This week, Bay Street veteran David Baskin paid a visit to another money manager in New York. The manager wanted to sell him on a strategy for a fixed-income fund, to be used by a pension plan that Mr. Baskin is involved with as a director.
It was quite a sales pitch. "He said his objective this year is not to lose too much money," Mr. Baskin said. "That's the best you can do. This is a poor schmuck with $50-billion worth of bonds."
A slow economic recovery, vanishing inflation and central banks that have been flooding the world in money have conspired to keep interest rates at ultra-low levels for years. Government bonds look unattractive. The yields remain low – 10-year U.S. Treasuries pay just 2.7 per cent – and for those who can't hold to maturity, there is the prospect of significant capital losses in the years ahead if growth, and inflation, heat up. (Bond prices move in the opposite direction of yields.) Many corporate bonds also look expensive.
"So what are you going to do with your money?" Mr. Baskin asks. For many investors, the only answer is stocks, baby. Since the great rotation has spun money out of bonds and into equities, the stock market has become the best game in town. U.S. equities in particular have staged a huge rally: The Standard & Poor's 500 is up 24 per cent on the year, on course for its best year in a decade, and has now risen 162 per cent since hitting bottom in early 2009. All 10 major sectors are on course for double-digit gains this year, a feat matched only once before, in 1995.
But the stock renaissance has been a global phenomenon, if not quite a universal one. While investors soured on some emerging markets this year, European and Japanese benchmarks have soared. Despite weak commodity prices, the Canadian market has also made respectable gains, with the S&P/TSX composite index up 7.6 per cent so far in 2012.
If not for its heavy concentration of mining stocks, the TSX would be doing far better. Big companies such as Magna International Inc., CGI Group Inc. and Manulife Financial Corp. have soared. Bank shares are near record highs. Royal Bank of Canada recently broke through $100-billion in market capitalization – the first Canadian company to do so since Nortel Networks Corp. got caught in the great tech bubble.
The flip side of any great market rally, of course, is that it will inevitably end. The S&P 500 has now gone for more than two years without a correction of at least 10 per cent. "We know we're going to have a ten-per-center. We have to," Mr. Baskin said. Market watchers everywhere worry increasingly of asset bubbles and inflated valuations.
So does this bull market still have legs?
The breakout of U.S. stock averages to new record highs is due in large part to the unprecedented market influence of the U.S. Federal Reserve, which has forced money into equities by making fixed-income securities less attractive. That's one of the effects of quantitative easing (QE) – the name for the bond-buying program the Fed uses to create new money to stimulate economic activity.
"This has been a central-bank-driven market," said Lorne Steinberg, president and portfolio manager at Lorne Steinberg Wealth Management in Montreal. "It's been all about forward guidance, making investors feel as comfortable as possible that rates will stay low for a very long time, so they'll keep on taking risk."
Quantitative easing is bringing about the reversal of some time-worn investing truisms in the process.
Traditionally, stocks would draw strength from improvements in the real economy. But the U.S. market is now in a counterintuitive situation: Stock prices rely, in part, on economic weakness to ensure the continuation of more Fed stimulus, said Don Coxe, chairman of Coxe Advisors LLP.
"For the first time in history … the last thing anybody wants is really big economic numbers, because the stock market couldn't withstand it," he said.
Ironically, he said, "for a bear market to come, what we need is for the economy to get strong enough that the Fed is forced to change its policies. As soon as we do that, we're going to have a big selloff."
In the spring, the Fed jolted investors when it ruminated on the prospect of scaling back its $85-billion-a-month bond-buying program. Interest-rate-sensitive stocks in particular, including those paying big dividends, were hit with losses upward of 10 per cent.
The market swiftly recovered when Fed chairman Ben Bernanke shelved the so-called "tapering" plan in September over broader economic concerns. But the episode was a stark indication of the vulnerability of equities to a shift in Fed policy.
As much as investors dread the taper, its eventual arrival will be accompanied by a natural consolation. Central bankers, including Mr. Bernanke, won't meddle with stimulus unless the economy can sustain it. "They're only going to raise rates if growth is improved," said John Zechner, chairman of J. Zechner Associates, an investment management firm. "So you've got this stacked deck for equity investors. It's a win-win scenario."
Even though every attentive investor knows that tapering is on the way eventually, its effects are not yet fully priced into stock values, Mr. Zechner said. "The market never fully corrects for something until it actually happens. It only corrects partly on expectations."
So while the effect of tapering is difficult to gauge, some market carnage seems likely. It depends on how those investors who were nudged into the stock market by QE react.
Many investors who abandoned the bond market have found refuge in dividend-paying stocks. Even growth stocks with relatively low dividends have yields beyond what five-year bonds pay out.
Traditionally, the Canadian banks and telcom stocks have paid dividends at about 70 per cent of the yield on five-year Government of Canada bonds, Mr. Baskin said. That relationship has flipped. Now the telcos yield about 4.5 per cent, more than double prevailing bond yields. "So why wouldn't you buy the stocks?"
The fear is that tapering, which will pull bond yields higher, could spark an exodus of those investors back into fixed income. "There are a lot of bond refugees in the stock market, because there's nowhere else to be," Mr. Baskin said. "The question is, how fast will they leave once interest rates start to rise?"
This year, those investors have become more comfortable with stock market risk as a number of anticipated financial calamities never transpired. The year began under the pall of the U.S. fiscal cliff, which gave stocks an early boost when Congress arrived at a compromise. Then midway through the year, investors stopped worrying so much about a hard economic landing in China, recession in Europe and stagnation in the United States.
"Stocks were cheap and unloved a year ago," said Patrick Ryan, a global equities specialist and portfolio manager at Lazard Asset Management in New York. "We had seen years of outflows from equities since the crisis, so they were kind of poised to move ahead with any kind of improvement in the macro environment."
The average stock multiple on the S&P 500 has risen substantially from a recession-era low of about 11 times earnings up to more than 16.5 currently, which is higher than the long-term average, although not by much. "You're really just catching up to historical norms in a lot of ways," Mr. Zechner said. "You can't argue that stocks are really cheap, but you certainly can't argue they're really expensive."
On top of expanding P/E multiples, corporate profits have soared, reaching new all-time highs this year as a percentage of the U.S. economy. There are investor worries on the earnings front as well, although those too might be overblown. "I think companies are smarter. They have lower financing costs, better use of capital and their margins are going higher," Mr. Zechner said.
Supporting stock markets is a global growth outlook that is ever-so-slowly gathering steam. "The U.S. led the world into recession and it's leading the world out of recession," Mr. Steinberg said. "The world continues to trudge along, and that's the story – slow growth, but growth." Just how stock investors like it, lest Mr. Bernanke gets any more big ideas.
SECTORS TO WATCH
On Oct. 29, each of the five biggest Canadian banks hit 52-week highs – four of them setting records – underscoring the sector's resiliency amid concerns that a housing bubble would take them down.
While recent gains may limit further upside, the housing correction is nowhere to be seen and the Bank of Canada recently pushed the eventual increase to policy rates further out into the future.
Going into this year, a vocal contingent of U.S. hedge funds built up a number of short positions against Canadian financial stocks, essentially betting that the housing and banking sectors were bound to correct. "How's that working out for them?" asked David Baskin, president of Baskin Financial in Toronto.
Pessimism towards Canadian banking is largely predicated on the belief that housing prices in Canada have gone up too far, too fast, and that residential real estate was due for at least a mild correction.
"We never bought the idea that the Canadian housing market is anything like the U.S. housing market," said John Zechner, chairman of J. Zechner Associates. "The American investors who are doing that don't understand Canada."
While the federal government has attempted to orchestrate a controlled slowdown in home prices through mortgage insurance restrictions, Canadians continue to take out mortgages and bid up home values. Real estate activity has fuelled bank earnings, with all five posting stock market advances of between 12 and 20 per cent so far this year.
"Despite the move, we haven't taken any money off the table there," Mr. Zechner said, adding that he still sees room for Canadian financial stocks to rise.
Valuations have expanded, but not so much as to make the bank stocks good selling candidates, Mr. Baskin said. "We don't think Canadian financials are overvalued. You're buying world-class companies at 11 times earnings with good dividend yields. That doesn't feel overvalued in this environment."
Adding to the investing appeal are dividend yields of of 3.5 to 4.5 per cent on bank stocks, which compares very well to the benchmark yield on five-year governments of about 1.8 per cent.
"We think the dividends are probably going up and we think the earnings are sustainable," Mr. Baskin said.
Netflix Inc. CEO Reed Hastings took the opportunity during a third-quarter earnings call last month to address the company's stock price. Such warnings typically follow a company setback. Netflix has the opposite problem.
"We have a sense of momentum investors driving up the stock price more than we might normally," Mr. Hastings said.
Such has the euphoria around social media stocks taken hold this year that the Securities and Exchange Commission felt compelled to issue a warning of its own. Investors should not be so clouded by meteoric growth that they abandon rational investment principles, SEC chairwoman Mary Jo White said the day before Twitter began trading on the New York Stock Exchange. "It can be hard not to think that these big numbers will inevitably translate into big profits for the company. But the connection may not necessarily be there."
Tech stocks are, as ever, some of the most speculative plays going.
The absence of profits has been a minor detail investors have been willing to overlook for the chance to buy into the unbridled potential of the Internet. A number of Internet-based companies with speculative profit outlooks have spiked this year, fuelling concerns of a concentrated bubble.
Both Facebook Inc. and LinkedIn Corp. stock have nearly doubled so far this year. While Twitter Inc. has yet to post a profit, the market valued the company at $23-billion (U.S.). Netflix has risen 260 per cent this year, now trading at a multiple of about 200 times earnings. Amazon's price-to-earnings ratio is meaningless since the company makes no money, which hasn't stopped investors from pushing its stock price up to $350 from less than $100 four years ago on the basis that Amazon will be able to make a lot of money in the future.
"In the meantime, it seems like investors are very willing to pay up," said John Zechner, chairman of J. Zechner Associates. "It's not logical. But the market's not always logical in the short term."
It's impossible to come up with a rational investment thesis for some of these stocks, said David Baskin, president of Baskin Financial. "We just don't know how to value them." He said he could justify Twitter's current valuation based on $1-billion in annual earnings five years from now. "I can't forecast what it's going to be doing five years from now, let alone five months from now."
European stocks, beaten down during the recession as some European Union members seemed to edge toward bankruptcy, staged strong comebacks as modest declines in deficits and unemployment have improved economic prospects.
The benchmark Euro Stoxx 50 index has risen by more than 13 per cent so far this year, and money managers say there is more room for growth as the region finally seems to be improving economic fundamentals.
Essentially, investors were willing to jump back into European equities once it was clear that the sovereign debt crisis and regional recession had finally begun to subside, said Lorne Steinberg, portfolio manager at Lorne Steinberg Wealth Management. "Europe having gone through hell, things had to bottom out at some point," he said. "You can smell that we're getting close to the point where European governments will be allowed to spend some money on fiscal stimulus,.
The most recent fund manager survey from Merrill Lynch shows that money managers are increasingly keen on Europe. Forty-six per cent of asset allocators are overweight in European equities, the survey said, the highest level since 2007.
Stephen Lingard, portfolio manager at Franklin Templeton Multi-Asset Strategies, said the rise in European equities shows that investors are anticipating rising earnings, even though that growth has not actually taken hold yet. "There has been very powerful re-rating of European equities. But earnings are still off their peak [from before] the financial crisis." As earnings catch up, however, there will be another jump in stock markets, he predicts. "The next phase of the European rally will be on the back of earnings expansion."
The European Central Bank's move to cut interest rates will add another degree of buoyancy to the market, Mr. Lingard said. "This is a new sign that they are serious about supporting this economic recovery that we are seeing in Europe."
Patrick Ryan, a global equities specialist at Lazard Asset Management in New York, recommends exposure to places like Italy and Spain, where the economies have been the weakest in the past few years – although some of the structural changes there could take many years to come to fruition. There is also potential for gains in the stronger economies like Germany, he said, because earnings there still lag their pre-recession peaks.
Solar stocks have outshone just about every other sector during 2013, but the threat of overproduction in solar panels makes a remounting of former highs unlikely.
The key index that follows 26 global solar companies worldwide has more than doubled this year, and some firms have seen their stock prices increase by as much as 700 per cent.
The problem, though, is that those gains were off abysmal lows, as the industry went through a deep depression from around 2010 to 2012, when many companies lost up to 90 per cent of their stock value. Even with this year's gains, most companies are nowhere near their all-time highs.
Canadian Solar Inc., which is based in Guelph, Ont., and makes most of its solar panels in China, has seen its stock jump from $3.50 (U.S.) at the start of the year to over $26. This past week's announcement that the company will report significantly better results in its third quarter than it has expected gave it an extra boost. Still, even with its enormous gains in 2013, Canadian Solar stock is still well below its all-time high of over $51 back in 2008.
Big players such as SunEdison Inc. and SunPower Corp. have seen their stock prices triple this year, but they, too, are far below their highs of past years.
One reason for the gains is that the problems that beset the industry a couple of years ago – an overproduction of solar panels and decreased demand in many markets – have now diminished, although they have not entirely gone away.
There has been a shakeout of panel makers with some going out of business, and China has made some modest moves to end the "dumping" of cheap panels around the world. The massive Chinese solar panel business has also seen some significant consolidation.
At the same time, some markets for solar power – in China, Japan and parts of the United States – are hot, and that demand is helping resurrect the industry. It helps that in some markets, solar-generated electricity, which has dropped dramatically in price thanks to cheaper panels, is now no more expensive than power from other sources.
Another factor is the bull run that has lit a fire under equities all around the world. That has pushed up speculative companies, such as those in the solar sector.
Khurram Malik, an analyst at Jacob Securities Inc. in Toronto, says solar panel stocks can be risky for many investors, despite the upward momentum. The best bets, he said, are companies that install panels or finance installations – rather than the panel makers themselves – because they will benefit from a continued decline in solar panel prices.
After shedding high-cost projects and announcing many billions worth of writedowns, gold producers may be poised for a rebound.
Gold miners suffered as the 12-year runup in prices for the precious metal ended two years ago. Gold prices had benefited as investors sought a safe haven through the financial crisis and recession. Additionally, the swell of monetary stimulus seen globally post-recession lifted gold's appeal as a hedge against inflation. Gold bugs foresaw no end to the frenzy.
The end of the gold rally "even caught the mining executives by surprise," said John Ing, president and gold analyst at investment dealer Maison Placements Canada Inc. As much as gold prices have tanked, falling by more than 30 per cent since the 2011 peak, company valuations have doubled those losses. The gold subindex on the TSX fell 60 per cent over two years, as the price correction has rendered great numbers of gold projects unviable, forcing a restructuring among some of Canada's biggest gold producers.
"Everybody got spoiled," Mr. Ing said. Producers expanded relentlessly into high-cost endeavours.
The swift reckoning has forced an adjustment in lifestyle for gold mining companies. "They're now all articulating the mantra of cost containment," Mr. Ing said. "At long last they're running their businesses like businesses."
Barrick Gold Corp., one of the world's biggest producers of the commodity and one of Canada's most successful corporations prior to the correction, has announced at least $13-billion in writedowns so far this year.
"They've cleaned up their operations. Their balance sheets are in better shape," said John Zechner, chairman of J. Zechner Associates. Barrick is among his top picks in a sector he sees as due for a resurgence. "It looks a little bit like the airline industry a few years ago."
The end of the gold market rout has been tough to call.
Back in April, so confident was Frank Giustra in gold's recovery, he promised The Globe and Mail he would "sing Patsy Cline's So Wrong wearing ladies' underwear" in the middle of downtown Vancouver if he was proven wrong.
The Vancouver mining mogul is steadfast in his belief that we haven't seen the last of the great gold bull market.
"I have no reason to visit Victoria's Secret any time soon," he said in an e-mail. "Standing by my prediction."