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Stocks registered further gains in November as the recovery off the October 16th lows continued into November with major markets across the globe moving higher, and the U.S. market achieving all-time highs despite the drags from the resource sector. Canadian stocks, which lagged most major markets with only a 1% gain, were held back by losses in the energy sector. Central banks continued to support the upward move in stocks by announcing new easing programs; this included a reduction in interest rates by the Peoples Bank of China, which drove the Shanghai Stock Index higher by 16.2% in November. ECB head Mario Draghi’s promise to do “whatever it takes” to get economic growth turned around in Europe helped to push the DAX Index in Germany up by 10.1% in November.
The question now becomes; does this momentum continue into year end and give us the traditional ‘Santa Claus Rally?’ Seasonal trades have worked recently but we still have concerns over excessively positive investor sentiment, slowing earnings growth, slowdowns in Europe and China as well as record high valuations for many defensive sectors of the market. We believe that U.S. stocks are well overdue for a full correction even though they may have enough positive fund flow momentum to carry them through year end. It is probably still too early to buy the resource sector since foreign investors are aggressively liquidating positions while slower economic growth and a strong U.S. dollar keep downward pressure on commodity prices. On the other side, most of the non-resource sector is over-valued on all historical measures as the investor search for ‘quality and safety’ has driven prices to record valuations. Our strategy continues to be to sell into strength, reducing overall stock weights in favour of cash and preferred shares.
The chart below shows how U.S. stocks have not seen a correction of more than 10% in over three years, much longer than average. Short term pullbacks have rewarded the ‘buy the dip’ strategy on stocks and reduced overall investor fear and volatility. We continue to see this ‘excessive optimism’ as one of the key shorter-term risks for stocks. Trim Tabs data recently showed the highest flows of money into U.S. equity funds since late 2007, coinciding almost exactly with the peak in the stock market prior to the financial crisis. Data points like that add to our conservative investment stance.
Third-Quarter earnings reports showed solid profits but also some possible warning signs. While profit gains were generally in line with expectations, many blue-chip companies posted weak sales growth or outright year-over-year revenue declines, causing worries about their long-term growth prospects. Others are reporting earnings increases driven by factors that don’t reflect sustainable improvements in their business, such as share buybacks and cost-cutting efforts. Earnings for companies in the S&P 500 came in with a year-over-year gain of 8.7%, the sharpest rise in any quarter so far this year, according to FactSet. Profit margins grew to record levels, coming in at 10.1% of sales in the third quarter, well above the long-term average of 6-8%. Rising profit margins and increasing sales have driven profit growth since the recovery began in 2009. But revenue grew only 3.8% year-over-year in the third quarter, down from 4.4% in the 2nd quarter and below the 4.8% average of the last 5 years. Another cause for concern has been the explosion in share buybacks, which boosted earnings per share by 2.35%, the highest level in more than 2 years, according to Barclays. Though stocks remain far from bubble territory, they are expensive relative to historical levels. The S&P 500 is trading at 16.4x analysts’ expected earnings for the next 12 months, vs the average of 14.1x over the last 10 years and the 13.5x of the last 5 years.
The BAML Global Earnings Revision Ratio (ratio of the number of earnings upgrades/downgrades) was unchanged at 0.67 in November, which is a two-year low. We question the sustainability of the rally with the ratio well below the long-term average of 0.80. A depreciating yen has helped positive earnings revisions in Japan, but that has been offset by weakness in Asia Pacific (excl. Japan), Europe and Emerging Markets. The Utilities sector was the only one monitored where upgrades outnumbered downgrades.