By David Baskin December 13, 2015
Someone commented that stock markets were invented to teach investors humility, and what a good job they do! The one thing we can predict about the capital markets, without hesitation, is that they will surprise us. Every year something happens that we (and many or most others) simply didn’t see coming. As 2015 draws to a close, here are some of the things we saw coming, some of things that startled us, and some modest thoughts about 2016.
• We were not surprised by the crash in commodity prices, and we went zero weight all energy and materials stocks (with the exception of some lumber) by 1st quarter of 2015. The dominant factors for 2016 in the commodity space will continue to be the Gulf States and their on-going self-immolation in a vain attempt to regain control of the market, and commodity demand from China, which not even the Chinese can predict with any confidence. We believe that the cure for low commodity prices is low commodity prices, and we are seeing mines closing down and drill rigs being taken out of the field. The fix for the current downswing will come from the supply side, and 2016 may see a wave of bankruptcies, take-overs and cutbacks as poorly capitalized smaller companies call it a day. We will continue to resist the impulse to overreach for yield even as dividend yields and low quality bond yields in the commodity sector soar – until the dividends are cut and the bonds default.
• We were surprised by the sluggish performance of Canadian REITs and utility stocks in 2015. We don’t see any risk of an interest rate increase in Canada in the near future, and many of these securities have a safe yield based on solid balance sheets and durable payout ratios. In a world where 30 year bonds pay just over 2%, and where the Bank of Canada is talking about negative yields, we think a reliable 6% cash on cash payout from REITs is attractive, and that tax preferred dividends of 4% from some utilities is a good deal. So we will continue to own securities from these firms.
• We were also surprised at the lack-luster to disappointing stock performance of the Canadian banking sector. We understand concerns about the housing market (which continues to defy gravity in Toronto and Vancouver), about lending to energy and other commodity firms, and about the encroachment of new financial technology on the banks’ turf. All of these fears are reasonable. However, the massive profitability of the Canadian banking oligopoly, its openness to new technology and to change, and the strength of the balance sheets and cash flows relieve any anxiety we feel. The banks are very cheap, offer great dividends, and we think their shares should do better in 2016.
• We were not surprised by the weakness of the Canadian dollar. Three factors, in our view, drive currency values. For Canada, the world perceives us as being commodity dependent, so as commodity prices dropped, so did the loonie. As the US Fed talked up the probability of interest rate hikes, and the Bank of Canada mused about negative yields, liquid reserves flowed south, adding to the selling. Finally, Purchase Power Parity (PPP), the oft-neglected favourite child of economists, was, as often happens, overwhelmed by the first two factors. Canadians have stopped shopping in Burlington Vermont, Buffalo New York and Seattle Washington, and northern-bound shopping tourists are now appearing. On a PPP basis the Canadian dollar is probably worth about US$.82. But we don’t expect to see a rebound to that price anytime soon. As a result, we continue to load up on good quality US stocks, even though the tax treatment of dividends is worse and the cash flow is impacted by withholding taxes. When the commodity tide turns, so will the fortunes of our currency.
• We were surprised and somewhat appalled by the carnage in the Canadian preferred share market. Re-set rate preferred issues took the market by storm in the wake of the financial crisis of 2008. They are now so widely despised that two of our major banks had to offer 5.5%, with a guaranteed floor of that yield on re-set, in recent offerings. This makes little sense given the more highly taxed yield on quality bonds which offer only about 2.5% for five years. Once the tax-loss related selling this month dissipates, there will be some great bargains to be had in this area, although liquidity and negative perception remain as problems.
• Finally, we continue to watch the growth and profitability of big tech with awe and amazement. Companies we own like Apple, Google and Microsoft, far from losing market share and dominance in their sectors, continue to bring out new products, increase sales and build the biggest bank accounts in corporate history. That some of these companies can be purchased at valuations that are much less than the average stock in the market makes little sense to us, so we keep buying them. We expect to do so in 2016 too.
To all of our clients, friends and followers, we wish you a happy holiday season and a wonderful New Year.