Financial markets are experiencing excellent performance for the second consecutive year. This performance may be surprising, given the weakness of the economy and the economic outlook, which has changed several times throughout the year.

At the beginning of the year, markets rose sharply as investors believed that interest rates would significantly decrease in 2024 and that the economy would remain robust. This increase was largely fueled by the performance of technology companies linked to artificial intelligence.

Mid-year, the market eased off, almost no longer anticipating rate cuts due to the strength of economic data. Cyclical stocks declined, while defensive sectors such as consumer staples and healthcare took the lead.

Since early August, the market has reacted positively to economic data and a slowdown in inflation. Markets have made significant progress again, but this time, the gains are more evenly distributed among sectors, with different leaders than before.

In our recent financial letters, we argued that it would be wise to adopt a more aggressive strategy as inflation and interest rates peaked. Furthermore, about two years ago, investors were very pessimistic, which we viewed as a great sign; proving once again that our contrarian investment strategy often pays off.

Our portfolios are showing returns very close to their benchmarks in 2024. After significantly outperforming between 2021 and 2023, especially in 2022 when financial markets dropped by about 15%, we have recorded a high absolute performance in recent years, achieving a return of approximately double that of our indices.

Transactions in Our Portfolios

The beginning of the year continued the momentum that started at the end of 2023. At the start of the year, our ten largest positions were all at their highest levels in recent years. We began to find them expensive. While we still liked most of these companies, we took profits in certain sectors, notably energy and technology. We increased our cash reserves and defensive positions, such as healthcare, gold, and utilities. With the strong rise in the technology sector during the first semester, particularly in major companies linked to artificial intelligence, we underperformed in the last months.

However, between June and September, in the face of market declines, we purchased stocks that we consider affordable and capable of becoming leaders in the next market cycle. These new stocks include Raytheon, Wynn Resorts, and Medtronic. Other stocks that we sold earlier in the year were repurchased at lower levels. For example, our largest position at the start of the year, Salesforce, was sold at $310 in March and was repurchased at $236 three months later after a disappointing quarter. Currently, the stock is trading around $288.

Our largest current position is Uber, which we purchased for the first time at $30 in the summer of 2022, after their first good quarter in over two years, and that we have never sold. We have increased this position several times when the stock dropped for no reason, most recently in September at $68. It is currently trading at $81. These adjustments have paid off, as we have outperformed our benchmarks since the start of the last bull cycle, which began two months ago.

Economic Data

Economic forecasts change frequently during a year, but 2024 has proven to be even more volatile than usual. What is clear today is that inflation in developed countries has decreased to nearly 2%, after peaking at 7.9% at the end of 2022. This is the largest drop since the early 1980s, attributed to a return to balance between supply and demand following the pandemic. This slowdown in inflation has led to a decrease in interest rates worldwide, largely fueling the rise in markets.

This decline in interest rates appears to be happening slowly and orderly, as the American consumer continues to surprise with their resilience, supported by a high employment level and wage growth surpassing inflation. Moreover, they have been little affected by high interest rates, as only 11% of their debt is variable, with long maturities.

The American consumer remains crucial, representing 34% of global consumer demand. In comparison, the Chinese consumer, the second-largest player, accounts for only 10% of this demand. The latter is under significant pressure, as a large majority of their net worth is in real estate, which is at its lowest levels in nine years.

In Canada, the situation is more challenging than in the United States. Canadian GDP per capita has decreased by 5% over the past two years, while immigration has masked significant structural problems. Canadians are more affected by rising interest rates and show lower confidence. The savings rate is near 8%, its highest level since 1996 (excluding the pandemic). Additionally, the Canadian manufacturing sector has declined by 4% over the past year.

Although inflation has significantly decreased, we remain skeptical about a stabilization below 2% in the long term. We also doubt that the strong rate cuts expected (eight in the coming year) will materialize. The American consumer remains resilient, and the slowdown in inflation has been facilitated by a 10% decrease in gasoline prices over the past year. Central banks, on the other hand, will continue to monitor the situation closely to avoid a resurgence of inflation.

Fixed Income Returns

In 2021, we stated that fixed income represented one of the largest bubbles in history, with some bonds yielding less than 1% for 50 years. The following two years validated this analysis, with the sector declining by 20%. In the third quarter of 2023, we dedicated a financial letter to the opportunity in the sector, particularly for taxable accounts. This sector has performed well since then, thanks to falling interest rates.

However, we believe that most of this rise is behind us. In recent months, although inflation and interest rates have decreased, long-term inflation forecasts have remained stable. Moreover, a significant drop in short-term rates could reignite long-term inflation. The spread between corporate and government bonds is at its lowest since 2005, indicating that investors are too optimistic in this sector.

We continue to find discounted bonds with reasonable after-tax yields, but we are now more cautious, favoring short-term, high-quality securities.

Sector Rotation in Play

Financial markets, especially over the past two months, have regained confidence. This rise is supported by a cycle of easing interest rates, strong economic stimulus announcements in China, stable credit markets, and the presence of $9 trillion in money market funds worldwide.

Since July, much to our satisfaction, market leadership has shifted away from large tech stocks. We believed these stocks showed signs of a bubble, as seven tech companies accounted for 71% of the rise in the US market in the first half, an unprecedented figure. These companies are trading at 45 times their earnings, an unsustainable level, while the rest of the market is at less than 20 times. Less than 20% of stocks outperformed the US index in the first half, the lowest in 50 years. The index has effectively become a tech index, with 50% of its weight in that sector.

The market often forgets that there is frequent turnover among the largest global companies. For instance, 52% of the 500 largest companies in 2000 no longer exist. Over the past century, about 20% of the world's top 10 companies remain in that position 10 years later.

 

New leaders have emerged since July, and we expect this trend to continue. These sectors include healthcare, historically the best sector when interest rates decrease slowly, as well as certain cyclical sectors benefiting from the resilience of the American consumer.

Canadian stocks are expected to perform well in the next cycle. They are much more affordable than their American counterparts and benefit from a weaker Canadian dollar and the American consumer, as a large portion of their sales comes from the United States.

Data centers and electric vehicles are generating a significant increase in electricity consumption. It is estimated that electricity demand could double in 25 years, with 40% of that demand coming from data centers by 2030. If this materializes, new industries could perform very well.

Positioning of Our Portfolios