Recession yet to be priced into the sectors that make up 74% of the TSX
The TSX, which has higher cyclicality, appears at risk in the near term, writes economist David Rosenberg. Photo by REUTERS/Mark Blinch/File Photo Our prior modelling work suggests that while some sectors have already gone a long way towards pricing in a recessionary outcome — notably, those with a growth tilt — a number have further to go before an economic downturn is fully discounted. In particular, cyclical sectors such as materials, industrials, financials and energy have not yet seen the sort of decline that typically occurs in a recessionary bear market.
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With this in mind, our belief is that this group will be the next shoe to drop and lead the stock market lower. Against this backdrop, the Canadian equity market — which has above-average cyclicality due to its sector exposure — is vulnerable. Based on a simple probit model, consumer discretionary (86.3 per cent), communication services (85.1 per cent) and technology (57.4 per cent) have priced in the highest odds of recession. In contrast, energy (43.1 per cent), financials (38.2 per cent), materials (37.1 per cent) and industrials (33.5 per cent) are implying much lower recession probabilities.
This disconnect will need to be resolved in the months ahead, and our expectation is that this will occur through further price declines and underperformance in cyclical sectors.
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The combined weight of energy, financials, materials and industrials is 74 per cent of the TSX, but only comprise 25 per cent of the S&P 500
As such, the S&P/TSX composite, which has higher cyclicality than the S&P 500 (due to its sector weights) appears at risk in the near term. After all, the combined weight of energy, financials, materials and industrials is 74 per cent of the TSX, but only comprise 25 per cent of the S&P 500. As a result, it shouldn’t be a surprise that the highest correlations of the TSX — relative to S&P 500 sectors — are also in the aforementioned cyclicals.
Therefore, until more bad news is embedded in these sectors, the underperformance of the TSX (vis à vis the S&P 500), which has played out over the past month, is likely to continue. Indeed, since peaking on June 13, the relative strength ratio of the TSX has broken down, falling 7.5 per cent from its high. This has occurred as the TSX has declined 4.9 per cent, whereas the S&P 500 has rallied 2.9 per cent over the same period.
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More On This Topic David Rosenberg: The stock market is signalling that a recession is coming David Rosenberg: Four reasons corporate bonds have become more appealing than equities David Rosenberg: Identifying opportunities for income investors by screening for dividend yield However, there is some good news: valuations should help limit the downside. Notably, the S&P/TSX composite trades in its 15th percentile on a trailing P/E basis and its second percentile on a forward P/E basis, suggesting long-term fundamental support.
David Rosenberg is founder of independent research firm Rosenberg Research & Associates Inc. You can sign up for a free, one-month trial on Rosenberg’s website.
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