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Financial Post / Rechtshaffen: Interest rates are still rising, but investors should start preparing for when they come back down

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Variable rates will likely be a benefit once again in the midterm

The Bank of Canada over the past 30 years has had six periods of interest-rate hikes, ranging from 1.25 to 3.2 percentage points, before this most recent set in 2022.

The one thing they all had in common was that it didn’t take long for each of them to be followed by a period of declining interest rates, ranging from 1.25 to 5.125 percentage points.

One logical reason for this is that rate rises are meant to slow down the economy, and rate declines are meant to boost the economy. There is a general view that the increases typically start too late, and so rates are still rising after the economy is already slowing. Once they really start to take effect, the impact can be too much, and the central bank has to do a quick about-face.

Let’s do a quick review of the six rises and falls since 1994.

In October 1994, the Bank of Canada’s overnight rate was 4.94 per cent. Over the next four months, it rose significantly to 8.125 per cent — a rise of 3.2 percentage points. Over the following nine months, it declined to 5.94 per cent, and one year later it was sitting at three per cent. This was a large rise and fall historically, but it outlines how quickly rates can rise and how steep the ultimate decline can be.

The next period of rate adjustments saw the overnight rate rise to 5.75 per cent from three per cent over a 15-month period in 1997 and 1998. The subsequent decline wasn’t as steep, but it did drop over the following nine months to 4.5 per cent in May 1999.

In October 1999, the rate was still 4.5 per cent, but then rose to 5.75 per cent by May 2000. One year later, it was back to 4.5 per cent and it was all the way down to two per cent by January 2002.

Over a 25-month period from March 2002 to April 2004, the rate went from two per cent to 3.25 per cent and back to two per cent.

During a relatively prosperous time, the rate rose to 4.5 per cent in July 2007 from 2.5 per cent in August 2005. But the financial crisis of 2008 started to rear its head, and rates fell first to three per cent by April 2008 and all the way to 0.25 per cent a year later.

More recently, the rate in June 2017 was at 0.5 per cent, rose to 1.75 per cent by October 2018, and then dropped to 0.25 per cent by March 2020 when COVID-19 began.

What does this mean for today? So far, we are 1.25 percentage points into an interest-rate-hiking cycle. Some think there are another one or two more points in front of us. Others think it will be less than that. What if the overnight rate goes from 0.25 per cent (where it was in February 2022) to 2.75 per cent? For many of us, that would be a bad thing because our borrowing costs would be meaningfully higher. However, if we were somewhat confident that rates would soon be heading down from there, would that ease our concerns?

History suggests this will happen. The six hiking cycles averaged 13 months in length. The current one is four months in. The six declining cycles began on average 5.7 months after the hikes stopped, but it happened within three months in three of the six scenarios. The average interest rate hike was 1.95 percentage points and the average decline was 2.85 percentage points.

History can be a guide, but certainly not a clear roadmap. If all we did was simply look at the averages here, it would suggest that we have another 0.7 percentage points of rate hikes, which would take another nine months to reach. Interest rates would then start to decline by September 2023 and eventually drop all the way back to 0.25 per cent (or more if it was possible).

Of course, each scenario is different, so things won’t simply follow these averages. The causes are different and the starting point on interest rates is different. That said, this cycle has been very repetitive over the past 30 years.

If I had to guess, I would expect the rate-hiking timeline will be shorter than 13 months, but that rates will move up by more than just 0.7 percentage points. I believe the start of the rate declines might happen sooner than September 2023. The implied policy curve for Canada currently suggests that rate hikes will peak in six months and then start to decline with the following year. This doesn’t mean that this is a fact, but it shows that even today, the implied policy rate is giving some indication of the same cycle we have seen several times before.

Another clue as to why the next cycle might look like the past is that even the Bank of Canada has said one of the reasons for increasing rates is so it will have some greater tools and leverage to help the economy by lowering rates if we go into a recession or something similar.

If that is the future, what does that mean for investors and borrowers?

Variable-rate borrowers will feel more pain in the near future, but it isn’t a one-way road. Variable rates will likely be a benefit once again in the midterm.

If you are looking at buying guaranteed investment certificates, annuities or bonds, it may still be a little early to lock in or invest, but there will likely be a sweet spot to do so later this year or in the first half of next year.

High inflation and higher interest rates seem like the obvious situation today, but this may shift in the not-too-distant future, so don’t go overboard with this investing thesis as it can turn on you. You want to be nimble.

The key message here is that we should not panic about runaway rate hikes. They will continue to rise, but it is also very likely that we will see rates fall shortly after the hikes stop. Maybe this rollover will happen by the end of this year or at some point in 2023, but being prepared for this scenario will allow for some investment opportunities and debt opportunities to be maximized.

Reproduced from Financial Post, July 12, 2022 .

Ted Rechtshaffen
Provided By:
Ted Rechtshaffen, MBA, CFP
President and CEO
tedr@tridelta.ca
(416) 733-3292 x 221

Market Commentary for June 2022

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Two Important Sources of Value – Stocks and Emotions


In May, the S&P500 dropped as much as 11% in the first 3 weeks and ended the month roughly flat.  In a month like this, and in a year like 2022, it is very important to start with investments that are valued at least somewhat reasonably, and then to avoid emotional decisions.  These two concepts form the theme of this months’ commentary.

There is a famous quote from author Mark Twain which states: “History doesn’t repeat itself, but it does rhyme.”

Famed investor Howard Marks used this quote in his most recent memo discussing the behavioural attitudes seen in bull and bear markets and lessons that can be learned from these ups and downs throughout the market cycle.[i]  Not since the COVID crash of 2020 have we seen such sustained downward pressure on the markets and in comparison, this certainly feels like a much different environment than just a couple years ago.

Even before COVID, some had referred to the decade long bull run as the “everything bubble”.  It wasn’t about picking winners and losers, but rather who was going to win the most in an environment full of optimism.  This often reached exuberance like we saw after the markets March 2020 low.

Market analysts and economists couldn’t help but draw comparisons to the early 2000’s tech bubble where euphoria had encapsulated everyone hearing about the gain’s others were making on their investments. In hindsight, taking stock recommendations from neighbors and taxi drivers was the sign of the end of those good times. It’s important to note that not all those companies during the tech bubble were bad businesses. I’m sure anyone would happily go back and invest in Amazon or Apple if they had the chance. The harsh reality that many learned at the time was that valuation matters.

If you could go back to the year 2000 and I told you about a company that over the next 21 years would nearly double their annual revenues, increase their earnings per share by over four times, and grow to have a market capitalization of $187 billion you would probably say this is a no brainer. Now what if I told you that had you bought at its peak in March of 2000 and held it until May of 2022, you would have lost 21% of your investment…This example refers to Cisco Systems (Ticker: CSCO) and although it’s just one example there are others like it.

Those who bought shares in Cisco did so believing they would manufacture and distribute key infrastructure to support the growing internet revolution and be an important player for years to come. Despite being largely correct, those investors (if any held on) would have lost 21% of their investment in the company. At their worst, those investors would have been down almost 90% in that first two years as a shareholder. Over this same time period the S&P 500 Index generated a total cumulative return of 314%.

Source: Bloomberg.

Investors buying Cisco in 2000 did so when the company had a Price to Earnings (P/E) ratio, an important metric in judging a stocks valuation, of 382 times. In comparison, the S&P 500 Index has had an average P/E of about 15 times going back many decades.

The point of this example is to demonstrate that price matters. So far in 2022, 22% of the companies traded on the tech heavy Nasdaq have returned at least -50% since their highs. One would not need to look further than Cathie Wood’s Ark Invest. Wood gained notoriety during the pandemic as her flagship fund ARK Innovation ETF (Ticker: ARKK), which delivered extremely high returns for investors on the back of its bets on companies like Zoom Communications, Tesla, Coinbase, and others. At its peak ARKK traded at $132.50 and to the end of May 2022 traded at $44.57 for a loss of 66%. By no means are we implying all the companies held in this fund are bad companies but that buying even good companies at unreasonable valuations is not investing, it’s gambling.

Today we have seen firsthand, celebrities and social media influencers touting the next big “thing” whether that be a new cryptocurrency, NFT, or “meme stock”. We here at TriDelta are active managers whose focus is on generating a favourable long-term rate of return in line with your specific circumstances, always keeping risk in mind. To the end of May 2022, the TriDelta Growth and Pension Funds have returned -6.76% and +0.11%, respectively. In comparison the MSCI World Index, a collection of over 1,500 companies globally, is -12.86% for Canadian investors. We continue to focus on high quality companies at compelling valuations rather than letting emotion take hold and getting swept up in the moment. In comparison to the funds benchmark P/E ratio of 16.95, the TriDelta Growth and Pension Funds have a ratio of 10.78 and 14.79.

On the topic of emotions, one of the best ‘value adds’ provided by working with a TriDelta advisor, is keeping emotions in check in good times and bad. Russell Investments Canada developed a calculation to demonstrate the value of a full-service Canadian financial advisor and determined working with such an individual can add 3.85% to the value of a client’s portfolio, in large part because of their ability to coach behaviour in stressful times.[ii] We here at TriDelta make it our mission to have a deep understanding of what you are looking to achieve and ways in which we can help reach those goals.

Through comprehensive financial planning, investment management, and other services (TriDelta Family Doctor Model), we help you to manage the emotional responses to market volatility.

As we face future months like May 2022, we believe that our approach to value oriented investing and long-term planning will maintain your financial peace of mind.

[i] Behind The Memo: Bull Market Rhymes (oaktreecapital.com)

[ii] How much is a financial advisor worth to their clients? | Wealth Professional

 

 

 

 

 

 

 

 

Market Commentary for May 2022

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Why There is Reason for Optimism

In March of 2020 the markets suffered one of the steepest drops in recent memory. From peak to bottom, the S&P 500 fell 35%. In hindsight many people who had been through the Great Financial Crisis a decade earlier saw this as an excellent opportunity to invest, while others allowed doubt to creep up to the surface. Will COVID ruin the economy? How will Central Banks and Governments be able to support businesses large and small? What happens when a large portion of the population can’t go to work? How long will a vaccine take? Now, over two years later these questions have largely been answered and while uncertainty still remains around COVID’s impact on supply chains, long term health impacts, and lingering inflation, we find ourselves in a much different investing environment.

The Bad

So far in 2022 there have been very few places to hide. To the end of April, stocks are materially negative with the S&P 500 -12.14%, the TSX -2.17%, and MSCI World -12.35%. Bonds, historically a safe haven in times of declining stocks, have had one of their worst periods in decades with the FTSE Canada Bond Universe down 10.22%. Preferred shares have also been negative with the TSX Preferred Share Index down 9.29%. So, what’s behind the market’s latest tantrum?

Rising Interest Rates

There is a lot of uncertainty around rising interest rates at home and abroad. Rising interest rates have a lot to do with economic growth, and people and businesses have become accustomed to extremely low interest rates. As of April 13th, the Bank of Canada raised the overnight interest rate to 1.0% which has increased the interest rate consumers see on the Prime rate to 3.2%. This is up from 2.45% earlier in the year. As many have experienced firsthand, a rising interest rate means people are having to put more towards paying off their mortgage and other loans which leaves less disposable income to be spent elsewhere. This in turn can hurt companies’ sales and slow their growth which can cause them to reevaluate their own plans. These companies also take on debt to help run their business. Rising interest rates also have a direct impact on the bond markets. When interest rates rise, bond prices fall. Think of the bond investor who owned a bond paying 2.0% but that same company is now offering a similar bond for 3.0%. That investor is going to sell their 2.0% bond for the new one to lock in the higher rate. This also impacts a bonds yield. Bond yields are important because bonds are perceived as much lower risk investments relative to stocks. If the bond yield rises enough, it forces investors to consider if the expected return inherit in their stocks is sufficient to justify the risk. This hasn’t been much of a consideration the last several years because bonds were paying so little.

Ukraine/Russia, COVID, and Inflation

The ongoing conflict in Ukraine is also a key consideration for many businesses and countries globally. While the loss of life is tragic, this war also impacts countries who rely on Ukraine for the food they produce and Russia for the many metals and minerals they export. Not to mention the oil and gas which Europe had become so reliant on! This conflict and the lingering effects of COVID have continued to drive inflation. China offers an example of this in their Zero COVID Policy which continues to lock down millions of people in their homes in an effort to quell the rising cases. This in turn has impacted their trading partners who rely on manufactured goods from China creating even more scarcity in some of the goods we rely on. These factors have continued to make sourcing goods and materials very difficult for many consumers and businesses which have further driven higher inflation (evidently, less transitory than we were originally told). People are having to put more money towards their mortgage because of rising interest rates, spending more at the grocery store and the gas pump will drive spending patterns away from more discretionary purchases like a new car or home appliance.
Presently, Canada’s headline inflation rate is 6.7% while in the U.S. it is 8.5% versus the stated 2% target inflation rate. Key to the global economy will be whether these Central Banks can achieve a “soft landing” as they raise interest rates and unwind the pandemic stimulus to rein in this inflation.

The Good

While there certainly appear to be many negatives in the market right now there have been some standouts which have helped investment portfolios and offer positives for the economy overall.

Commodities and Alternative Investments

In any period, there are always those who perform relatively better than the rest. Today, hard assets like metals, oil and gas, and real estate have outperformed the broader market in general. At TriDelta we employ a diverse portfolio of Alternative investments which includes real estate. We recently hosted a webinar with three real estate funds which have performed quite well (TriDelta Financial – Webinars) and have helped to insulate portfolios from some of the broader volatility in the equity and bond markets. These three funds have returned +0.77% to +7.5% to the end of April. We continue to view commodities positively and as a diversifier for portfolios. Oil and gas (+49.10% & +120.28% year to date), already on an upswing, have been propelled higher by policy decisions to cut off Russian energy. Several metals have also been pushed higher due to the conflict and increased uncertainty elsewhere. Gold is up 5.09% since the start of 2022.

The Consumer

Unemployment in Canada and the US continued to fall to historic lows at 5.2% and 3.6% respectively. A strong labour market has continued to propel wages higher.

The Value of Active Management
We continue to place an emphasis on active management for investment portfolios. Equity markets have generally not performed well. In terms of Canadian dollars and to the end of April the returns of various markets are as follows:

Here at TriDelta we have two equity funds managed by our Head of Equities Cameron Winser that have outperformed many of these broader markets. To the end of April, the TriDelta Pension Equity Fund has returned -1.14% and the TriDelta Growth Fund -6.44%. While we never pretend to know what the markets will do tomorrow, next week, or next year, we see these portfolios as being well positioned moving forward to capitalize on the increased volatility in the market. Both funds remain highly active into the start of this year and have hovered between 10% to 12% in cash to help take advantage of near-term opportunities. We think the performance of these two funds speaks volumes as to why active management is so important in times of market uncertainty.

Significant pessimism is actually a buy signal

We closely monitor market sentiment and see an extreme level of pessimism among investors. While we cannot rule out new lows, the short-term level of pessimism we are seeing suggests that the odds are increasingly skewed towards a market rebound. As Warren Buffett says, “be greedy when others are fearful”.   From National Bank research yesterday, came this nugget of information:  “Over the past 15 years, when our National Bank sentiment indicator signaled an extreme level of pessimism (which happened only 3% of the time), the S&P 500’s returns the following month were positive 80% of the time and averaged 4.2%. Over three months, it was positive 85% of the time, with an average gain of 8.5%. In short, while we cannot rule out new lows in the short term and we must monitor inflation closely, the level of pessimism we are seeing suggests that the odds are increasingly skewed towards a market rebound.”

So, What’s Next?

As mentioned above, no one can say with absolute certainty what the markets will do tomorrow, next week, or next year and anyone who makes those claims is not someone you would want to be associated with. No one can control what the market is doing or will do but what we can control is our emotion in times like today. Using history as a guide shows us that, over time, there have been more good days than bad and the key to seeing a favourable return is the ability to ride out the bad and stay invested with a long-term perspective.

The chart below shows that a $10,000 investment can become $2,933 by missing out on just 60 of a market’s best days over a 35-year period.

In times like today something we frequently hear is “I will invest when things calm down.” What people mean is they will invest once markets start to go up. The problem is that it is those first few days and weeks of significant recovery that get missed when you wait until “things calm down”, and that is precisely when someone can miss some of the very best days in the market.

“Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”
— Warren Buffett in his letter to shareholders, 2009

 

 

 

 

 

 

 

 

 

 

TriDelta Financial Webinar – TriDelta’s Up to the Minute Investment Thinking – February 17, 2022

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As the world turns, the conversation has meaningfully switched from the Covid-19 reopening to other areas of the market. In this webinar, you will hear about the investment impact of:
• Rising interest rates
• Rising inflation
• Global markets vs. North America
• Trouble in the Ukraine

We will speak to what TriDelta sees on the horizon and hear from TriDelta Portfolio Managers Cameron Winser and Paul Simon, and special guest Dana Love, Vice President & Senior Portfolio Manager at Dynamic Funds. They will discuss what we are doing to take advantage of these possible changes and where we think we are headed over the next 6 to 12 months.

Hosted by:
Ted Rechtshaffen, CFP, CIM, MBA, President and CEO, TriDelta Financial

TriDelta Q3 2014 Investment Report – Keeping the faith when the news is bad

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Executive Summary

5186232_s1Last quarter, our message was that Q3 is historically a positive quarter, but not as strong as Q1 and Q4. The message was also that we should expect to see our recent string of 1%+ monthly returns come to an end. Well it took until September, but it did indeed come to an end.

As the bad news from around the world seems to keep coming in, and people’s fears for the market escalate, TriDelta remains fairly confident in North American stock markets as we head into the fourth quarter. This isn’t because we are ‘fiddling while Rome is burning’. It is because:

  • corporate earnings remain strong
  • interest rates remain low (more on that further in our commentary)
  • the US economy is growing
  • you can buy BCE stock and get a 5.1% dividend that will grow every year or you can get a 5 year GIC at 2.5% that will not grow (and will get taxed more in a taxable account).

We recognize some of the challenges in the market and world, and are watching them closely but a big part of our job is to try to separate the meaningful information from the short term noise. For now, we believe that the meaningful information is telling us that stocks remain a better investment option than bonds or cash.

Two other notes on the month and quarter ahead. Only once in the past decade has a negative September been followed by a negative October on the Canadian and US stock markets. Of course, we all remember 2008 (sorry for reminding you).

As a final point, the broad US based S&P 500 has had a great run since March of 2009. However, within that run, the market has dropped 5%+ 11 different times, and each time has rebounded quite quickly and advanced further. As of this writing, for all of the noise, the S&P 500 still isn’t down 5% from its peak for a 12th time. While the TSX and other areas of the world were down more, the point is that these pullbacks are very normal, and we believe this is one more of them.

The Quarter that Was

The quick summary is decent numbers for bonds, a little weak for stocks, very weak for emerging markets, metals and mining and smaller cap stocks.

After a drop of 4.3% on the TSX in September, Toronto stocks ended the quarter down 1.2%.

The DEX Bond Universe saw a loss of 0.6% in September, and a quarterly gain of 1.1%.

Preferred shares saw small quarterly gains in the 0.5% range.

Both the S&P500 (US) and the MSCI World Stock Index had losses in September, and had similar quarterly returns with small gains of 0.6% and 0.4% respectively.

Currencies played a role in the quarter with the US dollar appreciating strongly against most world currencies and also to the Canadian dollar. Greater exposure to US dollar investments helped Canadian investor returns on the month. For example, while the S&P 500 was down 1.4% last month in US dollars, it was in fact up 1.6% on a Canadian dollar basis – for a 3% swing on currency.

How did TriDelta Clients Do?

Fortunately, most TriDelta Financial clients had a decent quarter.

Conservative clients did very well – with most up 1.5% to 2.5% on the quarter.

Growth clients were a little weaker – most were flat to slightly down on the quarter.

The reason that conservative clients did better was two-fold. Bonds and preferred shares outperformed most sectors of the stock market for the quarter, but within the stock market, large cap, dividend payers (outside of metals and mining) had solid returns, and these are the types of stocks that TriDelta owns in our Pension style portfolios. Of course, owning Tim Horton’s in Pension portfolios also helped.

Even in September, as the TSX was down over 4%, most of our Conservative clients (who are up between 8% and 10% on the year to date), kept September returns to a loss of less than 1%.

Over the long run Growth clients should outperform, but so far in 2014, our Conservative clients have seen better returns.

 

TriDelta High Income Balanced Fund

Some clients who are accredited investors ($1 million+ in investment assets or $300,000+ in household income or $200,000+ in personal income), have been able to invest in the TriDelta High Income Balanced Fund. This pooled fund aims to deliver high yields, and broad diversification, through stocks, options, and low cost leverage of bonds. Year to date the fund has returned just under 10%, and has been in the top decile (top 10%) of all balanced income funds in Canada. In Q3, the fund was up 0.7%. We are very pleased with the performance of the fund so far this year.

Pending legislation changes may mean that the Fund could be available to all non-accredited investors soon. We will keep you posted as soon as this change comes into reality.

Positive Dividend Changes Continue

We continue to pay close attention to dividend growing stocks. We believe that this is a strong part of long term, lower volatile investment success. Again this quarter we are pleased to say that there were no dividend declines, and the list of seven dividend growers are as follows:

Company Name % Dividend Increase Company Name % Dividend Increase
Home Capital +12.5% Emera +6.9%
Conocophillips +5.8% Royal Bank +5.6%
McDonalds +4.9% Verizon +3.8%
Bank of Nova Scotia +3.1%

The Quarter Ahead

10884799_sWe believe that interest rates are one of the biggest drivers of the market today, and the better handle we have on future interest rates, the better we will manage your overall portfolio. In summary, we believe that short term rates will rise in the US in late 2015, but only by a small amount. We believe that short term rates in Canada likely will track those of the U.S. – perhaps with some lag. We believe that long term rates in the US and Canada will remain fairly volatile, but could in fact move lower.

The basic message being that meaningful interest rate rises are unlikely to take place and that this helps guide our investments in two ways.

The first is that this will help the stock market as growth is encouraged by low borrowing costs.

The second is that long term bonds are a reasonable investment as well, and are not to be feared.

Here are 6 items driving our view of interest rates:

  1. “Everyone” thinks interest rates are going higher, but the market seems to be telling us something different. This can most easily be seen in the 10 year bonds in virtually all Western countries that have seen meaningful declines in 2014 – most notably in Europe.
  2. Yes it is true that Quantitative Easing will end by the end of this year, but US long term interest rates have actually fallen during most of the months that the US government has been reducing its bond buying. The noise about the end of Quantitative Easing has upset the market, but the reality is that long term interest rates may come down further from here. Don’t get caught up in the noise.
  3. Short term rates in the US are going to rise in 2015 – but it will likely be so small that it won’t make much of a difference? Fed Funds Futures currently give a 75% chance that the first US rate hike will be around September 2015 (still almost a full year away). There is a 50% chance of a second hike of 25 basis points (0.25%) by the end of 2015. IF both happened it would move the US Fed Funds rate from 0.25% all the way to 0.75%. This would mean that in 12 to 15 months, the US Fed Funds rate will still likely be at close to historical lows.
  4. Geopolitical risks (Russia, ISIS and Hong Kong) are providing a safe haven trade into bonds – especially in the US and Canada. This flood of funds into bonds is keeping interest rates low.
  5. As the largest debtor nation in the world, the United States doesn’t want to have to pay more on their own debt. Just like you want your mortgage rate to be low, imagine how much a country with $18 trillion of debt would like to have low interest costs!
  6. Household debt levels are significantly greater now than before the financial crisis. If the US Fed hikes rates prematurely, there is a risk of a recession.

Summary

While you don’t want to sift investment decisions down to a couple of numbers, we do feel that today, interest rates play a bigger predictor of future stock market returns than they have in a long time.

Fortunately for us, our view is that long term rates in particular, will be supportive of higher equity markets, particularly in the U.S., for the period ahead. Corporate earnings remain very important and have been largely positive of late, but we believe that low interest rates will also be key to continued earnings growth.

As an aside, investment markets tend to perform better from October to March than the 6 months that have just past. Let’s hope that trend continues.

May we all enjoy the beautiful fall colours that Canada provides, and remember to take time to be thankful for the good in our lives.

 

TriDelta Investment Management Committee

 

Cameron Winser

VP, Equities

Edward Jong

VP, Fixed Income

Ted Rechtshaffen

President and CEO

Anton Tucker

Executive VP

Lorne Zeiler

VP, Wealth Advisor

 

 

Why We Own Stocks

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With the equity market sell-off at the beginning of August, investors have been reminded once again that there is risk to investing in the stock market, but before hitting the panic button, it is worthwhile to review why we suggest allocating at least part of your portfolio to equities and why stocks are still likely to offer the best total return over the medium to long-term.

While some people have called the stock market a casino or worse, investors need to be reminded that each share of stock represents a fractional ownership of a business. When you buy shares of Apple, Pfizer, BCE or TD Bank, you are becoming a fractional owner in those enterprises. The value of that business is based on the future earnings and cash flow that those companies generate. Buying shares of good companies at a reasonable price has been and likely will continue to be one of the best methods of building long-term wealth.

The main reason that people have bought equities is to generate higher returns in their portfolio. This is called the Equity Risk Premium (ERP). The ERP represents the additional return that investors have earned owning equities over other asset classes. Historically, equities have provided a 4% higher return than bonds1 per year. If the investment is in a taxable account, that premium is even higher as equities generate capital gains and dividends, both of which are taxed at much lower rates than bonds (interest income). Please note though that the 4% premium is an average, meaning in some years the benefit will be much greater than 4% and in other years equities may earn a lower return than bonds or a negative return.

Inflation Hedge: While bonds offer security – a fixed coupon payment from issue to maturity date as long is there isn’t a default, investors bear inflation risk. This is the risk that if inflation increases, the fixed coupon payments from the bonds will have a lesser value, because these cash flows will not be able to buy the same amount of goods and services, i.e. have less purchasing power.

1727060_sSince equities are public companies, typically when inflation rises, these companies find ways to continue generating higher profits by raising prices and /or cutting costs. E.g. if inflation rises, Walmart, McDonald’s, Royal Bank and TransCanada Pipelines typically find ways to continue increasing profits (and potentially dividend payments to shareholders) through changes in pricing or cost cutting measures, thereby protecting the investor’s purchasing power.

Participate in Economic Growth: While economies do experience contractions from time to time, typically Gross Domestic Product (GDP) increases over time. As the economy expands, so should earnings of quality public companies (equities). Historically, these companies will generate more in sales and be able to increase prices during periods of economic expansion, and be able to reduce costs during periods of economic weakness, which should lead to higher earnings per share (EPS). Higher EPS typically leads to higher stock prices and often to higher dividend payments over time. In short time periods, particularly recessions, equity prices may decline even if earnings rise, but on a long-term basis, equities have been one of the best ways for investors to benefit from economic growth.

Low Interest Rates: While interest rates are expected to rise in the first half of 2015, we expect the increases to be small initially and the pace of the increases to be slow. Low interest rates benefit equities in a few ways: 1) relative attractiveness – institutions and individuals need to put their investment dollars somewhere. When interest rates are low, the relative attractiveness of stocks, particularly those that pay a dividend, is greater, i.e. when your choices are investing in a GIC paying less than 2%, and a government bond paying less than 2.5%, investing in stock that pays a 3% dividend and offers the potential for capital gains is quite appealing. 2) enhanced earnings – with low interest rates, companies need to devote less of their revenues to debt payments, which enhances profit margins and overall earnings. Higher earnings typically leads to higher stock prices. 3) Share buyback – many companies are using their savings on debt costs to buy back their shares on the market. If the number of shares outstanding decreases and earnings remains relatively the same, earnings per share (EPS) improves as well. From Q2 2013 to Q2 2014, U.S. companies bought back approximately 3.3% of their shares outstanding2; these share repurchases increased earnings per share.

While we do not expect equity returns similar to 2013 or 2014 in the year ahead, we still expect equities to outperform other asset classes in 2015. Because of their many benefits, equities should remain a key part of each investor’s portfolio over the long-run.

The overall percentage of equities to own in an investment portfolio, and the type of equities to hold (large capitalization vs. small capitalization, developed market vs. emerging market) are best determined by meeting with a trusted investment counsellor and /or financial planner. A trusted planner reviews their clients’ income and cash flow needs as well as taxes to determine the clients’ needed rate of return. An investment counsellor analyzes investments to determine the best return prospects relative to each investor’s willingness and ability to take risk in his investment / retirement portfolios.

 

[1] http://www.seeitmarket.com/quantifying-equity-risk-premium-13202/. Quantifying Equity Risk Premium, Allan Millar, January 30, 2013. Based on S&P500 Index return vs. U.S. Government and Corporate Bond Indices. Data set from Ibbotson 1926-2010.

[2] http://www.factset.com/websitefiles/PDFs/buyback/buyback_6.18.14. FactSet Quarterly Buyback S&P500, June 18, 2014.

 

Lorne Zeiler
Written By:
Lorne Zeiler, MBA, CFA
VP, Portfolio Manager and Wealth Advisor
Lorne can be reached by email at lorne@tridelta.ca or by phone at
416-733-3292 x225
Cameron Winser
Written By:
Cameron Winser, CFA
VP, Equities
Cameron can be reached by email at cameron@tridelta.ca or by phone at
416-733-3292 x228
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