Stocks – Cyclical Behaviour
“What is right is not always popular and what is popular is not always right.”- Albert Einstein
“It is impossible to produce a superior performance unless you do something different from the majority.”- Sir John Templeton
Geopolitical events continued to make headlines this quarter but did little to quell investors’ enthusiasm as markets continued to advance. Russia and the Ukraine managed to agree to a temporary ceasefire just as sectarian violence in Iraq exploded driving oil prices higher. China garnered attention with its hegemonic designs on the South China Sea much to the displeasure of Japan and Vietnam as well as pushing back on any pro-democracy desires in Hong Kong. In addition, Argentina once again threatens to default on its debt after losing a Supreme Court decision to creditors in the US.
The impact of the events in Iraq and the Ukraine spiked investor enthusiasm for energy stocks in Canada and the US. The industrial sector in Canada was also strong as the railroad stocks continued their ascent as economic conditions improved. Materials also posted strong gains as mining stocks in both precious and base metals performed well. Globally, investors’ confidence generally gained momentum with the exception of Europe where fears of economic stagnation grew. It was a surprise when the first quarter GDP estimate in the US was revised down to a dismal -2.8% following an initial estimate of -1.0% as a result of severe weather and curtailed spending.
|Toronto Stock Exchange||6.1%||6.4%||12.9%|
|91 Day T-Bill||0.2%||0.2%||0.4%|
* Europe, Asia and Far East Index
** Canadian Bond Universe Index
As North American markets achieve new highs, we note that it has been a nice ride for equity investors since the depths of the market decline in 2008. In this context, it is prudent to exercise some degree of caution in this environment, as markets tend not to continuously climb, as economies do not continuously grow. We do not pretend to know when, or if, there is going to be a correction in the near term. However, we see some signs that could potentially lead to a pullback.
Retail participation in the stock market has been accelerating over the past year. Overall, equities are now overweight in investors’ portfolios particularly in Europe where fixed income offers little return. There has been a noticeable recovery in the number of Initial Public Offerings (IPO’s) and merger activity at the corporate level has also increased. The number of investors utilizing margin (debt) to increase their equity exposure has also risen.
Propelled by the low interest rate environment, debt levels continue to soar in both the public and private markets. Concerns about consumer debt levels in Canada and the UK have been met with ineffective jawboning from the Canadian government and some restrictions on high ratio mortgages in the UK. In Europe, deflationary fears have caused the central bank to move to negative rates in the hope of maintaining positive growth in the economy through investment and spending. European authorities fear of slipping into a prolonged deflationary period like that of Japan following such massive credit expansion must be influencing their decisions. David Stockman, a former Director of the Office of Management and Budget in the US, remarked: “How could any adult believe that a benchmark rate cut of 10 basis points from an already microscopic level of 25 basis points, move the needle in an economy with $60 trillion of public and private credit debt?”
This appetite for equities is occurring in a slow growth, low interest rate environment. In the US, GDP forecasts for the year have been sharply curtailed following the drastic revision to the first quarter estimate. Canada’s growth will be directly affected by the lower US growth. Low interest rates have pushed investors towards higher risk equities particularly in the last year where smaller capitalized securities have dramatically outperformed their larger brethren. Official inflation appears to be at low levels to anyone who has lived through the last few decades, but the trend suggests some acceleration in the last few quarters. From a valuation perspective, multiples are on the high side, although not dramatically so as the profitability of companies has gone up. Despite the slow growth in sales during this recovery, profits have improved largely as a result of tight cost control, share buybacks and more limited capital expenditures.
Stocks – So what should investors do in this environment?
Our view is that it would be prudent to take some profits in securities that have substantial capital gains. When markets are going up it takes discipline to increase cash positions. Cash can provide a good option to purchase good investments on any market setback. Despite attempts by governments to eliminate the cyclicality in economic growth, it will persist. Do not lose sight of your longer term investment objectives.
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The opinions expressed here are ours alone. They are provided for information purposes only and are not tailored to the needs of any particular individual or company, are not an endorsement, recommendation, or sponsorship of any entity or security, and do not constitute investment advice. We strongly recommend that you seek advice from a qualified investment advisor before making any investment decision.