The final quarter of 2017 brought even more capital appreciation to our investment portfolios as U.S. tax cuts improved corporate earnings estimates and pushed stock prices higher. I won't hesitate to say that I am concerned that market valuations are becoming overextended. The challenge of the year ahead is to remain positioned for strong upside capture while being defensive enough to avoid some of the potential downside.
Market commentator James Grant (a favorite of mine) likes to say “the market wants to trick us.” He means that financial markets tend to produce paradoxical circumstances that lead to unexpected outcomes. Longtime readers of this space know that the main paradox in the current environment is the continuance of extremely low interest rates. Today we have almost full employment, a growing economy, record stock market prices and… depression level interest rates. (Rates are rising in Canada and the U.S., but very gradually and are projected to remain very low.) "Something has to give," a reasonable person might conclude. We know from experience that financial markets will follow their own elusive logic without consulting us.
The case for even higher stock prices depends on inflation remaining contained despite higher levels of growth and employment. Here the impact of technology cannot be overstated. “Stuff” purchasable from Amazon, Wal-Mart, Expedia or Canadian Tire remains highly affordable for most people. Rising house prices are an issue for some (especially in Toronto), but so far the impact has been to produce a “wealth effect” that supports consumption. I keep a close eye on wages and also on apartment rent prices in major North American cities. So far, no big worries. People forget that consumer price inflation rapidly causes pain of a sort that policy-makers cannot ignore. If inflation remains low despite ongoing low interest rates, then I predict the stock market stays strong. In fact, if people who have been watching this market from the sidelines jump in now, then we could see some of the “mania” that bull markets can create.
I’m looking for undervalued stocks that include a measure of safety as part of their appeal. Complimenting this strategy is a commitment to owning the growth-oriented technology stocks that continue to transform our lives. I see the biggest market risk to be in corporate bonds, which yield little interest but carry considerable downside price risk. My intention in 2018 is to find maximum total return within the confines of scrupulous risk management.
Mark Lloyd, Ph.D.
Vice President & Portfolio Manager