As you are aware, the stock and bond markets are experiencing extreme volatility and seeing a pullback at the moment.
WHAT HAS BEEN HAPPENING
In the case of bonds, we have seen a meaningful increase in interest rates (outside of the prime rate or bank rate set by the central bank). For example, 10 year Canadian Government Bond yields have gone up from 1.67% on May 2nd to 2.54% today. This jump of 87 basis points is a very sudden move in yields that we believe has been overextended and will partially revert back and trade in a range between 2.00% and 2.50%. The impact is that bonds, and preferred shares, and income oriented stocks with high dividends or investments like REITs, have all seen declines.
The Fed, by removing quantitative easing, in essence wants rates to move higher. The market has done that for them, and if and when the Federal Open Market Committee (FOMC) hikes overnight interest rates in the summer of 2014, it would be the Fed catching up to the markets at that point. If the global economies are as fragile as they are, the Fed being neutral could be their longer term plan (meaning no hikes even in 2014, and the markets would be currently mispriced). If the goal is to temper any inflationary concerns and economic growth, the loss in $1.8 trillion in market cap in the equity markets would help with that as well as the recent run up in interest rates.
In the case of certain types of stocks (utilities, telecoms, health care, consumer discretionary, etc.), this pullback is not at all surprising. These sectors have done very well for a number of months in a row, and we have been expecting some form of pullback during the summer – although the exact dates are always uncertain. The rise in interest rates is also part of the reason for this pullback.
In the case of commodity stocks, this pullback is due in large part to the belief that global growth will continue to slow. Precious metal (gold & silver) is just a continuation of weakness after multiple years of very strong growth.
WHY IS THIS HAPPENING
The main reason for these market corrections is related to the anticipation of the slowdown of the United States quantitative easing – or the US government’s program of buying a large amount of its own bonds. The purpose of this program was primarily to keep interest rates very low to allow the US economy to recover from the 2008 and 2009 recession. In addition to the mere anticipation of changes, US Fed Chairman Ben Bernanke confirmed those thoughts on June 18th when he outlined a potential timing and amount of scale back for quantitative easing.
What is very interesting, and not being discussed very much, is that the US government is getting more revenue these days as a result of an improving economy. With more revenue they are actually issuing fewer bonds as there is less of a need for these funds. So while all the news is on the fact that they aren’t buying as much of their own bonds, there is little discussion of the fact that they are issuing less at the other end.
There have also been some other indicators of a slower economy in China, which impacts global economic growth forecasts, in particular commodities.
A more specific issue in Canada for telecom companies (of which we have exposure) is the potential of a major foreign entrant like Verizon entering the space. This could squeeze profitability.
Some might also argue that there is almost a traditional slowdown in stock markets in the summer. Our view is that it all depends on the year, however, there is no doubt that among the seasons, the summer has historically seen lower growth than the other three seasons.
WHAT HAVE WE DONE
On the stock side over the past couple of weeks we have sold part of our holdings in Rogers and Magna, and have sold all of TransCanada Pipelines and Manulife. In almost all cases, these stocks have been sold at a good profit, and it has and will put us in a relatively high cash position for now and possibly the next few weeks, while we look for opportunities to re-enter the market with specific names at lower prices.
For now we remain at 0% to 1% exposure to precious and base metals for most clients, and while we are always open to opportunities in any sector, we are still holding off here for now.
On the bond side, we sold off one of our bigger bond positions at the end of April – in what was perfect timing in hindsight. We sold a Manulife bond, that matured in 2041. This had been a very good investment, having risen in price from $86 from the initial purchase to almost $101 about 7 months later. After the sale, we left the proceeds in cash as we didn’t see an obvious purchase candidate at the time. We have now purchased a couple of bonds late last week for most clients – allowing us to miss a good part of the 87 basis point interest rate rise on this investment.
TRIDELTA’S VIEW OF THE FUTURE AND OUR STRATEGY
In the world of market sentiment, there is a lot of history that suggests that when things swing in a certain direction, they tend to overswing and eventually come back. This is referred to as ‘reverting to the mean’ – A theory suggesting that prices and returns eventually move back towards the mean or average.
This is our general view of the interest rate moves of the past 7 weeks. When it comes to interest rates, we worry less about 3 or 5 years out. We focus very much on the next 6 to 9 months. That is where we see opportunities to make money, and where we feel we can provide an educated view.
In our opinion, there will actually be a decline in 10 year government of Canada yields over the next 6 to 9 months. We may not get the exact date right as the ‘overswinging’ is still in effect, but believe that interest rates will be in a reasonably tight trading range, and that at the moment, they are on the high side of that range. This means that if they come back to the middle of that range, bonds will go up in value.
This also applies to many of the income oriented stocks and REITs that have really fallen back.
As a result, on the bond side we have re-entered the fray, and while we are aware that things may be bumpy in the very near term, we are comfortable with this strategy.
On the stock front, we are back in a high cash position for a reason – even if it is a short term one. We do believe that there is still some room for a pullback. Most ‘normal’ pullbacks during a bull market will still be anywhere from 7% to 15% without changing the general direction of things. The Dow is down just over 6% from its peak, while the Toronto market is off 8.7%.
We believe that the basis for directionally strong stock markets continues unabated. That is:
Very low interest rates which make long term holdings of cash, GICs and short term government bonds a poor investment choice. There remains a LOT of money on the sidelines.
An improving US economy that is seeing solid growth in employment and corporate profits.
Stocks that pay a tax advantaged (in Canada) dividend of 4%+, while a 5 year GIC pays 2.5% if you are lucky.
It is important to remember that markets do go up and down, and that occasionally there will be short term losses. The key to investing is to have a long term plan that leaves your core approach to investing unchanged no matter the weather. Outside of that core, there are opportunities to add or take away risk depending on the changes ahead, and to take some profits on winning investments and wait for an entry point into something new.
At TriDelta we have been until quite recently, owners of long term bonds because the world expected rising interest rates when there were in fact declines. In the past weeks we have been making adjustments for what is happening, but believe that interest rates will come back for a little while before they start rising again. We believe we can benefit from that pause.
We have been more exposed to US stocks than most firms for quite a while, and that isn’t likely to change. One of the cushions for us over the past few weeks has been the relative rise in the value of the US dollar. While currencies are very hard to predict, we find that this is one of the hedges for portfolios that can’t be found in a fully Canadian dollar portfolio.
The great thing about a pullback is that it provides some better entry points for good companies, higher dividend yields, and sometimes a good opportunity to adjust the sectors of a portfolio as well.
Thank you for your continued confidence in us, and as we ride this pullback, we are working hard to balance patience and action in the best way for your money.
Please don’t hesitate to call if you have any specific questions or concerns.