Market rally warrants caution: McHugh

The market is in uncharted territory, according to notable quantitative devotee Pat McHugh, vice-president and senior portfolio manager at MFC Global Investment Management.

The rally of the S&P/TSX Composite from its March lows has been as unprecedented as the financial crisis that caused it.

The quantitative attributes of the best performing stocks is “perverse,” he says, with the statistically worst quintile of the TSX Comp delivering better returns than the best quintile.

Historically, the TSX returns 8% in the three months off the bottom of a bear market trough. The current rally has posted a three-month return of 41%.

“This is unprecedented,” McHugh exclaims. “Nothing in history has ever come close to that. For six months, we’re up 45%, on average its 15%. We’re in uncharted territory here. We could have a 25% pullback and still be in a bull market cycle. So, caveat emptor.”

McHugh points out that the price-to-earnings ratio for the overall index is still more than one standard deviation below the 25-year average, despite the rally off the bottom in March.

Over the same period, the price-to-book ratio for the index has recovered to within the 25-year range, but is still below the average for the past decade.

The key driver of the Canadian stock market is commodities. McHugh points out that when the Commodity Research Bureau’s (CRB) commodity price index rises, so too does the profitability of the stocks in the TSX index.

Rising commodity prices have an obvious effect on the bottom line for materials and energy producers, which benefits companies that service these markets, ranging from the banks that finance development to the technology and industrial firms that provide equipment. Nearly every sector gets some benefit from higher commodity prices.

He points out that the decline in commodity prices in this economic downturn was not only the largest in 25 years, but it also stood out for its relentless collapse. Past commodity declines have been gradual, with small rallies along the downward trajectory.

“What is troublesome is that in this whole drop, we never saw any blip, any rebound,” he says. “Let’s keep our fingers crossed and hope this is a brand new cycle and isn’t just a rebound in a long-term downtrend, and is in fact the bottom.”

This most recent collapse was straight down, and has only recently shown signs of recovery, although McHugh says there remain questions on the sustainability of the nascent rally.

It is unclear whether the commodities are actually being used for industrial production, or if the increases are due to China simply building stockpiles.

“This is one of the things we’re focusing on to find out, to give us some indication of whether or not this is the beginning of the cycle,” he says.

While much of the quantitative data suggests it is still a buyers market, McHugh cautions that risks remain. His best case scenario — with profitability beating the long-term average by one standard deviation — sees the TSX posting a compound annual growth rate of 14% over the next five years.

Using “normal” markets as a model — with profits returning to the long-term trend — rather than the best case, the expected five-year CAGR falls to just 3%, and the most pessimistic circumstances — profits lagging by one standard deviation — could see a five-year CAGR of nearly -11%.

Turning to the U.S. market, his worst case scenario for the S&P 500 sees a five-year CAGR of -1.7%, while a return to “normal” market conditions would see a CAGR of nearly 7%. The optimistic case would see a CAGR of just under 13%.

But while the outlook for S&P 500 returns appears more positive than that of the TSX, most Canadians would be best served steering clear of U.S. stocks.

“Obviously if we are starting a cycle in commodities, the Canadian dollar should be a strong performer, and that will have an impact on your U.S. and international holdings,” he says.

(09/17/09)