Why I Love My Job (Flattening The Curve)

But first, Happy Canada Day friends! We live in a great country. Not perfect, by any means (a bit chilly in the winter for us older folks, perhaps), but given the current situation, I can't think of any place that I would rather be living.

But that is not what my blog is about today. 

I get excited when our younger clients take an interest in investing. In this particular case, a 20-something year old who's grandparents were clients as well as his aunts and uncles, with a relatively small portfolio, but a great starting point from which to get building.

"Hello Scott, I finally worked up the courage to start building my own portfolio. So far I’ve identified BMO, Manulife and Suncor as a good place to start if I can get them at the right price. However my reasoning does relate back to the fact that BMO and Manulife both pay dividends. Originally I was looking to hold a GIC, however I think holding the above stocks might see a long term value change if things go my way as well as some dividend cash in the mean time. I was wondering if you have any idea whether either would be looking to cut their dividends due to this covid situation. All the best and hope you are staying safe."

My response:

We are all well here, hunkered down, but less so as the province and GTA open up. Hoping you and all your family are well!

Congratulations on taking a big step forward and thinking about your investment portfolio. There is a lot to consider. As I am uncertain as to how much investment management education you might have, I am going to offer up a few things to consider, but at any time, I am wide open to a much more detailed conversation with you, at your convenience.

1) What are your goals? What is it that you want to accomplish with your money? Obviously you want it to grow, but it is important to establish what you want to grow it to do for you and the timeline for doing so. Condo or house purchase, retirement, etc., I find it helpful to think in terms of where you want to be in 3, 5, 10, 20 year time frames.

2) We all have to take risk if we want to grow our money faster than the annual increase in our cost of living (inflation). I commend you for thinking beyond the GIC (which is pretty close to "risk-free"), which, if it earns 1%, is going to come up short relative to the 2% average annual inflation rate. Remember, your inflation rate may differ somewhat from the Stats Can average based on where you consume and what you consume (and the costs associated with your consumption of goods and services).

3) We are in somewhat unprecedented times. Economies are seriously depressed at the moment and the uncertainty going forward is enormous. Some more optimistic folks (economists, investors, politicians) believe that this will all bounce back rather quickly (a "V" shaped recovery). Personally, I tend to side with the critical thinker crowd and believe it is going to be more of a "W" shaped recovery. Some pretty smart people actually think it may be more of an "L" shaped recovery and we might experience a decade of low growth.

4) Consider that it is going to take a long time for consumers to be comfortable just leaving their homes just to buy basic supplies, let alone travel or dine out or be entertained (theatre, sports, etc.). That is going to continue to be a huge economic hit. Jobs lost in the hospitality sector are likely not coming back in a hurry. Household incomes could take be jeopardized after all the government sponsored programs dry up. Consumers would certainly be spending less. A vaccine discovery might ease this situation, but it will take time and in the interim there will be much damage done to the economy. There is an enormous amount of household, corporate and government debt out there: how will that debt get repaid if consumers and businesses are functioning at reduced capacity, which is highly likely? Financial services (banks and insurance companies) could take a big take a hit, I would say that could put pressure on their dividends. My business partner, Paul, who does the bottom-up research on the companies that we (High Rock) monitor suggests that banks are racking up provisions for credit losses, which will likely turn into "Gross Impaired Loans". If capital falls, they will be forced to raise equity (share issuance) or cut dividends (as did Wells Fargo). Share buybacks  (which helped drive prices higher through to 2019) have also been curtailed. Paul says that BMO is very extended in the energy space and received a poor rating from the Fed last week. It would not surprise him to see a dividend cut.

5) Given all the uncertainty, my question to any investor is how much risk are you comfortable taking? Try reading this on Suncor : https://www.fool.ca/2020/06/11/suncor-energy-tsxsu-stock-0-or-40/ for example. Suncor has already cut its dividend.

6) The portfolio that we manage for you is very broadly diversified, by owning 6 equity index ETF's that cover the global range and own thousands of various companies through many sectors. Owning individual companies in only 2 sectors increases the risk (but also the potential return), but you have to weigh that out against your long-term goals. The thing about diversity is that if a company is forced to cut its dividend, it will have its stock punished by investors (see MFC in 2007-09)

(It never recovered), but if you own many companies in a relatively small and diversified way, the impact is diminished significantly. If it was 1/3 of your investment, that would be a big hit and very difficult to recover from. About Manulife now, Paul says : "Guaranteed floor investment products (protected from downside risk) sell like crazy (expensive, but good revenue source for Manulife) but they produce negative convexity, which means that if equity markets drop, Manulife gets doubly hurt."

7) The portfolio that we manage for you now is positive by about 1% so far in 2020 (at the half way point), despite most stock markets being negative (you also own the Nasdaq index ETF, QQQ, which is positive). That is also a result of owning a portion of your portfolio in bonds (balance) which are the best performing asset class this year (even though they may pay minimal interest, they are a safe haven in times of economic stress).

8) So once again, back to you to determine how much risk you are willing to take with your savings. With economic growth likely not going to get back to 2019 levels until 2022 or 2023, it is difficult to see corporate earnings (upon which companies are paying dividends or retaining them for re-investment and growth), with much upside potential (other than pure speculation, which is gambling and not investing).

9) My recommendation, at least for the time being, would be to invest your hard-earned savings in your balanced and diversified portfolio ( as my good friend Tony Chapman calls it: "flattening the curve") with High Rock and let us professionals (lots of experience, education, insight and fiduciary duty) help you build and steward your wealth in our risk-adjusted manner. We are wealth and portfolio managers, not investment advisors. There is a big difference.

10) There is a tendency among some market participants to want to try to “get rich quick” and so they start day trading, it is certainly a fad now (it was in 2000-02 as well).  This never ends well, for the majority: https://www.msn.com/en-us/money/topstocks/barstool-sports-dave-portnoy-is-leading-an-army-of-day-traders/ar-BB15oo0r.

11) As always, it is your money and as a young adult, ultimately your decision as to what direction you take, but I would suggest that you focus on your strengths and build your career around that. If you find that you want to become an investing professional, let me know, High Rock is always looking for good, sharp, young minds. In the end, it is about making a plan and sticking to the plan and reaching whatever goals that you set out for yourself.

Happy, as always, to discuss any of this in more detail if you wish!

Be safe, stay healthy!

New Financial Literacy Curriculum

The province of Ontario has announced an update to the out-dated (2005) Math curriculum for elementary schools that will include the topic of financial literacy:

"In the 2005 curriculum, financial literacy concepts are limited to basic understanding of money and coins. In the 2020 curriculum, there will be mandatory financial literacy learning in grades 1 to 8, including understanding the value and use of money over time, how to manage financial well-being and the value of budgeting".

Sorry to all of the graduating grade 8's of 2020, but perhaps a few lessons for you to enjoy through the summer months (Ya right!) and perhaps for Premier Doug and Minister Lecce a primer of a few key elements:

Lesson 1) Banks (and other large financial institutions) : They are safe (for the most part) and highly regulated so as to give you the appearance of safety and stability. They are also public companies and therefore have shareholders who are their first priority. I worked for a number of banks and large financial institutions throughout my career. I know what motivates them: earnings and profits. This is not a bad thing, necessarily depending on your perspective, but if you are to utilize a bank as a client there are a few things that you should know.

If you put your money in a savings account or GIC, the bank will pay you interest of between 0% and maybe 1%. Then they will take that money and lend it at somewhere between 3% and 5% (or more) to those in need of capital for whatever purposes. A lot of that lending goes to homeowners for their mortgages and lines of credit. If you have savings and a mortgage with the same bank, you are giving them "free" money which they will gladly and quietly accept, making for their shareholders a quick 3-5% (simple math for the new curriculum) on it. They win. Clients lose. So Don't be that kind of client. 

In fact, if you are saving money or investing it and not making more than what the borrowing costs of your mortgage are, pay down your mortgage (or line of credit).

Lesson 2) Credit Cards : Never, never, never carry a credit card balance from one month to another. The interest payments at 18% or more (that is enormous when you think about what a bank savings account pays!) will never allow you to get out of debt, because you will build massive negative compounding (see positive compounding below and think the opposite) issues that will haunt you until forever! If you can't pay it off. Cut it up. Am I clear? Shareholders win big on this one. Opposite for the clients.

Lesson 3) Compounding : 

Simple math: if you invest $100 at the beginning of the year and you earn 4%, ($100 x 4% = $4) at the end of the year you will have $104. At the end of year 2 ($104 x 4% = $108.16), etc. In 10 years (invested at 4%) that $100 will turn into $148.02. 

If you were able to scrounge up an additional $10 to add to the investment each year for 10 years (invested at 4%). The total  jumps to $272.89.

If you change the return to 7% annually (adding the $10 each year), your total jumps again to $344.55.

If you can add some 0's to your amounts (i.e. $100 becomes $1000 or $10,000), you can imagine the upside!

Go get an excel spreadsheet, go to the "Formulas" tab, then to the "Financial" tab, type in FV and play with the numbers. Amazing what seeing the potential can do to stimulate you.

One day it might look like this (an actual 20-something year old's High Rock Wealth Forecast):

Lesson 4) Budgeting : Create a plan (or Wealth Forecast) that allows you to save something. Start with $10, move on to $100 when you can and keep building. Don't starve yourself, enjoy yourself too, but make an allowance to pay yourself. Income (or allowance) - expenses = savings.

Lesson 5) Investing : Everybody wants to "help" you invest. Some will tell you they can get you 7%, no problem. They have an agenda, so beware of the agenda. Ask them what is in it for them. Anything but an absolutely direct answer should be a red flag. Walk immediately away. You see, every financial advisor has a conflict of interest, it is called commissions (how they are paid). They want to "help" you so that they can take a piece of your 4% or 7%. In some cases, good help may be worth a 1% fee, but beware of how the costs of investing impact your compounding.

And always know that past performance does not guarantee future returns (even though some might not be so upfront as to tell you so)!

Mandatory reading: Beat The Bank , by Larry Bates and Standup To The Financial Services Industry by John De Goey.

Lesson 6) Risk : If inflation / the cost of living (your annual expenses) is 2% per year and you invest "risk free", lending money to the Government of Canada by purchasing a 90-day T-bill, that will earn you 0.19% before fees and taxes. So you basically won't be able to make your money grow and your purchasing power (i.e your costs increase faster than your money is growing) will erode. So you want to get better than 2% in your returns. 

Getting that will entail a bit of risk taking. You can buy the common shares / stocks of companies that you expect will grow enough to see the value of those companies go higher and increase their share value, but you need to be able to judge those companies and the fair value of their stock. Owning just one company will add significant risk (of the companies value going down). Owning lots of companies helps you to diversify and reduce the risk. Unless there is a major catastrophe when all companies values fall. Usually, the better companies can survive a catastrophe, but it is never certain which ones. So if you own a whole bunch of companies, you can ride out the catastrophe because, most will likely survive it. If you are young, time is on your side, so you can afford to take a little more risk (go for the 7% returns, perhaps?).

If you are a little older and /or need more cash flow to augment your lifestyle expenses , you may want to look at alternatives that will provide interest and dividend income (see last weeks blog) and further balance out your portfolio and reduce your risk (go for the 4% returns, perhaps?).

Lesson 7) Taxes: Especially now! Governments want their fair share for providing all the services (and bail-outs in times of crisis) and they are going to try to take it from you. It is inevitable and after the pandemic and it's associated costs, taxes are not going down. But be mindful of how you might best manage to be as efficient as you can as you invest. Maximize the use of your TFSA, that should be priority number 1.

There is more and as you get more wealthy (positive compounding), it gets more complex. Some try to do it on their own, if you can, you can certainly reduce your costs. However the professionals (good portfolio managers and Certified Financial Planners who know their stuff) should be able to add value and be responsible to you to do their very best to look out for your best interests (rather than be driven by commissions, a huge conflict of interest).

Avoid "day trading", the lure of big gains can come with enormous risk. History (not necessarily part of the math curriculum) has shown this time and again.

You don't have to "get rich quick". Make a plan, stick to the plan and compounding over time will bring you the benefits!

The Big Dilemma

A balanced, globally diversified portfolio has not been living up to its supposed (dubiously promised by many an advisor without the regulatory required discalimer that past performance is not a promise of future growth) 7% annual average return recently. Global equity markets (we use the All Country World Index ETF, ACWI as our proxy. This ETF is composed of about 50% US equity and 50% the rest of the world equity) have returned about 3% in price appreciation (capital growth) over the last approximately 2.5 years. Quick math tells me annual average return = 1.2%. Add in the distribution / dividend income of about 2.0% annually and the average annual total return becomes somewhere in the vicinity of 3.2%. All of this with a very generous bounce off the March 2020 lows.

Do the same with the Canadian Bond index ETF, XBB, with an annual average price appreciation of 3.2% (8% over the last 2.5 years) and annual distributions of about about 2.7% give you about a 5.9% annualized real return.

If your balance is 60% equity and 40% fixed income, you should be getting in the vicinity of 4.25% total return, before any fees. Not the 7% promised (if it was), I would say. 

If you had REITS  (-7.5%) (see Paul's recent blog on these) and Preferred shares (-27%) over the same time period in your mix, then you would likely be getting somewhat less (although the reasonable distributions in both might offset some of the negative price depreciation). With interest rates at or near zero, rate reset preferred shares are not likely going up any time soon and as they get reset, the distributions / dividends will fall too.

The problem is that everybody is fixated on the stock markets to get them these better than average returns and are scrambling to try to trade fundamentally very expensive (and risky) assets in order to "beat" the benchmarks. And as a result have created a casino out of the stock market. If you are a gambler, have at it.

If you are a long-term visioned portfolio manager who is focused on risk-adjusted returns over longer periods of time, stocks are too risky to be fully invested in (even 60% in a balanced portfolio).

The reality of a recession is that there will not be any economic growth to drive spending and earnings in any significant manner. That is why buying stocks at current levels (or even levels a few % lower) is fraught with risk.

The U.S. Federal Reserve ("Don't Fight The Fed") and all the central banks that have been adding liquidity are falsely driving prices of stocks to levels where they fundamentally have no business being (which means they are not likely over any longer time frame going to stay there, see 2002 and 2008). We all want our stock holdings to appreciate (even us under-invested types), but when they go up on a hope and a prayer (or a gamble), well that becomes a recipe for potential disaster (again). Older investors have shown a tendency to get out of the stock market altogether after experiencing big drops: a recent Wall Street Journal article quoting a Fidelity Investments study suggesting that about 1/3 of investors 65 or older sold all of their stocks between February and May of this year. 

It may be a good market for day trading (plenty of volatility), but as we tell the folks who ask us why we were not picking the bottoms or the tops: we don't have the ability to see the future and hind-sight is 20/20! We don't day trade and we don't gamble with our own money, so why would we do so with our clients money. Especially when they trust us to help steward their wealth over longer periods of time (i.e. to the end of their days and on to their beneficiaries).

So what do you do?

Generate income. Interest on bonds (in Paul, we have one of the best Canadian corporate bond traders / portfolio managers in the country at High Rock). Our higher yielding corporate bond portfolio generates over 7.0% in interest income (cash yield) on an annual basis at the moment. Even in our balanced portfolios we are earning between 3 and 4% in interest and dividend income alone. That means that you can take a lot less risk chasing capital appreciation in the stock market to get your annual returns up. 

If you are retired or retiring and you want cash flow from your portfolio for your lifestyle expenses, why take unnecessary risk?

Friends, we are in very unusual times, but we may be in one serious recession that could take a very long time to climb out of. A lot longer than some of the more optimistic folks are suggesting. The headlines may look positive, but a hard look behind the scenes (of the headline data) reveals some disturbing economic reality. Even the Fed sees a protracted period of low growth (i.e. not getting back to 2019 levels until well into 2022).

Chasing stock market returns could be disastrous, if you don't have a long time horizon to enable you to recover.

U.S. Federal Reserve Rains On The Parade

Not that it was a big surprise to most rational investors, but the perfectly priced stock market (see Tuesday's Blog "It's OK To Look Now") got a dose of reality yesterday when the Fed's Open Market Committee (FOMC) released its latest economic projections for the next couple of years and lo and behold, they do not see the US economy returning to 2019 levels until well into 2022. Historically, the Fed has been pretty optimistic about growth. Not so yesterday, so likely no (#2) "V" shaped recovery:

"The ongoing public health crisis will weigh on economic activity, employment and inflation in the near term, and poses considerable risks to the economic outlook over the medium term."

Median economic projections are for a -6.5% GDP growth rate for 2020. +5.0% in 2021. +3.5% in 2022.

Unemployment: 9.3% in 2020, 6.5% in 2021, 5.5% in 2022. Recall that at the end of 2019, this number stood at 3.5%.

That may not bode well for consumer and business confidence, which is the key to spending and investing and in turn corporate profitability (and stock prices, perhaps?).

#3, A Vaccine will be ready in the fall: According to The New York Times :

Covid-19 cases are ticking up in some re-opened states, although that could also be a function of more testing. 

Shedding a little doubt on #4, Trump wins in November (again from Tuesday's blog), the Economist says (at the moment) that they see Biden winning. And Real Clear Politics (showing many and various polls) has Biden ahead by anywhere from 7% to 14%.

So my friends, stock markets are looking a little more volatile this morning as reality appears to be setting in. All the big gains from last Friday have been reversed, which technically could ignite further selling as traders will look to lock in their profits from the big run-up from the March lows and momentum driven, computer generated traders jump into the fray. 

Just prepare yourselves for the greater potential for more stock market volatility, emotionally, if you choose to stay the course (i.e. stick with your current portfolio balance).

Standing by...

It's OK to Look Now

We might be in the heart of a recession (which officially began in February, according to the National Bureau of Economic Research's Cycle Dating Committee and was announced yesterday), but thanks to the stimulus from the Bank of Canada, The US Federal Reserve, other global central banks, the Canadian government, the US government and other governments around the world as well as the Bureau of Labor Statistics, Statistics Canada (for upending the employment forecasts for May) and all the FOMO (Fear of Missing Out), TINA (There Is No Alternative), stock market punters, short-covering hedge funds and super-confident optimists, our client investment portfolios are pretty much back to where they started the year (some slightly ahead, some slightly behind)!

For those of you who were afraid to look, you can look now!

The above are representative of our client portfolios and are actual client investment returns, after fees. As our client portfolios are more specifically tailored to their specific timeline goals and objectives, future cash flow needs and tolerance for risk and volatility, they may vary some from the above. And of course, past performance is not a guarantee of future returns, but we have worked darn hard to keep our client portfolios as sheltered from the huge swings in value (that may trigger unwanted emotional responses) from the volatility in financial markets as possible. That is what allows us to get back on a growth trajectory for meeting our clients goals in the future, more quickly. We started the year under-weight equities in our global and tactical models. We made some value purchases on the way down and we sold them out again as they got expensive. So we are back to being under-weight equities once again because they are really expensive on many fundamental metrics.

As David Rosenberg reminded us yesterday in his daily missive: 

Here is what current stock prices are telling us (about the future):

1) The recession is over and the recovery has begun

2) It is a "V" shaped recovery

3) A vaccine will be ready in the fall

4) Trump will win in November

5) No "second wave"

6) Employment will return to normal very soon

7) The coming 43% plunge in Q2 corporate earnings doesn't matter (because of all the stimulus and liquidity)

8) And that even if there is more stock market volatility, the market believes that the central banks and governments will dig even deeper to prevent any catastrophe.

So we have to ask ourselves what we believe. If we believe all of the above, then we should probably be buying equities too.

If we have any doubts, we ought to stay the course and keep some extra cash, gold and government bonds on hand.

It is the perfect time to re-think your portfolio strategy. 

Our best performing client this year (40/60 example above) has had only about 15-20% of the total portfolio allocated to equities. Now that, I find very interesting.

Do you really need to take all that much risk? Take a look under the hood. Ask yourself that question.

So Let's Recap:

1) Stock markets have completely decoupled from economic reality: Year to date the S&P 500 is down a mere 5.8% (as above).

Meanwhile, on the back of the Coronavirus / Covid-19 pandemic and lock-downs, Q2 economic growth in the US is expected (currently) to come in at -52%. 

Longer-term, the most recent report from the (non-partisan) Congressional Budget Office does not see the economy even getting back to its Q4 2019 level by Q4 of 2021:

S&P 500 earnings, a function of economic activity are not expected to reach their Q3 2018 peak until well into 2022.

Interestingly, since those days of better earnings (Q3, 2018), the S&P 500 is still up by some 5% (over about 1.5 years that is an average annual of 3.33%), notwithstanding the earnings recession that has evolved since. Bonds have been the best performer but ouch on the REIT's and Preferred's:

2) Not to be overly pessimistic, but the current and seemingly escalating civil unrest in the US does not seem to be a positive for the economy and that does not seem to be built in to economic forecasts at the moment.

3) If stock market risk, as a result of a lack of a fundamental reality for prices, is at levels that we have not seen since 2002 and the uncertainty is so palpable, real investors (stewards of wealth vs. gamblers) should be taking a good hard look at their asset allocation strategies (especially those who rely on their investments for cash flow and lifestyle expenses). We have already had a few clients want to adjust their equity / fixed income ratios and these are folks who do not panic easily.

4) The super confident optimists (I am a cautious optimist) and stock market cheerleaders will tell you that stock prices are looking past the current crisis / crises. I pose the question, how far past are we all supposed to look? 

5) And if we look out far enough, does all the current fiscal and monetary stimulus become inflationary? or worse, stagflationary?

6) Let's not forget all the government debt (in Canada too) that has and is being accumulated. How will that be paid for? Central banks will try to keep interest rates down to keep the costs of the debt down, but without serious economic growth, government revenues will not cover it (let alone balance the budgets any time soon) without some significant tax increases. They are not talking about that yet. 

I have to think that, with all this in mind, stock markets are getting way ahead of themselves and that the very stretched elastic band metaphor is now in play and by virtue of that volatility may once again rear its ugly head.

If you are prepared to live with 20-30% swings in your portfolio, stay the course. Otherwise, reflect on the reality vs. the myth.