The following commentary represents the opinions and analysis of Doug Nelson, President, Portfolio Manager, Nelson Portfolio Management Corp. as at January 7, 2018. Market and index returns noted below are for the period ending December 31, 2017. Market Statistics: Source: https://ca.finance.yahoo.com, https://ycharts.com.

• The Toronto Stock Exchange had a flat return from January 1 through to September. Therefore, all the gains for the year have occurred over the past four months. The return for the past three months was +3.29%. The 12-month return was +6.03%.
• In the last report I wrote: “Since the last report, the Toronto Stock Exchange had been flat for most of the summer. The market index returns from July 1 through to September 15th was zero. Yet, over the past two weeks the markets have rallied, resulting in a gain of +2.06% for the quarter”.
• The best performing sectors in the Canadian market this year were Technology (+18.74%), Industrials (+16.64%) and Financials (+9.34%) while the worst performing sectors were Energy (-12.48%) and Real Estate (+4.12%).
• As mentioned above, most of these returns have taken place over the past 3 to 5 months.
• Over the past three months the S&P 500 (the 500 largest companies in the United States) increased in value by approximately 5.71%, generating a 12 month return of +19.42%. The technology index grew by approximately +36%, health care +25% and banking +16%, US dollar terms.
• However, in the last report I mentioned about how the change in the value of the Canadian dollar has impacted investment returns outside of Canada. 12 months ago, the Canadian dollar was trading at approximately 76 cents to $1 US. Today the Canadian dollar is approximately 80.6 cents to $1 US. This is an increase of over 6%, which means that the returns from US investments are reduced by 6% when converting their returns into Canadian dollars.
• Note: Your portfolio holdings and rate of return reports are reported to you in Canadian dollars. Therefore, it is important to be cautious when comparing your portfolio reports to the US dollar based investment returns.
• This means that that in Canadian dollar terms, the returns on the S&P 500 is closer to 16.37%.
• Globally we have continued to see very good performance out of Europe and Asia. Since the last report the Europe / Asia / Far East Index (Symbol: EFA) has increased in value by 2.76% (+21.79% for the past 12 months in US dollars) and the Emerging Markets Index (symbol: XEM) +5.25% for the past three months (+25.51% Canadian dollars over the past 12 months).
• In the last report I mentioned the IShares Global Industrials Exchange Traded Fund (Symbol: XGI): The 12-month return was +23%.

As per other reports, here is a table showing the most recent returns by sector and market.

Table 1: Historical Returns for Winter 2017 (January 1 to March 31, 2017) vs. Spring 2017 (April 1 to June 23, 2017) vs. Summer 2017 (June 23 to September 29th, 2017) vs. Fall 2017 (September 29th to December 31st, 2017) vs. the Last 12 Months (January 1, 2017 to December 31st, 2017). Market Returns Source: ca.finance.yahoo.com. NFC Tactical Asset Allocation Pool source: Croesus software. The industry standard rate of return disclosure of 3, 6, 9 and 12 months is illustrated on your client specific investment statement. The time periods selected for the tables in this report were chosen to illustrate recent changes in the markets and with different types of investments.

If you have any questions or comments about these figures, please send me your thoughts.

Since the last report, what has happened with the NFC Tactical Asset Allocation Pool?

• Since the last report, the NFC Tactical Asset Allocation pool has increased in value by 2.71% for a 12 month return of +6.01% net of fees. By comparison the Toronto Stock Exchange Index has increased by 3.29% over the past three months and +6.03% for the year.
• In general, we talk about striving to capture 70% of the upside of the market while protecting against 70% of the downside of the market over time. With this in mind, 70% of the TSX return over the past 12 months is 4.22% (70% X 6.03% = 4.22%) vs. the pool return of +6.01%. The pool has done well over the past 12 months:

1. In October we received from Fundata (www.fundata.com) the September 30th detailed analysis report on the pool. At that time, for the 3 years ending September 30th, 2017, the pool had the 20th highest return and the 26th lowest level of volatility, measured against 145 other Neutral Balanced Funds available to Canadian investors in Canada. We receive this report on a quarterly basis. This means that the pool was ranked in the top 14% of this peer class over the past 3 years. We are very proud of these very significant results, both in terms of investment return but also risk management.
2. Currently in the pool we own a basket of 39 individual Canadian stocks. Over the past 12 months, 4 of these holdings had negative returns and 35 had positive returns. 14 of these holdings had a 12 month return less than the Toronto Stock Exchange (TSX) while 25 had returns greater than the TSX. The average 12 month return for the group was approximately +10% (vs. 6% for the TSX). The largest gains occurred with companies such as Genworth Canada (+26.48%), Pure Industrial Real Estate (+25.6%) and Rogers Communications (+22.5%). This helps to reinforce that our security selection approach is serving us well.
3. At this time in the pool we also own a basket of 13 US stocks, all of which had a positive return over the past year. The largest returns (in US dollars) came from securities such as Boeing (+95%), Abbvie (+54%) and Cisco Systems (+26%). We also own a basket of 13 sector specific US listed exchange traded funds that have generated the following 12 month returns (in US dollars): Video Game Technology (+59%), Global Robotics (+44%), Global Impact Strategies (+28%).
4. We have also invested into one of the first investment strategies based on Artificial Intelligence algorithms (Symbol: AIEQ). Most algorithmic investment strategies are based on historical back- tested data. By comparison an algorithm based on artificial intelligence is one that keeps learning and modifying based on new information. Since November 14th, AIEQ has out-performed the S&P 500 index by 50% (a 10% return for AIEQ vs. a 6% return for the S&P 500) while AIEQ has a price earnings ratio of only 15 (30% lower than the S&P500). Interesting stuff indeed.

What Have We Been Up To Over The Past Several Months?

• In the last report I wrote: “When North Korea fired a missile over Japan on August 29th, at that time I felt that the world dynamic had begun to change and that risks were definitely moving higher. A second missile flew over Japan on September 15th. Since then the rhetoric between the US and North Korea has grown exponentially. When this type of situation arises, what do you do? Do you ignore it, believing that this will never escalate into something? Yet, if it does, and the markets respond with a significant drop in value, then hindsight would suggest that it would have been prudent to be more defensive.”
• With these concerns in mind, I have held more cash over the last few months than I would have done historically. During this time, we have been looking for other complementary investment strategies that we feel are a) lower risk than the current market and b) are quite different from the overall market. A good example of this is AIEQ (https://equbot.com/).
• We have continued to add to our other non-core technology holdings that focus on specific sectors such as gaming, cyber-security, global payments and robotics.
• Due to the growth in the emerging markets, we have also increased our exposure in these regions as well with investments into the Vanguard Emerging Markets All Cap ETF (Symbol: VEE). The weighted average price earnings ratio is 30% less than the overall market and it pays a yield of almost 2%. Over the past 3 months we have seen a gain of 6% in this investment.
• This past fall we have also invested into an additional stock screening and portfolio evaluation tool called Y-Charts (www.ycharts.com). This tool helps us to continue to evaluate a wide range of stocks and exchange traded funds in a very detailed manner. This tool also helps us evaluate and construct portfolios that meet our risk and return targets. You will see me reference Y-Charts data frequently in future commentaries. We also expect this tool to assist us in evaluating and rebalancing individual client accounts.

What changes have been made to the NFC Tactical Asset Allocation Pool?

• Table 2 below illustrates the changes to the overall asset mix of the pool, over the past 2 years. Note that the pool is currently closer to being a neutral allocation (47% defensive, 53% growth), more defensive than it has been for the past 15 months.
• Table 2 also illustrates the geographic weighting. You will notice how the Canadian exposure has recently decreased as we have increased the US and global components of the pool. Today the Canadian exposure is approximately 71% whereas a year ago it was closer to 76%. Over the past 12 months the US exposure has increased from 18% to 22%, but the rise in the value of the Canadian dollar has temporarily reduced the returns on these investments. The change in global asset mix has been a positive contributor to the performance of the pool, but the currency moves have offset some of these gains on the short term.

Table 2: NFC Tactical Asset Allocation Pool: Asset Mix for the period ending as displayed. Source: Croesus Software.

Where Do We Go From Here?

In the last report I wrote: “Today the markets look to be strong with many positive trends in place. This is good! The summer months were quite typical in that little to no gains were achieved until approximately 2 weeks ago. So, after a summer of zero returns, it makes sense that we would begin to see some growth. Combining this with the hope that US tax reform is positive for the markets and we could see markets continuing to rise from here.” This is exactly what we have seen.

In the last report I also wrote: “Alternatively, it is hard to ignore the current valuation levels and other external, unpredictable areas such as the rising uncertainty relating to North Korea. If we ignore North Korea, we may do very well if markets continue to rise. Alternatively, with the high market valuations in place, if there is an unexpected event could we see a 10% to 20% market correction come quickly?” This is still a risk we need to consider.

Here is some further detail to consider. I’ve mentioned previously that the overall markets appear to be quite highly valued and are becoming quite narrow in focus. Here are some interesting figures I calculated when preparing my commentary:

• The S&P 500 is an index of 505 of the largest corporations in the United States. The top 10 holdings would be 2% of the total number of holdings. However, when we measure these top 10 holdings by market weight, these 10 companies actually represent 21% of the value of the overall index. This means that the other 98% of the companies in this index represent only 79% of its value.
• This begins to suggest that the markets in the US are becoming quite concentrated with companies like Apple, Amazon, Facebook and Google (4 of the top 10 largest firms) representing a significant component of the overall index. Therefore, as goes these firms, so goes the index, to a large degree.
• For example, in 2017 these top 10 companies generated approximately 33% of the total return of the S&P 500 index.
• To summarize: 2% of the number of companies in the US represent 21% of the value of the markets and were responsible for over 1/3 of the total return. I believe these are important figures to consider going forward.
• This also means that the remaining 98% of the companies in the US generated an investment return of only +8.62% in Canadian dollar returns. This is a far cry from the headline number of US market returns of +20%.
• It is also interesting to note that 1/5th (20%) of the companies listed on the S&P 500 index lost money in 2017. This tells us that not every stock in the US has been a clear winner and the market may not be as strong as the headline number suggests.
• It is also interesting to see that the mid-cap index of US companies (i.e.: symbol: XMC) generated a Canadian dollar return of only 9.29% (approximately) and the small-cap index of US companies (i.e.: symbol: XSU) generated a Canadian dollar return of 6.18%.
• Again, this is interesting because it suggests that the growth in the US market has been highly concentrated and has been dominated by the largest companies, especially those in the technology sector. The technology sector now represents 22% of the overall S&P 500 index.
• At this time the S&P 500 index is valued at a price earnings level of approximately 23 vs. the long term average of approximately 15 to 16. Last April, based on a wide range of other measures, the S&P was considered to be over-valued in 18 of 20 different categories (https://www.investopedia.com/news/sp-500-overvalued-almost-every-metric/ ). Since this article was written, the price earnings level is approximately 10% higher. Other analysis suggests that the US market is at its third highest level in history (https://seekingalpha.com/article/4110892-s-and-p-500-severely-overvalued-look-5-different-angles).

So, what’s the best approach in a time like this?

• It appears to me that as markets have continued to climb, so are the risks of a pending correction.
• This can be demonstrated by historical values, the number of ways in which market valuation can measured, and the increased concentration in returns.
• This doesn’t mean to say that markets can’t continue to increase in value. Markets could continue to climb into the March and April time period.
• The trend currently continues to be upward moving.

At this time, we continue to have a balanced approach. I continue to hold our growth oriented positions, but I have also a) increased our cash holdings, b) added some additional stop loss orders on some of our larger holdings and c) tightened up some of our stop levels so that we can more quickly exit positions should markets become uncertain, especially if this uncertainty occurs while markets are closed.

At this time, we continue to look for unique investments that are under-valued relative to the market. These types of investments will not have the same degree of concentration risk that we see with firms like Apple, Facebook, Google and Amazon and will likely perform much better during a market downturn.

If you have any questions or concerns about your personal portfolio, please let me know. I would be happy to meet with you at any time.

All the best!
Doug