Quarterly market outlook
Friday, 29 June 2018

Stock market outlook

A) The very long term

As we have pointed out in previous Quarterly Market Outlooks, the unprecedented liquidity injection by the developed world’s major central banks has made short term market forecasting very difficult. We, therefore, thought it would be helpful to update our views as to where North American markets in general and the U.S. market in particular might be situated in a longer term perspective.
As regular readers of our Strategy Notes will know, we have always been interested in market cycles. We divide these into cyclical and secular cycles. On average, secular uptrends comprise several four to four and a half year cycles and can last anywhere from 10 to 30 years. Over the last 120 years, there have been four secular bull markets. The first took 13 years from 1896 to 1909 and saw the Dow Jones Industrial Index gain over 200%. The second was in the 1920’s (1920 to 1929) and resulted in a 300% gain. The third lasted 30 years (1942-1972) and resulted in a gain of almost 800%. The fourth secular bull market was the biggest of the four and saw the DJII gain almost 1400% (from 1982 to 2000).
Secular downtrends tend to be shorter than secular uptrends – roughly 12 years on average versus 18.5 years for the average secular bull market – although the current secular bear market has lasted 17 years. In contrast, compared to the normal four to four and a half year cycle, the current cyclical bull market has lasted over nine years from its inception in March 2009, making it the second longest in history. Cyclical bull markets do not die of old age. They normally end as a result of a recession (nine out of the last 10 times in terms of the U.S. market). The extended cyclical bull market owes much of its unusual length to the extraordinary monetary measures taken since 2009 by the Federal Reserve Board and other central banks. 
The good news as we expand on in the section below in regard to the shorter term market outlook is that we do not currently see an imminent risk of a recession ending the bull market over the next 12 months unless there is a major unexpected exogenous shock to the U.S. economy (trade wars could fit into this category). The CEO of the Royal Bank underlined the difficulty of forecasting business cycles in the current era when he said recently: “I think we are in the eighth inning although it could turn out to be an extra inning game.” Although this cycle is certainly extended, the moderate recovery in U.S. GDP would tend to result in a drawn out cycle. However, it is still our view that we will see one more cyclical bear market before the current secular bear terminates.
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Outlook for our oil and gas holdings
Tuesday, 15 May 2018

Stock market outlook

In a Q1 letter to our clients, we wrote the following: “Year-to-date, both the S&P 500 and the TSX suffered 10% plus peak to trough declines. However, both the S&P 500 and the TSX hit all-time highs in January – at 2,873 for the former and 16,421 for the latter. In early February, both indices hit lows of 2,532 and 14,786 respectively. Technical analysts feel happier when stocks or indices retest lows but fail to break below them. That has been the case to date with both the S&P 500 and the TSX. The former bottomed again at 2,553 in early April while the TSX bottomed at 14,990 also in the first week of April. Technicians would be more encouraged by the fact that the S&P 500 – as at April 13 at 2,656 - is above its 200-day moving average of 2,615 while the TSX at its April 13 close of 15,273 is still below its 200-day moving average of 15,645.

In our April 1 Strategy Note, we provided our updated market outlook for 2018. In essence, in normal times, we take a historical multiple range for the appropriate investment criterion (EPS, CFPS and book value) and apply it to consensus forecasts for those three metrics for the TSX and to EPS alone for the S&P 500. However, assuming no large increase in risk aversion among investors, we think it fair to use the average for these metrics for the last three years. Applying these to Bloomberg consensus forecasts provides a target for the TSX of 16,630, which makes for a 9% capital gain and 12% total return from current levels. We would have a higher target of 18,000 for a total return of 20% if the 2018 year end oil price moved back to the $75 plus area a barrel, which we think is quite possible after the most recent rally in the WTI price.

In the case of the S&P 500, if we use a similar projected P/E of 17.3 times (the TSX’s last three year average) on blended forward 12-month EPS, we get a target of 2,785 for a capital gain of 5% from current levels and an 7% total return which is inferior to what would be the case for Canada’s index (+12%) using the same methodology (more so if oil prices rise to $75 a barrel). If these projections came to pass (although we have to rate the prospect as a possibility rather than a forecast at this stage), it would rival the performance of the TSX in 2016 when the Canadian index was the best performing equity market in the developed world. It is clear that Canadian equities are relatively very cheap chiefly caused by negative publicity on Canada’s inability to get its oil to tidewater, fears over NAFTA abrogation and  concern by international investors that the Canadian residential housing market would collapse like the U.S. housing market did a decade ago. We are confident that our housing market won’t replicate the U.S. experience – particularly after recent interviews with Canada’s big five banks although prices will correct - and clarity on the first two factors could be forthcoming in the next few weeks.”

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Interest rate outlook in North America - Part 2
Tuesday, 01 May 2018

As pointed out in our April 15 Strategy Note on North American interest rates, “10-year U.S. Treasury yields started the year at 2.46% and by early February had shot up to 2.80%, thereafter peaking at 2.95% on February 21. On March 27, for the first time since early February, however, the 10-year yield fell back below 2.8%. However, in the second half of April, the U.S. Treasury 10-year bond reversed and shot back up to a high of 3.03% before ending the month at 2.95%. We had admitted in that Note that forecasting where U.S. long term interest rates would go was not easy. “There are U.S. deficits to fund plus the Fed will be upping its pace of Quantitative Tightening by capping the amount of proceeds it reinvests from maturing securities, starting at $10 billion per month, and gradually increasing the cap over the year to September to a total of $50 billion per month. It has been estimated that this Fed balance sheet reduction would raise long term interest rates by 20 to 40 basis points which appears to have already been reflected through the rise in rates year to date”.

We did conclude in that Note that we might expect relatively tame inflation on the basis of moderating growth in the U.S. economy, which would leads us to expect long-term interest rates to remain range-bound. However, we admitted that there were a lot of negative and positive factors which would be influencing U.S. long term rates.

Among the negative factors, we highlighted inflation moving above the Fed’s two-percent target, as a result of higher wages, declining labour availability, higher housing and healthcare costs, and protectionist trade policies pushing up the price of imports. As mentioned above, the lack of Fed buying of Treasuries and rising budget deficits meant a sharp rise in net Treasury issuance this year compared to last year (almost triple 2017’s issuance of $550 billion).

On the positive side in terms of bond prices, 10-year U.S. Treasuries were yielding about 150 basis points more than the average among G-7 issuers (and that gap has widened in the second half of April). In addition, 10-year Treasuries have been yielding about 80 basis points above CPI - the biggest premium over inflation since 2016 and about 1% more than S&P 500 dividends – the biggest spread in four years. Finally, it seemed that the market had largely priced in the three Fed rate hikes the dot plot called for this year. We concluded that these factors should make U.S. 10-year Treasuries attractive to foreign investors. The recent increase in volatility in equity markets would also normally drive capital flows to safe haven long treasuries although in recent weeks volatility has declined somewhat.

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