Keep connected
Our investment management team is made up of engaged thought leaders. Get their latest commentary and stay informed of their frequent media interviews, all delivered to your inbox.
While we’re harping on some of the shorter-term risk issues for the stock market, we shouldn’t lose sight of the fact that investors, like the government, have been on a bit of a ‘borrowing binge’ lately. The allure of record low interest rates and rising stock prices has lead investors down that path of borrowing to invest. It’s not exactly an illogical move since many common stocks have dividend yields that are higher than the cost of borrowing, meaning that investors effectively get a ‘free ride’ on the growth of stocks. The chart below shows the level of margin debt in the U.S,.compared to gross domestic product (GDP). The problem is that the last two times that the ratio of margin debt to GDP got this high were in 2001 and 2008, not coincidentally the last two peaks in the stock market.
Another point worth considering is that this recent bullishness occurs at a time when U.S. stocks are looking somewhat over-valued compared to the rest of the world, particularly the developing economies. U.S. nonfinancial stocks now command a 45% premium to their global peers on a price-to-book basis, the richest in 12 years and well above the historical 30% premium. Moreover, the stock market value is now 112% gross domestic product in the U.S., which is higher than 96% of readings since World War II. It also towers over ratios of 44% in Germany, 41% in China and 62% in Japan. These differences have yet to make much of an impact as global investors have been seeking the safety and stability they view as being offered by the U.S. market. The S&P500 Index is up over 24% so far this year versus gains of just 12% for the MSCI World Ex-US Index, 15% for the Stoxx Europe 600, and a 1% loss in MSCI Emerging Markets Index.
So we like stocks in the long term but are pointing out some shorter-term risks, particularly in the U.S. stock market, due to sentiment and valuation indicators. But short-term market timing is always a riskier strategy that can easily leave investors on the sidelines with cash while stocks continue to go higher, and vice-versa. If we like the long-term outlook then we should just stay overweight stocks and look for opportunities to shift between sectors and individual stocks rather than trying to time the entire market. That is the strategy we are using right now, staying overweight in stocks versus bonds but de-emphasizing the U.S. a bit more in the mix and adding to developing markets such as China and South Korea, which benefit from continued U.S. growth as well as the ongoing recovery in Europe. Also, despite the sentiment and valuations concerns about stocks in the short run, we are now right into one of the seasonally strongest periods of the year for stocks. The chart below shows the average monthly return for U.S. stocks over the last 70 years. While we can clearly see where the “Sell in May and Go Away” adage came from, we also note that we are now well into the 4th quarter, the strongest recurring quarter of the year, with December being the best month in that quarter. Is there another ‘Santa Claus Rally’ to carry stocks into a strong year end?
But the best argument in favour of stocks is that global growth is picking up. From 2.7% year-over-year growth rate in the second quarter to a projected 3.75% by late next year, the first conspicuous expansion in three years, the global economy seems to have healed its wounds from the 2008-09 recession. U.S. stocks shine brightest when global growth struggles and tend to lag during global booms. Between 2003 and 2007, U.S. stocks almost doubled, but trailed gains of about 140% in Japan, 125% in Europe, and nearly 400% in emerging markets. From an asset allocation point of view, the signs all seem to point to the idea that investors should shift some money from U.S. stocks to the ‘growth’ markets that have lagged over the past few years, which would include Canada as well as many of the developing world markets.
Our view that global growth is picking up steam is supported by the continued recovery in Europe. While many dismiss the importance of Europe in the global recovery, since its growth has been so low for so long, a recent study from Barclays Bank dismisses that notion. Contrary to popular opinion, their data data shows that Europe has a bigger influence on global growth than the U.S. While Europe struggles to raise its economic growth rate, when it does it provides a more powerful boost to the world economy than the U.S. A 1% increase in aggregate demand in Europe’s developed nations gives 33 of 39 international economies a bigger lift in their gross domestic product, than if the higher demand had occurred in the U.S. The impact of the European demand rise on the entire world is more than 0.25 percent, three times the U.S. effect. The explanation is that that Europe has a bigger economy with greater trade links and its banks are more exposed globally. The ripples extend as far as emerging Asian economies and to some in Latin America. While it is often believed that the U.S. cycle is a bigger source of global growth shocks, these statistics suggest otherwise. They also support our positive view on global growth and cyclical stocks.