“The market is the most efficient mechanism anywhere in the world for transferring wealth from impatient people to patient people.”

Warren Buffett

 

Stock markets around the world started off 2016 in a very bad mood but for no apparent “new” reasons. The same 3 issues that I highlighted in my 2015 review (Oil, China, US interest rate tightening cycle) were still ongoing concerns after the calendar turned but it was like everyone came back from their holidays in a fearful state. No doubt the theatrical release of The Big Short on Christmas day contributed to the market’s foul mood (spoiler alert, the movie doesn’t increase one’s confidence in Wall Street!). So on the first day back to work in 2016, the selling began and it was fairly unrelenting for about three weeks which made for one of the worst starts to an investment year on record. And then, on February 11th the markets turned around and made one of the best recoveries on record also to finish the first quarter about flat. In fact as I explained in my 2015 recap letter, this has been a very exhausting market now for the last 18 months with markets really going nowhere but chopping around more than we have become used to over the last few years. With global economic growth continuing to underwhelm and interest rates remaining stuck around all-time lows, Chicken Little is getting lots of airtime with much doom and gloom filling the airwaves.

So what caused the market swoon and recover in the first quarter? In my opinion it was a combination of oil breaking below $30 (with the threat of financial contagion) and all the talk about negative interest rates. Low oil prices were not a new threat (although the trip under $30 a barrel unnerved the markets), but the talk of negative interest rates making their way to North America was a new dynamic that caused some indigestion. Our capital markets are built on the premise of positive interest rates (lenders expect to earn a return on their capital) yet almost 25% of global GDP is currently under the rule of negative interest rates! In the February market bottom, more than $7 Trillion of government bonds around the world were priced to yield a negative return! Why would anyone lend money at a certain loss? The proverbial mattress safe (or gold bar buried in the backyard) sounds better than a certain loss doesn’t it? If negative savings rates are eventually passed along to depositors wouldn’t rational savers start pulling money out of the bank accounts? I think the debate around this unconventional central bank policy tool that already has been implemented in Europe and Japan is what really unnerved markets. While there are lots of things to worry about, negative interest rates in the USA or Canada are not on my list (as in, I don’t think we will see them).

While the US Presidential election in November and the possible Brexit (England is having a June referendum on remaining in the Eurozone) are overhanging issues that likely will continue to cause market volatility, there are several positives to point out.

Firstly, the Chinese economy looks to be stabilizing (although I expect additional currency devaluations against the U$ over time). And the threat of additional (and unjustified) interest rate increases by the US Federal Reserve has moderated from the 4 increases expected this year to perhaps just one or two. Not only is this a positive for stock market valuations but the moderating strength of the U$ has provided a lift for commodity prices. I have been on record stating that no country wants a stronger currency in this low growth world and while America tolerated a revaluation higher over the last 2 years, enough is enough! America cannot raise interest rates in isolation, especially when much of the world is lowering rates (or even going to negative rates). So with the drop back in the U$, commodities have strengthened this year and the Canadian market is in fact outperforming with our heavy resource weightings (gold and silver stocks have been especially strong off their multiyear bottoms!). Lastly, US oil production is finally starting to decline and likely to gather speed as capital budgets have been slashed over the last year. While some think oil will never go above $50 again because supply will come back at the first sign of price increase, others think we are setting up for much higher prices a couple of years out due to the massive cuts in exploration and development budgets over the last 18 months (and I think you know I am in the latter camp). Supply never goes down as fast as rational people think it should (selling every barrel for a loss but we are going to make it up on volume!) and on the other side it will take longer than expected to ramp up production again. Meanwhile in spite of all the talk around electric cars and solar power, the world consumes more oil each year than the prior year.

So while the last 18 months have been incredibly challenging and rather unrewarding for rational investors, I do think we are setting up for better days and focusing on dividend income is still a solid approach in my opinion. As an example, the most valuable company in Canada once again is Royal Bank (after Valeant Pharmaceutical’s spectacular collapse over the last 6 months). While last year RBC’s stock price declined just over 8%, after the 4%+ in dividend income that was paid into accounts, the net loss last year was reduced to about 4%. This is certainly not what we want as investors but reacting to the weakness would not be constructive either. And now that the stock price is back on the upswing, there will be a period that the stock returns more than we expect also (just like oil prices!). As the Warren Buffet quote implies, patience is more than a virtue, it is a necessity for successful investors.