Economic analysis

Assume the crash position: How far will the stock market fall?

Canada’s stock market has suffered through a lost decade of returns. Why the bad times for Canadian investors could continue.

Businessman under a desk

In recent weeks, the world’s stock markets fell into a pattern as familiar as it was stomach-churning. Sharp losses on the volatile Shanghai Stock Exchange—ironically made worse by so-called “circuit breakers” Beijing designed to limit the damage—reverberated around the planet as investors in New York, London and Toronto grappled with the spectre of a runaway debt crisis in the world’s most populous nation. Chinese investors, meanwhile, woke up the next day to screaming headlines about the losses overseas and, naturally, reassessed the prospects for China’s myriad global exporters. Add continually falling oil prices to the volatile mix and a vicious cycle was born. “It scares the wits out of everyone,” says Eric Kirzner, a professor at the University of Toronto’s Rotman School of Management who is an expert in personal finance and investing. “You get up in the morning and get hit by the twin emotions of fear and greed. You say, ‘Oh my God, the market is going to zero.’ ”

The net effect was the worst-ever start to a year for U.S. stock markets after a seven-year bull run. The Dow Jones Industrial Average, which tracks the stocks of 30 American “blue chip” firms is down nearly 10 per cent since Jan. 1, putting it firmly in correction territory. The same goes for the broad-based S&P 500 Index, which last week closed at its lowest level in more than 12 months.

But an even bigger victim is Canada, where the resource-heavy S&P/TSX Composite Index is not only at its lowest level since 2013, but back where it was in 2006. Call it a lost decade for owners of Canadian stocks, which, now more than ever, rise and fall on the whims of the boom-and-bust world market for oil and various metals and minerals.

All totalled, nearly US$3 trillion was wiped away from the portfolios of global investors in recent weeks. More importantly, the stock market swoon has raised questions about China’s ability to manage its transition to a modern consumer-oriented economy, as well as about the strength of the U.S. recovery, on which global growth increasingly depends. The prevailing mood was captured by economists at Royal Bank of Scotland who last week advised investors to “sell everything”—a call Kirzner described as “kind of stupid.”

To be sure, there’s so far relatively little economic data, other than the flagging price of oil, to suggest the world’s outlook has changed markedly since last month (although panicked investors have a knack for finding ominous signs everywhere they look). The economies of China, the U.S. and even Canada continue to grow, albeit not as fast as investors and policy-makers would like, and there are signs Europe is on the mend.

That doesn’t make the stock market carnage any less painful, particularly in Canada. We’ve become so dependent on foreign companies to buy our oil, timber and metals that not even a US68-cent loonie is enough of a tailwind for export manufacturers in Ontario and Quebec to offset the damage that plummeting oil prices have done to Alberta drillers. Even companies with little to do with resources, from banks to biotech firms, are taking a hit, prompting much talk about the urgent need to diversify the economy.

In the meantime, the glory days for Canada’s stock market—when the S&P/TSX could be relied upon to outperform the U.S. S&P 500, as it did immediately following the financial crisis—are as good as dead. With global now markets faltering, too, Canadian investors are left wondering just how bad things will get.

Scroll left to right on the chart below to follow the stock market’s lost decade.

The dismal performance of Canadian equities over the past few years literally couldn’t have come at a worse time. After bailing out of the markets in 2008, Canadians were finally making their way back into stocks, given few other options to make money in a world of rock-bottom interest rates. They funnelled a net sum of $5 billion annually into equity funds over the past three years, compared to net outflows of between $10 billion and $14 billion between 2010 and 2012, according to data from the Investment Funds Institute of Canada. Similarly, investors last year sunk nearly $50 billion into so-called “balanced funds,” which include both stocks and bonds. That’s up from $27 billion in 2012. In effect, they fell into the classic investor trap of selling while prices were low, and buying when they were high.

Given that Canadian investors suffer a home country bias—not only do they tend to stick to buying domestic companies they’re familiar with, but the volatile loonie deters them from venturing beyond Canada’s borders—there’s a good chance many are stuck with portfolios heavily exposed to poorly performing Canadian stocks. And the outlook appears to be getting worse, not better. China, whose rapid growth over the past decade fuelled Canada’s resource boom, this week reported its slowest rate of growth in gross domestic product—just 6.8 per cent—since 1990. At the same time, a glut of crude oil, exacerbated by an ongoing price war being waged by Middle East producers against a new crop of U.S. shale oil and gas drillers, has pushed the price of the Western Canadian Select benchmark to just US$17 a barrel, the cheapest on record. Among the biggest losers, not surprisingly, are Canadian energy company stocks, which in 2104 accounted for nearly a quarter of the S&P/TSX. Encana Corp. is down nearly 70 per cent over the past year. The same goes for Teck Resources. Paramount Resources, meanwhile, has lost more than 85 per cent of its value in just 12 months. And when Canadian Oil Sands finally agreed to accept a takeover offer from Suncor Energy this week, after a rancorous struggle, the sale price of the shares, at $4.2 billion, was a fraction of Canadian Oil Sands’ $34-billion market cap in 2011.

Hard evidence of Canada’s malaise can be seen on the windswept Canadian Prairies, where once-busy regional railroads are rapidly being transformed into parking lots for railcars—both empty and full. Sheldon Affleck, whose Mobil Grain runs Saskatchewan Big Sky Railway and Last Mountain Railway, says the Saskatchewan shortlines are fast running short of space to store cars shippers once packed full of grain, potash and crude oil. “There are a lot of railcars coming into storage in the last few months due to the downturn in commodities,” he wrote in an email. “We have refrained from loaded car storage due to prohibitive insurance liability requirements, but there is a demand for that as well.”

Related: A mini-glossary of terms to know during the stock-market downturn

Yet while the slide in oil and commodity prices is now well-documented, if not nearly as well understood, its impact on Canada’s stock market was, until recently, partly offset by a couple of high-flying firms. As recently as August, Montreal-based Valeant Pharmaceuticals, a specialty drug company, saw its shares trade as high as $346 after it went on a massive acquisition binge. At one point, its market valuation even surpassed the Royal Bank of Canada’s, making it the most valuable company in the country. Since the S&P/TSX is cap-weighted, movements in Valeant’s share price had an outsized influence on the index’s overall performance—that is, until Valeant found itself mired in a complicated scandal that involved allegations, all unproven, of price-gouging and cooked books. The result? Valeant’s stock is now worth less than half of what it was just six months ago.

Another bygone strength for the Canadian stock market in recent years are the country’s big banks, lauded during the financial crisis for their conservative approach. But they too have suddenly found themselves in investors’ crosshairs because of their perceived exposure to Canada’s slumping growth. Short-sellers, who make money by entering into transactions that yield profits if a company’s shares drop, are also using Canadian banks and insurance companies as a proxy to bet against the country’s frothy housing market, which some observers say is as much as 30 per cent overvalued. So even though Canadian bankers collectively grew earnings by six per cent last year, the “sell Canada” movement contributed to a nearly 10 per cent decline in bank shares last year, according to Credit Suisse analyst Kevin Choquette. Some have been hit harder than others: while TD Bank’s share price has dropped 12 per cent since hitting a high in mid-2014, Scotiabank is down a full quarter over that time. However, Choquette believes bearishness on banks is overdone, writing in a recent note to clients that bank stocks will rally “as the market gets greater clarity on the Canadian economy as it adjusts once again to the commodity cycle.”

There’s just one problem. Global markets aren’t co-operating. Instead of allowing Canada to quietly adjust to its new normal, investors are questioning whether the countries underpinning the new economic world order—China and the U.S.—are up to the task.

(Frank Gunn/CP)

(Frank Gunn/CP)

As speculation mounts that Beijing is slowly losing its grip on the levers it uses to control China’s massive economy, investors have taken to studying each market swing in Shanghai, an index that used to receive scant attention, in the hopes of spotting some heretofore missed clue about an impending global calamity. The fear is that a China crash would eventually spill over into the U.S., touching off another global recession. If that happened, it goes without saying Canada would be in serious trouble, since we’re increasingly counting on a strong recovery by our biggest export customer—Uncle Sam—to offset the China-induced declines in our energy and mining industries. It’s the economic equivalent of a double whammy.

Already some observers claim to have spotted signs of a U.S. slowdown on the horizon. Bank of America analysts, for example, pointed to U.S. railroad cargo data, often a leading economic indicator, that in 2015 dropped by the most in six years. Concerns have also been raised about slower-than-anticipated U.S. retail sales over the holidays and a slump in manufacturing brought on by the high U.S. dollar.

Yet by far the biggest concern seems to be the slumping price of oil. Just 12 months ago, the notion that oil could fall below US$50 a barrel seemed silly. Then US$40 became the floor. Then US$30. A barrel of West Texas Intermediate, the U.S. benchmark for light, sweet crude, is now worth US$28 and some say prices could eventually fall as low as US$10 before bouncing back. That, in turn, has raised the troubling prospect that cheap energy—usually considered a positive when it comes to spurring global economic growth—may actually be symptom of a global economy stuck in a deflationary spiral where consumers and businesses refuse to spend money because they know prices will be cheaper tomorrow.

Related: What the oil crash means for Canada

The question is what, if anything, can be done to improve Canada’s outlook and the earnings of companies who do business here. Some, like London-based Barclay’s, believe the Bank of Canada may cut its trendsetting interest rate to zero this year after floating the idea of negative interest rates last month. Meanwhile, Prime Minister Justin Trudeau has suggested he’ll speed up his government’s infrastructure plan in an attempt to boost the economy. However, neither approach is guaranteed to have the desired effect. Further interest rate cuts would push even more money into Canada’s bubbly-looking housing market and cause further deterioration in the loonie. Meanwhile, the impact of deficit-spending schemes have been shown to be of minimal impact in a country like Canada where money can easily be moved across borders.

Jos Schmitt, the CEO of Toronto’s Aequitas Innovations, which launched its national NEO stock exchange earlier this year, says more needs to be done to diversify the country’s economy so we’re better able to weather the ups and downs of the commodity cycle without constantly being plunged into crisis mode. “We’ve been resting on our laurels for the past 15 years,” he says of the country’s reputation for relying on low-value “rip and strip” resource industries to drive growth while others seek to build the next Apple or Google. “We have a lot of potential, but we’re not executing on it.”

It’s a sentiment now shared by scores of disillusioned Canadian stockholders, too, many of whom are now 10 years older—and not much richer.

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