After suffering the first ‘correction’ in the past year in September (falling almost 5%), stocks snapped back in October, getting an early jump on the traditional year end rally.  The fuel for the gains were the exceptionally strong earnings reports, which started with the major U.S. money centre banks and finishing the month with big earnings beats from the major tech players such as Microsoft and Alphabet.  Stocks generated sharp gains for the major averages with the TSX up 4.8% while, in the U.S., the S&P500 gained almost 7%, on notable strength in the transportation and technology sectors.  In Canada, energy lead the charge again in October as oil prices jumped another 8%.  However, gains on both sides of the border were more ‘stock specific’ than ‘sector generalized’, depending mostly on how earnings call and outlooks were received.  Classic example of this was in the auto sector, where everyone has had to shut in production due to the semi-conductor shortage, higher labour costs and supply chain issues.  However, although the three biggest U.S. manufacturers beat quarterly expectations, maintained guidance for the year and delineated strong growth in electric vehicles, Tesla rose 41% for the while Ford was up 21% but GM only gained 3%.

The risk going into earnings were the global supply-chain problems.  On its earnings call, Apple said revenue was reduced by $6 billion in the quarter due to parts shortages and Covid-related manufacturing issues and cautioned they could lose even more revenue to the parts problem in the December quarter. Parts shortages plagued almost every hardware company that reported.  These worries about supply chain constraints, rising material inputs and labour costs were present in most consumer-centric and industrial companies (Amazon, 3M, Starbucks, Nike, FedEx, PPG, GM).

However, for investors, the revenue and profit gains seemed to be enough to offset the worries about rising costs.  Also, most of these companies indicated that they expected the semi-conductor shortage and other supply chain issues to lessen in 2022, even though they will still have a negative impact in the fourth quarter of 2021.  Financials were not impacted by these issues, which showed in the results of the money centre banks. ‘Cloud centric’ tech companies such as Microsoft and Alphabet were also somewhat ‘immune’ from those manufacturing issues.  Energy companies also reported blowout earnings on higher commodity prices.  The big players such as Chevron and Suncor re-instituted dividends and added stock buybacks into the equation to make use of the massive excess cash flows they are generating.  The biggest impetus to the recovery in October, though, once again came from the big tech giants which generally surpassed even elevated expectations.   Microsoft gainned over 15% on the month to displace Apple as the largest company in the world while Alphabet was up over 10% as search, cloud, online advertising and You Tube all generated great results.  With the biggest short term risks (third quarter earnings and fourth quarter outlooks) mostly out of the way, stocks look to be in a good position to resume their traditional ‘year end’ (a.k.a. ‘Santa Claus’) rally.  The ‘fly in the ointment’ however, could be the upcoming Federal Reserve meeting in the U.S. and the risk of another ‘2013 style taper tantrum’ on the expected announcement of a reduction in monetary support.

If we end up with a traditional year end rally, the question in early 2022 will be how long stocks can continue rising.  Stock investor expectations need to be toned down as we have ‘borrowed forward’ performance.  Investors are already ‘all in’ on equities, as stock fund assets as a percentage of investments in the U.S. are at their highest level in 70 years!  Moreover, investors have become accustomed to massive earnings beats in the past four quarters, and we don’t see the same level of outperformance ahead.  Stocks basically go up for two reasons;  earnings are growing or the multiple on that earnings is going higher.  We’ve reached the limit on the latter point in our view.   Stock market multiples are driven by interest rates and we have seen record levels of liquidity over the past decade and more aggressively in the past 18 months.  Stock multiples are at all-time highs yet interest rates are starting to migrate higher.  Bottom line, we can’t count or rising multiples to take stocks higher.  That leaves earnings.   They have had record growth in the past few quarters and will continue to expand, but the rate of growth is clearly slowing down and are at additional risk as third quarter earnings reports are showing some major industrial and consumer companies pointing to the supply chain disruptions and the negative impact of rising material and labour costs on profit margins.  Bottom line, the two main pegs of stock market gains are being knocked out and that will make returns tougher to achieve.

Are we getting closer to a market top?  Unlike bear-market bottoms, which tend to be short and violent, bull-market tops in the stock market tend to occur gradually over time, as first one sector or investment style hits its peak and turns down, and then another.  That means investors shouldn’t manage their stock portfolios on the assumption there will be an exact day before which it would make sense to be 100% invested and afterward to be in cash. Even if pinpoint stock-market timing weren’t incredibly difficult, it still would make more sense to gradually build up cash as individual positions hit their targets.  A recent illustration that not all sectors and styles hit their bull-market highs at the same time came at the top of the internet-stock bubble in early 2000. Though the S&P500 and Nasdaq Composite indexes hit their bull-market highs in March 2000, value stocks—and small-cap value stocks, in particular—kept on rising. The S&P500 at its October 2002 bear-market low was 49% lower than its March 2000 high, and the Nasdaq Composite was 78% lower, but the average small-cap value stock was 2% higher than it was in March 2000.  With valuations so extended in the ‘high growth’ sectors of the market and interest rates starting to firm up, we think we are close to entering a similar period to that seen in 2002.  Some stalling out in the big ‘FAANG’ names could hold the overall stock market indices in check, but we still see opportunities for gains in the more cyclical sectors of the market such as financials, industrials, energy and autos, where we see stronger earnings recoveries and much lower valuations than the ‘growth sectors’ of the market such as technology.  The trend has always been that investors become myopic during bubbles. They believe the universe of attractive investment opportunities is small and growth can be found only in a few select sectors.  That divergence presents opportunities because investors ignore the broad range of potential investments outside the bubble.  Today’s bubbles are following that precedent. Investors are squarely focusing on technology, innovation, disruption, cryptocurrencies, and housing, but very little else. They seem enamored with vacations in outer space and electric vehicles, yet ignore the dire need for improving logistical and electrical infrastructure.  Ironically, many equity markets around the world not known as hotbeds of innovation and disruption are outperforming Nasdaq Composite index so far during 2021.  We expect this trend to continue and it is one reason why we see the Canadian stock market achieving further relative gains.

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