2015 Year End Review

White Nuckles!

As I am writing the epilogue to a challenging 2015, I am listening to the talking heads on business networks forecast “volatility” in the markets for 2016.

“Volatility” is a good word to use when you don’t have a clue. And believe me, pundits do not have a crystal ball. Nor do we. But we do know what we can’t know – and that’s the future – which is why we will never be accused of being forecasters.

We are, however, challenged each quarter to make our best-guess assessments in order to do the job that you’ve hired us to do.

In 2014, we saw a weakness in preferred shares – which many considered a safe harbor – and avoided that sector. (You can read our post at http://ex-ponent.com_live/preferred-shares-often-misunderstood/) True to our call, preferred share investors saw a decline in their index (CPD) of more than 20% in 2015.

But 2015 was a tough year to make money almost anywhere you looked.

Stocks were down, bonds did poorly – with corporate bonds losing money in both Canada and the U.S. – and commodities faced another rough year, finishing in negative territory again.

The best choice for 2015 was “ABC”— anything but Canada. The sinking loonie helped boost returns for investments in markets outside of Canada.

The volatility of the markets was kind to our options portfolio, as well.

Looking Back

Two years ago, the consensus market forecasts were that (1) interest rates were going to rise; (2) the Chinese market was headed for a slowdown; and (3) the oil patch would be Canada’s economic leader.

None of those forecasts came true in 2014, and only one – weakness in the Chinese market – finally came to fruition in 2015. But bonds have continued to languish and so has Canada’s oil patch. Market cycles come and go, but market shifts often take much longer to take shape than expected.

In this quarterly installment of our market review, we will share with you what moved the markets here in Canada, in the U.S. and around the world.

We will also look at commodities and bonds and take a look forward to some of the key trends that we will be monitoring in 2016.

We’ll also tell you why we think we will make money again in 2016. There’s a good investment somewhere; our job is to find it for you.

2015 Market Highlights

China Slows Down

The big story in 2015 was China, whose economy was finally showing some cracks.

The economic slowdown in China caused ripples across all of the world’s markets, negatively impacting every key equity index. After a rocky third quarter, most of the world’s markets limped through the 4th quarter, ending the year with sluggish results.

Bonds a No-show

Bonds finally perked up and showed some life in the 3rd Quarter of 2015 in response to the turbulence in the equity markets. But as stock prices settled down, so did the bond market, retreating slightly to end the year with a negligible gain for government bonds.

Oil and Commodities Still Heading South

There was no relief in the oil and commodities market. Prices continued to collapse throughout the year, sliding still further in the 4th Quarter. Motorists are enjoying the lowest gas prices in years, but energy and commodities stocks have dropped through the floor.

Canada Markets Remain in a Deep Freeze

The plunging energy and commodity prices continued to have a negative impact on the Canadian economy and the markets throughout the year, including the 4th Quarter.

Bolstered by Our ABC Strategy

Our shift in assets to “Anything But Canada” helped boost our portfolio returns as the loonie continued to dive. The U.S. Market (S&P 500) was up just 1.4% for the year in USD, but it was up 20.7% in CAD terms.

After a summer rally, the European markets were hurt by the Chinese crisis in the 3rd Quarter and limped home through the 4th Quarter with a 3 percent decline for the year in USD (but a 10% gain in CAD).

 

4th Quarter 2015 Market Drivers

 

1      U.S. Markets

The following chart shows the market advances and declines for the S&P 500 throughout 2015. The blue line represents the start of the fourth quarter of 2015.

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As the chart illustrates, the U.S. market rallied during the 4th Quarter after a sharp drop in the 3rd Quarter during the Chinese crisis. In CAD, the S&P500 returned 20.7% for the year and 11.2% for the fourth quarter.  In USD term, the returns were 1.4% (so essentially dividend returns only) for the year and a 7.0% gain for the quarter.

Year of the FANG.  The U.S. market was led by four of the leading internet stocks (nicknamed “F.A.N.G.” by TheStreet’s Jim Cramer). The four tech powerhouses include Facebook, up 31% for the year, Amazon, up 111%, Netflix, up 128%, and Google, up 46% for the year.

Their performance helped keep the S&P 500 in positive territory. As the chart below demonstrates, an equally-weighted index (all U.S. stocks valued the same in the index) was down 2.2% for the year:

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The following charts display the “forward price earnings ratio” (current stock price divided by projected earnings 12 months out), “earnings yield” and “forward earnings per share” for the S&P500:

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1.1   Valuations

The good news of this market pull-back is that stock valuations have become much more approachable:

  • For 2016, the consensus is that the S&P 500 companies will earn $128 per aggregate share – even after weighing in the effects of a strong USD on U.S. multinationals and the negative market drag from the depressed energy sector.
  • The forward PE hit a five year high of 17, but ended the year at 15.7, which is closer to the historic median of 14.66. (You have to go back to the late ‘90s for a time when the forward PE ratio was consistently above 25).
  • The middle pane of the graph box above compares what each shareholder in the S&P500 would earn per share based on the earnings of the index.  This is known as the “earnings yield” and it allows investors to compare the market price and the yield on bonds.

In this case, owning stocks would yield 5.18% as compared to just 2.27% for ten-year government bonds.  This comparison shows that stocks still earn more than twice the yield of bonds, and thus continue to represent a relatively solid value.

What this tells us is that if we are going to see a significant market downdraft in stock prices, it will not be because stocks are overpriced, but rather due to unforeseen external forces.

1.2   Earnings

The bottom portion of the graph illustrates the expected earnings of the S&P 500 index.  In short, the growth has been fantastic for the past five years.  But you can see that the pace of the growth in earnings is waning.

  • Investors are currently worried that earnings will begin to fall as a result of the sluggish global economy. China remains the elusive clue. Is that economy slowing down for the right reasons as they move to a more consumer-oriented based economy, or is the slow-down due to more far-reaching economic issues?

 

1.3   Risk Appetite

  • Keep your eyes on the 10-year bond yields.  Investors will continue to have an appetite for stocks so long as the risk-free return is below inflation.
  • Investors continue to keep an eye on the U.S. Federal Reserve for hints of rising rates.
  • Clearly, the risk appetite is diminishing for investors. In the short term, a market drop can be scary and even painful.  But we see it as an opportunity.  We raised cash early in August and earlier in the year to have on hand to deploy as prices declined.

 

2     Canadian Markets

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  • You can see the movement of the TSX above.  The total return for the Canadian market has been down 1.3% for the quarter and down 8.3% for the year if we include dividends.
  • We continue to be of the opinion that if oil prices stay at these lower levels for a long period of time, the damage to the economic growth will be noticeable. Oil prices are set at the margin between the marginal buyer and seller.
  • Right now political instability in Iran and Saudi Arabia has created a paradoxical situation that has continued to drive down oil prices.  Both Iran and Saudi Arabia are in a situation in which they must pump more oil to fund their economic and geo political initiatives.  Not known for their diplomatic talents, these countries seem intent on making a difficult situation even worse for oil producers.
  • Closer to home, we are of the opinion that a large bankruptcy or merger is usually linked to lower prices that reduce supplies in the market place. Although this has not yet transpired, we are of the opinion that low oil prices will persist for at least another quarter.

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Above is our familiar look at the TSX from a fundamental level. The top pane of the chart looks at the PE ratio (what investors are willing to pay for a dollar of earnings). In the past five years, when investors were giddy, they paid up to 19.5X, and now they will pay about 12.5X.  From a historical valuation perspective, this is relatively low.

When we compare this valuation to Canadian bonds, we can see that the earnings yield that investors are receiving has not peaked; we are still at a level of 5% or so.  But when you compare that earnings yield to the 1.4% yield on a 10-year Government of Canada bond, it becomes very evident why investors are still enamoured with stocks. There are simply no acceptable returns available elsewhere.

The bottom pane on the earnings of the TSX paints a dismal picture. Earnings are down about 30% from their peak. We believe that companies that were able to hedge their exposure to falling currency values will soon benefit from those hedges.  Meanwhile, improved export sales due to a lower CAD seems inevitable, but these global economic shifts tend to take time.

In short, Canada is cheap and will probably get cheaper, with no catalyst for a change of opinion on that.  We continue to prefer exporting companies, especially those that can leverage the lower CAD costs as well.

3    Foreign Markets

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  • Above is the Morgan Stanley index that represents Europe, Australia and the Far East; the return is flat for the year after a small fourth quarter rally.
  • The rising USD is causing a problem for many Asian economies as their commodity input costs are priced in USD and thus not benefiting from the full benefit of lower prices. That imbalance keeps their export prices less competitive versus domestic U.S. manufacturers.
  • One of the primary hurdles in our eyes is that many emerging companies and governments have issued debt in USD. As the USD marched forward in 2015, interest payments in local currencies rose in step with the rise in the USD. Those higher payments can be a drag on these economies.  The more they pay in interest, the less they can contribute to the global economy.

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  • As the above chart illustrates, Europe was not immune to the global downturn, with a drop of about 3% in USD terms.  In CAD terms, Europe was up about 10%.
  • Europe is in the second year of its turnaround from a stock perspective.  We have some tweaking to do on that front, but our thesis remains intact.  We expect to make money in Europe well before we see a recovery in the Canadian market.

 

4    Bonds and Interest Rates

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  • The above chart of the U.S. 10-year bond shows massive volatility throughout the year. But it was all motion and no action. By year’s end, yields were only slightly higher than they were as the year began.
  • We would not be surprised to see a march upwards in yields here towards 2.75% or even 3% by this time next year.

The chart below from the Bank of Canada shows bond yields throughout the year:

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  • By comparing the bond yields of the 10-year Government of Canada chart above and the U.S. Government bond chart we showed earlier, you can see why our loonie is getting shot down in the sky. U.S. bond owners receive a substantially higher yield – and a currency that is appreciating.
  • This situation is not about to change soon. The low loonie will be with us for a while yet. We would be surprised (and actually a bit concerned) if our 10-year yields moved above 2% in the next year.
  • Ramification for all investors is that these low rates are pushing us towards taking on more risk in the equities market.  By now, we are beginning to sound like a broken record on these last two points.

 

5     Commodities and Currencies

Below is a table of currencies and commodity prices provided by National Bank Financial:

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As the table illustrates, energy and commodity prices have continued their downward spiral:

  • All the currencies are losing ground to the USD in 2015.
  • The numbers tell the story – commodities are weak, the USD is strong and global trade is slowing with the only bright spot being the U.S. economy.
  • This difficult commodity landscape is the reason we are very bearish on the Canadian economy and currency. We do think the worst is over in terms of our CAD losing value to the USD.  We might even see a counter cyclical rally during 2016, but nothing to change the overall downtrend. Remember, just because something is cheaper than it was a year ago doesn’t mean it’s worth buying.

 

6     Options

The following VIX chart measures the volatility of the S&P 500 on 30 day rolling periods.

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A few remarks:

  • Volatility has finally spiked.
  • Our option portfolios will benefit from higher premiums which should bolster fourth quarter returns.
  • Our strategy aims to convert market volatility into tax advantageous income by selling options and thus collecting option premiums.  The higher the volatility, the higher the option premium we collect.
  • When the VIX is above 16, that is when we see better performance from the option accounts vis-à-vis our conventional accounts. Since September, we have seen good option premium rates available to us.

 

7     Our Opinion

  • We continue to adhere to our base case investment thesis: We are seeing a replay of the 1990’s – low commodity prices, strong USD, and economic growth led by the U.S..  Clearly, the U.S. stocks reflect this.  Much like the 90’s, this period can last many years.
  • Our investment thesis for Canada is also much like the 90’s, but with the fiscal problems of the federal government replaced by the fiscal challenges of the provinces and the municipalities.  These problems are largely tied to an ageing population that is putting pressure on health care costs and pension obligations, combined with an ageing infrastructure system.  The Canadian consumer and housing markets are overextended, and the only thing keeping this train moving is historically low interest rates.
  • The low level of the Euro continues to benefit European based multinationals.  While not the screaming bargain they represented a year ago, the values are still very compelling.  The recent market softness should be viewed as an opportunity to redirect funds into these names.  We are even seeing signs of internal demand from European economies as well.  Like the U.S., Europe can self-sustain its economy to a certain extent.
  • We have become increasingly interested in areas such as personal technology, health care, specialized manufacturing and the internet.  Their growth is being driven by cyber security threats as well as technological advances in a vast swath of areas from manufacturing to large scale engineering projects.
  • We have to realize that technology and globalization have made economic activities much more price-sensitive. Your business can be replaced by a company half way around the world—or even by a new application.  So we look for companies that have pricing power, either through marketing, market dominance or sheer engineering knowhow.  We believe that investing in these types of companies (most happen to be outside our borders), offer us the best opportunity to help you achieve your financial goals in 2016.
Benoit Poliquin

About Benoit Poliquin

President & Lead Portfolio Manager

Benoit is responsible for the portfolio management and research efforts at Exponent. He is a member of the CFA institute and the CFA Society of Ottawa along with being a Certified Financial Planner in good standing.

Learn More About Benoit

Exponent Investment Management