At the beginning of last year there was a considerable amount of pessimism in regards to the direction of equity markets. Despite this wall of worry, equity markets rose sharply in 2019 with the US and Canada registering total returns of 31.22 and 22.77% respectively.
This is during a period when corporate earnings growth was mid to low single digits and when the US / China trade war was rearing its ugly head with numerous import tariffs placed by both countries.
Equity markets turned sharply higher after the US Federal Reserve Chairman, Jerome Powell, turned more accommodative in January 2019 when they admitted that the December 2018 rate increase was a mistake. In July the Federal Reserve actually cut rates for the first time in many years providing a catalyst for the equity markets to go higher.
The Federal Reserve is prepared to remain dovish even though the US economy and employment growth remain strong relative to most other countries and domestic inflation is starting to rise.
Earlier in the year the US yield curve turned inverted with short rates higher than long rates. However, for the latter part of last year, the yield curve turned positive once again with all global central banks having very accommodative interest rate policies.
Both investment grade and high yield US corporate bond spreads have remained at historically low levels.
Recently there was a survey of Wall Street market strategists. The consensus was the following:
Equity Markets will grind higher
Very little probability of a recession this year
But concerns persist – High Valuation and No Immediate Catalyst to Drive Markets Higher
2020 is an election year in the US with very contrasting economic policies from the left wing agendas of Bernie Saunders and Elizabeth Warren. On the other hand the extreme right wing policies of Trump makes for a very interesting election.
Personally, I think the election will be met by more centrist policies but anything can happen.
This week the US and China sign a Phase I trade agreement that will help to remove the uncertainty of global trade at least in the short term.
While most of the uncertainty of Brexit is still in front of the UK, there appears to be a wave of calm in the UK that can persist for a while.
Forward PE multiples in the US are currently over 18 times making this market not cheap by historical standards. The PEG ratio of the S& P 500, the PE divided by the future EPS growth rate, now stands at 1.8 times. This is the highest level in 25 years.
There remains considerable cash on the sidelines waiting for any type of pullback to get reinvested. In fact Warren Buffet’s Berkshire Hathaway has $130 billion of liquid cash available currently.
Under no circumstances do I advise you to liquidate all your stocks at this time. In order to reduce portfolio volatility, you can reduce your equity weight by increasing cash and you can also change your equity sector weights to take into account a possible recession.
Equity sector rotation continues to be a major theme amongst institutional investors. There are two types of sector rotation:
Switching out of defensive interest sensitive sectors like Reits, Utilities, Consumer Products and Telecoms into the cyclical groups like Financials, Energy, Consumer Discretionary, Materials and Industrials.
Switching out of high value Growth sectors like Technology into cyclical groups as summarized above
The main reasons for this sector rotation is to realize some profits in sectors that have high valuations currently that have outperformed the market into groups that benefit more from an economic pickup and that are much cheaper on a valuation basis.
I do recommend some switching as I have mentioned previously by the change in recommended sector weights for the eleven sub groups that I publish every month.
However, I do not want you to sell your entire positions in these quality dividend paying companies in defensive sectors. Many of the companies in these sectors should be core holdings like Alimentation Couche-Tard, Canadian Apartment and Granite Reit and Algonquin and Northland Power. Reducing your positions by some profit taking is a good strategy, but always maintain some exposure.
In regards to the high valuation Technology stocks, I would maintain my position as the projected growth in IT and artificial intelligence remains on track. Once again taking profits and rebalancing are good strategies as long as your investments in this fast growing sector are maintained.
Comparable to 1987, equity markets reached high valuations like they are today. A possible equity market correction of 5-7% this year is not out of the question even though the probability of an economic recession is very low.
I continue to recommend 25-30% cash for both portfolios at this time. Should equity markets experience any type of meaningful decline, I would use this as a buying opportunity unless the chances of a recession suddenly jump up sharply.
Peter McMurtry, BCom, CFA
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