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Another area of concern in the stock market is the continued breakdown in the ‘small cap’ indices. A real bull market should see expanding participation in the advance with traditional ‘breadth indicators’ moving to new highs along with the overall stock averages. We have seen pretty much the reverse of this over the past year. In the U.S., the S&P500 Index finished the year almost 8% higher than its July peak while the more broadly-based Russell 2000 Index finished right at those same July levels, despite a good bounce off the October lows. The ‘stock averages’ are clearly doing better than the ‘average stock.’
The difference is even more pronounced in Canada where the large-cap TSX60 Index finished the year with a gain of 9.1% and the TSX Composite Index was up 7.4%, but the TSX Small Cap Index actually fell by 5.2%! It doesn’t help that the small cap index in Canada is made up mostly of resource-based companies, and those certainly did worse than most other sectors since their peak in early 2011. The chart below compares the TSX Composite Index to the TSX Venture Exchange. While both indices rallied sharply off the 2009 market low, the Venture Exchange has struggled more recently, dropping almost 70% from its 2011 high. Weak global commodity prices have certainly not helped but the stocks have also seen mass liquidation from foreign investors amid struggles to meet capital needs.
This problem in the resource sector could now start to impact the rest of the economy as the pain spreads into energy as well. The majority of capital spending in Canada is related to the energy sector, and this will clearly be slowing down. This will also impact lending activity in the financial sector.
Canadian banks have struggled over last two months, starting with the breakdown in the energy sector and then 4th quarter earnings results which were ‘in line’ at best. While we don’t feel we are on the edge of any ‘major risk event’ with the banks, we do have to acknowledge that valuations are at the high end of the historical range and there are some disturbing trends in the outlook. While we’re not worried about the credit exposure to the energy sector, we have to be aware of the ‘revenue impact.’ Banks generate substantial fees from underwriting and loans to this sector and those will clearly be headed lower. This will also impact trading revenue for the capital markets activities of the major banks. Domestic loan growth has also slowed down and this could persist for a while as the real estate market slows down. Expenses have also risen sharply over the past few years; while some banks have started to shed some operations (CIBC and RBC in Caribbean) and undergone domestic layoffs (RBC and ScotiaBank), there have been substantial increases in regulatory and technology costs in an environment that has become much more competitive. Credit conditions have been about as good as they get over the last few years as well and we don’t see that trend continuing. The bottom line is that earnings growth is going to get a lot more challenged at a time when bank valuations are high. Not a great recipe for stock market gains for the group!