The market is irrational, but is it exuberant?

“Irrational exuberance” is how former US Fed chairman Alan Greenspan described the stock market during the dot-com bubble of the 1990s. Investor’s Digest of Canada columnist Edward Gardiner looks at the current market and sees irrationality but no reason to be exuberant. He recommends gold—bullion, coins or even ‘paper gold’.

Gold_StocksNo matter what happens, the stock markets, in Canada and around the world, keep on going up. Sure, there’s the occasional little blip for a few days or even a week or two. But eventually (usually fairly quickly) everything gets back on track and the markets start rising again.

For example, Moody’s recently downgraded the six biggest Canadian banks. What happened? Their share prices are still going up. The US pulled out of the Paris climate accord. While this might justify a short-term rise in US stock prices, it creates uncertainty in the rest of the world.

Financial markets usually hate uncertainty. But instead of going down (or at least stalling), markets continue to rise. The UK election was a disaster for Britain’s negotiating position on Brexit—which again should cause uncertainty for everyone else—but again, it doesn’t seem to matter.

In Europe, Greece is still broke and other countries (e.g. Spain and Ireland) are shaky. The refugee crisis continues to put a strain on the countries they are pouring into. The Middle East is still a mess. Russia and China are still not ‘playing nice’. The stock markets don’t care.

Personally, I believe a large part of the problem is that people no longer trust money. They would rather have things than cash.

In such an environment, stocks become the substitute for money. However, this only works if people continue to believe in the stocks. If we start to see more Home Capitals and Sears Canadas, this confidence may disappear.

What is propping up our ‘robust’ economy?

Meanwhile, back in Canada, everybody is gushing over how well the economy is doing. I’m more concerned with why it is doing well. Yes, exports are chugging along quite nicely, but that is due in part to the recovery of the oil and gas sector, and partly to the low Canadian dollar.

The rest of the economic growth seems to be based on debt—both government and private. I don’t believe that is healthy, or sustainable.

Much of Canada’s growth is coming from real estate, especially in Vancouver and Toronto. Even the politicians recognize that this is unhealthy and they are taking steps to cool things off mainly by blaming ‘foreigners’.

It’s a start, and it sends a message to homegrown speculators as well, but it’s not enough. When the crunch comes, and interest rates go up, it will be ordinary Canadians who get hurt, not just real estate speculators.

It’s not just mortgage debt that’s fuelling this economy. While I have no hard data, I have seen a lot of ads for debt counselling services and payday loans on the TV lately. An awful lot of people must be living beyond their means. What’s worse is that no one except a few old fogeys like me seems to see anything wrong with this behaviour.

It’s not just millennials that are piling on debt, either. Plenty of Gen-Xers and boomers are spending like drunken politicians. I’m beginning to suspect that when the crash comes, it’s going to hit hard.

Preparing for the ebb after the flow

What can an ordinary investor do to protect him/herself in such a situation? In the first place, minimize your exposure to debt.

If you have a mortgage, make sure you can still carry it if interest rates double or triple.

Second, hoard cash. There might be some stocks worth buying in the oil and gas sector but it depends on how long and how strong the recovery is.

The railroad stocks Canadian Pacific Railway Ltd. (TSX—CP; NYSE—CP) and Canadian National Railway Co. (TSX—CNR; NYSE—CNI) look good for now, but if a crash comes, there will be nothing for them to transport. You don’t need to bail out of them just yet, but I wouldn’t put any more money into this sector.

The Canadian manufacturing sector is dependent on consumer demand, and, if consumers can no longer afford to buy, that demand dries up.

It faces the added problem of a renegotiated NAFTA. Given US President Donald Trump’s inconsistency on this issue (one day it needs a complete overhaul, the next day only some minor tweaking), it’s pretty much impossible to make a call. I’m sure there are some good manufacturing stocks out there that will survive and perhaps even thrive in the new NAFTA environment, but I don’t know enough to figure which ones they are. Acting on the principle ‘when in doubt, stay out’, I am not going to invest in any Canadian manufacturing stocks in the near future.

I would definitely stay away from the big Canadian bank stocks. In fact, it is probably time to take some profits from this sector. I know they have lovely dividends, but sometimes there’s a reason for high yields. If Moody’s has doubts about the banks, then so do I.

You might also want to keep an eye on other traditionally high-yielding stocks such as utilities, telecommunications and pipelines. Make sure they have the financial strength to withstand a 15 per cent or 20 per cent drop in earnings without having to make a drastic cut in dividends.

With interest rates as low as they are, it almost goes without saying that investing in bonds is not at all attractive unless you want to keep some for diversification.

Other debt instruments, such as T-bills or GICs, aren’t much use either, except as a place to park cash. If you’re doing that, keep the maturities short. Regard the interest as an extra, not an important part of the investment.

Consistent with the cash-hoarding advice, I still recommend holding some gold. As I’ve said before, it doesn’t need to be actual gold bullion or coins. It can be ‘paper gold’ like Central Fund of Canada (TSX—CEF.A) or the Royal Canadian Mint (TSX—MNT).

Beyond that, all I can say is I don’t know any more than anyone else. I just seem to be more worried.

T. Edward Gardiner, a Bell Canada retiree, is a keen observer of the markets who lives in Ottawa.

This is an edited version of an article that was originally published for subscribers in the  July 21, 2017, issue of Investor’s Digest of Canada. You can profit from the award-winning advice subscribers receive regularly in Investor’s Digest of Canada.

Investor’s Digest of Canada, MPL Communications Inc.
133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846