Second Quarter Wrap-up
After a very strong first quarter in global equity markets, the second quarter continued with a positive return, although the momentum certainly waned. Unfortunately, the Canadian stock market had a rough second quarter, with the S&P/TSX Composite falling 2.35%. On a total return basis (including dividends), the Composite is now up just 0.7% year-to-date. The primary culprit is a reversal in the fortune of the Energy Sector that we saw last year. The TSX Capped Energy Index fell 13.8% the last three months and is now down 22.1% year-to-date. The TSX Capped Materials Index is also down slightly year-to-date, so the second and third largest sectors of the Canadian market are certainly weighing the rest of the market down. With a higher weighting in cyclical sectors, we know our market can be more volatile than our neighbors to the south, so international diversification is important for long-term portfolio management success; something we discuss often.
For the rest of the developed world, returns have been fairly strong this year. The MSCI All Country World (ex-Canada) index (CAD) is up 6.93% at mid-year. This number would be much higher if it weren't for the Canadian dollar which has been strong this year, up 3.7% against the Greenback and 4.8% against the Euro. The reason for this is likely due to economic data in Canada coming in stronger than expected, especially in the last couple months, and additionally that the Bank of Canada just raised the overnight rate by 25bps for the first time in almost seven years. Market movements are about expectations, and earlier this year the probability of this raise was close to zero, so this change of expectation is what has driven the Loonie higher. Forecasting currencies is difficult with so many factors at play, but we view the Loonie potentially showing some further strength in the near-term, pushing up to the 80 cent U.S. level, though it is our base-case scenario that this may be near the top of its trading range for the balance of 2017.
In bond markets, the FTSE TMX Canadian Bond Universe index has advanced 2.36% so far this year, but did pull back 1.2% in June with the Gov't of Canada 10-Year Yield jumping from 1.41% to 1.75% in one month. This is a big move and one that can rattle a bond portfolio with a high duration and interest rate sensitivity. Our portfolios were adjusted quite some time ago to be less rate-sensitive, which means lower duration and higher yield.
Lastly, on the commodity front, it has been a tumultuous ride indeed. After a brutal 2014-2015, and a strong 2016 rebound, crude oil and natural gas prices are down over 14% and 15% respectively, in U.S. dollars, this year. On the other side, Gold prices are up 7.7% year-to-date. Overall, the broad-based Thomson Reuters/CC CoreCommodity Index (USD) is down 9.2%.
Milestone strategy and outlook
We continue to reiterate our intermediate to longer-term positive stance on global equity markets. We are also seeing growing evidence of stronger economic growth on a global scale, and not just from the U.S. We are not dismissing the possibility of a continued near-term pause or even small correction due to current overbought conditions for global equities (not Canada). As Canaccord's U.S. Equity Strategist, Tony Dwyer, has described, and we agree, the outlook remains positive because: 1) our positive fundamental core thesis driven by credit remains in place; 2) a synchronized global recovery and domestic economic rebound continues; 3) corporate earnings and market valuations remain in an uptrend; and 4) the possibility of corporate tax cuts.
We will add to this by stating that what we are seeing through our lens is a global synchronized expansion, one that grows at about 2% per year. Outside of unforeseen geopolitical risks, we see low volatility as a normal feature of the benign economic and financial backdrop, and not as a warning sign. Market participants continue to be underweight equities and overweight fixed income, and we believe this will further support equity markets as the secular bull market continues, and especially now that equity markets appear, for the first time in years, to be supported by fundamental measures. If we continue to see rising interest rates, this could gradually push bond investors into other parts of the capital structure, like preferred share and equities. Although we believe rates will likely continue to rise, we believe it will be a slow ascent and that rates will ultimately not move to levels we have seen in past cycles.
We have posited in many of our recent commentaries that we are transitioning from an interest rate bull market to a fundamental earnings driven bull market, and so far this transition has been positive. In this environment, we believe earnings growth will be one of, if not, the largest driver of equity prices and valuations; this is an earnings story as opposed to just a sentiment story or an asset class that looks the best relative to its peers. So far the evidence of acceleration earning growth has proven positive. In addition, with improving fundamentals overseas, we are now seeing more opportunities in Europe and emerging markets whose valuations appear attractive on a relative basis.
We discuss the media often as they prefer to highlight negative news or promote the pessimistic prognosticators. We don't mind this, as on a daily basis, we look for data or perceptions that go against our view, to constantly attempt to poke holes in it. Four of the largest pushbacks we are seeing right now are a flattening yield curve, historically high valuations, U.S. equity markets being driven higher by a few select large companies, and high levels of debt among non-financial corporations. We discussed the yield curve on our blog about three weeks ago, so please read here for more details on that. We thought we would also post a chart of the current U.S. yield curve, which to our eye has flattened, but really is not that much different than a year ago, and in our view not of near-term concern at this point.
Source: Factset, Jeff Saut (Raymond James Ltd.)
One of the largest pushbacks is high valuations. Equities are valued on a price-to-earnings multiple, or P/E multiple, and in the past this ratio tends to be in the range of 13-18. A move below or above that range is typically viewed as under or overvalued. With the P/E multiple in the U.S. well above 20 currently, it is no surprise to see this be common theme among the media and economists, equity strategists, and commentators. It is our view that valuations today should be much higher than historical norm for many reasons, but primarily due to the fact that there are far more high growth, high margin companies in the S&P500 than ever before, there has been a massive shift from tangible to intangible assets, as well as the current environment we are in (secular low interest rates and inflation).
To this last point, as we are primarily talking about P/E levels, there is no doubt that just looking at this number in isolation suggest that stocks are quite expensive today. However, averages don't help explain current environments, and especially don't help with forward returns. In fact, the P/E multiple is one of the worst predictors of future equity market returns, so it is always interesting to see it commented on so often. One of the major flaws of the P/E multiple is that it doesn't take into account one very important factor, interest rates. To illustrate this point, an important historical notion to put forth is that if you remove the aberrational low P/E multiples of the 1970s and 1980s (where interest rates were historically high), and start from 1990, the average P/E multiple for the past 27 years has been closer to 24. In this context, markets are only fairly valued if not somewhat undervalued. Not only does the multiple not take into account interest rates, but there are other factors like taxes, regulation, and inflation that should all come together to account for where the P/E multiple should be.
The third pushback noted above is concentration, that a select few companies are driving the S&P500 higher. We can't refute the fact that strong returns from mega-cap companies like Alphabet, Microsoft, Google, Amazon and Facebook have had a strong influence on the returns of the S&P500. However, we find it interesting that there is so much talk about how this is abnormal and will likely come to an abrupt end, without anyone backing up those views. The fact is, though, that based on these charts below going back to 1980, the concentration today of the top ten largest companies in the S&P500 is actually a bit lower than the historical average (20% vs. 20.5%), and that the weighting of the largest component is also lower than average (3.73% vs. 3.8%). Does this seem abnormal to you?
Source: spindices.com, Jeff Saut (Raymond James Ltd.)
The last of the four pushbacks is debt levels of non-financial corporations. The negative pundits can't hit at jobs anymore, so they try to find something else, namely debt levels, which they claim happens near the very end of an expansion. It is indeed true that debt for U.S. non-financial corporations is the highest ever relative to GDP and that their debt is at a record high (almost $19 trillion). However, companies don't pay their debt with GDP; they hold it against incomes and assets. To help back this up, since 1980 the debt to total assets has average just under 45% and right now that level is at 44.5%, so we are actually slightly less than the historical average right now. Also, as we stated above with regards to P/E, this is not a good indicator of future performance either. To illustrate that, the record high for this ratio was 50.6% back in 1993, but that was at the beginning of the longest economic expansion in U.S. history. Perhaps you could argue that the value of corporate assets today are somewhat misrepresented, or financially engineered, to be higher than they actually are. But we find this argument falls flat as well, because if you take financial assets out of the equation, the current debt-to-non-financial asset ratio is 85%, which is right in the middle of the range for the past 40 years. You can drill down into more specifics on this, like debt relative to market value or others, and the data again shows that today's metrics are in line or average at most, and not over-valued like some may profess as a stand-alone statement.
We will finish this quarter's comments with a positive technical indicator which just flashed a buy signal. It is known as the Dow Theory, and is an extremely well known indicator to experts. Perhaps that is a downside, that it is so widely followed, however, it has historically been a good predictor of future returns. We won't go through all the components of Dow Theory, but we will say that just recently, a buy signal was registered when the Dow Jones Transports Average confirmed the all-time high of the broader Dow Jones Industrials Average. This has not been a good short-term market predictor, but has been reliable one for the intermediate to longer-term. In addition to this, however, the Dow Jones Transports completed a very strong chart formation to reach this high. This formation is called a 'Cup-&-Handle', and due to the nature of it and the length of time it takes to complete, it is known to be one of the more positive longer-term indicators, and thus one could take this new Dow buy signal with perhaps even more conviction.
Source: J. Lyons Fund Management, Inc.
"People forget that what prolongs a secular bull market is the phenomenon known as “the correction.” A rocket-rise type of bull market, one with little or no corrective action, always ends up as a short bull market! Thus, seasoned investors tend to welcome corrective action during secular bull markets. They know the more corrections, and the longer and the longer and more often the bull market is held back, the bigger that bull market will be – and ultimately the higher that bull market is fated to climb!"
Here is our Milestone Market Report on economic data, capital markets, commodities and currencies through March 31st, 2017: (click for PDF version)