Stock markets are frothy.
The S&P/TSX composite index was up 18% from Nov. 2, 2020 to Feb. 12, 2021. Over the same period, the S&P 500 rose 19%. Bitcoin has breached US$50,000.
Driving the market are investors who are both eager to get in on deals and fearful of missing out. As a measure of enthusiasm for stocks, the U.S. cyclically adjusted price earnings index is about 40% over its two-decade average — implying a dismal expected return of about 0.3% per year.
But when it comes to equities, fear of being left behind trumps fear of losses.
The traditional move when stocks seem too expensive is to shuffle into bonds. Ten-year Government of Canada bonds recently paid 1.0%. In the U.S., the 10-year Treasury yield hit 1.2% on Feb. 12, the result of selloffs and a steepening yield curve. Thirty-year Treasury yields hit 2.0% the same day — the highest since February 2020. The five-year to 30-year spread was 152 basis points, the highest since 2015.
In a nominal sense, a 1.0% 10-year Canada bond would seem to beat 0.3% from the S&P 500, but that is not the end of the story.
James Orlando, senior economist at TD Economics in Toronto, sees the markets in terms of risk. “Even though bonds have a nominal positive rate, their real rate is negative and they will lose purchasing power,” he said. “But with stocks, you are looking at high expectations, so expectations win.”
This faith in the future has a numerical explanation — the discount rate on future earnings. A dollar in a year is worth a cent or two less today, so the cost of waiting is very low. Low interest rates mean the cost of capital is low. Companies that start as gnats can grow to giants with low-cost borrowed money.
That puts senior bonds in an also-ran position compared with stocks.
“Bonds are just a hedge. They are not a way to make money,” said Avery Shenfeld, chief economist at CIBC Capital Markets in Toronto.
Instead, the phenomenal success of Tesla Inc., Amazon.com Inc., Shopify Inc. and other dividend-free tech wonders have driven even sophisticated market players to view these stocks as portfolio must-haves.
Norman Levine, a partner in Toronto’s Portfolio Management Corporation, owns tech stocks — but ones with earnings, dividends and conventional valuations. One such name is OpenText Corp., a business software consolidator based in Waterloo, Ont. that Levine said is “consistently profitable, [with] excellent management; [it] grows by acquisition and internal growth.” The stock also pays dividends.
He also likes Amadeus IT Group S.A., a dividend-payer that is trading at a discount because it does IT for the global tourism industry. Amadeus will be a “big beneficiary of a return to travel,” he said.
Levine also owns Netherlands-based NXP Semiconductors and Microsoft Corp.
Stocks also may seem more attractive than bonds from a risk perspective. “The high duration baked into low-yield bonds makes them intrinsically risky,” said Dominque Lapointe, senior economist at Laurentian Bank in Montreal. “There seems no catalyst for stocks to have a big correction. Stocks won’t be much affected by central bank tightening.”
In other words, rates will likely rise in parallel with improving equities. That will produce a brief negative hit for shares, but a massive reduction in prices of senior bonds, especially low-yield government issues.
Moreover, in anticipation of higher rates, long rates — not much influenced by central bank actions — have already been rising. Stocks seem promising if the pandemic abates, and their risk is acceptable given that they have an unbounded future.
Investors who need or want to own bonds, however, can look at BBB+ corporate issues.
“This year, the strategy has to be about lower-duration fixed-income assets,” said Romas Budd, vice-president and senior fixed income portfolio manager at 1832 Asset Management LP. “The trick is to get paid for risk. We don’t think you are adequately paid in high yield at these price levels.” He suggested investors consider quality corporates with terms shorter than five years.
Marc Henein, director of wealth management and senior wealth advisor with Scotia Wealth Management in Mississauga, Ont., highlighted three BBB+ issues: Enbridge Inc., maturing Dec. 5, 2022, and recently priced at $104.46 to yield 0.66%; Hydro One, maturing Apr 5, 2029, and recently priced at $11.49 to yield 1.48%; and TransCanada Corp., maturing Sept. 18, 2029, and recently priced at $107.41 to yield 2.02%.
Memories of the dot-coms are distant, 2008 seems like a technical mortgage glitch and even March 2020, when Covid-19 fear crushed stock prices, seems like an overreaction. Yet market multiples are far over their historical averages and businesses with scarcely any footprint on the ground or numbers for guidance are soaring. In the words of German composer Richard Wagner, “Imagination creates reality.” And imagination, for lack of a good alternative, is driving stocks.
The more daring and unrestrained the investment, the greater the potential gain — for now.