The Globe and Mail, Report on Business, Guest Column
July 12 2006
In April, 2003, when everyone was felling pretty beaten up after three years of falling stock markets, I wrote an article in the Phillips, Hager & North Quarterly Report entitled, "A View from the Bottom". The piece was an attempt to provide some perspective on what it should feel like at the bottom of an equity cycle. I pointed out a number of things investors should expect to see including a negative bias to business reporting, a slow RRSP season, a new-found love for real estate and in general, a high conviction by everyone (armed with their favourite statistic) that the stock market is overvalued. I concluded the piece by suggesting that equity returns over the next few years could be double digit given that values were again quite compelling. On the greed-fear scale, it was time to get greedy.
The timing of that article proved to be pretty good. By the time it was published, the market was turning around and it hasn't looked back since. That was a fluke of course, as I'd thought the market was looking attractive well before the article came out.
In any case, it seems to me that there are lots of extremes in the capital markets today. Canadians have had an exceptional run over the last three years. If we are nearing the top of a stock market cycle, what should we expect to see? What should it feel like? Every cycle is different, of course, but here are a few tried and true indications that we are close to the top.
First of all, the sales of Porsches and high-end homes will be very strong.
Brokerage firms will be reporting record profits due to a high level of merger and acquisition activity and lots of initial public offerings.
Related to that, foreign brokerage firms will be making an increased commitment to Canada. It happens every time. When the big guys from Wall Street have money in their jeans, Canada becomes part of their expansion plans. I should note that there are always long-term strategic reasons for starting up or expanding here. And those reasons stay in place until the markets slow down, at which time many of the firms retrench and pull back to the mother ship in New York.
At the top of the equity market, money flows into equity mutual funds (and other equity-linked products) will be very strong and investors' expectations for future returns will have moved up again.
In general, the market indexes will be hard to beat. Mathematically this makes sense. Holding cash in a bull market is a bad thing and indexes don't carry cash. Also, capitalization-weighted indexes are like momentum funds in the sense that they naturally rebalance with the market, not against it. In other words, the stocks that go up a lot become a bigger part of the market, which in turn leads people to buy more. In an attempt to manage risk and pursue value, professional managers tend to rebalance their portfolios against the market, which hurts returns in the short term.
As a result, value-oriented money managers, and those focused on absolute returns, will be out of favour. Also, investors that regularly rebalance their portfolio will have stopped doing it and will be heard mumbling, "It's cost me money every time I've done it."
At the top, there will be plenty of talk and expert opinion as to why the good times for the cyclical industries will last longer than previous cycles.
Finally, cash and bonds will be more attractive due to interest rate increases, but investor interest in these categories will be very low.
So are we near the end of this bull run? Certainly some of the signs are there. There are plenty of new Porsches on the road. M&A activity is high, as are brokerage firm profits. There have been a number of announcements in recent months about foreign brokers starting up or expanding a Canadian subsidiary. The S&P/TSX Composite Index has indeed been hard to beat, especially by the absolute-return, value-oriented managers. The consensus view is that we're in a super-cycle for oil and other basic materials due to China's unique influence, years of under-investment and a depleting resource (in the case of oil). As for cash and bonds, yields have moved up considerably, making fixed income securities more attractive.
None of us know what the market is going to do in the months to come. I do feel, however, that it's a time to be more fearful than greedy.