If I were to ask a room full of investors what is wrong with the Canadian stock market I would likely get an earful about the eurozone debt problems and the possibility of U.S. lawmakers failing to reach a debt ceiling deal by Aug. 2, 2011.
These problems are referred to as macro or top-down issues. But if I had to drill down to the root of the problem with the Canadian stock market I would single out the relative poor performance of our financial sector which has returned only 0.2 per cent
From a technical perspective a weak financial sector is a problem because bull and bear market cycles are historically led by the financial sector. The TSX financial sector warned of the pending financial crisis having peaked in May 2007, 12 months before the broader TSX composite peak of May 2008.Subsequently, the TSX financial sector signalled a pending bull market when some components bottomed out in late 2008 about three months before the broader TSX composite tanked in March 2009.
The structure of the TSX composite is a problem because only three sectors represent over 75 per cent of the TSX composite by weight with the financial sector at 28 per cent, the energy sector at 27 per cent and the materials sector at 23 per cent. The other seven sectors share the remaining 25 per cent and have little influence over the composite.
The bottom line is that, in order for the current bull market in Canadian equities to continue, we need the leadership of a strong financial sector.
The obvious problems holding the sector back are those bad news macro or top-down issues. The less obvious problem is more likely the good news issue of the current low interest rate environment.
It appears that Canadian consumers, who are enjoying the current low interest rate environment, are squeezing profits on loans made by the big Canadian banks. Think of the banks as retailers who basically buy money low and sell money high. They attempt to borrow cheaply at the short end of the yield curve, usually through deposits, and then lend longer-term loans at a higher rate.
Bankers now complain low interest rates are encouraging customers to stick with less profitable variable-rate mortgages rather than higher-margin fixed ones. In other words the combination of ultra-low interest rates and stiff competition results in a drop in net interest margins in their domestic operations.
The net interest margin (NIM) is the difference between what a bank charges borrowers for loans and pays out to customers on deposits. The low NIM has impatient investors selling their bank stocks because they can’t see the current low interest rate environment ending anytime soon.
Our chart today is the weekly closes of the a TSX listed Exchange Traded Fund, the iShares S&P/TSX Capped Financials Index Fund (XFN) plotted above the 10-year U.S. Treasury bond yield. According to the manager, the XFN seeks to provide long-term capital growth by replicating, to the extent possible, the performance of the S&P/TSX Capped Financials Index. The U.S. 10-year T-bond yield is a bellwether for North American sovereign debt yields.
Note the high price correlation of our two plots: surprisingly, when yields or interest rates fall as they did in 2007 and 2008, the financial XFN also fell in price. Note the subsequent rise in yields through 2009 and mid-2010 and the coincident advance in the financial sector.
Note the zigzag in the yields through 2010 and 2011 and the coincident zigzag of the financial sector.
Clearly we need a trend to higher bond yields to boost the financial sector and if you believe as I do that interest rates will rise we need to retain our Canadian bank stocks.
In order to get those U.S. 10-year T-bond yields back above 3 per cent we need some good news about the economy. So focus less on the eurozone problems and more on news such as American Airlines buying at least 460 new planes over the next five years in what it calls the biggest airline order in history.
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