At the start of March, we identified important clues for a potential turning point in risk appetite by investors. The outperformance of cyclical sectors and weak balance sheet stocks since mid-February, combined with the renewed decline in the four-week moving average of initial jobless claims, the pick-up in U.S. economic surprise indices, tightening in credit spreads and the bullish turn in market breadth, as exhibited by the rise in the New York Stock Exchange Advance/Decline line, made a sustained rebound in equities increasingly likely, in our view. In addition, the recent strength in the Chinese currency against the U.S. dollar, the ECB announcement of new stimulus measures and the Federal Reserve’s dovish tone contributed to improve market sentiment and supported the strong outperformance of stocks over bonds in March.
However we maintain our neutral stance on equity vs. fixed income for now as we are cautious about a potential market pullback. Even if we remain positive about stock market perspectives longer terms, we are noticing that some indicators do not confirm the most recent strength in equities and that key sentiment indicators are approaching extreme positivism. Moreover, we see little room for equity multiple expansion from here as the Fed started tightening monetary policy in December. Corporate profit margins also appear to be peaking and we remain in waiting mode for signs of stabilization or improvement in credit conditions before increasing our equity allocation.
For instance, the recent widening of high-yield credit spreads should be a source of concern to equity investors as it is uncommon to see credit spreads widening with equities on the rise. Wider credit spreads over the past two weeks are not in line with the improving investor sentiment and decline in global tail risks. Such divergence often tends to lead turns in risk sentiment (see the chart below).
Also, one of our favorite sentiment indicators, the S&P 500 12-month forward PE ratio divided by the CBOE VIX Index, is illustrating the strong positivism in investor sentiment. Indeed, this indicator is trading at the upper-end of its range since 1990 and is back to levels seen in early August just prior to the market correction (see the chart below).
U.S. equities also appear expensive based on the PEG ratio, which is the ratio of the forward price-to-earnings to the expected future earnings growth rate over the next five years (see the chart below). The S&P 500 PEG ratio is currently standing close to a more than 30-year high above 1.6x.
Historically, the S&P 500 returned a median performance of -1.4% in the month after the 2-month moving average in the PEG ratio exceeded the 1.5x level. More than 60% of the times U.S. equities provided a negative return over the following month (see the table below).
We also remain in waiting mode for signs of stabilization or improvement in credit conditions before increasing our equity allocation. The January 2016 Senior Loan Officer Opinion Survey on Bank Lending Practices gave a negative indication on the short-term outlook for earnings growth. The survey showed that a net 8.2% of banks reported tightening standards for commercial and industrial (C&I) loans to large and middle-market firms over the fourth quarter, while a net 4.2% of respondents reported tightening standards for small business lending. A majority of respondents who tightened either standards or terms on C&I loans over the fourth quarter cited a less favorable or more uncertain economic outlook, a worsening of industry-specific problems and reduced tolerance for risk as reasons for the change. Credit conditions historically tend to lead earnings growth by six to twelve months (see the chart below).
The bottom line is that some entry points are better than others and we believe that market conditions currently point to a less favourable environment for investors in the near-term. However, we remain positive about stock market perspectives longer terms and still expect equities to hit new record highs in 2016 as global economic growth should pick up, interest rates will remain low for an extended period and corporate profits should gain traction with a strong rebound in energy prices during the second half of 2016. If we are correct with our long-held view that the U.S. economy is nowhere near a recession in 2016, this would be the first time in more than fifty years that equities peaked more than twelve months prior to the start of a recession (see the table below). In other words, we believe that once again, the equity market is wrong in predicting a recession. It would not be the first time: As the Nobel Prize-winning economist Paul Samuelson famously quipped in 1966: ``The stock market has forecast nine of the last five recessions``.
Our regional allocation is unchanged this month with U.S. equities still our top overweight. We remain of the view that the U.S. is a relative bright spot for economic growth versus the rest of the world in the near-term. Low energy prices, an improving labor market and strong household formation boosting housing demand should continue to stimulate the U.S. economy. U.S. stocks are also reasonably valued against global equities with the relative 12-mth forward price-to-earnings ratio for the S&P 500 close to its 10-yr average. In addition, S&P 500 earnings estimates relative to the rest of the world remain on the rise, which historically coincided with relative outperformance for U.S. equities. We also continue to recommend that clients underweight Canadian equities as we remain cautious on the short-term outlook for the natural resources sector. The global crude oil market remains well oversupplied and global crude inventories should continue to pile up far into 2016. The pace of global stock builds will even accelerate in the second quarter of 2016. On the other hand, non-OPEC output growth is expected to turn negative in 2016 and with world oil demand expected to increase by 1.3% this year, the pace of global stock accumulation should significantly weaken in the second half of 2016, which in turn should act as a positive catalyst to energy prices. We will closely monitor the situation over the next few months to see how the global oil balance will evolve and how our investment recommendations need to be adjusted to take it into account. For now, we remain underweight Canadian equities. We also remain underweight Other Developed Markets as the rising year-over-year percent change in the EUR/USD represents a major headwind to Euro area exports and the relative performance of European equities (see the chart below).
Our sector allocation in Canada is unchanged this month. We still recommend that clients overweight the Consumer Staples, Telecommunication Services, Financialsand Information Technologysectors. In the U.S., we still advise clients to overweight the Consumer Staples, Consumer Discretionaryand Information Technologysectors. However, we are replacing Health Care from our list of top overweights with the Industrialsand Telecommunication Services sectors. The decline in the U.S. dollar and re-acceleration in U.S. economic momentum are welcome news to the U.S. manufacturing sector, which should lead to a rebound in the ISM Manufacturing index and the relative valuation of the Industrials sector against the S&P 500. Historically, there is a strong correlation between the ISM Manufacturing index and relative valuation of Industrials stocks (see the chart below). Also, upward earnings revisions as a percentage of total constituents for the sector are on the rise, which historically coincided with outperformance for Industrials.
Relative valuation for the Telecommunication Services sector appears cheap with the 12-mth forward PE ratio against the S&P 500 trading close to the bottom-end of its 15-year range. The sector also remains the highest dividend yielding sector in the S&P 500 with a 12-month forward dividend yield of 4.6%. Moreover, the Telecommunication Services sector ranks first in both our earnings and price momentum models.
Canadian Bond Allocation
We have built a quantitative model for timing relative performance between government and corporate bonds in Canada as an overweight position in the outperforming market segment during the appropriate periods can produce significant value-added results. Our quantitative model is based on a large series of macroeconomic and financial indicators that historically proved to be good predictors of relative performance between government and corporate bonds. These indicators include changes in credit conditions, yield curve, earnings estimates, and price momentum variables, among others. This model provides an objective assessment of incoming data.
Currently our model has a neutral exposure to fixed income securities of Canadian government vs. corporate issuers. Overall, we remain constructive on corporate bonds on the back of attractive valuations and all-in yields but our concerns about a potential shift in market sentiment might eventually provide us with an opportunity to increase our corporate exposure at better levels. Also, the 12-month forward earnings growth rate for the S&P/TSX Composite index remains on the decline, which historically coincided with relative underperformance for corporate bonds. Moreover, we remain cautious on the short-term outlook for the natural resources sector and a further decline in commodity prices could result in another round of underperformance for corporate debt. As a result, we advise clients to remain prudent and selective from an issuer and sector-exposure perspective. On the other hand, the Canadian economy should continue to benefit from the strengthening U.S. economy, past CAD depreciation, accommodative monetary policy and the recently announced Liberal stimulus package, which should keep defaults low outside of the metals and energy sectors and remain supportive for credit. Investor demand for high-yielding instruments should also increase in the context of historically low yields across developed market government bonds.
