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(Non)-Buyer’s Remorse: How should you invest in 2014?

You missed the rally. Now what?

Feb 1, 2014

by Max Fawcett


It was the best of times, it was the worst of times. In 2013, stock markets around the world rallied – except, it seems, here in Canada. Yes, the nine per cent return that the TSX delivered is better than the long-term average, but when the Nikkei was up 57 per cent, the S&P 500 30 per cent and even France’s CAC 40 was up 18 per cent, it’s easy to feel like we’ve missed the party. What makes matters worse is that many retail investors – and plenty of institutional ones as well – were underweight equities throughout the recent run-up in prices.

The question, then, is what to do now. Is the punch bowl empty, or is there still something to drink? Stephen Lingard, the managing director of Franklin Templeton Solutions, thinks investors might want to sip, not slurp. “I think a little bit of nervousness is good. We see sentiment levels in most major markets that are very elevated, and normally precede a correction. But let’s face it: if we get a correction, I do think that correction should be bought long term. I still think there’s value in equities as we grow out of this soft spot in the global economic cycle. But we’re getting to the stage where the easiest money has been made.” The problem, he says, is that retail investors have an uncanny habit of being late to the party. “My big concern for investors in 2014 is that after five years of tremendous returns, they’re finally going to come out of their shells, or their defensive mode, just in time to potentially take a correction on the chin.”

That’s why he suggests that anyone sitting on a larger cash position than they’d like scale back into the market in gradual, deliberate stages. “If you have monies that should be earmarked for equities but you’ve pulled it out into cash because you were nervous, by all means deploy some of that back. But do it on a fairly regular basis – monthly or quarterly – to try to get back where you want to be to meet long-term objectives.”

Europe Steps Back From The Brink

It’s hard to remember a time when European markets looked like a good place to put money to work. The continent is still just barely out of recession. But Lingard says Europe doesn’t need to see four per cent growth for its equity markets to outperform. More importantly, the formation of a so-called “Grand Coalition” in Germany between Angela Merkel’s centre-right Christian Democrats and the centre-left Social Democrats might include a minimum wage and other policies that are more tolerant towards inflation. “To the extent that they’re contemplating a minimum wage that’s actually above most of the periphery, above the U.K. – probably not as high as France, but who can really be that high? – I think it is a very positive sign that fiscal austerity is being replaced by a more reflationary mindset.”

Follow the Leader

Of all the stock indexes in the world, none performed better in 2013 than Japan’s Nikkei. And yet, according to Stephen Lingard, there’s a decent chance that it could repeat the feat in 2014. “If you look at it on a valuation basis, and Abenomics works and actually engineers a structural increase in growth in the Japanese economy, valuations are far too low,” he says. “Japan trades at a nearly 50 per cent discount to some of the major markets on a price-to-book basis, and a discount on a price-to-earnings ratio basis. I think you could see some nice gains out of Japan going forward.”


“We believe extraordinary policies (560 rate cuts since 2007) mean extraordinary outcomes such as macro and market booms in 2014. In our view, macro will be lifted by lower fiscal drag and lower banking drag. Meanwhile, we think Wall Street’s boom will likely continue until Main Street’s recovery becomes visible and tightening starts.”
– Michael Hartnett, chief investment strategist, Bank of America Merrill Lynch

“I continue to believe that it is plausible to expect the S&P 500 to lose 40 to 55 per cent of its value over the completion of the present cycle, and suspect that whatever further gains the market enjoys from this point will be surrendered in the first few complacent weeks following the market’s peak. That’s how it works.”
– Fund manager John Hussman

Up, up and Away?

As Sir Isaac Newton famously observed, “What goes up must come down.” And while that might seem like a useful rule of thumb in a market that has made a habit of setting – and resetting – all-time highs, it turns out that that reverse is actually true. That is, when it comes to equity markets, what goes up should continue, in the longer run, to continue in that direction. That’s partly a reality of inflation but also a reflection of the fact that, as Dianne Lob and Ding Liu noted in a recent report, “Market level has no predictive power.” Lob and Liu, who work for the New York-based asset management firm AllianceBernstein, note that since 1900 the S&P 500 has been within five per cent of its prior peak nearly half the time.

Instead, they say, it’s the market’s valuation that matters rather than its nominal level. And on that front, things look decidedly less treacherous. “At 18.7 times trailing earnings, the U.S. market today is more expensive than average but it’s not extremely expensive,” they write. “Outside the U.S., however, equities haven’t rebounded as far, so the MSCI World Index of developed-market equities remains close to its long-term average valuation.”

That’s Not A Bubble. That’s A Bubble

The dreaded b-word has been popping up a lot in conversations about the state of the stock market. Indeed, incoming U.S. Federal Reserve chair Janet Yellen addressed that concern in her testimony to the Senate Banking Committee, saying, “I don’t see evidence at this point of asset price misalignments at a level that would threaten financial stability.” So what do “asset price misalignments at a level that would threaten financial stability” look like? Here are a few famous examples.

The Tech Bubble
Peak: March 12, 2000
From March 12, 1999, to March 12, 2000, the NASDAQ rose by a staggering 116 per cent, as investors everywhere – not to mention analysts – lost track of reality and starting thinking “companies” like were worth something. By March of 2001, the Nasdaq had given back all of those gains – and then some. And despite a furious rally over the last couple of years, it still hasn’t retaken those highs.

Tulip Bubble
Peak: March 1637
Clearly, there’s something about bubbles peaking in March. Of course, this one happened nearly four centuries prior to the dot-com boom, and continues to be the fool’s-gold standard for speculative bubbles. And while accurate pricing information isn’t available, at the peak of the market, some tulip bulbs sold for in excess of 10 times the annual income of a skilled craftsman. When it popped, they were worth next to nothing – or, what you’d expect for what is essentially a glorified seed.

The South Sea Bubble
Peak: 1720
At the time, it seemed like a masterstroke. To help finance the war it was fighting against Spain, the British Crown created a joint-stock company in 1711 called the South Sea Company that offered an annual dividend and, more importantly, exclusive trading rights to Spain’s gold and silver-rich colonies in South America and the West Indies. In exchange, the winning bidder had to assume some of the nation’s wartime debt. Investors eventually came to believe that those rights could be worth a great deal, driving up the price of its shares and incenting the creation of other similarly configured joint-stock companies. By August of 1720, shares in the South Sea Company reached a peak of £1,000 – and then the bubble burst. By the end of September, those shares were worth less than £150.

The Bitcoin Bubble
Peak: ?
Given the volatility that it saw in November – surges of 50 per cent, followed by crashes of 35 per cent – it’s hard to say where it’ll be trading when this magazine hits newsstands. A safe bet: it won’t be where it was when it went to press. And despite the facts that Germany has officially recognized it as a “unit of account,” outgoing Federal Reserve chairman Ben Bernanke said some nice things about it and a growing number of retailers are accepting it as payment, it seems likely that the good times will end – and, in all likelihood, rather abruptly. As the Economist wrote in November, “The recent price surge, driven by Chinese investors stashing money offshore, looks like a classic bubble.”

Safety Is Expensive – And It Might Still Be Worth Paying For

Record-low bond yields have driven institutional investors into yield-bearing equities for a few years now, and the billions of dollars they’ve brought with them have pushed prices on shares of once-dowdy issues like utilities, telecoms and consumer staples companies up to valuation levels usually reserved for growth companies. As such, Lingard thinks safety in the equity markets in the form of these sorts of companies comes at a pretty steep premium right now. “On a structural basis, I don’t think there’s a lot of value in some of these consensus areas. One of the poster children is Nestle, which has been trading at 60 times [earnings] because people were buying it for the dividend and the bond-like properties. And yeah, there will be growth in that company, but how much do you pay for that dividend?”

But it’s too early, he says, to move out of that trade completely. “I’d like to think that story was done, because it would mean we’d be getting back into a healthier, trend-growth environment where monetary policy doesn’t need to keep interest rates near zero. I suspect it’s too early to claim that kind of victory. I’m not convinced that rates are going up to four per cent any time soon.”

Don’t Fear The Taper

If you’ve had a chance to review your portfolio’s returns for 2013, you might have already seen some red ink in your bond portfolio. You can put the blame for that squarely on the so-called “tapering” of bond buying by the Federal Reserve – or, at least, the market’s take on it. As it turned out, no tapering ever happened, and bonds recovered some (but not all) of the losses they suffered earlier this year. But it raises the question of whether bonds will get hit hard again when the taper finally happens.

Rumour has it that new Fed chair Janet Yellen may try to replace bond buying with forward rate guidance linked to specific targets for unemployment, and while Lingard thinks that should be broadly positive for stocks, he says it will almost certainly be accompanied by volatility. “We are talking about new policy tools that need to be digested by the marketplace,” he says. “So if there’s one thing I believe strongly about the next year is that we’re going to see more volatility than we saw this year, notwithstanding the head fake that we saw with the bond market in the spring.”

But, he says, bond and equity investors should be encouraged by the fact that their interests are roughly aligned with those of the Federal Reserve itself. “Everyone knows the Fed has a bad position if you look at its balance sheet. They don’t want this thing to unwind in an unruly way, with rates shooting straight up, because that would mean tremendous losses for them. I think we’re looking at a saw-tooth pattern with interest rates, where they track higher and they have a period where they consolidate.”

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