The third
quarter started off with positive momentum, but global equity markets finished
the quarter in negative territory as developments in the period took some wind
out of the markets’ sails. Market sentiment was impacted by the U.S. Federal
Reserve indicating that interest rates may remain higher for longer, prompting
a rise in bond yields across the curve. The U.S. dollar has also been strong,
as the U.S. economy hasn’t witnessed the degree of weakness seen in other parts
of the world. The third quarter ultimately saw the return of the bear market
with simultaneous declines of bonds and equities.
The current bear market in the
broader stock market is now entering its second year. It began with the tech
wreck that started at the end of 2021 and then spread to the broader markets in
2022. The S&P last reached a new high in January of 2022 and has been range
bound since and in fact the negative performance of the index has been somewhat
masked by the outperformance of seven stocks (Apple, Microsoft, Alphabet,
Amazon, Meta, Tesla, and Nvidia) nicknamed the “magnificent seven”. Without the
performance of these the market would be even lower. To put the current market
in perspective and to get a sense of how long the bear market may last, it is
helpful to look at past periods of market downturns.
Historically, bear markets in the
US stock market have varied in duration. On average, bear markets have lasted
around 1.4 years (or approximately 17 months) over the past century. However,
the duration can vary significantly from one bear market to another. Some have
been relatively short-lived, lasting only several months, while others have
persisted for multiple years.
For instance, notable prolonged
bear markets include:
·
The Great Depression: Lasted from 1929 to 1932,
nearly four years.
·
The early 2000s bear market, triggered by the
dot-com bubble burst, lasted roughly from 2000 to 2002, about two years.
·
The Global Financial Crisis, initiated by the
subprime mortgage crisis, spanned from late 2007 to early 2009, around 18
months.
However, the length of bear
markets can vary due to different triggers, economic conditions, policy
responses, and other factors impacting investor sentiment and market behavior.
It's essential to consider each bear market's unique circumstances when analyzing
their durations and market impact. But at this point the current bear market is
longer in length than average and with this in mind investors are hopeful that
the market is poised to improve over the next year.
The below chart
gives an interesting visual representation of what the last couple of years
have looked like for investors. The stock market reached new highs in January
of 2022 and proceeded to collapse that year hitting lows in October 2022 and it
has remained range bound since and only recently has the market tested the highs
made in early 2022.
Nevertheless, the
market has had some sharp rallies over the course of 2023 but so far these
shown to have been Bear-Market rallies but thankfully we remain off the lows of
2022. At of the time of this writing we are in the midst of yet another rally,
which was spurred on by positive news in the US economy. The current rally
began in early November after the last FED meeting when the central bank signaled
it would continue to pause hikes for the near term, the rally was further
fuelled by an encouraging inflation report that came out the week after.
Inflation in the US has dropped to 3.24% down from 7.75 % this time last year.
Sentiment was further bolstered by the third quarter GDP report in the US which
saw real growth of 5.2%.
Despite that recent encouraging
news, many market participants are still concerned that inflation will remain
sticky and that continued high interest rates in most developed economies along
with evidence such as lower oil prices and higher gold prices are signaling a
recession in 2024.
To help get a handle on whether
this current rally may be the beginning of a market breakout or another failed
rally it will help set some parameters within a technical analysis framework.
From a technical standpoint this rally has been very quick and steep, these
types of rallies are often the most unsustainable and subject to quick
snapbacks. By looking at the technical trends and using the SPY as a proxy for
the broader US market, we can see the strong surge that began since the last
FED meeting at the beginning of November. That was followed by another move up
after the encouraging inflation reading that came out the next week. From a
technical standpoint the market has become over-bought and going forward a best-case
scenario would be a period of consolidation between the 445 and 455 area after
which a breakout above 455 would be a very encouraging development and a sign
that the market could possibly resume an upward trajectory in December. A
healthy pull back to the 435-440 range to a support level in that area would
also be encouraging and might present a buying opportunity. A worst-case
scenario would be a pull back below the 435 level and could portend a deeper
correction and perhaps a test of 2022 lows as the market may be signaling an
impending recession in 2024:
Another encouraging sign from a
technical standpoint is that the breadth of the market is starting to spread,
and not just driven by the performance of the magnificent seven stocks. About
55% of the S&P 500 were trading above their 200-day moving averages as of
the beginning of November. That level breached 50% for the first time in nearly
two months, according to LPL Financial. the equal-weight S&P 500 -- a proxy
for the average stock in the index -- rose 3.24%. That was substantially more
than the 2.24% rise for the market-cap weighted S&P 500, although the equal
weight S&P has only gained 3% for 2023 versus the 18% rise in the overall
S&P
Given some of encouraging signs
with GDP, slowing inflation and stable interest rates, financial markets are
toying with a new scenario for the US economy in 2024, one which isn’t a hard
landing, or a soft landing, but no landing at all. In that outcome, inflation
melts away on its own accord, the Fed cuts rates substantially next year, and
economic growth remains healthy. That would be quite a different outcome than
in Canada or Europe, where inflation is coming down, but economic growth has
already stalled as a part of that process.
Portfolio Highlights
The portfolio depreciated 3.09% for the month of October
versus depreciation of 2.75% for the benchmark. Key contributors to under-performance
were investments in Industrials, Financials and to a lesser extent Materials.
Industrials were off given the market’s concern of an impending recession in
2024, Financials are more sensitive to interest rate risk and September into
October saw a spike in 10- and 30-year yields.
In terms of the industrials sector in the Value/Growth
portfolio, Valmont was the worst performer of the fund’s holdings for this
sector. This was due to an unexpected write-down from an asset impairment in
their Agriculture Technology division. This resulted in a considerable
reduction in their forward EPS estimate for the full year and disappointed
investors and led to a sell off which was exacerbated by general weakness in
the sector overall.
Financials underperformed in October, this was due the spike
in the treasury yields in both Canada and the US. This negatively affects the
long duration assets of the banks as the values of those assets decline as
interest rates rise and also affects the spread between short term deposits and
longer-term lending thus making achieving profit more challenging as well as
increasing risk if demand for deposits increases at the same time that the
banks long duration assets are declining in value.
Given that the US economy is
still performing well, the portfolio remains invested in the US at current
levels. At present there is significant value opportunity in the Canadian
market which incidentally has underperformed over the last year. Some of the positions
in energy, utilities and telecoms that were added in 2022 -2023 are trading at
a discount to their intrinsic value. Specifically, they look appealing now
because:
·
P/E ratios are lower than historical averages.
·
These companies are not over leveraged.
·
Continue to generate healthy levels of free cash
flow.
Besides having potential for
capital appreciation these stocks are generous dividend payers and will provide
cash flow and help to offset portfolio downside if the economy turns falls into
recession in 2024.
As a brief reminder. The fund
employs a strategy that employs a blend of growth and value. The fund defines a
value stock by using a filter that screens using all or some of the below
metrics as a starting point:
1. High/Low book value to market; market to book value and
higher/lower than peer group median
2. Market capitalization greater the 500 million
3. Return on Equity greater than 10%
4. Debt to Equity ratio less than or equal to one
5. Price to sales that is lower on a relative basis, with
the ratio ideally less than one
6. Enterprise value to EBITDA less than that of peer
companies
7. Low P/E relative to peers and relative to historical
averages
8. High dividend yield combined with high free cash flow per
share
Positions in ENB, BCE, CPX TRI
and AQN have been increased to take advantage of dividend yields declining. CPX
currently has a dividend yield of 6.71%. If yields were to normalize somewhat
by 200 basis points, this would imply a possible capital appreciation of 42%.
Currently CPX has a interest coverage ratio of 2.01 and dividend coverage to
free cash flow of 3.05x. Similarly, TRP has a dividend yield of 7.34%. If this reverted
to historical levels by about 250 basis points this would point to a capital
appreciation of approximately 51%. TRP has strong cash flow metrics as well
with interest coverage 2.25x and dividend coverage 1.95x. This suggests that
the current dividend is safe at these levels.
The fund added a new position MDC
an American home building company to capitalize on the spike in yields in
October that drove the price of the US homebuilders, along with stocks in
general, down and dividend yields up. Despite higher interest rates there is a
shortage of housing and the US and builders have displayed discipline by not
overbuilding to meet demand. They also have remained well capitalized and have
not accumulated excessive amounts of debt. The MDC investment has gained about
25% since October and if interest rates stabilize through 2024 we can expect to
see further gains and income. MDC currently has a 4.47% dividend yield which is
still above its historical yield which has roughly been around 3%.
The fund attempts to find high
growth opportunities in the various sectors as well and balances this with
value stocks.
In terms of growth the portfolio
continues to hold a significant number of high growth technology stocks. The
growth side of the portfolio screens for stocks with high possible future
earnings potential as well as potential to capture large proportion of market
share in their given industry. Stocks chosen generally will have revenue growth
in excess of 10% - 20% or more per year. Additionally, the fund screens for
companies that are growing free cash flow. As well the fund looks for committed
management teams with personal wealth invested. The growth stocks in the
portfolio carry low to no debt, are either profitable or they are incrementally
closing in on profitability. This strategy has added to overall portfolio
return while adding to volatility the portfolio aims to keep standard deviation
within
This year CrowdStrike has been an
outperformer rising 125% on the year and returning approximately 2.83% to
portfolio return. CrowdStrike is a cyber security provider that uses artificial
intelligence to ensure user endpoint protection and respond effectively to
cyber threats. Cyber security will continue to be a growing area especially as
the adoption of AI spreads. Crowd strike has increased recurring revenue 37%
year over year and has risen by 14 times in just the past five years.
Shopify has doubled in value this
year as the company returned to growth and has recently beaat analyst
expectations for both revenue and EPS growth. The company maintains that
they’re growing faster than ever before and that they’re taking share in the
market.
Another notable success in the
growth portion of the portfolio is HubSpot. HubSpot offers a software platform
specifically designed to help small and midsized businesses bring together all
their systems, people, and customers under a single solution. The addressable
market for HubSpot continues to expand, providing further growth opportunities.
HubSpot has added about 2.28% to the overall return of the portfolio to date.
Cash levels remain high for the near term. Short term money
market returns are 5% or higher, as such the portfolio can afford to keep
higher levels of cash and be patient in terms of finding attractive
opportunities in the market. If a recession does occur sometime next year the
portfolio will have ample cash to invest if asset prices decline.