Author Archives: Scalper1

My family and I recently went to see the musical Wicked . Having already been with my wife when it first opened in 2003, I was thrilled to relive the awesome and spine-tingling performance with my kids. The creative genius of Wicked is its backstory – the plot that no one hears throughout the Wonderful Wizard of Oz . Turns out, the wizard isn’t really all that wonderful, and the witch isn’t so wicked after all. This got me thinking about parallels to the world of finance and how things aren’t always as they seem. We all know that the S&P/TSX Composite Index is heavily skewed toward the financials (37%), energy (20%) and materials (12%) sectors, but attitudes towards these industries have become rather split lately. In the past few years, financials have been all aglow thanks to consistently improving quarterly results, whereas the resource sectors have been a source of pain amid lower earnings, dividend cuts and write-downs. While faith in the financial sector may be justified, investors might not realize just how dependent the Canadian stock market has become on its earnings and dividends. According to data compiled by Bloomberg, while financials make up more than a third of the market cap, the sector accounts for more than 50% of the earnings and slightly less than half of the dividends paid on the S&P/TSX Composite Index. Click to enlarge Something wicked this way comes? Outsized dependencies are rarely a good thing in investment portfolios. For example, in the late 1990’s investors became overly dependent on technology companies trading at ever higher multiples, and then found themselves in a post-financial-crisis love affair with emerging markets. In both of these cases, investors paid too little attention to the backstory: technology had become more than a third of the S&P 500 and paid no earnings, and emerging markets had become reliant on leverage and an ever-expanding China. Investors also became overly dependent on U.S. financials a decade ago when the sector contributed more than 50% of the S&P 500’s earnings and dividends in 2006 only to fall off a cliff when the financial crisis hit two years later. The financial sector also grew to almost a quarter of the listed market in 2006, well above today’s level of 17% (still high but just not as high). Does this mean Canadian financials are due for some sort of rude awakening? Not necessarily. It depends on whether Canadian banks will report more bad loans and will have to incur larger write-downs than are currently reflected in loan loss provisioning or the share price. Intuitively, the nearly 70% decline in oil prices over the past two years and the broadening difficulties in the Canadian energy patch would imply a greater risk of loan defaults. Moreover, banks could see declining revenue growth and weaker revenues as the indirect consequences of low oil prices work through the extensive supply chain. But for now, these worries are the backstory. Canadian share prices are following the lead story: The banks’ exposures are manageable, the banks are prepared, and they continue to stress-test their loan book. Importantly, investors should know what their exposures are. Right now, investors in Canadian stocks are highly dependent on earnings and dividends from the big banks. If Canadian financials were to dip, investors could be in for a rude awakening. With any luck, the energy and materials stocks won’t seem as wicked if the rise in commodity prices in recent weeks supports upward earnings revisions in the next few quarters. The best outcome for reducing dependency on the financials is growing earnings from other sectors, not falling earnings from the banks. What can Canadian investors do to help reduce dependencies and limit outsized domestic exposures to the financial, energy and materials sectors? I would recommend considering allocations to two sectors that are underrepresented in the Canadian equity markets, such as global healthcare and technology, where there has been better dividend growth and stronger secular growth trends. Source: Bloomberg. This post originally appeared on the BlackRock Blog