Equity Markets Checkup

November 2017

It has been a lucrative year to be an equity investor. Unless you’ve been invested in Canada. Or Australia. Or the U.K. But other than that it’s been great! As the following chart shows, equities in emerging markets, the U.S., and Japan have all posted solid returns.

Owing to our circle of competence, we don’t typically invest in emerging markets. Nor do we have any exposure to Japanese equities. But we do regularly analyze companies that are included in the S&P 500 index. So with the S&P up nearly 15% on the year, we thought it would be a good time to do a checkup on its fundamentals. We hope the following analysis will give you a better idea of the current state of the U.S. equity markets than what a superficial “Index Hits New High” newspaper headline may indicate.

Fast and Steady Wins the Race

Let’s start with the following chart. It shows that the S&P 500 is in the midst of one of its best runs ever. As of October 25th, it had been 336 days since the index decreased by 5% or more. This represents the fourth-best streak since at least 1930. The past year has indeed been one of the best-ever times to be an investor in the U.S.

Not only has the S&P 500 had an impressive run recently, but it has been a stress-free run for investors. The next chart shows the average weekly change in the index for every year back to 1952. Over that 65-year period, the average weekly change has been approximately 1.3%. The current year is well below that. In fact, 2017 represents the lowest average weekly change in any of these 65 years. Slow and steady may win the race, but fast and steady markets are what many investors dream about.

More precisely, momentum investors are the ones who thrive when markets continue to trend upwards day after day. If you have the confidence that you can buy high and sell higher, you can look very smart (and rich) in a bull market.

But we aren’t momentum investors. We are value investors. We like to buy low and sell high. So when indices like the S&P 500 have had such an impressive run, we find it harder to identify individual securities that are cheap enough to buy low. We also find ourselves spending more time selling high in order to realize the gains that the market has provided. Taken together, this can result in us carrying a larger cash balance than normal.

But we don’t buy or sell based on momentum. We pay attention to underlying fundamentals. That’s why the following table recently caught our eye. It shows a variety of common security valuation metrics applied to the S&P 500 as a whole. To summarize: the S&P 500 now looks about as expensive as it has ever been over the last 40 years.

Do the Same Metrics Apply in Canada?

The S&P 500 looks expensive. But how do Canadian equities compare? After all, the first chart shows that the S&P/TSX Composite has significantly underperformed its U.S. counterpart so far in 2017.

The next chart reinforces the notion that the TSX has had an underwhelming year. These data, compiled as of October 30th, show that while the S&P 500 set a record daily high 50 times so far in 2017, the TSX did so just eight times. You will be forgiven if you are now developing some envy directed towards your investing neighbours to the south.

Source: BMO Capital Markets Economics

Looking at the fundamentals, the TSX has not been the beneficiary of the same elevated valuation metrics as the S&P 500. The next chart shows the price-to-earnings (“P/E”) ratio on forward-looking earnings estimates for both indices. Not since 2003 has the TSX traded at a P/E discount anywhere close to its current difference versus the S&P 500.

It would be reasonable to assume that the lower P/E ratio for the TSX would mean that there are many more bargains to find in Canada than in the U.S. However, we would like to now insert our periodic reminder that the S&P/TSX Composite is not a well-diversified index. So simply looking at an index-wide P/E ratio does not give a useful indication of how the median Canadian stock is trading.

The following table reinforces this point. You can see that the S&P/TSX index’s year-to-date (“YTD”) returns are heavily influenced by two sectors at opposite ends of the performance spectrum. The energy industry is responsible for -47% of the TSX’s YTD performance. The banks, on the other hand, have offset nearly all of this by contributing 44% of the index’s 2017 YTD performance. To get even more granular, just three banks, Royal Bank of Canada (RY-TSX), TD Bank (TD-TSX), and Bank of Nova Scotia (BNS-TSX), are responsible for 50% of the TSX’s year-to-date performance.

Source: RBC Capital Markets

If you didn’t own any of those three banks’ shares in your portfolio, your personal returns in 2017 would look markedly different than the S&P/TSX Composite index as a whole. You may recall that we saw similar behaviour a few years ago when Valeant (VRX-TSX) had an incredible run that pulled the entire index up with it.

One more chart to hammer this TSX diversification point home. The next graph shows that since 2007 the aggregate earnings of the S&P/TSX Composite have increased by over 20%. But if we exclude the contribution of the banks, earnings growth from all of the other companies in the index would be zilch. Zero. Zip.

Finding a Needle in a Haystack

The S&P 500 looks to be trading near all-time high levels on a fundamental basis. Because this index is well diversified, we have observed similar overvaluation from many – if not most – of the individual securities within the index. This has made it difficult for us to find new, cheap investment opportunities in the U.S. During times like these it isn’t fun to be a value investor in the U.S.

While the TSX looks to be much cheaper, you can see that a great deal of its underperformance is attributable solely to energy companies. This has piqued our interest, so we have spent more time analyzing companies in the oil patch. But as we have shown, the lack of diversification within the TSX means that lower valuation metrics do not necessarily translate into a plethora of investment opportunities across all Canadian equities. So it’s not a fun time to be a value investor in Canada either.