We have two classes of forecaster: those who don’t know and those who don’t know they don’t know
– John Kenneth Galbraith
When asked about the stock market, I make it clear I don’t know what’s going to happen in the next month, quarter or year. It’s the easiest question I get because nobody knows. There are too many factors that influence the short-term vagaries of the market.
But my team and I do provide clients with a forecast for longer-term returns. Rather than try to get it exactly right over the next year, we focus on getting it approximately right over the next five years. We build forecasts from the bottom up, bringing together the fundamentals that influence corporate profits and the price being paid for those profits.
Today, the fundamental outlook is decidedly mixed. Certainly there’s lots to like out there. There’s an established recovery going on in the U.S. Lower energy prices will provide a significant boost to economic growth. And in general, the world is moving toward a better balance. The oil bullies are being reined in, and western countries are becoming more competitive due to weaker currencies (U.S. excepted), lower energy costs and narrowing labour cost differentials.
There are always things to worry about, however, and the biggest negatives today are powerful ones. The world is heavily leveraged, having failed to wrestle the debt issue to the ground after 2008. We’ve continued spending beyond our means due to government and central bank largesse.
The economy is walking a tightrope without the usual safety net, namely the ability to lower interest rates and crank up government spending. To reinforce this vulnerability, consider Canada’s circumstances: highly indebted consumers, weak job growth, modest wage increases, heavy dependence on housing and resources and austerity desperately needed in the two biggest provinces.
The weaker dollar helps, but the Canadian economy is not built for defence.
But however mixed the fundamental outlook is, valuation is a more important determinant of returns. Are stocks cheap or expensive relative to their profits and growth prospects? Valuation is the closest thing to gravity we have in investing.
Today, we’re at a point in the business cycle when assets are well bid. Stocks are trading at price-to-earnings multiples at the upper end of their historical range. There will be opportunities in any market circumstance, but in my view, it’s now a better time to sell a business than buy one.
As for fixed income, it’s a great time to be a borrower. Rock-bottom interest rates and accommodating bankers are an ideal combination. But there is a flip side: it’s a poor time to be a lender. Investors buying a Government of Canada bond (lending to the government) are getting a real yield (after inflation) approaching zero. This is not a sustainable investment strategy over the long term.
And with regard to the other major asset class in Canadians’ portfolios – real estate – cap rates are inextricably linked to those unsustainable (mortgage) rates.
Warren Buffett likens investing to baseball when he says, “The market has to keep pitching, but you don’t have to swing. You can stand there with the bat on your shoulder for six months until you get a fat pitch.”
There aren’t many fat pitches out there right now. I don’t know what’s going to happen to stock markets in 2015, but relative to the opportunities and risks, caution is warranted.
It’s a time to be diversified across a broad range of asset types – cash, bonds, domestic and foreign stocks and real estate – and make sure you’re not carrying more risk than your long-term plan calls for. •
Tom Bradley is president of Steadyhand Investment Funds (www.steadyhand.com). He will be presenting an investment sector analysis at the company’s Where to From Here session February 12 in Vancouver ([email protected]).
