January 2018

Elevated. But perhaps not overvalued.

We thought we’d provide our answer right away to the question on most everyone’s minds: Is the US market overvalued?

Looking out at 2018, we see continued growth in US equities but greater risk of drawdown. The market is always prone to a 5-10% correction, in any cycle, but after last year’s extended valuations we see greater risk this year. We appear to be late in the business cycle and so this is a difficult period to be a value investor. It favours the momentum or growth investor until the bulls stop running.

Here are some things to watch for this year, which could prevent the markets from advancing:

The Federal Reserve has started to unwind its balance sheet. The Fed will start to stop buying treasury and mortgage-backed securities and begin to gradually reduce its debt holdings. This reduction in liquidity may serve to have interest rates edge up and may depress stock and bond prices. This may then also serve to slow consumer and construction spending which could lead to a recession. Hopefully the Fed will engineer a slower rise providing bedrock for the economy. But anything is possible in the current US political environment.

On the positive side, several US economic indicators have strengthened over the recent months. Personal consumption has increased for 30 consecutive months and employment has increased for 83 consecutive months. 2nd quarter GDP was a robust 3% annualized growth.

Oil rebounded well the past month, moving up to touch $60 a barrel which should be a positive development for the economy and very positive for our own oil companies.

The rebuild efforts after the hurricanes in Puerto Rico, Texas and Florida could spur a slight bump in the economy driving up wages, particularly in those areas.

The housing and construction market has been solid this year, while the building supplies sector has been among the strongest segments of the retail sales market.

Globally, we expect European growth to continue its improvement – it’s been a long road. China should have solid growth, but with some fundamental risks due to past credit growth, and emerging market economies will continue to improve, we believe.

Although we are aware of some impediments to continued economic growth, we believe the risk of recession is diminished.

 

October  2017

1) Modest to good economic growth.

2) Dovish language from the Fed.

3) Permissive financial conditions.

4) An administration bent on delivering lower business taxes.

These are the four horsemen of an extended bull market.

The major indices of the Dow Jones Industrials and Transports, along with the S&P 500 and Russell 2000, are all hitting new highs together, which we view as a confirming indicator that the long-term bull market remains intact. The implication of the signal, in our opinion, is for another 6–12 months, or longer, of a general bull market trend, as it shows that the majority of stocks of different shapes and sizes are moving higher at the same time. Of course, there are always stocks that are not conforming to this trend, and this does not mean that short-term pullbacks will not happen, but it does suggest that calls for the end of the bull market could be very premature. We believe that the recommendation to hold stocks and buy on dips still appears to be the right position for most investors to continue with for the long term.

Low recession risk, renewed signs of broadening growth, still accommodative financial conditions, and an upbeat earnings outlook underpin this favourable view on equities over the next 12 months. We have a positive view on growth, and so we maintain a pro-risk stance in our asset allocation. As the U.S. economy moves into later economic cycles, we are on the lookout for any dips in some of the more notable data points, but we foresee very little risk of a recession in the next twelve months. As a result, we remain overweight stocks and underweight fixed income.

Geopolitical tensions, U.S. politics, and evolving monetary policy trajectories are possible sources of near-term volatility and keep us from adopting an even more bullish view. We see more compelling value in Japanese, continental European, and emerging-market equities than in recent memory.

Our investment management process continues to work well, participating in this bull market while giving us confidence that participation in any correction of the market would be muted.

 

July 2017

These are a few of the important indicators  that we keep watching as we progress through 2017.

Emerging Markets ~ US Wage data ~ US Fed pronouncements

Emerging Markets continue to show robust growth. South Korea is the market to watch and they are experiencing their fastest export growth in five years.

US wages are edging higher, ( wages really haven’t grown in a generation and median wage incomes being static for this long seems to be the real reason for the Trump win) and unemployment is now firmly under 5% . Wage data as indicated by the Atlanta Fed’s wage growth tracker will likely keep the Fed tightening in the face of US inflation pressure.

Other economic indicators we are looking at also continue to point to US inflation pressure and the requisite Fed tightening. President Trump (it still feels odd saying this) has been talking about federal tax cuts and infrastructure spending but seems unable to do much in the way of any governance thus far. The slim Senate majority will likely mean that any stimulus will be muted until after the mid-terms in 2018.

We are using the current lull in the markets to do some renovations to our investment management process! We have purchased some software to allow us to better filter out bad choices in the stock markets in Canada and the US.

spent 4-5 months tweaking, optimizing and back-testing the results and we are very proud to say that the back-testing has shown an increased edge over the benchmark in the areas of return, volatility, and turnover of our positions. In other words, we have improved our process so that the portfolios should provide better returns, with less volatility than the overall market and with only about a 30-40% annual turnover in the stocks that we buy and sell.

As we are implementing this summer you will note some larger cash positions while we wait for trades to settle.

If you have any questions about your accounts or our investment management process please give us a call and we can get together.

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April 2017

As we find ourselves  firmly in the throes of tax season, please know that you or your accountant can call anytime if you have a question or to replace a missing form or slip. We are here to help! Please use us.

It’s seventy-five days into the Trump Presidency and does else anyone think the Administration may not survive by the end of the year??

The USA, a country we count on as a stabilizing force, is now quickly becoming a driver of uncertainty. The broad sweep of potential scenarios and outcomes is difficult to grasp and yet the market seems to discount this and churns higher. We feel that the market may be focusing on de-regulation, tax cuts and infrastructure spending, and underestimating the negative effects of protectionist trade policies, volatility and geopolitical risk.

Meanwhile, we have been adjusting portfolios this quarter to reflect the heightened risk in interest rate policy. The Fed has now raised rates three times since December of 2015 (three data points - a trend!) and there are indications that at least two more rate increases may happen this year. To this end we have shortened your fixed income duration to below five years. There is no sense in fighting the Fed – it always ends in tears. Let’s not allow your fixed income portfolio to be a drag on the entire portfolio.

In any rising interest rate environment, sectors of stock markets will react differently. Financials usually do well, while utilities, consumer staples and Real Estate Investment Trusts may lag. We are adjusting our sector weightings accordingly.

There has been a plethora of good news on the economic front so we remain optimistic that the daily drama emanating from the White House is marginalized for the time being. We are watching closely however!

Here is a summary of some latest US data points:

  • Pending home sales rose 5.6% in March, much higher than the expected 2.4%
  • Case-Shiller home prices rose 0.9% for the third straight month
  • Gross Domestic Product was revised upward to 2.1% on an annualized basis.
  • The Dow Jones Industrial Average and the S&P 500 finished higher for the sixth straight quarter as of March 31st.
  • Chicago Purchasing Manager’s Index was 57.7, up from 57.4 – this is the right direction
  • The PCE index (Personal Consumer Expenditures – an index that measures everything except the volatile food and energy costs) was finally up above 2%, a level the Fed had been seeking for over 5 years
  • Consumer confidence rose from 114.8 to 125.6, the highest level since September 2000
     

So there it is. Data is coming in fairly strong. We have instability at the political level. Rates are rising. And…….the market seems not to care. But here is when the market will care: Prices will start to rise when many of the inputs start to coalesce. We believe this will start to happen next year. We will watch for inflation data, yes, but we will also be watching wages, employment and commodity prices. We will expect the market to then start pricing in inflation expectations. This will not be good. This is when we will be much more conservative.

 

January 2017

The year 2016 will go down as

above average for the market, with the Dow Industrials performance at about +14% for the year, the S&P at near +10%, and, most surprising, the Russell 2000 index of smaller companies at around +19%. And these performance numbers came after a January–February drop of more than 10% for the indexes, for a swing from bottom to top of over 30% for each of the major indexes. The higher-yielding and less-volatile stocks did best in the first half of the year, and then the more-aggressive growth stocks outperformed in the second half. But it wasn’t that clear, with few stocks and groups performing in-line with the indexes for most of the year, as rapid group rotation was the dominant theme, which made it very difficult for portfolios to adjust to the changes. We end the year with the market in a generally “overbought” condition with perhaps too much optimism for the near term, but within a longer-term trend that is still quite bullish. It’s possible the pattern for 2017 could be similar to 2016, with initial weakness leading to later strength, and that sector-rotation theme continuing as investors adjust to the changing times.

 

Our own portfolio behavior typically leaned towards the conservative side.  We carried a lot of cash at times during the year. Upwards of 15-20%. Going fully invested on the equity side into a fractious election with all of its ramifications seemed a little reckless. As Warren Buffet’s partner Charlie Munger famously once said, “It takes character to sit with all that cash and do nothing. I didn’t get to where I am by going after mediocre opportunities.”

 

That said, we did pile into stocks after the Trump win, as our equity investment process identified a number of infrastructure-related names and health care stocks that should turn out to be beneficiaries of this administration. We adhere to bottom-up quantitative, and value-oriented well-researched stocks. Everything we own pays a dividend.  In periods where the market moves higher in a rush or where the market has turned around after a long sideways-to-down action, it is the non-dividend paying smaller cap stories that make much of the gains.  Our boring, dividend-paying names get left behind. It’s okay.  We appreciate them all the more, when the market turns down. 

Just remember, making money hand over fist in a bull market means nothing when you give it all up in the next bear market.  Our style shows this time and time again in bear markets. In 2011 and 2015 the S&P / TSX dropped 11% both years and our accounts were flat. 

 

From all of us at Montgomery Asset Management of RBC Dominion Securities we hope you had a restful holiday with your families and wish you a prosperous and healthy 2017.  We are booking a full slate of investment management meetings in Ottawa, Toronto, Montreal, Florida and Arizona – where ever our clients are spending their time!  Please let Krista and Olivia know if you would like to meet in the next couple of months.