Wednesday, November 14, 2018
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Q3 Investment Report

The year 2018 to date has been very frustrating for investors, as just ten stocks out of 500 Stocks in the S&P 500 have accounted for all of the 9% gain in the index to the end of September. That means the remaining 490 stocks have collectively lost money. Most of those ten stocks also trade at price levels that are not at all attractive.

This unusual and unhealthy divergence clearly illustrates that the market internals have turned decidedly negative, and is an indication of more market weakness ahead.
The Canadian market has been the worst performing market in the world. Canada is simply under bad management. This is true no matter which party one chooses to support.

I have been very defensive for some time and the market has moved against my posture because I underestimated the quantity and duration of the QE stimulus program. I feel I have just been early, but I will be proven correct by the end of this cycle.

As I have mentioned in the past, the reversal of QE is as negative for the markets as the stimulus has been positive. The Central Bankers have manipulated the stock and bond markets to extreme levels in the face of a very slow growing economy. The US tax cuts boosted earnings and improved investor sentiment. It is abhorrent to witness the US running a colossal deficit of almost $1 Trillion while their economy is supposed to be on fire with almost full employment.

This is the first time in my memory that both the stock and bond markets are overpriced. Normally, bonds are considered a haven when stocks are weak but this time bond prices are just as weak as stock prices. The low level of interest rates greatly increases the sensitivity of bonds to rising interest rates. A relatively minor increase in rates completely wipes out the return from bonds.

There is an old saying; “Don’t fight the Fed.” There have been 8 increases in rates of one-quarter percent since 2016, and they are promising another increase in December and a couple more in 2019. Ten year US Treasury bonds are now paying 3.25% and the S&P 500 is paying 1.9%, so yield-pull towards bonds is increasing, which is negative for stocks. Some Fed Governors have recently observed surprise that the stock market has been ignoring the new policy of restraint.

In addition to increasing interest rates, the Fed has been selling bonds from the $4 Trillion inventory they purchased through QE since 2009. The plan is to sell $600 Billion/year, which is on top of the $1.2 Trillion of bond financing required to cover the fiscal deficit and off balance sheet spending. This $1.8 Trillion of bond sales adds pressure to the bond market and is a large reduction in the money supply. The stock and bond markets thrive on low interest rates and a growing money supply. Both are in reverse, so it should not be a surprise if markets decline.

Investors that are fully invested are facing serious stress due to increasing fragility of the markets, and what I see as an impending major correction. Today, the Bank of America analysts announced that the many analysts’ earnings estimates are going to prove to be unattainable due to the trade war and higher costs. The market is not prepared for earnings disappointments.

Our returns have lagged the market for some time but it appears our defensiveness is the correct posture and we have good cash reserves to bargain hunt, instead of waiting years to recover losses.

This report may possibly be dwelling too much upon the negative investment conditions enveloping the financial markets. I think I am being realistic and our clients’ portfolios are positioned to take advantage of an opportunity of a lifetime.

I have not mentioned that the European Central Bank and the Bank of Japan indicated they are also going to withdraw stimulus at the end of this year. There are approximately $5 Trillion of bonds outstanding in Europe and Asia that are paying zero or negative interest rates. The banks and institutions that own these bonds are facing catastrophic losses if interest rates escalate too rapidly. It could be a problem leading to panic selling if the losses threaten their solvency. Those bond holdings are poison on their balance sheets as rates escalate.

Aside from policy, the rate of inflation influences the level of interest rates. The trade war and higher costs are driving inflation up and reducing profit margins, which does not appear to be discounted by the markets.

As discussed, we are in excellent position to take advantage of lower prices. Our cash is worth more every day the market declines and we can look forward to making money over the next several years instead of recovering losses.

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