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Investors had anticipated weak second-quarter earnings amid slowing economic growth and ongoing monetary tightening. But results were better than expected, and stocks have rebounded. This episode, Stu Kedwell, Co-Head of North American Equities, explains why markets are rallying, and how portfolio managers adjust to these changing attitudes. [13 minutes, 52 seconds] (Recorded August 11, 2022)

Transcript

Hello and welcome to The Download. I'm your host, Dave Richardson, and delayed by my vacation, it's Stuesday on a Thursday. Stu, sorry, my wife insisted that we stay an extra couple of days in California. Whereas, I might push back occasionally and I always lose, but I'd occasionally push back. An extra couple of days in California… I think I'm okay. So we missed Stuesday, so I apologize.

Don't worry about it at all, Dave. It gave me the opportunity to see your lovely salmon blazer that is built for California. Is that pink or salmon? I don't know what color you’re wearing.

My wife says salmon. Unfortunately, the listeners can't see this work of art, especially the way it goes with my complexion. I look very California in Mississauga, Ontario, which is not really California.

You're nailing it. You're nailing it.

Excellent. So you want to go to video soon, Stu?

Well, I've been told I have a great face for radio. So, I don't know about the video.

You don't know about the video. But hey, I was listening to the radio this morning and they were talking about a particular stock that had a bad earnings report, but the stock actually went up. The analyst was explaining that the stock is going up because the news wasn't as bad as it was feared to be. What pops into my memory is my good pal, Stu Kedwell, said that several months ago that would be the sign that things were starting to improve. Or, that would set the table for an improvement in conditions. Obviously, we've seen a really powerful rally in markets over the last two or three weeks. What's causing this? How does this all pull together? Again, congratulations for proving why you're the smart guy on this podcast and I just ask the dumb questions.

I don't know about that, Dave, but let me give it a shot here. We’ve always talked about the valuation of a stock is a two-legged stool, right? There's the multiple that you pay and the earnings that are present today and will come in the future. The multiple is always heavily linked to interest rates and interest rates are often linked very closely to inflation. Early in the summer we had some very high levels of inflation which we felt were near peak and that they would come down. There's been a fair amount of evidence through the summer that the rate of change of pricing was starting to taper off. That was causing a rally in the bond market, which is then supportive of the valuation leg of the stool. It allowed us to then kind of shift our focus entirely to earnings. This week we got more positive news on the inflation front. So, it kind of goes back to the earnings front… Before I finish, I want to say that even though inflation is high and coming down, the reason that is a positive is because people have – just like we're going to talk about on the expectations of earnings – they have expectations about how much monetary tightening central banks will have to administer to get inflation down. If you think it's going to be a lot and then it's going to be slightly less, perhaps, that's a positive. There’s still going to be tightening, but there's going to be less than people thought. So through the summer, we've had some news flow. Some evidence that the valuation side of the equation… That we don't have to have as much concern about crushing valuation, which allows the market to really focus on earnings. There's cycles for any business. There's good and getting better. There's great but not getting better. There's great and getting worse, bad and getting worse, and bad and getting better. If you're okay with valuation and you can buy a bad not getting worse or bad and getting better, that's normally a pretty good time to own a stock, right? Because the earnings will improve and the valuation doesn't need to compress, so I'm going to capture that earnings growth. What we've seen in a variety of stocks is this notion that earnings in and of themselves we’re not bad, but maybe not as bad as people had feared. That's provided a bit of a reprieve for the stock market. We’ll see if that persists. I think on the positive side, this notion of slightly less a monetary tightening is favorable for long term investors. On the earnings side, the only thing we have to be wary of is that although we had positive reaction to stock prices, which is good, the reaction in some cases was quite strong. Where we sit today, this monetary tightening that's in the pipeline, we know that it works with a lagged effect. So, we raise interest rates. It doesn't impact things that day. I don't go home that night and say no dinner. I say we had a plan, so we're just going to do it. It takes a while to adjust that behavior. So as we get into the fall, we'll have to see the exact impact of that monetary tightening. When we sit here today… We were probably 3600 on the low on the S&P, or on that neighborhood. Today, we're sitting at 4250. While we've had improvement on the valuation side or on the inflation side, we've had improvement on the outlook of earnings. The governor for that is always price. If we had the first two things and we still sat at 3600, then you could say “well boy, this is a really good setup.” But we have rallied that call it 15% or so off the bottom. We just have to recalibrate. If I sat here at whatever it is, 4200 or 4300 on the S&P, and I said “okay, with inflation, where it's at, where interest rates are at, maybe a multiple of 16 to 18 times.” It suggests that we need to have a fairly soft landing and a reacceleration of earnings into 2023, 2024. That is going to be fairly healthy. That's the dynamic that any money manager is always trying to go through. You have the macro conditions which are less bad. That's been helpful to stock prices today. We have to then look at stock prices and say “well, where do they sit relative to what's likely to come now?” Three months from now, we'll just have a better view on the ultimate impact of some of the tightening we've seen. That’s how we're thinking about it. We're going through it stock by stock. Some stocks you have more comfort saying at this valuation, maybe we've seen the worst of earnings. I think the one thing that sticks out a little bit to us is some of the big growth stocks which have really snapped back quite significantly in the last month. When we look at those forecasts, these were businesses where people felt that they were going to grow at 25% or 30% for a very long period of time. This year they're growing at still a very healthy level, but maybe 18% to 20% instead of that 30%. Like something was pulled forward, they've had to slow down. When you look at the forecasts, the consensus forecasts around many of those names for next year, they almost all show a reacceleration. That's a little bit worrying because there's percentage growth and then there's absolute dollars. If I was a company with $5 billion of revenue and I was supposed to grow at 30%, the five and a half was going to be or the five was going to go to six and a half and so forth. That five went to maybe 5.8. So, there's still an extra $800 million of revenue. It's not bad, but it's not what it was. So people have recalibrated that this year is going to be slower, but then they've put higher growth back into next year. When you look at it on a dollar basis, you look at some of these businesses and you say “boy, they're going to grow by 800 million bucks next year or this year and next year needs to be like a billion and a half to get to that percentage growth reacceleration.” And you're like that's twice as much dollars of growth that's required. So, we're being a little bit careful on some of those big growth stocks. They had the biggest bounces and they often do off the bottom when you go back to past the bottoming periods. Normally what happens is what led the market before bounces significantly and then goes dormant for a very long period of time. That's probably the only kind of unique insight that we have sectorally within the market.

So, for investors looking at their statements or individual holdings that they have – nice little bounce here in the summer. It puts a little bounce in your step so to speak, as your portfolios come back a little bit off this correction. But too early to get really, really excited about this and still you want to exercise a little bit of caution in terms of the way you approach markets as this continues to play out. Because, as you say, we're not really, really sure just exactly how much of an impact all this tightening – and what is clearly a slowing economy, whether it's in a recession or not, a slowing economy – has on the potential for those profits to bounce back and for that growth to reaccelerate in the near term.

Yeah, I think that's the case. I would harbinger that between a shorter term focus versus a longer term focus. Then some people call me dollar cost average boy, but I'm just such a huge fan of dollar cost averaging when we're working through these types of environments because you're putting some money to work when it was 3600. You’re still put a little bit of money to work when it's 4200. From here, I think there is this short term set up for a little bit more chop around this scenario. Feeding money into that over time is a great way for long term investors to deal with these types of situations. I think generally speaking, if we were sitting here at the end of the October period of time, we'd had another round of earnings or another round of commentary from management about some of what they're seeing and how they're dealing with it. It gives us a bit more confidence about how earnings might look 12 months forward. That’s something that's very fundamental and that's a pretty reasonable approach in our minds. But that's very market wide. We're still finding some specific stocks that still look quite interesting.

Stu, I did not know that you were referred to as dollar cost average boy (DCB). I was driving around Los Angeles and there's all kinds of billboards with your face on it – Dollar cost average boy. It's the exciting blockbuster, I think, of the September/October movie release season. That should help you with theater revenues.

Well, Marvel will probably pick it up because they've been struggling, and DCB has some really unique strengths.

Dollar cost average boy coming to a theater near you. Stuesdays coming to a podcast wherever you download your podcast every week. Stu, lots of great stuff there. I really hope that the listeners in all seriousness give this a really careful listen because it really is that ebb and flow. You’re just in one of those points where it's really interesting to watch how this is going to play out. You really gave the roadmap for the different directions we could take here. I really like what you had to say today.

Great. Thanks very much, Dave.

Disclosure

Recorded: August 11, 2022

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