This was an unnerving and rather uninspiring year for stock market investors. Volatility increased and returns were unfortunately quite disappointing. The Canadian S&P/TSX Total Return Index was down 7.4% year-to-date, as of December 15, 2018. Indeed, most of the world’s major stock markets lost ground during the year, with German and Chinese stocks suffering the most, losing 15.6% and 19.2%, respectively. The only real saving grace for Canadian investors was the U.S. market; the S&P 500 Total Return Index was down 0.9% in local currency and up 5.8% in Canadian dollars.
Not surprisingly, the Odlum Brown Model Portfolio* had a tough year as well. As of mid-December, it was down 5.2%. Short of a meaningful year-end rally, 2018 will have marked only the fourth time in 24 years that our Model has had a negative return. While it would be nice to achieve positive returns every year, this is not a realistic prospect. In fact, we consider ourselves lucky to have averaged setbacks in only one out of every six years; whereas one in four is probably a more reasonable expectation.
It’s important to maintain perspective. Despite a down year in 2018, our Model has grown at a compound annual rate of 9.6% over the last five years, and 13.1% over the last 10 years. Meaningful exposure to the better-performing U.S. market over those longer horizons has helped generate returns that are significantly better than those achieved in the Canadian equity benchmark.
Politics, trade wars, high debt levels, less accommodative monetary policy, rising interest rates and worries about the length of the economic cycle are commonly cited reasons for the weakness in equity markets. While many of these concerns are valid, there are always things to worry about. A year ago, our newsletter was titled “No Storm Clouds on the Horizon” and in it we argued that the fundamental backdrop to the market was not worrisome like it was prior to the 2008/09 Financial Crisis. We feel similarly today. Interest rates are still relatively low, inflationary pressures are modest and while there are pockets of cyclical excesses in the world, we don’t see widespread imbalances. In general, we believe the global economy is in reasonable shape and growing, albeit at a somewhat slower rate in the face of higher interest rates.
Still, it’s important to acknowledge that fixed income and equity markets are sending signals contrary to our positive view and are behaving as if economic trouble is on the horizon.
Monetary policy has been extremely accommodative in recent years, and that has had a very positive influence on both the economy and asset prices. Unfortunately, monetary policy is not as supportive today. The U.S. Federal Reserve, and to a lesser extent other central banks, have gradually reduced monetary accommodation by raising short-term interest rates and moderating bond-buying programs. This shift in policy has caused the normally positive spread between long-term and short-term interest rates to narrow considerably. Investors are worried that the spread will turn negative, with short-term interest rates higher than long-term interest rates. Historically, that negative turn has been a reliable predictor of an economic recession.
Another indicator hinting of a weaker economy is the widening spread between the yield on corporate bonds and government bonds. The yield spreads on lower-quality bonds in particular have widened considerably. Corporations have issued a lot of debt in recent years to take advantage of unusually low interest rates and meaningful investor demand for investments that offer higher yields than government securities. Much of these borrowed funds have been passed on to shareholders in the form of dividends and share repurchases, rather than used to expand productive capacity. There has also been a general weakening of bond covenants in the face of robust investor demand. These factors have contributed to deterioration in corporate balance sheets and credit quality.
Many stocks are depressed and are behaving as if economic trouble is on the horizon. U.S. homebuilders and housing-related businesses in particular are priced as if industry profits are going to plummet. We don’t think they will, as housing is affordable and U.S. consumers are in good financial shape.
Canadian Energy stocks are trading near their 52-week lows and are valued as if domestic oil and gas prices will remain below the cost of production for an extended period, despite the fact that demand and supply are moving in directions that will ultimately lead to higher prices.
The shares of companies with above-average leverage have been hit especially hard, and we hold a couple of these within the Model. Present investor disdain for leverage is fairly indiscriminate, with shares of companies that are executing well and growing fast down meaningfully alongside those that are not.
Whether there is a turning point in the economic cycle on the horizon or not, our strategy remains the same. We believe in owning high-quality businesses for the long term. Our focus is, and always has been, three to five years, and we remain confident that the businesses we own will be bigger, more profitable and more valuable over our investment horizon.
We recognize that it is discouraging and worrisome when account values decline and headlines are negative. It’s natural to want to outsmart other investors and avoid market setbacks. Still, we firmly believe that those who try to time the market will do worse over time than those who accept volatility and remain invested for the long term, because investor sentiment and the markets are unpredictable in the short run.
While we don’t know whether investor sentiment and stock prices will improve in the near term, we can confidently say we are more optimistic than we were a year ago. Mathematically speaking, prospective returns are better when stocks are depressed and discounting tougher economic times, as is the case today, than when they are buoyant and foreshadowing a brighter outlook.
In our view, the political and economic factors weighing on the global economy are modest. Consequently, we believe any slowdown in global economic growth will be moderate. While concerns over corporate credit quality are valid, it is institutional investors who are most at risk, not the banking system. Banks are generally much better capitalized than they were prior to the 2008/09 Financial Crisis and thus the risk to the financial system and the overall economy is limited, in our opinion.
Prior to the Financial Crisis, there was opportunity to trade out of popular and expensively priced economically sensitive stocks when we were worried about the economic outlook. At this juncture, and similar to the situation in the late 1990s, many stocks are already discounting an economic setback. It didn’t make sense to sell in the face of uncertainty back then and neither does it today. Patience yielded rewards in the 2000s, and we think the same will be true over the next few years.
We wish you a happy and rewarding 2019.
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* The Odlum Brown Model Portfolio is an all-equity portfolio that was established by the Odlum Brown Equity Research Department on December 15, 1994, with a hypothetical investment of $250,000. It showcases how we believe individual security recommendations may be used within the context of a client portfolio. The Model also provides a basis with which to measure the quality of our advice and the effectiveness of our disciplined investment strategy. Trades are made using the closing price on the day a change is announced. Performance figures do not include any allowance for fees. Past performance is not indicative of future performance.
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