Executive Summary – Good times in the stock markets may last a while
Another quarter rolls by, and overall, it was another quarter of very solid returns for our clients. Can the good times for investment markets continue?
The pessimists of this world say “this has got to end soon”. The optimists say “maybe this is the new reality”. Our general view is that both are wrong. History teaches us that there are few to no “new realities” – eventually it repeats itself. At the same time, should we expect strong stock markets to end in the near future? We don’t think so.
Here are three reasons:
- Valuations are not unreasonable. The chart below is from JP Morgan based on the US S&P 500 index as of March 31, 2015. It shows current Price/Earnings ratios today as a percentage of the 20 year average of Price/Earnings ratios – so 100% would suggest things are at the 20 year average, 110% would be 10% over the average and 90% would be 10% under the average.
Value Blend Growth Large 116.4% 104.3% 91.7% Mid 124.4% 118.1% 98.5% Small 114.3% 107.1% 97.4%
This chart shows that while the overall market has a higher P/E ratio than the 20 year average, the higher valuation is skewed toward Value stocks, and in fact Growth stocks currently have valuations that are UNDER the 20 year average – especially among large companies. While this can provide some guidance for which types of names to buy in the market, it would suggest that on a purely valuation basis, despite several years of good markets, corporate earnings have mostly kept up. On its own, valuations would not drive us to lower our stock weightings.
- Rising interest rates should actually help stock markets. Over the past 52 years, a study of weekly stock market returns (S&P500) and 10 Year US Treasury yields, showed that when the Treasury yield was under 5%, there was a positive correlation between rising rates and stock market returns. Once the 10 year yields were over 5%, it became a negative correlation. Today’s 10 year US Treasury Yield stands at 1.9%.
Based on this data, the next 3% of interest rate increases will actually correlate to a rising stock market. It is our view that this process will take a few years. When you consider that German 10 year bonds are trading at 0.15%, you realize that there still is room for US 10 year bond rates to decline from here. Even if there is no decline, at least rising rates will be constrained within this type of Global rate environment.
There are a couple of reasons why stock markets would rise as interest rates climb. The first is that rising interest rates are often connected to growth in an economy, and if that growth is coupled with cheap money in the form of interest rates under 5%, it tends to be a good environment for stocks.
The other reason might be that rising interest rates are not good for bond returns, and if that is coupled with bond yields under 5%, it tends to be a weak incentive to invest in bonds. If money doesn’t want to be in bonds, it tends to create inflows to stocks. If bond yields were 10%, but there were some capital losses, most people would still be comfortable holding bonds.
- Retirees are forced to invest in stocks at these interest rates. Today, a 65 year old couple has a 47% chance of at least one of them living to age 90. Essentially this means that 65 year olds need their money to last at least 25 more years – probably 30 years to be ‘safe’.
If you have $1 million and GICs pay 8%, then they can spin off $80,000 a year and even with high inflation, you are in good shape.
Today, retirees can invest it in GICs and it will spin off $18,000 if they are lucky. This means they would have to drawn down their savings each year to make ends meet. Can retirees afford to do that for 30 years?
As a result, those with the largest portfolios (mostly those aged 65+), who used to have a much lower portion invested in stock markets, will need to be meaningfully invested in stocks (or high yield bonds) at least until they can get 4% or 5% on their GICs. That will take a while.
In the short term anything can happen. We fully expect there to be a 5% to 10% downturn at some point in 2015 because that happens most years. However, overall, we think that valuations, interest rates and demographics remain supportive for stock markets.
The Quarter that Was
The TSX had an OK start to the year, with a 1.8% return over the quarter. Of course, energy was down another 1.9% and financials were down 1.1%, but most of the smaller sectors helped to keep returns above water.
Declining crude prices continued to put pressure on energy stocks, but technically stocks are behaving well having put in what may be their low in December with higher highs and higher lows since then.
TSX earnings seem to have stabilized. Trailing 12 month corporate earnings numbers continue to fall, but the forward 12 month estimates have started moving up.
The Canadian financials have recovered from a very weak January where the index was down more than 8% on fears of a weaker Canadian economy (mainly Western Canada) and housing market.
The US S&P 500 was up just 0.4% in the quarter. But currencies added 9.1% for Canadian investors!!
In the US the best performing sector was Health Care, up 6.1%. The worst sector was Utilities, down 6.0%.
There was a very weak start in U.S. stocks on lackluster Q4 earnings where concerns over a strong dollar and slowing global growth were a recurring theme. This seems to have recovered somewhat.
Consumer sentiment has held up with the Consumer Confidence Index hitting a 7 ½ year high in January in the U.S.
Economic numbers were mixed with decent housing starts but weaker consumer spending, which may be somewhat related to the cold winter and heavy snowfall in the Northeast.
Earnings are stable as trailing numbers and forward estimates continue to rise.
With continuing drops in interest rates, bonds had a very good quarter, up 4.1%.
Global Central Bank policies continue to be the focus of headlines.
In Europe the ECB maintained a bias towards lowering rates and quantitative easing (governments buying their own bonds to keep rates low) in an attempt to keep their currency low and to stimulate growth.
In Canada, the Bank of Canada surprised with a 25 basis point rate cut on January 21st when no policy move was expected. The overriding concern is how Canada and its economy will deal with a US$50 a barrel environment for oil.
In the US, the Federal Reserve was quick to change its tone towards keeping rates steady instead of an expected increase. This was driven by deflationary concerns that came about from lower energy prices coupled with a strong US dollar.
How did TriDelta Do?
First quarter 2015 was very positive for TriDelta clients. Depending on risk tolerance/asset mix, most clients were up between 3% and 5.5% for the quarter, with the high growth oriented clients doing better, and the most conservative returning at the lower end of that range.
The TriDelta High Income Balanced Fund – was up 7.1% on the quarter.
The fund – which currently delivers a yield of over 7% – aims to provide income from diversified sources that include Global Bond yields, options, dividends and leverage. The fund is essentially a Global Balanced fund but we utilize a wide number of investment tools to achieve higher returns.
Some good regulatory news came through this quarter, which will allow all TriDelta clients the opportunity to own the fund (as opposed to only Accredited investors). This will come into effect in May and will allow for new investments as of the end of May.
Given a TSX return of 1.8%, we were very pleased with the results overall.
Our two biggest drivers for outperformance were:
- Between 30% and 40% of our stock weighting has been outside of Canada (U.S., Europe and Emerging Markets). Because of US currency gains and strong stock markets in Europe and Asia, these parts of the portfolio have done better than Canadian stock numbers.
- TriDelta has been significantly underweight energy, particularly with our Pension clients. In July we sold one of our two pure Energy stocks (Suncor), and bought the Pharmacy, Jean Coutu. To date, this trade has been a 40% swing to the positive. While we may find the value in Energy compelling at some point, for the most part, we find that our clients don’t want the volatility that comes with a high energy weighting, and we can find other industries and names that are more appropriate alternatives.
What worked well in Q1?
In our equity portfolios we continued to see the US$ working in our benefit. The leading performers had a US and technology slant with Avago Technologies and Apple leading the way.
Best Equity Performers – Core – Avago Technologies +31.0%, Fairfax Financial +18.9%, Moody’s +18.9%
Best Equity Performers – Pension – Apple + 23.7%, GlaxoSmithKline +22.1%, General Mills +16.9%
In the Bond and Preferred space, lower interest rates produced some nice winners.
Highway 407 6.47%, July 27,2029 bond was up 9.0% on the quarter as it benefits from a high yield and declining long term rates.
Brookfield Asset Series 18 preferred share was up 8.1% on the quarter.
What did not work well in Q1?
Before we talk details on what didn’t work, we have been asked by some industry colleagues “Why do you show people what didn’t work?” Our answer to that is simple:
- Transparency with clients is important
- It always helps an organization to review what isn’t going well
- It reminds everyone that even strong investment management returns include weak performers in a portfolio
- We like to be a bit different from the rest of the industry
This quarter, after the currency effect, Canadian stocks lagged the US (and most other world markets). Energy, Canadian Financials, and any business that seemed closely tied to Western Canada suffered.
Our weakest performing stocks were as follows:
Core – Michael Kors -4.3%, TransCanadaPipeline -4.3%, TD Bank -1.5%
Pension – Home Capital -10.9, ConocoPhillips -7.3%*, Corus Entertainment -6.5%
In the Core/Growth model, we still own all 3 of the weaker performers from this quarter. While we continually review our holdings for signs of problems, for now we are planning to continue to hold these names (always subject to change).
In the Pension model, we only continue to hold Home Capital. Its decline was largely based on fears of real estate declines and risk among non ‘A’ level borrowers. Home Capital is such a strongly managed company that has been able to work through much worse times than today, and we continue to like the name.
ConocoPhillips was actually sold on January 8th so we didn’t really participate in the losses for the quarter. Corus was sold (just in time) at roughly $22 on March 13th. It has since dropped 20%!
In the Preferred Share space, all rate reset preferreds (those that have dividends that will reset to a rate that is tied to the Government of Canada 5 year yield) had a very poor quarter. While we don’t see much in the way of increased interest rates in the very near future, we do believe that this sector of the market has been overly beaten up and is undervalued – and we may add to some beaten up names.
Cannaccord Series A 5.5% Variable was down 24.3% in the quarter, and represented our worst holding.
Its 5.5% dividend won’t reset until September 30, 2016, and at that time will reset at 3.12% above the 5 year Government of Canada yield, which today stands at just 0.6%, but could certainly rise in the next 18 months.
Dividend Changes in Our Portfolios
We continue to be pleased with a steady flow of dividend increases and no dividend cuts in our investment portfolios.
This quarter in our income oriented portfolios the top four dividend increases were:
|Company Name||% Dividend Increase||Company Name||% Dividend Increase|
|Canadian Utilities||+10.3%||Home Capital||+10.0%|
In our Growth portfolios, the overall dividend yields tend to be lower, but some of the trends of dividend increases have been very solid. Below are the four biggest percentage increases in the quarter:
|Company Name||% Dividend Increase||Company Name||% Dividend Increase|
What do we see in the Quarter Ahead
- More volatility by sector – you won’t see as much of the overall market moving higher or lower as much as a few sectors pushing much higher or lower.
- Interest rates remaining mostly stable to lower in Canada and Europe. The United States won’t likely see the Fed raising rates this quarter, but we still expect to see it this year.
- Oil looks to have found a base from a technical perspective and may allow for some trading gains, but we can’t see any big move forward as long as oil inventories keep pushing new heights. We believe it will be a lot of ‘one step forward, one step back’.
- Canadian dollar remains under some pressure, but seems to have found some support in the 78 to 80 cent range unless Oil makes a major move from here in either direction or there is another Bank of Canada rate cut.
TriDelta Financial is celebrating its 10th Anniversary this month and we are very thankful to our clients for helping us to reach this milestone.
We are planning to do a couple of special client thank you events in the coming year to celebrate – details to follow.
Enjoy the soon to be realized Spring!!
TriDelta Investment Management Committee
VP, Fixed Income
President and CEO
VP, Portfolio Manager and