It is a principle of finance that people will pay almost anything for what they don’t know. Stocks with dubious futures can soar in price when investors, fearful of being left out, jump on the bandwagon. Voices of caution are few and far between. Yet now they are being heard.
In New York, where you can buy a cocktail for $18 at upscale bars and men’s suits made with nice Italian cloth sell for $25,000 with one jacket and one pair of pants, analysts are warning that stocks are expensive, which is true, and urging people to be careful. The trouble is that there are few places to turn that don’t have a lot of risk.
There has been a dramatic recovery from the bottom of the Wall Street and Bay Street meltdown in 2008-09. In that eight-year period, the S&P 500 Composite has nearly trebled, the Canadian S&P/TSX has more than doubled and bonds have continued a massive run that began on 1983 when the Fed (U.S. Federal Reserve) and the Bank of Canada broke the back of double digit inflation and started what is now the second longest bond bull market in history. (The longest was the nearly 100-year decline of interest rates in the U.K. beginning with the defeat of Napoleon at Waterloo in 1815 and ending with the beginning of World War I in 1914.)
The question is “what’s next?” There is good reason to worry that the boom can’t be sustained. The terrific performance of large cap U.S. stocks has been spurred by share buybacks and dividend increases. These moves make stocks more desirable without doing anything about the basic business or profitability of the companies that pay them out.
Money returned to stockholders exceeded profits in the first and third quarters of 2014. Moreover, the proportion of cash flow used for stock repurchases has almost doubled over the last decade while it has declined for capital investments. Share buybacks have supported one of the strongest bull markets in the last half century. The question is: if the buybacks slow, will the stocks they have supported collapse?
There is a strong case to be made for the end of the bull market we’ve had for 5-1/2 years. Interest rate declines that sustained the stock bull could be slowing or even ending. Fed chair Janet Yellen is said to be considering letting interest rates rise. That will suck money out of stocks, especially if worried investors take their profits and buy into safe U.S. treasury bonds.
There are other worries. The global equities market is in poor shape. Global growth is slowing, driven down by war in Russia/Ukraine, epidemics in Africa, reduced capital spending in China and what the Islamic State (IS) may do.
There is still life in this market. Just because the averages are up in spite of recent and relatively small declines does not mean they will collapse any time soon. A major market swoon needs an event to trigger the numbers. So far, that’s not at hand. Just as a guess, however, any of today’s crises will be enough to sink the market. That could be a move by Russia into one of the former Baltic republics (Latvia, Lithuania, or Estonia which were part of the U.S.S.R.) more than token spread of Ebola into Europe or the Americas prompting a drastic curtailment in international travel, political chaos in China of the sort spurred by October’s Hong Kong democracy demonstrations, or some act of terrorism yet to be imagined. Needless to say, a crack in world trade for any reason would echo in Canadian export markets, especially grains. If you can’t ship it, you can’t sell it, after all.
What to do? The financial press is clogged with stories of stocks about to take off. Most are small to mid caps with no dividends but, say the authors, a lot of hope. Let me offer a few former hopefuls: Polaroid Corp., Commodore 64, Studebaker Packard and, of course, Nortel Networks. Each had industry-leading technology for a time. All but Nortel failed mainly for the company’s inability to keep up with changing technology. Nortel was a tech company, but its accounting was also material to its fate. Some savants may have known in advance of each company’s flop, but the stock kept trading, if only because the public could not or would not admit that each company had entered the space of the living dead.
How to avoid that fate? Invest in big companies with many product lines not wedded to any single technology. Big telcos like BCE Inc., big banks that do many things (our big six meet the standard), big manufacturers with deep pockets (Boeing, for example). And big consumer products companies with global scale, such as, McDonald’s, Procter & Gamble and Colgate Palmolive.
Each of these companies does so many things that no single event or problem can sink it. Each pays a healthy dividend and has a history of increasing dividends. None makes a toxic product, such as cigarettes, none makes a product closely tied to world commodity prices. These are defensive stocks with protection in depth.
Or go for a few bonds. A Province of Alberta 2.9 per cent bond due Sept. 2029 priced at $97.98 per $100 face value currently yields 3.08 per cent to maturity. It will drop in market price if interest rates rise, but if held to maturity, the payoff is certain. Or an IGM Financial six per cent issue due Dec. 2040, recently priced at $123.59 per $100 will yield 4.46 per cent to maturity. Yes, there is a capital loss, but that’s all figured into the price. You get more than today’s interest rates, so you pay more.
The present stock market trend, a slowing boom, is called a trend because it is not permanent. As I write this column, the omens are not good. Falling oil prices and concern about the stronger U.S. dollar, which will crimp American exports, have hurt investor confidence in recent weeks, leaving the S&P 500 Composite index down 3.3 per cent, the worst autumn performance since 2009.
Where to go next? If you are willing to take equity risk, Canadian stocks look good. David Rosenberg, chief economist for Toronto-based investment management firm Gluskin Sheff, notes that the consensus of analysts predicting market averages is that the TSX will rise 11.2 per cent in 2015, beating the predicted 8.1 per cent rise in the S&P 500 Composite next year. That would be a catch up, for the TSX lagged the U.S. averages in the fall. Rosenberg estimates that the TSX is undervalued by 12 per cent compared to its 16 per cent overvaluation at the end of summer.
These are number games. The math is valid, but nobody knows if the TSX will get to be a better deal, rewarding investors who wait to plunge, or the S&P 500 Composite will get richer, rewarding those already in the U.S. market. Timing is the key and almost nobody gets that right.
Stocks and bonds are worth only the money they will ever return to their investors. With an investment grade bond, the return can be calculated to the obsolete penny. With stocks, you can be sure only of sustainable dividends. So be aware, be wary and keep money safe in things that pay off no matter what the market does. Strong dividend stocks and bonds from governments with the power to tax and companies with massive scale are good defensive bets in trouble times.