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ECONOMIC STUDIES | NOVEMBER 29, 2018

ECONOMIC VIEWPOINT

Volatility May Remain High, but the Stock Markets Could Bounce Back

#1 BEST OVERALL FORECASTER - CANADA

The bull market that began after the 2008 financial crisis is nearly ten years old in the United States. However, recent months have been difficult for investors. While the U.S. stock market may appear to be expensive according to some indicators, those based on earnings and interest rates seem to indicate that it is still attractive. The Canadian stock market, meanwhile, looks like a bargain where things currently stand. Since the economic environment should remain favourable for a while yet, the indexes still have some potential for gains. The episodes of volatility, such as those seen in February and since early October, could end up being frequent, however, as investors will continue to try to anticipate the next recession.

A Second Stock Market Correction in 2018 The past two months have not been easy for investors, with major stock markets taking a nosedive. Even the U.S. market, one of the few to make significant advances in the first nine months of 2018, has seen virtually all these gains wiped out since the beginning of the fourth quarter (graph 1).

GRAPH 1 A second stock market correction in 2018

Index

3,000 2,900 2,800

S&P 500 (left) S&P/TSX (right)

2,700

2,600

2,500

2,400

2,300

2,200

JAN. APR. JUL. OCT. JAN. APR. JUL. OCT.

2017

2018

Sources: Datastream and Desjardins, Economic Studies

Index 17,000 16,500 16,000 15,500 15,000 14,500

This second S&P 500 correction in 2018, a decline of more than 10%, is reminiscent in many respects of the one that occurred in February. First, these corrections were preceded by a stock market upswing, with the S&P 500 jumping more

than 7% in the first few weeks of 2018 and making a similar leap in the third quarter of the year. The surge in technology stocks, which has been particularly strong in recent months, was also a vulnerability, and it comes as no surprise that the fall was especially sharp for this sector (graph 2). Furthermore, in February as well as October, the stock market correction was triggered by signs of wage acceleration and a significant rise in bond yields. Fears about the robustness of the global economy gradually won out, however, over concerns about the increase in bond yields in recent weeks.

GRAPH 2 The upswing in technology stocks may have been exaggerated

Start of 2016 = 100

170

S&P 500

160

NASDAQ

150

140

130

120

110

100

90

80

JAN. APR. JUL. OCT. JAN. APR. JUL. OCT. JAN. APR. JUL. OCT.

2016

2017

2018

Sources: Datastream and Desjardins, Economic Studies

Fran?ois Dupuis, Vice-President and Chief Economist ? Mathieu D'Anjou, Deputy Chief Economist ? Benoit P. Durocher, Senior Economist

Desjardins, Economic Studies: 5142812336 or 1 8668667000, ext. 5552336 ? desjardins.economics@ ? economics

NOTE TO READERS: The letters k, M and B are used in texts and tables to refer to thousands, millions and billions respectively. IMPORTANT: This document is based on public information and may under no circumstances be used or construed as a commitment by Desjardins Group. While the information provided has been determined on the basis of data obtained from sources that are deemed to be reliable, Desjardins Group in no way warrants that the information is accurate or complete. The document is provided solely for information purposes and does not constitute an offer or solicitation for purchase or sale. Desjardins Group takes no responsibility for the consequences of any decision whatsoever made on the basis of the data contained herein and does not hereby undertake to provide any advice, notably in the area of investment services. The data on prices or margins are provided for information purposes and may be modified at any time, based on such factors as market conditions. The past performances and projections expressed herein are no guarantee of future performance. The opinions and forecasts contained herein are, unless otherwise indicated, those of the document's authors and do not represent the opinions of any other person or the official position of Desjardins Group. Copyright ? 2018, Desjardins Group. All rights reserved.

ECONOMIC STUDIES

In any event, it is not unusual to see periods of high volatility on stock markets. Rather, it is the straight-line climb by the S&P 500 in 2017 that is the exception from a historical standpoint (graph 3). As a number of central bank leaders noted recently, the return of higher volatility on financial markets is a predictable consequence of the normalization of monetary policies,1 as investors can no longer count on monetary authorities to keep injecting liquidity to prop up asset values.

GRAPH 3 A return to normal after unusually low volatility in 2017

Index

2,900 2,700 2,500 2,300 2,100 1,900 1,700

2014

2015 S&P 500 (left)

2016

2017

2018

VIX index of S&P 500 implicit volatility (right)

Sources: Datastream and Desjardins, Economic Studies

Index 45 40 35 30 25 20 15 10 5

Are the Stock Markets Very Expensive? While central banks seem to be determined to continue the gradual normalization of their monetary policy, fairly high volatility should be expected on the markets in the coming quarters. Investors could also continue to worry about rising interest rates, which are reducing the present value of future corporate dividends and profits, and about the possibility of a recession since the growth cycle has had a long run (graph 4).

GRAPH 4 The U.S. growth cycle is already very long

Length of economic growth cycles in the United States

1991?2001 Current cycle

1961?1969 1982?1990 2001?2007 1975?1980 1970?1973 Average 1854?1957 1958?1960 1980?1981

0

36 30 24 12

73 58

12 24 36 48 60 72 84 In months

120 112 106 92

96 108 120

Sources: National Bureau of Economic Research and Desjardins, Economic Studies

In this context, it is important for the value of stock markets to be based on solid fundamentals to prevent an exodus of investors and a long downward trend. Highly overvalued stock markets, like in the late 1990s, would be in a very poor position to handle this type of environment.

Fears of market overvaluation relate mainly to the U.S. stock market, which is currently experiencing a particularly long bull period. The S&P 500 has not seen a decline of more than 20% and has more than quadrupled since its March 2009 low. It is not unusual for such performance to raise doubts about U.S. market valuation. What's more, some indicators, especially the ratio of U.S. market capitalization to nominal GDP, seem to point to a significant overvaluation (graph 5).

GRAPH 5 Relative to the economy, the stock market seems very expensive

In % 150

Ratio between Wilshire 5000 and U.S. nominal GDP

130

110

90

70

50

30 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015

Sources: Datastream and Desjardins, Economic Studies

However, the ratio between market capitalization and GDP does not take into account interest rates and corporate earnings. These two variables underlie every serious fundamental stock market valuation, as the main characteristic of a share is to provide an entitlement to a company's future profits.

The cyclically adjusted price-to-earnings (CAPE) ratio developed by Robert Shiller also shows that the S&P 500 is expensive from a historical perspective, but that unlike the tech bubble episode, it does not appear to be overvalued relative to the bond market (graph 6 on page 3). It is also important to understand that the CAPE ratio uses average real profits for the past ten years to valuate the S&P 500 (graph 7 on page 3). As the financial crisis is still pulling this average down considerably, one might wonder whether using a 10year average is the best approach right now. An alternative CAPE ratio based on earnings for the past five years would be significantly lower and only slightly above its 30year average.

1 For example, see the address delivered by the Bank of Canada Governor Stephen Poloz before the Canada?UK Chamber of Commerce on November 5, 2018, entitled "Making Sense of Markets."

NOVEMBER 29, 2018 | ECONOMIC VIEWPOINT 2

ECONOMIC STUDIES

GRAPH 6 Unlike the tech bubble episode, the stock markets do not appear to be overvalued relative to bonds

Index

70

S&P 500 cyclically adjusted price-to-earnings ratio (left)

60

Inverse U.S. 10-year yield (right)

50

40

30

20

10

0 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015

Sources: Robert J. Shiller, Yale University, Datastream and Desjardins, Economic Studies

GRAPH 7 The 2008 crisis is still weighing on the 10-year average earnings of U.S. companies

Index

S&P 500 real earnings

140

120

100

80

60

10-year average used in the Shiller ratio

40

20

0 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

Sources: Robert J. Shiller, Yale University and Desjardins, Economic Studies

Current Earnings Provide Solid Support In our opinion, very high corporate profits mean that the U.S. stock market is not all that expensive today (graph 8). After the January surge of the S&P 500, the price/earnings ratio based on earnings for the past 12 months was fairly high

GRAPH 8 The surge in earnings is a major boost for North American indexes

Profits/share

175 S&P 500 (left)

150

S&P/TSX (right)

125

100

75

50

25

Profits for the past 12 months

Profits/share 1,200 1,000 800 600 400 200

0

0

1995

2000

2005

2010

2015

Sources: I/B/E/S, Datastream and Desjardins, Economic Studies

at around 21; however, it has dropped recently to about 17, slightly below its average since 1987 (graph 9). A decline in this ratio is not surprising, as stock market indexes are stumbling and the spectacular surge in earnings is continuing. Companies comprising the S&P 500 are therefore headed for more than a 25% increase in profits in 2018. The U.S. tax reform certainly contributed to this excellent result, but a strong uptrend buoyed by record profit margins and robust sales growth was already noted last year (graph 10). Canadian companies are also posting quite remarkable profit growth, which drove the S&P/TSX price/earnings ratio down quite low.

GRAPH 9 The price/earnings ratios based on past earnings dropped sharply in recent months

Index 30

Price/earnings ratios ? Past 12 months S&P 500 S&P/TSX

25

20

15

10

5 1987 1990 1993 1996 1999 2002 2005 2008 2011 2014 2017

Sources: I/B/E/S, Datastream and Desjardins, Economic Studies

GRAPH 10 Sales growth has remained sustained, as the operating profit margin reaches a new record

S&P 500

In %

In %

12

Annual sales growth (left)

13

10

Profit margins (right)

12

8

6

11

4 10

2

0

9

-2 8

-4

-6

7

2012

2013

2014

2015

2016

2017

2018

Sources: Standard & Poor's, Datastream and Desjardins, Economic Studies

An Interesting Opportunity for Investors with Strong Nerves It is understandable for investors to be worried about the normalization of monetary policies and the potential end to the growth cycle. We should also expect the clearer rise in wages and interest rates to soon start putting the brakes on the spectacular earnings growth.

NOVEMBER 29, 2018 | ECONOMIC VIEWPOINT 3

However, there is a big difference between a slowdown in profit growth and a drop in earnings that would justify a real bear market. Since a recession does not appear to be imminent, the recent decline in stock indexes and price/earnings ratios strike us as exaggerated and could be a good purchasing opportunity for investors ready to stomach some volatility. In buying the U.S. stock market at a time when it appears to be valued fairly correctly from a fundamental point of view, an investor can expect to make a pretty normal return of about 7% annually in nominal terms. The gains could be even bigger on the Canadian stock market, which seems downright affordable. With interest rates rising but staying very low, we would be hard-pressed to find more attractive assets at the moment. Some more pessimistic analysts recommend turning to the money market, but this option sentences investors to very limited returns. A number of international stock indexes are also an interesting option after many challenging quarters, but the economic and political risks appear much higher on the international stage, particularly in Europe and emerging countries.

Investors who today opt for the stock market must nevertheless be aware that a true bear market could occur once the growth cycle ends. However, in the long term, this type of fluctuation has little effect, as such corrections are often followed by an equally strong rebound when growth begins to accelerate again.

Mathieu D'Anjou, CFA, Deputy Chief Economist

ECONOMIC STUDIES

NOVEMBER 29, 2018 | ECONOMIC VIEWPOINT 4

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