November 2017 Update

We continue to maintain a defensive position across our portfolios. We are holding a larger than usual amount of cash, government bonds, and commodities, with a reduced exposure to equities. At this time, we seek to protect our wealth rather than engage in excess risk taking.

Canada is possessed by a debt bubble of epic proportions, posing the largest risk to Canadian investors since 2008. The debt bubble has distorted investor return expectations across Canadian equities and other assets classes.

From the perspective of a value investor who enjoys reading financial statements, I find a general character of inflated earnings expectations, overvalued assets, and unsustainable revenue growth rates among today’s “top stocks”. These are the time-tested hallmarks of greed and overconfidence. The situation parallels valuations last seen in some respects before the 2001 stock market decline, and in other respects before the 1990 real estate decline. This is not to say that the timing of a similar decline is imminent, only that the odds are materially increasing.

I could talk about the real estate bubble, suspect bank earnings, tech stock castles in the sky, bitcoin, record low volatility, or how government bonds are now priced to earn more than equities over the next decade… but at the highest level there is only one factor driving this risk-blind behaviour. Investors have become accustomed to a coordinated effort by central banks to re-liquidate markets, a period lasting from 2009 until present.

Eight years of liquidity injections have rendered investment analysis largely obsolete. After all, why bother analyzing a company’s financial statements if a rising tide lifts all ships? The key to our success has always been a steady commitment to owning quality companies at a good price, and in a rational environment, that guiding principle has rewarded us well. But in an irrational market focused on short term performance, it doesn’t count for much. Conventional wisdom today is that dividends, cash flow, earnings power, and asset value aren’t very relevant to stock prices. One simply buys stocks today because they are going up.

This too shall pass. Like most things in life, just as the rules become obvious, the game changes.

2018 marks the beginning of a new phase of bank action, the reduction of global liquidity by about $1 trillion per year. This has already started in several forms such as increasing short term interest rates and the slowing of asset purchase programs by central banks (also known as quantitative easing, or QE). In the same way a rising tide lifted all ships, draining the pool means summer is over. It is my opinion that the reduction in liquidity will cause investors to re-evaluate risk, and materially change stock valuations, resulting in higher market volatility.

You will notice no alarm bells are going off and few are talking about these changes. Most people judge success through the rear-view mirror, where markets are up for the year, and Canada lead the pack in economic growth in 2017. From that perspective, a rear-view driver would naturally find nothing of concern. But the inescapable fact remains that the worst investments are made in the best of times, and this cycle will be no exception.

Although the market can carry on this untethered course for some time, the potential for a lasting gain becomes limited the higher prices go. With safety of principal my number one priority, I will not risk capital unless the odds in my favour. By reducing risk exposure and increasing cash, the long term advantage is ours. Time is on our side as the leverage bubble unwinds.

For the select few assets I do choose to hold, it is my view that there is a period of substantial appreciation on the horizon. Government bonds, energy, gold, and our other holdings have demonstrated real growth through historic market declines and economic contraction. As an investor who has personally and financially lived every good day and every bad day since starting the Growth and Income Portfolios, I hope you await the appreciation with the same solid confidence and anticipation as I do.

In depth portfolio and company-specific notes are available for clients only.

Interesting links:

Five star funds aren’t what you think https://www.wsj.com/articles/the-morningstar-mirage-1508946687

A simple explanation of faith http://monevator.com/patient-investing-faith/

Must read about making better decisions https://machinelearnings.co/why-are-we-so-confident-2c3151a6d5d0

Something I look for in interesting people https://waitbutwhy.com/2014/06/taming-mammoth-let-peoples-opinions-run-life.html

Please let me know if you’d like to chat about financial planning, long term investing, or private investment opportunities.

Cordially,

Ben W. Kizemchuk

Portfolio Manager & Investment Advisor
Wellington-Altus Private Wealth