But, in the end, stocks are just a proxy for the growth of the companies in the index which, in turn, is driven by the growth of the global economy.  The simple logic is that stocks should rise in line with the growth of the economy and the resultant corporate profits.   What changes with investment behaviour are the valuations attached to these stocks. On the valuation front, compared with bonds, stocks have not looked so cheap for half a century. European equities are cheapest level in the last 90 years relative to German bonds.  During this period, the dividend yield – the amount paid out in dividends per share divided by the share price, a key measure of value – has been lower than the yield paid by bonds (which moves in the opposite direction to prices). In other words, investors were happy to take a lower interest rate from stocks than from bonds, despite their greater volatility, reflecting their confidence that returns from stocks would be higher in the long run.  This has clearly changed over the past few years as now investors want a higher yield from equities.  If we look at the ‘earnings yield’ of stocks (i.e. total earnings as a percentage of the stock price), stocks are yielding over 800 basis points more than government bond today!   It’s not just government bonds either; corporate bonds are also the most expensive relative to the earnings yield of stock that they have been in decades, as shown in the chart below.  The chart shows spread (difference) between corporate bond yields and stocks earnings yields as well as the five-year average for this difference (dotted line).  Stock earnings yields traded below corporate bond yields for most of this period since investors also got growth from stocks so they could accept a lower yield.  The spread got as low as -400 basis points during the tech bubble when stocks were their most expensive.  But this spread has increased since the financial crisis in 2008 and now stands at a record level of over +400 basis points.  Basically investors have so little belief in growth going forward that they are willing to accept the much lower yield from bonds versus stocks of even the same company!

Stocks are Cheap

The lack of positive real yields on US government bonds has also started to drive investors into corporate debt in search of income, which is another reason why corporate bonds have done well recently.  It has also lead to the increasing popularity of ‘high income funds’ which focus more on corporate bonds and high yield stocks.  The fall in corporate credit spreads over Treasuries is something that usually occurs in an economic recovery.  But will the valuation differences eventually entice investors to move money into stocks?  While our view that longer-term bond yields will start to rise has yet to occur, we believe the economic recovery will eventually scare investors out of bonds once they realize that bonds can also have a negative return as interest rates start to firm up.  As confidence in the economic cycle becomes more widespread, money will flow to investments with positive real returns.  As some of these flows eventually make their way into stocks, PE (price to earnings) ratios should start to expand back to normal levels. This contraction of PE multiples over the last few years has taken stocks well below historical averages.  As an example, Global stocks are currently trading on a forward PE ratio of 11.5 times, 23% below the 15 level that has been the fair value range based on expected long-term earnings growth.

So does this make now a good time to invest?  Equities have not been so cheap relative to bonds since 1956, which turned out to be one of the best moments in history to have bought stocks.  We see similar reasons for long-term optimism today.  There’s a substantial amount of money sitting on the sideline earning almost no real rate of return but not willing to take risk yet.  This year Goldman Sachs published a widely read report arguing that: “Given current valuations, we think it’s time to say a ‘long good bye’ to bonds, and embrace the ‘long good buy’ for equities as we expect them to embark on an upward trend over the next few years.”  This report made headlines while markets were rising but has garnered little interest since stock prices peaked in late February.

Canada has been even more decimated than most stock markets due to our heavier weighting of resource stocks, which have borne the brunt of the downturn as investors worried about the global economy.  The chart below shows how the Canadian market starting doing better than the U.S. towards the end of the tech bubble in the late 1990s and the beginning of the bull market in commodities over ten years ago.  But that has reversed in the past year as investors worry that the bull market in commodities is over, primarily due to fears about growth in China.  While our bank stocks have held up much better than the U.S. banks, the same could not be said about the Energy and Basic Materials sectors, which have lead our market down sharply in the past year.

Canadian Stock Trailing US

So is the period of exceptional growth in China coming to an end and is the economy heading for a ‘hard landing’?  The history of the last decade has offered the Chinese government a valuable lesson: it is relatively easy to boost its economy but much harder to control physical and asset inflation.  This quick review of recent history explains why Scotia McLeod’s expert on China is staying away from the “China hard landing camp.”  First, the recent economic downturn and the cooling housing market are the intentional results of the harsh tightening cycle in 2010-11, including sharp increases in interest rates and much tighter bank lending criteria.  This contrasts with the view that the slowdown has been the result of any change in China’s secular urbanization trend.  With the urbanization ratio just crossing 50% last year, the powerful secular urbanization trend is still the friend of the China bulls.  Second, investors need to appreciate how much room to maneuver that the Chinese government still holds on these policies.  They have substantial foreign reserves and inflation has been sharply curtailed over the past 12 months.  Third, with the relatively quick response to the poor April macroeconomic data this time, the Chinese government might finally become convinced that the economic downside risk is now higher than inflation risk, and therefore begin to adopt a more aggressive easing agenda.  As such, this cyclical downturn has entered the third phase, during which investors should take advantage of, rather than concur with, the fear in the market for a hard landing of the Chinese economy.  While fears about China’s growth has lead many investors to believe that the great bull market in commodities is now over, our view continues to be that commodities remain in a secular bull market, but are consolidating within this secular bull market, much as they did during the financial crisis in 2008.  In terms of the longer-term urbanization trends and their impact on China’s (and other emerging economy’s) needs for basic raw materials, we believe that this secular bull market is positioned to last for at least another 7 to 10 years. 

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