Friday was a fresh record close for the TSX composite. Ending the day at 14,984, the broad market composite has now breached the previous peak marked last October and January. To be bullish from here one needs to believe that stock markets have now fully discounted world recession and credit crunch fears and have at last launched into the next bull market expansion in stocks.
Maybe they will. I wish I could believe this. My belief of course is irrelevant, only time will tell; but critical thought prompts us to look deeper than just the record close headline, and so we should look closely at underlying sectors for insight on present strength.
As I have noted in the past, the TSX 60 Index is overwhelmingly driven by the movement of its three main sectors Financials (29.45%), Energy (29.11%), and Materials (18.73%). The 60 largest cap Canadian companies that comprise the TSX 60 are the most relevant benchmark for our investible market, and in total the above three sectors account for more than 77% of the TSX 60 market cap. These sectors have undoubtedly been the patrons of our strong Canadian market gains since 2003, so their fate from here will be strongly indicative of our future market action.
When we break these main sectors down, we find that the all time high on the TSX this month has been heavily driven once again by energy and materials prices. Financials have continued to lag and have so far not yet broken out in a new up trend. And here is the rub, the higher energy and material prices go the worse it is for the rest of the economy including the profitability of the energy and materials companies themselves as their costs balloon and their production slips.
With oil nearing $130 a barrel, energy prices are scaring all but the most aggressive traders. Many that have been professional oil traders for the past 30 and 40 years are shaking their heads and warning that prices at present levels have gone too far too fast. Traders are estimating that anywhere from $10 to $70 of the present price is based on pure momentum speculation that prices will go higher still. See Oil Prices: Wall Street's game. This type of action brings concerns of a “bubble” forming.
Even in the US, if one strips out Exxon, Chevron and ConocoPhillips, profits at US companies are at their worst level in a decade. Without the profits from oil producers in the past 2 quarters, profits in the other S&P 500 companies tumbled about 30%. With data suggesting on-going economic weakness in the US and many other countries around the world, more earnings downgrades seem likely over the months ahead. See Oil Producers Mask Decade’s Worst S&P 500 Profit Drop.
At some point in this economic down cycle, demand slack will ultimately dent commodity prices. At the same time, the US 10-year Treasury yield having been negative in real terms for many months is now about equal to CPI. Negative real yields were another leg in support of the recent commodity price boom, positive real yields will also help shift capital out of commodities. The trouble is that historically commodity price corrections (even within secular bull trends) have been sudden and dramatic. History offers us our warning here, we must govern our animal spirits accordingly.
Cory’s Chart Corner
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