We also expect to see more of a ‘stock picking’ market as opposed to broad gains for particular sectors.  The logic here is that low interest rates have lead to a ‘rising tide’ for almost all the growth sectors of the stock market for the last few years.  But corporate profit margins have probably peaked for this cycle so earnings growth will be more of an individual stock story.  The chart below shows how corporate profits as a percentage of GDP (gross domestic product, or the total output of the economy) have started moving down from record levels.  The only other times we saw profits this high were at the peak of the economic cycle in 2007 (prior to the financial crisis) and in the 1960’s.  So if we aren’t going to be seeing an overall upward moving in profits, then stock selection is going to become even more important to overall investment returns.

Corporate profits too high as % of GDP?

We have seen the benefits of strong earnings reports on stocks market returns in February.  Companies such as DH Corp, Magna, CGI Group and Open Text all reported earnings ahead of expectations and saw oversized relative gains for their shares while many of the banks, airline companies and retailers have missed expectations and the stocks have suffered.  Energy stocks have been a different story as expectations were so depressed.  In that group, the company’s plans for capital spending, debt reduction and resultant production forecasts have been the bigger driver of stock performance.  The recent results from Encana showcased such an event as the company cut their capex down to $900 million from an initial level of over $1.6 billion and reduced output guidance.  But the stock ended up rising by over 20% on the day.

Two months into 2016 we are still seeing high levels of stock market volatility, further weakness in the economic data, more disappointments on the earnings front and continued support form global central bankers.  The main difference versus the past few years though is that investors seem to be seeing this cocktail as a ‘glass half-empty’ rather than ‘half-full.’  What this suggests to us is that there is more money ‘on the sidelines’ waiting for an entry point than bullish investors riding stocks higher.  The recent Enbridge financing reflects some of this.  The fact that the deal was upsized to well over $2 billion and the stock still finished higher by over 5% on the day suggests that there is a huge investor appetite for stocks in sectors where they see more safety, yield and valuation support.

But there are still many risks to deal with this year.  One of worries hanging over the stock market right now is how the all in the oil price is going to put more pressure on sovereign wealth funds.  Sovereign wealth funds may withdraw $404.3 billion from global stock markets this year if oil prices remain in the $30 to $40 per barrel range, according to the Sovereign Wealth Fund Institute.  Wealth funds, which have amassed about $7 trillion in assets, exited about $213.4 billion of listed equities last year as the slump in crude oil put pressure on domestic finances.  Sovereign funds from Norway to Qatar and Saudi Arabia are seeking to counter the erosion of their finances after crude prices more than halved in the past year.  Saudi Arabia’s net foreign assets tumbled more than $19 billion in December as the kingdom withdrew reserves to help sustain spending.  These funds have been large buyers in the market over the past few years and were expected to be strong, long-term holders of shares, much like the larger domestic pension funds such as OMERS, Ontario Teachers, The Caisse du Depot or the BC Invesment Management Corp. in Canada.  But, if their domestic economies come under more pressure due to the oil price collapse, these funds could turn into net sellers of stocks, adding further downward pressure to prices.  However, we also heard the same thing about Japan selling their U.S. real estate holdings back in the 1990s when those markets collapsed.  In the end, the funds did tend to be somewhat ‘longer-term’ in their thinking and held firm with their positions.

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