Being ready for the worst, and hoping for the best

• The end of tax loss selling and two pieces of good news have propped the market by a good 10% since brushing with bear market territory back on Christmas Eve.
• Good news notwithstanding, economic fundamentals have hardly changed in the past two weeks, and it is largely expected that the recent volatility will remain with us for some time to come.
• Despite their strongest beliefs, investors should never bet the farm on any possible or probable outcome. The best way to manage investment risk is to be ready for the worst and hope for the best.

In our new year update, we listed three main factors behind the market turbulence: late cycle concerns, trade war rhetoric and shrinking liquidity. We also opined that, for the market to stage a rebound, it needed some good news on one or more of the three issues, and that good news often surfaces when least expected. Low and behold, we have since then been served two pieces of good news that have propped up equities by a good 10%.

The first piece of good news was that trade negotiations with China have resumed, with the two sides voicing their best intentions to reach an agreement. The second piece came from the Federal Reserve Chairman, who announced that the Fed will be flexible and patient in terms of how it normalizes its balance sheet. There is another consideration, albeit that was a short-term one: tax loss selling, which exacerbates market losses when they occur, stopped after year-end, and that for sure has reduced the pressure on equity prices on both sides of the border.

Was that enough to justify a 10% rebound? Hardly so, but when the market becomes technically oversold, the way it was the week before Christmas, it uses any piece of good news to rebound, even though the fundamentals have hardly changed. A meeting with good intentions does not a deal make. And to decide on the next course, the Fed will need to figure out with less uncertainty where the economy is heading in terms of unemployment versus inflation. All what Chairman Powell said was that the Fed will be flexible, which is nothing other than stating the obvious. Not to mention that, soon after he made his statement, he followed it by another one clarifying that he did not think a recession was likely in 2019 and that the Fed would still need to normalize its balance sheet. By that, he meant that the Fed needs to get rid of the bonds it had accumulated since 2009. That in itself is a major liquidity drain. Thus, one can hardly detect any major change in policy, or anything more than paying some lip service to panicking investors and to President Trump.

As per the latest estimates, the US GDP is forecasted to slow down from 2.9% in 2018 to 2.5% in 2019. Such slowdown is not dramatic and should not have a significantly damaging impact on corporate earnings. Having said that, we know for sure that there will be less liquidity, i.e. less money to invest in 2019 and that in itself cannot be good for stocks. Moreover, corporates that repatriated cash from overseas and used it to buy back their shares will also have less cash on their hands as the fiscal stimulus fades, and that should also contribute to lower demand for equities in the intermediate term.

At home, the situation is a bit different. Here, economic growth is forecasted at a sluggish 1.7% this year, as weak oil prices, lower consumer spending and reduced real estate activity is taking a moderate tall on the economy. As such, the Bank of Canada has decided to keep interest rates steady, even though Governor Poloz did say that the recent softness is temporary and that, at some point in time, interest rates will have to go up from here.

Against that backdrop, and despite the recent good news and market strength, we remain somewhat skeptical with respect to the intermediate term and we reiterate our stance that, even though the market rally may have a lot of steam left in it for the short-term, the intermediate to long term potential for equities should remain subdued.

Moreover, there is one short-term consideration, albeit this is purely technical in nature. Since brushing with bear market territory back on Christmas Eve, the broad market climb has been one way up. A common technical principle is that the market has to test its previous lows before resuming its climb, and that has yet to happen. Therefore, one should at least consider the possibility of another setback, anytime in the next few days or weeks. With that in mind, a number of money managers have recently opined that investors should take their time before making any major decision because the recent volatility will remain with us for some time to come.

Markets move in anticipation, not after the fact. If you wait for the news to happen, you miss an opportunity. That's almost always the case, unless something totally unexpected happens. For that reason, we often recommend strategies that sound unpopular, or even totally out of sync with what's happening, such as investing in interest sensitive stocks when the interest rates are still climbing, or underweighting technology stocks when everybody is crazy about them. Guess what? In investing, this approach is the recipe for success. If you wait for the good news or bad news to happen, it will be too late. In our new year update of June 1st, we outlined five portfolio positioning moves for the next year or two, which we invite you to read and share with your investment advisor if you haven't already done that.

All this is not about guessing the next market move because nobody knows with any degree of certainty what it will be. A successful investor will never try that. The secret to success is to consider possible and probable outcomes and get prepared to weather different scenarios. Unfortunately, as the legendary Howard Marks eloquently expressed it, "probable things fail to happen-and improbable thigs happen-all the time..." That may sound a bit pessimistic, but the point is that, despite your strongest beliefs, you should never bet the farm on any possible or probable outcome. Always be ready for the worst, and hope for the best.

January 12 2019

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