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David Rosenberg recently suggested investments in sectors such as financial and consumer discretionary could be better for portfolios than consumer staples and health care.Deborah Baic/The Globe and Mail

Tuesday was another painful day for investors - and David Rosenberg doesn't exactly have soothing words.

The chief economist with Gluskin Sheff believes U.S. equities are only between one-quarter and one-third of the way through what he thinks is a "normal corrective phase," based on a range of indicators he has analyzed "with a fine toothed comb."

"The fact that U.S. equities can make little headway despite what would ordinarily be considered favourable corporate news like the record Alibaba IPO, the move by Hewlett-Packard to split into two companies, and reports of stepped-up bond trading volumes for the banks is a classic signpost that the main overhang in the market is principally one of excessive valuation that needs (and is in the process thereof) to compress - a market already more than fully priced for whatever good news there is out there," Mr. Rosenberg wrote this morning in his Breakfast with Dave newsletter. "That is the message from a 16x forward price-to-earnings multiple, which is at least 10 per cent above the norm."

But Mr. Rosenberg stresses a key point at a time when investors' nerves are getting tested: Don't be tempted to move entirely into cash. That level of hubris, he said, would imply you have complete confidence in timing the market. And as any investor who has been in the game for a while knows, that's nearly impossible.

"What it means is reining in the beta of the portfolio, dialling back on risk for now, and raising some cash to buy back the quality names you already own at better price points," he said.

"This corrective phase may not be over yet, but continuing to look for the forest past the trees is necessary because corrections are not the same as fundamental bear markets, and I do not see the conditions for one of those, at least not yet."

Mr. Rosenberg said he looks at seven indicators to gauge whether markets are poised to make a sustainable upward march again. Only one - the relative strength index of the small-cap sector - is flashing a green signal. "We will need more evidence than that to become convinced that a buying opportunity is at hand."

"So far, the S&P 500, even with all the ups and downs since the mid-September peak, has corrected by 2 per cent, even though it may feel worse than that given all the volatility. The VIX (volatility index) has only jumped 20 per cent, or less than half what one would like to see at an interim market trough. Both the trailing and forward P/E multiples have corrected by 30-40 basis points - again, a fraction of what we typically see when it comes time to start dipping more toes into the equity pool. Even the high-yield corporate bond market, which has corrected in relative terms more than other asset classes, has seen spreads widen 20 basis points since last month's peak in the S&P 500 - one-quarter of the widening that we tend to see before the dust settles. The 10-year T-note yield is down 20 basis points and again this is half of what is typical."

And there are cracks appearing as we head into the third-quarter earnings season. Analysts have been lowering their earnings forecasts for the quarter due to such factors as weakening economies overseas, sliding energy prices, and the hit to currency-translated earnings from the surging U.S. dollar, he noted.

But Mr. Rosenberg does have some good news for Canadian investors: valuations in our market have seen a significant improvement, especially relative to the U.S. The consensus earnings per share estimate by the analyst community for the TSX for the coming year edged up to $1,024 in September, a six-year high, from $1,013 in August. Analysts now see an 11.2 per cent rise in earnings per share for the TSX, beating out the growth rate of 8.1 per cent for the S&P 500, even as the TSX has performed much worse than U.S. stocks in recent months.

He notes that the PEG ratio, calculated by dividing the price-to-earnings ratio by earnings growth rates over the coming three years, fell to 0.88 times for the TSX this month from 1.15 times in September and from 1.16 times in August. That "means that in the span of two months, the Canadian stock market has gone from 16 per cent overvalued to 12 per cent undervalued in absolute terms," Mr. Rosenberg points out.

The lower the PEG ratio, the more a security or market may be undervalued given its earnings performance. Generally, a PEG ratio of 1 or less signals a potential buy for investors. A ratio well above 1 suggests a security or market is richly priced.

The S&P 500 PEG ratio is now 1.25 times, down just modestly from 1.31 times a month ago, due to the combination of the mild correction and milder increases in EPS projections in the U.S. "This in turn, means that the relative PEG ratio discount in favour of Canada - the TSX versus the S&P 500 - has widened in this corrective period from 12 per cent to 30 per cent," Mr. Rosenberg wrote.

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