We begin this week’s commentary by wishing you good health and happiness during these trying times. We want to thank you for entrusting us in navigating your investments through these challenging market conditions. Remember, our primary investment objectives are capital preservation, income generation and prudent growth. We want you to know that we are here for you in good and tough times.
This week’s commentary looks at the S&P 500 Index through two different lenses that lead to what we believe is the same conclusion. We analysed the S&P 500 technically, using the Fibonacci sequencing formula, and fundamentally, looking at earnings estimates and price earnings multiples.
We share our insight on dividends and conclude with how we, as professional wealth advisors, look to identify potential hurdles and provide solutions.
The following chart shows the S&P 500 Index price pattern for the period of May 8th to May 14th. As you can see, volatility continues to rein the stock market.
Source: Thomson One
The Technical Lens
A number of forces impacting markets, such as government stimulus and asset purchase programs, are providing a ‘floor’ for potential investment losses, even though we are witnessing deteriorating economic conditions, GDP, and corporate earnings as well as high unemployment. These are all the ingredients for a recession. Understanding the duration of the pandemic and the post-pandemic recovery is critical in deciding when to put capital at risk to achieve an appropriate risk-adjusted return.
We are not market timers and do not make decisions on a technical or momentum basis. However, since we believe that the markets are operating on sentiment and not fundamentals, a look through the technical lens is warranted. We have been analyzing the markets behaviour utilizing the Fibonacci sequencing formula.
Source: Thomson One, as at May 11, 2020
Without getting into the mathematical explanation of Fibonacci’s formula, which in analyzing asset prices helps determine support and resistance levels, we want to highlight the results of the analysis. The chart above indicates there is strong resistance for the S&P 500 to move higher than 2950. This pattern confirms many technical opinions that current market conditions are over bought or expensive. Therefore, placing money at risk today would not be prudent as we need confirmation that the market needs to break the 2950 resistance level.
Again, our portfolio management team does not rely on technical analysis, but we do examine whether the technical opinion confirms our fundamental opinion.
The Fundamental Lens
As outlined in last week’s messaging, we still believe the markets are ‘expensive’ from a fundamental perspective with a Forward P/E of over 23X projected earnings that have been revised downward drastically.The following chart illustrates the S&P 500
Index and the estimated earnings over the past year.
Source: Thomson Eikon
The purple line is the mean macro, or top-down, estimated earnings per share (EPS) provided by a number of Wall Street analysts. The orange line is an EPS estimate derived from a bottom-up approach by taking analysts’ mean estimates for each of the 500 companies and aggregating them to get an expected EPS for the index.
There is an $18 variation between the two approaches. What is concerning is that the bottom-up is reflecting a 21.4% drop in earnings for the S&P 500 for 2020 compared to 2019, while the top-down estimate is expecting a 10.2% drop in earnings.
Even if the market P/E ratio reverts back to the year-end 2019 level of 19.9X, the S&P 500 could end up at 2541 (19.9 x 127.69) or if year-end 2020 P/E ends up at the current Forward P/E of 23X, the S&P 500 would be at 2937, close to where it peaked on Tuesday, May 12, 2020.
We don’t believe this leaves much room for improvement unless the economy recovers faster and stronger, but unemployment would have to go back to 2019 levels of 3.7% for that to happen.
Summary of Analysis
As you can see from the two lenses, both suggest the markets have little room to move higher for now. We need conditions to improve and that is a function of the duration of the lockdowns and the pandemic.
Historical performance continually demonstrates the value of dividends and dividend growth for long-term investment returns. The following charts outline the payout ratios and the percentage change in dividends for the S&P 500 Index:
Chart 1: Payout Ratio Chart 2: Quarterly % Change in Dividends
Chart 1 illustrates the rapid deterioration of the average dividend payout ratio as companies’ earnings are falling relative to the dividends paid out. Chart 2 illustrates the average percentage change in the dividends paid this past quarter. The drop signifies that many companies are cutting their dividends and not growing them during this crisis. In order for these metrics to return to the mean, earnings have to recover significantly or dividends have to be cut more aggressively. Our thesis is in the short-term, more vulnerable companies will be cutting their dividends to bolster their cash flow and hoard cash.
We are pleased that, to date, none of our companies have reduced or eliminated dividends. Conversely, some companies have increased their dividend during this pandemic. In the US; Apple (+6.5%), Johnson and Johnson (+6.3%), Cisco (+2.9%), IBM (+0.60%) and in Canada; Power Corp, TD, National and Royal Bank announced dividend increases back in February.
We continuously focus on companies with strong balance sheets, earnings, and sustainable dividend payout ratios to provide the optimal long-term, risk-adjusted returns to help you achieve your financial goals.
Wealth Management Considerations
While we are working diligently during these volatile times, the IP team is also focusing on the inevitable recovery from this pandemic and the potential outcomes from COVID-19.
Our planning team, has been working with tax professionals and our investment team to find solutions to potential outcomes from the government responses to this disease.
The parliamentary budget office stated there is a real expectation the Canadian government deficit may hit $1 trillion dollars. Based on the amount of liquidity injected into the economy and the projected deficits we are discussing options/solutions on the following scenarios:
- Living expenses moving from a low inflation to a much higher inflationary trajectory once the economy is on a stronger footing towards recovery.
- Rising interest rates associated with higher inflation.
- Rising taxes to pay the deficits including potential for:
- Higher marginal tax brackets for high income earners.
- Increased corporate tax rates (negative impact to EPS and stock values and to private business).
- Increase in the HST
- Increase in the capital gains inclusion rate (sale of assets and tax impact; sale of your private business, etc.)
- Potential of a lower Canadian dollar based on Canada’s economic output and tax regime.
Our IP360⁰ family office approach will continue to provide our clients with the ability to “translate” these outcomes to optimize your personal and corporate objectives.
We look forward to the return of strategic wealth management and investment discussions based on your specific needs.