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While the old adage says that ‘stocks can remain mispriced longer than most investors can remain liquid’, the reality is that stock prices always return to trend lines at some point. While we will never know for sure when the market is going to peak, we can certainly indicate times when risks are elevated due to excessive valuations, rampant speculation and artificial supports for the market. We continue to see us being in one of those periods right now!
Finally, just to throw in one more ‘market top’ indicator, we have to recognize that investors become most bullish and fully invested at the top of any market move. That is just logical since markets would peak when investors are ‘all in’ and there are really no more new buyers on the sidelines. Measuring that time is always controversial but one measure of investor enthusiasm for stocks is their willingness to borrow funds to invest in stocks. The chart below shows the level of margin debt (i.e. borrowed funds) in the U.S. stock market. While record low interest rates have increased the attractiveness of borrowing to invest, the history of this indicator is that it coincides with overall peaks and troughs in the stock market. We can see in the chart below how borrowing peaked during the two prior stock market peaks, in 2000 and 2007. We can also see how this level of borrowing has been rising for the past six years but has stalled out a bit recently. Whether this is signaling a peak in stock prices won’t be known until after the market has turned down, but the chart clearly indicates that this measure is pointing to another period of heightened risk. It could go on for some time but the risk for a pullback is certainly well in place. This is just another reason for us to be cautious on the outlook.
Given all the points mentioned earlier, it should come as no surprise that we are maintaining a pretty cautious investment stance. Cash positions are at maximum levels and stock weights are at minimum levels. Within the stock market we remain underweight the resource group, as we believe we are still coming out of a ‘commodity price bubble’ much like the ‘technology bubble’ that ended in 2000 and took over 10 years to hit a final low. Excess investments from non-industrial players helped to create excess supply while a slowdown in emerging economies has dampened demand. Canadian companies that we like include those that can benefit from a lower Canadian dollar and have broader global footprints for growth. Magna and Martinrea have attractive valuations in auto parts, Canadian Pacific can benefit from further cost reductions and industry consolidation and is also tied to North American growth. CGI Group is our top pick in the technology sector as it benefits from U.S. government contracts and has been adept at acquisitions. In Health Care we like the AMCo acquisition by Concordia Health despite the large debt load. Excess cash generation will be used to pay down debt, while the company had added good growth potential in new drugs and trades a very attractive P-E ratio. In the U.S. we continue to like the large technology/media names such as Apple (for its growing ecosystem and lessening dependence on device sales), Alphabet (core Google can now be seen as having higher growth and being more profitable than thought), Disney (despite loss of ESPN customers from unbundling, the company will benefit further from continued growth of existing platforms and the cross-selling of content) and FedEx, as a clear beneficiary of both lower fuel prices and increased online selling. Outside of stocks, we like the yields available in the Canadian preferred share market and are less concerned than most investors about ‘rate reset’ preferred shares since we believe that interest rates will move back to ‘normalized’ levels over the medium term. While December is traditionally a strong month for stocks, we wouldn’t want to count on seasonal patterns in a year when risk levels are so high. Cash may not look like the best investment right now, but it certainly beats negative returns and we see that risk as being very real over the next year.