Much has been written in the press about the severity of the current market environment. We’d like to provide our perspective on the situation.
We have experienced almost 10 years of bull markets, during which time we have actually seen much more significant corrections than the current one. In the summer of 2011, we saw over 20% shaved off equities primarily due to the European debt crisis. In 2015, Canadian markets were severely affected by the oil price crash. The year after, we saw a mini-crash in equity prices following the Brexit vote. In February of this year, there were significant declines.*
The main difference between the current downdraft and the corrections mentioned above is that this downturn has been more prolonged (it’s in its sixth week). Most of those previous declines were more short-lived.
Here’s a brief analysis of what’s currently happening in the markets:
Starting on September 30, stocks globally have had their worst decline since the beginning of 2016. North American markets are down 7.2% in Canada (S&P TSX index), 6.7% in the U.S. (S&P 500 in CAD). International stocks represented by the MSCI EAFE index are down 7.7% in CAD terms. The technology-laden Nasdaq Composite has plunged over 13.4% (11.2% in CAD), its worst decline since October 2007.*
What has been unique about this market drop is that there was basically ‘no place to hide’ outside of cash, with bonds producing negative returns due to rising rates. Clearly, a significant contributor to the correction has been technology stocks or the so-called FAANG stocks (Facebook, Amazon, Apple, Netflix, and Google, now called Alphabet) which have had a tremendous run and were trading at lofty valuations. Due to the market-capitalization-weighted S&P 500 index, these stocks contributed about 40% of the performance on the way up and are doing likewise on the way down. In well-diversified client portfolios that are not technology-heavy, declines should be more moderate than the overall market, particularly in U.S. Equities. The Canadian market has not been helped by a precipitous decline in the price of oil, which has dropped over 25% since September 30.*
While the market appears very ‘oversold’ on a short-term basis we think that this decline is different from the February sell-off and is more indicative of the overall risk to stock markets that we have been wary of for many months now.
While the February decline ended up being just another opportunity to ‘buy the dip’ for further gains, the current pullback has been generated by a deeper set of problems. The stock market decline in early February was precipitated by rising interest rates and spreading fears that the U.S. Federal Reserve was about to become more aggressive on interest rates. But, at the same time, U.S. earnings were just starting to show the positive impact of the tax cuts and expected to grow in excess of 20% in 2018.*
Also, most investors and analysts were buying on the premise that there was a ‘synchronous global economic recovery’ taking place that was creating an extremely strong backdrop for more earnings gains. Those beliefs are now being challenged as major global companies in the U.S. are starting to feel the impact of slower growth in Asia, in the emerging markets and in Europe, as well as the effect of the trade and tariff wars.
Similar to the February decline, the current pullback in U.S. markets is also precipitated by increased fears of a more aggressive Fed interest rate policy, specifically after the October 3 comment from U.S. Fed Chairman Jerome Powell that U.S. short-term interest rates were ‘a long way from neutral’.
Despite quarterly earnings growth remaining strong, some corporations are expressing concerns about the road ahead, particularly the impact that tariffs and rising interest rates will have on growth. The breakdown of Apple, Amazon, Netflix, Facebook and Alphabet has lead the sharp losses for the Nasdaq and also signified the first real breakdown in these growth leaders in a number of years.
Rising interest rates have taken away the key liquidity support that had taken stock valuations higher over the past decade. Therefore, the compression in stock valuations that we are seeing now was a long time coming. It appears that equities are approaching a more ‘buyable level’ now, which hopefully will result in more stable equity prices (albeit, they may be flat for a while, but hopefully we’ve seen the bulk of the drops).
Looking at the Canadian market, the situation is quite different. Oil is now trading at the largest valuation discount to the overall market in more than a decade. We could be finally seeing an opportunity for better Canadian stock market performance. Shares of the industrial metals and bulk commodity producers continue to come under pressure, in part due to increased expectations for a slowdown in global demand over the next one to two years. There have been meaningful improvements within the metals, mining and other industrial sectors that make up a substantial part of the Canadian economy. These improvements, compared to prior economic cycles, suggest that these sectors may actually be better positioned now to withstand a slowdown in global demand than they have in the past.
The discount being applied to Canadian stocks compared to the U.S. market is approaching the highest levels ever seen, levels similar to those following the end of the technology bubble and preceding the commodities boom of 2003-2008. In fact, as it stands now (and as shown in the chart below), Canadian stocks are already trading at the largest discount to U.S. stocks in 15 years.
As always, we recommend that our clients stick to their long-term investment plan. Where necessary, we will rebalance portfolios to take advantage of the current market environment. Our goal is to avoid any irrational decision-making as a result of panic. This is demonstrated by the portfolio activity of clients who were with us during the financial crisis of 2008-09; this strategy worked in their favour and portfolios rebounded very strongly over time.
Senior Vice President, Business Development and Client Relationships, National
*The data used to calculate these numbers came from the following sources: C$, Oil, S&P/TSX, S&P 500, Yahoo Finance, MSCI, EAFE – MSCI, Barra.com
Returns from September 20 to November 21, 2018 closing values.