Market Review Fourth Quarter, 2009
Fourth Quarter Change in Cdn$)
Calendar Year 2009
Cdn 91 day T-Bills
U.S. 91 day T-Bills
Cdn 10 year Bond
U.S. 10 year Bond
Commodities (in US$)
Portfolio Management Strategy
What Worked (The return of risk)
– Utilities Stocks
– Canadian Small Cap Stocks
– Japanese Stocks
– Financial Stocks
– Federal Government Bonds
The Story of the Tortoise and the Hare – NL
We are all, undoubtedly, familiar with Aesop’s fable “The Tortoise and the Hare”. In this fable, the tortoise, tired of being ridiculed for being slow, challenges the hare to a race. The end result is that the cocky hare, while off to a flashy and fast start, gets distracted and ends up losing the race to the steady and methodical tortoise.
To bring this fable into the investment world, the tortoise is the very essence of value investing. The hare represents hot money. In the late 1990s and into 2000, the hare was the investor who showed amazing investment returns by owning the ever decreasing number of technology stocks that sent equity market indices skyward in a tizzy. Then, when it turned out they had chased these stocks to preposterous heights with no valuation metrics to support them, those stocks crashed and burned and left the hares in the dust. All the while the tortoise stocks, those companies that actually produced goods and services and had earnings and paid dividends that increased on a regular basis, were ignored and their valuations shrunk. That is, however, until the hare met his eventual fate and the tortoise stocks resumed their long-term trend from the bottom left corner of the chart to the upper right corner of the chart.
History repeated itself with the financial and commodity stocks in the mid-to-late 2000s. Hot money pushed these stocks to unreasonable and unsustainable valuations and again badly burned the investors who chased them and didn’t know when to sell. Again, it was the quality companies that provided investors with steady earnings and dividends and protected them while other stocks were falling hard all around them.
In the past two years, the governments of the world, faced with severe economic recessions, dropped interest rates to almost zero and flooded the world with liquidity in an attempt to jump start their economies. The result was a rush back into those very same hare equities that led the markets down, and a movement again away from the quality tortoise stocks.
Early last year, we wrote that the massive amounts of stimulus policies enacted by governments around the world should provide a floor or even a modest boost to economic activity. We also said that markets would rise when the stimulus appears to be working and would fall when fears surfaced. We then pointed out that our expectation was for economic recovery around the world to be tepid for a prolonged period. So far so good on these predictions.
Where we went wrong early in the year was in predicting that investors would be searching for sustainable yield to help restore their liquidity and that their risk tolerance would be reduced. In fact, investors broke into two camps last year. Retail investors decided, en masse, that the stock market looked too uncertain due to the economic and financial landscapes they were looking at. They bought bonds and GICs. Institutional investors (especially the hot money I referred to earlier) decided that the only way they could make back the massive amounts of capital they had lost in the past two years was to buy the low quality (but high volatility) stocks that had taken the markets down. With the S&P 500 up 70% from its low and the TSX Composite up 58% from its low, it seems fair to say that their strategy has worked up until now. However, as the Economist recently pointed out, these stocks have now been pushed up to the point where they are now nearly 50% overvalued on the best long-term measure, which adjusts profits to allow for the economic cycle, and are on a par with two of the four great valuation peaks in the 20th century, being 1901 and 1966.
In the fourth quarter, retail investors did return to the fray and, as Peter Walter predicted in his comment last quarter, they began the search for yield, buying lower quality reset preferreds, low-grade corporate bonds, and high-yielding income trusts. The result is that the spread between high-quality government and corporate bonds and low-quality corporate bonds has lessened greatly and the prices of many income trusts have risen beyond their fundamental valuations. In fact, we have taken some profits in the income trust area where we believe individual situations have become excessively priced and are looking at further reductions if this trend continues, especially as their January 1, 2011 end date comes closer.
Our equity portfolios are chock full of defensive, dividend paying, high quality equities and trusts. These securities have provided our clients with good and growing income streams along with an above average amount of capital preservation. We will continue to have strong representation in this area until we become more optimistic about the economic outlook. However, our hope is to reduce our dependence on this area over time and to shift our focus to companies that have the potential to show above-average earnings growth in what we expect to remain difficult economic times.
We believe that the hare’s days are numbered and that the tortoise will once again show that the value investing style produces the best long-term results.