Conditions on the stock markets are a little, um, subprime right now.
There's that word again. On financial markets these days, it's subprime, all the time. Here in Canada, we have the benefit of a fit economy and strong global demand for the commodities that underpin our stock market. And yet, global panic over a bunch of mortgage loans made to Americans with lousy credit ratings is ruining everything.
"There's no denying that Canadian fundamentals are very, very strong," Vincent Delisle, market strategist at Scotia Capital, said yesterday. "But local fundamentals have very little to do with what's going on right now."
The stock market outlook could hardly be more uncertain after the waves of selling late this week. We may be in the early stages of a bear market, or we could be seeing a pullback that will form the base for a rally higher in the next year. Either way, investors need to brace for more bad days ahead, look at ways of reducing risk in their portfolios and be ready to adjust to changes in the stocks and sectors that lead the market.
One of the difficulties with the subprime crisis is that it's impossible right now to tell how bad it will get. Billions of dollars were lent in the United States to people with subpar credit ratings, and the rate of default has been rising. Lenders are suffering, but so are hedge funds and financial institutions that bought into pools of these subprime loans. Day by day, new names of banks and funds tied to the subprime market are emerging.
The level of involvement by Canadian banks and hedge funds is unclear, but isn't yet thought to be significant. There's no subprime mortgage market to speak of in Canada, and there are no indications that Canadian banks were aggressive players in the U.S. market. Still, there's a serious risk for Canadian investors.
It all relates to the potential for gun-shy banks around the world to make it a lot tougher for corporations and businesses to borrow money. "If banks and other financial institutions are less willing to lend to corporate and business customers, it's possible that this would moderate economic growth," said Doug Porter, deputy chief economist at BMO Nesbitt Burns.
Slower growth would mean reduced demand for oil and metals, and that would hit Canada hard. About 44 per cent of the S&P/TSX composite index is accounted for by stocks in these sectors. Of course, all the other effects of slower growth would play out in Canada as well - lower interest rates, which would in turn bring down returns on bonds and guaranteed investment certificates, and lower corporate profits, which would weigh on the stock market.
After four strong years of returns from stocks, a growing number of analysts and investors are expecting a significant correction. Mr. Delisle said that as of the market opening yesterday, the S&P/TSX composite and S&P 500 indexes were off 6 or 7 per cent from their July peaks for the year. That puts the current slide on the same level as ones seen annually over the past few years. "Much as I don't like the market being down 6 to 7 per cent, we're not in correction territory yet."
Things could certainly get worse in the coming weeks, but Mr. Delisle sees good things a year from now. He pegs the S&P/TSX index at 14,200 in 12 months, which implies a mid-single-digit gain from here. He sees the S&P 500 rising to 1,625, which suggests a gain about double that size in the low double digits.
There are pessimists out there, of course. Nick Majendie, senior vice-president at Canaccord Capital Corp., said in a report this week that the most likely outcome for the U.S. market is a "short, sharp and nasty" decline of 20 per cent. Canada would be in for a similar decline.
