Tug of war
In our previous update, entitled The end of Quantitative Easing, we opined that the second shoe had officially dropped and that the equity market had finally lost its last major pillar of support, namely abundant liquidity. Developed equity markets have since seen ups and downs, in what seems to be a tug of war between positives and negatives. On the emerging markets side, the situation is a bit more delicate. Emerging markets indices have actually been flirting with bear market territory since last month. According to Mark Mobius, the well-known emerging markets guru (who recently left Franklin Templeton to start his own fund), emerging markets could lose another 10% before year-end.
What is supporting the US market now?
In a nutshell, it's earnings. To be more precise, it's the promise of stronger earnings, on the back of robust economic growth, lower corporate taxes and cash repatriation. Problem is, all three factors are temporary.
Yes, US economic growth remains on full throttle. However, this has been one of the longest economic recoveries in history. How long can it continue? There are genuine concerns that monetary tightening and a looming trade war will ultimately suppress economic growth. In any event, valuation multiples are now extremely high, suggesting that much of the promised earnings growth has already been priced in.
Secondly, while lower corporate tax rates will undoubtedly boost earnings in absolute terms, the impact will mainly be felt in the first year. Beyond that, the market will have to resume its dependence on organic earnings growth.
Thirdly, it would appear that the cash repatriated by corporations from overseas has been, or will be, mostly used for share buy backs and acquisitions rather than for capital investment or business growth. According to market research firm TrimTabs, US companies announced over US$ 400 billion worth of share buy backs during the second quarter of 2018. This number is almost double the amount of buy backs announced in the first quarter.
Now, share buy backs and acquisitions are great for equities: it reduces the supply of shares available in the market. However, again according to TrimTabs, investors dumped some US$ 50 billion of their equity holdings last June. Thus, excluding buybacks, net demand for equities during the month was negative. What is going to happen when buy backs slow down, particularly when all the cash brought back home is used, and corporate liquidity finally dries up?
The final stages
All this seems to suggest that, if it is not yet over, the bull market is now on borrowed time. That said, there are, as always, opposite views. For example, Citigroup's global equity team believes that the usual signs of a bear market are still scarce. For example, late-cycle bull markets are typically characterized by narrowing market breadth, i.e. when market gains narrow down to large cap growth stocks. According to them, we are not there yet, and therefore, short term corrections should still be viewed as buying opportunities.
Still, the long-term prospects remain patchy, particularly when we consider the short-lived nature of the cited strengths. According to Morningstar's Chief Investment Officer Dan Kemp, the expectation is that investors will not get any positive real return from US equities over the next ten years, mainly given unattractive valuations.
What about Canada
Here, the Bank of Canada (BOC) has just raised interest rates. David Rosenberg, of Gluskin Sheff, who does not share the BOC's opimism regarding the country's economic outlook, has been repeatedly warning against such move. Earlier in the year, Rosenberg had opined that there are too many uncertainties to warrant the market's high valuation multiples.
This view has been echoed by several analysts. A CIBC economist has recently warned of the sword of Democlitus, being the tariffs the US is threatening to impose on cars or other imports, which would be detrimentral to Canadian exports.
Regardless of your expectations, one has to always be prepared for the worst. For that, we gave a few suggestions in our previous update, namely:
First, keep enough cash for meeting your living expenses for the next few years;
Second, underweight US equities versus other markets; and,
Third, in terms of sector allocation, over-weight interest sentitive and defensive (consumer staples) sectors.
The above defensive measures would enable you to weather the storm, when it hits, with the least possible damage. Should the bull market continue raging for a few more months before it goes, you would still be getting some (albeit reduced) benefit from your reduced equitiy holdings while earning some decent dividends.
Our idea of an all-weather portfolio, i.e. one that can suit a broad range of possibilities, would consist of the following breakdown:
15-20% Canadian Equity
10-15% US Equity
10% High yield
25% Bonds (investment grade)
The above breakdown provides a 35%-45% exposure to equity, provided you do not exceed your Maximum Equity cap. This is conservative, but very commensurate with the current environment of tremendous uncertainty.
In terms of the equity breakdown, a slight bias in favour of Canada would mainly be justified by the fact that the Canadian market is less over-valued than the US market. Apart from that, the distribution between Canadian and US equity strikes a fair balance between the two markets, which currently differ in several respects:
On one hand, the TSX/S&P has a higher yield and carries a healthy exposure to Canadian banks (set to benefit from higher interest rates) and energy stocks (set to benefit from higher oil prices). With your Canadian component, you continue to ride the current momentum of higher interest rates and higher energy prices.
On the other hand, the US index is rich in technology, industrial and bank stocks, which have recently been among the best bull market performers. With the US component, you continue to ride the broad market rally, for as long as it lasts.
We advocate at least a 10% exposure to defensive, interest sensitive stocks. As elaborated in last month' update, the utilities, pipelines and REIT sectors have a business model that is inherently hedged to inflation. In other words, while you are exposed to the risk of higher rates in the short term, you are protected against such risk in the long-term, given higher rates are typically induced to combat inflation and most such companies are immune to it. In fact, we feel that, for retired investors who depend primarily on income, this should constitute a core component of their equity portfolio. As for more aggressive investors, it still offers some exposure to equity, with the expectation of moderate return from slowly rising dividends.
We also advocate a 10% exposure to high-yield bonds. This segment has already corrected by 10-15%. If we get a recession, the sector is likely to resume its losses due to higher default rates. Having said that, and barring a full blown trade war, we are yet to reach that stage and therefore, a good exposure to this sector will earn you decent interest income. Moreover, high-yield bonds tend to be more closely correlated to equities than to bonds. Thus you would benefit from a possible continuation of the bull market, albeit indirectly, and with moderately less risk. On that, please refer again to our take on high yield bonds.
The rest of the exposure is divided between cash and investment grade bonds. On that, we suggest splitting this exposure between US and Canadian fixed income instruments for several reasons: first, US fixed rate instruments carry a higher yield; second, the universe of US Dollar denominated bonds is much larger and offers more interesting opportunities; and third, some exposure to this universe offers a hedge against the risk of a lower Canadian dollar, particularly if the trade dispute with the US exacerbates.
What are the Risks
Like any other investing approach, this one is not without risks. The major one is obviously that of a full-blown bear market, triggered by excessive valuation and/or shrinking liquidity. We have partly mitigated that by proposing several measures, such as under-weighting equities in general, and over-weighting defensive stocks in particular.
Another major risk is that of a severe recession, triggered by a trade war or higher interest rates. That would crush both corporate earnings and commodity prices. In the short-term, technology, industrials, consumer discretionary and commodity-based stocks will all get hit simultaneously. Here again, your major mitigating factor would be your exposure to bonds and interest sensitive stocks. To fight recession, central banks will start reducing interest rates again and, who knows, if the recession is too severe, they might even bring back quantitative easing (Japan has done that before!).
A worst-case scenario could materialize if a trade war triggers both stagnation and inflation at the same time(i.e. stagflation). Cost-push inflation, triggered by tariffs, would suppress consumers' purchasing power and would prevent central banks from reducing interest rates. This would be similar to the stagflation of the seventies (caused by higher oil prices) which brought one of the worst bear markets in history. Under such scenario, both stocks and bonds would suffer and the only remedy would be high cash balances. Also, some exposure to the US Dollar would be a fair hedge against that risk. Still, this would be a lose/lose scenario for all. Hopefully the risk of that happening remains low for the time being, but this is a fluid situation that we will be watching very closely.
How to rebalance
The traditional rebalancing method, recommended by most advisors, is to reach a certain allocation and rebalance (to keept it) on a regular basis (say quarterly) based on market movements. There is a slight problem with this approach.
Suppose you have $1 million to invest and you have concluded that your most suitable allocation is 50% in equites and 50% in other asset classes. We will also assume that you are a fan of the FundScope approach and that you have capped your equity allocation at 50% because you need the remaining $500,000 to meet your living expenses for the next five years or so.
Now, what happens if your equity portfolio improves by 20%? Your portfolio size will improve to $1,100,000 while your equity allocation will improve from 50% to 55%. Should you reduce your equity allocation to bring it back to 50%? The point is: you still have most of your $500,000 in cash and bonds. Therefore from the suitability point of view, your increased equity allocation does not put you at a higher risk. So why unnecessarily reduce this best performing asset class and incur the additional expenses that come with frequent rebalancing?
In our view, portfolio rebalancing should happen for two reasons: suitability and market valuation. In terms of suitability, you should always review your cash needs to ensure you have enough of it to meet your living expenses, at least for five years (or more). On that, we will keep referring you to our Maximum Equity approach.
Regarding market valuation, and how it should influence your asset allocation, the concept is fairly complex but we will keep it simple for the sake of illustrating our point. How you do it in real life requires professional advice. Historically, the market's price-to-earnings (P/E) ratio has fluctuated, for most of the time, between 12 and 16 times. There have been many years during which the market valuation dropped below this level or exceeded it. There were even extended periods of extreme under-valuation or over-valuation. However, always, always, the market P/E ratio reverted back to its normal range.
Therefore, a sensible way to do it is to alter your equity allocation depending on market valuation. For example, if the market P/E drops below 12 times, you are now entering solid under-valuation territory and therefore you can start increasing your equity allocation for every one or two points of P/E changes. Likewise, when the P/E ratio goes above 16 times, you start reducing your equity component. However, all this should be done with one main caveat: never exceed the maximum equity allocation that you can afford, based on your cash needs. More on that in our next update.
July 15, 2018