Why the TSX Could Be Heading into a Bear Market in 2017

It has been a fantastic year for the TSX, but overvaluation and interest rate hikes could see a potential bear market in 2017. Investors should prepare by reducing exposure to names such as Toronto-Dominion Bank (TSX:TD)(NYSE:TD) and increasing allocation to cash.

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Year-to-date, the TSX has shown impressive double-digit returns of 14.98% and is only 3.9% off all-time highs set back in 2014. While news of a Donald Trump presidency may actually turn out to be good news for the TSX over the long term (his massive tax cuts and infrastructure spending are good news for the 76% of exports that go to the U.S.), there are a series of near-term headwinds both north and south of the border.

According to a summer report by BlackRock, the U.S. and Canada were the two most expensive equity markets on the planet. U.S. stocks are in the 88th percentile of their historical valuation when using its current price-to-earnings ratio of about 18. This means that U.S. stocks are more expensive than they’ve been in 88% of their history.

With interest rates expected to rise in the U.S., a growing probability of recession, and record valuations, U.S. stocks (and Canadian stocks) could be set for a pullback. Here is what Canadians need to know.

Rising U.S. interest rates are bad news for U.S. stocks

What happens in the United States is extremely important for Canadian investors (since the TSX often follows the S&P 500), so it is important to start there. There is no doubt that U.S. stocks are expensive—a current price-to-earnings (P/E) ratio of 18.3 puts U.S. stocks near the most expensive they have ever been.

More importantly, this P/E ratio has grown by 75% since 2011, and, according to Goldman Sachs, every time growth like this has occurred, historic crashes have followed. One of the main reasons stock markets have done so well is because interest rates have been falling (which makes stocks the most sensible place to earn returns since bond yields would be low).

Unfortunately, when interest rates rise, the reverse is true, and there is almost that no doubt rapid increases in interest rates are coming (and, in fact, they already have since Trump was elected; the yield on 10-year U.S. bonds has grown from 1.83% to 2.3% since the election).

In December, the Federal Reserve is widely expected to increase its short-term interest rate for the first time since last year (and before that, since 2006). This short-term rate is currently 0.25-0.5%, and analysts at Goldman Sachs estimate that it will grow to 1.5% next year. This growth is largely thanks to inflation expectations from a Trump presidency (high inflation requires high interest rates to control the inflation).

This is bad news for U.S. stocks. Currently, if the expected earnings for the S&P 500 in 2016 is divided by the current S&P 500 price, the result would be an earnings yield of 5.3%. Investors often compare this to the value of the 10-year bond yield to see how the returns of stocks compare to bonds.  The closer the gap, the more overvalued stocks are.

Before Trump’s election, the earnings yield was 5.3% and the 10-year bond yield was 1.83%, leading to a gap of 3.47 percentage points. The 10-year average is 4.4, so stocks seemed slightly expensive according to this measure. Now, the gap is only three percentage points, and the more this gap shrinks, the less likely stocks are to continue rising.

Combine this with the fact that the current economic expansion has been 91 months long (the fourth longest in U.S. history and the average is 58 months), and an economic slowdown is becoming more likely.

What it means for Canada

Canadian interest rate hikes usually follow U.S. interest rate hikes (typically, Canadian rates catch up 12 months after a U.S. rate hike). This means that the Canadian stock market (which is currently trading at a P/E ratio of 19 and well above its average) is at risk of declining as interest rates rise as well.

Investors can take advantage of this by taking profits on bank stocks like Toronto-Dominion Bank (TSX:TD)(NYSE:TD), which is one of the most expensive, and holding more cash to take advantage of buying opportunities.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Fool contributor Adam Mancini has no position in any stocks mentioned.

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