Will 2023 be a good year in the markets?
No guarantees, but I think 2023 is shaping up to probably be a decent year in the markets despite certainly some risks associated with recession and inflation and more people unable to make their monthly payments due to higher interest rates and inflation – not to mention anyone that loses their job.
Why do I think 2023 could be a good year:
1: With the S&P 500 down 19% in 2022 we are starting from a much lower level from which it will be easier to make gains (but again, that’s absolutely not guaranteed).
2. Most importantly, it was the significant increase in interest rates that acted as a strong “gravitational force” on stocks and especially on medium and long term bonds in 2022. Now, even if interest rates stay at about current levels the stock and bond prices have already moved down to reflect the stronger “gravity”.
3. For the first time in years, we can now easily earn close to 4 to 5% on very short-term cash and near-cash investments. That will be helpful no matter what stock prices do. (Yes, inflation is running higher than that but that’s a topic for perhaps my next newsletter.)
In my last newsletter dated December 5, I wrote that it was probably a good time to invest. See that newsletter again for more reasons why I believe that and exactly how to instantly achieve a diversified and balanced investment for some or all of your portfolio.
AMBITION IS THE MOTHER OF SUCCESS
(I very recently wrote the following for another publication that I contribute to, so a few of you may have already seen it.)
Think about the role that ambition plays in the greatest success stories both in life and in business.
For example, Tiger Woods was groomed and strived for greatness in golf from literally the age of two. Donald Trump has his detractors, but no one would accuse him of lacking ambition. When you think about the most successful CEOs in recent or past decades (Steve Jobs, Jeff Bezos, Elon Musk, Bill Gates, Sam Walton, Warren Buffett and the other greats), they all obviously had great ambitions.
In my analysis of public companies, I have often been struck by the raw ambition of certain CEOs. For example Shopify was started by a then 23 year old Tobias (Toby) Lutke in Canada in 2004. It would not have become today’s enormous world-wide company without his enormous ambition. And Chip Wilson of Vancouver would not have grown lululemon into an international giant without being extremely ambitious.
I have marveled at CEOs that were already multi-millionaires, even billionaires and yet they keep striving for growth. Alain Bouchard at Couche-Tard comes to mind as does Alain Bedard at TFI International.
Some companies seem to have growth and ambition embedded in their DNA. For example, Canadian Tire and CN Rail have both cycled through a handful of different CEOs in the past couple of decades. Yet their approach and thirst for continued improvement and growth and their success has remained consistent.
On the other hand, I have recently been frustrated to see that some companies with mediocre results seem to be complacent. They excuse poor performance and blame it on outside circumstances or even on their own “legacy” operations. Often, they refuse to set out profitability goals and generally exhibit a lack of ambition.
Great Ambition is not a sufficient trait to ensure great success but it’s almost always a necessary trait. Great success will rarely, if ever, be found where there is no great ambition. Success in all areas of life tends to come from setting ambitious goals and striving to meet those goals.
But goals alone are not enough. I’ve often been skeptical of grand plans for growth. I was more interested in companies that could tell me about actual past success. “Don’t tell me, show me”. But if a company appears to be unambitious and complacent then I will certainly not expect much growth
INVESTMENT VALUATIONS AND INTEREST RATES
(In May 2022 I wrote the following for another publications that I contribute to, so a few of you may have already seen it. My newsletter to you dated March 26, 2022 also covered this interest rate math although not in this detail.)
Higher interest rates and rising inflation are now top of mind for investors. And for good reason.
It’s worth reviewing just how powerful is the force of higher interest rates on investment valuations. The impact of higher interest rates is most direct and easiest to see on bonds and any fixed income investments.
Consider the following: The market yield on a US 30-year bond hit the incredible low of 1% on March 9, 2020, as markets panicked about the pandemic. I guess the buyers that day did not stop to consider that this was literally a 100 year pay-back period! Today [today here refers to May 30, 2022 when I wrote this but the math still applies], the market yield on that same bond is 3% and the value of a $1,000 US Treasury bond purchased on March 9, 2020, and with 28 years left to maturity is down to $625. That’s a massive 37.5% loss on a so-called risk-free bond! And if the market yield on that bond hits 5% in a year’s time, that bond with 27 years left will be worth just $414. The impact of higher interest rates on long-term bonds is absolutely dramatic. And it’s an iron-clad rule. It’s like gravity.
Even more dramatically, consider what happens to the value of a perpetual fixed income stream as interest rates rise. The formula for the value of a perpetual is simply the annual amount to be received divided by the interest rate. Therefore a risk-free $1 annual interest income to be received in perpetuity is worth precisely $50 if the market yield on such perpetuals is 2%. The value then falls by precisely half every time the market required interest rates double. So, it’s worth $25 at 4%, $12.50 at 8%, and $6.25 if the market perpetual interest rate went to 16%. This is so brutal and ugly that it’s almost comical. But it’s true.
The same powerful gravitational force works on equity investments as interest rates rise. But it’s not as easy to see or usually as dramatic for several reasons: The market required yield on equities is never precisely known but it is higher than for bonds and does not increase as fast as interest rates. And the dividends and earnings on equities can be expected to increase to offset some of the impacts of the higher market required return.
As an example, consider a company that currently earns $1 per share and pays out 50% of earnings as a cash dividend. Let’s assume a 20-year holding period and that the earnings will grow at 5% per year. In 20 years, the earnings will be $2.65, and the dividend will be $1.33. Let’s also assume the stock can be sold at 20 times earnings after 20 years and that the market required return on this equity investment is 7%. The math indicates that this stock is worth $21.96 today under those assumptions. But if the market required return on equities jumps to 10% then the value of this share should immediately plunge to $14.25 for a capital loss of 35%.
The above math explains why stock prices have fallen as interest rates have risen and as the market turned its attention to the probability that interest rates will continue to rise.
END
Shawn Allen, CFA, CMA, MBA, P. Eng.
InvestorsFriend Inc.