March 2017

The Monthly


With this commentary, we plan to communicate with you every month about our thoughts on the markets, some snap-shots of metrics, a section on behavioural investing and finally an update on some of the people at MacNicol & Associates Asset Management (MAAM). I hope you enjoy this information, and it allows you to better understand what we see going on in the market place.


“Sometimes me sits and thinks, and sometimes me just sits.” – A.A. Milne

Market Commentary: How are you Feeling?


Thus far, 2017 has been a year which has solidified a key axiom to remember as an investor and market analyst; that is, in the short term, the stock market is not the economy, and vice versa. Although intrinsically linked in the long term, a booming stock market does not require similarly gangbusters economic data, and strong economic data does not recuse the possibility of a falling stock market. The primary cause of this de-coupling is human emotion and forecasting, and in the current environment many investors seem to have an optimistic view of the effects Trump’s stances on corporate taxes, regulation and fiscal expenditure will have on future performance. This level of investor optimism has led to what is now being coined as the ‘Trump Bump’, and we believe the US President’s eponymous rally to be a perfect example of the effect of future expectations on the stock market.


The chart below, from a Bloomberg article on the subject, serve to elucidate the point, as it delineates the recent market rally by sector.

Exhibit 1


As can be seen, the primary ‘winners’ of the market rally have been those which would explicitly benefit from lower corporate taxes, less regulation, fiscal expenditure and domestic manufacturing; key tenets of Trump’s campaign. Financial stocks’ profitability would be greatly bolstered by lower taxes, higher interest rates and less regulation, with a specific emphasis on Dodd Frank. Industrials are typically major beneficiaries of fiscal expenditure programs, as are Technology stocks. Domestic steel and base metal producers rallied strongly on the possibility of an increased focus on US material sourcing, and the Healthcare sector also saw strong gains – driven by Health Insurance companies – on the prospects of the repeal of Obamacare.


Although US-centric, we believe this discussion to be an excellent example of how future expectations shape the investment environment. It should be noted, however, that market levels and valuations are wont to revert to the mean or average; by this, we mean that markets do not remain ‘overvalued’ forever. Optimistically, corporate results could outperform future moves in the stock market, which would serve to lower notional valuation metrics; pessimistically, the market itself could retrace its steps in order to reflect more reasonable or conservative valuation metrics.


The Break-Up


To expound on our previous comments on the end of page one, it is our personal belief that the latter scenario poses a significant risk to the market, and that investor sentiment has gotten ahead of itself, especially as it relates to the largest ‘Blue Chip’ stocks.


For example, the chart below – which was taken from well-respected market analyst Fred Hickey – charts a graph of the earnings growth of S&P 500 constituent companies (light blue line) versus the level the S&P 500 index (navy blue line).


Exhibit 2

As is readily apparent, the key take-away is that there has been a massive divergence between the value of the index and the actual earnings of the underlying companies; the two other periods where there have been similar divergences were the late 90’s and 2006 / 2007.  For most other years the two have been closely correlated, which speaks to our comments related to the risk of ‘reversion to the mean’, and what that means for the performance of the overall market.


This chart also adds credence to our earlier comments regarding the idea that the ‘Trump Bump’ is an optimism driven rally, which is rooted in bullish future expectations. Further evidence of this viewpoint is supplemented by the recent Investor’s Intelligence Survey, which quoted the percentage of bullish respondents at 63.1%. For context, the surveyors themselves consider readings above 55% to be the ‘Danger Zone’, and the recent reading is the highest of such data points since 1987.


The upshot that we’d like to communicate from this discussion is the paramount idea of investing with context, and always considering risk-reward. Prudent investors have espoused caution in regard to market valuations for some time, and many have ‘missed’ gains as a result of the Trump rally. However, this message of caution is deeply rooted in pragmatism and the belief of mean-reversion, whereas bullish cases are reliant on scenarios which continue to defy historical reference and rationalization. In the current environment, the risks in terms of capital loss of being heavily bullish are massive, whereas the potential gains of being strongly bullish are dubious. The tantamount goal of all managers should be to preserve capital and manage risk, and therefore, we are willing to forego what we believe to be short-term sentiment-driven rallies without logical footing.


Exhibit 3 below compounds this viewpoint, showing how, despite the fact that the Dow Jones Index has rallied over 80% during the period, constituent revenues are actually lower than they were in 2011. In many respects, we are in uncharted territory as investors, and we believe a cautious approach in such a scenario is warranted in order to protect capital.


Exhibit 3

Although these comments have had an intrinsically pessimistic tinge, we would also like to touch on the fact that there are always investible and intriguing markets and investment vehicles. The investible universe is vast and contains many investments which are uncorrelated and even negatively correlated, which means that there are rarely scenarios which require investors to completely liquidate their holdings and go to cash. As we’ve talked about frequently, we continue to believe investments in precious metals and gold to be an ‘insurance’ program and hedge against over-valuations and risks in traditional equities. We also believe our Alternative Trust provides a hedge against market volatility and exposure to assets which aren’t as susceptible to over-valuation driven by market sentiment. Even within traditional equities, there are enough possibilities where bullish cases and reasonable risk-reward scenarios can be found.


Although clearly subjective, it is our opinion that scenarios such as the one we currently find ourselves in act to highlight the value of capable active managers; we exist to manage risks and provide stable, risk-weighted returns. ETF and index-linked funds are fine in bull markets when most stocks and indices appreciate, but there is no risk management present, and the possibility of capital loss can be large without proper information. The key to remember is that 7% annual returns double your investment over 10 years; if you lose 25% in any given year, you need 50% appreciation in order to regain lost value. Asset management is a bit of a misnomer, we are risk managers, and our primary goal is to protect and conservatively grow your capital.


Behavioural Investing: FOMO – Not just for the Kids


Although slightly out of date, the term ‘FOMO’ or Fear of Missing Out, has become a common colloquialism to describe the feeling of exclusion felt by missing an important event, party or occasion. Now, however, it has been applied to adults and investors in order to describe investment activity which is driven by contrast rather than individual merits. By that, we mean that investors fear doing worse than their contemporaries or rivals in the short term, more than they fear the risk associated with participation.


In a recent Stanford study administered by Peter DeMarzo and Ilan Kremer, the idea of FOMO was applied to the investor mindset, specifically as it relates to the creation of market bubbles. What they found, through surveys and studies supplemented by economic models, was that individuals constantly compare their own performance in certain categories as being relative to their own peers, their own environment, and professional analysts. Rather than independent analysis, they favour ‘herding’ behaviour due to the relative ease of handling poor results in the event something goes wrong. If the outcome is poor, at least their contemporaries did poorly as well.

As is common with behavioural biases, the key to avoiding the FOMO pitfall is to conduct independent analysis and to actively seek out information that contrasts with your opinion. In order to have a truly defensible vindictive opinion, one must be capable of understanding and rejecting their belief of the counter-argument. Ideas should not be judged by the notional number of supporters, rather by the logic of their argument. Also, you will often find that losses are more acceptable when you are confident that your initial decision and thought process was as a result of logical progressive thought.

MacNicol & Associates Asset Management Inc.


March 2017