The following is an excerpt from Scott Barlow's collection of 10 charts that will define the markets in 2017. To view the entire series, click here.
The Canadian equity market as a whole is expensive – and possibly prohibitively so based on performance history.
Financial theory supports the idea that stocks should be more expensive on valuation levels (like price-to-earnings ratios) when bond yields are low. In very basic terms, stock prices are determined by estimates of future earnings growth. When bond yields are low, investors can expect to pay more in terms of price-to-earnings ratios for these earnings streams. A stock with an expected 10 per cent earnings growth is worth far less to investors when bond yields are eight per cent – why not just take the sure thing instead of taking equity risk for a mere two per cent more? – than when bonds are yielding two per cent.
Even if low yields are taken into account though, domestic equities are very expensive at the current time.
In our first chart, I account for the effects of bond yields on equity valuations by adding the price-to-earnings (PE) ratio of the S&P/TSX composite index and the government of Canada 10-year bond yield. At the end of October, 2016, for instance, the benchmark trailing PE ratio was 22.3 and the 10-year bond yield was 1.2 per cent, which equals 23.5.
In the chart, these values were calculated for the end of every week in the past 10 years. For each value, I calculated the future two-year cumulative return for the S&P/TSX composite index – these are the dots on the scatter chart.
The downward sloping trend line shows that the higher the PE ratio plus bond yield reading, the lower the future returns have been for the benchmark.
In the current market, the PE ratio and 10-year bond yield add up to 24. To find the expected future two-year return for the benchmark based on history, we look to the chart's x-axis at 24, and see where that meets the trend line. The y-axis meets that point at negative 10 per cent. This implies that with current equity valuations and bond yields, investors can expect the benchmark to decline by 10 per cent in the next 24 months.
This is obviously only one point in time. It also refers to the market in aggregate – there will continue to be individual, lucrative investments available. The outlook can improve if S&P/TSX profits improve because this would lower the PE ratio. Bond yields can also fall, which would make equities more attractive.