One of my five market predictions for 2014 was that sector rotation would make for relatively flat benchmark returns and underperforming investor portfolios. My belief is that widely-held market sectors – the top performers over the past three to five years, such as energy and mining – will underperform.
At the same time, new market leaders will arise that investors don't own in their portfolios yet. In this scenario, the end result will be a S&P/TSX Composite benchmark that treads water, and many investors trying to figure out why their portfolios were down so much.
The big omission in my predictions post was that I didn't identify candidates for domestic market leadership in 2014. Let me correct that now: Industrials have the best chance to lead Canadian equity markets this year.
Economists predict U.S. economic growth will exceed Canadian GDP by almost half a percentage point in the next twelve months. In addition, the reduction in Federal Reserve monetary stimulus is expected to support further gains for the U.S. dollar. The combination of these two factors should see outperformance by Canadian industrial companies where profits have historically climbed with U.S. economic activity.
To identify domestic stocks most likely to benefit from accelerating U.S. growth, I compared stock performance for all members of the S&P/TSX Industrials to U.S. economic data – specifically the PMI Manufacturing Index and industrial production.
The two charts below show the most likely candidates – Transforce Inc., Transcontinental Inc. and Russel Metals Inc.
The first chart illustrates the degree to which Transforce and Transcontinental have tracked the U.S. Purchasing Managers Managers (PMI) index for manufacturing sectors. As a transportation company, Transforce benefits from increased exports when U.S activity rises.
U.S. Manufacturing PMI vs Transcontinental Inc. vs Transforce Inc.
(year-over-year per cent change)
SOURCE: Scott Barlow/Bloomberg
Printing giant Transcontinental might be more of an, ahem, flyer. The company gets very little of its revenue from U.S. operations, yet stock performance has been very sensitive to changes in the U.S. economy over the past decade.
I debated whether to include Russel Metals in this theme, but in the end I decided to let readers decide for themselves. There is no significant correlation between Russell and the PMI Manufacturing survey, but there is a mathematical relationship between the stock and year-over-year U.S. Industrial production (the R is 0.60). Lately, however, the two lines on our second chart have been moving in opposite directions.
Russel Metals vs U.S. Industrial Production
(Year over year per cent change)
SOURCE: Scott Barlow/Bloomberg
Based on these numbers alone, Transforce Inc. looks like the most promising opportunity, in the event the U.S. economy accelerates as expected.