Congress finally applied some duct tape to the U.S. fiscal situation and Canadian investors should enjoy the resulting market rally. But investors should also keep in mind that, as annoying as the "fiscal cliff" process was, markets never really sold off, meaning there is limited room for equities to rally before they reach overbought territory.
We noted last week that while 2012 was a difficult year for energy and mining stocks on the Toronto Stock Exchange, their price-to-earnings levels to begin 2013 are almost exactly the same as they were a year ago; few stocks in those sectors are available at steep discounts. The same is true of the broader market. As the chart above highlights, the number of S&P/TSX stocks trading at 52-week highs is nearing the upper end of the recent range, while only a trickle of companies are plumbing annual lows. The Canadian market is not rebounding from deeply oversold conditions but is already reasonably healthy and may not have much room to rise in the short term.
A look at the Relative Strength Index shows limited, although not insignificant, upside for Canadian stocks. (Reminder: An RSI reading below 30 indicates oversold conditions in which a rebound is more likely, while an RSI above 70 indicates substantial risk of a pull back). The S&P/TSX Composite as a whole has an RSI at 52. That is more or less the middle of the range and not cause for concern. But, looking at the subindices, the bank index, with an RSI of 61, is creeping up quickly on overbought, short-term dangerous levels. Materials and energy stocks have more upside at 44 and 45 respectively.
So Canadian investors should feel free to enjoy the early year rally – we certainly deserve it after being forced to follow Congress's ham-handed incompetence. But as the month progresses, investors should be aware that equities could quickly get ahead of themselves. If the entire S&P/TSX Composite starts generating RSI readings at 70 or above, investors should hold off and await more promising conditions.