Sep 26, 2014 - ... long-term relative uptrend. Stocks to consider include Black Diamond. Group Ltd (BDI-T) and Westjet A
Weekly Trends Ryan Lewenza, CFA, CMT, Private Client Strategist
September 26, 2014
Buying Opportunity?
In recent publications we have underscored the potential for volatility to rise through the September/October period, in part, due to the US Federal Reserve ending its asset purchases in October and weak seasonality.
Given the sharpness of the decline, and in light of the fact that the S&P/TSX Composite Index (S&P/TSX) has been in a very strong uptrend since June 2013, we have fielded numerous questions on whether this is a major top, or just another buying opportunity. Based on our current readings, both fundamental and technical, we believe this is simply a much overdue and healthy pullback.
In the short-term we believe the S&P/TSX is setting up for an oversold bounce, with the materials and energy sectors possibly leading the bounce. These sectors are at oversold levels not seen since early 2013. Beyond the expected short-term bounce, we believe the S&P/TSX could consolidate in the 14,500 to 15,500 range over the next few months, as the markets acclimate to the end of QE.
Most bear markets are brought on by recessions. We believe the prospect of a recession is very low over the next 12 to 18 months, which is a critical factor in our constructive longer term view on the equity markets.
Chart of the Week Most Bear Markets Are Brought On By Recessions. Currently the St Louis Fed Recession Model is Forecasting a 0.30% Chance of a US Recession 120 U.S. Recession Probabilities 100 Less than 1% probability of US recession
80
60 40 20
0 '67
'72
'77
'82
'87
'92
'97
'02
'07
'12
Source: Bloomberg, Raymond James Ltd., Marcelle Chauvet and Jeremy Piger
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Weekly Trends
September 26, 2014 | Page 2 of 5
An Overdue Pullback In recent publications we have underscored the potential for volatility to rise through the September/October period, in part, due to the Fed ending its asset purchases in October and weak seasonality for the equity markets. For example, in our September 8 Open report we stated “the Volatility Index (VIX) has remained low for much of the year, but we see the potential for volatility to rise over the next few months.” This prediction has begun to manifest in the markets with the VIX increasing and the equity markets off from their recent highs. The weakness has been more pronounced in the Canadian equity market, with the S&P/TSX experiencing its first 200 point decline (September 19) since February 2014 and it being off 5% from its all-time high of 15,685. Given the sharpness of the decline, and in light of the fact that the S&P/TSX has been in a very strong uptrend since June 2013, we have fielded numerous questions regarding whether this is a major top, or just another buying opportunity. First, we state the obvious that it is near impossible to consistently call market tops, with the top only becoming clear after the fact. With that said, based on our current readings, both fundamental and technical, we believe this is simply a much overdue and healthy pullback within this six-year bull market. In this week’s report we outline the key factors behind our constructive longer term view on the equity markets, and highlight specific areas investors should look to buy on this overdue pullback.
Historically September Has Been the Weakest Month for the S&P 500 2.5% 2.0% 1.5% 1.0%
From a technical perspective, the recent weakness has caused some technical damage to the intermediate uptrend. The S&P/TSX has broken down through its 50day moving average (MA) and its uptrend that has been in place since July 2013. The S&P/TSX is currently trading at next technical support around the 15,000 level, which marks the lows seen in July and August. A break below this level would be technically bearish and would likely signal a steeper correction. The next major support after 15,000 is the 14,500 to 14,600 range. This range marks the intersection of the important 200-day MA (14,558) and the previous highs dating back to 2007 and 2011. We view that range as a critical level and effectively is our “line in the sand” for the Canadian equity markets. A break below that level would likely cause us to re-evaluate our constructive outlook and adopt a more defensive approach. In the short-term we believe the S&P/TSX is setting up for an oversold bounce, with the materials and energy sectors possibly leading the bounce. These sectors are at oversold levels not seen since early 2013. Beyond the expected short-term bounce, we believe the S&P/TSX is likely to consolidate in the 14,500 to 15,500 range over the next few months, as the markets acclimate to the end of QE. S&P/TSX Broke Below its Intermediate Uptrend 15,500
1.5%
0.7%
0.6%
0.4%
0.0% -0.1%
-0.1%
-0.5% -1.0%
-1.1%
-1.5% Monthly returns from January 1928 to present -2.0% Jan
Feb
Mar
Apr
-10.0
Source: Bloomberg, Raymond James Ltd.
Oct
Nov
S&P/TSX HEALTH CARE IDX
-1.9
S&P/TSX INFO TECH INDEX S&P/TSX UTILITIES INDEX S&P/TSX FINANCIALS INDEX S&P/TSX INDUSTRIALS IDX S&P/TSX CONS STAPLES IDX
0.9
Jul-14
Sep
S&P/TSX TELECOM SERV IDX
-0.9
12,500
Apr-14
Aug
-2.0
-0.9
Jan-14
Jul
S&P/TSX CONS DISCRET IDX
-2.8
-1.4
Oct-13
Jun
S&P/TSX ENERGY INDEX -3.1
2nd Support
Jul-13
May
S&P/TSX MATERIALS INDEX -5.8
13,500
11,500 Apr-13
0.6%
With the Resource Sectors Leading the Decline
1st Support
14,500
0.7%
0.5%
-9.0
S&P/TSX 50-DMA 200-DMA
1.5%
1.2%
1.2%
-5.0
Price return from 09/3/14 to 09/22/14
0.0
5.0
Dec
Weekly Trends
September 26, 2014 | Page 3 of 5
No Recession in Sight Moving over to the fundamentals, we note that most bear markets are brought on by recessions. Post-WW2 there have been 13 bear markets with 8 of them concurrent with a US recession. Non-recession bear markets such as 1998 and 1987 are often due to a commodity or exogenous shock. This is critical to our outlook as we believe the prospect of a recession is very low over the next 12 to 18 months. We base this view on three key observations. First, US GDP bounced back to 4.6% in Q2/14, with most economic indicators pointing to continued strength in H2/14. For example, manufacturing remains robust, consumer spending is healthy and the US labour market continues to improve. Current economic conditions are inconsistent with a recession, in our opinion. Second, the Federal Reserve Bank of St Louis publishes a probability model of US recessions based on four key variables (e.g., nonfarm payrolls and industrial production). Currently, this model is predicting a less than 1% probability of a US recession in the coming months. Lastly, the yield curve (difference between the 10-year government bond yield and 3-month T-Bills) remains steep as a result of the very accommodative policies by the Fed. This is particularly relevant as the yield curve has correctly signalled each recession over the last 50 years by “inverting” with the T-Bill yield rising above the 10-year yield as a result of Fed tightening. With the Fed expected to take a very measured approach to rate hikes over the next few years, the yield curve is unlikely to invert for some time, thus supporting our belief that a US recession is remote over the next 12 to 18 months.
Inverted US Yield Curve Typically Signals Recession and Bear Market 1200
2500
US Yield Curve (LHS) S&P 500 (RHS) Log Scale
1000 800 600 400 200 0 -200
If the North American economy continues to improve in line with our forecasts then this should support stronger corporate earnings growth, providing a fundamental underpinning for equities. For example, the S&P 500 and S&P/TSX are expected to deliver 7.8% and 18.5% earnings growth respectively in Q3/14. As we’ve discussed in past reports we expect stronger earnings to provide the fuel for further gains in this bull market.
50 '88 '90 '92 '94 '96 '98 '00 '02 '04 '06 '08 '10 '12 '14
Finally, from a valuation perspective, while equities are no longer cheap they are not at levels typically seen at major market tops. For example, the S&P 500 trailing P/E is currently at 18x (16.8x forward) which is just 1.5 multiple points above its long-term average of 16.5x. We define an overvalued equity market by being 1 standard deviation above its long-term average, which for the S&P 500 is 21.3x. Therefore, we would characterize the market as just modestly overvalued at present. Moreover, based on our analysis, the S&P 500 typically peaks at an average (median) P/E of 20.5x (19.5x), which is 2.5 multiple points above the current P/E level. S&P/TSX Earnings Outlook Continues to Improve 40%
Probability of US Recession is Very Low 120 U.S. Recession Probabilities
30% 100
20% 10%
Less than 1% probability of US recession
80
0%
60
-10% 40
-20% -30%
20
-40% S&P/TSX Forward Earnings Growth
-50% '02
'03
'04
'05
'06
'07
'08
0 '09
'10
'11
'12
'13
Source: Bloomberg, Raymond James Ltd., Marcelle Chauvet and Jeremy Piger
'67
'72
'77
'82
'87
'92
'97
'02
'07
'12
Weekly Trends
September 26, 2014 | Page 4 of 5
What to Buy? Given leading indicators continue to point to an improving North American economy we maintain a cyclical bias in our sector recommendations with an overweight in the financials, industrials, information technology and energy sectors. Below we summarize our rationale for our sector overweights and provide some investment ideas within each sector.
Financials: We remain constructive on the financials sector given the prospect of rising interest rates, solid earnings growth prospects, attractive dividend yields, reasonable valuations and continued strong technical trends. Within the Big 6 banks we see good relative value in Bank of Nova Scotia (BNS-T), with it trading at a P/B discount to its peer group. Historically BNS has traded at a premium. We currently prefer the lifeco’s to banks, as they are more highly correlated with rising bond yields, and we believe they offer higher earnings growth potential. Our preferred picks include Manulife Financial Corp. (MFC-T) and Sun Life Financial Inc. (SLF-T).
Industrials: Industrials stand to benefit from an improving economy and stronger capital spending trends. Technicals also remain bullish with the sector in a long-term relative uptrend. Stocks to consider include Black Diamond Group Ltd (BDI-T) and Westjet Airlines Ltd (WJA-T), which was recently upgraded to a Strong Buy from Raymond James Ltd.
Information Technology: The information technology sector is a large beneficiary of our stronger capital spending thesis. The sector also typically outperforms in a rising interest rate environment. Finally, technicals continue to improve for the sector. Our top pick within the sector is Open Text Corp. (OTC-T), which recently delivered a strong quarter and brokeout technically.
Energy: The energy sector has underperformed in recent weeks, in part due to strength in the US dollar. In the near-term we believe the US dollar could pullback, which would be supportive to the energy sector, while the long-term fundamentals remain healthy for the sector. We would recommend buying on this weakness. For growth we continue to like Suncor Energy Inc. (SU-T) and Canadian Natural Resources (CNQ-T) and Crescent Point Energy Corp (CPG-T) for yield.
BNS Looks Attractive Relative to Peer Group
Industrials Remain in a Long-term Relative Uptrend
1.35 BNS P/B Relative to S&P/TSX Bank Index P/B
1.30
0.16
1.25
S&P/TSX INDUSTRIALS IDX Relative to S&P/TSX Comp
0.15
1.20
0.14
Premium
1.15
0.13
1.10
1.05
0.12
1.00
0.11
0.95
Discount
0.90 '03
'04
'05
'06
'07
'08
Source: Bloomberg, Raymond James Ltd.
'09
'10
'11
'12
'13
'14
0.10 Sep 11
Mar 12
Sep 12
Mar 13
Sep 13
Mar 14
Weekly Trends
September 26, 2014 | Page 5 of 5
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