Earlier this week I had been enjoying the radio ads telling us with humour that surprises are not always good. Checking your parent’s browsing history, cold sores, etc. And then along comes the Bank of Canada cutting the overnight interest rate Wednesday morning. By noon the TSX index was up over 300 points and by Friday morning it was up over 500 points in total. And everyone was surprised. But was it a good surprise?
Let us review what the Bank of Canada was saying and see if we can understand why company shares were suddenly so much more valuable.
-The Bank of Canada believes low oil prices are overall negative for the Canadian economy (the price of oil has already fallen a further $10 since coming to this conclusion) and if oil stays where it is the central bank expects the economy to grow even slower than it had forecast.
-The central bank was trying to push down the interest rates charged by Canada’s big banks, making it cheaper for companies to borrow money to grow their businesses.
-A rate cut by the central bank likely means lower interest rates for variable rate mortgages, lines of credit and other loans based on the prime rate, which will likely boost consumer spending.
-The loonie immediately fell by more than 1.5 cents against the U.S. dollar. A lower dollar makes Canadian goods cheaper for U.S. buyers, helping to stimulate exports but increasing the cost of imports.
So why did the stock market go up so much? Point one tells us that the Bank of Canada believes falling oil prices are very bad for the economy. Is it not true that companies may struggle to perform well in a poor economy? Point two means companies can afford to expand to support sales in a poor economy. This seems silly until you get to point 3. Point 3 suggests that consumers will be able to continue on their spending spree buying houses and cars and increasing their indebtedness that is already at historic highs. All through December 2014 media piece after media piece reminded us that Canadian consumer debt is at an all time high, so borrowing some more makes sense(not really)? Point 4 reminds us that with a devalued dollar, exporters will be able to increase their sales but consumers will pay more for just about everything we buy because few goods are manufactured completely in Canada.
Seemingly, not the best set of reasons to quickly buy Canadian shares or get bullish on the future of earnings at large Canadian companies, which is what is supposed to drive share prices. So what’s up? Well your own portfolio might not be driven by use of debt but the market as a whole is. Most professional managers, investment banks, hedge funds, aggressive investors etc. all use debt to support their activities in the equity markets. The Bank of Canada announcement meant that investors using debt were going to see even larger profits if the market continues its upward trend. They wanted a piece of that, so in they jump. However, debt outstanding against investments, so called margin debt, is at all time highs and going higher. In the United States margin debt is higher in relative terms than it has been since 1929 and all investors know what happened to the stock markets in 1929.
Now my articles are supposed to be about you and your nestegg not about the professionals. What does this all mean to YOU? If you are a trader, jump in with the rest. This cut in the overnight rate signals continued cheap debt and is going to create volatility and upper momentum to stock prices. This will remain true until the sentiment turns to worry about prices and debt. Make risky profitable trades while you can. If however, you are a long term investor looking to buy companies at fair prices without borrowing to do so, stay out of the buying foray. If you have been in the markets the last 5 years and have profited handsomely by the increase in share prices, take advantage of the rising prices to take some profits and/or rebalance your portfolio. Sure there is not much you want to buy with your profits but that is an indicator that prices are high across many sectors and different types of investments.
Maybe it is a better time to have too much cash than too much debt.
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