This Market Factors begins with why expensive bank stocks might still have upside and moves on to diversifying a portfolio when the usual methods aren’t working. The diversion covers new information on AI-related psychosis and we have Quick Hits as always.
Financials
Banks: Expensive but still good
The S&P/TSX Bank index’s 73.9 per cent total return over the past 12 months more than doubled the S&P/TSX Composite performance but now we have a problem – the sector is hovering near record highs for valuations. Importantly, the banks are expensive based on forward earnings forecasts, not just trailing earnings, that already account for optimistic guesses for profit growth. Scotiabank strategist Hugo Ste-Marie, however, believes more upside is attainable.
Mr. Ste-Marie concedes that “some discomfort” is warranted at current valuation levels but believes the positives still outweigh these concerns. Earnings visibility - the reliability of expected profit growth - is high. The recent decision by the Office of the Superintendent of Financial Institutions to lower capital requirements for the banks is expected to increase bank profitability (as measured by return on equity) by roughly a full percentage point.
Mr. Ste-Marie’s recent meetings with institutional investors uncovered concerns with other large-cap market sectors leaving few alternatives beyond banks for large-scale capital allocation. The strategist also noted that while foreign investors have been net sellers of Canadian equities, banks have attracted significant foreign investment over the past 12 months. He notes that sustained inflows have corresponded with multiple expansion in the past.
Canadian banks are not the only global lenders trading at expensive levels. In Australia - a mortgage-heavy, commodity focused market like ours - banks have also seen considerable price-to-earnings multiple expansion over the past year.
Scotiabank retains an overweight recommendation on domestic banks, expecting investment inflows and positive policy changes to outweigh high valuation levels.
Scotiabank bank analyst Mike Rizvanovic has outperform ratings on Bank of Montreal, National Bank and Royal Bank.
Stock hunting
‘Negative beta diversifiers’
Diversification remains an effective tool to mitigate portfolio risk but the means to accomplish the task are hard to come by in the current market. Bonds and stocks head south together when inflation fears hit and gold failed to diversify equity portfolios during the recent outbreak of geopolitical tension. Emerging markets, just as dominated by tech as the S&P 500 in some cases, don’t help either.
Evercore ISI strategist Julian Emanuel offered a solution in a report last week that he calls “negative beta diversifiers”. These are stocks uncorrelated with the S&P 500 yet have improving earnings forecasts. The universe of stocks to screen for profit growth is large, thanks to a record number of companies, near 100, currently negatively correlated to index returns.
The list of diversifiers is long at 43 members but many of the stocks are in sectors – energy and financials notably – where Canadians would rather buy domestic stocks. Companies most likely to interest domestic investors include, in order of market capitalization, Costco Wholesale Corp., Coca-Cola Co., PepsiCo Inc., Altria Group Inc., Mondelez International Inc., Keurig Dr Pepper, Paychex Inc. and The Kroger Co.
Mr. Emanuel is clear that he believes technology stocks and the AI investment theme will continue to lead the market but, for investors concerned about a deflating asset bubble, quality diversification is rarely a bad idea.
DADO RUVIC/Reuters
Diversions
‘Amplification spiral’ of AI-induced psychosis
A new study by U.K. and German academics featured in Futurism attempted to uncover the roots of AI psychosis, the phenomenon of AI chatbots slowly ushering users down the path towards complete madness.
The study found that chatbots’ propensity to mirror and elaborate user beliefs while never challenging them can lead to an “amplification spiral” that motivates delusional thinking.
The ability of chatbots to mimic user speech patterns and hyper-personalize responses makes them even more dangerous. It gives the impression that the powerful library of information behind large language models is in agreement with user delusions.
The real concern for me is how widespread this phenomenon becomes. The hope is that it won’t spread too far into the general population and most AI users have enough introspective ability to stop a slide into serious mental illness.
The essentials
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Globe Investor highlights
David Rosenberg thinks the Bank of Canada’s next move will be to cut rates, putting enough pressure on the loonie to send it to 65 cents US
Jamie McGeever points out that oil’s big slide is softening the U.S. dollar’s inflationary bite and significantly lowering market bets for rate hikes across the globe
Short selling bets are building remarkably fast for SpaceX
Energy sector insiders are ramping up their bets against oil bears
This Number Cruncher identifies 10 Canadian companies that have raised their dividends for at least five consecutive years at a double-digit annual growth rate.
Quick Hits
CIBC analyst Krista Friesen believes that CANDU technology will be favoured as the federal government announced plans to expand nuclear power generation. This will benefit engineering giant AtkinsRéalis Group directly – they own the CANDU technology – and also Bird Construction Inc. and Aecon Group Inc. Separately, RBC Capital Markets analyst Maurice Choy cited TC Energy and Hydro One as likely winners in Ontario from nuclear power expansion and Capital Power and Transalta as potential beneficiaries if nuclear power is introduced in Alberta.
BofA Securities commodity strategist Francisco Blanch expects the global copper market to remain tight, supporting the commodity price. The global electrification trend is raising demand, while new high-grade deposits are rare and often in politically unstable areas like the Democratic Republic of Congo. Existing operations are operationally complex and often face significant regulatory challenges. Mr. Blanch did not provide his price forecasts but consensus guesses indicate US$6.25 per pound in 2029, roughly 20 cents US above current levels.
Morgan Stanley analyst Erik Woodring used a loaded term, “inelastic”, to describe the demand for computing power as AI applications proliferate through the economy. Inelastic means not subject to change in other factors and comes close to a guarantee. Mr. Woodring was discussing the continued strong demand for servers from Dell Technologies Inc. and Hewlett-Packard Enterprise despite big price increases. The analyst is assessing current conditions, not forecasting much into the future, but declared his belief that demand forecasts for next year are likely too low.
Read this week’s earnings and economic calendar here