Market White Paper: February 2016

          So far in 2016 the markets have been completely unforgiving and the only way to earn a reward is either through the chaos trade, going long gold as a hedge against currency collapse, or going short to start the year. We are not a hedge fund and do not have the ability to short the market, and if we did, we simply would not.

          Market performance year to date - markets are down greater than 10% with a 15% retracement from the all-time highs. We certainly are upset, but not panicked and not selling at what is likely a bottom, in fact we are more inclined to be buyers, we are simply uncertain in which areas of the market to buy. I want to give everyone a rundown of the major market themes, as there are major changes, and these corresponding uncertainties are driving markets crazy and generating significant volatility. 

          First we have to go back to the financial crisis, and the reaction by the US Federal Reserve. They lowered rates to “0” and even stimulated the markets providing artificially low interest rates. This has never been done before, was entirely experimental, courageous and could easily have failed, but there was no choice, this was the best plan and luckily for the Americans it worked! The market responded by entering a 7 year bull market, and asset classes such as income-generating assets exploded in value as yield was difficult to find due to low rates. Bond prices and income stocks shot up and have stayed elevated. In 2015 we came to the culmination of this trade - the US economy had recovered all lost jobs, consumer balance sheets are now clean, and we added a revolutionary technology in oil extraction that has changed the global power dynamics. 

 

  (Source: Bloomberg)

 

          As income investments entered their twilight, our portfolio focus shifted towards growth investments. They would not be affected by rising rates, and generally speaking they had phenomenal balance sheets with net cash and no/low debt. We made this adjustment in 2015 and it is the reason we had positive returns, against a market that was down 8%. The chart below illustrates European rates declining over recent years. 

 

  (Source: Bloomberg)

 

          As we begin 2016, the Americans are in a mindset to raise rates, but globally rates are going lower; as usual, a tale of two worlds. The Americans led us forward by trying an experimental monetary policy that happened to work, and put them in the best economic shape we have seen in years, as the European’s wasted time and dealt with internal troubles within nation states - Greece. The Japanese as well as the Greeks have adopted the same zero rate policy years after the Americans and are playing catchup.

          This leads us to the primary market uncertainty, do we focus on the American Economy with rising rates, or the European and Global Economies with negative interest rates? (A literal, do we focus on the good or the bad?) This question needs an answer, and the uncertainty surrounding it has caused the markets to sell off in 2016.

          This uncertainty has really hurt markets and looks to be preventing the USA from further rate hikes at the moment, which has had a profound, and in our opinion, an exaggerated impact on stocks.

 

Some of the major impacts in 2016 that are different:

     1.  We think the USD has topped. This chart depicts the USD vs. CAD in white, oil in yellow. Oil is at the exact same price as January, basically the bottom and the USD has lost nearly 10% of its value vs the CAD. Given the inverse relationship between oil and the USD, it seems that as oil continues to reach new lows, the USD is facing resistence and failing to break to new highs - the chart below depicts the beginning of a breakdown in this trend. This is good news for ‘snowbirds,’ bad news for USD currency investments, and great news for oil and commodity investments.

(Source: Bloomberg)

 

     2.  Global financials are hurt, but will recover. In a negative rate environment, Europe flushed their banks down the toilet, leading all global banks lower. In a span of 6 weeks, global financials have lost nearly 25% of their value, many after record 2015 earnings and trading well below book value. We think this is short term and although the bottom may not be in place yet, we expect a full recovery will occur. The chart below illustrates the decreaase in share price of European Banks.

 

 

  (Source: Bloomberg)

 

     3.  After the Fed rate hike, a more significant correction occurred than the ordinary market reaction. We typically expect the market to shake after a rate hike as it is usual to sell down up to 10%, we are slightly below that level and -15% from the top of the market. If this is not a usual correction, the decline will continue and newer lows could be reached (we think it is a usual correction).

 

(Source: J.P. Morgan Asset Management)

 

Conclusion

          The primary reason a market would sell-off further from where we already are is a one word answer - Recession. Is there going to be a global recession? We answer that question with a resounding and definitive no! US unemployment is below 5% and adding 150k-200k jobs per month, demographics are good, and their debt is at a responsible level. Europe is improving and even Canada having entered a tough patch on oil prices is not net down a huge amount of jobs nationwide. We have certainly lost energy jobs and will continue to see a decline at these oil price levels, but we are adding in other areas to try to offset. If a recession is not likely in our minds, you must stay invested and look to take advantage of low prices.

          It is of our opinion that the market will eventually follow the leader (USA) not the laggard (Europe, Japan). Given this global contrasting-rates environment, we would need all our stocks to be high dividend, net cash, high growth stocks - unfortunately, those companies rarely exist. So, the next best thing to do is to have a higher cash position and let the market sort out what it wants. We will continue the plan of safety first, having the best balance sheets enter the portfolio. We will continue our endeavor to search for growth, maintaining a continued focus on safe and growing yield now that the market has changed.

          We think the high return stocks of 2015 will take a breather in 2016 and we will find greater returns in many of our laggards in 2015, such as energy and commodities. The growth stocks are still amongst the best in the market, but must be bought very selectively in 2016. When we view our portfolio we can rarely identify any stocks that we foresee having lower earnings in 2016 than 2015.  We are not expecting multiples to contract to crisis levels and believe that the most likely scenario is that global markets move higher led by a strong US economy and sensible earnings growth within the companies.

 

Chris Stuchberry
Portfolio Manager
416-572-5429

 

 

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