Why a Major TSX Sell-Off Is Becoming Increasingly Likely

By almost every measure, stocks are due for a sell-off. Investors should prepare by reducing exposure to overvalued sectors, keeping a higher cash balance, and hiding in strong dividend payers such as TransCanada Corporation (TSX:TRP)(NYSE:TRP).

| More on:

You’re reading a free article with opinions that may differ from The Motley Fool’s premium investing services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

The TSX just celebrated a big milestone — the index closed in early February at nearly 15,950, which would mark an all-time high. The TSX has sold off since then, but many investors are still optimistic. While it is, of course, possible that the market can continue higher without a material 15% or 20% sell-off, the question for investors is if the reward of staying fully invested exceeds the risk.

Based on the concerning valuation metrics of both the TSX and S&P 500, the answer seems to be no. The recent all-time highs are a perfect opportunity to take profits on strongly performing names and to increase cash balances which can be used to buy discounted names during a sell-off.

Where should investors look to take profits? Canadian banks are a good place to start. Banks have led the TSX year-to-date and comprise 35% of the index, and they currently trade at about 12.6 times their projected 2017 earnings. Since 2000, banks have only traded at these levels very briefly in 2009-2010 and again around 2005-2007, when bank return on equity and earnings growth were much stronger.

With a long-term average price-to-earnings ratio of 11.2, banks no longer represent good value, and investors should look to take profits on what has been a nearly 8% run-up in 2017 alone.

It’s not just banks that are expensive

While banks are an easy target to take profits from given the recent massive run, both the broad S&P 500 (which strongly correlates to the TSX) and the TSX are looking quite expensive. Starting with the U.S. S&P 500, valuations are becoming extreme.

The Shiller price-to-earnings (P/E) ratio is a popular way of measuring the valuation of the U.S. index, and the Shiller P/E ratio is calculated by comparing the past 10 years of earnings to the current value of the index. The long-term average Shiller P/E ratio is 16.73, and the current Shiller P/E ratio is 29.25.

Since 1880, these levels have only been hit twice. The first time was Black Tuesday, which was immediately before the Great Depression stock market crash in 1929. This occurred at a Shiller P/E of 30. The second time was during the Dot-Com Crash around 2000. The Shiller P/E briefly spiked up to about 45 before this crash occurred, and this is the only precedent for valuations at current levels (and they did not last long).

The U.S. stock market is also overvalued according to the “Buffett Indicator,” which compares the value of the stock market to the U.S. GDP. Currently, the stock market is about 122% of GDP, and these levels have only been hit twice since 1950. The first was, again, before the Dot-Com Crash around 2000, and the second was briefly in 2010-2011.

The current strength in stocks is due to low interest rates (which make investing in stocks more appealing), but rising interest rates are now putting stocks at risk. The Federal Reserve could raise rates three times in 2017 due to strong economic growth from the U.S., and this is certain to pressure stocks.

Increases in U.S. rates also put upward pressure on Canadian rates, and the TSX is looking just as bad as the S&P 500 from a value perspective. According to National Bank, the TSX is currently trading at its highest valuation at this point in 2017 since 2001. The bank has a 15,600 target price on the TSX, which is below the current level the TSX is trading at.

TransCanada is a good place to hide

While banks may be overvalued and susceptible to a sell-off, pipeline companies have several macroeconomic tailwinds, including expected oil price strength (years of underinvestment and OPEC supporting the market will put a floor on oil prices), and a pro-pipeline U.S. administration.

TransCanada Corporation (TSX:TRP)(NYSE:TRP) represents a good way to play this strength, especially with the recent Keystone approval. TransCanada has a strong $26 billion capital growth program and will grow its dividend by 8-10% annually through to 2020.

Should you invest $1,000 in Maya Gold And Silver Inc. right now?

Before you buy stock in Maya Gold And Silver Inc., consider this:

The Motley Fool Stock Advisor Canada analyst team just identified what they believe are the Top Stocks for 2025 and Beyond for investors to buy now… and Maya Gold And Silver Inc. wasn’t one of them. The Top Stocks that made the cut could potentially produce monster returns in the coming years.

Consider MercadoLibre, which we first recommended on January 8, 2014 ... if you invested $1,000 in the “eBay of Latin America” at the time of our recommendation, you’d have $20,697.16!*

Stock Advisor Canada provides investors with an easy-to-follow blueprint for success, including guidance on building a portfolio, regular updates from analysts, and two new stock picks each month – one from Canada and one from the U.S. The Stock Advisor Canada service has outperformed the return of S&P/TSX Composite Index by 29 percentage points since 2013*.

See the Top Stocks * Returns as of 3/20/25

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.

Confidently Navigate Market Volatility: Claim Your Free Report!

Feeling uneasy about the ups and downs of the stock market lately? You’re not alone. At The Motley Fool Canada, we get it — and we’re here to help. We’ve crafted an essential guide designed to help you through these uncertain times: "5-Step Checklist: How to Prepare Your Portfolio for Volatility."

Don't miss out on this opportunity for peace of mind. Just click below to learn how to receive your complimentary report today!

Get Our Free Report Today

More on Bank Stocks

A worker drinks out of a mug in an office.
Bank Stocks

Royal Bank of Canada: Buy, Sell, or Hold in 2025?

Royal Bank is down 6% in 2025. Is it time to buy the dip?

Read more »

chart reflected in eyeglass lenses
Stocks for Beginners

Seize the Dip: Investment Opportunities Await This April

If you're looking for one and only one opportunity during a market dip, buy this top stock.

Read more »

hand stacks coins
Bank Stocks

Here’s How Many Shares of IGM Financial You Should Own to Get $1,000 in Yearly Dividends

Besides its attractive dividend income, IGM Financial’s strong long-term growth fundamentals could help its stock outperform the broader market in…

Read more »

A person looks at data on a screen
Bank Stocks

Where Will Bank of Montreal Stock Be in 5 Years?

These factors give Bank of Montreal (TSX:BMO) stock the potential to outperform the broader market in the next five years.

Read more »

calculate and analyze stock
Bank Stocks

Where Will TD Stock Be in 3 Years?

Here are some key reasons why I expect TD stock to reward patient investors handsomely over the next three years.

Read more »

Pile of Canadian dollar bills in various denominations
Bank Stocks

1 Dividend Stock Down 10.2% to Buy Now for Lifetime Income

A high-yield stock with a nearly 200-year dividend track record is a screaming buy right now.

Read more »

calculate and analyze stock
Bank Stocks

Why Smart Investors Own Canadian Financial Stocks

Top Canadian stocks like these could help smart investors get strong returns on their investments in the long run.

Read more »

customer uses bank ATM
Tech Stocks

2 Canadian Bank Stocks to Shield Against Market Downturns

Anchor your portfolio with dividends and stability built to outlast trade war turbulence with Royal Bank of Canada (RBC) and…

Read more »