Market Review Quarter 1, 2018
What Worked What Didn’t
Non-Canadian Oil Canadian Stocks
Emerging Market Stocks Energy Stocks
Non-Canadian Stocks Cannabis Stocks
First Quarter 2018
Equity Markets % Change (in Cdn$)
S&P/TSX Composite -4.5%
TSX Energy -9.4%
TSX Financials -3.5%
S&P 500 2.1%
First Quarter 2018
Bond Markets % Change (in Cdn$)
FTSE TMX Cda Bond Universe Index 0.3%
Short-term Returns and Short-term Memories – RD
In the last commentary I wrote about the unusual period of low volatility in the markets during 2017 and how we expected that was about to change. Sure enough, 2018 has had a rather bumpy start. The Dow Jones Index has already experienced two 10% corrections. Last year it was devoid of any major volatility. Similarly, the S&P/TSX Composite has experienced much more volatility than it did in 2017 and in the first three months of 2018 it is down -4.5%.
Although some investors may find the renewed volatility unsettling, it was last year’s calm markets with unreasonably high valuations that we found unsettling. Last year, despite a myriad of risks that investors largely ignored, 2017 was among the least volatile market in ages. Ironically, when the market continues to rise and volatility declines, investors get complacent. They start to think prolonged periods of market gains equates to low risk and want in on that rising return, low volatility band wagon. That causes them to take more risk and purchase stocks at higher price to earnings valuations. The opposite occurs in stock market declines. When prices are going down, investors get nervous and pull out of stocks when they are becoming less expensive/more reasonably valued. A sign of the “this is easy” investor mentality is reflected by the fact that 2 major Canadian bank brokerage sites crashed in the early part of January due to so many investors wanting to open up their own brokerage trading accounts in order to trade cannabis stocks. Investors didn’t remember or did not want to remember what happened to the market indices in the last recession (in 2008 the TSX was down over 30%). We have not had an economic downturn in almost 10 years so increased volatility and lower market returns are likely some time in the future.
We were not finding many values in 2017 and knew that ultimately, high valuations always get brought down by something at some point (e.g. interest rates, regulation, trade friction/tariffs, credit conditions, political instability). As we stated before, we have been conservatively positioned. Trump’s ’I win you lose’ mentality did not strike us as a long term positive for global economic growth. Nor was the end of a long period of low and lower interest rates. Corrections in the market, like we have been experiencing, are more the norm and valuations do matter. We also mentioned last quarter that the FAANG stocks (Facebook, Amazon, Apple, Netflix and Google) that had been responsible for almost 40% of the markets’ 2017 move seemed to be a target for increased regulation. That too has come to pass this quarter with both Amazon and Facebook in the cross hairs of increased regulation that will likely put a damper on their profits (and valuations). We have avoided the high multiple technology stocks as we are striving to protect investors from the downside.
We reduced exposure to higher multiple stocks and those facing business challenges in the changing market environment and added stocks that had sound business models but had been overlooked. Inflation is coming back into the system and short-term interest rates are rising faster than long-term rates. Hence the yield curve is flattening. This suggests that long-term economic prospects are not as rosy as investors would like them to be. Keep your eye on the long-term and what your risk appetite is. Recall that what happens to stock markets in a recession, such as in 2008, is not pleasant. Long-term memories help achieve superior long-term returns.
We’re Number 77! – NL
As a Canadian, I thought it was pretty embarrassing, in 2017, that the Canadian stock market, as represented by the S&P/TSX Composite Index, was the 72nd best performing stock market in the world, out of a total of 93. And that included the parabolic spike during the fourth quarter in cannabis stocks, which are, believe it or not, part of the healthcare index. What did I know? That dismal performance was unfortunately outdone in the latest quarter, as Canadian stocks sunk to number 77.
Canada’s stock market has been hollowed out over the years by a combination of companies going private as well as takeovers, many of them by foreign companies. That has led to the unfortunate situation that our market is dominated by resource and financial stocks. Depending on the timing, that can be a good or a bad situation.
From 1999 to 2008, commodities were in a huge bull market. For example, the price of crude oil bottomed out at US$10.75 per barrel and went on a ten-year run, culminating with a price of US$147.30 in April of 2008. During that same period, the prices of most industrial and precious metals went pretty much parabolic, taking the shares of their producers with them.
During that time, the Canadian stock market was the top performing one in the world and it was easy to score great returns as an investor. Also, the value of the Canadian dollar went from a low of $US0.62 in 2002 to a spike high of $US1.10 in the fall of 2007, making Canada a favourite place for foreigners to invest. Our bank stocks (which represent the majority weighting in Canadian financials) were a paragon of virtue in comparison to almost all banks around the world following the financial crisis. This helped Canadian stocks do relatively well in the period following the market bottom in 2009.
Unfortunately, that is all in the past.
Since that time, commodity prices have collapsed and are only now returning to levels that are profitable for the companies producing them. This bodes well for their share prices. And the world’s banking system, while not perfect, is substantially healthier than it was ten years ago, removing the advantage Canada’s banks had during that period. In fact, the high personal indebtedness of Canadians is now drawing the attention of the rating agencies, who are worried that higher interest rates and/or a decline in housing prices could spell trouble for our banks. We are not afraid of that happening at present, but we are monitoring the situation carefully.
The S&P/TSX Composite index is not much higher today than it was in 2008, so buyers of Canadian index funds and index ETFs have collected their dividends, however they have made no capital gains over the past ten years. You won’t hear too many proponents of ETFs talk about that inconvenient fact. They just talk about their fees.
Fortunately, we have been able, over that same period, to report investment returns much better than the index because we pay absolutely no attention to it. We are value investors, meaning we scour the world’s stock markets for good quality companies who may have temporarily fallen on hard times but whose long-term prospects remain promising.
What that means, however, is that there are times when value investing shows strong returns, and times when it does not. A recent study, as quoted in Report on Business, shows how a U.S. portfolio of the 30 largest stocks in the index, rebalanced annually from a starting point of 1927, grew at an average annual rate of 9.8%. A portfolio of value stocks climbed at an average annual rate of 13.3% during that same period. That 3.5% annual difference, over that period meant that a $1,000 invested in the large-cap portfolio was worth $4.8 million at the end of 2017. Pretty impressive until you see that the value portfolio, over that same period, was worth $84.1 million by the end of 2017. I have obviously simplified the process, but I expect you can grasp the gist of it.
The point I would really like to make, however, is during that 90-year period, there were times when value stocks underperformed, with the past five years being an excellent example. However, investors who have stuck with value investing have been richly rewarded over the long term. Patience is often required.
We hope, and believe, that the period of underperformance in both Canadian stocks and value stocks will soon be coming to an end and a return to their pattern of long-term outperformance will be forthcoming. While Canadian stocks have continued to languish so far this year, value stocks have very recently begun to outperform growth stocks. There is no assurance that this outperformance will last, but we believe that investors are finally looking away from the narrow group of technology and related stocks that have led the market in most recent years and are now focusing on value stocks which offer lower valuations, higher yields, and we believe superior price performance in the future.
Playoff hockey – FB
Playoff hockey hardly seems like an appropriate heading for a note on the capital markets but I do feel its relevant not only because the local team is in the playoffs but for other reasons as well. In hockey, as in investing, there are periods when playing solid defence as opposed to aiming high is the appropriate strategy. Its been 9 years since the markets bottomed in early 2009 and since then an effective strategy has been to play aggressively and emphasize risk acceptance. In other words, play offence.
History never repeats, but it can certainly rhyme. And after 9 years of bull markets, with many equity valuations stretched and some in nose bleed territory, it seems to me that its high time we paid attention to defence to best ensure the long term purchasing power of our clients’ capital. To that end we have, for most clients, been modifying our equity exposure. In the “what we did” section at the end of this Commentary Rhonda and Anish will be explaining some recent changes to our equity holdings.
I mentioned stretched equity valuations but another worrying issue is market leadership. Over the past year the business headlines and the market have been dominated by high tech issues in the US. Names like Amazon, Facebook, Tesla and Twitter have been leading the market higher. Similar types of companies were leading the market in 1999 through early 2000 and while current conditions are not as extreme, the similarities should not be ignored. For reference, in the year 2000, Nortel was the stock de jour … until it wasn’t. At its peak Nortel was trading at over 100 times earnings, a ridiculous number and one that long-term value investors found laughable. Some of today’s stock market leaders have exceeded the lunacy levels of the year 2000. By way of example, Amazon trades at a PE multiple of 233 times, Netflix is at 244 times and the PE multiple on Tesla and Twitter are both infinite as those firms are not profitable.
So we feel its time for defence even in the face of a strengthening US economy. With valuations on most companies stretched and a period of rising interest rates seemingly approaching we have, and we will continue to, play defence. In the short term it may not be popular but it’s the long term that counts.
On the operations side, Carol Williams who is one of our client administrators, will be retiring at the end of April to spend more time with her family and more time in PEI with her husband. Carol has been a vivacious and energetic member of our office and we wish her all the very best in her retirement. As with every departure there is an addition. Geeta Ramnarine has recently joined our administrative team. Geeta comes to us with extensive industry experience and we feel fortunate that she is joining our firm.
Fixed Income March 2018 December 2017
Cdn 91 day T-Bills 1.09% 1.05%
U.S. 91 day T-Bills 1.76% 1.45%
Cdn 10 year Bond 2.11% 2.03%
U.S. 10 year Bond 2.74% 2.40%
Commodities (in U.S.$) March 2018 December 2017
Oil 64.94 60.42
Natural Gas 2.73 2.95
Gold 1327.30 1309.30
Currency March 2018 December 2017
Cdn/USD 1.2885 1.2568
Cdn/Eur 1.5853 1.5001