Careful: Canadian stocks near record highs

As Canadian stocks rally, money managers are becoming uncomfortable with valuations.

The S&P/TSX Composite trailed U.S. indexes over the last three years, but has rebounded this year as mining shares recovered and energy shares surged thanks to a weaker Canadian dollar.

But that big advance and a significant volatility drop is a sign of complacence among investors, say some experts, since they aren’t factoring in risks that could roil markets later this year.

“There’s a lot to worry about, when we look at Canada,” says Sadiq Adatia, CIO at Sun Life Global Investments.

Read: Exercise caution as energy stocks test highs

Adatia says slower economic growth and continued job weakness could mean the average Canadian household could start spending less. And if the housing sector – a big reason for elevated consumer debt and a source of economic growth – were to slow down, that would create additional headwinds.

“A lot of people are forgetting what happened in the U.S. where consumers borrowed record amounts to buy homes before the collapse,” Adatia says.

South of the border, the economy recovered after a big tumble in the first quarter. A stronger GDP and improving manufacturing sector bode well for the job creation and domestic consumption.

While Adatia says Canadian stocks will draw strength from the Fed’s accommodative policy, investors must be mindful that the U.S. economy will be strong enough to prompt an interest rate hike sometime next year.

“People don’t realize things will change quickly once monetary policy in North America turns restrictive,” says Adatia, who expects a Fed rate increase in 2015.

Shailesh Kshatriya, senior investment analyst at Russell Investments in Canada, agrees that for the rally to continue, economic fundamentals must justify equity fundamentals.

Read: TSX run isn’t done, say experts

Kshatriya adds, “Given the run up we’ve seen, quite frankly it would be good to see a correction.”

However, he remains bullish, citing expectations of stronger earnings margins in commodity stocks, which account for nearly 40% of the market, in Q2. Kshatriya targets 15,300 this year for the TSX.

What’s more, energy company profit margins have benefited from the run-up in oil prices. And margins for mining companies, Kshatriya believes, which are finally starting to bottom out could turn positive over the next few quarters, as a recovery in copper and gold prices boosts revenue.

Yet stocks aren’t relatively expensive, historically. The trailing price-to-earnings ratio of the S&P/TSX Composite is currently around 21, well below the high of 35.4 in 1999.

Ron Meisels, director of research at Phases & Cycles, says stocks could well correct in the near term. But with the S&P/TSX Composite trading above the 200-day moving average and that indicator itself trending upward, the momentum is positive. The index could well rise to 16,000 later this year.

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“The important thing to remember is that the direction [for the TSX] is up,” says Meisels.