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Morgan Stanley’s chief U.S. equity strategist Michael Wilson made a bold statement in his Weekly Warm-Up research report, one that serves as a wake-up call for investors. In writing, “The cat is out of the bag. No longer can equity investors ignore this risk [of rising bond yields] and just assume rates will stay lower forever,” Mr. Wilson is warning of a wholesale change in global equity performance patterns.

The past decade has been characterized by consistently low interest rates and scarce profit growth. Investor assets have gravitated to the relatively few companies – notably the FAANG group of mega-cap technology stocks – that have been able to generate outsized earnings growth.

The end result was the dominance of expensively valued technology stocks in the S&P 500, mirrored to a lesser extent by the importance of Shopify Inc. in generating positive returns for the TSX. The big increase in market capitalization for these stocks pushed the benchmark’s average price-to-earnings ratio to levels well above the historical average.

Mr. Wilson thinks this is about to change, as rising bond yields indicate that we’ve entered the mid-cycle stage of the market cycle. “Our cycle analysis… [calls] for falling PEs this year,” he writes. “It’s what always happens at this stage of a recovery.”

The reason for the PE decline is that as the recovery takes hold, more companies will generate strong earnings growth. Investor assets will move out of expensive stocks and gravitate towards more attractively valued companies generating similar profit growth. Buying earnings growth at cheaper stocks prices will generate outperformance.

The strategist emphasizes that the average decline in PE ratios is 28 per cent at this stage of the cycle, over a period of years. The current forward PE ratio for the S&P 500 is 22.8, so Morgan Stanley’s estimate is that it drops to 16.4 times. For purposes of illustration, if the PE ratio declines all at once in 2021, it would represent a more than 1,000-point plummet in the U.S. benchmark.

This type of market volatility is unlikely, thankfully. The re-rating of U.S. stocks has historically occurred over multi-year periods, while profits (the denominator for PE ratio calculations) are growing quickly enough to cushion the blow.

The stock price pain of multiple compression will not be spread evenly among sectors. Mr. Wilson expects the ‘most egregiously priced’ sectors to be hit hardest and this puts a bullseye on technology stocks. Conversely, sectors with the most positive correlations to interest rates, like resources and banks, should outperform.

-- Scott Barlow, Globe and Mail market strategist

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Stocks to ponder

Intertape Polymer Group Inc. (ITP-T) This dividend stock has a unanimous buy recommendation from eight analysts and is benefiting from record sales at Amazon. Last week, the company reported a blowout quarter with its earnings soaring from spiking e-commerce activity. Jennifer Dowty has this profile of the stock.

The Rundown

The trouble with bitcoin: Why the crypto craze can’t last

Words of caution about bitcoin may seem quaint after a year in which its price has shot from less than US$10,000 to more than US$56,000, and financial institutions have rushed to embrace cryptocurrencies. But, investors thinking of including the crypto in their portfolios should take note: it has yet to stage a monetary revolution, and many warn the speculative rush is bound to end badly. Ian McGugan takes an indepth look.

Here’s what income investors should do as utilities sector comes under pressure

Tech stocks have been getting a lot of media attention. But the real concern for income investors should be what has happened in the utility sector recently. After starting the year strongly, the S&P/TSX Capped Utilities Index went into a slide in late January. It rallied back last week but is still down 5.3 per cent from its high of Jan. 26. The main culprit weighing on utility share appears to be interest rates - and the threat that they will rise further in the months to come. What should income investors do? Gordon Pape shares his thoughts.

Short sales on the TSX: What bearish investors are betting against

Short selling has been at some of the lowest levels in years on the TSX this month. Larry MacDonald looks at why, reports on how heavily shorted stocks are unusual outperformers right now, and lists the stocks with the highest short positions.

After shining through last year’s turmoil, high-profile tech superstars are suddenly in an increasingly troubling spot

Tech stocks performed brilliantly during last year’s bad times. The question now is how they will stand up to this year’s good times. Ian McGugan looks at the prospects for the big tech.

Also see: How to play the great reopening: Look to small caps, Canada and away from U.S., tech

U.S. energy shares look for next spark as investors eye recovering economy

Investors betting on U.S. energy shares have enjoyed a blistering rally, as the sector leads a move into value and economically sensitive stocks that has gripped the equity market. How much further that run continues could hinge on the success of the economic recovery, supply dynamics in oil markets and whether companies can stay disciplined on spending. Lewis Krauskopf of Reuters reports.

Others (for subscribers)

The most oversold and overbought stocks on the TSX

Monday’s analyst upgrades and downgrades

Monday’s Insider Report: Billionaire businessman invests an additional $2-million in this cannabis stock

Globe Advisor

The Financial Times: Have long-suffering areas of equity markets priced in life returning to normal?

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Ask Globe Investor

Question: Can you explain why my broker raised the adjusted cost base of my iShares Core S&P 500 Index ETF (XSP) units recently? I know it relates to a distribution from the ETF, but I’m concerned because I did not receive any cash, and the higher ACB caused the unrealized gain I had to evaporate. As a small retail investor, I am baffled.

Answer: What we have here is a case of a reinvested or “phantom” distribution, and I can assure the reader that many investors are just as baffled as he is by these non-cash payouts.

If you invest in exchange-traded funds, chances are you have already encountered a phantom distribution – or soon will. In 2020, more than 200 Canadian ETFs declared these under-the-radar distributions.

“It really has become a big issue over the past couple of years,” said Lea Hill, president of ACB Tracking Inc., a company that provides adjusted cost-base calculations for a fee. “Experience tells us that most investors, and/or their accountants, do not fully grasp the tax implications of phantom distributions received over the time they have held their positions.”

Let’s try to demystify the topic, using XSP as an example.

According to the iShares website, on Dec. 22 XSP declared a total distribution of $1.92382 per unit, of which 26.792 cents was paid in cash. The rest – $1.65590 – was classified as a reinvested distribution. (ETF providers typically publish estimates of reinvested distributions for each of their ETFs in the fall, with final numbers at the end of the year.)

So if that $1.65590 wasn’t paid in cash, what did the investor get exactly?

Answer: a tax liability.

Throughout the year, ETFs buy and sell securities. This triggers capital gains and capital losses, which the ETF tallies up at the end of the year. If the net result is a capital gain, the ETF distributes it to unitholders for tax purposes – but on paper only.

The mechanics of how the ETF does this are a bit complicated, but the key thing to understand is that the unitholder, in effect, receives a distribution that is immediately reinvested in the fund. After this paper transaction the investor still has the same number of ETF units, trading at the same price, as before the reinvested distribution.

In the case of XSP, if you refer to the “2020 Distribution Characteristics” for iShares ETFs published on the BlackRock Canada website (look under “Resources” and “Tax Information Centre”), you’ll notice that XSP’s reinvested distribution of $1.65590 exactly matches the ETF’s total capital gains distribution for the year.

For the unitholder, the reinvested capital gain will be reported on a T3 slip and taxed in his or her hands. To recognize that tax has been paid, the unitholder must then increase the ACB of the units by the amount of the reinvested distribution. Failing to do so could result in the investor paying more tax than necessary when the units are eventually sold.

Some brokers adjust “book value” or “average cost” figures to account for reinvested distributions. But my advice is to double check the broker’s numbers.

Keep in mind, too, that brokers who adjust book values may not get around to doing so until several months after the year-end distribution was declared. An investor who sells during that window might make the mistake of using the unadjusted ACB, Mr. Hill said.

“Thus, the investor would pay tax on the amount of the phantom distribution twice – once … through the T3 received, and again by failure to increase the adjusted cost base, upon [the ETF’s] sale,” he said.

As for the reader’s concern that the increase in his ACB eliminated the unrealized gain that was previously shown on his statement, that is true – but only for tax purposes. Bumping up the ACB didn’t actually change the original price he paid for his units; all it did was increase his cost on paper, which will reduce the capital gain (or increase the capital loss) he will have to report when he eventually sells his units.

--John Heinzl

What’s up in the days ahead

What should investors make of Rogers Communications’ takeover offer for Shaw? David Berman will have some thoughts.

Click here to see the Globe Investor earnings and economic news calendar.

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Compiled by Globe Investor Staff

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