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July Newsletter - A Positive Outlook

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The equity markets have indeed been on a long bull run. Almost ten years, which is truly unprecidented. Bull runs have three defined phases. 1. Denial, 2. Acceptance and 3. Euphoria. We are reluctantly in phase 2 but we are nowhere near Euphoria.

 

Sadly, at least here in Canada newspaper journalists, looking for drama, are starting to use the word “Crash” again to garner readership. Last Thursday, Reprt On Business had an article entitled “How to brace yourself for the inevitable stock-market crash”. Really?

 

Market outcomes are never totally predictable.  We will likely have a healthy and normal market correction at some point, meaning a drop of 10% but a not likely a "crash", meaning a drop of 40% to 50%. As much as corrections are painful to go through, they really are a sign of a healthy market and for that short period we have to learn to let them pass to then recapture the upside potential. A "crash" or recession is a much different animal and we will do our best to keep clients out of harms way and keep everyone calm through the duration.

 

To take a view to the future, we look to several indicators which help signal the onset of a correction or recession. The good news is that all the key indicators are still relatively positive in both Canada and the US. Unemployment is extremely low. Interest rates are similarly and historically low, although ticking up ever so slightly. Inflation is very much under control and sub 2.0%. These are all indicators of stable economies, and therefore stable stock markets.

 

Let’s provide some comfort, before naming the caveats.

 

Believe it or not, the bond market is a fairly good predictor of the equity markets. During “normal” times, short term bonds have lower yields than longer term bonds. This would seem to make sense because the longer you are willing to hand money over, the more you would expect to get paid for it. These yields describe a curve on a chart called the “yield curve” which currently looks like this. The "Y" or vertical axis represents the yield to maturity. The "X" axis represents the term to maturity of the benchmark Government of Canada Bonds.

Source: http://www.investingforme.com/historical-yield-curves

 

During times when the generally accepted indicators are particularly bad, (high unemployment, inflation and interest rates) the yield curve looks very different. Short term yields are higher than longer term yields. This suggests that there is a higher demand to borrow short term money and so the yields go up. Demand exceeds supply meaning people and businesses need money. The last time we saw this was prior to the stock market crash of 2008. Below is the yield curve of 2007. Note the one-year yield is higher than everything out to 10 years. As we now know, this was the precursor of a horrible stock market decline. Of note here is the difference between the short term and long-term yields. In the picture below it was virtually zero in 2007. From above, the difference is well over 1%. This is much more consistent with stable equity markets.

 

 

 

Source: http://www.investingforme.com/historical-yield-curves

 

Now for the Caveats

 

The important caveat is that events can be unpredictable and any one could have the potential to spook investors into exiting the markets. Specifically, for example, if south of the border, Donald Trump chose to boost his waning popularity by starting a war with North Korea. This would result in equity market gyrations of unknown size or duration. The comfort factor here would seem to be that world equity markets seem to be far more resilient and recover far faster than they did ten years ago. The examples of this would be both Brexit and the November U.S. election.

 

In our view

 

There is still value left in the market. The situation isn’t bleak and there are other places in the world to find value such as emerging market Asia. For now, brace for slightly higher interest rates, a potential correction to a 10-year bull market and possibly a further correction in real estate prices. All of these are weatherable. It will sting for a bit but keep in mind the age-old adage “Whatever doesn’t kill you, makes you stronger”.