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The S&P/TSX Composite Index is trading at recessionary valuation levels and that, combined with the extreme breadth of weakness and the dramatic underperformance of cyclical stocks, has BMO chief strategist Brian Belski expecting a strong rally in Canadian stocks.

Mr. Belski calculates that Canadian stocks are trading at an average trailing price to earnings ratio last seen during the depths of the financial crisis and during the recession of the early 1990s. He notes that the S&P/TSX Composite is hovering within 5 per cent of its pre-Covid peak, yet profits are fully 40 per cent higher.

These recessionary valuation levels assume a sharp decline in earnings ahead but Mr. Belski does not expect this to be the case. He adds that these are likely trough valuations, or extremely close to them, and that historically this indicates strong returns for the next 12 months.

Mr. Belski also emphasizes that the extreme breadth of the recent sell-off – the sheer number of companies hitting new 52-week lows – implies that a bounceback is probable.

Significantly more than half of non-resource index stocks are at 52-week lows and less than 5 per cent of non-resource stocks are making new highs. The strategist notes that both of these results are two standard deviations from their historical averages.

“This type of indiscriminate selling is another strong contrarian indicator,” writes Mr. Belski. “Our work shows the S&P/TSX price performance 12 months after the breadth of companies hitting new lows to this extreme is almost 15%.”

Economically-sensitive, cyclical market sectors have significantly underperformed defensive sectors, providing another sign the market is in oversold territory, according to BMO. Mr. Belski noted that the performance spread between cyclical sectors like consumer discretionary, industrials and technology and defensive industries like consumer staples and utilities is at extreme highs.

Mr. Belski’s analysis indicates that when cyclical underperformance reaches current stretched levels, the market as a whole tends to rebound by more than 10 per cent in the following year. In the current case, he believes investors are over-estimating the pace of the global economic slowdown.

Mr. Belski has made a plausible argument here that domestic equities are a bit of a coiled spring after a 15 per cent sell-off since the end of March. Importantly, his perspective is bullish from both a fundamental standpoint – valuations – and also the technical factor of market breadth.

-- Scott Barlow, Globe and Mail market strategist

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