in earnings as we move towards what's likely, even if we have a soft landing, around where earnings are going to bottom out. So things are playing out the way you'd expect. It's just a question of where we go from here. As you look at these different groups of stocks. We still got this one set of stocks, although having maybe a touch of a pullback here, still, that's been the leadership area, those AI stocks and those leadership tech stocks. A touch of a correction, but not much given where they've come. And what happens with those stocks? What happens with the stocks that we'd expect to lead as rates start to fall, which is in more utilities and financials, and then all these consumer-related stocks? So why don't you talk about the different groups of stocks and what we're looking for in each of those groups, and then what that signals around the market overall and in terms of how that will play out as we move forward.
Thinking about it in those three buckets is a pretty interesting way to think about the market today. So I'll start with the last bucket first. Your stable cash flow stocks, reasonable balance sheets, not a lot of growth in the best of times or the worst of times. It's just a very stable growth. And those stocks tend to be heavily influenced by interest rates. So as more central banks start cutting, the signs that the Federal Reserve is going to start cutting, you start to see those stocks do better. And as a portfolio manager, you're sitting there saying, okay, before we talk about the other buckets, I think we're going to be in this period where rates are coming down so I can own those stocks and I can put them over here and that feels okay. And that dovetails into the second group of stocks, which I say is the average stock: somewhat economically sensitive, pretty good balance sheet, not one of these large growers, but a somewhat cyclical growth. They haven't had a lot in the last 18 months. And when rates start coming down, in the initial phases, interest rates are coming down because the economy has slowed. Will it be a soft landing? Will it be a little bit of a harder landing? It's probably somewhere in between, not like a significant slowdown, but you're trying to judge when will things get better for them on the revenue front. Maybe their revenue growth has been a handful of percentage points, and it can be mid-single digits, and the valuations are okay. And as the market starts to see slightly better revenue growth, those stocks can do better. And then the final bucket is the artificial intelligence and some of the tech stocks where the growth has been spectacular. The question really becomes, will it live up to those expectations? And the analogy for that one is, in the summertime, when you get the first blast of heat in June and you're like, oh, boy, it's hot. It's going to be for a while. And then you get to the middle of July and it's hot and you're like, yeah, but it's only six weeks left. It's going to be cooler. And I think that's what those stocks are going through. One of them reported last night and the growth was strong, but it wasn't getting better off a high level. So that's the challenge that sits in front of those stocks. Those are the three buckets. The first one, you feel okay about. The second one, you're trying to time the recovery. You're saying, stocks are at reasonable valuations. My risk there is time. I'm going through a bit of a slow patch in the economy. The day that the stock market decides to look through the slow patch and say the Fed is going to restimulate, I don't know exactly what day that is, so I'm going to deal with the volatility in the short term around that because I know the other side starts to look better. And on some of the higher valued tech stocks, the issue there is, some of them have valuation support that kicks in. For some of them it could be a little bit farther away. And those ones, it's really like, can the estimates carry on and keep accelerating? And these are just big numbers that the stock market needs to deal with. So you can be a great growth company, but the law of large numbers gets a little bit difficult to escape for just about anyone. Those are the three buckets that any portfolio manager is dealing with. Running a dividend fund, you're in bucket utility and stable business anyways. But broadly speaking, I think those are the three buckets that investors are dealing with.
We have to get Marcello on to talk about the tech bucket in a little bit more depth. We'll get him scheduled over the next few weeks. But as I'm out talking to people, I hear a lot of comments around the idea that the market looks a little bit like 2000, where you've had this run of companies in a really exciting area. There's no doubt that artificial intelligence is going to be a life changer for us. It's going to have an impact on us the same way back then we looked at the internet and just being able to go online and look up stuff at your fingertips in ways that you could have never imagined even 5 to 10 years earlier, and then what the internet would become. There was no doubt the internet was going to become something, but the valuation of those companies was already anticipating almost everything the Internet could become at that point. Then you get that big correction back or that big normalization in the valuation of those companies as great as they are. The rest of the market still looks pretty good, but nevertheless, what happens is those leadership stocks come down a lot. The rest of the market, it's hard for it without that previous leadership to really generate great returns for you. Is that the market we're in? Am I missing something in that comparison?
I'm not sure we're at quite the same extremes as the tech bubble. But your point is valid in the sense that the whole stock market traded around 26- or 27-times earnings in 2000. And today, the whole stock market is around 21 or 22 times. So that's one difference. The second is, those large companies were huge consumers of capital as they built out everything. There was not any free cash flow. The large companies today generate a fair amount of free cash flow. And then the third component is that the average stock back then traded around a mid-teens multiple, not far off today. So two of the things are different, one of the things is similar. When the Nasdaq corrected in 2000, for the average stock, the earnings did go down a little bit because there was a slowdown, and the multiple did contract a little bit, and the average stock corrected 10 or 15% or something like that. And the big companies corrected, obviously, quite a bit more. I do think the free cash characteristic of the big companies will be a difference versus that period of time, even if they do go through a correction. And what's in front of them is quite significant. Remember back then, there was hundreds of companies that were going to rework and re-engineer and make a go of it on the internet. Today, there's a smaller handful because it takes huge capital to be involved in anything. So there are some differences. But during that corrective period in 2000, there was this shift in leadership. The Fed interest rates were right around 5%. The Fed started to lower interest rates to restimulate the economy in the back half of 2000. The overvaluation in some of those businesses still had to sort itself out in the stock market. And we got a little bit of a pullback, maybe 10 to 15% in the average stock. But then they found their footing, and they emerged as the new leadership as the Fed cut interest rates into 2001 and 2002. And then coming out of that, financial stocks did quite well, commodity stocks did quite well. There was a new source of leadership. As the old saying goes, there's always a bull market somewhere. So often when you get a corrective activity in the headline index, that's the ingredients for leadership change. There's definitely parts that rhyme with that right now.
Yeah, but such an important point. And again, we've gone over it with Marcello before, but we'll get him on to get an update because I think we had this conversation maybe two and a half years ago making the comparison back to 2000 back then. And of course, we've gone beyond that. But that difference, you're right, where there's so many companies and then a lot of those companies that were at extremely high valuations, you couldn't even put a price earnings multiple on because they didn't have earnings. And this is a smaller group of companies. One of the things Marcello talks about is that, typically in these different areas of technology, you have a lead or a merge or one or two companies that end up being the dominant players in that particular space. And at that point in time, you weren't really sure who those companies were going to be, whereas this time we can see who the winners are most likely to be. And they've got real revenue revenues and real cash flow. And that makes a big difference. Again, as we pointed out at the front-end, rates are coming down. That's always a good thing when we're looking at risk assets.
Yeah, I think that's right. I think the last part of that conversation, as rates do come down, we're going to have to look at how the yield curve behaves. It would be great to see 25 or 40 basis points of slope in the yield curve. If it gets much beyond that, is the bond market expressing some type of concern around fiscal deficits, these types of things? We'll have to watch for that then. So you've perfectly encapsulated the three buckets that we're dealing with today and how we might move forward.
This is the clarity that can come from being on vacation for a couple of weeks, Stu. You have to take care of your body, mind and soul, so that you can be even more effective in expressing yourself on an important podcast like ours.
Well, I'd like to tell you I missed it on my vacation, but I missed you for sure. And obviously, talking to all the loyal listeners, it's always a privilege.
Well, I know they missed you. I actually bumped into someone at a dinner reception. He goes: I listen to that Stu's day thing. You know what? I love that Stu energy. And so he's going to be loving this because you're recharged. There's no doubt about that.
All right. Well, very kind comments. And thanks very much, Dave.
Thanks, everybody. And thanks, everyone, for listening. And we're going to have a nice good run because we've had our vacations and we'll be back on our regular Stu’s day routine. And there's going to be a lot to talk about. A lot of stuff is going on. I think markets, along with the political scene in the US, is going to be really interesting as we move through the fall and into the winter. So, Stu, thanks again. And thanks, everybody. We'll talk to you next week.