Citi global quantitative strategist Dirk Willer believes markets are exiting bubble conditions and has atypically blunt advice for equity investors: “Kick them when they are down – which is now.”
In other words, his research suggests investors should expect stocks to continue lower once there are clear signs an equity bubble has started to burst. And that time has arrived.
Mr. Willer used two methods to identify a stock market bubble that began in October 2020. The first is the popular Shiller cyclically adjusted price to earnings (CAPE) ratio, which uses long-term trailing earnings to gauge market valuations. When the CAPE ratio goes two standard deviations above the historical average, as it did in 2020, this signals bubbly market conditions. (A standard deviation is the average amount of variability in the dataset relative to its mean. A higher deviation would indicate the current level is further from the long-run norm.)
The CAPE’s current ratio of 32 is still far above the long-term average of 17 - things are clearly still bubbly.
The strategist also used the inflation-adjusted level of the S&P 500 relative to the long term-trend to pinpoint when U.S. stocks entered a market bubble. The S&P 500 also climbed two standard deviations above trend in October 2020.
Citi emphasized that betting against stock markets when a bubble begins is rarely profitable – markets often remain in strong rally, bubble environments long after they begin. They did find, however, that global stocks will continue to fall once the bubble breaks, as it has now.
Mr. Willer noted that when stock indexes fell below the two standard deviation threshold for the CAPE ratio and the inflation-adjusted S&P 500 versus their long-term trends, median returns were reliably negative for the next three months, six months and one year after the bubble exit.
Citi’s analysis found that the best way for investors to avoid the dangers of a stock bubble implosion is to emphasize value over growth stocks. The strategist noted that the MSCI Value index level is fully 1.6 standard deviations below long-term trends, suggesting that value stocks will outperform growth stocks in the year ahead.
It is not my intention to suggest that investors try and time the market and short U.S. or global stocks – that is a dangerous practice suitable for only the most experienced and risk-tolerant investors.
Mr. Willer’s compelling work, however, does have important takeaways for all investors. First, it signals that buying the growth stock winners of the pandemic period is probably a bad idea, even if they are much cheaper now that a year ago. The megacap technology stocks that came to dominate the S&P 500 are most responsible for the bubble, and are likely to be most negatively affected by its deflating.
Favouring attractively valued stocks over high growth alternatives is another clear implication from Citi’s research report. Above all, investors should brace themselves for equity market volatility for the next 12 months and prepare for the distinct possibility markets are headed lower.
-- Scott Barlow, Globe and Mail market strategist
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Stocks to ponder
Pet Valu Holdings Ltd. (PET-T) The retailer of pet food, treats and toys, based in Markham, Ont., is not new to the Canadian business landscape: It has been around for more than 40 years and has over 700 franchised and corporate-owned locations across Canada. But the stock is new. The company completed an IPO in June, 2021, when the shares began trading on the Toronto Stock Exchange at $20. Today, they trade at $31.60 for a gain of 58 per cent since their debut. This performance stands out among promising companies that have floundered as interest rates rise and investor enthusiasm wanes. And as David Berman tells us, there are still reasons to believe Pet Valu can keep the momentum going.
The Rundown
Four reasons why the bond market rout may be over
Battered government bond markets have just put in their best weekly performance since early March, suggesting a painful surge in yields due to high inflation may finally be abating as the focus turns to growth fears. Central banks have only just started tightening policy and inflation remains elevated, so there’s reason for caution. But here are four key shifts that suggest a turning point for the world’s biggest debt markets.
‘Mom & pop’ investors left high and dry in tech, crypto meltdown
It’s almost a cliché that retail investors are always late to an investment boom – but the outsize exposure of household savers to frothier elements of frenzied markets since lockdown means they are feeling the hit from this bust more than most. A string of surveys and investment flow snapshots show that retail investors have significantly ramped up holdings of tech stocks and cryptocurrencies, which are now joined at the hip more than ever. Having marched to the top of the hill first on the way up, they are the markets tumbling fastest on the way down. Jamie McGeever of Reuters reports.
Also see:
U.S. retail investors turn bearish and elusive in latest selloff
Bitcoin is increasingly acting like just another tech stock
Bitcoin was conceived more than a decade ago as “digital gold,” a long-term store of value that would resist broader economic trends and provide a hedge against inflation. But bitcoin’s crashing price over the past month shows that vision is a long way from reality. Instead, traders are increasingly treating the cryptocurrency like just another speculative tech investment. David Yaffe-Bellany of The New York Times reports.
The latest in online broker perks for clients is basically free cash paid every month
The bank-owned online broker that brought you commission-free stock and ETF trading has ramped up the level of competition again with a new offer. National Bank Direct Brokerage now allows clients to participate in securities lending, which means allowing their fully paid shares to be lent to other investors who want to pursue strategies like short-selling. Rob Carrick tells us more about it.
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Friday’s Insider Report: Bill Gates cashes out over $645-million from this large-cap dividend stock
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Friday’s analyst upgrades and downgrades
Thursday’s analyst upgrades and downgraded
Globe Advisor
How top advisors are managing portfolios with the threat of another recession
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Ask Globe Investor
Question: In the last two years, my spouse and I have converted our RRSPs to RRIFs with minimum allowable payments. While we are both in reasonably good health, we wonder if we should accelerate our RRIF payments to take advantage of income splitting while we are both still living. One of our incomes from a company pension is almost 50 per cent of our total combined income. That pension will continue for the spouse after the pensioner passes away.
We both have room in our TFSAs to contribute about half of our total RRIF values. Most of our RRIF investments are in U.S. ETFs and Canadian mutual funds.
We seem to recall from reading your previous articles that in-kind transfers are not allowed to a TFSA. If so, our RRIF investments could be sold and reinvested in our TFSAs in something more appropriate for the current inflationary situation. We appreciate your helpful advice. – G.M. and R.M.
Answer: You are correct about the transfer rules. You can’t move assets directly from a RRIF to a TFSA. You would have to withdraw them from the RRIFs in-kind or in cash. Those withdrawals would be taxable. The balance could then be contributed to your TFSAs.
Based on your comments, any such withdrawals would likely generate a high rate of tax for the person with the pension plan, as that money would be on top of the pension income and the mandatory withdrawals.
A better option might be to have the spouse without the pension income make the extra withdrawals, as he/she would be in a lower tax bracket. You would have to calculate the tax implications under each scenario or consult a financial planner.
--Gordon Pape
What’s up in the days ahead
Canadian big bank stocks have tumbled about 15 per cent over the past three months, as concerns of an oncoming recession rattle equity markets. David Berman will tell us why the potential rewards for buying into this dip are becoming hard to ignore.
Market themes for the weekahead: Recession talk justified? Follow the data
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Compiled by Globe Investor Staff