Research Report: Upward Bias Bumpy Ride

BY: Richard Croft
Covid-19 was center stage throughout 2020 and will continue to frame expectations in 2021. The rise of new variants, the rollout of vaccines and the sentiment driven upward trajectory of financial markets, are influencing investor psychology. The overriding question being whether financial markets have gotten ahead of themselves.



Covid-19 was center stage throughout 2020 and will continue to frame expectations in 2021. The rise of new variants, the rollout of vaccines and the sentiment driven upward trajectory of financial markets, are influencing investor psychology. The overriding question being whether financial markets have gotten ahead of themselves.

Here is what we know:

  • Vaccines are our best hope for beating back the virus. The US, United Kingdom, and Israel are leading the way with aggressive vaccination protocols, ample supplies and broad take up among citizens. Interestingly, China is an outlier having had difficulty getting its citizens to roll up their sleeves. Not sure if that reflects distrust of the communist government, or a laissez faire attitude given the small number of cases in the country.
  • Global central banks have assured investors that they are unlikely to change course until sometime in 2023. Meaning that low interest rates and bond buying programs – albeit at a slower pace – should limit downside chop.
  • Governments are aggressively pushing stimulus packages aimed at re-distribution of wealth, low-cost daycare, and infrastructure improvements. The result is massive deficits that so far have been financed by central bank bond purchase programs that allow governments to borrow at zero interest rates.

With what we know, economists have been raising their forecasts for GDP growth with the latest data implying significant upward momentum. According to the Organization of Economic Development (OECD), “prospects have improved over recent months with signs of a rebound in goods trade and industrial production becoming clear by the end of 2020. Global GDP growth is now projected to be 5.6% this year, an upward revision of more than 1 percentage point from the December OECD Economic Outlook. World output is expected to reach pre-pandemic levels by mid-2021 but much will depend on the race between vaccines and emerging variants of the virus.”

Here is the challenge. Equity markets are forward looking, and to this point, have been bolstered by outsized re-opening expectations. Little attention has been paid to bumps that could shudder expectations because of unanticipated re-opening anomalies.

The risk is that any disappointment in the recovery resulting from say, the emergence of vaccine resistant variants, unexpected changes in tax policy, political shocks, or premature amendments to central bank policy, could rattle investors. With the S&P 500 up nearly 100% since the March 2020 lows mostly on the back of positive sentiment, it is vulnerable.

Sentiment is fickle and marginal headline noise reflecting quirky economic data can tip the fear / greed scale. Especially if headlines stoke inflationary fears, a distinct possibility given the stimulus induced expansion of the money supply.


Pandemic quirks will cause distortions in many of the so-called indicators of economic health. For example, average wages will decline as lower paid service workers re-enter the workforce.

During the pandemic, employees’ earning more than $60,000 annually worked from home and were not impacted as much by the pandemic. In fact, workers earning more than $60,000 per year have virtually recovered to pre-pandemic levels (see chart).

Those working in lower paying service sectors – i.e., hospitality, entertainment, and travel – lost their jobs and had to rely on unemployment benefits and wage subsidy programs. Most expiring in September.

As the economy re-opens those jobs will reappear and become part of the average hourly wage calculation. The US has regained about 1.5 million service jobs but that is still well below the 8.5 million that existed prior the pandemic. As the US economy moves towards full employment, we will see a decline in average wages that would normally indicate an economic slowdown. But in this case, it is heralding an upward bias to economic activity.

Another potential quirk is inflation. So far, the US Federal Reserve has dismissed inflationary bumps as transitory. A position that Chairman Powell reiterated at his Wednesday press following the FOMC[1] meeting.

The FED expects year over year inflation to bump higher in the next report skewed by base year biases and supply chain challenges. Which is to say, annual inflation data will rise as the pandemic induced deflationary data gets dropped from the calculation.

To appreciate base year biases, we need to understand how Consumer price index (CPI) is calculated. The CPI formula takes the average weighted cost of a basket of goods in a month and divides it by the same basket from the previous month. It then multiplies this percentage by 100 to get the number for the index.

In the early days of the pandemic, prices for goods in the CPI basket were declining through to the end of April 2020.

As the early pandemic datapoints get dropped inflation will spike higher on the back of a string of positive months. But this inflationary spike should be short-lived as the trendlines normalize (see table).

We see this playing out in the price of West Texas Crude. In the early days when pandemic restrictions forced lockdowns (January 2020 through April 2020), there were fewer cars on the road resulting in a sharp fall-off in oil prices.

Since November 2020, oil prices have rallied more than 50% (see chart) which is clearly inflationary. However, this too is seen as transitory and should abate as consumption patterns normalize by the third or fourth quarter.

Supply chain distortions are more difficult to quantify. Not so much as a reflection of their transitory makeup. The question is one of timing.  In the early stages of re-opening, there is expected to be an exponential rise in consumption. The challenge will be getting enough supplies to meet spiking demand. The question is how these imbalances will impact pricing? It could be dramatic as witnessed by the price surge in base metals and lumber.

Over time, business adjusts, and supplies ramp up to meet demand. The question is not will market forces return to supply / demand equilibrium, it is a question of when.

Some believe that the 1960s and 70s inflationary spiral may reappear given the massive fiscal stimulus and central bank quantitative easing. We think that is a stretch. For one thing, deviations in long term inflationary trends generally occur when business is caught off-guard as happened during the 1960s and 70s spiral.

From 1945 through 1965, US companies were able to increase productivity, provide job security, reasonable wage growth with no hint of inflation. After twenty years of post-war boom, the notion that inflation would be a problem was not on anyone’s radar.

The concept of just-in-time delivery did not exist in the 1960s, so companies had to maintain high levels of inventory. In the 1970s, the FED raised interest rates to quell inflationary expectations. Higher rates made it difficult for companies to finance overstocked shelves, which forced them to raise prices. The circular nature of the strategy lead to higher wage demands from unionized workers that had significantly more clout than today.

In 2021, central banks have more tools to manage inflation expectations. Proven strategies, better communication, global interfaces, a go big or go home mantra and quicker reaction times. Globalization, despite our previous caveat, has created more efficient supply chains with better technology eliminating the burden of excess inventory and punitive cost of carry metrics. And for the record, there is no way inflation will catch anyone by surprise.

Another post-pandemic quirk is the push to raise the minimum wage. Adhering to the rule that the best time to push an agenda is during a crisis, the Biden Administration wants to include a national $15 per hour minimum wage in its massive US infrastructure bill (It was also included in the April 19th Canadian budget).

There is a risk that rising labor costs over the next four years will cause distortions that are expected to be transitory but, have the potential to impact longer term trends. Just another worrisome tidbit that keeps inflation risk front and center for many economists.

That said, some large national companies have been front running the minimum wage initiatives. Walmart and Amazon announced pay raises, and higher minimum wages that took effect in 20 States as of January 1st.

But they have been the exception rather than the rule. Data from the Atlanta FED illustrate how wide the variations are. About a quarter of the workforce has seen wages shrink steadily for the past two decades, while another quarter posted an increase of almost 14% in the year through March 2021.

Divergences like these cannot be captured in average or aggregate figures. Nor can we know why companies like Walmart and Amazon took these preemptive steps. Was it to circumvent government scrutiny, or is it an attempt to aggressively hire before the labor market tightens?

Reading tea leaves in a fog creates headaches for policy makers, especially the FED, which increasingly views wage growth for low-income workers as a key measure of how close the economy is to full recovery.

Chairman Powell has been very clear: there will be no change to the FED’s dovish policy until the US has made substantive progress on the employment front. The latest employment report – outlining an increase of more than one million jobs – is a step in the right direction. But as Powell pointed out, it is just one report! It is not how the FED defines substantive.


We understand why investors are optimistic. The question is quantifying the risk associated with those high expectations so that we can assign probabilities about the merits of a particular position. To gain some perspective, we can look at sentiment indicators, some of which are concerning, others not so much.

The ratio of put option volume relative to call option volume has been below 1.0 since November 2020 (see chart). A six month stretch of below trendline is unusual and for many technicians is concerning.

The put call ratio compares the trading volume in put options with the trading volume in call options. Technicians use the put-call ratio to forecast market turns. A high ratio with heavy trading in puts – a ratio greater than 1.0 – indicates strong bearish sentiment and given the contrarian bias of the indicator, implies the possibility of a market bottom. A relatively low put-call ratio – a ratio less than 1.0 – with heavy trading volume in calls indicates bullish sentiment and a probable market top. As with many other technical indicators, the put-call ratio assumes that most investors are wrong.

We also have concerns about the well-publicized speculative excesses in meme stocks, SPACs and crypto currencies promoted by online chat rooms, pump-and-dump schemes and sometimes the result of exceptional research by individual investors.

Our concern is that the frothy speculation is becoming more widespread. According to Ned Davis Research, “Economic surprises continue to come in on the upside, just as they have for many months now. Yet at the end of Q1, the DJIA price-to-dividend yield finally got to the overvalued zone going back to 1920.” At the same time, “the S&P Industrial Average price-to-sales is at record highs, and our crowd sentiment composite shows excessive optimism, which may mean a lot of good news has been discounted.”

On the positive side, market breadth has been improving which can help offset the froth. Note the positive slope to the advance decline[2] lines for the S&P 500 index and the Nasdaq 100 index. Breadth among S&P 500 stocks has been moving higher since the beginning of February. Nasdaq breadth has been choppy but has been in a strong upward trend since the first week of March.


If the 2020 stock market taught us anything, it is the importance of staying in tune with the main indexes. In February 2020, the Nasdaq and S&P 500 were at record highs and the economy was practically at full employment.

The February 2020 peak shifted quickly with practically no indicative signals. Distribution, or selling by institutional investors, was not heavy. But on February 24th, 2020, the Dow Jones Industrial Average plummeted more than 1,000 points. Apple stock gapped below its 50-day moving average, days after the company warned that coronavirus problems would cause it to miss sales targets. With a break in the indexes and some leading stocks, the rout was on.

By April 4th, 2020, the S&P 500 made a follow-through that confirmed a rally attempt. Although the Nasdaq had lost a gut wrenching 1,500 points since February 25th, 2020, a double bottom set the stage for a major rally.

Staying the course was the correct approach as investors benefited from an astonishing rebound. The Nasdaq recouped all its losses in record time and added more than 30% from its February 2020 peak. Nasdaq ended 2020 with one of the five best years in its history.

The main indexes continued their bull run through the first quarter of 2021. There were some twists and turns as investors moved from growth to value to growth. Still as of the end of April 2021, equity markets have demonstrated exceptional resilience.


With investors betting on an economic expansion, any forecast for the remainder of the year must recognize the shift in market leadership. Cyclical and value stocks are expected to outperform as the economy emerges from coronavirus restrictions. And within this thesis, small cap value stocks have been particularly strong.

Since November 9th, 2020, when Pfizer (PFE) and BioNTech (BNTX) said their Covid-19 vaccine was more than 90% effective, the iShares Russell 1000 Value ETF (IWD) has been outperforming the S&P 500.

Interestingly, the switch from growth to value stocks follows the conventional playbook in a not-so-conventional time. If investors are anticipating the economy to improve and broaden out from pure stay at home plays, all else being equal, investors should gravitate to cheaper sources of growth.

According to State Street Global Advisors, the rotation to value and cyclicals shows up in index performance and ETF fund flows. Since the second week in December 2020, S&P value has out-performed S&P growth. That is a longer stretch than we have seen in years.

We are not diminishing the role of big tech names like the FANG stocks and Microsoft. It is simply a recognition that companies with a singular focus – i.e., Zoom, Door Dash and to a lesser extent Netflix – will be challenged during the re-opening phase.

The sectors we expect to benefit from a decline in coronavirus cases include consumer discretionary, particularly travel, restaurants, and retail. We also favor money center banks as they are well capitalized from regulations dating back to the 2008 financial crisis and should benefit from an improving economy and rising interest rates. Financials should continue to benefit in a cyclical recovery with accelerating earnings growth, increased dividend payouts and stock buybacks. Mind you all this hinges on keeping a lid on COVID-19 infections. If vaccine resistant COVID variants emerge bullish optimism will wane.


One of the strongest stock classes in the early stages of an economic recovery are small-cap stocks. Note the supporting chart that illustrates the performance of the Russell 2000 ETF (representing small cap stocks) relative to the S&P 500 Depositary Receipts (Symbol: SPY). Those numbers go a long way towards supporting the case for economic expansion in 2021. Small wonder that many analysts are bullish on this class.

We look for more upside in global small caps, which tend to lead in recoveries and expansions, but which have lagged the recovery in many leading economic indicators. That said, small-caps (measured by the Russell 2000 Index) are attractive trading at a 35% price-to-book discount when compared to large caps (measured by S&P 500 stocks) according to Bloomberg. That compares to the historical average of 18% price-to-book discount.

November 2020 was the Russell 2000’s single best month ever, and the outperformance of small-cap stocks versus large caps since then, is the highest since early 2000. And while it is true that early 2000 was a major market top, generally such extreme turns in performance between small and large caps leads to sustained momentum.

We are also seeing an improvement in small-cap fundamentals. The percentage of Russell 2000 companies without profits peaked in October 2020 at close to 50% according to Investors’ Business Daily. Since then, the trend has been declining. Analysts have raised expectations for 2021 which is a positive, but also concerning as seismic shifts like this have historically marked turning points. Hence the notion that 2021 could be a bumpy ride.


Stocks follow earnings which is why we said late last year, that 2021 should be a good year for equity investors. Most companies excelled at managing the pandemic economy by lowering operating costs. Lower costs and stronger sales suggest that, according to analysts, S&P 500 earnings will surge nearly 25% in 2021, more than double the 10-year average of 10% and the best increase since 2010 (when EPS soared 39.6%).

Naturally, the earnings surge will also benefit from base year biases. Remember we will be measuring 2021 against the appalling numbers posted in 2020 that saw a 13.6% decline in S&P 500 earnings. Still, 2021 earnings should top pre-pandemic results. The 2021 full year earnings estimates range from US $165 to US $185 for S&P 500 stocks. That tops the US $163 number for 2019.

We think all 11 S&P sectors will see a year over year earnings spike, led by industrials (78%) and consumer discretionary stocks (58.9%)[3]. The energy sector could see an even larger gain if its losses in 2020 are counted. In consumer discretionary, analysts expect seven of ten industries to report double-digit revenue growth, including the Covid-stricken hotels, restaurants, and other leisure industries.


The US FED has suggested that interest rates will remain near zero through 2023. We have opted to take the FED at its word although it may be challenged if the economy improves faster than expected. A point echoed by Bank of Canada’s Governor Tiff Macklem.

One must also recognize that the bond market has a history of acting independently hampering efforts by central banks to control the slope of the yield curve. To that point, we think ten-year treasury yields will end 2021 somewhere between 1.6% and 1.75%, just slightly above current rates.

We are witnessing a remarkable period for equity markets. For the first time in history, stocks have rallied for a year after being down more than 30% at a point during 2020. On average, stocks gain about 65% in the first two years of a new bull market, with an average gain of 41% in the first year.

But… that is a best-case scenario and will not come without a few bumps along the way. Especially as we enter the seasonally challenged May through August period.


In our mind, fixed income securities (i.e., government and corporate bonds) carry great risk. Short term interest rates are near zero with inflation running at 2% per annum. Ten-year government of Canada bonds are yielding 1.55% which means that investors holding these securities are losing 45 basis points in purchasing power annually. Considering that interest is taxed as ordinary income, the after-tax annual loss of purchasing power can be greater than 80 basis points depending on your tax bracket.

Since the onset of Covid-19, institutional investors (notably pension plans) have been shifting away from fixed income allocations into value stocks and REITs (Real Estate Investment Trusts) that offer above average dividends and distributions. Theoretically, shifting away from fixed income into equity allocations raises the risk quotient on the portfolio. But applying theoretical allocation metrics in an abnormal environment has not been working.

The challenge is that equity assets are more volatile in the sense that daily price action oscillates more than a fixed income security. But in terms of risk, we would argue that up or down daily price oscillations are less likely to cause angst than a steady downward sloping performance that has become the norm for bonds.

To mitigate daily oscillations, we frequently sell options – a strategy that we apply within the option writing, income, and alternative strategy pools – to enhance yield and reduce variability. The trade-off is limited upside offset by higher yields and regular cash flow that is paid out to our clients who are seeking income.

Consider one example that we believe makes our case. Have you noticed despite the strong performance of North American equity markets that; some stocks have been left behind? Notable among the group is BCE Inc. (TMX: symbol: BCE) which recently traded at $58.50. Well off the highs of August 2016 when the stock traded above $63 per share.

BCE is not a growth company. Because of its size and strategy, there are better places to seek growth. However, for clients seeking income within a diversified portfolio, the company is a strong candidate within our income-oriented pools that provides tax advantaged cash flow.

BCE is rich in cash flow with a management team intent on giving back to shareholders. Management has increased the quarterly dividend 17 times since the financial crisis. The most recent bump occurring in January where the quarterly dividend was increased to 87.5 cents per share. Given the trajectory of the dividends, we look at BCE as an alternative to bonds within our diversified pools. A strategy that is not as far-fetched as you might think.

You may recall that prior to the financial crisis BCE was in play. The Ontario Teacher’s Pension Plan (OTPP) wanted to use the cash flow from continuing operations to fund a portion of their pension liabilities. A strategy that looks and feels like a fixed income alternative.

The initial deal fell apart when two hedge funds that were partnering with OTPP were caught with a flood of redemptions at the height of the financial crisis. In the end, the hedge fund partners could not come up with their share of the capital necessary to take BCE private.

But that was then, and this is now! Since the fall out from the financial crisis BCE management has done exactly what OTTP thought was reasonable. Increasing dividends to the point that it looks and acts like a high-end income trust with a tax efficient distribution plan.

In the current environment, you could argue that what is bad for bonds is probably not good for BCE. All true to a point. However, with interest rates expected to rise, we know with certainty fixed income securities will fall in price. Such is the teeter-totter effect where bond and preferred share prices move inversely to the direction in interest rates.

For BCE, the linkage between rising rates and a lower stock price is not as clear cut. To begin with, the yield on BCE (5.938% given the most recent dividend increase) is well above the 1.55% rate payable on ten-year government of Canada bonds. As such there is some room to maneuver in a market where BCE’s income is also expected to increase. To that point, the variability in BCE’s cash flow gets reflected in management’s push to continually bump up the dividend, vastly different from the fixed interest payable on a bond.

Secondly, what is underlying the higher interest rate scenario, is a normalization of the economy which means more growth and perhaps, higher inflation. Any run up in growth is positive for BCE’s earnings trajectory and while an increase in inflation is not a positive, it is certainly not a major negative for the company. What we have then, is a company that looks and feels like a fixed income proxy in an income-oriented portfolio.

We can augment the quarterly dividend payouts by selling covered calls on BCE. The sale of covered calls increases the total return from the position. If the manager were to say, sell the BCE December 60 calls at 90 cents per share, the covered call adds the equivalent of another dividend in 2021. Under the current rules, income from the sale of an option is taxed as a capital gain. Thankfully, the government did not change capital gains inclusion rates in their April 19th budget.

Think of the premium received from the call option as an enhancement to an income strategy. Again, something that is not possible with a fixed income instrument. From a risk perspective, the sale of the call option provides some downside protection by reducing the per share cost base from $58.50 to $57.60 ($58.50 current price less the 90 cent per share option premium = $57.60 per share out of pocket).

The yield to maturity, keeping with our fixed income alternative analogy, over the next 8 months is 6.12% assuming the stock remains where it is currently trading. The pool[4] would receive three dividends totaling $2.63 per share plus the 90 cents per share option premium (see accompanying table).

[1] The BCE covered call strategy is an example and should not be interpreted as a strategy that has been established within our income-oriented pools.

If BCE shares are called, we would sell our shares at $60 in December. In that scenario, the return gets bumped to 8.73%. Again, calculated assuming the current stock price ($58.50), the sale price if assigned ($60), the premium received (90 cents) plus three dividends totaling $2.63.

As you can imagine there are many Canadian opportunities to exploit the covered call writing strategy. Some situations would even benefit from a higher rate scenario… notably the Canadian banks. The return if unchanged metrics are not as good as with BCE Inc. However, I suspect banks will begin bumping their dividend payouts – probably every six months – when the government allows them to do so. Probably sometime in the third quarter.

Presently, Canadian banks are flush with cash that will most likely get returned to shareholders. Unlike BCE Inc., I think the big five Canadian banks have more upside and the added security that will benefit from a rise in interest rates. Banks borrow short term and loan longer term. Any bump in inflation expectations will widen the gap between treasury bills and ten-year bonds and increase profit margins for commercial banks.

The covered call strategy works with any of the Canadian banks and has been one of the major plays within the CPC Option Writing pool. As an example, consider CIBC which at the time of writing, was recently trading at $127.90 with a dividend yield of 4.687%.

If one were to buy the shares and sell the CIBC January 130 call at $3.50 per share, there is an immediate benefit that the out-of-pocket cost for the shares is reduced to $124.40. Between now and the January 2022 expiration we should receive three dividends amounting to $4.38, assuming CIBC does not increase the quarterly dividend before the end of 2021.

The return if the stock remains at its current price through to the January expiration will be 6.33%. If the stock rises and the shares are sold at $130 per share, the return is 8.02%.

[1] Federal Open Market Committee

[2] The Advance-Decline Line (AD Line) is a breadth indicator based on Net Advances, which is the number of advancing stocks less the number of declining stocks. Net Advances is positive when advances exceed declines and negative when declines exceed advances.

[3] Source: Investors Business Daily

[4] The BCE covered call strategy is an example and should not be interpreted as a strategy that has been established within our income-oriented pools.

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Richard Croft, Chairman & CIO

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