Citi’s Montreal-born U.S. equity strategist Tobias Levkovich wrote the best sentence I’ve read in a research report this week: “With equities climbing 78 per cent of the time, it pays to be an optimist, but too many indicators suggest caution now.”
This one sentence covers a lot of ground. The strategist is granting that in being bearish the odds are not in his favour but the evidence pushing him towards this view is so overwhelming that he feels he has no choice. Mr. Levkovich’s year-end target of 2700 for the S&P 500 – almost 15 per cent below current levels, underscores his conviction.
In the report “Keeping it Simple”, the strategist first tackles the common bullish argument he hears from institutional clients – something called Marshallian K analysis (a new term for me also). Marshallian K says that asset prices will climb to the extent central bank-driven money supply growth exceeds GDP growth.
With extensive monetary expansion underway to cope with the pandemic, and the U.S. economy contracting, the Marshallian K perspective says the equity market rally is justified. Stock valuations, and economic data beyond GDP, don’t matter in this framing.
Not so fast, says Citi. Actual equity market returns historically show “tighter correlations [than with Marshallian K analysis] with both forward earnings expectations and [trailing 12-month operating earnings]”, writes Mr. Levkovich, “implying that the increased money supply must turn into profitability.” Strong evidence of renewed corporate profitability is not yet evident and this suggests the stock market rally will be on fragile ground until it appears.
The strategist cites a number of other reasons to be bearish. The ratio of S&P 500 market capitalization to total corporate revenues – he likes this better than Warren Buffett’s favourite market cap to GDP ratio because it includes foreign sales for U.S. multinationals – is hitting levels last seen in 1999.
Mr. Levkovich also notes that banks have tightened credit availability for commercial and industrial companies, and this historically results in lower profits with a nine-month lag. In addition, U.S. corporate spending expectations have collapsed, and this again suggests lower profits, hiring and business activity in the months ahead.
There are strategists and analysts with far more bullish views – Andrew Garthwaite at Credit Suisse and seemingly everyone who works for Morgan Stanley’s research department, for example. Mr. Levkovich’s outlook is only one perspective but I am impressed by his conviction and believe it’s one investors need to take seriously.
-- Scott Barlow, Globe and Mail market strategist
This is the Globe Investor newsletter, published three times each week. If someone has forwarded this e-mail newsletter to you or you’re reading this on the web, you can sign up for the newsletter and others on our newsletter signup page.
Stocks to ponder
North West Company Inc. (NWC-T) This stock is seeing positive price momentum after the company reported better-than-expected quarterly earnings results last week. The stock pays its shareholders a quarterly dividend with a current yield of 4.8 per cent and based on the average target price, offers investors a potential total return, including the dividend yield, of over 16 per cent. Looking at the stock’s valuation, it is trading at a discount relative to historical levels suggesting there is room for multiple expansion. Jennifer profile has this profile. (for subscribers)
Enghouse Systems Ltd. (ENGH-T) This low-profile Markham, Ont., company specializes in paying low prices for troubled businesses that supply good quality software used in contact centres, telecommunication networks, transportation systems and for video conferencing. For 12 straight years, it has raised its dividend and this month hit an all-time high thanks to the trend of video conferencing in the era of COVID-19. Sean Silcoff has more on the stock. (for subscribers)
The Rundown
The hidden danger in breaking free from a do-nothing investment adviser
The financial upheaval caused by the pandemic highlights how much more there is to adviser-client relationships than just investments. There’s managing debt and loss of personal and business income, navigation of government benefits, estate planning, providing moral support and more. You pay for services like this when you work with an adviser via fees and commissions. Clients who realize they’re not getting what they paid for will be on the move in the months ahead, reports Rob Carrick. (for subscribers)
Trading sports books for brokerages, bored bettors wager on stocks
Millions of small-time investors have opened trading accounts in recent months, a flood of new buyers unlike anything the market had seen in years, just as lockdown orders halted entire sectors of the economy and sent unemployment soaring. It’s not clear how many of the new arrivals are sports bettors, but some are behaving like aggressive gamblers. There has been a jump in small bets in the stock options market, where wagers on the direction of share prices can produce thrilling scores and gut-wrenching losses. And transactions that make little economic sense, like buying up the nearly valueless shares of bankrupt companies, are off the charts. Matt Phillips of The New York Times reports (for subscribers)
Also see: Main Street’s boldest take on Wall Street in bankruptcy stock frenzy
These ETFs are a way to own some gold and get income as well
In uncertain times, like now, investors turn to what are known as “safe haven” assets. These include cash, government bonds, and gold. The problem for income-oriented investors is that none of these offer any appreciable cash flow. But now there is a way to own some gold and get income as well. Two Canadian ETFs are using covered call writing on gold stocks to generate cash flow, which is somewhat akin to eating your cake and having it too. Gordon Pape tells us more. (for subscribers)
The Fed’s message: Forget Buffett, start day trading
The stock market rebound of the past three months has made Warren Buffett look like a know-nothing and know-nothings look like geniuses. The greatest investor of all time has sat on US$137-billion in cash and missed out on the massive surge in share prices since late March. Meanwhile, day traders betting on a quick bounce back from the pandemic have enjoyed double-digit gains. But the sudden rise of day trading seems to be more about the U.S. Federal Reserve than about a changing of the guard, says our Ian McGugan. (for subscribers)
Why one of the most common ways to value stocks says little about the future returns of the TSX
Savita Subramanian, quantitative equity strategist at Bank of America Securities, has provided convincing evidence that price-to-earnings valuations are the most important driver of U.S. equity performance over longer time periods. U.S. investors, then, have reason to be concerned about the current high P/E ratio of more than 21 times. The same model applied to domestic equities, however, produces much more mixed results. Scott Barlow provides this analysis. (for subscribers)
Second-wave wobble reveals more about markets than the virus
A sudden bout of angst about resurgent coronavirus cases in parts of the United States and China was enough to ensure last week was the worst for world equity markets since March. Both the second-wave narrative and much of the evidence for it have since dissipated, allowing almost an instant rebound this week. But the whole episode revealed something about the speculative froth in market pricing, as opposed to considered assumptions about a clearly ongoing recovery. Mike Dolan of Reuters tells us more. (for everyone)
Also see: Wall Street rally wins more fans as economy hints at recovery
Others (for subscribers)
Tuesday’s analyst upgrades and downgrades
Wednesday’s analyst upgrades and downgrades
Tuesday’s Insider Report: Chair of this Canadian large-cap tech company unloads over US$22-million of stock
Wednesday’s Insider Report: Multiple executives are buying this large-cap dividend stock
Number Cruncher: Six utilities and two telecom companies with dividends and downside protection
Ask Globe Investor
Question: I am looking for an exchange-traded fund that pays a dividend every month to help make up for my lost job. I noticed that the iShares Diversified Monthly Income ETF (XTR) has a yield of about 5.8 per cent, which seems pretty good. However, it also has a management fee of 0.55 per cent plus a management expense ratio of 0.62 per cent. This adds up to 1.17 per cent, which sounds more like a mutual fund. Am I making a mistake in my calculation or is that correct?
Answer: You are making a mistake. The MER, which measures the annual cost of owning a fund, includes the management fee (plus the fund’s operating costs and taxes). So you’ll be paying roughly 0.62 per cent in costs annually to own XTR, not 1.17 per cent.
Now for the bad news. XTR’s holdings – which consist of eight other ETFs that invest in Canadian and U.S. stock and bonds – don’t generate enough income to cover XTR’s high yield. In 2019, roughly 46 per cent of XTR’s monthly distribution of five cents a unit consisted of return of capital, or ROC. (This information can be found in BlackRock Canada’s “Tax Information Centre” under “2019 Distribution Characteristics.")
ROC is the portion of a distribution that doesn’t consist of dividends, interest or realized capital gains. To generate its 5.8-per-cent distribution, XTR is augmenting the income generated by the underlying ETFs by paying you with a portion of your capital in the fund. This is money that would otherwise remain invested in the fund and grow over time.
When a fund pays out a significant amount of ROC, it often exerts a drag on the unit price. This is precisely what has happened in XTR’s case: The units, which closed Friday at $10.25, are trading about 10 per cent lower than they were a decade ago. That doesn’t mean investors lost money, though, because they collected distributions along the way.
The lesson here is that, when an ETF pays an unusually high distribution, you need to dig a little deeper to see how the yield is being generated. A large amount of ROC isn’t necessarily a bad thing, but you should understand that in exchange for receiving a high payout now you’re sacrificing growth in your capital over the long run.
--John Heinzl
What’s up in the days ahead
Rob Carrick tells us why you should jump on an annuity now if you’re interested.
Click here to see the Globe Investor earnings and economic news calendar.
More Globe Investor coverage
For more Globe Investor stories, follow us on Twitter @globeinvestor
You may also be interested in our Market Update or Carrick on Money newsletters. Explore them on our newsletter signup page.
Compiled by Globe Investor Staff