Opportunity in Today’s Market

 

In the third quarter of the year, the S&P/TSX was down 0.5 percent while the S&P500 gained 6 percent in Canadian dollars. Since the end of the quarter, we have seen a sharp drop in global markets and as value managers we see this as an opportunity.

The US economy is in good shape and that trend is set to continue for quite a while.

“Economic activity has been rising at a strong rate, unemployment is low, the number of people working is rising steadily, and wages are up. Inflation is low and stable. All of these are very good signs,” said Jay Powell, Chairman of the Board of Governors of the Federal Reserve Board.

Consistent with this view, the US Federal Open Market Committee boosted its target range for short-term Treasury Bills to 2 to 2.25 percent, the eighth rate rise of the current cycle, and stated that monetary policy was no longer “accommodative”, maintaining artificially low interest rates in order to stimulate economic growth.

Median forecasts by the Fed’s policymakers point to one or more interest rate rises this year, followed by three increases in 2019 and another in 2020. The Fed expects that rates will plateau at 3 to 4 percent in 2020 or 2021. So, interest rates are going to continue to go up. But keep in mind, forecasts, even by the Fed, are highly uncertain. We will have to see how events unfold.

The bond market is reacting in sympathy as signs of a strengthening US economy bolstered expectations of further interest rate rises. The US economy propelled ahead with the real GDP increasing at an annual rate of 4.2 percent in the second quarter. The current dollar GDP, the measure that incorporates inflation, rose 7.6 percent. The 10-year US Treasury yield jumped to 3.19 percent, the highest level for the global benchmark for bond markets since July 2011.

European interest rates are still unbelievably low, but they too are beginning to rise. The yield on the 10-year German Bund, a benchmark for the eurozone, jumped to 0.53 percent, the yield on the 10-year British gilt rose to 1.66 percent — the highest since January 2016 — and the equivalent French bond yield rose to 0.87 percent. These rates have a lot of room to move higher as the European economy strengthens and as the central bank takes its foot off the accelerator.

Rising interest rates are generally considered a negative for the stock market; however that is not quite accurate. When interest rates are low as they are now, by allowing rates to rise, the Central bank is signalling that the economy is in good shape and does not need an additional boost from a stimulative interest rate policy — a positive environment for equity investments; not so much for fixed income.

 US 10-year Treasury Yield

The US economy has reached a “normal” stage of the economic cycle without any further need for monetary policymakers to be accommodative with interest rates or provide long-term guidance to markets. To quote Charles Evans, the president of the Federal Reserve Bank of Chicago, “The US economy has been expanding continuously for just over 9 years, since June 2009. This is the longest expansion in postwar history. However, it is also the weakest economic recovery of the postwar period. Importantly, there does not appear to be anything on the horizon that would derail this expansion for at least a couple of years.”

Profits are improving nicely. Inflation is in the middle of the 2 percent target range. Wages are starting to increase across the economy and certainly in the companies that we talk to. Operating rates in companies are still below the level that will stimulate strong capital spending. As well, there is a lot of fiscal stimulus — the tax cut and higher public spending — to bolster the market. All positive.

 Change in Real GDP

It was a relief that the US, Canada, and Mexico reached an accommodation on a replacement for NAFTA,  now named the US, Mexico, Canada Agreement (USMCA). Notwithstanding all of the ballyhoo, the new agreement is very close to the original. The status quo on trade is very important. Businesses have arranged their supply chains around it and it has been serving everybody very well.

Canadian economic growth has lagged our southern neighbour, but it is starting to pick up; second quarter GDP rose at a respectable 2.9 percent annual rate. The largest point of difference in our two economies is the impact of federal government policies on economic growth. In the US, the tax cut gave the economy a nice bump up. In Canada higher taxes have been a drag on our economy; although we do have higher public spending. Government policy does matter.

With the trade issue now settled, Bank of Canada Governor Stephen Poloz will likely follow the US and raise the interest rate — for a third time this year.

The Portfolio

It has been an interesting year. Our performance in the Canadian portfolio has been good — about 5 percent better than the index.

Last year we bought Equitable Group again (we had previously sold it in 2016). Equitable Group, the parent of Equitable Bank, has about $25 billion in assets. It was founded in 1970 and has become Canada’s ninth largest Schedule One bank. Equitable Bank offers a diverse suite of residential lending, commercial lending, and savings solutions, including high-interest savings products and GICs.

When the stock price of Home Capital, its direct competitor, fell for good reason, Equitable dropped in sympathy, even though it did not suffer the same problems that plagued its competitor. Equitable stock dropped from $70 to the $40’s when we bought it. Now 18 months later, it has recovered to over $65.

Why did we buy it? It is a classic example of where we find investment opportunity. We like companies where the market has overreacted to unexpected and dramatic news that upon study we believe is temporary and fixable.

That was exactly the case at Equitable. We spoke with a number of people at the company and at other companies and banks that supplied Equitable supportive financing. In all cases, they stated that Equitable’s business was sound and their competitor’s problems, rather than hurting the bank, would send more business its way. At that point, the company traded at a very low valuation and we expected a relatively rapid recovery.

On the other hand, the US market has been challenging. According to JP Morgan, growth stocks have had double the return of value stocks since the market peak in October 2007.

While the broad US market is up just over 10 percent this year, the rise has been driven by a very narrow group of companies led by the FANAA’s (the poster boys of large growth stocks). If you exclude just 3 stocks from the index — Apple, Amazon, and Microsoft — the market is not at a new high. At the end of September, one-fifth of the S&P500 companies were off 20 percent or more from their 52-week high.

As investment managers who focus on the fundamental value of a business and the potential risk as well as the potential return, we see this moment as a wonderful opportunity. We have seen situations like this before and on every occasion; value has been the final arbiter of stock prices in the end. We are on the cusp of that again.

As a result of tax reform, a strong economy, and the excellent performance of many companies, the US market is actually cheaper today than it was a year ago. The forward Price to Earnings (PE) ratio of the S&P 500 has decreased from 24X to 18X. Value stocks are even less expensive at 14.5X, well below the historic average. This gives us great confidence in our portfolio. It combines both the opportunity for substantial gain in combination with only modest risk. Our portfolio is filled with these opportunities, and for that reason we are optimistic that the next couple of years should be good for your investments.

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