With this commentary, we plan to communicate with you every month about our thoughts on the markets, some snap-shots of metrics, a section on behavioural investing and finally an update on some of the people at MacNicol & Associates Asset Management (MAAM). I hope you enjoy this information, and it allows you to better understand what we see going on in the market place.
“I’ve missed more than 9,000 shots in my career. I’ve lost almost 300 games. 26 times, I’ve been trusted to take the game winning shot and missed. I’ve failed over and over and over again in my life. And that is why I succeed.” – Michael Jordan
Market Commentary: The Winds of Change
Following the worst opening to the year on record for US stock markets, all three major markets found their respective near-term bottoms on February 11th, while the Canadian TSX seems to have bottomed slightly earlier on January 20th. Since those bottoms, the TSX has rallied 11.5%, with the S&P 500, Dow Jones, and NASDAQ all rallying 8.1%, 7.3% and 9.9%, respectively. Consequently, while in our last missive we reasoned that a near-term market bounce was likely, and that the market was oversold, we are now attempting to decipher whether the recent market bounce is indicative of a return of the bull market, or whether the recent rally is attributable to what is colloquially referred to as a ‘dead cat bounce’ – a short-term rally which precludes a resumption to the downside. As with most things in life, the current scenario is convoluted, so we would like to present what we believe to be all relevant data before asserting our own opinion on the likely outcome.
The most positive recent development has been a strengthening of economic data in both the US and Canada. As stated above, Canadian GDP and inflation data were both above estimates, and US GDP and employment data has been relatively strong. As a result, we have seen a rebound in a metric known as the ‘Citi Economic Surprise Index’, which we have often referenced before. In the past, we have noted that the index is more useful for mapping the current scenario, rather than acting as a predictive statistic, however, it has also historically been mean-reverting and seems to be heading back towards positive territory at the moment, which bodes well for the current economic environment. Chart 1 below shows this index chart for US economic data, pitted against European economic data, and displays the relative strength of US data in that regard over the last few months. As a reminder, the index serves to show how many key economic statistics are able to beat expectations, gross of those which failed to meet expectations. A positive reading is seen as bullish.
Another positive development has been the compression of what are known as yield spreads, or the difference in interest rates that companies are able to borrow relative to government interest rates. In times of economic distress and uncertainty, corporate yields rise, which signals doubt about their ability to pay debts moving forwards. A compression of these yields signals a return of confidence in the underlying economic environment and in corporate liquidity. This is typically positive for creating a ‘risk on’ environment, and tends to benefit growth and small cap stocks. We are hopeful that this compression of corporate yields will result in a return in capital to the small cap space, following a prolonged ‘risk off’ period dating back to August of last year. Chart 2 below shows how far yield spreads have fallen in the last few months. As a side note, another contributing factor here has been the stabilization of oil prices, as many of the companies measured in this index are oil stocks, which saw their borrowing rates skyrocket during the precipitous fall in price of their underlying commodity.
From a valuations perspective, as can be seen on the first page, markets have widely returned to where they have been, on average, over the last few years. This means, to us, that the market is not exactly in a deep value scenario and that it is not a time where we would be comfortable buying everything in sight. As opposed to a month ago, where stocks were vastly over-sold, stocks have now temporarily entered overbought territory, where 80% of all stocks are above their 30-day moving average. Certain areas of the stock market are certainly more valuable than others, however, we do not believe that the market in its entirety is undervalued; we would be more comfortable in referring to it as fairly valued. Despite underlying economic growth strengthening on a relative basis, we do not see enough growth to justify, in our minds, a significant multiple expansion of equities. Thus, stocks, on average, are likely to maintain their current multiples and grow in price at a rate equal to earnings growth, which remains fairly muted. This overall picture of improving underlying North American economics, tightening corporate yield spreads, and a fairly valued stock market, lead us to continue to believe that 2016 will be a stock pickers market, with indexers underperforming most actively-managed funds. We are also of the belief that, if the economic scenario maintains its strength – or at least stability – and corporate yield spreads continue to tighten, that we may finally revisit a ‘risk on’ scenario which would facilitate capital infusion into growth and small cap stocks which have been punished since last August. As stated previously, it is likely that large cap constituent stocks will be limited in price appreciation due to their reliance on underlying GDP growth, which is muted. Growth and small cap stocks have the unique ability to experience out-sized returns due to their nascent or growing target markets, or revolutionary products which allow them to steal market share. These types of stocks are hurt in times of uncertainty due to relatively higher multiples and less financial history, however, in ‘risk on’ scenarios, they tend to outperform. We are currently looking to build on some of our growth names that continue to exhibit strong growth in their underlying business, but have simply suffered from market sentiment.
Interest rates continue to be an issue of debate across Canada, the US, and Europe. The European Central Bank (ECB), which already offers negative interest rates, is expected this Thursday to announce a further cut to rates which will push these rates into further negative territory. Additionally, they are also expected to increase their asset purchase program. Although the long-term effects of negative interest rates are uncharted and dubious territory, in the near term, we expect this to be positive for stock markets due to the accommodative nature of these actions, which will serve to abate some fear of further economic slowdown in Europe. With improving economic data, the question of an additional rate increase by the US Federal Reserve is back on the forefront. Although unlikely to occur in March due to recent market volatility, we believe that it is a real possibility that, if economic data continues to strengthen, another interest rate increase of 25 bps could occur as early as April. However, some believe that the government’s fear of a further strengthening of the USD and ensuing damage to the manufacturing sector may deter this action. In Canada, we are still feeling the effects of low oil prices, as well as food inflation caused by the strong USD. Despite the effect on consumers, there are many that believe the Government of Canada would like to force the currency lower, following its recent short-term rally. This would mean another additional interest rate cut by the Bank of Canada, with some rumours of possible negative rates here at home as well. Because of this, we remain favourable to hard assets, USD and gold, all of which have historically proven to preserve wealth in the face of depreciating currencies.
We have frequently referred to our affinity for using gold as ‘portfolio insurance’, and we have also pointed to 2016 year-to-date performance as a prime example of this ability. Gold, of course, has always been known as a ‘safe haven’ asset to shield against market collapse or decline, however, the yellow metal also acts very strongly as an inflation hedge. Given this attribute, we especially favour the commodity in a prevailing economic environment where multiple sovereign nations (including, possibly, our own) are employing negative interest rates, whose sole inherent purpose is inflationary. Negative rates are actually charging banks to deposit money with the central bank, with the idea being that this will cause them to deploy more loans and stimulate spending and the economy. This is the best-case scenario, or the scenario that central bankers are aiming for when instituting negative interest rates. On the other hand, if negative rates are either unable to promote spending and inflation, or if both remain flat, then there is a resulting loss of confidence in the central bank of that nation. Such loss of confidence is the type of scenario which we believe would benefit gold greatly. Even if this does not occur in Canada, the simple increasing prevalence of the development world-wide, we believe, is enough encouragement to hold a decent weighting of gold bullion and precious metal equities.
Behavioural Investing: Mental Accounting
For the Behavioural section of our monthly, we would like to discuss a phenomenon known as ‘Mental Accounting’, which was coined by Richard Thaler, and deals with our own internal feelings and treatments of different sources or uses of cash. Thaler states that, as humans, we tend to overweight the importance of certain income streams, while underweighting others and treating them entirely differently.
An example of this, as usual, can be seen in gambling. We have all seen this scenario: a player wins money, takes out their initial investment, and subsequently loses the entirety of their winnings with a dismissive shrug, stating that it was ‘all winnings’. The objective fact is that they now have less money than they did at a previous time, however, they have less emotional attachment to the funds and thus place less value on them. The same can be seen in many aspects of investing, for example:
- An investor inherits a position in a company, perhaps owned by a family member, and refuses to sell the stock, regardless of the scenario, because it is viewed as a gift.
- Dividend income is re-routed into speculative and risky stocks, outside of their traditional income, because it is viewed as ‘free’ capital.
These are only a few individual scenarios, but the takeaway is clear: it is vitally important for a successful long-term investor to treat all capital equally, regardless of source. Treat each new dollar with the same integrity and discipline as you would your first, and avoid slowly increasing your risk profile with capital which has been gained as a result of past investments.
This month, we are fortunate to have been joined by two new members to the MacNicol & Associates family: Stephen Lang, and Daniel Millar.
Steve joins us from Manulife Private Wealth and brings 18 years of experience in banking and investments. He and his wife enjoy cooking, fitness, and travelling. In his spare time, Steve is also completing his MBA from Dalhousie University.
Daniel arrives at MacNicol after several years in a similar role with a leading ETF distributor. He has been involved in financial services for most of his adult life. He lives in rural South Western Ontario with his beautiful wife Judy – she was foolish enough to say “yes” over twenty years ago – and two teenaged boys. Christopher, aged 18, is completing his final year at Stratford Northwestern, where he played on the basketball team for four years. Sean Daniel is in grade ten, and is currently working out with the rugby team. Daniel enjoys – make that LOVES – coaching basketball. He was an assistant coach on the senior boys team at St. Michael Catholic in Stratford this year.
We are very excited to welcome both Stephen and Daniel to the team, and hope that you will get a chance to meet them as well in the near future.
David A. MacNicol, B.Eng.Sci., CIM, FCSI
MacNicol & Associates Asset Management Inc.