May Monthly Views Newsletter - Patience is Key but Be Prepared to Buy 

Jeff Hunter - May 09, 2019

Patience is Key but Be Prepared to Buy 

Late March we discussed prudence and patience when deploying new capital into the markets. What we saw was a potential inverse head-and-shoulders pattern, which would have been short-term negative but ultimately, a longer-term positive. What transpired was a rising wedge, a technical negative. Simply put, the market continued to edge higher through May but only running on fumes. While Trump’s tariff tweet seemed to be the culprit, it could have been multitude of factors that led the markets to pull back – the market needed to recharge before it headed to new higher. Instead it kissed new ground before retreating – it was too early to form a relationship with new highs.

The yellow zone is where we could see the markets fall towards but that if you find a company at a good price, then pluck away! The thing is this is not the environment to chase companies but rather to be patient and let the companies come towards you. I believe that any time you are late stage in a market cycle that it is important to stay in the driver’s seat.

Bankers Being Bankers – They’re doing it… again!

The great recession in 2008 was caused from subprime mortgages imploding. Bankers packaged these high risk (garbage) subprime mortgages together into one instrument called a collateralized mortgage obligation (a CMO for short). These CMOs were then sold to funds, individuals and institutions as investment vehicles as a ‘safe’ instrument that earned a higher return. By selling these packaged mortgages to investors it removed the risk to the bankers, so they could continue to lend to people who had a high risk of defaulting. When these subprime mortgages ultimately imploded, the resulting financial crisis ensued.

History doesn’t repeat itself, but it rhymes

Take us to the 2016 election of President Trump. Trump’s focus was to water down regulatory hurdles to help spur continued growth in the economy – a strong economy helps supports future votes. The Trump administration had many close ties to Wall Street and sought to encourage more lending by trying to strip away many of the post-crisis financial rules.

This takes us to leveraged loans

A leveraged loan is a type of loan that is extended to companies or individuals that already have considerable amounts of debt and/or a poor credit history. Lenders consider leveraged loans to carry a higher risk of default, and as a result a leveraged loan is costlier to the borrower. These leveraged loans can then be packaged into collateralized loan obligations (CLOs for short). Bankers earn hefty fees on these products which are then sold to investors which helps shelter the bankers from losses and incentivizes them to lend further to exposed companies that should otherwise not be qualified. Hmmm…. Where have we heard this before???

What is next for the markets

The growth in risky leveraged loans has been tremendous and has recently ballooned past the $1 trillion mark. In the short term, this helps flood markets with excessive cash which helps companies buy back stock, acquire other companies and help push markets higher. As markets propel higher, retail investors feel more indestructible and are willing to take on more risk.

On the other spectrum, Pensions have funding obligations whereby they must meet certain return expectations. In a low interest rate environment, the traditional investment strategy that involves a healthy conservative fixed income position doesn’t produce the returns needed to meet these obligations. The result is that these large institutions start heading down market and take on further risk which pushes more money onto companies and markets.

There is a meeting in June amongst FOMC members which will they will review the neutral rate, which is at 2.65%. If they hint at moving the neutral rate lower to the 1.5-2% range, it would crush real rates and be extremely bullish. If the neutral rate remains where it is, it could lead us closer to the tightening part of the credit cycle, a less rosy picture.

What does this mean for me, the investor?

Stick to quality investments, avoid flavour-of-the-day traps, and be globally diversified. While there continues to be plenty of opportunities in US markets, international and emerging markets have been somewhat neglected and as such, their valuations are very attractive. If you are still 100% Canadian invested, then please call as you are putting yourself at a disadvantage regardless of the current market conditions. The idea is to again find quality companies with strong balance sheets and continually do a health check on your fixed income. Trying to get equity-like returns from fixed income tends to provide you with an equity like experience in a down-turn.

By better protecting your portfolio for long-run growth (think Manulife, PIMCO and Canso), you can use the volatility to your advantage. Markets continue to point higher and the cost of a substantial loss on the portfolio is significantly greater than the additional benefit of moving down market into junk bonds.

 

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