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Canadian stocks in Canada rallied by 4.7% in October, the best monthly gain in 3½ years! Banks lead the way higher, gaining 6.5%, as fears about a housing slowdown in Canada dissipated. Rails stocks lead the Industrials sector higher as stronger economic growth and continued cost cutting helped both CP and CN Rail beat earnings expectations. The Technology sector was the only one to fall as CGI Group was hurt by their involvement in the Obamacare launch issues. Gold stocks also held back the index on late month weakness in commodity prices. U.S. markets were also higher on reasonable earnings releases while European indices continued their recent recovery.
October started off slowly, losing ground in the first week, but stocks have rallied again following end of the U.S. government shutdown. While the data releases since then have been spotty and weak (due in some part to delays in data collection when government employees were out), stock investors have seized on this by assuming that the fears about the tapering of government bond purchases (quantitative easing) would now be delayed into 2014. In a sense, stocks are at a point where ‘good news is bad news and bad news is bad news.’ What that means is that stronger economic data (good news) could once again raise the fears that the U.S. Federal Reserve moves closer to the dreaded tapering event, which could lead to a sell-off in stocks. But very weak economic data (bad news) is also bad since it means that the stimulus is already wearing off and the Fed has few options to get growth higher. Luckily, at least for those investors who have committed to stocks, the data has been mostly in this ‘Goldilocks’ range (not too hot; not too cold), which has allowed stocks to rally. Third quarter earnings releases have also supported stocks, as over 65% of companies reporting thus far have beaten earnings expectations and over 50% have beaten revenue projections. While companies are once again beating estimates based on share buybacks, low interest rates and stringent cost controls, the cynics continue to be unimpressed by the lack of revenue growth.
The earnings strength has been supported by profit margins moving to all-time highs along with a recovery in global economic growth. The chart below shows the BAML Global Wave, a composite indicator which measures the direction and momentum of global profits. After suffering the sharpest contraction in history during the financial crisis and the subsequent recession, the indicator had a V-shaped recovery in 2009-2010 before losing momentum again in 2011/12 on the Euro economic crisis as well as a slowdown in China. Over the past two quarters we have seen an upturn again in this indicator which sets the stage for stronger growth for the balance of 2013 and into 2014, with a consequent improvement in corporate earnings growth which should support higher stock prices.
Profit growth is really the best story supporting a longer-term positive outlook for stocks. While low interest rates will also be supportive of higher stock valuations, investors will need to see continued earnings growth in order to commit funds to the stock market. Our view continues to be that profits will surprise to the upside. Many of those who point to stocks being over-valued use long-term average profit margins as the basis for their work. Using “normalized” profit margins suggests that the current high rate of profitability will have to correct back down to longer-term averages, leading to some declines in profits and subsequent weakness in stocks. But we argue that companies are more adept now at maintaining higher profit margins using stock buybacks, more efficient management of cash, lower interest costs, higher productivity from more intense capital use, diversification of labour costs, streamlined sales processes and synergistic acquisitions. All of these tools are helping companies grow profits at a greater rate than they can grow their sales. This is not a ‘one-time’ or cyclical occurrence. The chart below shows the path of profit margins over the past 60 years. Profitability was on a downtrend for almost all of that time, hitting an absolute low following the end of the technology boom and the recession in 2001. Although profits also took a huge step down in the 2008 recession, the overall trend has clearly been higher for the past 12 years.
Yet profit margins in the ‘mid-teens’ remain well below the 20% levels seen in the 1950s, which was also a period of lower inflation. This is a key support for stocks going forward. If this profitability trend can remain in place, along with an expanding global economy and low interest rates, then the stock market can truly experience another longer-term bull market.