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The bull market in stocks has been going on – and on, and on – for eight-and-a-half years, enriching investors but also leaving them with a nagging question: What comes next?
The underlying economy is sound. In the United States, the jobs market is roaring, the Canadian economy has recovered from last year's oil-induced dip and even Europe has emerged from the sovereign debt crisis that once weighed on the region.
But central banks are now tightening ultra-accommodative monetary conditions that had spurred economic activity and asset prices. It's still unclear what co-ordinated rate hikes will do to stocks and bonds.
Also, valuations are stretched. Based on reported profits, the S&P 500 has a price to earnings ratio of more than 22, which is its highest level since the days of the dot-com bubble.
Worried? The Globe and Mail has assembled a roundtable of six experts to help you find your way through the uncertainty ahead. And though they have their differences, our experts delivered what could be the keys to a profitable year ahead: Buy late-cycle stocks with solid profits (that would be a No to marijuana stocks), get bullish on Japan, consider preferred shares and position yourself for a weaker Canadian dollar.
Oh, and expect a U.S. recession in as little as a year.
Our roundtable consists of David Rosenberg, chief economist and strategist at Gluskin Sheff + Associates – and a globally recognized contrarian; Kim Shannon, president and co-chief investment officer of Sionna Investment Managers, a Morningstar fund-manager-of-the-year award winner with 30 years of experience; Vijay Viswanathan, director of research and portfolio manager at Mawer Investment Management in Calgary, who won a Lipper award in 2016.
Jennifer Radman, head of North American equities and senior portfolio manager at Caldwell Investment Management, joined us from New York; Chris Currie, portfolio manager at Goodwood Inc., provided expertise in fixed income; and Adam Butler, chief investment officer at ReSolve Asset Management, offered ideas that could juice returns if markets struggle.
The Globe and Mail: What does the market look like to you today?
Rosenberg: The OECD recently published a report saying we have the most synchronized global expansion in the past decade. Technically, that's true. But what they don't tell you is that different geographies are at different stages of their cycles right now.
If we're talking about the U.S. stock market, when the unemployment rate has come down to roughly 4 per cent, you know that you're in the late stages.
We don't have to run for the hills. But I think that you want to step up the quality of your portfolio, focus on liquidity and non-cyclicality. I think we should just enjoy this coming year because it will be the last year of the cycle. Right now, our U.S. equity portfolio is about 20 per cent correlated with GDP. Eight years ago, it would be more like 90 per cent. Focus on companies with earnings visibility and predictability.
In Canada, I have traditionally liked the banks a lot. But I think the regulatory backdrop is going to change. There are obvious question marks over housing-market issues. The only thing I can say with a large degree of conviction is that the Bank of Canada is going to be sanctioning a weaker Canadian dollar through the year. We are focusing on Canadian companies that have a very high U.S. dollar revenue stream.
Shannon: I don't think economics tells you the future of the stock market. Markets reflect human nature as much as they do underlying fundamentals, and human beings have a tendency to obsess.
Where are we sitting in the market? With 10-year Government of Canada bonds offering below 2 per cent, equities don't have to offer a lot [by comparison]. The historical average expected return is 9.5 per cent, before inflation. But we are in a sideways market of 6 per cent or less. Equities are a bit pricey, and that explains the low expected return.
So investors should be in stocks. But I agree with David: It's a risky market. It's probably the end of a cycle. So be really well diversified. Avoid excessive levels of risk. Be concerned about what is novel and new.
I think illiquidity is the big issue today. Days-to-trade on large and small-cap stocks has definitely lengthened out. I'm worried that that's going to cause some problems.
Viswanathan: Not to sound like a stereotypical Calgarian here, but we are riding the bull right now and we know we're going to get bucked off. We just don't know when. And the key is not to get gored.
So we're very cognizant of valuation: Avoiding the trendy names that are at the very high end of valuation range, and adding those names that are fair value or lower. I think it's very hard to find cheap stocks in this market, though not impossible.
We look at balance sheets to make sure companies have resilient cash flows and that they can live to fight another day.
So does that lead you to own less cyclical companies that can sustain earnings in a down market?
Viswanathan: We've seen a significant run-up in high quality, safe-haven type companies. In Canada, we have found opportunities in late-cycle names in the energy sector over the past six to 12 months. But in higher quality names, we feel a lot of those are expensive.
We are bottom-up stock pickers, so we don't pick a certain region. But globally, we are finding more opportunities in Japan and India.
Radman: We are in a high-valuation, low-growth world. So it's tough in this environment to just buy a broad base of stocks. We are very bottom-up and pick parts of the market that can work: Things that are in a company's control, and don't need the market to go higher and the economy to be stronger.
When you have a focused portfolio, there are always opportunities where companies are in different cycles – where they might be putting a new CEO in or changing their businesses and so forth.
Butler: I would certainly echo Kim's point on expected returns: 5 per cent to 6 per cent, before inflation, and that's assuming equities are trading at fair value. I think there is a lot of evidence that equities are trading far above fair value.
It's a weird market, where stocks like Apple and Neflix and Facebook seem to be cheap on an earnings basis. But the median stock is exceptionally expensive.
Investors have some very uncomfortable choices here. We know what bonds are going to return over the next 10 or 12 years: The global aggregate bond index yields 1.7 per cent, the U.S. aggregate yields 2.6 per cent. Canadian bonds are a bit lower.
Currie: Corporate bond spreads are very low. But when you get low interest rates, if you have a bond that yields, say, 3.5 per cent, you're outperforming the index by a huge margin. Hence the incredible demand for corporate bonds.
U.S. rate hikes are well-telegraphed. But there are a lot of issues in Canada that will keep a lid on rising rates. Plus, a falling Canadian dollar is actually quite stimulative to the economy, so I think the corporate sector in Canada is going to have a good winter and a good spring.
A lot of cautious comments here. So how much of my portfolio should I be putting into marijuana stocks and bitcoin?
Radman: I get questions about companies and whether I've heard of them. And I have one basic question in return: Are they profitable? And people never know the answer. Understanding what you're buying is important, and a lot of people don't. With bitcoin and marijuana stocks, I think many investors would be hard-pressed to explain why they have invested.
Rosenberg: I think the easy money on pot stocks has been made. Going forward, you're buying into a sector where the pricing mechanism will be regulated by the government. How the sector is priced in the future is open to debate, so bear that in mind.
I think bitcoin is a massive bubble. Most people I speak with who are buying bitcoin don't really have much of an understanding of it. It's a classic greater fools theory.
Butler: Bitcoin is strange because it's the only rally that no one seems to be participating in. Show of hands in this room who owns any bitcoin … [none]. I don't know anyone with any sort of meaningful exposure.
In terms of the biggest risks, what worries the roundtable the most?
Shannon: The thing that worries me is that investors are taking on more and more illiquidity. Twenty years ago, you could make a 7.5 per cent target return with a portfolio of bonds and cash. But today, you might have 25 per cent illiquid investments between hedge funds and private equity and infrastructure, with virtually no fixed income and cash. In their chase for return, investors feel obliged to invest in more esoteric products that have less liquidity. And we don't know what could happen.
Rosenberg: You're talking about one form of liquidity. But there is also central bank liquidity. Central banks have always had a role in influencing asset values but they have probably been more influential over the past decade than they ever have been.
If you asked me what is going to change the most in the coming year, I would give you a one word answer: liquidity. It is the oxygen tent for risk appetite.
This decision to replace [U.S. Federal Reserve chair Janet] Yellen I think will go down as a colossal error, because we are losing a lot of experience. The central bank, as a group, is going to be more hawkish next year. We are three rate hikes away from inverting the yield curve, and of course every economist will find a new reason to just ignore it.
There is also a big risk in Europe. If the European Central Bank starts to taper earlier and more aggressively, the market is not prepared for that. You could get reverberations in the European bond market, and there will be opportunities there: We can short the European bond market.
Currie: I also see liquidity as a risk. We tend to gravitate toward larger bond issues and higher-rated credits, shorter maturities, lower duration [with less sensitivity to interest rates], those types of things.
I suspect a lot of investors feel protected by holding bank stocks and utilities because of the steady dividends. But what do you think of these sectors in an era of rising interest rates?
Shannon: When you are in a low-return environment, dividend yields matter a lot. Today in Canada, dividend yields are close to 3 per cent, which is about half the total return we are expecting on equities.
There are enormous amounts of money in dividend strategies today. You start to wonder: Is it overdone? I think that's a concern. Naïve investors might be focused on buying the highest-yielding stocks, but they are the riskiest ones out there.
Butler: I think the whole dividend phenomenon is misguided. The idea that dividends provide stability is absurd. In 2008 and 2009, Manulife was down about 70 per cent, Royal Bank of Canada was down about 60 per cent. There should be no preference for dividends over share buybacks or other distribution strategies. But shareholder-yield portfolios – where management is buying back shares with conviction and paying down debt and paying out dividends – are not expensive, while dividend-yield portfolios are currently trading at a premium P/E to the market. It's a topsy-turvy world when dividend stocks are trading at a premium.
Rosenberg: What are dividend stocks today? If I defined a dividend stock as a stock with a yield greater than the belly of the Canada curve [or the yield on 5-to-10 year Government of Canada bonds], then 10 of the 11 sectors in the S&P/TSX composite index are dividend stocks. Technology is the only sector that isn't.
Ten years ago, there was not one sector – not even the beloved dividend areas of telecom, financials and utilities – that paid what you got in the belly of the curve. And the TSX dividend yield was 2.3 per cent then; today it's 2.8 per cent.
It has broadened out because the corporate sector understands who their investors are. Something important happened: Last year, the first of the baby boomers turned 70. At that age, you are undertaking your first profound asset mix shift. You're starting to take down your equity position and lift your bond position because you need the cash flow.
And who controls the wealth in society? It's not the millennials. It's still the boomers.
Butler: I want to challenge the assertion that demographics should be driving investors into high-yielding equities. It just doesn't compute: They're not tax efficient.
Rosenberg: I know, but what is the definition of a high-yielding stock today? I mean, 1.5 per cent in the context of a 1 per cent Government of Canada bond is high.
Butler: Maybe. But it still doesn't explain the preference for dividends versus other forms of cash distribution. Why not prefer companies that have a high aggregate shareholder yield, rather than a high dividend yield?
Rosenberg: It's a combination of the yield, payout ratio and dividend growth. I don't think anyone bought Canadian bank stocks because of the yields. It's because they never cut their dividends. It's the stability and the fact that they are recurring.
Shannon: I think dividends do make sense for investors, and they are a good anchor for investing. I'm glad that in Canada we are not buying into share repurchasing to the same degree as in the U.S. because I don't believe management teams always buy shares for totally honourable, profit-maximizing reasons. History shows that, in aggregate, they don't.
Viswanathan: I don't think dividend investing is going anywhere. I think there is a demographic need for income and it's still going to be a big portion of overall returns.
Vijay, is your portfolio weighted in favour of dividend stocks?
Viswanathan: We don't look at it that way. We are always pushing management teams to allocate capital prudently. Whether that's reinvesting in the business, or paying a dividend or buying back shares, we're agnostic. I agree with Kim though: I think management teams generally do a poor job of buying back stock. If a company doesn't have opportunities to reinvest in the business at decent rates of return that are going to be higher than their costs of capital, then give it to shareholders.
Jennifer, are you embracing dividends or shying away from them?
Radman: We look more at the cash that companies are generating. Instead of giving it back to the investor, if a company has good opportunities to invest it, that's the preference for us. But they have to do it efficiently.
Viswanathan: If a company reinvests in the business and can generate 15- to 20-per-cent returns on that capital deployed, that's better than what we would be able to do as investors.
Are there names that stand out as prudent capital allocators?
Viswanathan: Constellation Software Inc. is one that comes to mind.
Speaking of capital allocation, how about the FANGs [Facebook, Amazon.com, Netflix and Google]? Everyone I've spoken to in money management expresses some degree of skepticism but also keeps buying them.
Radman: It's interesting to see how the market treats certain companies. Take Tesla for example. If you weren't a new-age company, and you missed so massively on what you have promised people, you wouldn't have a stock price. And yet Tesla is down only about 20 per cent. Facebook has a huge amount of additional operating expenses predicted for next year, and the stock didn't move at all. Investors seem to be treating new age companies and legacy companies very differently.
Are there risks that are being amplified too much, such as the potential termination of the North American free-trade agreement?
Rosenberg: We know that NAFTA is going to influence some parts of consumer staples, automotive, a couple of companies in the industrials sector. I think the bigger impact is on the economy, through central bank policy and the Canadian dollar.
In Canada, business investment is going to get hurt. There's this cloud of uncertainty. This is one of the reasons why I'm bearish on the Canadian dollar. With NAFTA, it comes down to investing around a weaker Canadian dollar. It creates winners and losers. The winners will be Canadian companies that have strong recurring U.S. dollar revenue streams.
Butler: I think the fear of rising interest rates is massively overblown. It's driving people away from fixed income and toward what are effectively equity bets. The challenge is that these moves mean that you are relying on sustained positive growth, benign inflation and abundant liquidity conditions as far as the eye can see. Those are the only environments in which equity risk outperforms.
What you are ignoring is the potential benefit from rate instruments, especially duration, if one of those three things doesn't happen.
You have to think more deeply about diversification. Everybody just thinks about the risk of potential rate increases. That's one potential risk. Even if it does manifest, it is unlikely to mean that your bond allocation is going to take a meaningful hit. And by moving away from duration risk, you are ignoring a number of other potential risks to the portfolio.
Rosenberg: I fully agree with that. Underlying inflation is about 1.5 per cent, and that's at the peak of the cycle. What is going to cause inflation to go up from here? I think the principal risk over the next 12 months is a deflationary shock rather than an inflationary shock.
Currie: And the long end of the bond market, in the 30-year area, is actually going down. So what people lose focus on is the fact that investors who are buying 30-year bonds are not buying into that inflationary argument. They're looking further down the road, and seeing a turn toward less inflation.
Shannon: What do you think is the possibility that we will hit a new low for rates?
Currie: Commodities were extraordinarily weak in 2016 [when the yield on the five-year Government of Canada bond fell below 0.5 per cent]. I would defer to commodity experts, about whether they see the potential for $30 oil again and super low copper.
Rosenberg: We are probably not more than 12 to 24 months away from the next recession. That's not a dirty word. It's part of the cycle. And look where the peak was this cycle: We can't even break 3 per cent [for the yield on the 10-year Treasury bond]. That's telling you something.
I think we are going to retest that U.S. low. I've never seen a cycle where bond yields failed to melt in the context of an economic recession. I'd say the same for Canada too.
So where should investors be putting their money now?
Rosenberg: Canadians really have to shed our home bias. We're only 2.5 per cent of the global market. I'd be taking more profits out of the U.S. and allocating increasingly towards Japan.
About three months ago, Japan broke out of what had been a well-defined 25-year secular bear market. I think we are seeing better growth dynamics, albeit it from a low level. There are a lot of secular changes taking place, a lot of taboos are being broken that is going to keep the rally going. The female participation rate is rising and it's generating a lot of income. Japan is importing foreign labour. You are seeing a lot of changes in terms of corporate governance.
A mountain of cash, which at one point was 20 per cent of GDP, is coming off of corporate balance sheets. And you're seeing capital spending and dividend payouts. Over the past year, Japan has the second-best dividend growth in the OECD, at roughly 10 per cent, but with a payout ratio that's less than 30 per cent.
The other nice thing is that Japan only has a 10 per cent correlation to the S&P 500. Can the S&P 500 correct and Japan hold up? The answer is that it probably can. I think there is a 30 per cent upside here.
Butler: Hedged or unhedged?
Rosenberg: That's an interesting question. I'm modestly bearish on both the yen and the Canadian dollar, so I think you can go in unhedged. It won't hurt you. I have no bullish case for the Canadian dollar right now, unless you think oil is going to $70 or $80 a barrel, which I don't.
Shannon: Canada is only 2 per cent of the global benchmark right now, in terms of market capitalization, but the U.S. is 55 per cent of the benchmark – and we're asking global investors to put half of their wealth in the U.S. and less than 10 per cent of their total life savings into the domestic economy. I'm really questioning that.
Rosenberg: It's a global market and we have to treat it as a global market. Where are the opportunities? The reason most Canadian portfolio managers will have most money in Canada is because it's safe. If things go wrong in your global exposure, investors will say 'Why did you get me in this for?'
Butler: I think it's awfully hard to argue that Canadians are better off keeping a large proportion of their savings in an economy that is heavily concentrated to so few different economic risks and drivers – and in an economy in which they also make their living.
If you expand the whole concept of diversification and think about human capital – part of your wealth is what you have in your investment portfolio, and part of your wealth is the income you will generate from gainful employment – obviously your gainful employment is going to depend on how the Canadian economy does. Accounting for human capital, there is an even greater incentive for investors to think more broadly about harnessing growth from international regions.
Vijay, how much cash should investors have in today's conditions?
Viswanathan: Our clients give us their hard-earned capital and they tell us to be fully invested. In the Canadian equity fund, which I co-managed, we have a natural cap of 5-per-cent cash. And cash levels in the portfolio are higher now than they were in 2009. And I think that's a by-product of the opportunities that we're finding.
In terms of balance, there have been some shifts in our firm from equity into fixed income and cash. And away from the U.S. and Canada, to outside of North America.
Shannon: We're contrarian value managers with a Canadian focus. So interesting bets that we're finding would be stocks like Fairfax Financial Holdings Ltd. We've recently had major hurricane damage, and generally speaking when you have had big catastrophe losses, you tend to find stocks like Fairfax better priced, which is an opportunity. Six months or a year later, it gets melted away into history.
Boardwalk Real Estate Investment Trust is located in the West. The economy is weak out there. The REIT is struggling a bit in this environment, so this is the right time to buy if you're a patient investor.
And we're interested in asset managers. People are worried about the hype surrounding ETF growth and artificial intelligence, so you see some weakness in stocks like CI Financial Corp. and Guardian Capital Group Ltd. Both look attractive: Great firms with great management teams at the right price in this environment.
Currie: In terms of where we would focus, it's the mid-term duration, five-to-seven year 'yieldy' investment grade bonds, with yields between 3.75 per cent and 4.25 per cent – which would put you in the BBB space.
In our fund, we can invest in a limited amount of preferred shares. That market has really dried up in terms of new issues though.
Preferred shares fell [from 2013 to early 2016] because [bond yields were falling and] the reset yield on preferred shares was going to be less, and in some cases significantly less, than the existing coupon that the investor held. The market just plummeted.
The market corrected itself, though, when underwriters came up with minimum reset rates, designed to solve the problem of a negative interest rate adjustment. A lot of preferred shares come out now with the existing coupon as the minimum reset going forward. For a retail investor, given the tax efficiency, it's a pretty attractive security.
Butler: Investors are looking at a 3.5 per cent to 4 per cent return for a typical 60-40 stock-bond portfolio. That's not going to cut it for pensions, endowments or retirees.
One choice is to stick with what's comfortable: You're used to stocks and bonds, and names in your portfolio that you pass on the way to work. And you're okay with the fact that that portfolio will generate low returns.
Alternatively, you can nudge towards sources of return that are less reliant on traditional sources of risk. Things like value, momentum, trend, carry, low-beta, etc. There are a handful of strategies that investors can add to their portfolios.
Investors need to think more broadly about diversification. They need to have portfolios that are truly balanced. A 60-40 stock-bond portfolio is 95 per cent equity risk: You are 95 per cent reliant on a period of sustained positive growth, benign inflation and abundant liquidity conditions. We may not see that going forward.
This roundtable discussion has been edited and condensed.