Every cloud has its lining...including this correction
At the peak of the bull market, and before the positive impact of tax cuts had started to trickle in, the S&P 500 price-to-earnings ratio (P/E) was north of 20 times. That was, by all standards, a sign of gross over-valuation. However, the combined effect of a 10% correction and a 10% growth in corporate earnings has changed things to the better. Based on the most recent estimates of corporate earnings for the next year, we are looking at a forward P/E ratio of just about 15 times. All of a sudden, one can no longer talk of excessive market over-valuation. Historically, the median range of the market P/E ratio has been 12 to 16 times. So as we write this update, we are now at the high end of the historic P/E range.
As far as Canada is concerned, we are already looking at a much more reasonable P/E ratio of 13 times. Now that the trade deal has removed much of the uncertainty, the main factors suppressing Canadian equities remain the threat of higher interest rates and US/ global contagion.
As such, we've seen quite an improvement from a valuation perspective. However, we are not yet ready to declare the US market fairly valued, or to call the end of the correction, for various reasons. The three main factors behind the correction, namely the approaching end of the economic cycle, monetary tightening and trade wars, are still standing.
In terms of economic cycle, there are concerns that the Fed will overshoot and trigger a recession, as it often does. Higher interest rates are never good for the economy, and some cyclical stocks, in the real estate and industrial sectors, are starting to feel it. Add to that the worsening fiscal situation. The US budget deficit is starting to reflect the inevitable impact of massive tax cuts. By the time we reach the next presidential elections, there is a good possibility that the budget deficit will have reached unsettling proportions. The US admninistration is already worried and pushing for spending cuts. When the government spends less, economic growth slows down.
In terms of monetary tightening, the Fed continues to scale down its balance sheet by selling bonds in the market. In a previous update, we spoke about the increasing supply of bonds, caused by the Fed scaling down of its balance sheet, but also by the increasing US Government funding needs. Increasing bonds supply means lower prices, i.e. higher yields. There is more bad news: by the end of the year, and barring major problems, the European Central Bank (ECB) is expected to start shrinking its own balance sheet by selling bonds. This will take out significant liquidity from the market and will suppress demand for financial assets, including both stocks and bonds.
Last but not least, the issue of trade wars and tariffs is not about to go away any time soon. This week, the market rallied on news that the US and China might start discussions, raising hopes that a trade deal could be reached. Even if this is the case, the road to a final trade deal will be a bumpy succession of good and bad news. If a new deal with Canada and Mexico took almost two years to reach, how much time will it take to resolve all the pending issues with China?
The main point here is that slower economic growth means slower earnings growth. Given earnings have been lately a major pillar of support for the bull market, one can only be concerned that when the eanings euphoria dies, the bull market will die with it. The question is when, not if.
That leaves us with two questions that are almost impossible to answer: when will the next bear market start (if it hasn't already) and how long will it take to clear. Even though we have a view on both points, we recognize one should never bet the farm on any possible outcome and must be prepared for all possibilities. So having cautioned that all views should be taken with a grain of salt, here is our take.
In terms of timing, and despite all the concerns about earnings growth, there is one important factor that keeps helping stocks: the absence of a better alternative. Considering that higher interest rates are all but a certainty, investors remain extremely wary of bonds. And given they cannot put 100% of their money in cash, the only major remaining alternative to bonds is stocks. Therefore, it is quite possible that the bull market will survive until we reach the peak of the monetary tightening cycle. By the time the cycle of higher interest rates is over, bond yields will have become seriously attractive and difficult to resist. By then, earnings would have started to slow down, making people ready to start replacing stocks with bonds. Considering that the Fed has few more rounds of tightening ahead, the end of the monetary cycle will likely be some time in 2019. Remember however that markets always move on anticipation, not after the fact. In other words, once investors feel confident that tightening is about to end, they will not wait for that to happen. They will start selling stocks ahead of time.
As we just said, guessing the timing is an impossible task. A better way to do it is to start moving assets gradually from stocks to bonds. Thus, with each major rally in stocks, or with each increase in bond yields, one can reduce equity holdings and increase bond holdings by a notch. You will not catch the equity cycle at its peak, nor will you catch the bond cycle at its trough, but you will improve your long term portfolio return.
As far as the magnitude of the next bear market, and how long will it take to clear, one can only look at history as a guide. As we write this update, we are looking at a market that is about 7% off its all times high. Assuming that the 2019 earnings forecast stands, we are roughly at a forward P/E ratio of 15 times. From today's level, to get into a bear market (i.e. 20% off the highs) we need to drop another 13% off the highs, or another 15% from where we are today. That will take us to P/E ratio of 13 times or so based on 2019 earnings. Thus a 15% further drop from where we are today, take or leave few percentage points, looks like a plausible scenario.
In other words, thanks to the combined effect of earnings growth and the stock market correction, we might hopefully be looking at something less than a catastrophic bear market. Rather than a 45% drop similar to that of the year 2000 or the years 2008-2009, there is now a good possibility (but of course no guarantee) that the downside will be more contained.
Having said that, the market always tends to overshoot. Moreover, we had opined earlier this year that, when the bear market materializes, it will not impact all sectors by the same proportions. Over-valued technology companies will likely be hit the hardest. Other sectors, which are more fairly valued, will suffer less. Likewise, for countries where valuation is more reasonable (e.g. Canada), the downside should be more contained. But that's for a more detailed discussion in future updates. For now, just remember that any predictions should be taken with a grain of salt and that you ought to be prepared for all possible outcomes. For that, recognizing that we sound as a broke record, we reiterate that you should not put in equity any money that you think you will need in the next five years ort so. For that, again and again, please refer to our "Introduction to the Maximum Equity Allocation Approach". And always talk to a professional advisor before you make any investment decisions.
November 3, 2018
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