Deutsche Bank believes that the Canadian housing market is overvalued by 60 per cent.Deborah Baic/The Globe and Mail
When everyone says that you have a problem, maybe it's time to accept the fact that everyone could be right.
No, this isn't a self-help column, but rather a sober look at the Canadian stock market.
Canada has been drawing a lot of criticism, particularly from beyond our borders, from observers who are warning of dire consequences should our overheated housing market take a tumble.
Even within our borders, skepticism is rising: "Since the global financial crisis struck, Canada has rightly been heralded as a flag-bearer for economic resiliency," said Eric Lascelles, chief economist at Royal Bank of Canada, in a note. "However, this glowing narrative is starting to lose its sheen."
A new fund, expected to be launched early next year, will allow sophisticated institutional investors to bet against the housing market for the first time. The details on the Spartan/Libertas Real Asset Opportunities Fund are still a bit fuzzy, but it serves as one more reminder that Canada is making a lot of people nervous these days.
However, rather than using sophisticated techniques to bet against the market, why not just avoid it altogether and take bigger positions in equity markets in the United States and elsewhere? It could easily prove to be the big, bold bet of 2014.
Of course, the S&P/TSX composite index is already struggling. As 2013 ticks down, it has scraped together a mere 8 per cent return, lagging every other developed-market index by a wide margin. It is 11 per cent below its 2008 record high, while the S&P 500 hit a succession of record highs this year.
Even more demoralizing, consider that Canada emerged from the 2008 financial crisis relatively unscathed, with its banking sector in good shape compared to the carnage that occurred in the United States – yet Canadian stocks have still managed to underperform U.S. stocks.
Since the start of 2007, a seven-year period that includes the bear market downturn and the bull market rebound, the S&P/TSX composite index has lagged the S&P 500 by 20 percentage points.
The future doesn't look any better, at least if you pay attention to the chorus of warnings from the likes of the OECD, the International Monetary Fund, Goldman Sachs, Deutsche Bank, Nobel Prize-winning economist Robert Shiller and Emrys Partners.
Emrys who? That's the firm founded by Steve Eisman, who bet against the U.S. housing market prior to the downturn and is now warning of dire consequences for Canadian banks and mortgage originators like Home Capital Group Inc. should the housing market turn.
Sure, that's just his opinion. But Deutsche Bank believes that Canada's housing market is overvalued by 60 per cent, the OECD warns that Canada is at risk of a price correction and Goldman Sachs has recommended a bet against the Canadian dollar as its top trade for 2014.
As for Mr. Shiller, the world's most renowned bubble-spotter who showed remarkable prescience for his published views on the tech bubble in 2000 and the U.S. housing bubble several years ago, he recently said he is worried about "bubbly home prices" here – particularly in Vancouver.
There's more at risk in Canada than a housing correction, though.
China's slowing economic growth continues to weigh on base metals prices. And there isn't much to like in gold given the backdrop of low inflation and a Federal Reserve bent on winding down its bond-buying stimulus program.
Oil producers, another pillar of the S&P/TSX composite index, are struggling with high development costs, a glut at U.S. refineries and rising production from rival U.S. producers.
To be sure, some Canadians aren't blind to the risks of staying heavily invested in Canada.
Mr. Lascelles pointed out seven factors that will constrain economic growth over the next few years:
1. Current account deficits are at 20-year highs relative to gross domestic product
2. The economy is operating near full-potential, leaving less room for improvement
3. The housing market will become a drag on growth as affordability declines and the construction boom fades
4. Slowing household credit growth will weigh on consumer spending
5. Canadian businesses have little excess cash to unleash a corporate investment boom
6. Competitiveness is low, resulting in plant closures
7. Economic conditions will feel a lot worse than official GDP numbers suggest as the performance gap with the United States grows.
Add it up, says Mr. Lascelles, and he recommends under-weighting Canadian stocks, which is something Canadians tend not to do. Domestic stocks represent 64 per cent of our equity portfolios, on average, even though Canadian companies represent less than 4 per cent of the global market. In other words, we tend to be really, really bullish on Canada.
Perhaps it's time for investors to take a more realistic view of our condition – and the first step is to recognize that we have a problem.
David Berman