The HLG Blog - December 19th, 2023
| *Strategy | 1 Mth | 1 Yr | **5 Yrs |
| Juiced GIC | 3.15% | 3.31% | 2.89% |
| XBB | 4.48% | 1.44% | 0.82% |
| 3CDiv Cad | 7.06% | 6.81% | 9.23% |
| XDV | 6.52% | -2.22% | 6.80% |
| 3CDiv Glbl | 6.88% | 5.72% | 9.55% |
| SDY | 4.65% | -4.93% | 7.37% |
| Alternative Strategy | 4.68% | 5.12% | 8.59% |
| XBB/PSP/XRE/CIF/Gold | 6.37% | 7.46% | 5.89% |
*The portfolio’s Juiced GIC, 3CDiv Cad, 3CDiv Glbl and Alternative Strategy use a mix of client portfolio returns, Morningstar results and model portfolio returns to generate the returns listed above. Similarly, the ETF returns for XBB, XDY, SPY and XBB/PSP/XRE/CIF/Gold use Morningstar returns to generate the above listed returns. The returns have not been audited for accuracy and individual client returns will generate slightly different results. Furthermore, the above listed returns are not a guarantee of future returns.
**The 5Yr returns are annualized returns. The results have not been audited for accuracy and should not be used as a guarantee of future returns.
Juiced GIC
The duration on the Juiced GIC Strategy has extended marginally to approximately 4.7 years. The expected yield on our Juiced GIC strategy is 4.40%. A 75th percentile 5-year GIC is paying approximately 4.93% at the end of November.
This is strictly my opinion. Both the 5- and 10-year US bond futures enjoyed significant rallies in November. In the case of the 5-year futures the rally broke above two significant highs. The 10-year futures broke one significant high and tested a second. In both cases it wouldn’t surprise me if prices correct lower (yields rise a little) as we complete 2023. The strong rally suggests rates should continue to decline as time moves forward.
Looking at the Canadian and US Yield Curves interest rates have remained stubbornly high in the shorter term. If the economy remains strong and inflation persists any decline in rates will be gradual.
Currently three of our fixed income holdings, DXO, DXV, DYN2226, and LYZ801F (26% of the total fixed income holdings) are generating yields greater than the 1-year GIC.
Our overall fixed income strategy is designed to benefit should a recession occur. Although I don’t believe 5-year interest rates and longer will fall that much I do think they will remain stable or fall marginally creating some capital appreciation for the strategy. Maturities less than 5 years, I believe, will fall sharply and quickly in the event of a recession.
At this time, I think holding our duration around 4.7 years will capture the higher yields in the short term plus generate some capital appreciation in the event bond prices do continue to rally.
3CDiv Cad
Last month we spoke about owning stocks with strong and consistent growth in earnings, free cash flow, dividends and share buybacks. Early results have been encouraging.
Typically, when the index generates strong monthly returns our models have underperformed. This time we marginally outperformed. This is a good early signal.
Prior to November 2023 the 3CDividend model has delivered a monthly return greater than 6.5% twice in the past ten years. In both cases the generated solid returns in the subsequent year. This bodes well for the year ahead.
The 3CDiv Cad Model currently generates an approximate 2.63% dividend yield. Financials, Consumer Staples, Industrials, and Information Technology make up 65% of the Canadian holdings.
Our largest positions are:
| Stock | Symbol | Target Weight |
| Alimentation Couche-Tard | ATD | 7% |
| Fairfax Financial | FFH | 6% |
| Hammond Power Solutions | HPS.A | 6% |
| Open Text | OTEX | 5% |
| Quebecor | QBR.B | 5% |
As the portfolio evolves, we are trying to reduce the number of holdings in our Canadian Portfolio to 20 to 25 names. Currently we have 33 names so a little more work to do.
3CDiv Glbl
The Magnificent 7 has become the new term to describe the biggest 7 stocks in the S&P500. The 7 stocks are Apple (AAPL), Alphabet (GOOGL, GOOG), Microsoft (MSFT), Amazon (AMZN), Meta (META), Tesla (TSLA), and Nvidia (NVDA). Clicking on the hyperlink you’ll see those 7 stocks are up 71% YTD versus 19% for the S&P500 and 6% for the S&P493.
Currently Microsoft and Alphabet each have a 3.00% weight in our portfolio. Apple, Meta, and Nvidia rank highly and could be added to our portfolio. The holdback is portfolio diversification and determining what stock would be replaced. Amazon and Tesla don’t qualify for our focus list.
The November YTD return the HL Group uses as a benchmark (80% S&P500/20% Europe, Australia, Far East) was approximately 18.2% compared to our model at 10.9%. Over the past three years the Dividend-Growth Model has outperformed the benchmark. Over the past five years the model is 11.7% compared to 12.2% for the benchmark.
If the Magnificent 7 begins to underperform, which is possible given how expensive the stocks are, then our dividend-growth model is in a much better position to continue generating strong results. As a matter of fact, our dividend-growth model is on new historic highs while the benchmark is still 8.2% below the high posted in December 2021.
Information Technology, Consumer Discretionary, Health Care, Mutual Funds and Industrials constitute 80% of the strategy. The dividend yield is estimated to be 1.20%.
Like our Canadian portfolio, the global portfolio is very diversified. Our most concentrated holdings are UnitedHealth (UNH-USA) and Zoetis (ZTS) with target weights of 6% each.
Like the Canadian portfolio we found stocks with strong and consistent growth in earnings, free cash flow, dividends and stock buybacks outperformed the S&P 500 by a large margin.
We don’t want to make significant changes, but we do want to position for stocks that are in unique parts of the economy and then try to focus on names that are trending well. Currently, 79% of our holdings are performing better than the S&P 500 based on the criteria discussed in the previous chapter.
Our concentration in Mutual Funds is a little misleading since it is very diverse. The Dynamic Power Global Growth Class and the Fidelity Global Innovators Funds can focus in areas of the market where the fund’s managers believe there will be strong momentum. Historically they have identified stocks that my analysis would not identify. We have also identified the iShares Robotics and Artificial Intelligence Multisector ETF (IRBO) as an interesting opportunity to build on the growing opportunities in the Artificial Intelligence space. Finally, we have built a small position in the iShares Core S&P 500 Index (XUS.USD) and the iShares MSCI EAFE ETF (EFA) to gain exposure to areas we’re not analyzing as closely.
We believe we have a robust set of names that will create a robust portfolio in the event of a recession.
Alternative Strategy
The Alternative Strategy remains weak relative to its benchmark over the past year but continues to outperform over the 5-year timeframe.
The strategy consists of four subsectors, hedge funds, private equity, real estate & infrastructure, and gold.
The value of the alternative strategy is fourfold. First, it’s historical long-term return is comparable to the 3CDiv Cad and 3CDiv Glbl models. Second, the alternative strategy hasn’t suffered the sharp selloffs experienced by the equity models. Third the strategy has held value or continued to grow when the other strategies have been breaking down. Finally, when adjusting the return for risk the alternative strategy clearly has the best risk adjusted return.
The hedge fund strategy has been in a lengthy correction since hitting a peak in October 2021. YTD the Hedge Fund Strategy is marginally profitable. Of the three corrections the strategy has experienced over the past 17 years the current correction has been the
Looking forward the idea of owning stocks that are well positioned to increase dividends or buy back shares should generate strong portfolio returns over a five-to-ten-year timeframe.
longest in duration but the smallest in magnitude. We review the strategy quarterly. Our goal is to preserve the long-term return but reduce the risk.
The private equity strategy remains highly volatile in the short term but in the long term is our best strategy. After a 31% decline from November 2021 to September 2022 the strategy is slowly moving higher. Our trailing 5-year return remains very strong at 20.00% per year. We remain confident in the strategy for the long term but will continue to monitor individual holdings.
Real estate and infrastructure have struggled the most over the past 6 months. Our belief remains the holdings we have are high quality and will show both strong dividend income and capital appreciation as interest rates begin to fall. With the sharp interest rate reversal, we also witnessed a strong rally in the RE&I portfolio. Currently the strategy has an estimated dividend yield of 6.10%.
Gold has been one of the strongest parts of our portfolio generating YTD growth of 10.69% in Canadian $ terms. Gold tends to do best during periods of uncertainty which seems to be the case now.
Outlook and My Four Favourite Charts
The first chart I always look at is the difference between 6-month interest rates and 2-year interest rates. The above chart is the US comparison in blue and the red line shows the subsequent 1-year return in the S&P 500. To help you understand, a year ago the differential had never been more positive at +1.33%. The S&P return a year later in April 2023 was 0.91%.
I like the 6mth vs 2’s because it’s a good gauge for banks’ willingness to lend. When the curve is positive the banks are making money and will continue to lend. When the curve is negative the banks are losing money and scale back on their lending activity. The spread bottomed in June and has slowly been narrowing.
The yield curve would suggest there is still downside risk for the S&P 500.
The second chart is the 1-year change in US Unleaded Gas Prices which is the solid red line in the above graph. The solid blue line is the 1-Year subsequent return of the S&P500 (80% weight) and the Europe Australia Far East Index (20% weight) staggered by a year. Because falling gas prices is good, you’ll notice the red line is inverted. Unlike the yield curve this chart suggests inflation is coming under control and the stock market should do well.
If the stock market is going to fall, we need selling pressure to come from somewhere. The above chart looks at the Distribution of Corporate Equities and Mutual Fund Shares By Income Percentile in the U.S. to the end of 2022. Top 20% income earners in the United States earn over $153,008 per year. The top 1% earned over $591,550 per year. Respectively their incomes grew 3.78% from 2022. The highest income growth was in the lowest income earners at 7.14%.
In 2016 the top 20% income earners controlled 87.7% of the equity market compared to 78% in the early 1990s. You can see during past selloffs the concentration of ownership by high income earners declined. Although we have seen concentration of ownership flatten out, we have not seen a significant selloff.
Based on net worth we have seen a similar phenomenon. The top 10% of Americans based on net worth have increased their equity holdings.
It’s hard to imagine a significant selloff in the stock market if the people who own the stocks don’t sell.
The CNN Fear and Greed Index evaluates the data from 7 indicators; Market Momentum, Stock Price Strength, Stock Price Breadth, Put and Call Options, Market Volatility, Safe Haven Demand, and Junk Bond Demand. CNN then compiles the data into a single number to determine whether the market is overbought (extreme greed >80) or oversold (extreme fear <20).
The index hit an Extreme Greed high of 98 January 1, 2020, and an Extreme Fear low of 2 March 11, 2020. The S&P500 January 1, 2020, close was 3257.85 and continued to rally another 3.9% until February 19,2020. During this 8-week period the Fear and Greed Index was already collapsing warning investors something was wrong.
The S&P500 bottomed out on March 23, 2020, at 2237.40, two weeks after the Fear and Greed Index hit it’s low. The week the S&P500 hit its low and began a sharp rally, the Fear and Greed Index rallied in a similar fashion.
Since May we saw the market peak in June and enter a subsequent correction. The Fear & Greed Index now suggests a rally in the S&P 500 through the end of 2023.
Conclusion
A lot has changed over the past 6 months. I believe we’ve seen a peak in interest rates and the stock market weakness through the summer was, as I expected, a correction and not a major sell-off.
What’s interesting is how some clients reacted during the last correction. The S&P500 has been in a rally since October 2022. As the Fear & Greed Index shows, a correction should have been expected last summer.
There was a surprisingly high degree of negativity during the correction and a lot of money moved from equities to cash and GICs. I believe the markets will continue to rally and, as the markets rise, the cash and GICs that came from the markets will flow back in.
Looking forward it seems inflation is starting to come under control which will allow the central banks to lower interest rates or, at worst, maintain them. Either way, I believe this will be positive for the stock markets.
Parting Thought: GIC’s
The correction we experienced from July through October has been curious in the sense we’ve had a lot of clients ask about liquidating stocks and buying a GIC paying 5% or greater.
The logic behind the question is simple. For a lot of clients our long-term return has been in the 5% range so why not eliminate all risk and lock in.
In the 1988 movie “Big” starring Tom Hanks there is a scene at the end where Josh (Tom Hanks) has decided to become a kid again and Zoltar granted his wish. Susan, his girlfriend doesn’t understand and asks why he wants to be a kid again. Tom Hanks replies, “I have a hundred reasons to go home and only one reason to stay.” Susan asks what the one reason is, and Tom Hanks replies, “you of course.”
The one reason is purely emotional and that’s how I feel about GICs. There are a lot of reasons not to buy GICs but only reason to buy them, peace of mind.
One of the biggest lessons I learned working on the trading floor is the importance of taking emotion out of investment decisions. Fear and greed being the two worst emotions.
GICs offer guaranteed returns, guaranteed principle if held to maturity, and a return that is competitive as far as fixed income assets are concerned.
Drawbacks to GICs include:
- No potential for capital appreciation. When rates decline, bonds and stocks have a high probability of capital appreciation.
- Basic GICs don’t offer possible income increases. GICs that do offer additional bells and whistles have significant restrictions.
- Tax inefficient.
- Liquidity, if it exists at all, is limited and expensive.
If you know the expenses you’re going to incur in the next year then return OF the money takes precedence over return ON the money. If you can get a 5% return OF the money, take it. A one-year GIC makes sense. For that matter, forecasting your cash flow needs for the next five years and locking in these attractive yields makes sense.
Here's an example. Johnny X has a $1,000,000 and has been working with the HL Group for several years. His asset mix has been 40% Fixed Income, 30% Equity and 30% Alternative. Historically we used the Juiced GIC strategy for our fixed income.
His portfolio would have generated a 6.71% return and income (orange line) would have grown from $45,000 in 2006 to $68,940 in 2023 which translates into a 2.1% annual pay raise. A 2.1% increase is roughly in line with the Central Banks inflation goals.
Johnny likes the idea of locking in a 5% return. Currently a laddered GIC would pay 1yr 5.52%, 2yrs 5.34%, 3yrs 5.01%, 4yrs 4.95% and 5yrs 4.85%. The average would be 5.134%. Although past returns are no guarantee of future returns the idea of locking in Johnny’s cash flow for the next five years at a rate which is hopefully greater than inflation is very appealing.
By taking 22.5% from the Juiced GIC strategy and placing it in a laddered GIC portfolio Johnny essentially guarantees his income needs for the next five years and can leave the remainder of his portfolio to benefit from long-term growth strategies.
The chart above shows what would have happened had we started this strategy in 2006. By the way GICs in 2006 were paying over 5.00%.
Historically, Johnny’s income would have started at $45,000 and has now grown to $68,200 or a 2.00% annual growth in income. For the peace of mind Johnny achieves a 1% decline in income over 17 years is probably worth it.
Bearing in mind GIC’s were paying over 5% in 2006 what would have happened if Johnny insisted on putting his whole portfolio into a laddered GIC portfolio?
His annual income would be roughly the same as it was in 2006 and instead of his portfolio continuing to grow it would be shrinking dramatically. Using the Central Banks 2% inflation goal Johnny’s income would remain the same, but his standard of living would be reduced by almost 23%!
Emotions can be very dangerous when it comes to investing. Don’t let one reason overrule the 100 reasons to make a better long-term decision.
phl