Fundamentals should support more gains – Canadian stocks eked out a slight gain for the first half of 2017 while U.S. equities posted a nearly 10% return. Since 1957, in years when the TSX and S&P 500 logged a positive first half, they both posted a gain for the full year 89% of the time, with an average return of 18.6% for the TSX and 15.1% for the S&P 500.2 We think the path ahead will be forged by supportive fundamentals. Corporate earnings are projected to rise 25% for the TSX and 15% for the S&P 500 over the next year.1 Despite full valuations, the ratio of the earnings yield for stocks versus the 10-year treasury rate is slightly above the long-term average, reflecting accommodative rates and rising earnings, signaling a still-favourable environment for stocks.
Sector imbalances pose a challenge for the TSX – The energy, materials and financials sectors make up two-thirds of the TSX index, which makes the domestic market sensitive to the business cycle, commodity prices and potential headwinds from slowing loan growth and a softer housing market.1 Over the past two years, those three sectors provided an average annual return of 4.9%, but posted declines averaging -5.2% in the second quarter. Meanwhile, the more defensive sectors (telecom, consumer staples, utilities) had an average return of 2.3%, reflecting a shift toward low-volatility industries. Stateside, the best performing sectors in the S&P 500 through the first half of the year were technology and health care, which posted an average return of 16.7%.2
Rising potential for a pullback – We expect policy risks (including distractions and disruptions in Washington), global regime conflicts, political unrest, progressing Brexit negotiations and central bank actions to grab more of the spotlight moving forward. This could take the form of temporary but more frequent pullbacks. The last 5% decline in the S&P 500 was more than a year ago, and we've only experienced two 10% corrections in the past six years. In the past three years, the market has averaged a return of 11.2% in the six months following a pullback of 5% or more. During that time, the average annual return of the S&P 500 was 9.6% and 3.1% for the TSX, demonstrating the opportunity pullbacks create within an ongoing bull market.2
Action for Investors - With fundamentals (outlook for economic and earnings growth) still exhibiting positive trends, we recommend buying the dips in stocks. Position for volatility by rebalancing your equity-fixed income mix, raising cash to the high end of your recommended cash range and proactively rebalancing sector allocations. We think financials, energy and materials should be a combined 41% of your portfolio's allocation to stocks. Consider trimming overweights and adding to more defensive domestic sectors and those with exposure to global growth trends, such as technology and health care.
2. Morningstar Direct.
Past performance is not a guarantee of how the sectors will perform in the future.
Equity Investments involve risk, including the loss of principal