Entries from November 2017 ↓


Two days ago we talked killer taxes. Then a couple hundred people came here to, shockingly, reveal what they earn. Then my Porsche-driving fancy portfolio manager buddy Ryan baffled us with some crazy stock formula so he could look clever. Just another laconic weekend at GreaterFool.

Let’s put some of these things together and see what squirts out. First, there’s no doubt a huge number of people you know, including house-horny family members, are financially pooched. Most don’t actually realize it. Debt is massive, taxes are rising and the real estate market’s surfing on an epic wave of credit. Rising interest rates and tighter lending regs in 2018 threaten that.

Canada is in worse shape when it comes to family debt than were Americans before the housing market there blew up 12 years ago. Our borrowing equals that of the Japanese when that country imploded in 1993. Here’s a chart the OECD turned out last week, to put things in perspective and scare you.

Private sector debt has doubled in a decade, and two-thirds of that is mortgages. Stats Canada says Canadians’ wages, after inflation is accounted for (and it’s historically low) haven’t increased in fifty years. This is why dads in the 1960s could support a family of four, buy a house, maybe a cottage, then retire comfortably on a single income. Today it’s a struggle for two working people to buy a condo, let alone have a kid. The cost of living – pushed ahead by taxes and real estate – led directly to a borrowing orgy once interest rates collapsed. Now it’s starting to unwind.

What’s the point?

Well, taxes are about to rise more in Canada because governments cannot live within their means, either. Soon your CPP premiums will be increasing, but higher benefits won’t arrive before today’s teens are tomorrow’s wrinklies. Real estate prices will take several years to melt lower, but as they do mortgage rates will be increasing. A Fidelity survey found 80% of people plan to “rely heavily” on scrawny public pensions to get by, and almost half of pre-retirees figuer they’ll need to dump their houses to raise cash to live on.

You have a choice. Do what everybody else is, and pray. Or not.

Given that all other countries have suffered a reversal when its citizens pigged out on this much debt, it’s reasonable we will, too. Credit is not infinite. When it begins to contract, those who need access to it on a routine basis are whacked. Time for another chart, just to belabour the obvious…

In three words: you must invest. Being apathetic, keeping the bulk of your net worth in one vulnerable asset, on one street in one city is now a really bad idea. Sure, own a house if you want one, but also strive to have a balanced approach to your finances – maxing out your TFSAs, taking part in your company’s matched RRSP, income-splitting with a spousal plan, opening a joint non-registered account and, above all, not being afraid of markets or the future. Sitting in cash, in GICs, in some bank bond fund, paralyzed after reading a doomer web site written by a guy who can’t afford a new Star Wars backpack is a dead end.

Invest in the kind of balanced, diversified portfolio this blog has oft suggested. Load up on exchange-traded funds, avoid [email protected], don’t gamble by flipping individual stocks (even weed) or buying cryptos, or being sucked into high-fee mutuals. Also recognize that while technical-analysis gurus like Ryan make a living riding the ebb and flow of markets, average investors do not. A 10% or 15% correction that lasts a few weeks or months will be irrelevant to your long-term future. Every shred of research has shown you’re better off investing today and staying invested rather than trying to time markets.

If you have a little money, open an online TFSA account and get started. If you have enough, look for a fee-based advisor. If you have an ‘investment’ condo plus a house, dump the sucker. If you have a variable-rate HELOC, start paying down the principal. If you’re self-employed, take salary instead of dividends, feed an RRSP and avoid an audit. If you’re sixty, take early CPP and push it into your tax-free account. If you’re twenty-five, wait to buy property unless you dwell in Halifax or Regina (and invest in fuzzy underwear). If you’re coming up to retirement, house-rich and asset-poor, bail.

Good luck. You have five weeks.

Still bullish, but…

RYAN  By Guest Blogger Ryan Lewenza

For some years now I have maintained a fairly consistent bullish view of the equity markets – more recently as a Portfolio Manager at Turner Investments and previously in my old role as Chief Canadian Equity Strategist at Raymond James. This view has served our clients well with our portfolios delivering solid returns for investors. And I continue to have a favourable view of the global equity markets given improving economic momentum, rebounding corporate profits, bullish technical trends, benign inflation readings, and supportive central banks. That said, my bullish view is not set in stone and will change as these tailwinds turn to headwinds. As the influential economist John Maynard Keynes once quipped, “when the facts change, I change my mind.”

So what could cause us to change our view?

From my perspective, the three biggest risks to the equity markets are: 1) high equity valuations; 2) rising geopolitical tensions and/or a policy error; and 3) rising interest rates. Today I focus on the third – higher interest rates and how they affect the equity markets.

To show how interest rates impact stock prices we need to dig into some mathematical formulas and financial market relationships. So this might hurt a bit, but it should be educational and rest assured Garth will follow up this post up with some funny and biting commentary about some sketchy real estate agents and entitled millennials.

With the US economic expansion now in its ninth year and some central banks now starting to hike rates, I believe we are in a slow transition from ultra-accommodative monetary policies to more restrictive policies and that this should help drive interest rates higher over the next few years.

Currently, the US 10-year Treasury bond yield is at a low level of 2.35% with economists forecasting it to rise to 3% by Q1/19. While we don’t see rising rates derailing the bull market in 2018, we do see higher interest rates ultimately leading to a peak in the economy and stock market. To understand this we need to look at some formulas and relationships.

10-Year Treasury Yield is Forecasted to Rise to 3% by Q1/19

Source: Bloomberg, Turner Investments

Let’s start with equity analysis 101 and the dividend discount model (DDM). The DDM assumes that the value of a stock is based on its future dividends and then discounting them back to the present value. There are two main DDM models – the Gordon growth model which assumes a constant dividend in perpetuity and a two-stage DDM model which assumes an initial higher growth phase followed by a long-term low growth phase. For simplicity (and to try to limit readers from heading for the exits), let’s look at the Gordon growth model.

Below we show the formula which is the dividend divided by the difference between the cost of equity (Ke) and the long-term dividend growth rate. An example will help. Say you have a stock that pays a $1 dividend, and that dividend is expected to grow 6% over the long-run. The last input we need is the cost of equity (Ke) and it is based on the risk-free rate (10-year Treasury yield) and a risk premium. Stay with me!

If the cost of equity is currently 9% based on the 10-year Treasury yield of 2.35% (risk premium being 6.65%), then the stock value based on the Gordon growth model would equate to $33.33 ($1/ (0.09 – .06)). If the risk free rate (10-year Treasury yield) rose 1%, pushing the cost of equity up to 10%, then the stock would now be valued at $25.

Hopefully, I haven’t completely lost you, but all I did was illustrate through a mathematical relationship a stock’s fundamental value based on different 10-year bond yield levels.

Gordon Growth Model for Valuing Stocks

Source: CFA Institute, Turner Investments

Another way to understand the relationship between stock prices and bond yields is by comparing historical stock valuations (P/Es) with bond yields. Below is a scatter plot of the S&P 500 P/E ratio and the US 10-year Treasury bond yield at various times over the last 60 years.

Note how the P/E ratio generally rises as the 10-year bond yield increases. This makes intuitive sense since as the economy accelerates and the stock market rallies, bond yields typically rise. But note how around the 5% level this positive relationship begins to break down with P/Es then contracting as the US 10-year bond yield continues to rise. Historically that 5% level was the dividing line where it typically resulted in a peak in the economy and stock market. I believe in this current environment that the 5% level is likely to be lower this time, probably closer to 3.5%. So based on this analysis I don’t think we need to worry about the stock market until the 10-year yield gets into that 3 to 3.5% range, which, based on current economists’ forecasts, looks more like a 2019 story than 2018.

Relationship between Stock P/Es and Bond Yields

Source: Bloomberg, Turner Investments

Finally, there is another widely used tool for comparing the stock market to bond yields called the “Fed Model”. It came to prominence in the 1990s and it attempts to compare the relative valuation between the stock market and bond yields. Specifically, it compares the earnings yield of the S&P 500 to the US 10-year Treasury bond yield. To determine the earnings yield of the S&P 500 you simply take the inverse of the P/E ratio for the S&P 500. Currently, the trailing P/E ratio for the S&P 500 is 21x resulting in an earnings yield of 4.6%.

Subtracting the S&P 500 earnings yield of 4.6% from the US 10-year Treasury yield of 2.35% results in a premium of 2.25% for stocks and captures the relative attractiveness of stocks compared to bonds. But as the US 10-year yield rises (and possibly the earnings yield declines as stocks continue to move higher) the premium will narrow resulting in bonds becoming more attractive versus stocks. As this happens, investors will look to reduce their equity exposure and add to bonds, possibly resulting in a peak in the stock market.

So, there are a few different ways to look at the relationship between interest rates and the equity markets. For now, low interest rates are bullish for the equity markets and support our continued bullish view. However, as bond yields move higher, this will begin to reduce stocks relative attractiveness and likely result in a peak in the stock market. The key now is trying to determine exactly when this will occur so we can make the necessary adjustments. Where is my crystal ball when I need it most?

The Fed Model

Source: Bloomberg, Turner Investments
Ryan Lewenza, CFA,CMT is a Partner and Portfolio Manager with Turner Investments, and a Senior Vice President, Private Client Group, of Raymond James Ltd.