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Q2 2021 Commentary


2021-07-09, Joe Jugovic

Over a year has passed since the bottom of the pandemic-induced global bear market. While the last number of months remained challenging on the health front with many countries in the grips of a third wave, the financial markets continued to focus on the light at the end of the tunnel. Global indices and our funds generally produced positive mid-single digit returns in the quarter, resulting in attractive double digit performance year to date.


To date, we’ve witnessed a “V” shaped economic recovery, and a powerful one at that. The chart below is illustrative of both the sharp downfall and corresponding increase in corporate earnings over the past 18 months. As the chart shows, earnings fall significantly during recessions and rebound considerably in the recovery phase. What has stood out with this recent occurrence is the sheer magnitude of the snap-back in earnings.

Source: FactSet, Compustat, Standard & Poor’s, J.P. Morgan Asset Management

Stock markets are forward looking and earnings are a big driver of returns. This year’s recovery has outpaced those following the two previous significant bear markets in 2001 and 2008 and, correspondingly, so has the market performance. One of the reasons investing in the midst of a recession has historically been so fruitful is the investor’s opportunity to take advantage of these highly variable earnings swings. When earnings collapsed last year, so too did the market, offering us the opportunity to invest at attractive prices based on normalized earnings. A low risk/high reward period.

This is illustrated in the following chart which shows the price to earnings multiple (P/E) of the U.S. market. Valuation multiples simply reflect the willingness to pay more or less for a business or an asset over time. When investors are fearful, they won’t pay as much. When they are optimistic, they’re willing to pay much more. Historically, valuations have proven to be an excellent factor in indicating long-term returns as well as providing a margin of safety. Last year, very briefly, the entire market was very attractively valued… today is a different story with the broad S&P 500 Index trading at near record multiples (more on that a little later).

Source: FactSet, FRB, Robert Shiller, Standard & Poor’s, Thomson Reuters, J.P. Morgan Asset Management


Now that last year’s significant uncertainty has abated and the high velocity V-shaped recovery has occurred, we are likely transitioning into a mid-cycle economic expansion. Why does that matter for investors? Historically, the largest market returns come from those periods of fear and uncertainty (i.e. the past 12 months) in which the combination of future earnings recovery and multiple expansion offer significant potential.

At the current cycle transition point, however, equity returns are typically driven by further gains in earnings as opposed to further valuation expansion. Referring to the first earnings chart again, there are often years of continued earnings growth following a recession, just at lower and often uneven levels.

During a mid-cycle expansion, the market opportunity is less robust – downside risks start to increase as expectations grow alongside valuation risk. As the previous valuation chart shows, the multiple of the market has increased by over 50% and sits at elevated levels (with high hopes). Investors need to be more selective.

High expectations define the psychological juncture at which we now find ourselves. In past letters we alluded to the speculation taking place in select areas of the market, but hadn’t seen data showing sidelined cash getting put back to work … until now. The chart below shows the tidal wave of cash being invested back into equities. Strategists at Bank of America estimate that if the pace of inflows continues at the same clip for the remainder of the year, equity funds will take in more money in 2021 than in the previous 20 years combined!

Source: BofA Global Investment Strategy, EPFR, Financial Times

These flows can and do add a tailwind to the equity markets. Historically, significant money flows have chased performance rather than precede it. Combining this recent huge shift towards equities with the speculation in other areas raises some concern. But as with most things associated with investing, it’s not that simple. This onslaught of capital into equities is likely just as much a reflection of lacking acceptable alternatives as it is to unbridled optimism.

Historically, investors have been able to generate a reasonable return investing in the bond market and with much less volatility. The chart below shows the investor’s dilemma. The blue line is the nominal yield – meagre, but still positive. The black line is the real yield, which considers the return to the investor after accounting for inflation. Six decades of data illustrate only a few times where the opportunity to generate a return has been this poor. The current negative return shows a loss of purchasing power. Until this changes we will likely continue to see significant flows into equity markets.

Source: BLS, FactSet, Federal Reserve, J.P. Morgan Asset Management

The million dollar question is when will it change? When will yields potentially move higher and offer a reasonable alternative to stocks, and what will be the cause? On the flip side, it would be detrimental to equities if the recovery failed and inflation were to drop significantly due to economic weakness. The U.S. Federal Reserve’s assertion that current inflationary forces are only transitory had better be right. They have all but guaranteed the markets that they will remain accommodative for a prolonged period of time. As long as interest rates stay at these near zero levels, they provide no competition to stocks and desperate investors looking for a better than negative real return are forced to march up the risk ladder.

We consider the possibility that inflation may turn out to be stickier than the prevailing consensus and persist at a higher level than policymakers are assuming. The American economy has significant momentum – consumers which make up 70% of GDP are in a better position coming out of this recession than at any time in recent history. Construction is booming and labour shortages are common. Yet the Federal Reserve continues to keep emergency policies in place while the economic emergency has passed. The policies have led to significant asset inflation, including real estate, stocks, bonds, art, digital currencies etc. Still, they fan the flames. We see a risk that policymakers may have to change their tune at some point, sooner than later. This doesn’t mean the end of the cycle, but it does mean potentially significant volatility and a shock that investors don’t seem to be ready for given how sensitive our economy/markets are to extremely depressed interest rates. The offsetting factor here remains the continued unknowns, including COVID variants and the fact that most countries globally are in a much more challenged position than the U.S.


In our balanced strategy, we took the opportunity to rebalance our equity allocation lower, but remain overweight relative to our history. In our equity strategies we are invested in resilient business franchises that trade at a valuation advantage to the broader markets. Our bond portfolio remains well-balanced between corporates for yield and governments for defensiveness and liquidity. We expect our consistent approach to risk-managed investing to continue to be well rewarded in what may become more challenging markets as we move through the cycle.

All views and projections are the expressed opinion of QV Investors Inc. and are subject to change without notice. This Update is provided for informational purposes only. QV Investors takes no legal responsibility from any losses resulting from investment decisions based on the content of this Update.


Joe Jugovic | Advising Partner

Joe fulfills an important mentorship role in the ongoing development of QV’s investment team.