Where investors should look before they leap
The markets are due to go sideways for at least five years, says this Canadian analyst, and investors should be careful what they buy.
There’s a perfect storm coming.
It’s gathering behind an overvalued stock market and an unattractive bond market, and it may soon burst upon us.
Be prepared, says one Canadian analyst. But be very wary as well.
Do not be tempted into trying “a slew of new investment products” that promise stock-market returns without stock market risk.
Mr. Keith Richards is a seasoned veteran of the wealth management business and he recreates his strategic thinking regularly for the readers of Investor's Digest of Canada.
Right now, he’s thinking about how to deal with a stock market that he believes will be headed sideways for quite a while.
The bullish cycle is winding down, he says, and he is holding several exchange-traded funds (ETFs) to take advantage of its late stages.
He gives us a reading on these storm warnings, beginning with that oft-used weathervane, the price-to-earnings ratio.
Returns cut in half
Historically, the average price-to-earnings (P/E) ratio for the S&P 500 Index is around 16. This average is calculated from trailing earnings, adjusted for inflation, over the previous 10 years.
Typically, markets can be considered “cheap” and stage a strong rally when that ratio drops below 10, says this analyst. Things get expensive when it works its way back up to the low- to mid-20s.
In the 1920s and the late 1990s (both dangerously exuberant times), the market’s P/E ratio soared above 30 and 40, respectively. As a rule, says Mr. Richards, when the ratio hits 20-25, there’s a sharp correction.
The last time it hit 25, in the mid-1960s, returns on the S&P 500 were eventually cut in half!
Now, the P/E ratio for the S&P 500 has pushed past 20.
As far as Mr. Richards is concerned, there may be no more than seven to 10 per cent upside left in the markets. They are about to enter a limited trading range in which they will move sideways.
What’s more, they will stay in that pattern for at least five years.
Hitting the ceiling
Mr. Richards is looking for a high point at which to exit the markets. For the S&P/TSX Composite Index, it would be about 13,000 (it’s at 12,044 this morning). For the S&P 500 the number is 1,250 (1,174 this morning) and for the Dow Jones it’s 11,500 (10,888 this morning).
After that, stock prices will hit their heads on the “ceiling” and will likely be pushed lower. So will it be time to get out of equities?
Not so fast, says this analyst. Interest rates seem certain to rise in the next year, which is not good news for the bond market, either. And today’s bond and GIC yields are downright puny.
Ain’t gonna happen
Here is where some investors may be led astray, says Mr. Richards. They may turn to so-called “guaranteed” investment products.
Many of these products — “income-enhanced” mutual funds, high yield funds or segregated funds — promise a high return with little risk. They are “squarely aimed at the retired or nearly retired investors who are terrified of losing more than they already have.”
But this analyst makes no bones about it — this promise is an illusion.
“Let me emphatically state right here and now that you can’t have a higher-than-market return (or higher-than-market yield) without an equally high potential for risk, or at least, an unpredictable return. Sorry — it just ain’t gonna happen, no matter what the nice investment adviser or the handsome man on the television commercial tells you!”
If you do insist on trying one of these products, adds the analyst, look very carefully at the prospectus. Many guarantee only a portion of your income if the markets decline.
What’s more, the management expense ratios (MERs) alone will reduce your ability to benefit from any remaining strength in the market. Mr. Richards has a different way of getting ready for the storm.
The last legs
To play the “last legs of the bullish cycle,” he has two big index ETFs. iShares CDN S&P/TSX 60 Index Fund (TSX-XIU), covering the top large caps on the TSX, trades today at $17.76.
He also has an ETF that replicates the S&P 500, but hedged to the loonie. iShares CDN S&P 500 Hedged to Cad$ Index Fund (TSX-XSP) is trading at $13.56.
He also keeps a hand in the energy sector, with iShares CDN S&P/TSX Capped Energy Index Fund (TSX-XEG), which is trading this morning at $17.72. He continues to hold several blue-chip stocks, although he does not identify them.
For the fixed income side of the portfolio, Mr. Richards is selling longer-dated bonds to capture the gains made during the recent bond bull market. He is moving the capital into the short end of the curve, focusing on one to three-year terms in high quality corporate bonds.
As the markets reach the ceilings this analyst foresees, he will be reducing his position in equities, he says. But that day is not quite here.
He leaves his Investor's Digest of Canada readers with this thought. You don’t need to be victimized in the gathering storm. Prepare yourself carefully — and stay away from investments that promise more than they can deliver.
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