When Tim McElvaine looks at the market today, he can’t help but feel frustrated. Last summer the founder and president of McElvaine Investment Management was awash in buying opportunities, but today he’s holding more cash than he has in a long time. The reason, says this deep value investor, is simple: stocks aren’t cheap anymore.
It may be his Vancouver address, but McElvaine uses a marine analogy to explain what’s happening. “Sometimes, the rocks are completely under water,” he says. “Other times, the tide is out, and there is a whole bunch of stuff lying on the beach. Lately, the water has come in a little bit.” In other words, he says, he’s “not finding a ton of stuff to do.”
Michael Sprung, president of Sprung Investment Management, is also having trouble finding good buys. Some of the best stocks—reliable, dividend-paying companies—have been run up in price by people chasing yields. Other businesses have become more expensive as investors who were burned in the 2008–09 crash finally move back into the stock market. According to EPFR Global, a company that tracks worldwide mutual fund flows, US$146.23 billion moved into equity funds year-to-date as of April, while $118.86 billion went into bond funds. That’s a shift from the pattern over the past five years, when $301.75 billion left equity funds and $1.31 trillion flowed into bonds. “All of the ratios have gone up—price-to-earnings, price-to-book—and they all tend to be above their long-term fundamentals,” says Sprung.
With valuations above where they were last year—from April 2012 to April 2013 the S&P/TSX composite index’s P/E climbed 5.2%, while the S&P 500’s is up 10.9%—many investment experts are now calling this a “stock picker’s market.” Rather than being able to buy almost anything at a good price, like you could in 2009, investors have to be choosy. That’s even true within some beaten-down sectors, such as energy and materials, where companies are dealing with industry headwinds such as falling commodity prices, which could depress these stocks further.
It’s in times like these that sticking to your investment discipline is crucial. Investors have to be quick to act when there’s any sort of correction, such as in mid-April when both the S&P 500 and S&P/TSX composite dropped nearly 4% in a week. The only way to do that is to keep your eye on companies you want to own, but you think are too expensive. That’s what both Sprung and McElvaine are doing. They’re holding more cash in the hope that they’ll be able to deploy that money if the market falls.
It’s easy to get impatient in a market like this, says Irwin Michael, president of I. A. Michael Investment Counsel, but be careful: if you overreact on the upside or the downside, you’ll get burned. “Just because something is down doesn’t mean you should buy it,” he says. “It has to fall within your view.” Michael has been able to find opportunities, he says, because he’s sticking to his strategy. For him, that means finding companies that trade below tangible book value, have low P/E multiples and strong cash flows.
Despite rising valuations and a soaring American stock market—the S&P 500 is up 136% since it bottomed in March 2009—it’s hard to know if we’re in the midst of a bull run, a sideways market or the prelude to a fall. The more investment managers one speaks to, the more it seems like it’s all of the above. What everyone can agree on, though, is that investors are still nervous. While markets are generally up, the money that’s been flowing into equities is coming from people’s bank accounts rather than from their bond allocations. That’s a sign that people aren’t quite ready to commit to the markets. “People are feeling good about next year, but they don’t have a sense of where the world is going in three years,” says Ed Devlin, executive vice-president and head of Canadian portfolio management with Pacific Investment Management. That uncertainty has led investors to safe, large-capitalization securities. In other post-recession upswings, it’s the growth stocks that rise first, but that’s not what’s happening now. “It’s a different kind of rally,” he says.
Much of the market rise has been brought on by government policy, namely low interest rates and quantitative easing, and not real economic growth that a sustained recovery requires. Devlin says that monetary policy, mostly in the United States but also in the other parts of the world, has put a wedge between the real economy and financial markets. “Broadly speaking, stocks, bonds and many different other asset classes are expensive, and they are that way because of policy, not underlying fundamentals,” he says.
Noel Archard, head of BlackRock Canada, points out that for a market to fire on all cylinders you need to see government, consumers and private businesses all spending money. He’s seeing some encouraging signs that this is starting to happen, but it’s slow going. The private sector is deploying more capital—according to Thomson Reuters, global merger-and-acquisition activity in the first quarter of the year is up 10% over a year earlier—and U.S. consumer housing starts are up. However, hiring is still sluggish, and overly indebted governments are cutting back. Archard doesn’t think we’re in a bull run, but he does say that at this point the market is “a pretty fast cow.”
To find a historical precedent to this recovery, you have to look all the way back to the 1980s, says David Fingold, a vice-president and portfolio manager with Dynamic Funds. He explains that when the early ’80s recession ended, commodity prices fell, which is what’s happening now. Between 1980 and 1986, crude oil prices plummeted by 71%. While oil hasn’t gone down by that much this year, prices are falling—bad news for producers like Canada—but an “incredibly bullish” sign for most developed economies, says Fingold. That’s because lower fuel prices should reduce the cost of food and other goods. When these expenses go down, consumers have more money to spend elsewhere. That can buoy the economy and markets. In the four years after the market bottomed in August 1982, the S&P 500 was up 128%, and it kept climbing from there.
There are signs this post-recession bull has a ways to run. Sam Stovall, chief investment strategist with S&P Capital IQ and noted stock market historian, says that since 1948 the S&P 500’s trailing P/E has been, on average, 20 times. Today it’s 17.5 times. When he looks at it on a forward-earnings basis, it’s still cheap, trading at 14 times earnings versus an average of 16. He calculates that if the S&P 500 were fair value it would be at 1,785; today it’s at 1,586.
He’s also valued the market another way, by using the “rule of 20.” He takes the trailing P/E and adds the rate of inflation. If the total is higher than 20, the market is overbought. If it’s below that number, it’s undervalued. Today, the market is at 19.5, which means that for the market to be fairly valued it would have to hit 1,620. So, no matter how you look at it, “we still have a little ways to go,” he says. Stovall’s also found that when inflation is between 1.5% and 2.5%—around where it is now—the market has risen, over the next four quarters, 80% of the time and, on average, by 10%. Finally, to those who are worried about a market correction, he says that contingency should be “routinely anticipated.” Since 1945 there have been 56 pullbacks (a decline of 5% to 10%) and 19 corrections (declines of 10% to 20%) and countless “digestions.” Market declines of between 5% and 20% happen at least once a year, on average. In a Feb. 19 report, he wrote that “forecasting a decline of 20% or less is not rocket science and time probably shouldn’t be wasted on such efforts.”
There are a number of other reasons why Stovall thinks that equities still have some upside and why a bear market—a drop of 20% to 50%—won’t arrive anytime soon. Historically, unemployment has fallen below 5% before a market top, and a recovery will have been going on for an average of 58 months at that point. It’s been only 46 months since the last recession officially ended, and the U.S. unemployment rate is still high at 7.5%. Then there’s investor sentiment. Several research services regularly survey investors on whether they expect markets to rise or fall. When Stovall looked at sentiment readings dating back to 1987, he found the average bullish reading is 39. It’s 42 today, so we’re more bullish than average, but the readings are still below the market peak average of 57.
So while markets are up, and stocks are no longer dirt cheap, there has been no irrational exuberance. Fingold attributes the upswing to date in part to companies’ buying back shares. With bond yields so low, it doesn’t cost companies much to borrow money to repurchase equity. Between June 30, 2008, and Dec. 31, 2009, S&P 500 companies issued US$577 billion of equity; between March 31, 2010, and Dec. 31, 2012, $649 billion of equity was removed from the market. “When companies are sopping up the supply of equity, markets have a tendency to move up,” he says.
We also haven’t seen what’s been dubbed “the great rotation,” the anticipated mass move from bonds into stocks. Brian Belski, BMO Capital Markets’ chief investment strategist, says bonds are still the main place for investors to stash money, even with today’s low yields. That will change when interest rates rise and bond prices fall. As soon as people start losing money in fixed income, they’ll jump into stocks. “We’re nowhere near the end of this,” he says of the markets’ ongoing rise.
Of course Canada isn’t operating in isolation. In an increasingly interconnected world, events in the U.S., Europe and China have a big impact on our markets. One of the reasons we did so well immediately following the recession—the S&P/TSX composite index was up 77% between March 2009 and December 2010—was that the Chinese government was injecting massive amounts of stimulus into its economy. A lot of that spending has been pulled back since, and that’s caused the Chinese economy to slow. In the first quarter of 2013, the country’s GDP grew by 7.7%. It’s still growing faster than any developed nation, but it’s a slower pace than the country has been used to. Archard thinks the slowdown has been purposeful. He also thinks it will continue. While it’s unlikely GDP growth will stall, China’s new president, Xi Jinping, “will keep the pot more at a simmer than a boil” going forward. That slow growth will affect commodity-driven economies such as Canada’s, because when China’s economy slows, the demand for commodities drops.
Europe’s troubles could also hamper the market’s progress. Most of Europe’s problems are financial, and problems with one region’s banks can spread to damage confidence in the financial sector globally. While Europe has generated fewer screaming headlines this year, Michael thinks it’s not in the clear yet. There are concerns over a triple-dip recession in the United Kingdom, Greece has a 27% unemployment rate, and France “will have a day of reckoning as well,” he says. He’s also concerned about the 20% tax that Cyprus slapped on bank account deposits larger than €100,000. If Spanish, Italian and Portuguese citizens sense that such a tax could be implemented in their countries, then they could start hauling money out of their accounts, putting banks in peril. As bad as that sounds, Devlin doesn’t predict any doomsday scenarios. “We should expect some volatility, but we’re not forecasting that it blows up,” he says.
In the year to come, the country that Canadian investors need to pay the most attention to is the U.S. It’s our dominant trading partner; the healthier it gets, the more we export. Archard is optimistic that the worst of the American financial crisis is over. Housing is coming back to life—U.S. home prices rose 9.3% in February, the most in almost seven years—while personal incomes are slowly rising. Archard thinks that the country will continue to get stronger, but investors need to be patient. It will take more job creation and faster income growth before the economy can switch into the next gear. It will probably take 18 to 24 more months for that to happen, he says.
Since the U.S. economy is only slowly improving, Federal Reserve chairman Ben Bernanke has made it clear that he won’t raise interest rates until 2015. It’s likely Canadian rates will stay put until then too, says Devlin. If we increase rates before our neighbour does, then our loonie would likely rally, and that would hurt our economy. We might see an extremely modest rate increase—perhaps a quarter of a percentage point—“but it won’t go up a lot,” says Devlin.
It’s important to think long term, says Archard. Investors do have to be more active than they have in the past. That means recognizing value in places where others don’t. It doesn’t mean buying and selling on every news event. If investors pay attention to the day-to-day fluctuations, it will feel as if a bear market is around every corner. But stick to your convictions and be “entertained by the news cycle, rather than horrified by it,” he says.
That’s McElvaine’s approach. He wants to own stocks for years, so the daily ups and downs, and the talk of bull versus bear market, don’t bother him. However, he’s not ignoring what’s happening around him, either. In his 20-plus years of investing, he’s never seen a more uncertain environment than this one. “There are so many unknowns,” he says. So while he is taking a cautious approach, he’s also hoping this uncertainty will give him a chance to spend his cash. After all, uncertainty can be a savvy investor’s friend. Right now, he’s got his eye on Canadian mining stocks. He hasn’t owned one in a long time, but share prices have recently come down a lot. He’s also looking outside of Canada for overlooked buys. “The U.S. is much deeper and in some ways a less-followed market than Canada where every stock has half a dozen analysts regardless of the market cap,” he says.
At the end of the day, finding good stocks in this environment requires patience. “Don’t make it more complicated or convoluted that it needs to be,” says Michael. “It’s about patience and staying power.”