It's time to plan. Or perhaps more aptly stated, it's time to invoke our longstanding existing plans. 2017 fades into the history books as another strong year for investors, marking the 9 th consecutive year of gains for the U.S. equity markets and the 7 th year of gains since the 2008 financial crisis for the Canadian market.
The S&P 500 index earned a total return of 21.8% in 2017 and the S&P TSX Composite index posted a 9.1% total return. Accordingly, risk appetites are running hot. For instance, speculative and junior marijuana and blockchain stocks dominate the leaderboard on Canadian markets almost daily with frantic media hype and trading volumes suggestive of a typical holding period that spans just a few weeks...hardly the stuff of disciplined investment. Bitcoin, that most enigmatic of things...is it a currency? an asset? a commodity? the mother of all Ponzi schemes? closed the year above $14,000...15x the level where it began the year.
The implied volatility of U.S. stocks (VIX...the barometer sometimes referred to as the "fear" gauge) has been plumbing all-time lows below 10, and the S&P 500 index has posted an almost unprecedented string of 14 successive months of positive returns. Here in Canada, job creation has been nothing short of sensational, with a whopping 422,500 jobs created year to date, such that the unemployment rate at 5.7% is at the lowest level in recorded statistics, going all the way back to 1976 (Chart 1).
So, does all of this good news portend a bad ending? Of course not, and there's no immutable law that says another good year can't follow a long string of successful years. But it does call for caution, particularly since stock market valuations are at or above long term averages in both Canada and the United States (Chart 2) - which is not in its own right either a necessary or a sufficient condition for a decline in stock prices, but in combination with other risk elements it could be problematic.
As we all know, trying to time markets is invariably a failed strategy. Goodreid's tried and true approach over a thirty-year period has been simply to try to be better during good times and less bad during poor times. We have succeeded in this challenge as evidenced by our North American Balanced Composite performance record vs. our peer groupbenchmark, the Globe Canadian Equity Balanced Index, which measures performance of the typical balanced fund in Canada. Goodreid has outperformed in 12 of the 13 years since we started tracking this composite, including this most recent year.
A cautious or more defensive stance must ensure that we don't choke off opportunity. It should be viewed as a dial with varying degrees of risk exposure as opposed to a switch, which has only two options, risk on or risk off. The tools at our disposal include the management of asset mix, our degree of exposure to select industries and sectors, and security selection. Past experience shows that most investors find their portfolios over-weight their targeted equity exposure when stock market corrections inevitably occur. This happens for a couple of reasons: first, arithmetically, equity weightings naturally rise during strong markets and secondly, psychology leads investors to reward what has rewarded them and to eschew that which has disappointed them.
Rebalancing to target asset weights as outlined in your investment policy statement is something that we do on an ongoing basis and we will continue to do in 2018. This is a natural and recurring feature of our practice; as each of you have specific goals, constraints and risk tolerances and your specific target asset mix was purposely built to achieve those goals while respecting your risk limits and constraints. We know that many clients openly question the validity of bonds in their investment portfolios at times like these, with interest rates near historic lows and rising. We too are certainly mindful of the impact of low but rising interest rates on a bond portfolio, but history teaches us that bonds often "zig" when stocks "zag"...a truism that is easy to forget nine years into one of the strongest U.S. equity bull markets in history.
We also know that sectors react differently to the various stages of an economic cycle, as certain elements of the economy are more interest rate sensitive than others, while other sectors are more inflation, growth and capacity utilization sensitive. Thus it pays to be mindful of clues (and they are indeed only just clues, as opposed to empirical facts as economics remains an imprecise social science) that the economy may be moving from recession to early expansion to middle expansion to late expansion and finally back into recession. Economic cycles have been getting longer since about 1980, coinciding with the rapid rise of the service sector, and with the advent of business practices like just-in- time inventory management, and for various other reasons as well, but by no means has the business cycle been eradicated. Thus taking profits in fully valued defensive sectors for reinvestment into cyclical sectors as an expansion takes hold makes sense, just as taking profits in fully valued cyclicals for reinvestment in defensive sectors also makes sense as an expansion gets long in the tooth (Chart 3).
Finally, company specific attributes help to shape performance during positive and negative times in the market. The time will come, perhaps in 2018, or maybe in later years, to position equity portfolios more defensively, reducing beta (or specific company volatility) and cyclicality. Characteristics like revenue visibility and stability, low operating leverage, formidable balance sheet and financial strength and consistency of growth take on added importance in a slowing economy. In a nutshell, the emphasis shifts towards companies where we have a high level of confidence in the company achieving financial forecasts and executing on its business plan and away from more rapid and dynamic, but also more erratic growth situations. We will be closely watching a number of indicators including the slope of the yield curve, employment growth, retail sales and purchasing manager indices as well as market breadth and other sentiment measures to guide us in making this pivot.
Furthermore, we will be diligently and proactively trimming winning stocks within Canadian and U.S. equity portfolios, so as to preclude the risk of any one single stock growing to an undue weight in clients' overall portfolios. Again, this is an ongoing feature of our practice and an essential element of prudent risk management.
To be clear, this defensive game plan is not market timing, which we consider to be a fool's errand. Rather this is strategic asset allocation and investment strategy in practice with a view to firstly, protecting capital and secondly, growing it responsibly amidst a potentially more challenging investment terrain. 2017 was another solid year for Goodreid clients, both in absolute terms and relative to our formal benchmarks. We enter 2018 with a continued resolve to be diligent stewards of your wealth and we wish you all the best in the coming year.
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