Is a new bull market beginning? The S&P 500 has surged 14 per cent since the start of the year. Despite dire warnings of calamity ahead, the Canadian and U.S. economies continue to power ahead, with some of the lowest unemployment rates on record.
The resilience of both the market and the economy has surprised many people, including me. Now may be a good time to ask whether we skeptics may have missed a turning point.
To answer that question, let’s go back a few months. At that time, a recession seemed imminent.
The biggest reason to brace for a downturn was the inverted yield curve – bond market jargon for a rare situation in which the yield on short-term bonds rises above the yield on longer-term bonds. This unusual pattern has been an uncannily accurate predictor of economic trouble over the past five decades.
Toward the end of last year, Royal Bank of Canada economists (and many others) looked at a deeply inverted yield curve and predicted a downturn would hit Canada in the first quarter of this year. That sounded entirely reasonable.
Except it didn’t happen. What occurred instead were a couple of major surprises, starting with the amazing rise of artificial intelligence (AI) software.
The release of ChatGPT in November demonstrated how quickly researchers were closing the gap between human brainpower and its machine facsimile.
By January, a hundred million people had tried ChatGPT, according to a UBS study. Everyone agreed AI was on the verge of changing our lives, even if nobody was sure exactly how.
Investors didn’t wait around to find out. They bid up the price of seven big stocks that seemed likely to benefit from AI. The rapid rise of the magnificent seven – Alphabet Inc., Amazon.com Inc., Apple Inc., Meta Platforms Inc., Microsoft Corp., Nvidia Corp. and Tesla Inc. – pushed the entire S&P 500 index higher.
But it wasn’t just AI that delivered good news. Real estate markets also confounded the skeptics.
In late 2022, many observers assumed home prices were headed for a crash this year. Both the Bank of Canada and the U.S. Federal Reserve were hiking interest rates at a frantic pace. Soaring mortgage costs seemed destined to crush property values.
The crush turned out to be more of a love tap. Canadian home prices slid in late 2022 and early 2023, but held steady far above prepandemic levels. They are now showing signs of renewed strength. The Teranet-National Bank House Price Index gained 4 per cent between February and May.
The U.S. home market has also remained surprisingly robust. The SPDR S&P home builders Exchange Traded Fund, which tracks major U.S. home builders and makers of building products, has rocketed 25 per cent higher since January.
So, given all this, how should gloomsters like me revise our opinions?
I think we should be slightly more optimistic about the broad economic outlook. The yield curve is still inverted and a recession may be coming, but it seems increasingly likely to be a shallow, short one.
Housing is usually the bellwether for the economy and it’s difficult to see how the North American economy can slide into a deep, protracted recession so long as housing demand is running as strong as it is now.
A report this week from Benjamin Tal at CIBC highlighted the massive labour shortage in Canada’s construction sector. The need for workers in that sector, combined with a wave of retirements by boomers in all sectors, seems likely to put a lid on any sustained rise in unemployment rates.
It’s not clear, though, that a somewhat improved economic outlook will translate into big gains for the stock market.
As we discussed in this space last week, the recent advance in the S&P 500 has been nearly entirely concentrated in seven AI-related stocks. At their current lofty valuations, they are vulnerable to any disappointment. If AI doesn’t prove to be a fast path to increased profits, the magnificent seven have a long way to fall.
Look beyond the giddy stock prices of those few companies and the prospects seem somewhat better. Most shares in both the U.S. and Canada are trading at ho-hum multiples of what analysts expect their earnings to be over the next 12 months.
However, those valuations still aren’t in bargain-basement territory. Rising bond yields have made it possible for investors to reap guaranteed payouts from bonds that are only a hair less than what a typical stock is generating in earnings.
Given the growing competition from newly attractive bonds, most stocks seem to be only reasonably priced. Meanwhile, central banks keep reiterating their determination to keep interest rates high until they slow the economy and grind down inflation to 2 per cent.
All of that makes it unlikely that we are witnessing the start of a new bull market. More likely, this is a time for hunkering down with the safe and sensible. Dividend-paying stocks may not be as sexy as today’s AI hotshots, but they seem positioned to generate superior returns over the next few years. Bonds could do even better.
Ian McGugan