Quarterly Market Commentary
Quarterly Market Commentary
as of September 30, 2019
What's happened since the last report?
The following commentary represents the opinions and analysis of Doug Nelson, President, Portfolio Manager, Nelson Portfolio Management Corp. as at October 1, 2019. Market and index returns noted below are based on the price changes for each quoted item for the period ending September 30th, 2019. Market Statistics: Source: https://ycharts.com.
- Over the past 3 months the Toronto Stock Exchange Composite Index (TSX) increased in value by approximately +1.69% from July 1, 2019 through to September 30th, 2019. For most of the summer months the markets were negative, dropping to a decline of -2.10% from July 1st to August 23rd and then having a strong return in September of +3.87%.
- Similar to what we saw in the 2nd quarter, most of the returns for that three-month period were negative except for a strong rally in the last few weeks of the quarter. The returns since April 23rd, 2019 have been flat.
- Over the past 12 months the returns for the S&P TSX Composite Index have been mostly flat, showing a gain of +3.44% on the index since October 1, 2018. The returns for the year on the Index were zero for the 11 months from October 1, 2018 through to August 26th, 2019. Thus, all of the gains for the last 12 months occurred in just the past few weeks. See Chart 1.
Chart 1: The S&P TSX Composite Index (the Toronto Stock Exchange) for the 12 Month Period Ending September 30th, 2019. Source: YCharts.
In the chart above, please note the following observations:
- The S&P TSX Composite Index (the Toronto Stock Exchange) declined by over -12% in the fall of 2018 and had recovered this value very quickly by late March 2019. Between April 23rd, 2019 and September 30th, 2019 however the returns have been mostly sideways. You can see how the returns for the past 12 months were zero up to August 26th, 2019 and it has been the gains in the last few weeks that resulted in a positive return for the year.
Now let’s look at the performance of the key U.S. indexes over the past 12 months.
Chart 2: The New York Stock Exchange Index, Nasdaq Composite Index and the U.S. Small Companies Index (symbol: XSU) for the 12 Month Period Ending September 30th, 2019. Source: YCharts.
In the table above, please note the following observations:
- By comparing Chart 1 and Chart 2 we see that the Canadian market was one of the top performing markets over this past year, even with a return of only +3.44%.
- By comparison, the New York Stock Exchange Index (a U.S. index of approximately 1900 companies) declined by -0.92% while the Nasdaq Composite Index (a U.S. index of approximately 3300 companies that are mostly health and technology related) declined by -0.47%.
- Perhaps most interesting is the decline in the value of small companies in the U.S. at -10.54%. When the U.S. market is touted as being strong and healthy, whereas I see weakness in the smaller, more local companies, this may suggest that the market and the economy is not as healthy as one would hope.
Chart 3: The MSCI EAFE Index (Europe – Asia – Far East), MSCI Emerging Markets Index and the value of Gold (symbol: GLD) for the 12 Month Period Ending September 30th, 2019. Source: YCharts.
In the chart above, please note the following observations:
- The Europe – Asia – Far East index (EAFE) declined by -4.11% over the past 12 months while the Emerging Markets Index declined by -4.34%.
- By comparison, the value of Gold began to surge in June leading to a 12 month return of +23.36%. Gold is considered by some to be a store of wealth particularly in times of crisis. Are we in a crisis or entering a new crisis? Many of you will remember that Gold had a very significant gain from 2006 through to 2011. Since the high in August 2011 it has been trading 25% to 40% lower than this high. In June 2019 we saw the first significant positive move upward for Gold in 8 years. This may be an important indicator of things to come.
If we dissect this a little further, Chart 4 shows how different components of the Toronto Stock Exchange contributed to the returns over the past year. The three largest sectors of the Toronto Stock Exchange index are materials (11%), energy (17%) and financials (33%). These three sectors make up 61% of the Toronto Stock Exchange index today. Approximately 54% of the materials index is made up of the Gold companies, which represents approximately 6% of the index overall. The Canadian banks make up almost 70% of the financial services index, which represents approximately 21% of the value of the Canadian stock market.
With this in mind, Chart 4 is really interesting. During the market declines last fall, when the Canadian market (S&P TSX Composite Index) declined over -11%, the financial index declined the same amount, energy declined by over -30% while the materials stocks hardly declined at all (see the left hand most column in Chart 4). Between January and April (the second column) each of these three areas contributed to the rebound, but since April we have seen considerable divergence. Both the materials and energy sectors declined from April to June (the third column), while the financial sector held its ground. Beginning in June and continuing through most of the summer (see the far-right column) leadership came from the gold mining stocks while energy continued its rather significant decline. Once we got into late August the leadership changed once again. The materials companies started to decline, and it was the banks and energy companies that created the gains we saw in September.
Chart 4: Comparing the 12 Month Returns ending September 30th, 2019 of the S&P TSX Materials Index (symbol XMA), S&P TSX Energy Index (symbol XEG) and the S&P TSX Financial Services Index (symbol XFN). Source: YCharts.
With this being said, the Canadian technology sector (5% of the S&P TSX Composite Index, symbol XIT) and the Canadian real estate sector (4% of the S&P TSX Composite Index, symbol XRE) also had a good year with gains of +34% and +14% respectively. The technology sector in Canada is dominated primarily by four companies: Shopify, Constellation Stocks, CGI and Open Text. We own CGI and Open Text in our portfolios, but it was Shopify that had the standout year doubling in value. This means that two companies (Shopify – technology sector) and Barrick Gold (and the other gold mining companies in the materials sector), contributed to almost 50% of the total gain of the Toronto Stock Exchange over the past year.
What’s the point of this? This emphasizes a point that we have noted in the past: the gains in the markets are coming from a very small number of companies. In Canada, the out performance was created by 4 technology firms and 4 gold mining companies. In the U.S., Europe and Asia we see that overall markets were flat to down over the past year, with the exception being from the defensive sectors (real estate, consumer staples and utilities). Perhaps this is further evidence of the importance of being cautious at this time.
Here is my updated table of the quarter by quarter performance of countries, regions and sectors.
Table 1: Asset Class, Region and Sector Returns Over Past 4 Quarters. Source: YCharts.
In Table 1 above we observe the following:
- Over the past three months we see that the Canadian financial services sector had a solid gain of +4.44%. As per my comments previously, this sector gained close to 8% from mid-August to the end of September. This gain took place because of the belief that interest rates would be reduced due to a slowing global economic environment. When interest rates decline, the profits for the banks and the insurance companies tend to be greater.
- The real estate sector had a great year. Looking at the 2nd column from the right we see that during the fall of 2018 when most everything was declining; this sector held its ground well. So far this year this sector is up 18%. We continue to like this sector and it remains a fully weighted position in our portfolios.
- The third item to note is the change in the value of gold.
In this environment, how has the NFC Tactical Asset Allocation Pool performed?
Over the past three months the NFC Tactical Asset Allocation Pool generated a positive return of +1.56%. Due to our higher concentration towards the financial services sector in Canada, most of our gains for the past year also came during the last 6 weeks. This is similar to what we have seen with the Toronto Stock Exchange.
Looking back to the start of the year, we know that due to i) the speed in which the markets recovered from January 1st to February 15th and ii) our defensive position at that time, we missed out on a large part of this upside move in the market. But since then we have continued to exceed our targets.
For example, since February 15th the pool has gained by 4.2% while the TSX index has gained by 5.18%. 70% of 5.18% is 3.6%. This means that our balanced approach has captured 81% of the upside of the market. Over the past three months the Toronto Stock Exchange generated a positive return of +1.69%. 70% of this amount is +1.2% vs. the NFC Pool generated a return, after-fees, of +1.56%. This means that over the summer months we captured 92% of the upside of the market.
Over the past 12 months the NFC pool generated a positive return of 1.29%. By comparison, 70% of the upside of the Toronto Stock Exchange return is +2.4% (3.44% 12 month return X 70% = 2.4%). This means that over the past 12 months we did not meet our target. During the January 1st to February 15th period of time the Toronto Stock Exchange gained in value by +10.5% while the NFC Tactical Pool gained in value by 3%, capturing only 30% of the upside move in the market. We just didn’t expect the markets to rebound as quickly and as strongly as they did. Had we captured 70% of that upside move our 12-month portfolio return would have been closer to +5.3%, significantly greater than the 12-month market return of +3.44%. By missing out on most of this upside gain over this 45-day period of time our 12-month returns were impacted quite significantly.
This fact raises and interesting question about the markets today and how we, as portfolio managers, need to continue to assess and reassess how best to manage portfolios through volatile market environments. More on this in the What Have We Been Up To Lately section.
On a calendar year basis, at this time we see the following.
Table #2: Calendar Year Returns of the NFC Tactical Asset Allocation Pool. Source: Croesus software. YCharts. Note: the YTD (year to date) figure below is for the period of January 1, 2019 to September 30th, 2019. The 2013 figure is the period of time from September 3rd, 2013 to December 31st, 2013. The NFC Tactical Pool launched on September 3, 2013.
This chart shows the degree to which we have met our goal over time of striving to capture 70% of the upside moves to the market while striving to protect against 70% or more of the downside moves to the market.
In the first row you see the total returns of the pool after all fees and expenses have been deducted for each calendar year. On the second row we see the calendar year returns of the S&P TSX Composite Index (the Toronto Stock Exchange). The third row calculates 70% of the upside move to the TSX index while the next row shows, in those years where the market declined, the 70% downside protection target.
So how have we done?
- 5 out of the past 7 periods we met our targets.
- The two periods of time when we didn’t meet our target were those years that saw strong, concentrated moves to the upside. In 2016 this was the strong gain in the materials sector from January through to June and in 2019 this was the strong gain we saw overall during the first 45 days of the year.
- Yet by comparison, in 2018 and 2015, the combined declines of the Toronto Stock Exchange were -22.73% (-11.64% + -11.09%) while the NFC Tactical Asset Allocation Pool declined by only -0.92% (-2.62% + 1.7%). During these two down years we protected against 96% of the downside move to the markets.
- What do we learn from this? Our approach to managing risk seems very appropriate and prudent, but at times when we do see larger upside moves in the market we have typically lagged.
So, from my personal perspective, this makes me wonder if we could be doing some things differently so that we continue to protect well against the downside yet are able to participate more fully when these larger moves happen to the upside. More on this in the next section.
What Have We Been Up to Over the Past Several Months?
- Romspen Mortgage Investment Fund: One of the new core investments that we have added to the pool and client accounts is the Romspen Mortgage Investment Fund (symbol: RIC1010) (romspen.com). Based out of Toronto and funding mortgages of commercial and industrial projects across North America, the Romspen fund is close to $4 billion in size with a 25-year track record. The volatility in this fund has been low because of the shorter-term nature of the loans, while generating a return of 6% to 8% annually.
- Can we achieve higher returns with less risk by slightly modifying our stock selection strategy? This question goes back to what I referenced earlier. We have learned that our investment strategy has consistently protected well during times of market decline. We have also learned that we have not always fully participated in the upside moves to the market when they occur after a market decline has taken place. Several research articles on the market overall also suggest that as much as 70% to 80% of the trading volume day to day comes from automated trading systems. This means that these trading systems may push markets down faster than in the past, but they also may be creating faster upside rebounds. The question for me remains the same: Can we create a portfolio that consists of a combination of strategies, that will protect well during market declines but also generate reasonable upside returns when markets rebound?
Over the last month in particular we have been exploring different stock selection strategies and pairing together complementary strategies to see if we can create some unique combinations of upside returns while also protecting against downside risk. As expected, no one strategy over time is able to achieve both outcomes. Instead, it is always a combination of multiple, complementary strategies that can create this outperformance. This is nothing new. This type of insight and knowledge dates back to the mid 1990’s.
However, what makes this approach more dynamic for us today is our use of the YCharts software program (www.ycharts.com). This tool has enabled us to model many different types of strategies and then evaluate those strategies during both upside and downside periods of time.
We began by looking at some of our favorite strategies that we feel have stood the test of time, and then did a deeper analysis of some of the individual investments within these strategies. In essence, if we feel that these are some of the “best strategies”, could we then also determine the “best investments” within each of the “best strategies”?
This analysis took us down many different paths. We looked at different ways in which we could filter and sort through different Canadian, U.S. and global stocks, looking to find combinations that helped us reach our target.
Interestingly enough, we did uncover some very positive outcomes:
- Our refined models outperformed the Toronto Stock Exchange considerably over each of the last 1, 2, 3, 4- and 5-year periods of time with strong double-digit returns.
- During periods of more significant market decline they also protected better than average. From September 1, 2014 to January 20, 2016 the Toronto Stock Exchange declined by -19%. Our model portfolio declined by only -6%. During the September to December period of 2018 our model portfolio declined by only -2% when the market declined by almost -12%.
- In short, the downside risk protection seems to very good while the upside gains over time is also very good.
These are very positive outcomes that we will be monitoring closely and gradually implementing to our live portfolios. Of course, past performance does not guarantee or predict future performance, so a slow and steady approach is always prudent.
Yet the insights we have gained through this process are very exciting and intriguing to us and we look forward to implementing them and monitoring our progress over time. However, despite how wonderfully interesting this is to us, we recognize that in the end we are just doing our job as best as we possibly can: by reflecting on and learning what we have done well and where we can find areas to improve.
We love what we do.
Where Do We Go from Here?
The world continues to be an interesting, dynamic environment. The news of the day focuses on the uncertainty around trade with China, Trump’s presidency and whether he will be impeached, trade wars and tariffs, the U.K. leaving the European Union with “no transition deal” with the European Union, continued tensions in the middle east and questions around the Canadian economy and bigger infrastructure projects. The extent to which these issues will have on the market remains to be seen.
What we do see today that is very clear is an inverted yield curve. I have been talking about this for close to a year now and over the summer we have seen this finally and fully take place. Here’s an interesting and helpful explanation (https://business.financialpost.com/investing/canadian-yield-curve-inversion-dives-to-deepest-level-since-2000). Typically, an inverted yield curve forecasts a recession, which also typically creates a downside move to the stock market. Yet we see many market commentators suggest that a recession likely won’t happen this time. This time will be different, they say, all with very good reasons why they believe this to be so. In the end, we really won’t know until we know, but when we add up some of the other things I have noted in this commentary, such as the very narrow market leadership, the move towards Gold, the lackluster global returns over these past 7 to 12 months and the significant declines in the small company stocks; my view is that we are better to err on the side of defense at this time.
While the figures noted in this commentary are based on September 30th, 2019 (Monday), by today (now Wednesday morning of the same week, October 2nd, 2019), we see that markets have dropped by -2.5% to -3% over the past day and a half. Will this continue? We will see. But we recognize that volatility in the markets is significant and market leadership tends to be narrow. Therefore, we need to continue to be active in our management style and err on the side of defense.
I very much appreciate the opportunity to be of service to you in this very important area. I appreciate the trust, confidence and responsibility that you have placed in my team and I. As a result, I write these more detailed commentaries so that you can be aware of the types of things we are looking at, how we are evaluating our performance / decision making and how we are always looking for ways to improve what we do regardless of the market environment.
I would be delighted to meet with you at any time should you have any questions or concerns about your portfolio. I can also prepare for you at any time a more comprehensive analysis of your personal portfolio.
All the best!
- Book Value vs. Market Value On Your National Bank statements: The book value information on your National Bank statement is not your net invested value. Rather, the book value is the total of your invested value minus withdrawals and plus any dividend income received. Thus, part of your investment return over time will show up as part of your book value. Therefore, please do not compare the book value and market value on your National Bank statements and believe that the difference is your investment return.
- Discrepancies between the Nelson portfolio reports and the NBIN (National Bank Independent Network) monthly statements: We see that in some cases there are some small discrepancies between the total portfolio value seen on the Nelson statements and the NBIN monthly statements. In most situations these discrepancies are caused by the timing of when the NBIN statements are produced and when the data concerning the quarterly distribution for the NFC Tactical Asset Allocation Pool is provided to NBCN. This is a timing issue and not an error. Should you have any questions or concerns, or if you identify other discrepancies, please let us know immediately.
- Paper vs. Secure E-Mail Link: It is NPMC’s preference to provide to you this quarterly portfolio package by e-mail. However, if you would like to receive this package in paper format, please let us know and we will accommodate your preference accordingly.