The US stock market continued to rally in the last 3 months of 2017, fuelled by ongoing optimism about the US economy and by US corporate tax cuts becoming effective as from January 2018. The S&P 500 index rallied by 19% in 2017 but it should be noted that approximately 40% of the increase in the index was accounted for by just 7 technology stocks (Amazon, Apple, Facebook, Microsoft, Google, Netflix and NVIDIA). Furthermore, with the euro appreciating 14% vs the US dollar in 2017, the S&P 500 index was up just 5% for the year in euro equivalent terms (excluding the contribution of the big US technology stocks, the index was down 2% in euro equivalent terms). Despite strong market momentum and investor euphoria, all US stock market valuation metrics indicate that a pullback is likely to occur some time in 2018. The US stock market’s P/E ratio is currently 35% above its historical average while the cyclically adjusted P/E ratio (also known as CAPE or Shiller P/E ratio) is at its highest level since just before the 1929 stock market crash and the 2000 internet bubble crash. And most market participants, fund managers, analysts and reputable publications like the Economist and the Financial Times argue that the US stock market is getting frothy and the likelihood of a pullback is very high. The timing of the pullback is impossible to predict when market momentum is intact, economic fundamentals and company earnings remain strong and there is no specific catalyst to trigger a sharp correction (apart, perhaps, from a North Korea triggered geopolitical event). However, a 10%-15% stock market pullback in 2018 is a very probable scenario and if it happens it will bring US stock valuations down to more reasonable levels (when one also accounts for the 8%-10% average US companies’ earnings per share boost in 2018 arising from the US corporate tax cut from 35% to 21%).
European stock markets are nowhere near as expensive as US stock markets and the surge of the euro in 2017 has capped European stock market gains. Germany’s DAX and France’s CAC 40 indices are now just marginally higher vs their summer 2015 peak and the French CAC gave up all of its post French election gains in the summer before rebounding towards the end of the year. And on the basis of various valuation metrics, European stocks are currently much more attractive than US stocks.
Regarding banks stocks valuations, US banks are much more expensive than European banks (by up to 40% based on current and forward P/E ratios). Hence the Active Banking Fund gradually exited buy hold positions in US banks in the last quarter of 2017 and increased buy hold positions in European banks. US banks remain attractive as short-term plays on pullbacks (“buy the dip”) and for as long as US stock market euphoria and upward momentum continues and assuming that US banks earnings remain strong, we will continue entering US banks on pullbacks of 3%-5% to profit from the rebound. This is a relatively low risk strategy that has been profitable for the fund throughout 2017. Regarding European banks, having underperformed substantially in the last quarter of 2017 (vs US banks) they rallied in the first 10 days of 2018 on expectations that the ECB is gradually becoming more hawkish and will soon start providing guidance as to the timing of the first interest rate hike in the eurozone (expected in early 2019).
Canadian banks continue to perform well in terms of earnings and profitability, boosted by the strong performance of their US retail operations. All Canadian banks experienced a pullback between April and September 2017, partly due to rating agency downgrades and partly due to concerns about the future of NAFTA, but rebounded in the last 4 months of the year. Concerns about the US pulling out of NAFTA resurfaced last week and this has led to weakness in the Canadian dollar and the performance of Canadian stocks.
Looking forward into 2018, given the various stock markets’ relative valuation levels, we will stick with the fund’s current strategy of being overweight in a small number of highly profitable European banks and taking short-term positions in US banks on pullbacks. We expect that European banks will outperform US banks in 2018 on the back of stronger economic growth in the eurozone, declining European non-performing loans and a more hawkish ECB. UBS has estimated that a 1% increase in eurozone interest rates (a 1% parallel shift in the euro yield curve) will boost European banks average earnings per share by 40%. Regarding Canadian banks, we view the fund’s Canadian banks portfolio as a low volatility/high dividend play and once the NAFTA uncertainty goes away (regardless of the outcome) we will add to the fund’s current Canadian banks positions.
