Expectations

It is always an interesting question to contemplate - what are an investor’s expected returns? There are a lot of factors that can contribute to the answer, depending on one’s investment experience and behavior. A new investor with a long time horizon may have very high expectations, for example. While an investor who just experienced a significant selloff may have a different view and a person invested in fixed income and GICs could have a very different response.

Generally, after a significant correction, an investor’s return expectation should increase and not decrease, but often it is the opposite. And after a strong period in the markets, investor’s expectations will go up when they should, generally, be moderating. An investor’s investment goals can also be an influence as some are very satisfied with their rate of returns while others could be disappointed based on unrealistic expectations. The other key question is time. Are we looking at short-term (weeks or one quarter), or multiple quarters or years?

The truth is we don’t know.  Equity markets will often provide us with surprises. Interest rates have been declining for decades, as one example. How many times has the phrase ‘yields are going higher’ been discussed?

The S&P 500 just finished a strong first half of 2021 with a return of 12.7% while the TSX Composite Index was up 17.3%. This return would likely be more than twice many investors’ expectations for a full year! It’s yet another example that ‘average’ returns are never average. After a slower recovery in 2020, Financial stocks, which are nearly 40% of the index, were up 23.4%, helping the TSX, along with the energy sector, which rebounded 37% as oil prices rose to 3-year highs. The Information Technology sector, which led the index in 2020, had a strong finish to June and is up 21.7% this year. That’s not to say there were not any corrections, as sector rotation meant certain sectors and companies were out of favour for extended periods. For example, Shopify had been rangebound for a year, until mid-May, while Amazon had traded sideways for 10 months, until recently perking up and trading to all-time highs. Sometimes ‘good’ businesses and great long-term stocks go through quiet periods where expectations need a chance to catch up with the share price.

The earlier question leads us to ponder whether the market can build on the best first half in 39 years, and what could be the possible downside risks? Is an investor overweight equities now and should they be rebalancing their asset allocation? Would they be comfortable with a ~10% market selloff from current levels? Looking out at a 3-5 year outlook, are you comfortable with your portfolio? After a strong first half, rebalancing from an overweight equity viewpoint is a great way to ensure that your investment objectives and goals still line up.

The surprising strength of the first half is yet another reminder that timing the market is very difficult and should be avoided. Part of the price of admission for an investor looking for higher returns is volatility and higher risk. The first half of 2021 was much different than 2020!

After a notably quiet stretch, many analysts are anticipating a break in the lull. The simplest reason: Trading desks tend to become more lightly staffed during the summer as employees take off for the holidays. That generally means there is less liquidity in the markets. In turn, any surprising economic data, corporate or monetary-policy news tends to impact the market harder than they otherwise might.

I thought that Frances Horodelski, a former BNN Bloomberg TV personality and someone who’s followed the markets for ~40 years, put together a great concise list of economic and trading pros & cons for the current market environment.  There is something for everyone on this list. Often, in a strong market, the ‘pros’ will matter more. When periods of weakness arise, the ‘cons’ tend to get more attention.  Pros include:

1. Lots of liquidity with no real end in sight.  Despite the Bank of Canada reducing its bond purchases, even it remains easy. There will be talking about it from the Fed and depending upon jobs, QE tapering could happen earlier than currently expected, but unlikely in 2021.  Rate hikes are a later 2022 story.  Employment in the U.S. is still 6.8 million below pre-pandemic levels, a key focus for the Fed.
2. Economic momentum is positive and maybe even accelerating in many parts of the world as opening up continues, albeit bumpily in areas.
3. Earnings momentum is strong and also maybe even accelerating.
4. Earlier supply chain worries could ease as 2H unfolds alleviating some inflationary concerns.
5. Active sector and stock rotation has kept the markets from getting too far ahead of themselves. Index moves are more rational despite some ridiculous single stock price jumps.
6. Sentiment - some measures, such as investors intelligence are at concerning levels. The American Association of Individual Investors (AAII) % bulls has been perking up, but not yet off the charts. And other sentiment measures such as the CNN Fear/greed index are neutral.
7. Valuation isn’t outrageous although debatable.  The TSX is relatively cheaper at 16x forward earnings and 2.2x book vs the SPX at 21x and 4.6x.  But there are still 173 U.S. companies below a market multiple on trailing 12 month earnings - many in single digits.
8. According to JC Parets’ list of risk on-risk off indicators, the market is still in risk on mode albeit marginally. 
9. The interest in growth again and a break out (again) in semis are good indicators for risk on. 
10. Global dry powder in the hands of private equity remains high. 
11. Insiders remain bullish and buyback activity is high.

Cons are a combination of waiting for a negative surprise and market internals: 

1. Will the talking about tapering turn into actual tapering earlier than currently built into expectations and rate hikes happen sooner than indicated by the latest dot plot 
2. Will inflationary pressures not be temporary causing the Fed to react sooner crimping valuation?
3. Will speculative fever around meme stocks and IPOs result in too many burnt hands and a move to risk off?
4. A number of internal indicators suggest a tired market - volume, advance decline line, new high list not expanding (new low list isn’t either), important resistance levels proving short term blocks (for example, energy and copper), struggling financials despite very good news.
5. Put:call ratio and skew are at levels often coincident with a correction.
6. Average index targets around 4200 and 21000 for the SPX and TSX from strategists have already been achieved.
7. Bespoke’s Irrational Exuberance index is at an all time high

I’d add there’s always a list of worries. On one hand, the market has already priced in many of those concerns but sometime they don’t play out as expected. However, when complacency creeps in, that is usually the time to be worried! For investors with a longer-term horizon, it’s a great time to be away focussing less on their portfolios if they are comfortable with their asset allocations. It’s time to recharge, whether it is enjoying the good weather, or spending time with family and friends. We can never have enough of those experiences, and after last summer’s quarantine restrictions, what better time to catch up?!