After suffering throught a dismal year in 2011, stock market investors have decided to see the glass as ‘half full’ rather than ‘half empty’ in the first few weeks of 2012.  The result has been the strongest first two weeks for North American stocks in 25 years.  The bullish among us will quickly point out that the January barometer is a key indicator for the year ahead, particularly the first 5 days, and that the phrase from the Stock Trader’s Almanac is that “so goes January, so goes the rest of the year.”  Of course the omnipresent skeptics among us would also quickly point out that 25 years ago was 1987, the year of the stock market crash, when stocks fell over 22% in the U.S. on the 19th of October and the Toronto market also gave up all of their accumulated gains for the year. 

But markets have pulled back a bit after the fast start and, as of the time of writing, it looks more like the best start to a year since 1997!  What has been behind the recent strength is simply better economic data.  U.S. payrolls, consumer confidence, business spending and manufacturing have all been improving in recent months.  Not exactly robust but at least going in the right direction.  Meanwhile, in troubled Europe, the data has also started looking better, particularly in stalwart Germany, the backbone of EuroZone growth.  In fact the German stock market has been the strongest of the major industrial markets thus far in 2012, a great sign for those who see the stock market as a traditional ‘lead indicator’ of economic activity.  Stocks have fulfilled this forward looking role over the years much better than the ratings agencies, which have filled the headlines recently with the multiple downgrades of sovereign debt in Europe.  We have often likened the predictive value of the ratings agencies to that of the line markers in football; they move the first down yardage stakes to where the play currently is, but they are not the ones actually moving the ball up and down the field.  We see the ratings agenices in much the same way; they are a lagging indicator of what the market has generally already identified and when they move their ratings, they are usually just ‘catching up to where everyone else already is.’  So we’re more encouraged by the forward looking indications from strong stock markets than discouraged by the backward looking indications coming from Moody’s, Fitch, S&P or even the World Bank when they downgrade global growth or the bond ratings of various sovereign entities.  The markets already know those economies have problems; that’s why their debt is trading anywhere from 50c down to 7c on the dollar!

This is the point in the winter when the seasonal tail winds generally do abate though. February, on average, is among the weaker months.  The S&P 500 is up 4.7% as of the close last Friday (Jan 27th).  When the stock market ends January with a gain, it has historically finished the full year in the black 82% of the time.  It will probably be another extremely volatile year for stocks, with headlines from Europe and China dominating the early part and then the U.S. elections the second half of the year.  But at least we’re off to a good start!

Looking back at 2011 one more time, it’s interesting to see the sectoral breakdown in the Canadian market and how it differed from the strong markets we saw in 2009 and 2010.  The table below shows sector returns in Canada for last year as well as the prior two.  What’s interesting is how the Basic Materials sector was basically responsible for almost half the market’s gains over the 2009-2010 period and then accounted for over half of last year’s losses.  Energy and Materials together were in fact responsible for more than 100% of last year’s total stock market losses.  The opposite impact came from the defensive sector (Consumer Staples, Telecom and Utilities).   While those 3 sectors clearly lagged the main index when the stock market was rising in 2009/10, they actually rose last year when the stock market fell.   No wonder they’re referred to as the ‘defensive’ sectors of the market.

2011 Sector Returns

However, the outperformance of the defensive sectors last year (the aptly-named ‘risk off’ trade) has made the valuations of these stocks excessive in our view.  It’s hard to justify why a company like TransCanada Pipeline, with a 5-year growth rate of about 6%, should trade at 18 times earnings while auto parts giant, Magna, trades at only 8 times earnings despite having an 11% growth rate over the same 5-year period.  Investors seem to be paying a fair premium for safety right now.  Our view is that you should increase the risk level in your portfolio when you are getting paid to do it……the much cheaper valuation of cyclical stocks like Magna does suggest we are getting paid to take that risk now.

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