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John Zechner
January 6, 2017
But let’s step beyond the vagaries of the press and see what other financial markets are starting to price in. Bond investors have been accused of being somewhere between ‘overly conservative’ to ‘downright bearish’ in their outlooks, but the reality is that bond market investors have done a better job of predicting economic and financial market events than their stock market cousins. The chart below shows that we have once again come to the ‘fork in the road’ where stock investors and bond investors see different paths. While the S&P500 stock index has continued to rally since early November, the Goldman Sachs FCI, which is an indirect measure of credit conditions, has been falling since late August and has clearly diverged from the path set by the stock market. If history trends hold, there would appear to be some risk in stock prices. However, funds flow into stocks has been strong recently, which could allow momentum to carry this divergence further for now.
Following on this theme of investment funds flows, it is clear now that many stock market investors were ‘on the sidelines’ prior to the U.S. election, holding higher levels of cash. Since the election, confidence has improved, the U.S. dollar has moved higher and the U.S. Federal Reserve raised short-term interest rates for the first time this year in December. In response to this we have seen a massive shift in funds from bonds to stocks, with the global stock market capitalization rising by $2 trillion in the last two months of 2016, while global bonds decreased in value by about the same amount.
Most of the gains in stock prices over the past four years had been due to the impact of lower interest rates. Price-Earnings multiples rose and investors paid much more for the slower growth, high dividend paying stocks. Nowhere was that more apparent in Canada than in the pipeline stocks such as TransCanada and Enbridge. Both companies have mid-single digit profit growth rates, at best, and had generally traded at about 12 -15 times earnings over most of the past three decades. Given their stable growth and dividend yield, the multiples on both stocks rose to trade well over 20 times earnings. Yield, stability and safety became the buzzwords for superior stock performance. But now we have begun to see a large shift from those defensive stock sectors (utilities, telecom, consumer staples, pipelines) to the cyclical sectors (industrials, basic materials, energy, financials) as investors factor in expectations of both stronger economic growth as well as higher interest rates. While this move accelerated after the U.S. elections, it is worth noting that this move had started back in July when interest rates hit their all-time lows. This shift in stock sector performance reverses a trend that we had seen over the prior four years and is shown in the chart below.
The rationale behind this move is the belief that economic growth is on the verge of accelerating will lift corporate profits, which had fallen for five straight quarters. While this move in the cyclical stocks may be accurately forecasting better growth, the valuations are getting excessive and subject to large downside risk if this expected growth doesn’t materialize!
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.