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Investment Ideas The market bust no one understands, why cash isn’t trash now, and the perplexing poor performance of TSX bank stocks

I don’t pretend to be able to consistently predict what the market’s future path will be because, if I could do that, I’d be living in Connecticut or La Jolla, Calif., in a house the size of an airport. I like to think, however, that I understand why the market has done whatever it’s done after the fact.

This brings us to Canadian bank stocks because I’m in the unfortunate position of not fully understanding why their performance has been so poor. In a market where global growth fears dominate, since Sept. 30, the S&P/TSX Bank Index (-9.4-per-cent total return as of Monday’s market close) has underperformed the far more economically sensitive S&P/TSX Diversified Mining Index (-9.2 per cent).

The Canadian economy is approaching the end of its credit cycle after a long period during which consumers gorged on mortgage debt and drove housing prices higher. This is no doubt part of the reason bank stocks are under pressure.

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The flattening yield curve may also be playing a role. Banks – which borrow funds at short-term interest rates and lend them to clients at longer-term rates – prefer a steep yield curve because it makes basic lending more profitable. Historically, however, bank stocks have shown little or no correlation with the yield curve, likely because their businesses are diversified well beyond basic lending.

Neither the credit cycle or the yield curve is sufficient to explain the extreme degree of pessimism the banks have endured in the equity market.

Bank of Nova Scotia analyst Sumit Malhotra says that banks haven’t been this out of favour since 2007.

“The divergence between fundamental trends and share price valuation is the most significant we have seen since 2007, a scary reference point given the ‘late cycle’ concerns that have weighed on the stocks over the past few months.” Mr. Malhotra said in a recent report. He notes that credit quality indicators for bank balance sheets remain healthy, and the outlook points to continued profit growth through 2019.

U.S. bank stocks are also getting sold, even though the Americans are at a much different stage of the credit cycle – they already had their housing-related credit crisis a decade ago.

Morgan Stanley analyst Ken Zerbe, in a note on Tuesday, went as far as saying that “winter is coming” for U.S. banks.

“We cannot ignore the growing risk of a bear credit market next year preceding a recession,” he said. Mr. Zerbe notes that the market is valuing bank shares as if the economy is headed toward recession, and suggests that few investors are interested in buying bank stocks “without clearer indicators of accelerating economic growth” – something that is unlikely to arise anytime soon.

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Canadian investors have historically displayed near-bulletproof levels of confidence in the domestic bank stocks and it’s hard to believe all this faith has been jettisoned in the past few months. So the severe pessimism apparent in stock valuations, combined with the global nature of bank stock weakness, is making me nervous that I’m missing something important.

-- Scott Barlow, Globe and Mail market strategist

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The Rundown

The stock market boom no one loved has become the bust no one understands

The boom no one loved has become the bust no one understands. From 2009 to September, 2018, Wall Street climbed higher and higher, despite armies of doubters who warned that higher share prices were just the flip side of the ultra-low interest rates that went along with a slow-growth economy. Now, the narrative has flipped. Despite an apparently healthy economy, stocks have turned nasty and volatile. Why? Reasons, my friend. Reasons. Ian McGugan takes a look at all of these reasons (for subscribers).

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The Big 6 made $45.3-billion this year. Who’s shining brightest?

Fans of Canadian bank stocks will appreciate this number: $45.3-billion. That’s the total profit generated by the Big Six banks in fiscal 2018 (which ended Oct. 31) – and the gargantuan number reinforces why the banks have been delivering stellar gains and rising dividends over the long term. Buying all six bank stocks and holding on during rallies and downturns makes a lot of sense. But it’s also worth taking a closer look at their individual performances to gain an understanding of which bank is leading the way. David Berman looks at a number of ways to slice and dice their financial results. (For subscribers).

Cash isn’t trash any longer: This year’s top performing investment may also be 2019′s best bet

When everything else is faltering, cash becomes king. With stocks, bonds and commodities all in an unusual, simultaneous slump this year, cash and cash equivalents stand to best them all as a top-performing financial asset. The returns offered by cash proxies such as guaranteed investment certificates and short-term government bonds, while modest, are at least positive. Long-term Canadian bonds, on the other hand, have retreated as yields have increased, while the S&P/TSX Composite Index is down 8 per cent this year. Also in negative territory: equities, corporate debt and government bond indexes in many global markets, as well as a range of commodities from crude oil to gold and copper. The global downturn in financial assets this year has produced a rare top ranking for cash. Tim Shufelt reports (for subscribers).

Beware of these zombie stocks on the TSX

The markets are on edge and trend followers are running for the exits. Woe be to the firms that need to raise money while fear stalks the land. They risk becoming zombie stocks that shamble around a bit before keeling over. Even in good times, firms with negative earnings fare poorly and are, as a group, best avoided. But Norman Rothery focuses on stocks that are, potentially, in much more dire circumstances. To find them he use a measure that’s colloquially known as earnings before the bad stuff. More formally, I’m talking about earnings before interest, taxes, depreciation and amortization, which goes by the handy acronym EBITDA. Norman Rothery takes a look at the zombie stocks (for subscribers).

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Smart and not so smart things people are doing with their TFSAs as the contribution limit rises to $6,000

The long wait for a higher TFSA limit is finally over. You’ll be able to contribute up to $6,000 to a tax-free savings account in 2019, up from $5,500 in five of the six past years. The limit was set at $10,000 in 2015, then dialled back for the next year. The 2019 limit was confirmed by the federal government in a list of adjustments to personal income tax and benefit amounts based on the latest inflation trend. Inflation has been low in recent years, but we’ve now seen enough upward pressure on prices to trigger the higher TFSA limit. To mark the occasion of a higher limit, let’s look at smart and not so smart things people are doing with their TFSAs. Rob Carrick takes a look (for subscribers).

How Canopy is pushing into the U.S. cannabis market while staying onside of TSX rules

Officially, Canopy Growth Corp. is steering clear of investments in the United States. Over the past year, however, Canada’s largest cannabis company and its affiliates have been quietly securing U.S. exposure through a series of legal manoeuvres that stay onside of Toronto Stock Exchange rules but position Canopy for a rapid move into the U.S. market. Since October, 2017, TMX Group Ltd., the exchange’s parent, has not let TSX-listed cannabis firms operate in the United States, where marijuana remains federally illegal. That has forced companies to think creatively, spinning off subsidiaries, swapping shares and lining up conditional warrants, which allow them to acquire future positions in U.S. companies. Mark Rendell reports (for subscribers).

Through the market turbulence, this Buy and Hold Portfolio continues to gain ground

These are the times that try our souls – especially if you’re a buy and hold investor. As stocks tumbled last week, the obvious temptation was to sell everything and run for the hills. But doing so would defeat the whole purpose of buy and hold. You have to stick it out for the long haul, which means in good times and bad. Choosing good companies, stay with them, and avoid emotional reaction to market swings. The strategy works. Despite the sharp correction we experienced in recent weeks, Gordon Pape’s Buy and Hold Portfolio gained ground in the latest six-month period and is averaging a return of better than 11 per cent annually since it was launched in June 2012. (For subscribers).

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Why a flat yield curve isn’t always a cause for concern

Since the start of the year, investors around the world, economic pundits and commentators have been worrying about an impending inversion of the U.S. Treasury yield curve and what it means for the economy and stock market. Academics have measured the yield curve by the difference between the 10-year Treasury note and the three-month Treasury bill rate, while practitioners by the difference between the 10-year and the two-year yield. When the short rates exceed the long rate, the yield curve is said to be inverted. Well, as of last Tuesday, they got what they were afraid of; part of yield curve inverted with the five-year note yield below the two-year. George Athanassakos explains why this isn’t always as bad as we think.

What investors need to know about split shares

Many investors don’t realize that there are actually two kinds of split shares – preferred shares and capital (or class A) shares. Split share corporations issue both types of shares to the public and use the cash to invest in a basket of dividend-paying companies. Even though split preferred and split capital shares are exposed to the same underlying portfolio of stocks, they behave in different ways and have dramatically different risk profiles. John Heinzl explains (for subscribers).

What is a fair percentage fee to pay an investment firm?

The hardest-to-answer question Rob Carrick gets from readers is whether they’re being charged fairly by their investment adviser. The first problem in answering this question is that portfolio size has a huge bearing on fees. The investment industry’s primary goal is to attract high-net-worth clients, which is does by offering fees that could be 1 per cent of the client’s account value or even less. Smaller accounts might pay between 1 and 2 per cent. The second problem is that fees can’t be assessed without considering value. The fee charged by an adviser who manages a client’s investment portfolio provides financial planning, tax help and periodic hand-holding might justifiably be higher than someone who just managed investments. (For subscribers).

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De-fanged? What advisers can tell clients about the bearish turn for the FAANGs

The plummeting value of the FAANGs – losing roughly $1-trillion in market value – is likely a discussion many advisers are having with clients in recent days. After all, Facebook Inc., Apple Inc., Amazon Inc., Netflix Inc. and Google (Alphabet Inc.) had fuelled many portfolios in recent years. Until they didn’t. In the past couple of months, the FAANGs have had the opposite effect on portfolios as these mega-caps have fallen from all-time highs reached earlier this year. By late last month, all had entered bear market territory, losing 20 per cent or more from their peaks. What’s the next move for the FAANGs? Joel Schlesinger reports.

Others (for subscribers)

Pondering a stop-loss order for battered dividend stocks? Read this first

Top 10 investment risks for 2019

S&P warns Hydro One of possible downgrade if Doug Ford government intervenes again

You can’t handle the truth: A few views of the ugly stock market

These stocks are due for a bounce: Goldman Sachs

Quirky Canadian stock tickers now range from NERD to CARS to WEED

Tuesday’s analyst upgrades and downgrades

Tuesday’s Insider Report: CFO trades this large-cap dividend stock yielding over 5%

Monday’s analyst upgrades and downgrades

Monday’s Insider Report: CBC’s ‘Dragons’ Den’ star is buying this stock

Others (for everyone)

The Globe’s stars and dogs for last week

Onset of U.S. recession may take longer than expected after yield curve inverts

Deep losses leave Big Tech with small earnings multiples

The next worry for U.S. stocks: shrinking profit forecasts

Tightening U.S. financial conditions to end Fed cycle. And soon: McGeever

Oil traders focus on deteriorating economic outlook rather than OPEC

Struggling hedge funds cling to dollar, U.S. yield curve bets

Ask Globe Investor

Question: My wife has turned 71 this year and has to convert her $300,000 RRSP to a RRIF. I was going to use the Mawer Balanced Fund. What is your current opinion of this fund? Also, with the strong emphasis on bonds in a rising rate environment, would my wife be better to own pure equity funds (no bond portion) and put maybe 50 per cent into GICs or cashable GICs?

Answer: I like the Mawer fund and continue to recommend it. It has posted above-average results over all time frames. But your idea of an equity portfolio supported by laddered or cashable GICs would also work in a rising interest rate environment and would have less downside risk than bonds.

--Gordon Pape

Do you have a question for Globe Investor? Send it our way via this form. Questions and answers will be edited for length.

What’s up in the days ahead

With a major U.S. acquisition not happening and bond yields easing off, is it time to give Hydro One a place in your portfolio? David Berman will share his thoughts.

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Compiled by Gillian Livingston

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