McMurtry Investment Report Newsletter – February 2018
February 2018 – What is going on with Equity Markets?
Peter McMurtry, B.Com, CFA, Financial Writer for Do-It-Yourself Investors
Monthly Investment Newsletter https://mcmurtryinvestmentreport.ca
About a week and a half ago equity markets commenced a major reversal with the US S & P 500 falling at one point this week by over 10% from its high before recovering a little to close off just under 9%. The TSX followed suit falling by over 8% with Europe registering a 9% decline.
However over the last year the US market is still up over 13% on a price basis, while the Canadian is really lagging by declining almost 4% over the same time period. Europe and Emerging Markets are up by almost 16% and 23% respectively.
After such a powerful run in the US equity market following the Trump election victory and the recent passing of the US tax reform policy that significantly lowers US corporate tax rates, a period of reflection is not entirely unexpected. Before the recent equity decline, the PE multiple on the S&P 500 2018 EPS had reached over 21-22 times, high relative to the historical average of 17 times.
Differing from many retail investors, I have always believed that one’s investments must be properly diversified by asset class in order to provide stability to a portfolio in periods of extreme volatility and market declines. Many investors striving both for yield and capital growth have chosen a much higher equity weight than is warranted. Bond yields have been much lower than historical norms and this has heavily influenced many investors to become much more risk oriented than they really should be.
In my opinion, this recent market meltdown was simply a market valuation correction as opposed to the much more prolonged declines from a possible impending recession. There are numerous explanations for the decline as follows:
- Computer program selling based on algorithms that automatically triggered selling when certain market parameters were reached
- Double leveraged equity ETF’s that effectively sold twice as much upon a market correction
- US yr / yr wage inflation reached a high of 2.9% on an annualized basis
- US 10 year Treasury yield reached a high of 2.88%
- Inflationary expectations are beginning to rise based on higher wage inflation, lower US dollar and ongoing US trade protectionist policies that will lead to higher domestic inflation
- Rising interest rates imply that future earnings, dividends and cash flows are discounted at a higher rate causing their present value to decline accordingly
- US Quantitative easing is reversing itself causing Treasury bonds to be liquidated
- China, Japan and Europe are losing confidence in escalating US government deficits and are no longer buying as many US Treasury bonds causing yields to rise
There is no evidence of an impending recession as global economic growth remains robust and the US 2-10 year yield curve continues to steepen. In addition the US high grade corporate bond spread over US Treasuries remains historically low, implying no issues with credit defaults.
After the recent market meltdown the PE of the S&P 500 has fallen back to 18.3 times, only marginally higher than the historical long term average of 17 times. In addition the EPS of the overall market are rising much faster than expected based on continuing strong global growth, tax reform and a pickup in revenue growth as well.
Equity markets will continue to have their eye on climbing US interest rates and rising US wage inflation. I am not exactly sure how high the 10 year US Treasury bond yields have to go before causing more competition for stocks. My guess is that the 10 year US treasury yields need to reach 3.75-4% levels before equity markets experience another swoon in valuations.
At this point I recommend that investors use the recent market dip to gradually add 3% more equity to their total portfolios, all targeted into the US market. However there is no need to rush into new positions as the markets will most likely remain quite volatile over the immediate future.
The bond market is in the midst of a bear market and it is essential to keep bond maturities and durations at very low levels until the recent rise in interest rates has run its course.
The same logic can be applied to the interest sensitive areas of the equity market, namely utilities, telcos, REITS and pipelines. Taking into consideration that interest rates are only beginning to rise after many years of decline, it is very important to keep low exposure to these equity groups despite their attractive dividends. Earning a 4% dividend but losing 10% on your capital is not a good investment in my opinion.
There is another very important issue to address at this time. Canadian equities have sharply underperformed most global markets and this trend seems to be continuing.
Once again there are many explanations out there as follows:
- Ongoing uncertainty over NAFTA
- US corporate tax reform policies make Canada less competitive
- Ongoing pipeline disputes between BC and Alberta over environmental issues are causing Western Canadian crude prices to trade at one of the highest discounts relative to West Texas Intermediate on record
- Energy and base metal prices are beginning to reverse their recent uptrend, thereby exacerbating Canada’s much more heavily weighted cyclical equity market
- US dollar has been weak versus all global currencies including Canada. This hurts our competiveness in the midst of trade negotiations. Fortunately this trend seems to be reversing itself with the loonie dropping back below 80 cents US. for the first time in a long while.
As many of these issues will not be easily resolved in the short term, I am recommending in both my model portfolios a further reduction in Canadian equities relative to US. Last month I increased my US equity sector weight to 55% US and 45% Canada of the North American equity component. Now I am advising a further increase to 60% US and only 40% Canada.
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