As we wind down the year to the holiday season, investors are breathing a sigh of relief. Markets finally appear to have bottomed at the end of October and we began to see the appearance of the seasonally typical fall rally. Pretty much all markets, including the Canadian market which has been a laggard this year, finally turned positive. There is still a ways to go before we return to the old highs, but without being too optimistic, should this rally hold, we could possibly be reaching new highs before the year is out.
We are in the Green Zone in our short-term Price Action or “Footsteps” indicator, yet still in the Yellow in our longer-term “Stoplight” or Equity Action Call. The latter, as we have seen in the recent past, has been slower to react than we would like. We therefore use it now more as a cautionary tool, rather than a firm indicator of the market conditions. As such, we are fully invested and we continue to overweight the portfolio holdings more on those stronger Growth Stocks, such as the tech stocks side of the market.
We have seen the stock market improve dramatically this month. We have also seen the Fixed Income market, bonds and “preferred shares”, improve. The Fixed Income was always the safety piece of the portfolios. However, since inflation raised its ugly head and interest rates began to climb, those assets were hit even harder than stocks over the past couple years. They also took banks and other financial stocks with them.
Interest rates fortunately now look to have topped out as inflation numbers are either going sideways or, in some cases, even receding. The all-important safe haven of US Government Bond rates are well down from their highs. The problem is that inflation and rates both had a quick and strong run up. Though they may be halting, or declining come the spring, it does take time for those past increases to finish working their way through the economy and for the full effect to be felt. So far, their effect on the economy has already been to drastically reduce growth globally (especially in China), such that there are fears still of moving into a recession.
That said, the most recent indicators lead us to believe that any recession may be at worst case a “soft landing”, rather than a more difficult hard landing and deep recession. In this respect, I provide the following snippets (and links for the full reports) from our BMO Economics Department:
“Canadian Real GDP fell at a 1.1% annual rate in Q3 versus a consensus call of +0.1%...
Bottom Line: There are plenty of unexpected cross currents in today’s release, but the big picture is that the Canadian economy is struggling to grow, yet managing to just keep its head above recession waters. One way to capture that is that in the six months to September GDP rose 0.04%, or basically unchanged. The significant (upward) revisions to Q2 show us to not read too much into the decimal points on this report—don’t like today’s news? Just wait, it will change tomorrow. For the Bank of Canada, the net result of the Q2 revision, the downside surprise for Q3 and the decent start for Q4 is nearly a wash, with perhaps a slight downside tilt. (Unlike us, the BoC was expecting growth of 0.8% in Q4.) So, overall, today’s mixed report reinforces the point that the Bank is done hiking rates, but doesn’t really advance the cause for rate cuts, as the economy isn’t showing signs of further deterioration early in Q4.” Full Report
“We received a welcome moderation in headline and core PCE inflation for October this morning. PCE inflation was virtually flat last month, increasing less than 0.1% and below consensus expectations…
Bottom line: There are signs consumers are becoming a bit choosier and price conscious, but no major pull-back in consumer spending that would signal an impending recession. The markets and the Fed should cheer this report as it points to the current restrictive monetary policy having its intended effect on inflation, while also raising the chance of a soft-landing scenario.” Full Report
Both the Canadian and U.S. economic reports point to economies that are indeed slowing, that rate hikes may be done, and that a soft landing is more likely the worst case.
Other concerns, of course, continue to be the geopolitical situation with Russia/Ukraine and Hamas/Israel wars, and the rhetoric out of nations like Iran and North Korea. The wars are obviously awful situations, but they have not led to any financial contagion in those regions at this point. And the rhetoric from others so far, is mostly just that. This all creates confusion and uncertainty, which leads to volatility in the marketplace, but is not typically cause for too much concern for the stock market nor cause declines.
As we have said many times, the first thing we look at each day is the direction of the U.S. Dollar versus the global currencies. The USD is still the safe haven in times of worry. And right now, money is moving away from the U.S. into other currencies as the wall of worry is overcome. That is because of the indications that inflation is dropping, and interest rates have probably topped out. The need of the safety and security of the USD therefore becomes less attractive, and money moves elsewhere, including back into stocks. Markets move higher.
In the very short term, markets have moved up from the bottom rather quickly this past month and may be at least temporarily overbought. We also see a fair bit of tax loss selling and rebalancing at the beginning December by the institutions. Whether these turn into a pullback remains to be seen. If that occurs, we would consider that it would not only be somewhat healthy but also probably quite limited. More importantly, it would provide a good setup for the next run with the typical Santa Rally due in the latter half of the month.
Another positive occurrence we are seeing is that more of the industrial stocks, small to mid size companies, and financial stocks (including bonds and preferred shares) in particular, are all moving higher. They are finally taking part in this latest rally. We are seeing important market participation widen and markets cannot sustain a long-term rally without them. Those segments of the market had all been weaker most of, if not all year. But now with the lower inflation news globally and resulting in the prospect that rates may have topped out and may possibly decline (at least minimally) come the spring, there is increasing expectation that any recession will be a soft landing. This leads us to consider that once we get through this next couple of weeks, we could see a very strong next leg up in the markets.
With rates potentially topping out now, we have also been able to move Fixed Income assets in the portfolios out of money market investments and into more lucrative longer term quality government bonds and high-quality preferred shares. A preferred share is one which entitles the holder to a fixed dividend, whose payment takes priority over that of common-stock dividends. As these shares and government bonds had dropped in price as rates climbed, they are also now paying a higher and very nice dividend with an excellent opportunity for capital gains too.
Seasonally, we are in the best part of the year as we move towards the Santa Rally in mid December. In the stock component of portfolios, we are fully invested currently owning a mix of Exchange Traded Funds (ETFs – baskets of securities) alongside several individual stocks. The rally and market strength will allow us to now become more concentrated in the portfolios with the reduced risk. The ETFs we have owned have the advantage of having provided us with a wider opportunity for diversification and thus reduce security risk when markets are rocky. We can own the whole sector – such as the whole sector of tech stocks, without the greater risk presented by owning just the one. A bad report can drag down a single stock, less so for a sector ETF.
The downside is that is that diversification can actually “water down” returns as markets move to the upside since the overall rate of return is more an average of all the assets held in the ETF as opposed to picking the strongest stock of the bunch with higher return and risk profiles. Also, come each year end, the ETF’s potentially spin out their earnings in year end distributions. This is a taxable event we would want to minimize. It does not affect the market value, but simply increases the number of units while the price drops while tax must still be paid on those distributions. We would therefore look to consider selling the ETF and thus avoid the distributions and maintain tax efficiency.
We point this out because as it appears the market may now be stabilizing, the “risk” of owning an individual stock typically declines. We would in this environment therefore rather move away from the ETFs and the sector plays and average returns they represent, such as software or other tech, and instead “drill down” to own the actual stronger and best stocks within those sectors. In a preferred world, we would rather own all individual stocks over broad sectors of ETFs.
Just to clarify, when we are picking securities, first we want to know if we even want to be in the market. Then, if we do, which markets: the US, international, Canadian stocks, commodities, real estate etc. Then, in a stronger market environment, we want to best drill down to the stronger sectors of the markets we want to own. And finally, down to the strongest individual stocks in those sectors. The deeper we drill, the greater the potential for returns. Note all the while, we do always need to maintain a suitable level of diversification, restrict the size of positions, and the number of stocks in a single sector.
As a quick note for the snowbirds among us. With the US Dollar dropping, the Canadian Dollar is therefore improving. This may soon be a good opportunity to begin buying US Dollars for those lucky birds heading south for the winter.
For those that are looking to borrow, or buy property and need a mortgage or line of credit and or have one coming up for renewal; a shorter term mortgage may be appropriate as rates flatten out or even begin to potentially decline in the spring. We do have to caution everyone however, that we do not consider that loan rates, lines of credit and mortgage interest rates are going back down to where they were just a couple short years ago. A look at longer term mortgage rates over the past seventy years shows we are not a whole lot higher than that long term average. A decline is increasingly likely, but not to the extremes many have got so used to. As always, if you or your family are considering borrowing or renewing, please contact our team so that we may enlist our BMO partners for preferred services, rates and terms for our clients.
Markets look to have bottomed out at the end of October and with the initial rally, are potentially looking to push to new highs. Our short-term signals are all Green Zone and the longer-term Equity Action Call is turning higher as cash and short term money market become less attractive. We may be booking some profits over the next days as the market takes a breather during tax loss selling season. We will be utilizing our Stoplight and Matrix to move away from those broader ETFs, as we look for an opportunity to drill down for stronger potential in individual stocks.
There is always the possibility of a slowdown or recession, and this could moderate the outlook. We will be watching our signals and charts closely. Come mid month however, we more so expect the beginnings of the Santa Rally in earnest.
Should you have any questions or concerns or would like to review your portfolio or financial and estate plan, please contact us anytime. We look forward to meeting with you whether by phone, virtually or best of all, in person.
Should we not have the pleasure of speaking with you before then, we would like to wish you and your families the Best of the Holiday Season. And for those that celebrate, a Very Merry Christmas, Happy Hanukkah and to all a Happy and Prosperous New Year!!!