Bank of Montreal chief investment strategist Brian Belski released a five part warning to Canadian investors Friday titled, "Signs of TSX Froth."
Mr. Belski lists low volatility, the highest TSX 12-month forward price to earnings ratios since 2000 (indicating analyst expectations for the coming year may be unrealistic), the dominance of energy stocks and the large number of share prices hitting 52-week highs as solid reasons to expect a pullback in the domestic benchmark's performance.
The most compelling reason to worry, however, is the S&P/TSX Composite's drastic outperformance of commodity prices at a time of slowing global economic growth.
The chart below compares the equity benchmark to the Bank of Canada's commodity price index. Historically, the TSX has closely tracked commodity prices because of the index's outsized weightings in mining and energy stocks. Since the fall of 2013, however, equities have climbed higher by 26 per cent while commodity prices have been flat to lower.
SOURCE: Scott Barlow/Bloomberg
Divergences between commodity prices and the TSX are not entirely novel. In the 2006 to 2008 period, the TSX successfully predicted the sharp spike in resource prices that began in late 2007.
But the global economic growth outlook that drives commodity and resource equity prices is now much different. As Mr. Belski notes, economist forecasts for growth continue to move lower. In June of 2013, economists expected 3.7 per cent global growth for 2014 and four per cent for 2015. Projections now call for 3.2 per cent and 3.7 per cent respectively.
The Chinese economy, the largest source of demand for almost every commodity, is also growing at a much slower rate than during the pre-financial crisis era. China saw their economy grow 7.8 per cent in 2013, sharply lower than the 12.7 per cent in 2006 and 2007's 14.2 per cent.
The Canadian equity market is priced for higher commodity prices and a greater level of global economic activity than experts expect. Unlike in 2007, the odds are higher that equity prices reflect excess optimism rather than an accurate forecast of future growth.
Mr. Belski advocates that investors should shift assets from Canadian equities to U.S. markets. He writes, "We believe U.S. corporate fundamentals remain the beacon for the rest of the world with regard to earnings consistency, balance sheet strength and operating efficiency."
In terms of specific U.S. market sectors, Mr. Belski recommends financials, industrials and technology. In the first instance, he believes the fear hangover from the financial crisis has bank stocks trading at valuations that understate future profitability. Industrials are expected to benefit from the steady return of corporate spending. In technology, Mr. Belski feels "the consistency of large cap tech remains under appreciated."