Third Quarter 2014

Market Review Quarter 3, 2014


Third Quarter           

Equity Markets                                                                                    % Change (in Cdn$)

 S&P/TSX Composite                                                                                        -1.2%

S&P 500                                                                                                           5.6%

MSCI/Europe                                                                                                    -2.8%

MSCI/Far East                                                                                                   1.9%

TSX Energy                                                                                                      -7.3%

TSX Financials                                                                                                   1.9%

Interest Rates                                                                              September 2014         June 2014

Cdn 91 day T-Bills                                                                                0.92%                             0.90%

U.S. 91 day T-Bills                                                                               0.02%                             0.03%

Cdn 10 year Bond                                                                                 2.15%                             2.24%

U.S. 10 year Bond                                                                                2.52%                              2.53%


Commodities (in U.S.$)                                      September 2014       June 2014


Oil                                                                               91.39                            105.48

Natural Gas                                                                   4.13                                4.44

Gold                                                                            08.90                          1328.20



Portfolio Management Strategy


What Worked                                                  What Didn’t


– Long-term Bonds                                         – Small and Mid-Cap Stocks

– Large Cap U.S. Stocks                                 – Commodities and Commodity Stocks

– Railroad Stocks                                            – Canadian Dollar




Finally? – NL


After a strong first half, Canada’s stock market (as represented by the S&P/TSX Composite Index) returned to its old ways in the third quarter, declining 1.2%.  This decline was led by sharp losses in energy, metals, and gold stocks as commodity prices took a licking in the quarter.  As we wrote in last quarter’s Commentary, there is a strong correlation between commodity prices and the Canadian dollar, so it wasn’t just Canadian stocks that had a rough quarter as the Canadian dollar also had a rough time, declining 4.75%, closing at US$0.8922.  And the loonie wasn’t exactly alone.  Almost all currencies weakened versus the U.S. dollar during the quarter.  It wasn’t just a strong greenback, though, that hurt commodity prices.  Worries concerning a slowing economy in China (the biggest single consumer of most commodities) also contributed to the malaise. Speaking of economic worries, the performance of European stocks actually made Canadian stocks look good in the quarter as investors fretted over slowing growth in most European countries.


Despite the fact that major U.S. stocks (as measured by the S&P 500 index) were only up slightly in the quarter when viewed in weak Canadian dollars, they were stars compared to stocks in other world markets.  Complicating things, however, was the fact that large capitalization stocks were virtually on their own as both mid-and small-capitalization stocks suffered with investors fleeing to the relative liquidity of bigger companies.  Additionally, within the S&P 500, it was an ever shrinking number of larger companies that were propelling the index higher.  Like most indexes, the S&P 500 is market cap weighted, meaning the bigger the capitalization of an individual stock, the more influence it has on the index’s movement.  When one looks at the ‘equal weighted’ S&P 500, it actually declined during the quarter.


This poor performance by most world stock markets therefore begs the question:  Are we finally experiencing the long anticipated and much needed (we would argue) correction in stock prices? We hope so!


September was a poor month for stocks almost everywhere in the world, save for China and Japan.  At time of writing, October hasn’t fared much better.  Be it worries over economies either not growing as fast as expected or even sliding back into recession or worries over declining commodity prices, investors are showing their nervousness.  Add in stubbornly low interest rates (foreshadowing continued economic weakness) and worries as diverse as Russia, ISIS and Ebola, and it is no surprise that stocks are acting poorly.


So why do we hope we are finally in a correction?  The answer is simple:  We have been finding it extremely difficult to find stocks in North America that we were willing to initiate new positions in at their current valuations.  There are many companies whose fundamentals we like, whose revenue and earnings prospects are enticing, and who show great promise for dividend growth.  The problem for us as value investors has been that their share prices were already expensive.  In other words, there was no value in North American markets.  Share prices had already been driven beyond what we considered reasonable by investors pouring into stocks in search of growth and yield as bonds (their normal investment vehicle) continued to show record low interest rates.


The next logical question should then be:  If North American stocks are too expensive to buy, why are we not selling the stocks we already own?  Well, as detailed in Rhonda’s comments below, we actually did sell some stocks in the latest quarter, raising our cash positions to as high a level as they have been in a few years.  But we haven’t sold as much as you would have assumed given my earlier comments and the reason is that while stocks were getting too expensive to buy, they weren’t expensive enough for us to wholesale sell either.  This actually bodes well for the severity of the correction as it means that while valuations are expensive, they are not egregiously so.


One area where we have reduced our exposure is energy.  The world is awash in oil thanks to increasing production (especially in North America) mostly due to shale oil discoveries (what ever became of ‘Peak Oil’?).  Increased supply combined with demand kept in check by slow economic growth and ever more efficient use of energy, have caused oil prices to decline by about 20% since June.  While this is bad for oil companies (as well as provinces, states, and countries that produce oil) there are multiple fringe benefits from lower oil prices.


First, lower oil prices result in lower gasoline and diesel prices.  This is like a tax cut for consumers.  Watch economic activity this Christmas season benefit as consumers have more money in their pockets to spend.  Second, it is really bad for the bad guys.  From Russia to ISIS, lower oil prices means they are starved for funds and are not able to finance their treachery.  These two then lead to the third benefit of lower oil prices: higher stock prices.  A paper published in the Journal of Financial Economics in 2008 by Gerben Driesprong, Benjamin Maat, and Ben Jacobsen shows that an oil-price decline in one month “indicates a higher stock market return the next month” and that the larger the decline in oil prices, the larger the subsequent rebound in stock prices.  So far the price of oil is down 20% with no floor in sight.


We have cash to spend at the right price.  We see declining stock prices and declining oil prices.  This combination means that sometime in the near future we will have the right mix come together to allow us to increase our equity weightings.  In the meantime, valuations in Europe and Asia are more attractive than they are in North America.  I will leave it to Darren to discuss below, but don’t be surprised if Europe and Asia are our preferred destinations initially, when we decide to begin deploying our cash.



Natural, Normal and Welcomed – DS

Hmmm, the markets are down this year but I can’t say I am surprised.  After the huge 2013 run, 2014 was always going to be a year of consolidation.  News flow is almost exclusively negative. Putin’s invading Ukraine and will likely cut gas supplies to mainland Europe over the winter.  China having challenges as Hong Kong’s citizens are demanding democracy.  Argentina defaulting on its debt (again) or not.  Commodities are in free fall and the standby rational for weak markets is the anxiety around whether the U.S. is going to hike interest rates.


Standing back from those sitting a little too close to the flames, it would appear the world is not really in such a bad place.  The U.S. is recovering nicely and continues to add workers to its payrolls albeit at a lumpy pace.  Housing prices are rising.  There is even demand for Canadian lumber again to fuel the resurging U.S. housing market.  Consumer demand, the primary driver of the U.S. economy is ticking higher, so the outlook for the U.S. while not rosy is at least becoming somewhat rose-tinted.  Europe hit bedrock in 2012, it did a dead-cat bounce last year and is now ever so slowly moving off the bottom.  Putin’s Ukraine incursion is causing issues for export-oriented German, Scandinavian and Swiss companies that target Russia.  Naturally, business confidence in these countries has fallen recently.  However, winter is fast approaching so while the Europeans are notorious for delaying negotiations, for “having a glass of wine between meetings”, old Mother Nature’s frosty winter grip is likely to see an end to the Russia gas delivery issues and possibly a modicum of peace in the Ukraine.  On China, heaven-only-knows why a slowdown to a 7.5% annual GDP growth rate is causing such consternation.  Over the 2004 to 2008 timeframe China was averaging a 9.4% annual GDP growth rate.  Now in 2014, the 7.5% expected annual GDP growth rate is seen as almost pedestrian to many long-term China watchers despite it being three and a half times higher than the Canadian 2014 GDP growth estimate.  Again, stepping back from the flames, breathing, and then viewing the underlying data over a five year time frame, the bigger picture becomes clearer.  In 2007 the World Bank reported China’s GDP per capita was US$2,651.  In 2014 per capita income for China is expected to reach US$7,333 or to be 176% higher than in 2007.  Clearly this means the Chinese will buy more and will produce more.  In effect, China is now a bigger target (and getting bigger by the day) for American, Canadian and European exporters and service companies.  China’s resource appetite will continue unabated although the commodities demanded may change.  The country is also likely to continue using its large store of capital to grow its companies and to become a more meaningful economic entity on the global stage.  What’s not to like about that?


Russian myopia is dragging on European markets.  Russia is as dependent on Europe as Europe is dependent on Russia.  One needs oil and the other needs money from its oil and mineral reserves to build its emerging market economy.  While possibly a little unrealistic on my behalf, I expect a return to the bad old détente-like days prior to Glasnost and the introduction of Perestroika is not in Russia’s best interest.  I may even hazard the opinion that Soviet political tensions will die down this year or in early 2015, thereafter the Ruble will again strengthen on the back of the country’s enormous mineral and oil reserves and possibly a peaceful resolution will be eked out in the Ukraine.  For now, economic sanctions, export blockages by Russia and by the European Union (think tit-for-tat) and a weak Ruble are hurting the average Russian.  Mr. Putin maybe the ex-head of the KGB and currently in control of the Soviet government but as the last Russian elections clearly showed, even he is not immune to the will of the Russian people.


On Europe, the markets likely got a little ahead of themselves in 2012.  Timing in many cases was the enemy for many an investor.  Looking back to the onset of the Global Financial Crisis, the U.S. was first into the abyss.  The United Kingdom (“UK”) subsequently went dark around 18 months after the U.S., with Continental Europe falling into fiscal and financial Armageddon perhaps as much as 12 to 18 months after the UK.  Given the timeline of events, why investors thought it logical to pour billions of dollars back into Europe last year is beyond me.  From my humble perspective, they were either too late to buy heavily discounted European stocks at an historically weak Euro or too early to capture the economic uptick associated with a full blown economic recovery in the region. Naturally, earnings disappointment happened and the drag associated with Russian sanctions on the stronger, exported-oriented more fiscally prudent economies of Germany, Scandinavia and Switzerland have weighed heavily on European indexes.  Consequently, what went up must come down.  Well at least that’s the story for now.


We have, as many of you know, been calling for a correction for some time.  We are prepared with ample cash reserves as Norman noted previously.  We will deploy that capital as prices weaken to buy more of our existing holdings that regularly increase their dividends.  Better prices may also allow for an attractive entry price for some high quality companies that, due largely to lofty valuations, we do not currently hold.


In light of the above, yes 2014 is a little disappointing after the excitement of 2013 but perhaps the world is not really as bad as it seems.




October, 2014


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