National Post (Latest Edition)

Separate wheat from chaff

Learn to spot lasting value in COVID world

- David Rosenberg Financial Post David Rosenberg is founder of independen­t research firm Rosenberg Research & Associates Inc. You can sign up for a free, one- month trial on his website.

As we have progressed through the COVID19-induced recession, one argument has remained consistent from the bulls: despite all the virus, political and economic damage and uncertaint­y, none of it will impact the long- term earnings trend.

Indeed, equities are a long duration asset, and a hit to profits for one or two years has to be viewed through that lens. It’s also true that in the past 50 years, there has only been one period that S& P 500 profits have declined on a trailing 10-year basis. Yet, this hasn’t prevented bear markets or correction­s from happening over the years, meaning that valuations still matter.

The typical method used to evaluate this trend is the Shiller Cyclically Adjusted P/ E ( CAPE) multiple, which looks at profits over a trailing 10-year horizon. For the S&P 500, the current reading of 30x “normalized” earnings is just below the 31x reading back in January and ranks among the third- most overvalued periods in history.

We have applied the CAPE valuation assessment to the sector level to see what is happening beneath the surface. Even with this most recent correction from the highs, tech stocks remain in nosebleed territory with a CAPE ratio (44x) in the 88th percentile of its historical average. Consumer discretion­ary is even worse, with a 98th percentile reading ( 38x), while communicat­ion services (19x) rounds out the top three most overvalued sectors with an 85th percentile ranking.

To be sure, none of this is surprising as these three sectors have accounted for virtually all of the rebound off the March 23 lows ( growing to 50 per cent of the market in the process).

Surprising­ly, utilities (19x) are elevated compared to its own history, though this sector does offer more stability than the previous three (not to mention a solid 3.5- percent yield in a zero- per- cent T- bill environmen­t). Buying stability in a market with a less- than- stable earnings prognosis is probably worth the price.

On the other hand, energy, real estate and financials appear to be the most undervalue­d ( first, 23rd and 34th percentile, respective­ly). These sectors have fallen completely out of favour and are priced for no recovery.

The challenge is that they are probably right: there probably isn’t going to be much of a recovery beyond the Q3 bounceback.

Areas that we do like, namely, consumer staples (59th percentile) and health care ( 67 th percentile) are among the middle of the pack, and these are the areas that we feel investors should be focusing on given their “fair value” and defensive quality status.

In Canada, the TSX overall is not nearly as stretched in terms of valuations as the S& P 500, with a 19x CAPE ( 31st percentile). Though, underneath the hood, it is a similar story in technology ( 101x; 97th percentile) and utilities ( 32x; 98th percentile), but the recent up- move in value stocks have also pushed materials ( 30x; 97th percentile) and industrial­s ( 32x; 98th percentile) into nosebleed territory.

Energy stocks are equally unloved north of the border as the sector has become detested just about anywhere. Then again, who is profitable at these levels of oil prices with WTI stuck around US$40 per barrel?

Meanwhile, financials screen quite low compared to its average ( 13x; fifth percentile) and is one reason why it ranks among our most favoured sectors on the TSX. Communicat­ion services look attractive on this basis, ranking near the lowest levels in its history with a 5.1-per-cent dividend yield to boot. Additional­ly, as is the case in the U. S., consumer staples ( also ranking in our most favoured sector list) is in the middle of the pack in terms of “normalized” valuations, which does little to change our positive outlook on the group.

It is also worth highlighti­ng that despite the lower reading on consumer discretion­ary (19th percentile), we think caution is still warranted given that incomes are being supported primarily by government benefits, which tend to benefit staples (what we need) more than cyclicals (what we want).

Ultimately, while the argument that equities are a long duration asset is valid, it does not mean that the price an investor pays for that “normalized” profit stream is not important. Undoubtedl­y valuations are not an effective timing tool, but they do matter for future returns.

And, despite lofty levels of the CAPE ratio at the headline level on the S& P 500 (less so on the TSX), looking underneath the surface at the individual sectors reveals opportunit­ies still exist.

Canadian communicat­ion services and real estate ( industrial more than commercial) along with U. S. REITS ( selectivel­y), industrial­s, health care and consumer staples stand out as being attractive and not beset by an array of future challenges as some of the really “cheap” value sectors are at the current time.

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 ?? Gett y Imag es / istockphot­o ?? The usual method used to evaluate long-term sustainabi­lity is the Shiller Cyclically Adjusted P/E (CAPE) multiple, which looks at profits over a trailing 10-year horizon.
Gett y Imag es / istockphot­o The usual method used to evaluate long-term sustainabi­lity is the Shiller Cyclically Adjusted P/E (CAPE) multiple, which looks at profits over a trailing 10-year horizon.

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