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How likely is it that the S&P/TSX outperforms again in 2023? We think a look at sector weights in each index may help answer that question.
With the S&P/TSX weighted 61% to Financials, Energy and Materials, conventional wisdom holds that the TSX is a highly concentrated index, while the S&P 500 is much more diverse. However, the S&P 500’s weighting in mega-cap tech should raise similar concerns over concentration. Entering 2022, the S&P 500 held a 25.5% weighting to the combination of Microsoft, Tesla and the FAANG stocks, which has since fallen to ~21.5% currently.
As we look out at 2023, it is worth considering a bit of history. In the twenty years from 2002 to 2021, the S&P 500 outperformed the S&P/TSX about 55% of the time (11 of 20 years). In the last ten years, however, this has risen to 90% (9 of 10 years). For these twenty years, we highlight:
- The TSX Rule of Three: When two or more of the TSX subindices for Financials, Materials and Energy posted positive annual returns, the index has outperformed its twenty-year average return of 9.9% about 85% of the time (11 of 13 years). When all three sectors were positive, the figure rises to 100% (8 of 8 years).
- The Rule of Three and the S&P 500: When two or more of the same TSX sectors posted positive returns, the S&P/TSX has beaten the S&P 500 about 54% of the time (7 of 13 years). When all three have been positive, the figure rises to 63% (5 of 8 years).
- When the S&P 500 Info Tech Sector slows: In years where the S&P 500 IT index posts sub-20% returns, the S&P/TSX has outperformed about two thirds of the time (8 of 12 years).
Given this backdrop, we think the TSX is better than 50-50 to outperform the S&P 500 in 2023 for at least three reasons:
First, the S&P 500 IT index is down 23% YTD, but 2022 follows three roaring years which saw the IT index climb 191%, from the end of 2018 to the end of 2021. Given a weaker global economic outlook and stretched valuations for IT names, we think FOMO will reverse and weigh on IT valuations in 2023.
Second, we think a deep global recession is less likely than the combined probability of a mild recession or modest economic recovery in 2023. Absent a deep recession, we see good prospects for both Energy and Materials in 2023. Significant underinvestment in recent years has kept commodity supplies tight. As a result, even if economic conditions worsen, commodity prices may hold up better than expected, particularly if China’s reopening trajectory improves.
Lastly, our greatest concerns are tied to Canadian financials, which are likely to face increased credit provisions as higher rates weigh on consumers and the housing market. This does not preclude a positive year for the sector, but potentially reduces it to a 50-50 proposition.
In our view, the most likely outcome looks like a two-out-of-three sector year for the TSX with weaker than trend returns for S&P 500 Info Tech. The combination increases our confidence that S&P/TSX will continue outperforming the S&P 500 in 2023.
As always, we continue to invest in high quality companies with strong free cash flows, clean balance sheets and capable management teams. Our affiliate, Veritas Investment Research Corporation, continues to provide us with compelling investment ideas and remains one of the best research shops on the street.
Year-to-date through October 31, 2022, the NASDAQ was down 29.3%, the S&P 500 was down 17.7% and the S&P/TSX was down 6.2%. Over the same period, our Canadian Equity Fund fell 3.8% and our Absolute Return Fund was 8.8% lower. (Performance based on F series).
We remain focused on capital preservation during the current market volatility while pursuing opportunistic investments to drive returns.