ZOHAR LAZAR
In late August, U.S. President Donald Trump jumped on Twitter to boast. “Longest bull run in the history of the stock market, congratulations America!” he wrote. Unlike many of the President’s fevered dispatches, this one was grounded in reality. The Standard & Poor’s 500 Index had climbed for more than 3,400 days without a 20% correction, and it has kept going. The trouble is that the longer the U.S. bull runs, the greater the danger it will collapse and take other markets down with it.
It’s been a tumultuous year. The S&P 500 returned 9.4% to the beginning of October, but other markets have been flat (Canada) or negative (Europe and emerging countries). U.S. stocks benefited from corporate tax cuts and deregulation, while Canadian companies lagged behind due to worries about trade negotiations and competitiveness. But some money managers and analysts say Canadian equities stand a shot at catching up this year.
Unfortunately, there’s still lots to worry about in just about every major market. Yes, the new United States-Mexico-Canada Agreement (USMCA) has been negotiated, but other international trade skirmishes are verging on all-out war, interest rates are rising, and household debt is perilously high.
Key financial and economic warning lights continue to flash in the United States. Unemployment is low, factory capacity utilization is high, and inflation is rising—now between 2% and 3%. The yield curve on U.S. Treasury bonds is also flattening. The Federal Reserve has hiked short-term interest rates over the past three years, and they are almost as high as long-term rates. A flat yield curve usually portends a recession in the next year or so. “It tells you that most of the recovery is done, and the risk of overheating starts to become a bit more pronounced,” says Eric Lascelles, chief economist with RBC Global Asset Management. “A bit less risk-taking is appropriate, and that’s broadly what we’ve done over the last 18 to 24 months.”
Betting on the U.S. next year is also a wager that the country can win any trade war it instigates. That’s a dangerous assumption, especially when it comes to China, says Kristina Hooper, chief global market strategist with Invesco. “Both economies would feel a significant amount of pain,” Hooper says. “China could win because they have the ability to play a long game that the U.S. cannot.”
The Fed also intends to keep raising interest rates, which will put heavily indebted companies in peril. Colin Wong, a portfolio manager for U.S. equities at Calgary-based Mawer Investment Management, has been steering clear of trouble. “Most of the companies in our portfolio have below market leverage,” he says. “We want to be resilient in many different scenarios.”
Worries about U.S. stocks often prompt Canadians to retreat to their home market. “I definitely prefer being exposed to the Canadian market,” says Charles Marleau, president of Palos Management. A couple of major events this fall have bolstered confidence. LNG Canada, a joint venture of five multinationals, announced it’s moving ahead with a $40-billion liquid natural gas export facility in Kitimat, British Columbia. That was a sign to foreign investors that large energy projects still have a shot at getting built in Canada.
The other event, of course, is the new USMCA. Candice Bangsund, vice-president and portfolio manager, global asset allocation, at Fiera Capital thinks worries about trade will lift. “It’s fear versus fundamentals,” she says. “We think valuations are unfairly depressed, and we could see a nice pop in the Canadian stock market.” In particular, value-oriented sectors such as energy, industrials and materials could perform well.
Unfortunately, other traditional forces are not falling into place. In the past, Canadian stocks have performed well late in the U.S. economic cycle, as commodity prices climbed. “We didn’t see that this time,” says Stephen Lingard, a senior vice-president and portfolio manager for Franklin Templeton Investments. He suspects it has to do with Canada’s problems getting its heavy crude oil to market as a result of the lack of pipelines and rail infrastructure.
Other Canadian exports haven’t picked up as strongly as in the past, either. “This isn’t just in the past year, but more from a structural perspective,” says Beata Caranci, chief economist for TD Bank Group. The U.S. sources more materials from China and Mexico, and Canada has suffered a loss of business investment since the recession.
Like the Federal Reserve, the Bank of Canada is increasing interest rates—it began last year. Consumer debt levels are near record highs, so households will have to spend more to pay off loans.
Many money managers are worried about a possible real estate bust too, especially in Toronto and Vancouver. “We’ve been concerned about Canadian finances, so we just avoid some sectors generally,” says Felix Narhi, chief investment officer at PenderFund Capital Management. The firm has no exposure to Canadian banks, which could take a hit in a severe real estate correction, and avoids companies that are heavily dependent on domestic consumers.
Given the fears about North America, it’s natural to consider Europe or emerging markets. But there are dangers there as well. Britain is still negotiating its exit from the European Union, and a new populist government in Italy is pushing ahead with ambitious spending plans in defiance of European Union budget rules. “Worst-case, you get something that’s similar to what we saw with Brexit,” Bangsund says.
Emerging markets, meanwhile, have been pummelled as a result of a rising U.S. dollar and Trump’s bombastic trade rhetoric. “We’re a little underweight in emerging markets now, but I could see that changing next year,” says Lingard. Several things have to happen to make developing countries attractive again. The U.S. would have to dial back its trade threats, and the greenback would have to decline. That would ease the pressure on countries that borrowed in U.S. dollars. “There’s definitely some opportunity for those with better fundamentals, growth prospects and cheaper valuations,” Lingard says.
With so many risks ahead, investors may feel tempted to go to cash and sit next year out. But opportunities remain, and diversification across sectors, geographies and asset classes spreads risk. “The game plan for 2019 is you win by not losing,” says Brian Madden, a senior vice-president and portfolio manager at Goodreid Investment Counsel, which involves taking “modest and measured risk.” Investors should consider defensive sectors, such as utilities, pipelines and consumer staples, where companies are insulated from product cycles and commodity prices.
Investors nevertheless face a paradox. “A large fraction of cycle returns are generated toward the very end,” Lascelles says. “No one wants to be out early.” Ignoring the warning signs and getting out too late? That’s worse. /J.C.
Five things to fear
1) The crypto bubble bursts
Outside of bitcoin true believers, investment professionals generally have two views of cryptocurrency: confusion and derision. “It’s probably the greatest Ponzi scheme of all time,” says Brian Madden, a senior vice-president and portfolio manager at Goodreid Investment Counsel. The astounding boom in bitcoin and other cryptocurrencies can only be a speculative bubble, he says, but how and when it pops is anyone’s guess. Madden lays out a couple of scenarios. Coordinated action by regulators could stamp out bitcoin. Or large holders could cash out for traditional currencies, resulting in a loss of confidence and a death spiral. It’s enough to keep him away—not just next year, but forever. “I wouldn’t touch it with a 100-foot pole,” he says.
2) Canadians don’t buy that much legal weed
Many fund managers believe cannabis stock valuations are detached from fundamentals—licensed pot producers are trading at astonishingly high multiples of even the most optimistic earnings forecasts. If Canadians are not as enthusiastic about legalized recreational cannabis as the market assumes, a crash is a real risk. “More people are not going to smoke pot because it’s legal,” says Larry Berman, chief investment officer at ETF Capital Management. “It’s insane to believe that.”
3) Regulators crush Facebook
Tech stocks have soared this year, along with their valuations. “Some of these are priced to perfection,” says Charles Marleau, chief investment officer at Palos Management. The margin for error is non-existent, and an earnings miss can send share prices tumbling. Longer term, Facebook, in particular, could be in trouble. Regulatory pressure and privacy concerns could force the social media giant to change how it serves up user data to advertisers, hampering its ability to make money. After a year of bad press and Congressional hearings, Facebook can ill afford another mistake.
4) Interest rates spike
The Bank of Canada is slowly but surely raising rates. But they could move higher and faster than anticipated. “The pendulum doesn’t go from one extreme and back to some middle ground,” says Hap Sneddon, founder and chief portfolio manager of CastleMoore Inc. “It tends to swing all the way back to the other side.” An interest rate spike would hit indebted Canadian households hard as they’re forced to curtail spending, pulling down consumer stocks.
5) China goes “nuclear” on trade
The United States and China have already slapped tariffs on each other, but the trade fight could escalate. China has a monopoly on many rare earth metals, and banning sales to U.S. companies would hurt defence contractors and makers of smartphones and other key technology. China might even deploy the “nuclear option,” says Kristina Hooper, chief global market strategist with Invesco. China could curtail its purchases of U.S. Treasuries or sell existing holdings, driving up borrowing costs for U.S. governments and businesses. The impact is hard to quantify but potentially terrible for U.S. stocks too. “It could prove very painful,” Hooper says. /J.C.
ZOHAR LAZAR
Even the fearless can fail
After years of investing success, it’s easy for star fund managers to believe they’re invincible. But as these dramatic comedowns show, sometimes it’s wise to temper bold strategies with a bit of fear and caution.
BILL ACKMAN
WIN: Large holdings in Canadian Pacific Railway and real estate investment trust General Growth Properties propelled Ackman’s Pershing Square Holdings fund to a 40% gain in 2014, and its assets under management soared to more than $20 billion (U.S.).
LOSE: Ackman then went long on Valeant Pharmaceuticals and shorted Herbalife Nutrition. Valeant plummeted and Herbalife soared. After three years of losses and net redemptions by investors, Pershing Square now manages just $8 billion (U.S.).
JOHN PAULSON
WIN: In early 2007, Paulson was convinced that the overheated U.S. subprime mortgage market was going to blow, and he figured out a way to short it—buying credit default swaps. Correct on both counts, investors rushed to give him their money. By 2011, Paulson & Co. was managing $36 billion (U.S.).
LOSE: Several of Paulson’s large investments soon skidded, including Sino-Forest Corp., Citigroup and a gold bullion ETF that is still his biggest holding. Investors have fled his hedge fund, and its assets have shrunk to $8.7 billion (U.S.).
DAVID EINHORN
WIN: Einhorn started shorting Lehman Brothers shares in 2007, arguing that the investment bank had a huge exposure to illiquid real estate investments and wasn’t accounting for it properly. Lehman went bankrupt in September 2008.
LOSE: Einhorn’s Greenlight Capital hedge fund has lagged the Standard & Poor’s 500 badly since 2015. In the first six months of this year, it declined 18.3%, compared with a 2.6% return for the S&P 500, as Einhorn stubbornly maintained big short positions in his so-called “bubble basket” of stocks—Amazon, Tesla and Netflix. All have kept gaining. The fund’s assets declined to $5.5 billion (U.S.) this past summer from about $12 billion in 2014.
JOHN HUSSMAN
WIN: The articulate and still widely read Stanford University economics PhD correctly predicted both the 2000 tech bust and the big crash of 2008, and his flagship Hussman Strategic Growth Fund trounced the S&P 500 through both debacles. Investors stampeded in, and the fund grew to $6.2 billion (U.S.) in 2010.
LOSE: Hussman has been predicting another big crash almost ever since—he really is a perma-bear. Worse, he’s spent huge sums to hedge his fund’s portfolio. The stocks in the fund have performed well, but it has lost half its value since 2011. Investors have fled, and it now has just $324 million (U.S.) in assets. /J.D.
Hanif Mamdani: Leveraged loans are red hot—how can you protect yourself?
Mamdani doesn’t want to be called a bear, but his market outlook is far from rosy. The award-winning fund manager is head of alternative investments at RBC Global Asset Management, and he implements complex hedge fund tactics, including arbitrage, and strategies for profiting from mergers and other events. But he’s been playing it safe lately.
How would you characterize markets today? They are at a critical juncture as we transition from easy money brought on by quantitative easing to tighter money. Over the next 12 to 15 months, we could see as many as four more Federal Reserve rate hikes, which may bring us to the end of the tightening cycle. That’s when we could enter a bear market for credit and for stocks, and we may not be far from a recession. That’s not a firm prediction, but history has been a good guide. We’re clearly late in the cycle here.
So, are you a bear? I don’t want to sound overly bearish. The way to make money is to own pieces of good businesses over long periods. But it’s a paradox: You want to be responsible and careful, but to make money, you know you have to take prudent risks and, on balance, be long chunks of the market. Right now, though, U.S. valuations look particularly high, so it will be difficult to generate the kinds of returns we’ve seen over the past 10 years. At the same time, risk is building up in the credit system.
What’s the worry with credit markets? The leveraged loan market is red hot—loans are being issued with less and less in the way of covenants, and some aggressive capital structures are being financed. We could hit a default cycle late next year. That would bring wider credit spreads, which then cause future returns to suffer.
What can investors do? You can generate an acceptable return by buying bonds. In the middle of 2017, the two-year Government of Canada bond was yielding about 0.7%. It’s now at about 2.3%, which is a good starting point. Then ask yourself what else you can do. There are some corporate bonds with two years of term left that give as much as 300 basis points in credit spread on top of the two-year Government of Canada bond. Don’t go too far down the credit spectrum—stick to at least BBB—but you can assemble a portfolio of short-duration fixed income securities that can make you 4%.
What about cash? We have well over $1 billion in cash right now in a $6-billion portfolio, which is more cash than I’ve had in my 30-year career. Some of it is real cash, but a lot is in what I call smart cash—instruments that might mature within three to six months, or corporate bonds that have high coupons. We can anchor the portfolio on very safe stuff and earn a 4% yield. That gives us a margin of error to then take selective risks.
What other opportunities are out there? We’ve made money in the event-driven space, such as mergers, bond tenders, deleveraging transactions and divestitures. For instance, we bought about 60% of Aimia’s preferred shares, and did it at prices near $10 or $12. They’re $25 at par. We thought the risk-reward story was pretty good, even though it wasn’t clear what the end game was going to be for Aeroplan. The shares have since doubled in price. We also noticed that the U.S. regional banking space was down more than 10% over six months, while Canadian banks with U.S. regional exposure were up about 10%. Is there a divergence there? We could go long on some good U.S. regional banks and hedge our exposure [by shorting] companies here. That’s what we do—we try to exploit relationships that have gone askew. /B.B.
ZOHAR LAZAR
De-fence! De-fence!
The climb in North American stock markets since 2009 is the longest since the Second World War. How should investors worried about a crash protect themselves? “It sounds boring, but it really depends on your age,” says Moshe Milevsky, a professor of finance at York University’s Schulich School of Business. If you’re in your 20s, stand pat and weather the slump—you’ll have plenty of time to recover. If you’re near retirement age, it’s time to take precautions.
Buy more bonds The traditional advice as investors age: Reduce your stock weighting and go heavier on bonds. Of course, the trouble now is that bond yields are near historic lows, so consider using bonds to lower your risk in only the accounts that will supply your income. You can go higher on equities in other accounts.
Diversify Defensive investors shift out of risky sectors such as tech and into steadier ones like utilities. They do the same geographically—retreating from emerging markets to North America. But take care, because industries and regions are more correlated than they used to be. “You want a market that is not correlated with the S&P 500?” Milevsky quips. “Venezuela.”
Opt for cash instead of gold Gold used to be three things: a store of value, an inflation hedge and cash. Now it is more like a commodity—an unpredictable one. Cash pays no return, but holds its value in times of low inflation, and you can invest it following market dips. /J.D.
Stock picks of the pros
OSCAR BELAICHE
Senior vice-president and portfolio manager with Dynamic Funds | His focus: Equities—searching for growth at a reasonable price
You can argue that equity valuations are not that expensive, at least not like in 1999, and relative to fixed income they’re reasonably priced. The economy and earnings are growing. So, we’re underweight fixed income and overweight equities. We were in more defensive interest rate sectors, like REITs, utilities and pipelines, but unless we’re going back into a recession, these industries are not necessarily a good place. We’re diversifying into health care, which is defensive, but it’s growing.
Brookfield Business Partners (TSX: BBU.UN) | This company offers individual investors a way to play the private equity market. It buys companies, turns them around and then takes them public or sells them to others. It’s a small cap, but should keep growing.
Comcast (NASDAQ: CMCSA) | The U.S. cable giant has very depressed valuations because of concerns about online rival Netflix and higher debt from its recent purchase of Sky PLC. But Comcast’s share price should rise as the debt is paid off.
MARIAN HOFFMAN
Portfolio manager, Sionna Investment Managers | Her focus: Canadian large-cap and dividend stocks
The Canadian market had been trading at lower price-to-earnings and price-to-book multiples than the S&P 500. So, bizarrely enough, we’re feeling better now than we were a year and a half ago. We are seeing more volatility, but that tends to produce opportunities. We’re building defensiveness by being overweight consumer staples, though we are concerned about the over-levered Canadian consumer, so we’re underweight consumer discretionary and banks. /B.B.
CI Financial (TSX: CIX) | The asset management firm has strong cash flow and a conservative balance sheet. It recently cut its dividend, but did that to focus more on buybacks. That was prudent and opportunistic.
Saputo (TSX: SAP) | The Montreal dairy processor’s share price was hurt by trade uncertainty, but it’s one of the largest companies in its industry. With a healthy balance sheet and strong management, it will bounce back.
JONATHAN NORWOOD
Portfolio manager on Mackenzie Investments’ Cundill Team | His focus: U.S. value stocks
We’re in a classic late cycle in the U.S, but we’re not concerned. The names we buy are in sectors that do well late in the cycle. We’re staying away from distortions in the market, like those in high yield, certain areas of tech and marijuana in Canada. We’re also steering clear of Canadian banks, because of worries about the housing market. U.S. banks are trading at a considerable discount from Canadian banks. /B.B.
Wells Fargo (NYSE: WFC) | Scandals have caused the bank to trade at a steep discount to intrinsic value. Rising rates, better digital offerings and expense control will result into a higher return on equity.
Transocean Ltd. (NYSE: ROE) | Offshore drilling is in again. Rig and vessel rates are normalizing. The world’s largest offshore drilling contractor is the best of the bunch.