February 2024 Commentary

Over the past year, equity markets have rebounded from
the price weakness experienced in 2022. The market
correction that commenced in November 2021 led to
significant declines in equity markets over the subsequent
year. The US S&P 500 fell by -12.2%, while the Canadian
TSX Composite experienced a more modest decline of –
5.8%, buoyed by its heavy exposure to the then robust
energy sector. However, during the rebound, energy
markets weakened, causing the TSX Composite to rise by
11.8%, while the technology-driven S&P surged by 23.3%.
It’s important to note that all these returns are denoted in
Canadian dollars.

What insights can be gleaned from these fluctuations? Not
much. The US and Canadian markets are vastly different,
the latter being highly concentrated in financials and
cyclicals while suffering from a very narrow opportunity
set.

The primary driver of equity markets is valuation,
specifically the discount rate applied to future cash flows.
As interest rates surged from historical lows in early 2020,
equity valuations contracted. This contraction had little
correlation with the profitability of the companies in the
index or any indications of slowing growth in their
respective markets.

To illustrate this, consider the US 10-year bond yield. Forty
years ago, in 1994, the yield stood at approximately 13.5%,
gradually declining to a low of 1.4% in 2012. Subsequently,
over the next eight years, the yield fluctuated between
1.5% and 3.0%, reaching 1.7% in January 2020, before
plummeting to 0.5% in March 2020. It then rebounded and
steadily rose to the current level of 4.2%.

As for how long the current rates will persist, it’s anyone’s
guess.

The Federal Reserve employs interest rates as a tool to
regulate the economy. If domestic growth becomes too
hot, leading to inflation, interest rates are raised to cool
things down. Market observers closely monitor statements
from the Fed for hints regarding the direction of rates.
Therefore, when inflation data began to trend downwards
in the fourth quarter of 2023, aligning with the Federal
Reserve’s preferred inflation gauge of 2%, the central
bank’s narrative shifted from expectations of higher rates
to the possibility of rate cuts in 2024. This shift contributed
to strong performance in both equities and fixed income
markets in December and into 2024.

Furthermore, in January of this year, US gross domestic
product experienced robust growth of 3.3% in the fourth
quarter, surpassing expectations. Yet, the yield on the 10-
Year Treasury retreated to 3.95% from its peak of 5% in
October. This suggests increasing market confidence in a
soft-landing scenario, where inflation decreases while the
economy continues to grow.

When lower rates eventually materialize, we anticipate
that it might broaden market performance and provide
support to the overall equity market beyond the dominant
players. Although we observed increased market
participation towards the end of the fourth quarter in
2023, major tech companies continued to dominate and
accounted for most of the major index returns in the US.
What implications does this hold for the small-cap asset
class? In the past, we’ve noted that large-cap stocks,
particularly in the US, have outperformed small-caps for
over a decade. However, this has led to relatively attractive
valuations for small-cap stocks. Presently, the trailing
price/earnings ratio of the S&P 500 stands at 24.5x,
compared to 17.9x for the S&P 400 mid-cap index and
14.4x for the S&P 600 small cap index.

We believe investors should be paying more attention to
small cap stocks as an attractive asset class than has clearly
been the case during the past several years. While there
will be bouts of volatility ahead, history has shown it pays
to be positioned early when the tide turns, and market
conditions improve.