Another volatile quarter faced investors during the summer months of 2022. U.S. equity performance in Q3 can only be described as a wild ride, recording at one point an intra quarter 14% advance only to give it all back (and more), to finish the quarter in negative territory. This retrenchment occurred on the back of the weakest September since 2008 and is the first time since 1931 that a reversal from a double-digit gain to a loss, has happened. The Canadian equity market held up better than other world markets, but the commodity complex began showing cracks, especially the oil and gas sector, which fell by 4.3% during Q3. For the quarter, the S&P/TSX Composite fell 1.4%. The U.S. based S&P 500 Index, was off 4.9% in local currency, but advanced 1.3% when translated to Canadian dollars, which along with virtually all world currencies took a drubbing at the hands of the U.S. greenback. The small company Russell 2000 Index fell by 2.2% in U.S. dollar terms. The FTSE Canada Short Term Bond Index declined 0.3% in Q3, while the Solactive Laddered Canadian Preferred Share Index retreated by 6.5%.
The continuing weak results all point to an extremely conflicted investor who is worried about the central bankers FINALLY getting religion and taking on inflation and asset bubbles that had developed in both the equity market and the real estate market. Their actions have been noted and acted upon (just look at bond yields!!). Markets have repriced and now we wait to see if the Bank of Canada and U.S. Federal Reserve’s actions will also have an unintended consequence (such as a financial accident that the Bank of England is concerned about). The other worry of course is that they will tighten too much, driving the economy into a deep recession. The Fed’s aim is a terminal Fed funds rate of 4% to 4.5%, and if inflation responds by dropping below that level (yielding positive real rates), the Fed may pause. This would give the lagging portions of the economy, most notably the job market, time to respond to the tightening.
Bonds are back as a meaningfully productive asset class, but not before their re-set was a major contributor to the portfolio damage unleashed in 2022. On a standalone basis this year, both Canadian and U.S. broad bond indexes have suffered close to a 15% loss. As can be seen on Chart 1, a U.S. based conservative balanced account has experienced a drawdown of nearly the same extent as in 2008.
Goodreid’s approach to the fixed income market is finally bearing fruit. For a number of years, as rates fell to unprecedented low nominal levels (even going negative in some European countries), we steadfastly refused to extend term, believing that at some point yields would normalize and, in the process, hurt those who held longer term fixed income investments. As can be seen on Chart 2, real yields, represented by TIPS (Treasury Inflation-Protected Security), are back to pre-global financial crisis levels, paying 1.75% annually over CPI.
Goodreid’s Canadian portfolio approach has been re-vitalized. For an extensive analysis of our new process please refer to one or our latest eArticle – In Profile: Goodreid’s Canadian Equity Portfolio. In summary, our approach emphasizes quality, then looks for attractive valuations. We search for companies with strong balance sheets and prudent capital structures. We also expect the companies in our portfolio to earn a profitable return that is considerably greater than the benchmark average. Once we identify these companies, we wait patiently until we can purchase them at a discount to their intrinsic value.
This approach resulted in a strong quarter for Goodreid’s Canadian equity model portfolio, as we finished the quarter ahead of the S&P/TSX Index by over 4%. This outperformance was led by individual stock selections of four standout companies in four different sectors. Stella Jones (+20%), a utility pole and railway tie producer; Saputo (+18%), the largest dairy manufacturer in Canada; Restaurant Brands International (+14.9%), known for owning the Tim Horton’s and Burger King franchises; and Richelieu Hardware (+14.2%), which supplies kitchen and bathroom hardware to manufacturers.
The U.S. large capitalization portfolio also outperformed in the third quarter. Our barbell approach to the market’s risk appetite has proven to be a successful strategy in 2022. Our overweight defensive positioning in healthcare issues has been beneficial. The S&P 500 Index healthcare weighting stands at 14%, while Goodreid’s U.S. large cap portfolio has a 22% weighting. On the risk-on side, companies such as Freeport McMoRan and General Motors have secular tailwinds that we believe will carry them to new heights. During the quarter we trimmed overweight positions in Apple and Lowes, which made room for a new position in a major drug distributor, McKesson Corp.
The U.S. small cap portfolio’s performance was mildly disappointing in Q3, but we are pleased with its relative yearly performance, especially given the outstanding year it had in 2021. Often after an out-sized performance, portfolios experience a regression to the mean. As a U.S. based group of companies, the small cap portfolio has escaped the negative effect of an extraordinarily strong U.S. currency.
Earnings season is right around the corner and the equity market is bracing for a cautious outlook from corporate leaders. We believe that much of the negativity is already built into market prices, but poor markets can easily become poorer markets, so we cannot dismiss the possibility of further market weakness. In that event we expect a “market bottom” to be created, with prices spending little time at those levels. Keep in mind that markets are forward looking vehicles, and the slightest whiff of a Fed pause, or declining inflation could lead to a powerful rally. But these moves are best defined as “trading” opportunities. Our interest at Goodreid is the long-term value embedded in our holdings. We believe the market has likely over-reacted when compared to long-term opportunities. Chart 3 is an interesting analysis of market performance after a period such as the one we are in. Not only is it encouraging, it is exciting to know that after exasperating periods of market weakness out-sized gains are the norm. The key is to manage to exacting standards every day and let the type of results shown in the table happen.
At present, we see the market sitting on a fulcrum. Will the market go to new yearly lows based on disappointing earnings, stubborn inflation, and a continuation of a strong labour picture? Or will the labour market show some weakness, core inflation come off the boil and corporate earnings hold up better than expected? Regardless of the road we travel, either through extended tough economic times or a mild and short-duration downturn, the destination is the same; a new economic cycle that will carry markets higher.
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