Does history repeat itself because nobody listens?

When Canada’s real estate balloon starts to fizzle will it take Canadian financials stocks down with it? Behavioural finance analyst Ken Norquay recalls lessons of the past for readers of The MoneyLetter and cautions against getting left behind when the big fund managers make their move from financial stocks to oil and gold stocks.

“Those who cannot remember the past are condemned to repeat it.”  (George Santayana, philosopher, 1863-1952).

With this wisdom in mind, let us remember the once-glorious American financial institution, First National City Bank of New York, later dubbed Citibank. In its day, FNC was the world’s largest bank. But, between 2007-09 its share price dropped to less than 10 cents on the dollar. Why? Because of the U.S. real estate and sub-prime mortgage fiasco. It’s history. The U.S. banking crisis, caused by irresponsible mortgage lending, is history.

I am concerned that Canadian investors have forgotten this lesson. When I remind young people of this historic event, they scoff as they buy and flip their third house: “That could never happen here in Canada.” Then they try to explain why it could never happen. It’s not that they are forgetting history: They are denying history.

Are bank stocks and insurance stocks risky?

I am concerned that Canadian bank stocks and insurance stocks, any stocks involved in mortgaging and real estate, are extra risky at this time in the economic cycle.  Let us remember the history of iShares S&P/TSX Capped Financials Index ETF (TSX—XFN), the Canadian exchange traded fund that invests in all the major banks and insurance companies in Canada. From 2007 at the top to 2009 and the bottom, this ETF fell from more than $28 a share to less than $12 a share. Now it is more than $36 a share.

For ‘buy-low-sell-high’ investors, the U.S. mortgage fiasco created a wonderful opportunity to buy high-quality Canadian financial stocks at bargain prices. I believe that such an opportunity lies just ahead. If (when) Canada’s real estate balloon starts to fizzle, the financial stocks could decline again. (For the record, the re-organized Citibank (NYSE—C) went from the equivalent of $570 at the top to less than $10 a share at the bottom. Today it trades around $58. Long-term investors are still down almost 90 per cent from the 2007 high.)

Provincial governments in British Columbia and Ontario are concerned about excessively high housing prices. Furthermore, the federal government, through Canada Mortgage and Housing Corporation (CMHC), has taken action to cool down the frenzied speculation in housing prices. These governments recognize that there is a problem in the real estate sector. Our concern is with the financial stocks, the banks and insurance companies, who have piled billions and billions into mortgage lending in an inflated housing market. Mortgage investing is supposed to be safe. Buying a home is supposed to be a safe investment. Bank stocks are supposed to be safe investments. Please remember 2007-2009, when history showed us that these investments are not always safe.

Is this trend your friend?

Let us also consider today’s investment trends:

The U.S. stock market is in an uptrend, having registered a new high on March 1. (The S&P500 hit 2400.) The TSX Composite index had also hit a new high a week before, finally surpassing its 2011 high by 1.6 per cent. The long-term trend of the Canadian stock market is neutral (trendless).

The trend of long-term U.S. interest rates changed from down to up in July 2016. That down-to-up trend reversal was confirmed earlier this month by the chairman of the Federal Reserve Board, who openly declared that the intention of the Fed is to announce several incremental increases in short-term interest rates over the next year or two. Canadian long-term interest rates (20-year + maturities) mirror the trend of the States, but short-term rates do not. The Bank of Canada has not increased short-term interest rates because Canada’s economy is too weak.

Let us briefly remember the Counter-cyclical Model I introduced in my stock market book, Beyond the Bull. The model recognizes a repetitive sequence of economic events that accompany major stock market tops and bottoms. First, long-term interest rates bottom. (This happened last summer.) Then, approximately six months later, the stock market peaks. (It is peaking now.) Then, about six months later, the economy rolls into a recession. (Anticipated in Q3 or Q4 2017.) Based on this methodology, the S&P500 all-time high of 2,400 on March 1, 2017, was the high for this cycle. Those who like to buy low and sell high should sell now.

The U.S. dollar measured against ‘the basket’ has been in an up-trend since the financial crisis in 2008. There was an acceleration and climax in the up-trend leading into 2015, followed by a modest up-trend since then. The short-term rally triggered by the U.S. election has run its course and is gently cooling off. The Fed’s intention to raise U.S. short-term interest rates supports continuation of the long-term uptrend of the U.S. dollar.

The Canadian dollar, measured against the U.S. dollar, is in a trendless sideways drift within the context of a long-term down-trend.  The two factors that most influence this trend are: 1. oil prices, and 2. the difference between Canadian and U.S. short-term interest rates. The recent decision of the Bank of Canada to not increase Canadian interest rates, even though the Fed is increasing U.S. rates, puts additional downward pressure on the loonie.

Gold’s historical high occurred in autumn of 2011 at $1,920.00 U.S. per ounce. It dropped to $1045.00 in December 2015 and has been in a gentle up trend since then.

Oil prices declined dramatically from summer 2014 to winter 2016. Prices are currently trending up on the long term, but down on the short term.

Trade financial stocks for oil and gold stocks

We encourage speculators to participate in these two up-trends by trading Canadian gold mining and oil stocks. In previous articles, I have recommended certain specific gold mining and oil stocks that are currently in volatile up-trends. Traders love volatility. However, let us not forget the lessons of history with respect to trading. In my stock market book, Beyond the Bull, I emphasize how everything is connected to everything else. If oil prices and gold prices are rising, this puts upward pressure on the related stocks. But if the overall stock market is in a down-trend, this puts downward pressure on all stocks, including gold mining and energy stocks. It is important to have proper trading rules and discipline. Investing and trading are different skill sets.

Remembering 2008 and 2009, let us assess how risky the financial stocks might be at this time in history.

When I was a rookie financial consultant in the late 1970s, I gave a presentation on the five symptoms of a market top. This is what to look for:

1. Parabolic price rise. The price is increasing and the rate of increase is increasing.

2. Excessive use of leverage. Speculators are borrowing money to buy.

3. Presence of many first-time investors and inexperienced investors in the market.

4. The participation of large numbers of foreign investors in local markets.

5. Overwhelming optimism that the up-trend will continue for a long time creates an urgency to buy.

Examining these five conditions, we make two important observations:

1. These conditions are NOT present in today’s stock market.

2. These conditions ARE present in today’s real estate market.

This is why I am so concerned about Canada’s financial stocks. The big banks and insurance companies are all in the mortgage business. Mortgages are supposed to be safe investments. But Toronto average house prices rose 27.7 per cent this past year (Feb. ’15 to Feb. ’16.) If higher mortgage interest rates, anti-speculation taxes and more conservative mortgage lending cause the average house price to drop back to February 2016 levels, mortgages would not be such safe investments.  If real estate speculators merely lose the 27 per cent they have just made in the past year, most mortgages loaned in this past year would become quite risky. Canadian banks would be in a mini-fiasco, similar to the major U.S. fiasco of 2007 to 2010. But that’s not the real danger for stock market investors.

If big pension fund and mutual fund managers decide to reduce their exposure to the financial stocks and increase their exposure to the gold and oil stocks, they would be selling stocks that are near their historical highs and reinvesting the proceeds in stocks near their historical lows. This is what prudent investment managers are expected to do.

Imagine the effect this multi-billion-dollar stock market tidal wave would produce: financial stocks down—gold and oil stocks up.

This is an edited version of an article that was originally published for subscribers in the April 2017/First Report of The MoneyLetter. You can profit from the award-winning advice subscribers receive regularly in The MoneyLetter.

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