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Market performance always represents the net effects of the numerous conflicting forces acting on equities at any given time. Until 2018, for instance, the positive effects of FAANG stock price momentum were easily strong enough to overpower concerns about very high valuation levels for the technology giants. The valuation concerns were still there, just too weak to have notable influences on market prices, and they slowly gained in intensity.

Framing market behavior as a tug of war like this is more relevant than usual now. A deeper look at the painful sell-offs in recent weeks highlight a market where powerful negative forces are changing quickly, from higher bond yields and too-strong (in the inflationary sense) growth in the U.S. to a deteriorating global economy.

WATCHING THE SPREADS

High-yield bond spreads provided bear market

warnings in the past, but no signal this time (yet).

S&P 500 (left scale)

Merrill Lynch U.S. high yield option-adjusted

spread index (right scale)

3,500

25%

3,000

20

2,500

15

2,000

1,500

10

1,000

5

500

0

0

1997

2000

2003

2006

2009

2012

2015

2018

September 26

THE G L OBE A ND MAI L,

SOURCES: SCOTT BARLOW; BLOOMBERG

WATCHING THE SPREADS

High-yield bond spreads provided bear market warnings

in the past, but no signal this time (yet).

S&P 500 (left scale)

Merrill Lynch U.S. high yield option-adjusted

spread index (right scale)

3,500

25%

3,000

20

2,500

15

2,000

1,500

10

1,000

5

500

0

0

1997

2000

2003

2006

2009

2012

2015

2018

September 26

THE G L OB E A N D MAIL, SOURCES: SCOTT BARLOW; BLOOMBERG

WATCHING THE SPREADS

High-yield bond spreads provided bear market warnings in the past,

but no signal this time (yet).

S&P 500 (left scale)

Merrill Lynch U.S. high yield

option-adjusted spread index (right scale)

3,500

25%

3,000

20

2,500

15

2,000

1,500

10

1,000

5

500

0

0

1997

2000

2003

2006

2009

2012

2015

2018

September 26

THE G L OB E A N D MAIL, SOURCES: SCOTT BARLOW; BLOOMBERG

U.S. utilities stocks are the poster children for investors’ evolving fears. Arguably the market sector most at risk from higher interest rates and bond yields, the S&P 500 utilities index dropped 5.1 per cent between September 13 and September 26.

Then, after weaker than expected Chinese economic data were released, and a series of global industrial firms reported weaker revenues from overseas, markets began fretting intensely about falling global growth. From September 26, the utilities index – considered insulated from a weakening global economy - jumped 7.3 per cent.

Despite Thursday’s market strength, prominent strategists like Merrill Lynch’s Savita Subramanian expect volatility to continue for the foreseeable future, as investors try and figure out what to worry about, and how much.

Citi’s (Montreal-born) chief U.S. equity strategist Tobias Levkovich helped sentiment with a report Thursday concluding that weakness in the industrials sector is not pervasive enough to signal major market problems. Nomura analysts blame China for equity weakness, noting that aggressive speculative traders have been placing pessimistic bets on global markets as China’s economy slows.

There is one indicator that matters most to me – high yield bond spreads – as a signal that the equity rally is over and a prolonged bear market is imminent. Credit Suisse strategist Andrew Garthwaite has previously written that widening junk bond spreads have provided a warning before eight out of the last nine bear markets.

Spreads haven’t budged yet, so I’m willing to look through the current bout of volatility in hopes of further equity gains. I’ll also be watching sector returns to uncover which market forces are winning the tug of war to drive the index direction.

-- Scott Barlow, Globe and Mail market strategist

This is the Globe Investor newsletter, published three times each week. If someone has forwarded this e-mail newsletter to you, you can sign up for Globe Investor and all Globe newsletters here.

The Rundown

Amid turbulent markets, four views on how much Canadian exposure to have in a portfolio

Pretty much everyone agrees on the importance of diversification in building portfolios, but the consensus falls apart after that. The truth of diversification is that there is zero standardization. To prove it, let’s look at the question of how much Canadian stock market exposure to have in a portfolio. Next to the overall stocks/bonds breakdown, this is may be the most important matter of diversification for investors to answer. All stock markets have plunged lately, and the TSX and Nasdaq stock index were in a full-on correction at one point this week.. But if you look at the past several years, Canada has been a dismal performer. Without some exposure to stocks in the rest of the world, notably the U.S. market, you would have missed out. Rob Carrick looks at four views on how much exposure to Canadian stocks to have in a portfolio (for subscribers).

How market bears are returning to take over world markets

For investors trying to call the end of the bull run for stocks, the headline performance of the world’s equity markets this year may not be telling the whole story. Up until Wednesday’s decline, Wall Street’s S&P 500 had been up 2.5 per cent for the year, continuing its longest bull run in history. Meanwhile, the MSCI All-Country World Index, a widely watched gauge of world stock market health, had lost just 5 per cent despite fears of a global trade war and a slowdown in China’s growth. But according to data analyzed by Reuters, the proportion of stocks, regions and sectors that are technically in a bear market has shot up since the start of January, prompting some analysts to conclude the bull run may already be over. Reuters reports.

If you’re looking for beaten-up stocks, this is a sector to watch

Beaten-up forestry stocks led us into this bout of market mayhem. Will they lead us out? West Fraser Timber Co. Ltd. epitomizes the forestry sector’s dismal state. The stock price tumbled 28 per cent since mid-August amid falling lumber prices and concerns that higher borrowing costs are depressing homebuilding activity. There are many factors weighing on the broader stock market right now. But the factors driving the forestry sector – from trade tariffs to declining Chinese economic growth to some disappointing corporate financial results – could be key to the overall volatility. David Berman reports (for subscribers).

Rate-reset preferred shares having their day, but could turn nasty again

There are no perfect solutions in investing. This includes rate-reset preferred shares, which you have to be loving if you’re a yield-starved investor who bought these securities in the past year or two. Rate resets were designed for just the sort of rising interest-rate environment we’re seeing these days. With a bond or what’s known as a perpetual preferred, your yield is your yield. As rates rise and your yield looks less competitive, the price of your bond or preferred share will fall. Rate resets address this by providing the issuer the opportunity every five years to reset your yield to adjust for changes in rates. As long as rates are rising, there’s a tailwind for rate resets. That’s the backstory for the strong price gains for rate resets in the past few years. The Solactive Laddered Canadian Preferred Share Index, used as a benchmark by the BMO Laddered Preferred Share Index ETF (ZPR), has annualized gains of 11.7 per cent for the three years to Sept. 30. Rob Carrick reports.

Investors outlook 2019: What to watch out for in the year of fear

A furious U.S. President who lurches from one blowup to the next, overvalued U.S. markets that seem long overdue for a correction, Canadian stocks that can’t regain their mojo and turmoil across much of the rest of the world – 2019 is shaping up to be the year of investing dangerously. John Daly, Joe Castaldo and Bryan Borzykowski report for Report on Business Magazine (for subscribers).

Looking ahead: The Retirementality

Listen to Rob Carrick’s new podcast on retirement, listen to here or download on iTunes or on Spotify. There are three episodes, one aimed at millennials, one at Gen X and one at baby boomers.

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Others (for subscribers)

Buckle up: Wall Street volatility is back with a vengeance

Wednesday’s sell-off was very different from last week’s

Thursday’s analyst upgrades and downgrades

Thursday’s Insider Report: Five insiders have dumped this marijuana stock

Wednesday’s analyst upgrades and downgrades

Gordon Pape’s model RRSP portfolio’s performance shows why investors need to be vigilant

After another day of losses, pot stock investors left wondering if the market’s tipping point has arrived

These 20 defensive U.S. dividend stocks protect on the downside

What analysts are saying about Tesla’s quarterly results

Others (for everyone)

How bears are taking over world stock markets

Citron’s Tesla U-turn dealt short sellers a $1.11-billion loss

Tariffs begin to take bite out of U.S. corporate earnings growth

Ask Globe Investor

Question: In your model Yield Hog Dividend Portfolio, why is the “book value” of your cash negative?

Answer: The negative $2,218.95 figure doesn’t actually represent the book value of the portfolio’s cash. It is simply an accounting entry that is required to reconcile the total book values of the individual stocks with the portfolio’s initial value of $100,000. Such adjustments are necessary because book values change when I sell a stock, buy a new stock or add to an existing stock.

To take a simple example, imagine the portfolio initially consisted of just one stock purchased for $100,000. If the stock appreciated to $110,000 and I sold it and bought a different stock for $110,000, the book value of the second stock would be $110,000. The table would then need to show an adjustment of negative $10,000 to bring the portfolio’s total book value back to $100,000 – the starting value we use to calculate the portfolio’s return.

--John Heinzl

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

Our Jennifer Dowty interviews Kurt Reiman, the chief investment strategist from BlackRock Canada, for his latest thoughts on markets and portfolio positioning.

Click here to see the Globe Investor earnings and economic news calendar.

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Compiled by Gillian Livingston

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