Momentum

Momentum is one of the most powerful and persistent phenomena on the financial markets. Stocks whose prices have risen the most in recent months tend to continue to outperform in subsequent months. Often, momentum takes hold of an entire stock market sector.

Momentum shouldn't exist, since - in theory at least - the market is efficient and always values a stock at its fair value, taking into account all available information.

The market is not always efficient

In practice, however, the market - by which we mean all investors - is sometimes slow to understand the importance of a change, such as a technological innovation. This explains, for example, why, despite its position as leader in the industry to which it gave birth and its strong growth potential¹, Tesla's shares took 2 years after the launch of the Model 3 to reach their peak in 2021. The market simply refused to believe Elon Musk's growth predictions.

We may now be seeing a similar phenomenon with technology stocks and, possibly, many other stock market sectors.

Indeed, we can imagine a world where the innovative and transformative power of artificial intelligence - driven by abundant, low-cost solar energy - pushes up the productivity and profits of listed companies for many years to come. Such a scenario - which a majority of investors would no doubt have found unlikely or even far-fetched 2 years ago - is gaining increasing support in the markets. This explains the inexorable rise in those stock market sectors perceived as benefiting most from this scenario, despite analysts being slow to adjust their profit projections. In fact, analysts generally lag behind when momentum takes hold of the market.

Riding the wave

The army of investors-individuals and institutions-who favor hot stocks are betting on momentum and riding a wave, as it were.

All surfers will tell you, however, that all waves break eventually, and you have to know how to get out of them before they crush you against the reef. The same applies to the financial markets. After being slow to react to a piece of news, investors end up going overboard and pushing share prices too high. When these companies' profits finally disappoint investors' now unrealistic expectations, the pendulum swings back and these stocks underperform the rest of the market - the wave breaks. The Tesla wave can be said to have broken in November 2021, and its shares have since been the worst performers of the S&P500's major stocks.

So, after a 1000% rise in Nvidia and a 115% rise in the tech sector since October 2022, is it time to ride out the wave and move on?

Who knows? First of all, just because a stock or a sector of the stock market has gone up a lot doesn't necessarily mean it's become too expensive. What's more, even after they've reached their "full value" - which no one can really determine a priori - we know that stocks with momentum can continue to rise for a long time. Just ask former Federal Reserve Chairman Alan Greenspan, who coined the term "irrational exuberance" in 1996 to describe the behavior of the stock market, particularly the technology sector. The market continued to rise by over 130% after his remark, until the wave finally broke in early 2000.

This poses a dilemma for momentum investors, but is of no concern to the majority of us who have a diversified, balanced portfolio.

An ocean liner rather than a surboard

To return to our maritime analogy, if the momentum investor is on a surfboard, the diversified, balanced investor is sailing an ocean liner. The 3-meter wave that sends the surfer crashing to the bottom will hardly be felt by the liner's passenger sipping his pina colada on deck.

When the wave breaks, momentum investors will rush to the exit to limit their losses, undoubtedly dragging the whole market down. Well-advised balanced investors, on the other hand, will take advantage of the downturn to buy equities, while selling a few bonds that will probably have appreciated in value in the turmoil.

Bon voyage!

Market Review

Canadian equities: key rate cut

Canadian equities ended the second quarter down 0.5%, bringing their first-half return to 6.1%. The Bank of Canada was the first G7 central bank to cut its key rate, with a 0.25% cut in early June.

In contrast to the U.S. stock market, the technology sector (-5.6%) dragged down the performance of Canadian equities. This decline was mainly due to Shopify, which accounts for over 40% of the sector. Difficult economic conditions led the e-commerce platform to revise its sales forecasts downwards for the second quarter, resulting in a 13.9% decline in its share price over the period.

The financial sector declined by 2.2% this quarter. Royal Bank's performance (+6.6%) partially offset the difficulties encountered by other players such as Bank of Montreal and Bank of Nova Scotia, whose shares fell by 13.2% and 10.7% respectively. Loan loss provisions continued to rise significantly, signalling a deterioration in credit quality. That said, if interest rates continue to fall, this could ease the burden on borrowers. Meanwhile, National Bank announced the acquisition of Canadian Western Bank for $5 billion, and has seen its share price fall by 7.8% since the announcement.

The materials sector was the best performer both in the quarter (+6.9%) and in the first half of the year (+12.6%). Although companies in the gold and copper industries enjoyed a good quarter, it was silver that caught the eye, up 23.8%. The boom in the solar energy sector has led to a surge in demand for silver, which is needed in large quantities to manufacture photovoltaic panels.

Bombardier was the best performer in the index, up 50.9% over the quarter, thanks to its efforts to reduce debt and focus on its most profitable products. However, the Industrials sector was down 3.6%, mainly due to the underperformance of Canadian Pacific (-9.8%) and Canadian National (-9.4%), which together account for almost 50% of the sector.

US equities: techno again

U.S. equities continued to perform well, rising by 5.5% in Canadian dollar terms over the quarter and 19.5% for the year to date.  

The index's rise was entirely attributable to the performance of the technology sector, which rose by 13.6% during the quarter, benefiting from increased interest in artificial intelligence. The emblem of this AI craze, Nvidia, enjoyed another excellent quarter, up 36.7%. The company briefly became the world's largest market capitalization, overtaking Apple and Microsoft, before falling back to third place. Apple also announced a partnership with OpenAI to integrate ChatGPT into its Siri voice assistant. Since this announcement, the share price has climbed 9.1%, closing the quarter up 22.8%.

The recovery of technology stocks from their correction in 2022 has significantly increased their share of the index, to almost a third. This is the first time this sector has reached such a proportion since the tech bubble burst.

International equities: Macron's bet

International equities in developed countries generated a return of 0.7% in Canadian dollars during the second quarter.

Depreciation of the yen is usually positive for the Japanese stock market, as it boosts exports. However, after a decline of almost 30% over the past three years, concerns are beginning to emerge. The yen's weakness is driving up import costs and, consequently, inflation, which could force the Japanese central bank to raise interest rates. Japanese equities rose by 1.4% (-3.5% in CAD) over the quarter and by 19.6% (8.8% in CAD) year-to-date.

The US elections promise to bring their share of entertainment in the months ahead, but French politics aren't lacking in interest either. Faced with the rise of the far right, President Emmanuel Macron has decided to call early elections this summer, just weeks before the start of the Paris Olympics. The uncertainty generated by this surprise election campaign partly explains the 6.8% drop in French equities over the quarter.

It was the strong performances of the UK stock market (+3.4%) and Switzerland (+2.6%) that enabled international equities to close the quarter up. Although its weighting in the index is less significant, Denmark - the leader among developed-country stock markets since the start of the year - stood out, up 27.2% in the first half. This increase is entirely attributable to the pharmaceutical company Novo Nordisk, which is struggling to meet growing demand for its drugs for the treatment of type 2 diabetes and obesity.

Emerging markets: Taiwan and India lead the way

The MSCI Emerging Markets index returned 6.3% (in CAD) in the second quarter of 2024.

Taiwan stands out with a return of 15.0% in the second quarter of 2024. This performance can be attributed to strong growth in its technology sector, underpinned by global demand for semiconductors and other advanced technologies. Shares in Taiwan Semiconductor (TSMC), which manufactures the world's most advanced chips for design companies such as Apple and Nvidia, are up 24.0%. TSMC has announced plans to build a third manufacturing plant in Arizona to ensure the production of advanced semiconductors in the United States and better support its American customers. Nvidia is also looking to increase its investments in Taiwan.

India also saw an increase of 12.0%. Economic reforms and infrastructure investments are beginning to bear fruit. JPMorgan has decided to include India in its diversified global emerging markets index from June 2024, which could lead to significant flows into the market. India has also taken steps to improve foreign investors' access to its capital markets, including rapid digitization and policy reform.

China, which accounts for over 22% of the Emerging Markets Index, faces challenges in the form of geopolitical tensions, weak growth prospects and high trade tariffs. Despite Beijing's stimulus measures, China's performance (6.7%) lagged that of Taiwan and India.

South Korea returned -2.2%. Despite its technological advances and export-led economy, South Korea faced challenges, with domestic demand held back by high inflation and interest rates.

Bonds: slight rise

The bond portfolio generated a return of 0.9% over the quarter, down 0.4% year-to-date. The main determinant of this portfolio's performance, the yield on 10-year Canadian bonds fluctuated within a range of 3.3% to 3.9%, ending the quarter slightly up at 3.5%.

Two factors are currently exerting significant influence on 10-year yields, one on the upside and the other on the downside. On the one hand, the prospect of central bank rate cuts and a possible economic slowdown is prompting investors to buy bonds, putting downward pressure on rates.

On the other hand, the explosion of government debt in recent years - particularly in the United States - has raised fears that it may become unsustainable. The possible election of Donald Trump to a second term as President of the United States, and the resulting tax cuts, does nothing to reassure investors. They are therefore demanding a higher interest rate to compensate for this risk.

For the time being, the debt levels of the Canadian and Quebec governments are of less concern, which partly explains why bond rates are lower on this side of the border.

Notes

[1] Although the modern electric vehicle industry began with Tesla, the electric car was invented in the 19th century, before the combustion engine. History of the electric car: an impressive evolution!