As we discussed at our recent client quarterly presentation, we have taken somewhat of a barbell strategy with our large sector exposures split between what we consider offence and defense companies or growth versus value. In the current environment, it is important to position the portfolio to benefit from the economic recovery while not fully depending on it, so our current split between offence or growth stocks, which are typically more dependent on trends independent of an improving economy is about 38% versus defense or value stocks, which are more dependent on an economic recovery is about 49%.
In our March 31st Strategy Review, we attempted to show that even though things were really bad and were expected to get a lot worse in the near term in terms of number of Coronavirus cases and the shape of the North American economy, it appeared that, at least based on historical declines in price, forward earnings and forward price/earnings (P/E) multiples (ie. valuations), that a lot of the bad news was likely baked into the stock market. And from the lows of March 23rd, we have seen a tremendous rally in both the S&P500 and the TSX, up 34.5% and 35.3%, respectively.
We witnessed the S&P500 drop -33.9% from its February 19th high through to the low reached on March 23rd as the global coronavirus pandemic unfolded. While the news regarding the virus, and the spike in cases here in North America, is likely going to get a lot worse before it gets better, our sense is that the world is waking up and doing what it can to help prevent the spread until a vaccine or treatment is found.
This decade will be remembered for a few things. From a stock market perspective, it will not only be remembered as the longest bull market in history, but also the best performing decade in history. However, some strategists have also coined this the most ‘hated bull market in history’. That’s not necessarily a bad thing because if everyone had been in love with this market and fully invested, then who would be left to buy it? Let’s start by recapping where we were a year ago as compared to today.
At our recent investment meeting a discussion ensued about the fact that Elizabeth Warren had taken over as front-runner in the Democrats’ race for US president. I think the general consensus is that Trump will win again in 2020, but you probably would have said that about Hillary Clinton three years ago at this point in the race. A Warren President would likely mean higher taxes, more regulation and perhaps some form of Medicare for all. It would probably be the opposite of a Trump second term, meaning more uncertainty for the markets surrounding the electoral outcome.
How about those Raptors!? I have to admit I am more of a Leaf fan but I definitely got on the Raptor bandwagon; after all, how often do you win an NBA championship? The S&P500 also seemed to have a bit of a bandwagon feel midway through the second quarter. After a positive move in April, the S&P500 lost, in US$ terms, almost 7% in May as trade talks were derailed and President Trump tweeted that he would raise tariffs from 10% to 25% on $200 billion worth of goods and potentially introduce tariffs on an additional $300 billion. Then there was the attempt to use tariffs as a weapon against Mexico to reduce or eliminate the number of illegal aliens crossing into the US. That was resolved quickly, but it was enough to kill the positive market sentiment from April and to send the market lower. Exhibit 1 shows the Ned Davis Short Term Sentiment Indicator. Optimism rose to 78% bullish (positive on the stock market) on April 29th, 2019 after which the stock market corrected sharply before bottoming at 16% bullish on June 3rd, 2019. We did not get on this selling bandwagon and stayed nearly fully invested. In June, the market recovered all that was lost in the previous month.
Last week we attended a retail conference in Toronto which included the Who’s Who of Canadian ‘bricks and mortar’ retail. The first question the moderator asked of each panelist was whether there were any signs of a slow-down at the retail level or a shift in consumer spending patterns that might signal some caution. They all answered no. So take that with a grain of salt but over all the years we have been analyzing companies, we have found that the boots on the ground research is often the best research. We mention this notwithstanding the negative rhetoric regarding slowing global growth, a complete U-turn in US monetary policy and a yield curve inversion between the 10 year Treasury bond and the three-month Treasury bills which can be a leading indicator of an economic downturn.
We will start by stating the obvious, valuations have become a whole lot cheaper. However, earnings growth is beginning to slow, and we put more weight on that particularly with short term interest rates on the rise. Let’s start with a quick review of what we think has caused the market selloff during the fourth quarter as it helps to establish the correct course of action going forward.
The latest quarter has been influenced by increasing market concern around protectionism as both the NAFTA trade issue came to a head and we saw the implementation of new tariffs on China. In any negotiation, there are usually winners and losers but when we compare the returns of the S&P500 over the past three months and year to date to Canada, or even globally, it feels like the S&P500 is in a “Heads I win, Tails you lose“ scenario.
No one wants to be a contrarian just for the sake of being one but right now it might pay to take advantage of the volatility. It feels like everyone involved in capital markets has turned more negative. While the investment outlook does feel a little less certain given the headlines on protectionist trade issues and foreign investment limitations on sensitive US technology that has resulted in a spike in volatility, volatility was at 20-year lows so some level of normalization should probably be expected. In Exhibit 1, we compare volatility as measured by the VIX, commonly referred to as the Fear Index, to high yield credit spreads (the interest rate demanded by investors in high yield bonds over similar maturity investment grade or government bonds).