Market set up looks positive as we head into 2024
We think the market can power higher through year-end and beyond. That, in a nutshell, has been our call for the last few months, despite the pervasive negativity surrounding the geopolitical environment as well as the interest rate and economic outlook. First, as we discuss below, interest rates have come off the boil with the U.S. 10-year treasury coming down to the 4.4% range, after briefly topping 5%. That is a significant tailwind for equities and, not surprisingly, the market has been led by so-called high-duration (i.e., highmultiple) Tech stocks. Still, the participation in the market has broadened to include other sectors and stocks beyond Tech. That’s an encouraging signal and a good omen for better performance to come from the very undervalued Canadian stock market, which is not blessed with many “sexy” Technology stocks (Shopify being one exception).
The pummeling of many high-quality, interest-sensitive stocks this year presented a compelling buying opportunity, in our view. Not only do these stocks have a significant margin of safety, but they also offer high dividend yields, which in many cases are competitive with bonds in this new higher interest rate regime. In some cases, an alternative method of taking advantage of these high-quality companies is through their corporate bonds – several of which are trading at a discount, making them even more attractive on an after-tax basis.
With the Bank of Canada and the U.S. Federal Reserve (the “Fed”) now expected to be on pause, we believe we will enter a new era with increased rate stability. Our work suggests that the market tends to act well when interest rates are stable, which makes intuitive sense since traders and investors at large have historically rewarded visibility and stability with higher valuations. As such, investors tend to offer higher reward to “value” stocks (i.e., Banks, Utilities, Energy Producers, etc.), relative to expensive growth counterparts, 12 months after interest rate stability is achieved.
Our belief that a near-term peak in long-term yields is near has positive implications for the aforementioned value stocks. A decline in longer-term interest rates provides a tailwind for years out cash flows, thus significantly increasing valuations for those stocks which have high free cash flow. We also conducted analysis of sector performance after a 3% increase in long rates, and our analysis showed that, as expected, the market posts healthy returns with the largest beneficiaries being defensive sectors.
In July of last year, despite a near-unanimous opinion to the contrary, we stated that a recession was not a foregone conclusion. While it remains a possibility for 2024, our proprietary recession model now shows the probability of such an event ticking down to just over 40% (from 60% last year).
This view appears to be well supported by earnings report comments from industry leaders in the U.S. We hasten to add that messages from large public companies during earnings calls should be taken with a grain of salt as they do have a vested interest in putting their best foot forward and increasing shareholder value. Still, in aggregate, comments taken from Fortune 500 corporations across sectors do provide three interesting insights: 1) inflation is becoming less problematic; 2) a recession does not appear imminent; and 3) earnings are generally stabilizing. All these points are a good counterweight to the bearish chorus we have been hearing all year. The bottom line is that investors still need to be selective, but our bullish call for stocks through year-end stands.
Credit market continues to be well supported
Another encouraging element is the credit trend with corporate yield spreads and credit default swap spreads tightening significantly in the last month. This is a good indication that the fixed income market is getting less concerned about a severe economic slowdown in the near future. Reports of a more benign core CPI that clearly reduces the need for further rate hikes – along with attractive yields, a tax efficient market structure, and the lower corporate bond issuances – were all major drivers behind the positive trend and are expected to continue supporting credit markets into the new year.
Objectively, after seeing spreads tightening by more than 10% in less than four weeks, and now hovering close to – if not at – their tightest levels year-to-date, a period of consolidation is expected. From a yield perspective; however, the corporate bond sector remains attractive, providing a great combination of capital amortization and coupon that will continue to aid a recovery in performance. Even Canadian bank credit spreads that were negatively impacted last spring from the U.S. regional bank crisis have recovered amid a more challenging earnings environment, indicating that despite short-term challenges, markets are focusing ahead to the recovery.
We expect continued strong demand from investors looking at locking attractive yields for longer terms in the current more tax-efficient fixed income market, one of our main investment themes. We also believe that demand for longer-term securities could increase from non-taxable investors. More specifically, the credit spreads of securities in the Financials sector priced closer to par (coupons ranging from a high of 4% to a low of 5%) have not fully participated in the latest rally, which means these securities offer an attractive solution for registered and non-taxable accounts. As an example, the yield on a 5-year bank subordinated debt with a low coupon and deeply discounted price, compared to a more current coupon, can be as much as 20 to 25 basis points more expensive. With the recent decline in Guaranteed Investment Certificate yields from their cycle peaks, and as we approach the busy season for registered accounts, current coupon bonds from financial institutions offers an attractive alternative that could further support credit markets over the coming months.
Technical analysis
As we consolidate our notes for this month’s strategy comments, the S&P/TSX Composite Index is about to complete its best three-week rally in two years, and the S&P 500 Index is on track for the best three-week rally since the post-pandemic bear market lift-off in the spring of 2020. This might prompt some to think there might not be much upside left in this rally, but we think it’s just the opposite, and for a few reasons.
First and foremost is the action in the U.S. 10-year yield. The 10-year yield has been the key driver for equity market weakness since the correction began in the summer and it has definitively reversed back to the downside accompanied by new sell signals in short- and medium-term momentum gauges. There is some support for the 10-year yield across 4.34%, but the last few times medium-term momentum gauges rolled over from such steep overbought extremes resulted in the 10-year yield coming all the way back to its 200-day moving average, which is currently at 3.99%. That will be a massive tailwind for equities if that’s what transpires.
The magnitude of the recent rally has also had a noticeable impact on our medium-term timing model, which had been negative since mid-summer. Momentum gauges will still take a couple weeks before they’re fully positive again, but buy signals in that model typically result in rallies that last three to six months or longer. Earlier in November, a “breadth thrust” occurred on the NYSE as well. A “breadth thrust” is when NYSE breadth goes from heavily negative to heavily positive over a short period of time and reflects what we like to refer to as an “everybody back in the pool!” moment. Since 1950, the average six-month return on the S&P 500 following this signal is +16.9%, with 100% accuracy, and the average 12-month return is +24.8%, also with 100% accuracy. The signals since the credit crisis are even better, with a 12-month return of 36.7%.
On the sentiment front, at the end of November we saw the biggest three-week increase in the number of bulls in our Composite Sentiment indicator in more than seven years. However, sentiment still remains well below the levels where it becomes a headwind for equities (i.e., we are still in the zone where more bulls means more money being put to work in equities, which is clearly a good thing).
Finally, we are also now in the seasonal “sweet spot” for equity markets. Historically, November is the best month of the year for both the S&P/TSX and the S&P 500. Not only that, but the November to January period is the strongest consecutive three months of the year, with average returns of 4.30% for the S&P 500 and 4.33% for the S&P/TSX. So, between the improvement in our medium-term timing model, strong seasonal tailwinds, and a more favourable interest rate backdrop, the bias for equities should remain to the upside well into the first quarter of next year.
In terms of what to buy, there are two great opportunities right now. First, we remain in the early stages of a new cyclical bull market where the pro-cyclical, economically-sensitive areas of the market continue to outperform. This includes Industrials, Consumer Discretionary, Information Technology and Communication Services. In addition, if we are right on our call for long-term interest rates, we should expect to see interest-sensitive stocks catch a strong bid. This is particularly important to Canadian investors since these stocks account for approximately 38% of the capitalization of the S&P/TSX Composite Index.
Please contact your BMO Nesbitt Burns Investment Advisor if you have any questions or would like to discuss your investments.
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