Monthly Partner Memo – March 2022

February 28, 2022 | Paul Chapman


Take comfort in the knowledge that your capital is being managed the way your friends complain they wish theirs was managed.

“Whatever you do, do it well. Do it so well that when people see you do it, they will want to come back and see you do it again, and they will want to bring others and show them how well you do what you do.” - Walt Disney

Disclaimer: Note that the contents of this memo are all my thoughts, and not the views of RBC Dominion Securities.

Friends & Partners,

Firstly, my heart bleeds for the people of Ukraine. If you want to help, the Canadian Red Cross has launched the Ukraine Humanitarian Crisis Appeal to respond to those affected by ongoing conflict in the country. Canada matches the donation for the first $10mm – you can give here. As well, the Canada-Ukraine Foundation (CUF) is active with humanitarian support for Ukraine (link here), and Save Life Foundation based out of Ukraine has been in operation since the events of 2014 (link here).

The market’s continued their volatility in February, and this is where investor fortitude really gets tested. We are wired to want to minimize our ‘risk’ and sell when things feel bad, and buy when things feel good. The problem is we should usually be doing the opposite. Interestingly, markets tend to look past conflict.

This past week, upon the Russian invasion of Ukraine, US Equity Markets staged the biggest one-day reversal on record. And was followed up by another rip-your-face-off rally. You can’t and won’t time these, so panicking is never a preferred approach. Trading around and whipsaw is the greatest enemy of performance – getting on the wrong side of trades has huge negative drag on a portfolio.

History may not repeat but it often rhymes. There always remain risks that are difficult (impossible) to predict, but geopolitical events are usually short-lived in terms of market weakness, and don’t spell disaster longer term:

Source: Mackenzie

Looking forward, the two key questions regarding the conflict are: 1) Does Russian and Ukrainian energy and commodity supplies get materially disrupted (meaning persistently higher inflation), and 2) Does the conflict spill beyond Ukraine? (i.e. if Putin attacks a NATO country, it will massively increase the chances of a major military conflict between NATO and Russia, and that would be a material negative for markets).

The overall outlook remains murky, and I’ve been calling for heightened volatility the past few months which has certainly played out in spades. And while there are always deafening calls for a new or permanent bear market on the horizon, we continue to advise that we adhere to our discipline and process. As well, there are a number of drivers that should continue to ultimately support the markets over the longer-term, which is our key focus. We build portfolios to weather the noise, preserve capital, and build wealth over the long term. “It isn’t investments that get tested in turbulent markets; it’s investors.” - Jason Zweig, Wall Street Journal

Lastly, I am honoured to have the trust put in me to manage a portion or all of my client’s savings. The position carries with it the responsibility to communicate and report to you what I would expect as a client, and I enjoy communicating directly with you through this memo. My clients know they can always reach out for a conversation, and that I am available all hours of the day, 7 days a week.

Thank you for your support and referrals, my practice has experienced some of the fastest growth ever at the firm. We've found that our clients' referrals have been the best way to continue to grow. We are selectively accepting new clients, so please continue to let us know if you have recommendations of long-term investors like yourself who would make a good fit for our wealth management approach.*

When It Comes to Investing, Don't Give Into Your Fear

Easier said than done, I know. Take this past week for example – Russia invades Ukraine, the market tanks out of the gate, things can only go lower, right? Who knows what will happen? You sell. Then, just your luck, the markets have a face-ripping rally in the following hours and days. The move higher has been much stronger than the move lower!

You could have said this in March 2020 too when Covid struck and markets imploded. Or the 2008 depths of the Financial Crisis, or many other times. We’ve seen this movie before.

How did it go if you sold out at those moments? You would have gotten paralyzed, and not understanding how the market kept ripping higher in the days afterwards. “The market has to be wrong” you tell yourself, and you can’t bring yourself to get back in, thinking “it will drop back to the lows for sure”. You would have evaporated significant wealth, and many have. Stats show that those who miss just a few of the biggest up-days materially underperform over time.

The outlook is always uncertain, but it rarely pays trying to time your way thru volatile markets. Anyone who says they can do this consistently is lying, and likely only got lucky once or twice.

Stay invested. Exceptional compounding over an extended period is extraordinarily powerful. That said, it is important to acknowledge that long-term and short-term investment performance can frequently diverge. Joel Greenblatt, the famous value investor, undertook a study of investment firms. One of the conclusions was that, of the investment firms with top quartile performance over a ten-year period, 79% of those saw bottom quartile performance in at least three of those ten years, and excellent long-term performance came with multiple periods of short-term underperformance.

Try not to lose sleep worrying about whether you ‘look’ foolish in the short term. No one is watching – except you. We employ obsessive work ethic, discipline and process, and focus our efforts on our clients and portfolio management. We partner with the best managers on the planet, evaluating the prospects of businesses we own and businesses we do not own with the goal of building a collection of high-quality companies at discounted prices. Alternative strategies are an integral part of the portfolio to not only add value over time, but to preserve capital and maximize risk-adjusted returns. This allows us, and you, to be able to sleep at night.

As Warren Buffett said, “games are won by players who focus on the playing field – not by those whose eyes are glued to the scoreboard.” Dedicate to the game and the score will take care of itself.*

Russia/Ukraine Conflict – What You Need to Know

This chart from my friend Brian Belski at BMO sums up the market impact and potential outlook well:

Source: BMO

To provide some context, Russo-Ukrainian relations in their current form dates back to the Russian annexation of the Crimean peninsula in February and March of 2014. The intentions were to gain further access to the Black Sea and underpin a strategic geographical advantage over an increasingly westernizing Ukraine. Ever since the annexation, there had been tensions in the Southeastern Provinces of Ukraine, where combat between Russian backed separatists and Ukrainian troops has resulted in a stalemate, until today.

Commodity prices may continue to get squeezed (Russia represents considerable commodity production which accounts for the world’s largest exporter of natural gas, wheat, and agricultural fertilizer inputs) and may continue to increase some inflationary pressures. Interestingly, Canada is heavily commodity-driven, so this isn’t entirely negative for our markets here.

Irrespective of the intensity of the geopolitical event, history tells us that instances of geopolitical stress have tended to trigger more short-term volatility than any sort of long-term trend reversal. This suggests that the global economy and markets are resilient to these types of events, and prevailing macro-economic trends continue to be fundamental drivers.

So, at this point, the majority of market impact is likely to be region-bound to Eastern European financial markets and could have a limited impact on global commodity prices moving forward. I’m not trying to diminish the terrible human tragedy that is occurring, and the plight of the Ukrainians deserves international support and assistance. But from strictly a market standpoint, as things stand now, we have seen the ‘worst-case’ scenario in the region so far. Point being, in the coming weeks, if Russia establishes a puppet government in Ukraine and withdraws its forces and ends the bellicose rhetoric, the fighting and the struggle will being to fade from the headlines and the markets will look past the event and refocus on the Fed (i.e. interest rate increases). And to that point, if there is one potential “positive” from this event for the markets, it may reduce the chances the Fed makes a policy mistake, meaning they raise rates more quickly than the market anticipates.

If you want to get smarter on the matter, there’s a more in-depth special edition report from RBC on the situation and the implications here. *

Should We Even Be Comparing Russia/Ukraine Conflict to Other Geopolitical Events?

While we understand the impulse to assess stock market reactions to other military conflicts, there may actually be other events that could be more useful reference points, as they reflect the complexities of the current climate more appropriately. Perhaps the most appropriate way to think about it is actually by comparing it to other growth scares that we’ve encountered since the 2008 Financial Crisis. There are 4 to consider:

  1. The European debt crisis of 2010
  2. The US debt downgrade of 2011
  3. The industrial recession of 2015–16
  4. The sell-off of late 2018 sparked by Quantitative Tightening and the China trade war.

Each one shocked the investment community with a previously unthinkable event of significant magnitude, and investors struggled to understand the implications for markets and the economy early on. All caused fears of recession to rise, though none resulted in an actual economic recession. The 2010 and 2011 shocks took place in the aftermath of a major crisis when markets still felt fragile in terms of the investor psyche. The 2018 China trade war was geopolitical in nature with ramifications for the global economy but also had the backdrop of aggressive Fed tightening layered in.

Those major growth scares have been accompanied by drawdowns of ~15–20%. All of these have represented buying opportunities, with strong rebounds averaging ~25–30% in the 6–12 months that followed. As of late February 2022, the current drawdown has reached ~12%, not quite in growth scare territory. On this basis, we could see some further volatility and downside, followed up by a very strong rebound in the coming months.


Source: RBC US Equity Strategy, Bloomberg 

Are We Nearing Peak Investor Anxiety?

Investor sentiment is the worst it has been in years (this is almost always a contrary indicator – i.e. people are selling at the lows when they feel most bearish about things). Investor sentiment is the lowest we’ve seen since early 2013, almost a decade ago, and worse than the depths of March 2020 when Covid railroaded us.

Source: AAII

We are close to capitulation levels that in the past have typically marked entry points for long-term investors. Based on this indicator, the S&P 500 has been up 15% on average over the next 12 months 86% of the time. And on a three-month forward basis, it’s been up 5% on average 84% of the time.

Source: RBCCM

And they’re also hoarding cash – this is eventual fuel for the market. Money market mutual fund assets total $5.5 trillion currently, that’s a big number…*

Are We Nearing Peak Inflation, Recession and Rates Hysteria?!

The yield curve tells us a lot about the state of the markets and outlook for the economy – it is the single most-followed indicator on this front. When it ‘inverts’, that spells trouble for the economy – months after this happens, we almost always enter a recession. But last during the eight major rate cycles in the U.S., equity market always peaked well after the yield curve inverted (10 months, on average), never before, and was only then followed by a recession 4 months later.

The yield curve hasn’t inverted yet, but we’re getting close. Inversions of yield curve lead US recessions by 17 months, on average. Interestingly, the S&P 500 can still log gains even once the yield curve inverts, as it typically takes time for losses to materialize. We aren’t there yet. Yield curve flattening doesn’t necessarily portend a weak stock market either, and this is where we are today. Despite common perceptions, flatter yield curves have actually been better for stocks than steeper ones. The S&P 500 has averaged a 10.8% annualized gain during past periods of prolonged curve flattening (11 flattening cycles since 1976, and only one resulted in losses).

So, investors are grappling with two questions:

  1. What’s the inflation outlook?

  2. Is the Fed willing to drive the economy into recession to choke off inflation (like in the early 1980’s)?

Interestingly, while core CPI (the main current inflation indicator) is skyrocketing, inflation expectations are actually quite subdued. It is also interesting to note that used car prices are off over 30% from their highs, and this accounts for ~1/3rd of the inflation readings in the US.

On the other hand, inflation spirals when wage expectations become aggressive (and people aren’t exactly taking many pay cuts these days). Wage growth expectations are usually quite sticky. And unless central banks can guide expectations back down, they may have little choice but to increase rates and induce a recession to crater wage expectations.

But there are a number of signs pointing to slowing inflation pressures and employment growth potentially cooling in the coming months. Economic growth is set to cool somewhat, and retail sales trends are softening, foreshadowing a job market slowdown finally. This may help some pressure off central banks to tighten as well.

Regardless, we are certainly going to see an increase in interest rates. Equities typically showed some volatility around the start of Fed hikes as we’ve seen, but tended to make new highs within 6-12 months.

Source: JP Morgan