Juggling Dynamite

Yesterday, Canada’s TSX stock index closed at 18,215, breaking below its previous July low of 18,329. As I noted in Tech leading lower, the February 2020 high of 17,944 is the next price test on deck for the TSX. As of today’s open, the Canadian benchmark is -18% since March and just 1.5% above where it topped 32 months ago at the outset of COVID.

Under the hood, financials (31.5% of the index) are -24% from their latest high, fossil fuels (17.7% of the index) are -15%, materials (12% of the index) are -29%. The relative strength of financials and fossil fuels has softened the overall index losses to date; that’s unlikely to last.

As I have mentioned many times, our base thesis is that North American stock benchmarks should follow other sectors and emerging markets in retesting the March 2020 lows as this giveback cycle unfolds–some 35% lower for the TSX and 28% lower for the S&P 500. And prices may not bottom there.

With the popping of the everything bubble, the assets most inflated by easy money and speculation have the farthest to fall. Case in point, Canada’s tech leader Shopify was briefly the TSX’s most expensive company by market capitalization last November. It has fallen 85% since and is now 25% below its March 15, 2020, crash low, 7% below where it first traded after its IPO in May 2015.

Canada’s gold mining index has lost 40% since July 2020 and is today 20% above its March 2020 crash low and back to where it was in December 2005. With the much over-loved, over-levered real estate sector in hard return, Canada’s real estate investment trust index is -30% since March 2022, 11% above its March 2020 low, and back to where it was 16 years ago in the fall of 2006.

Before we leap at the chance to buy dividend-producing equities at the lowest prices in many years, we must appreciate that stock market bottoms do not happen while the US Fed is hiking interest rates, nor even when they pause.

Precisely, in 2007-09 and 2000-02, the market bottom did not materialize until 18 and 21 months after the Fed had been cutting interest rates once more (as shown in the table below, courtesy of Nick Gerli). Since 1969, the bulk of cycle losses happened during the 14-month average time between Fed cuts and market bottoms.
Today, far from cutting interest rates, central banks have pledged to further tighten monetary conditions into 2023. It bears remembering that the worst recessions and bear markets have coincided with a downturn in real estate–the most widely held asset class. That’s just started now.

Capitulation selling in equities is still to come. As shown below, courtesy of ISABELNET.com, from an all-time high average of 66% of client assets allocated to equities at the peak in late 2021, allocations have pared back to the 60% range–still higher than the 2007 cycle top and far above the sub 40% typical of past cycle lows. Equities and real estate have not yet priced in the gravity of this downcycle, but investment-grade bonds have pulled no punches; 2022 has been the worst year for investment-grade bonds since 1920. We note that this is the only asset class where prices historically bottom before central banks have completed their tightening cycle. Once the recession is evident and central banks near a pause, investment-grade bonds traditionally strengthen on safety-seeking inflows. As policymakers cut rates again, the bond price gains for each percentage cut are noted in blue below (courtesy of Ayesha Tariq) –some upside to look forward to as other assets work lower.

Self-dealing is when a fiduciary acts in their own best interest in a transaction. It is text-book corruption and apparently widespread among government and regulatory representatives on the left and the right. Undermining objectively determined policies and the rule of law is indefensible and socially destructive, so why do we tolerate it? See Government officials invest in companies their agencies oversee:

Thousands of officials across the government’s executive branch reported owning or trading stocks that stood to rise or fall with decisions their agencies made, a Wall Street Journal investigation has found.

More than 2,600 officials at agencies from the Commerce Department to the Treasury Department, during both Republican and Democratic administrations, disclosed stock investments in companies while those same companies were lobbying their agencies for favourable policies. That amounts to more than one in five senior federal employees across 50 federal agencies reviewed by the Journal.

Technology shares led overall markets higher from 2020 through 2021 as government hand-outs, low-interest rates, and spare time enabled both a retail spending boom and a gambling frenzy in financial markets.

From the March 20, 2020, COVID crash lows of 6,879, the tech-heavy Nasdaq composite index broke through 10,000 by July 2020 (not 3 months later) and 16,000 by November 2021. The benchmark then tumbled 33% to 10,646 by June 16, 2022. After rebounding into mid-August, the Nasdaq relapsed and, this morning at 10,569, is a new 52-week-low and back to where it was in July 2020. We are now less than 9% above the pre-COVID cycle high of 9,731 on February 9, 2020, but still 53% above the March 15, 2020 crash low. We are early days yet, March 15, 2020’s low remains our base case retest this cycle.

As shown below by my partner Cory Venable, the Nasdaq composite’s September 22, 2022 close at 10,876, was more than 1% below its 26-moving average for only the 5th time since 1987. The previous four incidents (see red circles) marked the onset of the last three recessions and major equity bear markets. The massive valuation overshoot in the recent everything bubble–and hence the downside now–is hard to appreciate until quantified and compared historically.

While tech has led the overall stock market, semiconductors–a critical component of the most widely used technology–have historically led the technology sector. Last week the semiconductor index (SMH) closed below the previous June low, now -40%  since November 2021 and the lowest since July 12, 2020, but still 44% above its March 15, 2020 crash.

Thanks to its heavy weight in financials, fossil fuels, and materials, Canada’s TSX is still just over 15% under its March 2022 top and following at a lag, just as it did in 2008 (peaked in June 2008, when the Nasdaq peaked in July 2007) and in 2000 (TSX peaked in September 2000 when the Nasdaq peaked in January 2000). There’s no precedent to hope that the TSX’s relative outperformance will hold. As shown below, a breach of the July low of 18,329 and then the pre-COVID high of 17,944 are the next downside tests, but the March 2020 low remains a surreal 39% below Friday’s close.

The damage to Canadian balance sheets and the economy from plunging equity in homes and stock markets is about to get ugly. Unfortunately, financial mania has earned it.