Two basic rules and five portfolio repositioning moves for 2019

• Given the major issues behind the market setback remain unresolved, the short-term market outlook remains highly uncertain
• Even in the case of further possible turbulence, investors can still do well if they follow two basic investing rules.
• In light of the recent market setback, we have identified five portfolio positioning moves that should help you out-perform the broad market in the intermediate term.

Introduction

If you've been a regular visitor of this website and have heeded some of our precautionary warnings, you should be rejoicing at the opportunities that this market setback offers. Congratulations!

Since we issued our first warning though, back in August of 2018, equities have lost nearly 15% and are now more reasonably valued. To be ready for the next year(s), a radical portfolio review, and some portfolio repositioning, are now in order. If you have not done that yet, or if you haven't had that discussion with your financial advisor, it's now high time to do so. In this new year update, we offer two basic rules to follow and five key investment strategies to consider.

Two basic rules

New year resolutions are made to be broken, but if you resolve to follow our two basic rules, you will do well with your investments. The first one is to always ensure that you have enough in cash and short-term bonds to meet your needs for the next three years or so. Such period is also referred to as your "Investment Horizon". The idea behind it is to be able to weather market setbacks, as they happen, and to hold on to your equities until the market recovers its losses. Otherwise, if you are forced to sell in order to meet your cash needs, you will be converting temporary, paper losses into permanent, non-recoverable losses. This is a situation you can easily avoid if you follow this first rule.

When we say three years, please treat it as an educated guess, inspired by previous historical patterns. Investing is never an exact science. Historically, most bear markets have cleared within a maximum period of five years. In other words, when you invest in equities and suffer immediate paper losses, holding your equities for five years should allow you, in general, to recover your losses. A couple of bear markets have taken longer than that, but these were extreme cases. For an elaborate disussion of this point, please refer to our "Introduction to the Maxiumum Equity Approach".

So why three years now and not five? Simply because we are no longer at the market peak. Equities have already dropped nearly 15% off the all times highs. More than half of the listed companies are already deep into bear market territory, with losses ranging from 20% to 40%. In other words, much of the bear market, if bear market we get in 2019, is already behind us. Moreover, the S&P 500 is now trading at a forward P/E ratio of 14, which is fairly reasonable. Obviously, there is a possibility of further losses, if ongoing concerns persist, but the point is that a good part of the bad news has already been reflected in today's prices. Given where we stand today in terms of market valuation and market cycle, one can afford to be slightly more aggressive with respect to investment horizon. A three-year horizon, versus the usual five-year period we typically propose in times of roaring bull markets, is reasonable in the current environment. Having said that, we always stress that this is a matter you should decide upon in conjunction with your advisor, because it highly depends on your personal circumstances and on market conditions.

The second rule is to avoid emotional decisions and trust the cycle. In the long-term, equities remain the best performing asset class. There is no need to panic and sell at the wrong time. If the recent setback surprised you, or caught you unprepared, then something must have gone wrong in terms of your portfolio positioning. Setbacks like this one are a normal part of the investment cycle and should be treated as opportunities to rebalance your portfolio. But to do that, you need to have the resolve and confidence in the market cycle. Of course, you also need to have followed the first rule.

To illustrate this point, imagine Investor Joe's situation, back in August 2018. His portfolio size was $1 million and he has to draw $50,000 each year to meet his cash needs (after considering his full spending budget and all income sources). If he had assumed a five-year horizon back then, he would have kept $250,000 in cash ($50,000 times 5 years). By now, he would have some $225,000 left, after accounting for his withdrawals during the period. That gives him two major advantages: first, he can afford to wait for the market to recover, because he has enough cash to meet his needs for the foreseeable future. Second, now that his investrment horizon has dropped to three years, he only needs to keep $150,000. Thus he can afford to invest the remaining cash, or some of it, to rebalance his portfolio.

What to expect for 2019

Having stated the rules of the game, what should you expect for the next year or so? To start with, the three main factors behind the 2018 market rout remain in effect, namely: 1) late cycle concerns, 2) shrinking liquidity and 3) trade war rhetoric. In order for the market to stage a rebound, it needs a dose of good news on one or more of the three issues. But good news does come when we expect it the least, so it's not all doom and gloom.

On the first one, namely late cycle concerns, investors are worried that the current boom cycle has lasted for too long and is about to end. When the economy slows down, corpporate earnings slow down with it and that impacts equity valuations. Although US economic growth remains robust, we are starting to see cracks in some cyclical sectors such as real estate. Moreover, growth is indeed slowing down in Europe and China and this is bound to affect our part of the world. The US, on which we heaviliy depend as Canadians, cannot hold the global economic fort all alone.

While we share the common concern that economic growth, and with it corporate earnings, will eventually slow down, we do see a couple of silver linings in all this. First, the market has already discounted much of the anticipated slow down. Second, an eventual slow down will force the Federal Reserve to halt, if not reverse, its monetary tightening cycle. We expect it will do so some time in 2019, possibly before the middle of the year. When that happens, the pressure on equity prices will subside.

This brings us to the second factor, i.e. shrinking liquidity. For the time being, the Federal Reserve is reselling bonds in the open market at the rate of $50 billion a month. This is draining an enormous amount of liquidity from the market. Moreover, by the end of 2018, the European Central Bank should have stopped buying bonds in the market, thus depriving it of a major source of liquidity (that was partly offsetting the Federal Reserve action). Without directly being felt, this whole process is having a significant negative impact on demand for equities, and other financial assets, simply because there is less money to invest. Unfortunately, there will even be less of it in 2019. Shrinking liquidity is the stealth, and most serious enemy, that equity markets will have to confront in the first part of 2019.

As for trade war rhetoric, this is not something we expect to be resolved in the short term. It will be a bumpy road, albeit we do believe a deal will be reached in the end because it is in everybody's interest.

Will market weakness persist in 2019 or shall we see a sustainable rebound? We are more inclined to believe that the former scenario has a higher probability of prevailing, simply because the major issues leading to the current turbulence remain unresolved. Yes, the recent positive news on the trade dispute with China, or some other positive developments, might give the market a temporary boost early in the year. However, chances are that any such rebound would be followed by another setback later in 2019 or in the following year, simply because the worst is not over yet. For the market to stage a sustainable rebound, three things have to happen:

First, the extent of the upcoming slow down or recession, and its impact on corporate earnings, has to be established;

Second, the Fed has to reverse course, and that can happen only after the debate on the first point is settled; and

Third, trade war rhetoric has to subside.

We are strong believers that all three things will happen, possibly before the 2020 US presidential election. So while the short-term outlook remains highly uncertain, the intermediate term should be more favourable.

How to reposition your portfolio

Against this backdrop, how do you position yourself for the next year(s)? The views we are about to summarize are a compendium of suggestions that we have already expressed in previous market updates and which we continue to advocate.

First and foremost, we believe it is time for investors to consider a very healthy dose of exposure to high yielding equities in the financial, utilities, pipelines, telecommunications and real estate (REITS) sectors. If we all think that an economic slow down is inevitable, the Fed and with it other central banks (e.g. the Bank of Canada) will slow down on monetary tightening or even reverse course. When that happens, interest sensitive or high yielding equities will benefit.

You might ask whether it is not too early to load up on interest sensitive stocks, particularly if we are expecting more interest rate hikes in the first part of 2019. This is a perfectly valid point, except that the losses already suffered by this segment are significant, and therefore any further downside should be contained. Moreover, the yields are already quite healthy, ranging between 4% and 6%. So while you wait for your favourite scenario to prevail, you will be cashing decent income. Further, always remember that markets move in anticipation, not after the fact. If you wait for interest rates to stop rising before you buy this segment, you will miss the opportunity.

Second, consider including some preferred shares funds in your portfolio, preferrably Canadian ones. Most Canadian preferred shares are structured such that the dividend rate is either floating or subject to reset every five years. In other words, share prices tend to move up and down with interest rates. Currently, yields range between 4% and 6%. The main risk here is that, if we get a recession and interest rates start decreasing, the yield on your preferred shares will go down with it.

Here again, the question arises of whether it is a good idea to load up on an asset class that is likely to suffer in a recessionary environment. Normally it is not. However, in this particular case, we think the prices are already heavily discounted, and the yields sufficiently attractive. Even if interest rates drop and the yields on preferred shares go down with it, you will continue to enjoy a decent spread of 2% to 3% or so over 5-year Canadian government bonds. This is an excellent risk premium for an asset class that is less risky than common equities.

The beauty of Canadian preferred shares is that they are ideal for pairing with high yield common equities. The two classes typically move in opposite directions, as one should benefit from lower interest rates while the other suffers from it (and vice versa). So you have a near-perfectly diversified combination that hedges your bets against both scenarios while rewarding you with a generous income stream.

Third, consider bargain hunting opportunities in some downtrodden segments. In our series of articles on bottom fishing opportunities, published between November 29 and December 17, we covered three potential markets, namely Europe, emerging markets and Canada. We believe all three geographies have the potential to out-perform the US in the intermediate term, mainly on the back of more attractive valuation. Moreover, we believe the geo-political and other issues plaguing all three regions have been, or will eventually be resolved. In the case of Canada, the revamped free trade agreement has removed much of the uncertainty. In the case of Europe, we believe Brexit and other challenges to European unity will be eventually overtcome, simply because it is in everybody's interest to keep the Union together. As for China, we also believe that an eventual resolution to trade war rhetoric will be reached, also because it is in everybody's interest to do so, even though the road will be long and bumpy.

Fourth, we believe the energy sector has already taken a good beating and is ready for a rebound. We say that simply because we trust the cycle. Low prices are not sustainable given many producers do not make money at oil prices below $50. Eventually, low prices will lead to less supply, whereas demand will continue to grow in tandem with population growth.

Fifth, avoid any overweight exposure to technology and other growth sectors. Despite the significant market losses already incurred, the sector remains richly valued. Also, we are seeing some cracks in the business model of some FANGs, including Facebook, Netflix and Apple. Regardless, the problem is that when price-to-earnings multiples are high, the companies are easy targets of investors wrath. On the first sign of bad news, the market reacts with brutality. Unlike value stocks, where losses are contained by low multiples or high yields, there is hardly anything to stop the free fall when a growth stock falls out of favour.

History often repeats itself. Typically, growth/technology stocks that out-perform in the late phases of the bull market tend to under-perform value equities in the following cycle. Accordingly, and considering that valuations remain high, we expect this sector to under-perform in the near term and to require a longer period to recover its recent losses.

Have a good 2019!

January 1, 2019

Important disclaimer: this article and other articles or content of this website reflect the views of FundScope Limited and /or its contributors and should not be construed as investment advice or recommendations to make specific investment decisions. Neither FundScope nor any of its content contributors will take responsibility for any errors, omissions or misrepresentations, or any responsibility for investment decisions or losses made as a result of reading this artile or using our website. We shall not be liable for any damages, direct or consequential, arising from the use of this website or or any of its content. Investors are strongly advised to conduct their own proper due diligence and use the services of investment advisors before making any investment decisions.