The Road to Here
About 15 months ago I wrote a newsletter called Born Under a Bad Sign in which I outlined why some of the world’s top money managers and analysts expected the next decade to be a lost one for stocks and bonds, and why investors might be lucky to earn a net rate of return of between 1-2% per year after inflation and fees.
However, for the remainder of last year those predictions got off to a rough start. By the end of 2021, the following had occurred in the markets:
- North American equities were at or near record territory. The S&P 500 ended the year just under 4800, and the tech-laden Nasdaq landed at just over 16000. The TSX stood at over 21000, peaking three months later at just over 22000). They had come through the pandemic with flying colours. When compared to the pre-pandemic markets of December 2019, the TSX was up 23%, the S&P 500 was up 48%, and the Nasdaq a staggering 77% after almost two years of lockdowns.
- While bond rates were climbing slowly, 10-year US and Canadian government bond rates reached 1.5% by year end. Central bank rates in both countries ended the year at, or near, zero.
- In Canada, housing prices continued their inexorable rise. Across the country average prices were 17% higher than two years earlier. In Toronto and Vancouver specifically, the increases were more than 25%. Mortgages were still available at almost record-low levels.
- Unemployment rates in Canada fell from a peak of 14% during the peak of the Covid lockdowns in March 2020 to 6% in December 2021.
- Bitcoin had exploded from less than $10,000 Canadian in December 2019 to $80,000 Canadian in November 2021. Things have changed somewhat since then.
There were some tell-tale signs that suggested good times were over; the boldest being a steady rise in inflation globally, to levels we have not seen for 40 years. Interestingly, many observers put much of the blame on the war in Ukraine, but a closer look at the data suggests there are other culprits.
Inflation bottomed in Canada during this cycle in May of 2020 at -.04% (Bank of Canada website). Given how the lockdowns were implemented and the markets were performing, this was not surprising. Since then, massive amounts of stimulus globally helped create a surge in the purchasing of products (vs. services). The overall CPI increased, and, by the end of 2021, it hit 5% in Canada and 7% in the US (almost three months prior to the war in Ukraine starting).
Bond rates were low at the end of 2021 but were still rising from record-low levels set in July of 2020 when the 10-year Canadian bond rate was about 0.5%. From there they climbed to 1.5% by December 2021. Long-term bonds were one of the few asset classes that lost money in 2021.
Where we stand
It is July 1st as I write this, and the first six months of the year have converted annus mirabilis into annus horribilis faster than a speeding ticket. Let’s consider how many things have gone wrong:
The S&P 500, Nasdaq, Russell 2000, Euro Stoxx, and the Hang Seng are all in bear market territory. The Hang Seng, seeing a drop of more than 20% from their prior peak over the last 12 months.
Inflation has continued to climb; this time, exacerbated by the war in Ukraine. Oil has certainly had a very real impact on consumer prices but arguably not as much as in the past as shown by this graph (below) from The Federal Reserve Board of St. Louis. It shows oil prices for the last 72 years adjusted for inflation. In real terms, we have seen much higher prices than we have now, and for longer periods of time.
The Bank of Canada (BOC) and the Federal Reserve (FED) have increased base rates several times from near-zero to 1.5% in Canada and 1.75% in the US. Jerome Powell and Tiff Macklem now seem determined to quash inflation regardless of how much they must raise rates. Estimates now are that both rates could be above 3% by the end of the year. While those rates are rising, so have longer-term bond rates and as of mid-June, US and Canadian 10-year yields were above 3.5% (the highest in more than 10 years). An increase of 2% since December means investors would have paper losses on 10-year bonds of about 15% YTD. However, as we shall see, some things have started to change in these markets
Cryptocurrencies have collapsed and lost more than two-thirds of their market value since last November (over $2 Trillion USD). This highly unregulated market has also experienced a number of fraudulent transactions and a number of exchanges have had to close or declare bankruptcy as a result of excess leverage. Bitcoin has dropped from $70,000 to less than $20,000 USD and other cryptocurrencies have fallen even more.
The war between Russia and Ukraine has brought untold suffering to the Ukrainian people and caused hundreds of billions of dollars of destruction and cost. Commodity prices have skyrocketed (especially oil, gas and wheat). Since the war does not appear to be moving towards a quick resolution, commodity shortages and sanctions against Russia could be in place for years. However, as with the bond market, there are some surprises with respect to commodity prices (below).
China’s zero-covid lockdown strategy along with a housing crisis that has been years in the making (this is China’s Minsky Moment*) has dramatically curtailed China’s growth for this year and added to supply-side problems. Many experts feel that this slowdown in Chinese growth will be permanent because of a shrinking population that is aging more rapidly than most other countries. Combined with an authoritarian political model that does not follow the rule of law (as investors in democracies understand those rules), this makes China a less attractive destination to invest capital. For a more detailed analysis of China and globalization overall, I suggest you buy Peter Zeihan’s new book The End of the World is Just the Beginning. Those places in the world that will succeed will need the right combination of demographics, resources, and short supply chains
*This is the definition of a “Minsky Moment as written in Investopedia: Minsky Moment refers to the onset of a market collapse brought on by the reckless speculative activity that defines an unsustainable bullish period. Minsky Moment is named after economist Hyman Minsky and defines the point in time where the sudden decline in market sentiment inevitably leads to a market crash.
Another image seems appropriate given what has occurred in the first six months of 2022; long before even my time (yes, they had clocks back then), in the early days of black and white movies, there was a very successful comedy duo of Stan Laurel and Oliver Hardy. Of course, plots were simple; they inevitably got into trouble, and then out of it. The photo above shows them with one of their most famous quotes.
It seems to me that the first half of this 2022 has been like one of those “messes” Stan always managed to create. Is there anything we can imagine for the rest of the year, or at least next year, where Stan might come to the rescue? Here are some bright, if small lights, I am seeing now that may change either the course we are on or how much damage might be inflicted in total:
- There are several commodity prices, such as wheat, that peaked two weeks after Russia invaded Ukraine at $12.94 USD per bushel and are now (June 30th, 2022) at $9.27 (a drop of 28%). Other commodities off their recent highs include copper, nickel and tin, which are between 23-50% lower today; Lumber is 60% less than in March; steel and iron ore are down about 15% each, and even gold has briefly dropped under $1800 from over $2000 and is generally seen as an inflation hedge. If these drops hold, they will show up in future inflation statistics.
- Oil is challenging because replacing up to 5-million barrels per day from Russia could take years if sanctions remain. However, if prices for oil (about $110 USD per barrel) remain at these levels, then by next March the year-over-year figures will show a 0% gain and, as such, a reduced impact on CPI figures.
- GDP figures for Q1 in the US showed a 1.6% drop and in Canada a .2% drop in May. It begs the question of whether or not an economic contraction in Europe and North America has already started.
- Housing sales in Vancouver and Toronto are both 35% and 41% lower in June 2022 than a year ago. Prices have also dropped in Toronto by 14% according to the TRREB (Toronto Regional Real Estate Board) since February. From an average of almost $1.35M to $1.1M. Prices have been relatively flat so far this year in Vancouver. Far less than the 12% increase YOY.
- While bond rates have been rising almost all year they stopped for a breather in the US, Canada and Europe. US 10-year bond yields have fallen 60 bps from 3.5% to 2.9% in about two weeks. That is a very rapid drop. In addition, we are close to what is known as an inverted yield curve where short term bonds (2-years) have higher interest rates than longer durations. As of now it is almost flat. When yield curves invert, they often are a precursor of a recession and rates do not rise much after they occur.
- The S&P 500 PE ratio has now dropped to less than 20 which is below its’ average of almost 22 since 1980 (Multpl.com). Of course, a recession would trigger lower earnings in the future.
Source: https://www.multpl.com/s-p-500-pe-ratio
There are a lot of maybes in my observations. Interest rates and inflation could keep rising until the FED/BOC triggers a hard landing recession. However, these few items above might mitigate inflation, slow down the economy, accelerate a milder recession, and create a peak for current interest rates lower than markets currently expect.
Navigating roadblocks and detours
If you recall, the subtitle of this newsletter is how much do bear markets impact your ability to build or preserve wealth? (A lot less than you might think).
Why would I think that bear markets have a relatively minor impact on one’s ability to build or preserve wealth? Two reasons. Asset allocation and portfolio rebalancing. We have written about both before but in these markets and economic conditions, a disciplined approach to asset allocation and rebalancing will make a difference.
Asset Allocation
It is our belief that proper asset allocation includes a blend of private and public assets, as shown in the asset mix of our Nicola Core Portfolio Fund pie chart below as of March 31st, 2022. As you can see, public equities were just over 22% of the total vs typically 60% in traditional balanced portfolios.
This model has resulted in our clients achieving higher risk-adjusted returns since January 2000 and this is particularly notable during bear markets including the one we are experiencing now. The slide below shows the Nicola Wealth Core Composite, a composition of performance representing all fee-paying client portfolios with a Nicola Core mandate, against the S&P 500 in the four bear markets since 2000.
This is important for two reasons; The first is that a more diverse asset allocation model can provide better risk-adjusted returns with lower volatility. Two research groups (Morningstar and Dalbar) analyze actual investor returns and how they differ from market returns one would earn by simply not trading when markets are volatile (i.e., buy and hold). Here is a quote from Morningstar’s 2021 analysis called Mind the Gap.
Why would investors earn less than the funds they invest in? It all comes down to timing.
Our annual “Mind the Gap” study of dollar-weighted returns (also known as investor returns) finds investors earned about 7.7% per year on the average dollar they invested in mutual funds and exchange-traded funds over the 10 years ended Dec. 31, 2020. This was about 1.7 percentage points less than the total returns their fund investments generated over that span. This shortfall, or “gap,” stems from inopportunely timed purchases and sales of fund shares, which cost investors nearly one sixth the return they would have earned if they had simply bought and held.
For over 30 years, financial services market research firm DALBAR has released its Quantitative Analysis of Investor Behavior report, which measures how investors’ decisions affected long-term performance in their portfolios. DALBAR research shows that investors consistently underperform, by trying to “time the market.”
This is their most recent analysis of 30 years of investor results when compared to the S&P 500; on average, investors lose about 3% per year.
In both studies, the amount of underperformance annually is the same or more than the typical fees one would pay to invest in a well-diversified portfolio with a qualified advisor to keep the investor investing and behaving rationally.
The results discussed so far show the benefits of buy and hold when it comes to volatile markets and publicly traded assets. A loss of 3% is significant over time. As a simple example, $1m invested at a 3% return (due to bad investor behavior), versus a 6% annualized return amounts to a $3.3 million-dollar difference over 30 years, or 130% more money.
If that were not compelling enough, there is an additional way investors can add to their long-term results. That is to rebalance in a disciplined and systematic way.
Rebalancing
How does rebalancing work? Imagine you started a traditional balanced portfolio of 60% public assets and 40% fixed income at the beginning of a year and six-months later your public assets dropped to under 50% of the total and fixed income rose to more than 50%. Rebalancing simply means selling enough fixed income to bring back your equity position to 60%. In effect, the model “forces” an investor to “buy low and sell high.” The Dalbar and Morningstar studies clearly show most investors do the opposite to their long-term detriment.
We reviewed data on rebalancing by examining all major US bear markets since 1929 and comparing buy and hold results with active rebalancing. We modified the rebalancing process from quarterly to annually and from one-third of the portfolio to 100%. The best results are highlighted below. Ideally, we rebalance every 3-6 months and with 50-66% of the portfolio. Simply doing so in a disciplined fashion added about 1.4% per year in net returns.
According to the Dalbar and Morningstar studies, between a truly diversified asset allocation model, and rebalancing consistently, one could possibly improve long-term returns by as much as 3% annually.
Our own Nicola Wealth Core Composite as measured since January 2000, has outperformed the Morningstar Neutral Balanced Portfolio by about 2.5% net of fees over more than 22 years. Details of the results can be found at our website (https://transfer.nicolawealth.com/investing/#marketplace).
The road ahead
So, what observations can be made about where we find ourselves in terms of markets and the economy?
- The Bear in most equity markets is upon us and based on how quickly this has occurred compared to previous bear markets, it is likely not over yet.
- While interest rates are rising, and inflation may not yet have peaked, there are at least some reasons to hope that they may turn sooner than most analysts believe.
- We may already be at the beginning of a global recession now and current geo-political and macro-economic events are exacerbating the challenges to global growth.
- While all of these issues can cause economic pain, they do not have to have a major impact on effective wealth building or preservation. Two major factors that will help maintain wealth and cash flow are diversified asset allocation and portfolio rebalancing. Both require discipline and work.
I think it’s best to end with some positive thoughts. Bull and bear markets fluctuate and only rarely are they in equilibrium. What we are experiencing now is normal and necessary.
These quotes from JP Morgan and Warren Buffett sum it up nicely. We need bear markets to be able to buy well. This is where future returns are made.
This material contains the current opinions of the author, and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. This material contains the current opinions of the author, and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Nicola Wealth is registered as a Portfolio Manager, Exempt Market Dealer and Investment Fund Manager with the required securities commissions. Nicola Wealth is registered as a Portfolio Manager, Exempt Market Dealer and Investment Fund Manager with the required securities commissions.
Comparisons of the historical performance of Nicola Wealth funds or models to the historical performance of indexes, mutual funds or other investment vehicles should only be undertaken with consideration of the differences that exist between the underlying investments that comprise the compared investment vehicles. Indexes may be primarily composed of a single asset type/asset class (i.e., 100% equities or 100% bonds) whereas Nicola Wealth funds may or may not contain a combination of exchange-traded equities, marketable bonds, private investments, other alternative investment classes and exempt products. When making any comparison of historical performance, these differences and their impact on the performance of each comparable should be taken into account.
The Nicola Core Composite returns represent the total returns of Cdn. dollar-denominated accounts of all fee-paying portfolios with a Nicola Core mandate. The composite includes clients who are both fully discretionary and nondiscretionary. Historical net of fee composite performance returns is calculated using individual realized time-weighted client returns net of fees and is presented before tax. The Nicola Wealth inclusion policy is based on clients’ weights at calendar month-end. The composite returns are asset-weighted based upon ending monthly market value. The Nicola Core mandate may change over time. Additional information regarding policies for calculating and reporting returns is available upon request. The composite returns presented represent past performance and is not a reliable indicator of future results, which may vary.
