The problem for many other markets, particularly Canada, that rely on commodities for growth is that this strength in the U.S. dollar has lead to a shift out of commodities due to worries about global economic growth (and thus the demand for physical commodities) and the fact that commodities are priced in U.S. dollars.

The mining industry around the globe is suffering amid a price collapse for some key metals.  Iron ore has lost more than half its value since the boom days, trading at $80 (U.S.) a tonne from a high of $190 in 2011.  Metallurgical coal has sunk to $120 a tonne, down from $330 in 2011 (although that was viewed as unsustainable since the price rise was driven by supply constraints due to floods in Australia).  Copper has retreated to $3.03 a pound, once again testing that key US$3 level, compared with a high of $4.50 in 2011.   According to the CRU estimates, the iron ore market has a surplus of about 100 million tonnes over demand and the metallurgical coal market has a surplus of about six million to eight million tonnes because projects developed during the commodity boom are now starting to produce.  All of this has had a significant impact on Canadian stocks as the commodity-intensive Energy and Basic Materials sectors each suffered double-digit percentage declines in September as international investors dumped commodity stocks.

As this scenario continues to unfold it will also become self-correcting at some point.  A higher currency has the same impact as an increase in interest rates as it slows down economic growth (mostly by increasing imports and driving down export growth).  That might postpone any plans of ‘tightening’ policy by the U.S. Federal Reserve.  On the other side, the lower currency values in Europe and the emerging economies should help to stimulate growth and drive commodity demand higher again.  Also, the debt accumulated by the U.S. will eventually put pressure on that currency.  All of this should eventually create a great buying opportunity in Canadian resource stocks, not unlike what we saw in early 2009.  The bad news is that this will still take some time and perhaps a bear market in stocks overall before anything other than a ‘trading bounce’ occurs.

Adding to the bad news is that the flow of money into the U.S. has created something closer to what we would call ‘bubble conditions’ in both the bond and stock markets.  The value of the S&P 500 Index topped the value of U.S. economic output earlier this year for the first time since the tail end of the tech bubble.  The climate for investing in U.S. stocks has been close to ‘ideal’ (low interest rates, improving economic growth and strong profits) and they’re starting to reflect that.  While similar arguments could have made about stocks back in 1998, they did continue to rise for another two years, so the momentum could continue to the upside.  But, as shown in the chart below, the longer-term value for this measure is closer to 60%.  Even assuming that low interest rates are here to stay and corporate profit margins will remain near their recent all-time highs, stocks are still reflecting this optimism.

U.S. Stocks Valued at More than GDP

We see a greater risk of a correction in stocks than we have seen in over 3 years and have moved to a much more defensive investment strategy.   Moreover, we are now starting to see a few cracks in the growth story in the U.S., which poses a risk for global stock markets since Europe has already slowed down, China is struggling with the transition to a ‘consumer-driven’ economy and the other emerging are being restrained by higher costs of capital as their currencies have fallen against the strong U.S. dollar.  Ford Motor this week took down guidance for the 4th quarter as well as their profitability outlook in Europe.  This was followed by overall vehicle production data that will show a 6.3% decline in the 4th quarter of 2014 versus a 16.5% gain in the 3rd quarter and a 17.2% gain in the 2nd quarter.  The Market PMI was revised down to 57.5 from 57.9 and the Manufacturing ISM dropped to 56.6 from 59.0.  Both are strong numbers still but are clearly losing momentum; the New Orders Index dropped from 66.7 to 60.0 while the backlog of order dropped below the critical 50 level.  We have seen similar results recently from the ISI Survey Data. We also expect that once third quarter earnings reports start to come out that the stronger U.S. dollar will not translate foreign earnings very well.  All of this adds to our worry that stocks are ‘ahead of themselves’ and in need of a correction before the bull market can resume.

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