Interestingly, this rush to raise equity in the energy sector is probably one of the reasons why the capital markets activity results in recently reporting earnings for the Canadian banking sector has been better than expected.  While the overall bank earnings have been coming in slightly better than expectations, there were mixed reactions to how those numbers are being achieved.  Wealth management operations continued to grow and retail banking helped the banks report better-than-expected second-quarter earnings.  But investors were more interested in the trend in the loan books for the banks, particularly as they apply to the energy sector.  Gross impaired loans grew at all the banks with as much as a doubling of the level from last year at CIBC.   However, three of Canada’s biggest banks delivered a notable shift in tone after the price of crude oil rebounded to its highest level in ten months, easing concerns about loan losses to the energy sector.  Oil briefly touched above US$50 a barrel, putting it well above the price used in the banks’ worst-case stress tests and nearing the point at which stability could return to the struggling sector.

We are not overly bullish on the Canadian banks at current levels and see more potential upside from U.S. banks, which have lower valuations, more potential for earnings and dividend growth and should benefit from an expected increase in U.S. interest rates.  Banks are also facing headwinds from a slowdown in loan growth and an overall shift in the use of technology in financial services which will require substantial spending over the next few years.  But we are also not concerned about substantial risk in the sector.  Canadian banks have shown strong diversification in their loan books which has reduced overall risk.  This was clearly evident during the financial crisis.  Their international diversification initiatives have also improved longer-term growth opportunities.  Wealth management operations continue to grow and are more stable and profitable than their traditional loan businesses.  Meanwhile, the valuations of the banks are not particularly ‘stretched’ on an historical basis and you will also receive a dividend yield of about 4% while waiting for economic conditions to improve.   There are areas of the market where we see higher levels of risk right now than the Canadian banks.

With first quarter earnings now firmly in the rear view mirror, we can look back on where we stand on overall market valuation.  Earnings growth was negative on a year-over-year basis, due in large part to the sharp drop in energy earnings.   However, rising input costs are also starting to put downward pressure on profit margins, which had risen to all-time highs last year.   The clear trend during reporting periods over the past few years has been somewhat disappointing revenue growth but earnings exceeding expectations.  The more sceptical view was that this was being driven by ‘financial engineering’ including substantial share buybacks, debt refinancing and more aggressive accounting policies with regards to capital spending.  These benefits seem to have run their course and earnings are now being impacted by higher debt charges, rising wages and slower overseas sales.  The result is that profit margins are falling, as shown in the chart below.  With slow revenue growth already in place, lower margins will only serve to slow earnings growth even further.  For stock investors who are already paying record high valuations on stocks, slower earnings growth is not going to make the situation any better.

Profit Margins Falling From Peak Levels

The bottom line for us in financial markets right now is that the stock market rally has run its course and that stocks face more headwinds in the months ahead from weak earnings, slower global economic growth, high stock valuations and less impetus from aggressive central bank policies.  These risks are somewhat mitigated by the fact that most investors already recognize these risks and have lower commitments to stocks than they have had historically.  Market sentiment is clearly still negative, which is why the current rally has continued as it draws in money ‘from the sidelines.’  If the economic fundamentals start to improve then these moves will be justified, but we still see more risk than reward in stocks at current levels.  Our proprietary Asset Mix Indicator has moved back down to a level of -2 in May, after rising up to +3 at the market lows in early February.  Component values for this indicator are shown in the chart below.

JZechner Asset Mix Indicator

We have moved to an underweight position in stocks after selling almost all of our holdings in the gold, base metals and energy sectors.  We remain overweight U.S. stocks given that we expect further weakness in the Canadian dollar and have a higher comfort level with the valuation of U.S. banking, technology and transportation stocks.  We also still have an overweight position in Canadian preferred shares given their yields of close to 6% and the increasing institutional interest in this sector as a source of income.  In our hedge fund we have a short position in the energy sector, crude oil and some U.S. cyclical stocks.  We have offset those with some long positions in the ‘beaten down’ health care sector as well as a few special situations where we see the stocks trading substantially below their net asset values.   This group includes Torstar Corporation, Hudson Bay Company and Uranium Participation Corp.

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