The Best Offense is a Good Defense: Investing in a Volatile Market 


The Canadian market posted a loss of 5.2 percent, and the US market declined 1.2 percent, in the first quarter of the year. Our portfolios remained essentially flat in the quarter.

This was the first three-month period in years where all of the major world market indices were down. This happened despite great earnings results, and strong, improving, economic numbers. In January, stocks went on a pronounced tear, egged on by celebratory tweets from the President of the United States. By the end of the quarter, that was a distant memory. All of the indices were down.

What happened? As we just said in our last letter, stock markets have performed very well, dare we say surprisingly well.  Ever since the November 2016 election in the United States improving economic data, the relaxing of the onerous regulation that was hurting profits, a major tax cut, and continued government stimulus drove the market higher. These trends continue. However, after fifteen months, stock prices moved ahead faster than the economics.

The television pundits (with whom we can sometimes be counted) focus on the immediate term; the daily barrage of presidential chaos. Don’t fall for that. It is an explanation, not the cause. The cause of the market slowdown is that the stock market got ahead of the economy and we have to wait until the economy catches up for additional improvement.

The daily news barrage is just noise. We all know the market has only two directions — up or down. It does not know sideways. So world markets, taking the lead from the United States, have to mark time for a few months to allow the economic data to catch up to the level of share prices.

That means more volatility — the S&P500 has already come down 10 percent from peak to trough since January. We expect this volatility to continue, perhaps through the summer, as the economics catch up to the market.

There are two risks that could derail the situation. First, the economic recovery in the United States. The Federal Reserve considers the economy and the labour market to be healthy, and in consequence they expect to raise interest rates at least twice more this year and three times in 2019 from the current level of 1.5 percent to 1.75 percent. Short term interest rates next year should therefore approach, or possibly exceed, 3 percent. As Jamie Dimon, CEO of JP Morgan says, “It would be reasonable to expect a 10 year Treasury note yield of 4 percent”. Only one year ago, people thought rates at this level unthinkable.

As Fed Chairman Powell said, “Our overarching objective will remain the same: fostering a strong economy for all Americans — one that provides plentiful jobs and low and stable inflation”.

Second, the Trump effect. The President’s style of negotiating is to bully his opponent. It takes advantage of the common tendency for people to rely too heavily on the first piece of information offered (the “anchor”) when making decisions. “Anchoring” is a well known psychological strategy, well discussed in books by Nobel Laureate Daniel Kahneman and the late Amos Tversky.

But Trump’s “rants” are very public and unnerving to many. The stock market is bouncing around on his “trade war” fears. Will it happen? How will China, with its own great skill in negotiation, react to the Trump style? How might tariffs imposed by the United States and China affect growth and inflation? It is too early to tell.

In the meantime, the US economy is rolling along. The new US tax bill represents one of the most significant changes to the US tax code in over thirty years as it changes individual, corporate, and international taxes. This could lift corporate earnings by over 17 percent and add to the momentum in US equity markets later in 2018. This is the backbone of our current optimism.

The FAANG stocks (Facebook, Apple, Amazon, Netflix, Google) which led the United States market for more than a year, have faltered, falling by 17 percent since their January peak. Business models that just a few months ago were changing the world have now come into question. The lack of privacy for Facebook customers has caused serious and legitimate concern. Another tech darling Tesla, is bombarded with negative news based on the continuing over-promising and under-delivering by its celebrity chairman, Elon Musk. This has damaged sentiment. While these stocks were up 0.7 percent for the quarter, they all have recently been pulling the market down.

Consistent with our strategy to seek capital growth in a safe, comfortable, and lower risk way, we did not participate in the meteoric technology rise and are now not suffering “the agony of defeat”.

The Canadian market has fared worse this year than the US markets, in part pulled down by the bastion of safety for the last nine years, the higher dividend paying companies. The S&P/TSX Composite High Dividend Index was down 7.5 percent in the first quarter. Although a few of these companies are in our Canadian portfolio, we have still managed a positive return for the quarter. It is proof, that in a rising rate and volatile environment, it is not enough to have high yielding companies but rather quality companies that are reasonably priced with the probability of growing cash flows.

Increasing dividends are a characteristic of companies that are generating increasing amounts of cash. At Kingwest, our strategy does not focus on dividends, but it does emphasize growing cash flows. The resultant higher dividends are an added bonus. Last year was no exception. The year began and ended with a dividend yield in Canada of 2.7 percent and 2.1 percent in the United States even though the portfolio values rose substantially. Dividend growth in our companies was strong, reflecting improving business conditions, increasing 5 percent in Canada and an impressive 22 percent in the United States.

The excellence of this cash generation is, fortunately, typical. We can expect similar dividend growth in future years. While we do not emphasize “investing for income”, it is a wonderful benefit of our value approach.

Magna International

Management at the Canadian-based global auto parts manufacturer clearly sees their business improving. This may seem at odds with general investor fear about how technology is rapidly changing the way people drive and the way cars are powered. However, we invested in Magna because it is at the forefront of automotive industry and we believe the company will benefit from these disruptive forces. As self-driving technologies and electric motors become more prevalent, Magna will continue to grow its profits as it builds higher value cars for whichever manufacturer best navigates the changing marketplace.

Magna’s stock has returned nearly 30 percent over the past twelve months. Its dividend is 50 percent higher than it was when we invested in the company nearly three years ago. The stock is still undervalued and we continue to expect good performance in the years ahead.

We remain optimistic. Our portfolios are in a reasonably defensive position. We have been selling, and not buying, over the past number of months. Our portfolios hold over 10 percent cash. Prices of some securities are beginning to come down to attractive levels, but we are in no rush to buy.

Rest assured, safety first ‘trumps’ potential growth at this moment.

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