H & L opinion

Can the bull market continue to run?

February 27, 2017

Valuation Matters

I will start with a simple premise – global capital equity markets (“stock markets”) are discounting machines where intrinsic value is simply the net present value of expected future after tax cash flows. Said another way, the intrinsic value of a company’s share price is found by discounting the summed total future expected earnings (or free cash flows) by the cost of capital. For illustrative purposes we can look at a single stage discount model where we assume company free cash flow grows at a constant rate into perpetuity. In reality, this is largely an unrealistic assumption but useful to help form future stock market expectations.

Value of Stock today = Free Cash Flow tomorrow / (Cost of Equity Capital – Free Capital Growth Rate)

Most professional money managers and financial academics would agree with this premise, as Warren Buffet famously said, “In the short term the market is a popularity contest; in the long term it is a weighing machine.” So, though the stock market may act irrationally in the short run, our primary concern should be designing an asset allocation strategy that best serves your long-term 5% plus aggregate portfolio growth target while maintaining reasonable cash balances to tactically take advantage of market dislocations.

Positioning in the Cycle

The world has become increasingly globalised with most large capitalised companies having multinational operations and/or global supply chains. Underpinning the global economy is the US dollar as the major reserve currency. Unfortunately, a globalised economic system relying to a large extent on the liquidity of a single country’s currency inherently contains some fragility. This systemic fragility tends to increase as debt burdens – as measured by debt to GDP – increase. This is not my idea, nor is it a new idea; it is known as the Triffin dilemma. This fragility was recently evident in 2008, when a crisis within a relatively small segment of the US housing market (sub-prime) led to a full scale Global Financial Crisis. Only after taking extreme measures, were governments and central banks able to save the world’s financial system. These measures include fiscal stimulus, dropping short term interest rate close to zero, providing unlimited liquidity to banks with vulnerable balance sheets, and embarking on unconventional quantitative easing (actively purchasing financial assets). The benefits of these extraordinary actions were the prevention of an economic depression and strong rallies in many stock markets. However, the consequences are onerous government debt burdens (US government debt doubled to over 20 trillion USD under the Obama administration), limitations on future central bank policy, and a theoretical misallocation of capital into financial assets instead of investments in the economy.

So the question now is – will the bull markets in Canada and the US continue?

There Is No Free Lunch

The fallout from the actions taken to prevent the Global Financial Crisis from morphing into an economic depression will eventually have to be addressed. In the developed industrialised world this will likely happen through a combination of less government spending, some privatization of open-ended liabilities (i.e. healthcare and pensions), deregulation, tax restructuring, and higher bond yields, which will force the cost of equity capital higher. I believe these factors will prevent the TSX composite index, and maybe even the S&P 500 index, from rallying as aggressively as it has since the mid 90’s (Table 1). This will likely mean responsible active management will outperform passive management strategies. This coupled with fewer future government benefits will force individuals into greater personal responsibility for managing their retirement picture.

Table 1: Slower 5 Year Compound Annual Growth Rate

Index 1991-1996 1996-2001 2001-2006 2006-2011 2011-2016 2016-2021
S&P 500 12.18% 9.16% 4.31% – 2.35% 12.20% 0.83%
S&P/TSX Comp 11.03% 5.34% 10.92% -1.52% 5.04% 2.20%
FTSE 100 10.71% 3.85% 3.73% 2.44% 4.68% 0.32%
NIKKEI 225 -3.60% -11.42% 11.70% -12.72% 16.78% -0.96%
ASX All Ord 8.40% 7.03% 11.08% -5.56% 5.74% 1.02%

The Impact of the Potential Rising Government Bond Yields

There has been bond bull market (falling yields) in both Canada and the US over the last 35 years and stock markets have been major beneficiaries (Chart 1). In the US, the 10 year Treasury yield hit a monthly high of approximately 15% in August of 1981 before falling to a low of 1.5% in June 2016. During that long decline in yields the S&P 500 returned a massive 1,823%. Prior to this run, during the previous 35 year period post World War 2 the 10 year US Treasury yield continually increased and the S&P 500 gained a more modest 684%. Obviously, stock market valuation depends on more than just nominal government bond yields, but as 2016 may have marked the bond yield trough, markets may struggle to post the same returns that investors have grown accustomed to. Both the US and Canadian government bond yields are likely to rise over the coming decade due to an improved US economic outlook, the slow extrication of central banks from direct market intervention, and investors becoming increasingly uncertain with the fiscal health of government balance sheets. We can look at expectations for future government bond yields to roughly determine which way the cost of equity capital will move. This relationship exists because the required return on equity should be greater than the required return on debt (less risky); and corporate bond yields are priced off the equivalent maturity government bond yield. Clearly, rising costs of capital (the discount rate in the calculation above) will negatively impact intrinsic value calculations, holding all else equal. So as government bond yields rise, so too will the cost of equity capital (though maybe not to the same extent).

That being said, the adjustment process in bond yields will likely be choppy and rise only gradually as rapid changes would result in economic calamity. Since 1900, the US monthly 10 year Treasury yield averaged 4.75% with a median being 4%. The average and median absolute value monthly adjustment over the same timespan was 11 basis points (bps) and 3 bps, respectively. This is just a fancy way of saying from a current US 10 Treasury yield of 2.42% it will take 5 to 18 months to climb back above 3%, assuming straight linear movement higher (low probability). Central banks have tremendous influence on government and agency debt yields and are unlikely to permit yields to spike.

Therefore, the next question we should ask is – will earnings growth accelerate faster than the cost of equity capital?

Green Shoots for Economic Growth

The three fundamental factors for long-term economic growth are technological innovation, available capital stock, and labour demographics. Deregulation and tax restructuring can impact both the available capital stock and labour participation by boosting personal savings and employment opportunities. These are the easiest policy changes to implement in a timely fashion, and thus could have an immediate positive impact. Tax reform and the removal of excessive regulation, which punitively impacts small and mid-sized companies (generally the most innovative and largest job creators in the economy), can incentivise investment. Under President Trump, the US appears ready to embark down this path, and there is even potential for a fiscal infrastructure spending bill. The combination, could lead to an acceleration of nominal US GDP and corporate earnings growth. Admittedly, this is a Goldilocks scenario, but if it comes to fruition we could witness the continuation of the bull market for a few more years. Canada, as a natural resources economy, materially benefits from strong US growth.

The Bull Market Could Continue To Surprise

Earlier this week, a great research piece was release by Newfound Research titled, “Anatomy of a Bull Market” that tracked the S&P 500 bull and bear markets since 1903. A bear market is usually defined as a 20% or greater drop from the peak. Attention should be paid to the US stock markets for reasons discussed above and because their markets represent roughly 59% of the global equity market. Therefore, it is likely any large gyrations in US stock markets (positive or negative) will spill over into Canada. Newfound Research findings showed there have been 12 bull markets (including the current one) with an average length and total return (trough to peak) of 8.1 years and 387%, respectively. Over the same time period there have been 11 bear markets with an average length and total loss (peak to trough) of 1.5 years and 35%, respectively. They have the current bull market starting in March 2009 lasting just over 7.8 years with a total return of 248%. Finally, the annualised return over the 113 year period is 9.8%. A couple conclusions can be drawn from this historical data. First, it is far better for investors with a long time horizon and moderate ability to bear risk to be more exposed to the stock market than not. Secondly, by historical measures the current US bull market is neither abnormally long nor strong.

The last bear market in Canada occurred in 2015 corresponding with the collapse in oil prices. Fundamentally, there is not currently any early warning sign of an imminent bear market or recession – the yield curve is not inverted, inflation expectations remain low and stable, the US and UK banking systems are more resilient than prior to the Financial Crisis, central banks are not rapidly raising short term rates, and North American unemployment ex-Alberta is low.

That being said, there are storms on the horizon that could eventually lead to bear markets. I continue to believe that NAFTA may be adjusted but an all-out trade war with the US is unlikely. The more immediate concerns are external. This year, elections will take place in the European Union’s largest economies. How France and Germany vote may signal what becomes of the disastrous monetary union. Second, likely sometime in the next several years; China (the current engine of global growth) will have to face down their low quality lending standards and this could lead to an Asian financial crisis.

However, in my opinion the greatest long term risk is slow GDP growth in the developed industrialised world. For example, Obama was the first sitting president to never achieve a 3% plus nominal annual GDP growth rate. In Canada, economic growth has materially slowed since the crash in the oil markets. Without GDP growing faster than government debt, debt to GDP ratios will get worse and eventually debt burdens will become unsustainable. If this happens, government open-ended liabilities will need to be overhauled; the biggest tending to be social security and healthcare. This concern is warranted if we look back to the discounting equation. If growth remains tepid while the cost of capital moves higher than market valuations will diminish.

What does all this mean?

The risk of equity markets in Canada and the US entering a bear market though heightened is still low. Pundits have called this the most hated stock market rally. One of Sir John Templeton’s famous investing quotes is “Bull markets are born on pessimism, grown on scepticism, mature on optimism and die on euphoria”. Economic and market optimism has risen dramatically since Trump’s election victory, so I would say we have entered the “maturating” phase of this North American bull market. Therefore, it is still more likely that we will experience periods of consolidating gains, and/or corrections within the context of a bull market. I define consolidations as a pullback of less than 10% and corrections a drop of 10-19% from the peak. Unless there is a negative change to the fundamental outlook, these pullbacks are generally healthy for stock markets and should be bought (within the constraints of your agreed upon asset allocation). True, the current market’s P/E (price to earnings) multiple is a little elevated and the current price is slightly above H&L year-end targets. However, if earnings growth accelerates than current valuations will be warranted. Also, more attention should be paid toward the confidence bounds placed around the targets (Table 2). From that respect, the TSX Composite is not yet in worrying territory, and as of this writing oil appears to have stabilised in the low 50 USD per barrel range; any appreciation in WTI into the high 50’s, or even, low 60’s USD per barrel range by year end would provide a significant tailwind to Canadian energy equities. As an aside, H&L year-end targets are derived from an average of four to six models depending on the index.

Table 2: Potential 2017 Returns Above Target (%)

Index Feb 12th Close Target (year-end) Expensive above Overvalued above Valuation
S&P 500 2,316 2,030 2,246 2,461 Caution
S&P/TSX Comp 15,729 14,527 15,955 16,519 Neutral
FTSE 100 7,259 6,695 7,885 8,334 Neutral
NIKKEI 225 19,379 16,087 18,766 21,839 Caution
ASX All Ord 5,772 5,188 5,798 6,577 Neutral

Looking south of the border, I would no longer consider US markets cheap, and yet not overpriced either. US stock markets also provide better investment diversity. The biggest issue for Canadian investors is the currency risk as the CAD/USD exchange rate is tightly correlated to movements in oil prices. From a Canadian investor perspective, if oil prices move higher, an appreciation in the Canadian dollar will pull down returns on US assets (Table 3).

Table 3: CAD Equivalent Maximum Potential Returns Before Flagging as Overvalued for 2017

Index Overvalued above Market return Currency return Total return Market
S&P 500 2,461 6.27% -0.64% 5.63% Bull
S&P/TSX Comp 16,519 5.02% n/a 5.02% Bull
FTSE 100 8,334 14.81% 10.28% 25.09% Bull
NIKKEI 225 21,839 12.70% 6.14% 18.84% Bull
ASX All Ord 6,577 13.96% -3.30% 10.66% Bull

In conclusion, when looking at the broad market indexes caution is warranted. However, equity investment opportunities do exist and currently there is not yet a high probability catalyst that would cause me to advise selling everything and run for the hills. In fact, I continue to believe there is a nice opportunity in large capitalised UK companies. I doubt the FTSE 100 rallies 14% plus in 11 months, but the UK was the fastest growing G7 economy in 2016 following rapid depreciation in the pound stemming from the surprise Brexit vote, and this will likely keep the UK economy humming along in 2017. For example, for a Canadian investor, a high single digit stock market return plus a low single digits dividend and appreciation in the British pound relative to the Canadian dollar would equal a total return north of 10%. Therefore, I recommend being selective, keeping some balance in your portfolio, and investing with a theme. Long-term, I advise that we prepare your account for rising interest rates. This means keeping the weighted average duration for fixed income under 5 years, purchasing financials (banks and insurance companies) on pullbacks, and limiting exposure to utilities, consumer staples, and REITS.

Derek Hamill | Investment Associate

H & L Capital Professional Management

Scotia Wealth Management a division of Scotia Capital Inc.
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