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First Quarter 2014


Market Review First Quarter, 2014

Equity Markets

S&P/TSX Composite

S&P 500

MSCI/Europe

MSCI/Far East

TSX Energy

TSX Financials

First Quarter (% Change in Cdn$)

5.2%

5.3%

5.5%

-2.1%

8.7%

1.9%

Interest Rates

Cdn 91 day T-Bills

U.S. 91 day T-Bills

Cdn 10 year Bond

U.S. 10 year Bond

March 2014

0.92%

0.05%

2.46%

2.72%

December 2013

0.89%

0.07%

2.77%

2.97%

Commodities (in US$)

Oil

Natural Gas

Gold

March 2014

101.51

4.37

1284.80

December 2013

98.16

4.34

1204.80

Portfolio Management Strategy

What Worked

– Gold Stocks

– Auto Parts Stocks

– Utility Stocks

What Didn’t

– Canadian Financial Stocks

– Airline Stocks

– Japanese and Chinese Stocks

Corrections Should Be Welcomed, Not Feared – NL

Stock markets around the world had an amazing 2013, with double digit returns generally being the norm. Canadian equity markets did okay last year, but lagged pretty much every other market. It was a stretch to expect last years’ surprisingly torrid pace to continue into 2014, and so far, it hasn’t. Canada, however, was the exception in the first quarter as its stocks outpaced those in most of the world, gaining a very respectable 5.2%. To foreign investors in Canada, the sharp decline of the loonie negated much of Canada’s outperformance. However, for Canadian investors it had the opposite effect as it lifted the returns of most foreign markets to levels that equaled or exceeded our domestic returns, when viewed in Canadian dollars.

Energy, utilities, and materials stocks led the way in Canada, while financial stocks provided somewhat of a drag on results. Earnings headwinds held back Canadian bank stocks in the quarter. Strong oil and natural gas prices gave energy stocks their lift while gold and fertilizer were behind the strength in materials. The utilities were somewhat of a surprise as they were a major beneficiary of lower bond yields, given their sensitivity to interest rates.

Speaking of interest rates, while we still expect bond yields to eventually head higher, it is becoming like the words of the Jewish philosopher Maimonides, in describing the continuing delayed arrival of the messiah, “that though he may tarry, yet do we wait for him each day”. First quarter economic growth was held back by poor weather conditions in much of North America. Interest rates had little reason to rise and lots of reasons to decline due to lower than expected economic activity. While some of that activity, such as restaurant meals and movie going cannot be made up, other economic activity such as auto sales and new home construction was hopefully simply delayed.

The world’s economic outlook continues to brighten, although the pace of recovery remains painfully slow. As stated above, extreme cold and heavy snows may have hurt first quarter GDP in North America. However, economic and business confidence indicators point to stronger growth ahead. In the U.S., initial jobless claims are at their lowest level since March 2006. As well, indicators such as the University of Michigan Consumer Sentiment index and the Conference Board Consumer Confidence index are at high levels and are improving and earned income is at an all-time high. The Conference Board of Canada’s comparable index is also improving. Yes, as Rhonda points out in her comment, China’s growth is slowing from its previous torrid pace. It was, however, an unsustainable pace and growth elsewhere in the world is picking up much of the slack.

Since their bottom in March of 2009, stock markets around the world have had a fabulous run. To the end of March, the Canadian stock market is up about 90% and the U.S. stock market is up an astounding 275%. Add in dividends and the returns are even more impressive. So does that mean that stock prices are getting carried away and headed for another bubble? We don’t believe so, but we do feel that markets are long overdue for a meaningful correction.

On their own, the stock moves of the past five years, as cited above, could indicate we are near the end of the road for this bull market. However, this has not been a normal market recovery. It is the aftermath of a near-death experience in equity markets in 2008 and 2009 and stock prices in the U.S. only recently passed their old highs and have yet to return to record levels in Canada. Earnings continue to improve from their recession bottom and a bright economic outlook argues for that trend to continue. Valuations, however, are another matter. Record low interest rates have caused massive fund flows out of fixed income and into equities. This, in our opinion, has caused stock prices to temporarily get ahead of earnings and has made it difficult for value investors, such as ourselves, to find much to buy in the markets.

One thing we are not is momentum investors. On a recent trip to Arizona, my wife Shelley couldn’t help but comment that on CNBC (yes I had it on even though I was on vacation) all anyone wanted to talk about were momentum stocks such as Amazon, Facebook, LinkedIn, Netflix, Tesla, Twitter, and biotech names such as Alexion and Vertex. Shades of the tech bubble of the late 1990s. Well, as of this writing, the chickens are coming home to roost as these stocks have fallen out of bed and are down quite a bit from their frothy peaks. They are also causing the rest of the market to correct in sympathy, but nowhere near to the same extent. We couldn’t be happier.

We obviously like it when stock markets go up. But it is decidedly unhealthy and dangerous when they go straight up. It is normal to have corrections once or twice per year. It has been over two years since North American markets experienced a 10% or more correction. Corrections are healthy as they take the froth out of bull markets and help restore order. They also give investors a chance to again buy stocks they like at more reasonable levels. Ignore the panic headlines that accompany any normal correction. The media likes to use blood to get your attention. Human nature is to run when prices head down. Human nature would make a lousy investor. Buy when others are fearful. Sell when others are euphoric. Very difficult to do. It’s how we make money for our clients. At the time of writing we believe we are in the middle of a meaningful correction. We are paying close attention to the improving valuations that corrections bring and will be using our cash reserves to buy quality stocks that others scorn out of short-term fear.

I would be remiss if I didn’t take this opportunity to remember Jim Flaherty, who died as this was being written, at the too young age of 64. No matter what your political leaning, Jim Flaherty will be remembered as the Finance Minister who got Canada through the financial meltdown in the best condition of any major country in the world. In addition, he was a tremendously charitable and likeable person. Jim, thank you. Canada is a better place because of you.

Getting Lost in the ‘Wheats” – RD

A week or so after the Russia/Ukraine dispute was the top news story, I attended one of my son’s Scouting events and was struck by the expert tone that two parents had adopted in speaking of the then current stock market environment. These parents proclaimed the political incursion by Russia was going to put the market in serious peril and would result in a market plummet. They applauded each other’s prescience to fear the markets. I had been listening quietly. They began to congratulate each other for their wisdom in avoiding the markets. As my career has been devoted to analysing stocks and studying what influences the markets, I felt I had some insight to offer. It was at that point that I put forth a differing opinion. These gentlemen, however, continued to speak over me, not interested in hearing why I might hold the opposite view. They did not know what I do for a living. Even if they did I am not sure it would have mattered (so steadfast were they in their conviction of impending stock market doom). The difference in opinion, I suspect, had to do with time horizons and by extension, long term global economic impact.

The dispute concerning Ukraine is destined to have little long term economic and by corollary, stock market impact. However, the news cycle magnifies such world dramas. So while the stock market wobbled somewhat during this short period (and has completely recovered) the negative financial market impact of the Ukraine crisis was felt most in the commodities market, specifically corn and wheat, hence the title of this article. This is a market casual investors have little information about. Ukraine has become a significant crop exporter and was the 4th biggest seller of corn last year and is expected to be the 6th largest supplier of wheat this year. The price of wheat rose quickly, over 20%, after the news hit and may eventually have an impact on food importers if it persists. However, according to the IMF (International Monetary Fund), Russia accounts for 2.9% and the Ukraine another 0.4% of global GDP with U.S. exports to this area equally as miniscule. So while food importing companies indeed did have a new issue to deal with, the bulk of the world’s stock market capitalization was not at risk (unpredictable weather has a huge part to play in food price inflation but that’s beyond the scope of this article).

Had the parents at the Scouting event been inclined to lower their heads to listen, my view would have been to not lose sight of the forest for the trees. Experienced investors look at the situation as a whole and try mightily not to be distracted from the underlying fundamentals and more significant global economic issues. While there are concerns with Russia and the Ukraine, more significant equity market events relate to Asia and U.S. earnings growth rates, the interest rate environment and valuations. China’s fast growth has slowed but it is still growing quite strongly. The U.S. has had continued steady recovery. Even Europe, surprisingly, has shown some stability and is on the road to recovery. Interest rates are on the way up but from very low levels so I am not concerned about this in the short term.

Then there is the matter of valuations.

As value investors we find opportunities where others don’t because we have a longer time horizon than many. The U.S. market has performed exceedingly well over the past 5 years and its stock market has recovered to well above its level before the 2008 financial crisis hit. The European monetary union countries have vastly outperformed all other areas over the last year as those stock markets recover from their crisis. While in some regions favourable valuations are harder to find than in the recent past, many market sectors still have gems to mine. Valuations matter and now Asia and Latin America are on our radar screens as is the underperforming Canadian market. Now, back to the Russian/Ukraine crisis for a moment. Our investment in Carlsberg, which has 40% of earnings coming from Russia, suffered some weakness in the last quarter. Time to raise a glass. Cheers. But don’t get lost in the ‘wheats’.

April 2014


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