October was… well it was something. For the second time this year, global equity markets had a substantial selloff. Also for the second time this year, the financial media tried to one-up each other with inflammatory headlines:
Source: Business Insider, CNBC, ABC News, CNN, news.com.au, The Chronicle Herald
Taking a step back from the bearish headlines, the following chart quantifies just how bad October was for some major indices. The biggest selloff came from the tech-heavy Nasdaq Composite, as investors decided to turn their backs on the once high-flying FAANG stocks (Facebook, Amazon.com, Apple, Netflix, and Alphabet).
Taking a second step back from the headlines, the next chart shows year-to-date returns for these same indices. Although the Nasdaq suffered the worst drop in October, the FAANG stocks had a tremendous year up to the end of September. As a result, it is still the best-performing index year-to-date, with a 5.8% return. Across the other indices, it has been a noticeably different year than it was 12 months ago, when emerging markets were up 30% and one of the worst-performing indices was the S&P/ASX 200, which was up only 3.1%.
We have been cautious about equity valuations for some time now, so the market action in October didn’t surprise us. As a result we won’t paint this most recent pullback in a negative light. It is what it is: stock prices went down. Admittedly, we do have a net-long position in our Absolute Return Fund, so a broad market pullback does cause the value of the Fund to decrease. But pullbacks also make it easier to find securities to buy at bargain prices, which may be the hardest thing to do as a professional investor.
You would be forgiven for thinking that the October selloff resulted in a plethora of buying opportunities popping up. While there were some, the next chart shows that markets (specifically the S&P 500) still look quite expensive. Compared to one year ago, many of these metrics do look cheaper. But compared to the market’s long-term history, these metrics are still hovering near their most expensive deciles.
Source: Goldman Sachs Investment Research
Why are equity valuations still so elevated? Well, for one thing, equities are currently popular investments. The next chart shows that investors’ current allocations to equities is on par with where it was prior to the financial crisis, and is second only to where it was during the dot-com bubble. Trending the other way has been cash allocations.
With interest rates declining steadily over the period shown in this chart, we believe investors have been finding it difficult to generate acceptable returns from fixed-income securities. Thus, they have chosen to allocate more cash to equities in the hopes of offsetting the decreasing fixed-income returns. In a bull market, a reallocation like this can look like a brilliant move. However, equities are riskier than debt investments. So if equity markets continue their recent downward trend, many of these investors may find themselves realizing losses that eat into their previous returns quickly.
The next chart shows that even though investors have been increasing their equity exposure, there has been only one main vehicle though which they have been doing so: ETFs. ETFs are largely thought to be passive investments, as the holdings of the largest ETFs mirror major indices like the S&P 500 (the constituents of which are chosen by a committee employed by Standard & Poor’s). However, we have previously shown that individual investors in ETFs are anything but passive: when markets selloff, investors tend to liquidate their ETF holdings, which could put more downward pressure on equity valuations.
You’ll also notice that the single-largest net buyer of U.S. equities has been corporations; in other words, corporate buybacks. This has been another topic we have discussed in detail; in sum, there is ambiguity about whether buybacks can put upward pressure on share prices, so it would be interesting to see if a decrease in buyback activity would temper other investors’ enthusiasm for equities.
Lastly on the U.S., the unemployment rate is currently at historic lows and the economy looks to be firing on all cylinders. That’s the good news. The bad news is that if the unemployment rate is so low, where will new workers come from to fuel additional growth? With such strict immigration laws, the U.S. cannot benefit from an influx of new workers in the same way Canada has. This means that employers will have to entice new workers to join by offering higher wages. Indeed, the following chart shows that management teams cite increasing wages as the single-biggest item putting downward pressure on margins.
Don’t get us wrong. We’re happy to see workers being paid more. But this money is going to have to come from one of two places. Either: (1) companies raise prices to offset the increasing wages, or (2) companies eat the increased cost, which puts downward pressure on earnings. In the case of (1), these increased wages are simply passed on to consumers, which puts upward pressure on inflation. This would then put the burden on the Federal Reserve to raise interest rates more quickly. In the case of (2), decreased earnings are passed on to shareholders, which puts downward pressure on equity valuations. In either case, it’s hard to see how the economy can keep going at the pace it has been without a readjustment from either (1) interest rates or (2) equity valuations.
Back home in Canada, things have not been going well for investors. Lacking a technology sector that has benefited from FAANG-like valuations, equity markets are in the red across the board. In fact, as the next table shows, the only major asset class generating positive returns year-to-date has been the boring three-month Government of Canada T-Bill. This almost means that the best domestic investment philosophy for Canadians has been to stuff their cash under their mattresses.
Source: RBC Capital Markets
Looking at the S&P/TSX Composite index specifically, the next chart shows us where the negative returns have been generated. Two years ago we pointed out that one of the biggest risks facing Canadian investors is their lack of diversification (#5 in this list). As we said at that time, “the S&P/TSX Composite index is dominated by the Financials (banks), Energy (oil and gas), and Materials (mining) sectors”. While we were primarily concerned with the banks at that point in time, 2018 has proven to be a perfect storm affecting all three of those sectors, contributing to driving the TSX down 7.3% year-to-date.
Source: RBC Capital Markets
We realize we sound like a broken record, but we’re going to say it anyway: we will continue to position the Absolute Return Fund defensively. October may have been emotionally difficult for some investors to endure, but that doesn’t mean that the selloff is behind us forever. Valuations, especially in the U.S., still look expensive, and we don’t buy expensive stocks. We would much rather stuff cash under our mattresses.1
What we did do in October, though, was add a few new positions and increase the size of the positions of our favourite names. We also realized some of the gains from our inverse ETFs that do well during broad market selloffs like these. This will continue to be our approach during any future market selloffs, as we keep our focus on how the Fund performs over the long-term, not during periods of short-term volatility.
1 Note: we wouldn’t actually stuff cash under our mattresses. Nor should you. That’s an unambiguously bad idea. If you’re going to stuff it anywhere, stuff it under the insulation in your attic.2
2 Note: don’t actually do this either.