In section one of this Market Factors I managed to combine a victory lap and a mea culpa on my market forecasting ability. Section two covers a derivative strategist’s Bubble Risk Indicator and the diversion discusses an important investor Achilles Heel.
Confession time
Welcome volatility and cross-border news creep
There are often times that Canadian economic and market discussions get poisoned by newsflow creeping into the country from the U.S. The most common example is wealth disparity, where local arguments assume that Canadian wealth disparity is the same as the U.S.’s abominable “let them eat cake” policy towards the poor.
I think I made the same mistake in reverse, extrapolating the Canadian economic context to the U.S. market backdrop. The domestic economy is flagging while the U.S. economy is accelerating. I was tracking, and loosely forecasting, the U.S. market as if its economic environment was as stagnant as ours. This has important ramifications for equity market leadership.
Scotiabank strategist Hugo Ste-Marie published a report Monday welcoming last week’s volatility in the S&P 500. The index level was buffeted by selling in the megacap tech stocks while under the surface, a whole bunch of smaller stocks were rallying.
The S&P 500 advance/decline reading – the number of stocks rising versus falling – hit a new high last week. This is what a healthy rotation and a recovering economy looks like – the rally is not faltering, it is spreading to more market sectors as growth recovers.
The equal-weighted S&P 500, where all stocks affect the index return by the same proportion rather than the conventional benchmark where larger stocks disproportionally drive results, was up 1.6 per cent to a new high last week.
In periods of slow economic growth there are only a few stocks capable of significant profit growth. Investor assets gravitate towards these stocks, making them expensive in terms of price to earnings and other valuation metrics. Investors pay a premium for growth.
When the economy accelerates, more stocks generate profit growth and investors leave the expensive growers to buy stocks representing similar strong profit growth, but at cheaper multiples. This is what’s happening south of the border.
Before the Iran conflict, I was expecting the equal weight S&P 500 index to outperform as economic growth improved but backed off on that thinking high energy costs would slow growth. I was too slow to reapply that logic because I got caught up in the Canadian economic perspective.
In extrapolating sluggish domestic economic conditions to the U.S., my expectation was that market leadership would remain narrow, in stocks representing secular growth stories like AI.
It looks like a healthy sector rotation is underway in the S&P 500. The best way to track its progress is through the relative returns of the S&P 500 and S&P 500 equal weight index. There are also possibilities like renewed conflict in the Middle East or moronic trade policy that could interrupt the process, halt the U.S. economic recovery and send investor assets back into AI stocks.
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Market risks
Bubble indicator about to go off
BofA Securities derivatives analyst Riddhi Prasad’s Bubble Risk Indicator (BRI) is signaling big market moves ahead. The BRI combines asset returns, volatility, momentum and fragility to produce a score from zero, indicating little risk of a bubble, to one, indicating significant risk.
The current reading for the tech-heavy Nasdaq 100 is bumping up against the 0.8 threshold that indicates a high probability of market volatility, although the BRI does not predict whether the move is a decline or surge higher.
Ms. Prasad noted that the AI-adjacent stock rally was undeterred by signs of a surprisingly hawkish Federal Reserve. For the BRI, when a rally is unfazed by macroeconomic headwinds, this is a sign of bubbly market behaviour.
The Nasdaq 100 returns have nearly doubled the S&P 500 since March, another frothy indicator. The strategist believes, however, that this performance discrepancy can continue.
For investors with derivatives expertise, Ms. Prada recommends Nasdaq 100 call spreads with December expiry. These would be profitable with a big move in either direction. All market participants should be paying careful attention to AI-related stock exposure, even if it’s through passive index investing.
Diversions
Investors’ Achilles Heel
U.S. venture capitalist Ted Lamade argued that investors’ biggest blind spot is probability math in Our Achilles Heel. I agree.
Mr. Lamade recounted a conversation with a high school valedictorian unhappy and confused about not being accepted into their first choice (presumably Ivy League) school. Mr. Lamade pointed out that there were roughly 25,000 U.S. valedictorians every year and the entire Ivy League only accepted 15,000 new students annually. The probabilities were stacked against acceptance.
Investors fall for hedge fund claims about performance that are almost mathematically impossible. Mr. Lamade repeated a Charlie Munger story where a hedge fund manager told the latter they could generate returns of 20 per cent per year. Mr. Munger pointed out this was impossible and the manager replied that it probably was but clients wouldn’t give him money if he promised less.
Stock picking is another area I think investors underestimate the math. Outperforming the index by picking individual stocks over any extended period of time is very, very unlikely. Attempts to do so can often lead to excess portfolio risk, particularly in periods like now when the S&P 500 leadership is speculative and narrow.
Mr. Lamade also discussed the importance of occasionally trying to buck the odds. The greatest successes in business were often dismissed as delusions. Amazon.com’s idea of selling books online was derided at the time, for example. Individual successes can also occur without probabilities in our favour. The trick is knowing when the process of trying to beat the odds is satisfying and when insurmountable odds aren’t worth confronting.
The essentials
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Globe Investor highlights
Norman Rothery looks at two dividend strategies that doubled the market’s growth
With nuclear ambitions stirring again, David Berman makes the investment case for AtkinsRéalis Group
Larry MacDonald looks at the latest shorting bets on the TSX
The 2026 Globe and Mail digital brokerage ranking
Rosenberg Research strategists share their thoughts on how to invest if the U.S.-Iran peace deal has legs
Quick hits
Scotiabank analyst Chris MacCulloch re-opened the company’s coverage of the oil and gas sector with Cenovus and Suncor Energy as his top two large-cap stock ideas and Advantage Energy Ltd. as top mid-cap pick. The analyst believes the sector has not fully benefited from the recent spike in energy prices and current stock prices do not reflect the high free cash flow yields.
Losses are piling up on SpaceX bonds. The company issued US$25-billion in debt after its successful equity IPO. The 30-year portion of the bond issue was initially priced at 1.75 percentage points above the comparable Treasury yield. The spread is now 0.28 percentage points wider than that versus Treasuries as the price of the bonds declined. Traders cited by Bloomberg suggested that the early weakness was caused by speculative buyers looking to sell.
Citi analyst Scott Gruber reports that natural gas demand is not keeping up with forecasts. Natural gas demand for the first quarter in the U.S. was up 2.4 per cent year over year but Mr. Gruber describes this as “paltry relative to expectations when the AI cycle began.” Solar power is taking a larger share of data centre-related power demand than expected.
BofA Securities rates strategist Katie Craig recommended buying Canadian two-year bonds and selling U.S. two-year bonds on March 12. Ms. Craig felt at the time that the policy divergence between the domestic and U.S. central banks (Canada more likely to cut rates while Fed more likely to hike) was underpriced. The trade was profitable and the strategist is now recommending leaving it on in anticipation of more profit.
Read this week’s earnings and economic calendar here