2018 1st Quarter Review - A Shift in Prevailing Winds?
Recent market weakness on the back of geopolitical sabre-rattling has left some investors wondering if we are at the dawn of a new investing climate. Trade agendas and trade agreements combined with low interest rates have given way to trade renegotiation, belligerent statements, and rising interest rates. Are these simply posturing strategies or shifting prevailing winds?
Of note this quarter, and developed in detail within this market update:
- Canadian markets were difficult on investors.
- U.S. and European markets fared slightly better.
- Our Loonie lost some ground this quarter.
- Changes in the yield curve continue in the bond markets.
- Options came back to life thanks to bouts of market gyrations.
- You can also simply get to our Conclusion.
The Canadian market posted a -4.5% total return for the S&P/TSX while the S&P 500 posted a -0.8% total return (1.7% in CAD), and the top 50 European stocks (D.J. Stoxx 50) posted a -2.1% return in CAD.
Moreover, these negative returns have been posted in an environment where stock market indices can move up or down 2% or even 3% in a single trading session. This volatility illustrates the uneasiness on the part of investors as to where we are heading.
As always, we are thankful for the health of our business, as it is a reflection of the support we have received from many of you in the way of referrals and insight in how to improve our service.
Investor expectations, illustrated below, are bullish for Canada as well. Earnings per share (item 1) are expected to grow 16% in the next twelve months. However, to be blunt, we find these expectations on the high side given that the Canadian business climate has turned much less business-friendly. This earnings growth is predicated on stable oil prices and an export-friendly backdrop supporting a healthy real estate market. Reality seems all too ready to disprove this rosy outlook.
Much like their U.S. counterparts, Canadian companies are loading up on debt as their debt/share is expected to grow by nearly 74%. Unlike the in U.S. where the sales are expected to grow by 8%+, the sales expectations in Canada stand at an anemic 1.68%. The Canadian market remains more attractively priced than the S&P 500, but the fundamentals do support this discount. Rather, the question is whether the discount is large enough…
To get a clearer picture on whether the market is expensive or not, let us now look at prices relative to earnings.
The earnings growth endured in the first quarter of 2018. Should global growth continue, commodities will sustain their upward trend. The top pane charts the price of the S&P/TSX Composite Index for the past five years. The market has given up the heights of the beginning of the year and is now resting on the highs reached in 2014 and 2015. The valuation (middle pane) has now made the market as attractively priced as it has been in the past five years given the earnings growth (bottom pane) of 2017 and early 2018.
The above chart illustrates the behaviour of the S&P/TSX Composite Index since the beginning of 2018. Returns are down significantly. The S&P/TSX Composite price return is -5.19%, with dividends buffering some of this loss, which translates into a total return of -4.5% for this first quarter.
The chart above lists the sectors that comprise the Canadian market. What is most interesting is that there was only one positive performer in the S&P/TSX: the technology sector. Some of the more sedate market components, such as consumer staples, utilities and telecom services, were some of the worst performers. Just as we had done South of the border, we took advantage of these lower prices in Canada to add names in the food retail and telecom sectors.
In the following table, we have highlighted the best and worst-performing stocks for the quarter on the Toronto Stock Market.
The top performers in Canada this year were speculative names. Companies that did not exist just a few years ago (or are staging a comeback after going bankrupt) dominated the top five. In fact, the best-performing companies belong to a segment that did not exist a few years ago: cannabis stocks. Conversely, the weakest performances were largely due to the oil and gas sector. What is most peculiar is that oil prices rebounded in 2017, but oil stocks diverge from this trend. The important question is: are stocks lagging the commodity or are they leading it?
The current market softness has created a very interesting situation: pricings are much more attractive. Illustrated below (look for the blue dots), we see that the U.S. economy is doing quite well as the earnings for the 500 largest companies in the United States (as illustrated by the S&P 500) are expected to grow by nearly 30% over the next 12 months.
Sales and dividends are also expected to increase, albeit at a much more reasonable pace. The valuation metrics (bottom pane) show that the markets are becoming less expensive. This makes sense: profits are going up while the prices of stocks are going down.
There are reasons for falling stock prices, but lack of growth in earnings is not one of them. Geopolitics are more to blame. The United States have a president who, with his social media posts, can move markets, initiate and then resolve trade wars in a matter of days, and thus foster a climate of uncertainty. And uncertainty is something that market participants dislike even more than recessions or rising interest rates.
Debt could become a problem:
Another reason for market participants’ dwindling appetite for stocks is the perspective of corporate debt levels increasing by over 36% next year. Given today’s low rates, the low cost of debt combined with positive sales momentum can translate into spectacular earnings growth. However, debt needs to be added with a certain temperance. Clearly, investors are worried about an absence of restraint when it comes to companies taking on debt.
Charting the current situation
Below is our indispensable three-pane chart. The five-year evolution of the S&P 500 Index is charted on the first pane. The middle pane charts the price of the index divided by its earnings, the famous price-to-earnings ratio. The bottom pane depicts the growth of the index earnings.
Evident in the right-hand portion of the first pane is the price increase reversal that happened in the first quarter of 2018. This reversal happened at a time when the growth in earnings (bottom pane) was actually accelerating. The net result is illustrated in the middle pane: the price/earnings ratio, while still high, is back to the average level experienced in 2017.
In the chart below, we track the S&P 500 Index evolution so far this year, in addition to the results of reinvesting the dividends (called “Total Return”).
The Total Return Chart above of the S&P 500 shows us that the return for the index was negative in the first 90 days of 2018.
Below is the chart that tracks the various industrial groups comprising the S&P 500 Index. We refer to this chart often as it depicts the leadership of the index. When investors are bullish about the future, the leaders tend to be the more aggressive industries, such as technology.
Tellingly, while the market turned in a negative return in the first quarter of 2018, this chart shows that the Internet retailers (read “Amazon”) are the leaders. The laggards from last year, such as department stores or home entertainment companies, have bounced off their lows to become some of the best performers of 2018.
We often shop for potential picks in the lower section of the chart, looking for quality names that have been momentarily discarded. We have highlighted four industry groups (look for the four blue dots above) that were laggards in the first quarter of 2018 where we uncovered some bargains in some solid industries such as food and drug retailers or health care technology companies.
Technology still dominates the top-performing list of names in the past quarter (see the chart below). Micron and Seagate were at death’s door in mid-2016 as they had fallen 66% from their previous highs in 2015. They have since rallied by 5 times that level thanks to the rising prices of their wares. Netflix and Amazon continue to be this market’s darlings. However, bear in mind that our hard criteria of dividend-paying policies with healthy balance sheets mean that you will rarely see any of our picks in the top-performing section in a market that rewards this kind of explosive growth.
We are continuing to see a complete discounting of consumer staple names, such as General Mills (a recent addition). Many market participants are turning up their nose at steady but slow-growing stocks with little debt and generous dividend policies. On the contrary, these names appeal to us. No amount of geopolitical tension or economic slowdown will affect the business of cereal makers or consumer products such as shaving cream and soap. These stocks are on sale and have not been this attractively priced in years.
Europe-based stocks are following their U.S. counterparts lower. The IEV exchange-traded fund that invests in 366 of the largest stocks based in Europe lost 2.2% in USD terms. Just as in the United States, earnings growth is strong, but geopolitical events in Germany, the U.K. and Italy dominated the headlines and brought uncertainty for investors.
As illustrated below, our dollar versus the U.S. dollar was down about $0.03 during the first quarter of 2018. Whereas our beloved loonie was worth north of $0.80 in the early part of the year, we closed the quarter with a slide of our dollar down to the $0.77 level.
Interest rates continue to be very important tools to assess both the current and future health of economic activity. We are monitoring what is known as a “flattening” yield curve; that is, where short-term (60-day or 1-year maturities) interest rates are close if not equal to long term (20- or 30-year maturities). Should short-term interest rates move higher than long-term rates, this would be a flare warning us that not all is well economically.
Looking at Canadian rates below, the white line is the most recent interest-rate curve, while the dashed blue line depicts the rate curve of 12 months ago. The top white line tracks corporate bonds while the lower white line tracks the Government of Canada bonds.
We see that rates have increased all along the curve, with most of the increase happening in the maturities of fifteen years or less. We can also see that the largest increase in interest rates was seen in government bonds in the 5-year maturity.
Thankfully, the yield curve is still shaped in a way that benefits the economy, but this shape has most definitely “flattened”, and a rise in the Bank of Canada in the overnight rate would accelerate this trend. The implication is that a flat yield curve would dramatically slow our economy.
Case in point would be the rise in the 5-year interest rate. This rate is critical for the mortgage market. We have witnessed a dramatic drop in real estate prices in the Greater Toronto Area and the lower mainland of British Columbia. Higher mortgage rates only compounded the effects of regulatory efforts to curb runaway real estate prices.
Let’s look at the chart:
Remember that as yields or interest rates rise, bond prices fall. Bond investors lose in a rising rate scenario.
Let's look at the yield curve in the U.S.:
The flattening of the yield curve continues in the United States. The Federal Reserve raised rates once again in March, and the question is whether it will raise interest rates twice or three more times in 2018. Despite rising interest rates, the differential between corporate rates (upper lines) and government rates (lower lines) has not changed much in the past year.
This differential, known as a spread, shows the willingness on the part of investors to lend to corporations in an effort to gain additional interest income. An increased spread would mean that investors demand an even higher interest income for bearing an additional risk. Also, a higher spread would negatively impact stock prices as many companies are adding debt, since a higher debt cost would be detrimental to corporate profits.
The options market has come back to life in 2018. Market gyrations in the first quarter and renewed uncertainty mean that option premiums are finally back to normal levels.
The VIX index, which tracks the 30-day volatility of the S&P 500, spiked above 30 early this year. A VIX in the vicinity of 15 is ideal for option-selling strategies. Should the current market conditions prevail, we expect that our option premium income will increase as our current option sales will expire and be replaced with new option sales generating higher option premiums.
For the first time in many quarters, we are finally seeing value in many sectors and stocks. The typical dividend-paying, steady-growing stocks are on sale. These global brands are being shunned by investors as growing “too” slowly. Needless to say, we have deployed and will continue to deploy capital to invest in these names. Cereal makers, personal grooming brands and household cleaners have businesses that are reliable. Granted, they may not have growth profiles that rival some of the hottest technology names, but we have experienced that, in turbulent times, investors tend to flock to stable names, even if they are currently unwanted.
In Canada, we are witnessing the same phenomena. The pipeline operators, grocery retailers and telecom oligopoly owners are currently being shunned by investors. This is leading to once-in-a-decade valuation scenarios. These very same stocks, which were selling at historically high valuations just 24 months ago, are now simply ignored. We are happy to deploy capital in these dividend stalwarts even at the cost of short-term vigour.
The performance of our portfolios has been better than the overall indices this quarter. We tend to lag the indices in fast-rising trends and tend to catch up when the trends reverse. This is quite normal as our stock selection; steady dividend income and higher cash balance help us mitigate downward markets.
Some of our cash reserves have been used this quarter, and we have our eye on five or six more names. Should the market softness continue, we would expect to obtain “our” desired purchase price and to further deploy more capital.
The market weakness is not due to economic events. Geopolitical sabre-rattling and policy mistakes on both sides of our border are creating uncertainty for investors. This uncertainty may turn into an economic slowdown, depending on the political outcome, which is why we are looking at adding stocks that perform well in more difficult times.
In fact, our research shows that the U.S. economy is quite strong, and in fact dealing with some scarcity in terms of labour and such things as transportation capacity and input pricing inflation.
Canada’s economy continues to face many headwinds. As such, we will continue to be defensive in our stock selection, especially since these defensive stocks are quite attractively priced.
Our European holdings continue to be our strongest performers, and we have no plans to make any changes on this front.
As always, we thank you for your continued support, and we remain at your disposal for any questions you may have pertaining to your portfolio or financial situation in general. Many of you have also been quite generous with referring your friends and family to us. We are very grateful for these introductions.
Benoit Poliquin, CFP, CFA
President / Lead Portfolio Manager