Stock market to underperform in Q2

Stocks soared in the first quarter. They'll languish in the second.

(Photo: Patti McConville/Getty)

Investors who bought into the market six months ago are feeling pretty good right now. Since early October, the S&P 500 has climbed an amazing 24%, while the S&P/TSX composite index has risen nearly 6%. Not bad, especially considering the losses many experienced in 2011. Some hold out hope this market rally will finally replenish lean retirement portfolios. But if the past few weeks are any indication, recent returns have been as good as they’ll get for a while.

Since March 1, the S&P 500 has added a measly 3.2%, while the Canadian market has actually fallen by 3.3%. Many experts say that, for at least the next quarter, the markets will continue to move sideways at best. “We’re coming off a staggering recovery,” says Vincent Delisle, equity research director at Scotia Capital, “so the market will catch its breath over the next few months.”

There are several reasons why the market will stay flat, if not fall slightly, in Q2. First, valuations are more expensive today than they were six months ago, which means there are fewer deals to be found. At the end of October, the S&P 500 was trading at about 13 times earnings; today it’s around 14.5 times. Good U.S. employment numbers and less worry about Europe also helped bring confidence back to the market. But a Greek, Portuguese or Spanish default, America’s still-growing debt and slowing Chinese growth remain concerns.

Finally, the rally didn’t happen because investors moved money out of safe fixed income and into equities; it was new money—contributions and previously uninvested cash—that flowed into stocks. In fact, people are still buying bond funds in droves. According to research firm EPFR Global, in Q1 of this year, US$105 billion went into bond funds around the world, compared to $15.6 billion in the first quarter of 2011.

Greg Nott, Russell Investments Canada’s chief investment officer, says that we’ll likely see this sideways movement for more than just a quarter, though he does think markets will finish the year a few percentage points higher than today. The next big rally will come when people finally feel comfortable enough to move a pile of that fixed income back into equities, he says. When that will happen is anyone’s guess, but we may start seeing a small change in fund flows if America’s economic data remain positive.

Markets could also rebound if corporate profits prove stronger than expected, says Norman Raschkowan, Mackenzie Financial’s executive vice-president of investments. While he thinks profits will be strong, they won’t beat expectations.

Another catalyst for a continued rally would be an interest-rate boost, which the U.S. Federal Reserve said won’t happen until late 2014. However, continued strong economic results could force the Fed’s hand. If that happens, bond prices would fall and, says Delisle, people would convert some fixed-income assets back into equities.

For now, though, investors shouldn’t get fooled into thinking Q1’s strong returns will continue. In October, when stocks were cheap, Delisle advised clients to buy. Now he’s telling them to realize their gains and wait until markets look attractive again. “Take some profit and get back to a more neutral standing,” he says. “And pull back expectations.”