Prepare clients for a market correction

Analyzing Canadian companies’ price-to-earnings ratios has worked for stock pickers over the last few years, especially since many businesses had stronger earnings than their stock prices reflected.

Listen to the full podcast on AdvisorToGo.

But, even though markets will remain positive, a correction may be on the way, says Gary Chapman, senior portfolio manager and managing director of Canadian equity at Guardian Capital. He manages the Renaissance Canadian Growth Fund.

Until now, he adds, companies’ stock prices were rising quickly because interest rates have been low and competitive. The U.S. economy was improving, and global economic fears were fading.

Read: A look at the global economy, for more markets in 2013

Plus, multiple price-to-earnings revisions were taking place in Canada in sectors such as consumer staples, information technology, consumer discretionary and industrials—those sectors rose between 24% and 43% over the last few years.

Read: Outlook good for consumer discretionary

In contrast, notes Chapman, the energy and materials sectors were down around 29% during the same period. So the relative weakness of resources has been masking the Canadian market’s underlying strength.

In 2013, for example, the S&P 500 returned 32.4% in U.S.-dollar terms and price-to-earnings multiples expanded. Meanwhile, the TSX returned only 13%.

Then, in 2014, the U.S. market outperformed the TSX again; the TSX posted returns of 10.6%, versus the S&P 500’s returns of 13.7%. Still, major non-resources sectors in Canada rose between 22% and 49%, while the resource sectors were down between 2.5% and 5%.

Read:

Part of the reason stock prices were rising so rapidly up until 2012 was their cheap valuations following the financial crisis, says Chapman. He found stocks recovered from their lows between March 2009 and December 2012, but that they remained cheap due to turbulence in Europe, and the possibility of the U.S. receding again.

So, “as we came to the back half of 2012, our view was stocks would proceed to have price-to-earnings multiple revisions upward as economic fears dissipated. And this [was] the case.”

Now, however, most stocks aren’t cheap relative to historical averages.

Read: Consider active management to earn income

Don’t jump out of the market

Stocks are still inexpensive considering where interest rates are, says Chapman. So, “we think positive returns will continue into 2015 with one caveat: because multiple [price-to-earnings] expansion [was] so quick and dramatic in Q4 2014 and Q1 2015,” investors should be cautious.

Read: Cut exposure to REITs, utilities

Still, he adds, a market correction caused by interest rate increases won’t mean the end of the bull market. “It will take much higher short rates [and] long rates, and a much more expensive stock market, to end this bull market. Interest rates could [still] back up by 150 to 250 basis points. But, when short-term rates do begin to rise, this might cause another pullback in the market.”

Read: Easy monetary policy doesn’t protect against bubbles: Fed official

On the flip side, continues Chapman, “history suggests that if a rise [in rates] is due to a strong economy, earnings growth will continue to drive stocks higher until we’ve had several increases.”

Further, Chapman predicts there will be enough liquidity in the market to support upward multiple revisions. “There’s sufficient external liquidity even though the Fed has ended quantitative easing, and sufficient internal liquidity with investors’ cash earnings.”

Read: How a liquidity crunch would impact markets

“We expect funds to flow out of money markets and bonds, and into stocks,” and he anticipates retail money and pension money will flow into stocks.

Read:

Will there be more global volatility?

Look to low-vol for long-term returns

How negative rates affect economies