Great start

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   By Guest Blogger Ryan Lewenza

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It’s been a great start to the year with the global equity markets performing nicely in the first quarter of the year. The US markets were the standout this quarter with the S&P 500 up 10%, while the TSX and EAFE (Europe and Far East) were up roughly 6%. What’s behind these strong gains?

First quarter performance for key equity markets

Source: Stockcharts.com

The advance has been driven by a combination of three main factors: 1) the rising prospect of interest rate cuts this year by some key central banks, 2) an improving corporate earnings outlook, and 3) strength from the technology sector, particularly those stocks like Nvidia and Microsoft, which have exposure to the rapidly growing AI industry.

We called for this market strength in our 2024 outlook, so we’re very pleased to see these gains. Now the million-dollar question, can it continue? We think so.

In the very short-term we’re overdue for a market pause or pullback. The markets have been down only 4 of 22 weeks since November so we’re probably due. Also with the strong gains, the equity markets are technically overbought.

For example, one indicator I track is the percentage of stocks in the S&P 500 above the 50-day moving average, and currently this is elevated, at 75%. When this indicator gets above 70% it signals overbought. So, we’re due for a bit of a pause, allowing markets to rebuild what I call ‘internal energy’. Right now that internal energy looks a bit exhausted, like I get after a night out with the boys.

But, outside of this, we’re still bullish and see more gains ahead.

First, April is historically a good month for the US equity markets. Since 1960, April ranks as the 2nd best month of the year for the S&P 500 with an average monthly return of 1.45%. May and June then tend to be weaker months for the markets.

Second, since 1960 the S&P 500 has gained at least 9% in the first quarter 13 times. The market then went on to rise in the second quarter nine (69%) of those times and, more importantly, it finished the year higher in every instance but one. So, history is on our side for more gains.

Third, the outlook for corporate earnings continue to improve. Last year corporate earnings kinda sucked (that’s the technical term in the business) but better days lie ahead. S&P 500 earnings were flat last year but are expected to rise 10% this year. Given the very high long-term correlation (0.96) between S&P 500 earnings and stock prices, this is clearly positive for this year.

Long-term correlation of the S&P 500 and earnings

Source: Bloomberg, Turner Investments

Fourth, in our view it’s not a matter of if the Fed will cut rates but rather when and by how much. The chart below shows S&P 500 returns following the start of Fed rate cuts going back to 1970, and in every case other than the tech crash of 2000, the S&P 500 rallied on the cuts.

So, against this backdrop how could you be too bearish about the markets right now?

S&P 500 returns following the Fed rate cuts

Source: WSJ

Well, that’s the US markets but what about our own Canadian maple stocks? There’s no denying the TSX has lagged the US markets over the last decade. A paucity of technology companies and an abundance of resource stocks is the central factor behind this underperformance. But we believe better days lie ahead for the TSX and therefore investors shouldn’t throw in the towel on our Canadian stock market.

First, commodities tend to trade in long-term bull/bear cycles lasting roughly 6 years. During periods of commodity strength the TSX outperforms the S&P 500 and vice versa. This can be seen in the chart below. It overlays the relative performance of the TSX to the S&P 500 with commodity prices. You can see when commodities are out of favour, like they’ve been over the last decade, the TSX tends to underperform. But when it’s the opposite, as the early 2000s, the TSX outperforms.

We are in, or nearing, one of these new bull commodity markets given: 1) we’re due and history points to a fresh up cycle, 2) commodities tend to do well in a higher inflation environment that we’re now in, and 3) there has been a major underinvestment in energy and mining over the last decade, which, with the still high demand for resources, could lead to higher prices due to the supply/demand imbalance.

Relative performance of  TSX & S&P 500 with commodity prices

Source: Bloomberg, Turner Investments

Second, the TSX is pretty darn cheap, especially compared to the expensive US markets. The S&P 500 is trading at its highest price to book ratio in decades (4.7x) versus the TSX at around 2x and on a P/E basis, the TSX is trading at a monster discount. Currently, the S&P 500 is trading at a forward P/E of 22x compared to the TSX at 15x. This massive gap can be easily spotted in the chart below.

I ran some analysis this week that really highlights this historic gap in valuations. Since 2003, the S&P 500 has traded at an average 1x P/E premium to the TSX. Of course, it should trade at a premium to the TSX given that the US economy is the strongest in the world with many of the greatest companies to ever exist. Apple, Google, Tesla, Starbucks, Eli Lilly and Nike to name just a few of these amazing companies. Sure, Shopify is pretty awesome but we also have duds like Blackberry and Nortel.

The TSX, with its focus on banking and resource companies, should trade at a discount to the more dynamic S&P 500 but at 6x P/E differential, that seems overblown. Put simply, the TSX is attractively valued relative to history and the S&P 500 and now we just need a catalyst (BoC cuts, 2025 election?) for this historic discount to narrow and the TSX to start outperforming.

Readers know we’re big global investors and hold a roughly 40% weight to US and international stocks. But we’re going to keep with our roughly 20% exposure to the Canadian markets given the factors I outlined.

So, today’s message: the good times should keep on rolling for the global equity markets. So stay the course!

P/Es for TSX and S&P 500

Source: Bloomberg, Turner Investments

Ryan Lewenza, CFA, CMT is a Partner and Portfolio Manager with Turner Investments, and a Senior Investment Advisor, Private Client Group, of Raymond James Ltd.