What’s Dovishness Got to Do With It?

Markets rose again in March as central banks reaffirmed their dovishness. Sentiment could change quickly, but until then ‘don’t fight the Fed’ is back.

Equity markets marched higher for another month as global central banks reaffirmed their dovishness on interest rates. As a result of the continued strength, North America’s major indices completed their best quarterly performance since 2009. It was a broad-based rally as asset prices rebounded from the lows we saw at the end of 2018. With the first quarter in the books, the S&P/TSX Composite Index is up 12%, while the S&P 500 and Nasdaq have gained 13% and 16%, respectively.

Markets remain increasingly focused on interest rates. The dramatic reversal by the US Federal Reserve to back off of its planned rate increases sent bond yields lower and risk assets higher. Fed Chair Jerome Powell put on a brave face as a hawk for a few months, but recently he has fallen into place amongst the doves.

Fears of a global recession have been dismissed, for now. The return of a low-yielding market has brought back TINA (There Is No Alternative) for income-starved investors. Once again, central bankers appear ready to extend the global economic cycle by keeping rates lower for longer. An inversion of the yield curve is typically considered a predictor of recessions; this time around, it’s being seen as an anomaly.

The Canadian market and economy appear to be on increasingly shaky ground. Western Canada is still dealing with a broken energy sector and the long-expected housing slowdown is starting to show signs of materializing. Calls to short the Canadian banks are back. It has been a popular trade in the past and it may be again. Whether or not it will work this time remains to be seen.

Looking at markets on the whole, there hasn’t been much change since the Fall, despite the sell-off and recovery. We aren’t at new highs in equities and earnings growth is slowing. What will it take to push higher? A China trade deal would be a start, as tariffs have slowed the Chinese economy and that is beginning to affect Europe.

Globally, profit growth has slowed. Buybacks are keeping the market going and a strong US dollar is the biggest risk to growth. A profit recession is a very real possibility, as the strong gains experienced last year due to tax cuts will make for difficult year-over-year comparisons.

Going forward, sector leadership will be important to watch. If rates remain low, defensive sectors that typically pay a yield will see a flow of funds. In a low-growth environment, investors will pay a premium for scarce growth, which could keep software stocks in a favourable position.

With the recent strength in markets, investors have chosen to believe central bank accommodation will trump slower growth and delay a recession. This sentiment could change very quickly to become more fearful, but until then ‘don’t fight the Fed’ is back and should be obeyed.

Ideas with Purpose

Purpose Core Dividend Fund (PDF) is quite different from most other dividend funds, thanks to its sector cap. This discipline has been a driver of recent outperformance. The Fund runs with a much smaller allocation to financials than the typical dividend fund (particularly in Canada) and much larger exposures to traditionally defensive, yield-generating sectors such as consumer staples, healthcare and utilities.  PDF is designed to outperform in the type of environment we see on the horizon.

Purpose Multi-Strategy Market Neutral Fund (PMM) generates returns from equity, currency and commodity markets, with aggregate performance that moves largely independently of equity and fixed income benchmarks. Because the Fund has the flexibility to swing from fairly aggressive to very defensive posturing, it has the potential to be highly accretive to portfolios, particularly when markets are volatile and generally under pressure.  PMM adds much-needed diversification and improves a portfolio’s overall risk/return profile.

— Greg Taylor, CFA is the Chief Investment Officer of Purpose Investments.

All data sourced from Bloomberg.

The content of this document is for informational purposes only, and is not being provided in the context of an offering of any securities described herein, nor is it a recommendation or solicitation to buy, hold or sell any security. The information is not investment advice, nor is it tailored to the needs or circumstances of any investor. Information contained in this document is not, and under no circumstances is it to be construed as, an offering memorandum, prospectus, advertisement or public offering of securities. No securities commission or similar regulatory authority has reviewed this document and any representation to the contrary is an offence. Information contained in this document is believed to be accurate and reliable, however, we cannot guarantee that it is complete or current at all times. The information provided is subject to change without notice.

Commissions, trailing commissions, management fees and expenses all may be associated with investment funds. Please read the prospectus before investing. If the securities are purchased or sold on a stock exchange, you may pay more or receive less than the current net asset value. Investment funds are not guaranteed, their values change frequently and past performance may not be repeated.

Certain statements in this document are forward-looking. Forward-looking statements (“FLS”) are statements that are predictive in nature, depend on or refer to future events or conditions, or that include words such as “may,” “will,” “should,” “could,” “expect,” “anticipate,” intend,” “plan,” “believe,” “estimate” or other similar expressions. Statements that look forward in time or include anything other than historical information are subject to risks and uncertainties, and actual results, actions or events could differ materially from those set forth in the FLS. FLS are not guarantees of future performance and are by their nature based on numerous assumptions. Although the FLS contained in this document are based upon what Purpose Investments and the portfolio manager believe to be reasonable assumptions, Purpose Investments and the portfolio manager cannot assure that actual results will be consistent with these FLS. The reader is cautioned to consider the FLS carefully and not to place undue reliance on the FLS. Unless required by applicable law, it is not undertaken, and specifically disclaimed, that there is any intention or obligation to update or revise FLS, whether as a result of new information, future events or otherwise.

Canadian Preferred Shares: A Lower-risk Income Stream

Canadian Preferred Shares: A Lower-risk Income Stream

Canadian preferred shares were hit hard during the broad sell-off of the fourth quarter. The S&P/TSX Preferred Share Index declined more than 11% over the three-month period, roughly mirroring the decline in the S&P/TSX Composite Index. However, unlike the equities, preferred shares have not recovered; instead, they have remained mostly flat. This opens up an opportunity to solve a problem created by policymakers.

One of the casualties of monetary policy in the aftermath of the credit crisis and Great Recession has been the ability of savers to generate income without taking undue risk. The major central banks of the world, including the US Federal Reserve Bank, the European Central Bank and the Bank of Japan, have used unconventional techniques such as quantitative easing (QE) to drive down both short- and long-term interest rates. As a result of these policies, forty percent of government debt globally in mid-2016 carried negative interest rates. Today, negative interest rates on government debt are still not unusual in many countries. Investors have fewer options to generate income in this environment and therefore need to look elsewhere. We suggest investors consider the benefits of the preferred shares from Canada’s top corporations.

Income Options for Individuals: Traditional Sources vs. Canadian Preferred Shares

Yield Annual Income Equivalent Monthly Income Equivalent Monthly Income After Tax
30-Year Government of Canada Bonds 1.98% $19,800 $1650 $767
Money Market Funds 2.00% $20,000 $1,667 $775
Life Insurance Annuities 4.40% $44,000 $3,667 $1,704
Royal Bank of Canada – Series H 5.20% $52,000 $4,333 $2,629
Toronto-Dominion Bank – Series FB 5.20% $52,000 $4,333 $2,629
Manulife Financial – Series L 5.50% $55,000 $4,583 $2,780
Power Financial – Series P 5.60% $56,000 $4,667 $2,831
Brookfield Asset Management – Series T 6.00% $60,000 $5,000 $3,033
TransCanada – Series A 6.20% $62,000 $5,167 $3,134

As a direct result of unconventional central bank monetary policies, Canadian savers have been penalized with low income from traditional bank accounts, money market funds and government bonds. For example, most recently the pre-tax income generated from $1-million of savings in risk-free money market funds is about $20,000 annually, or under $2,000 per month, according to a Purpose Investments analysis of common money market products. While this is a vast improvement from the rates available in the mid-2010’s, it is hardly an income stream that rewards savers for years of responsibly putting money away for retirement or other financial goals.

One alternative to risk-free interest income is to purchase a life insurance annuity, taking only marginally more credit risk over a traditional savings account. Currently, life insurance annuity rates provide roughly 4.4% cash-on-cash return for a typical 60-year old individual, according to quotes provided to Purpose Investments. That represents a lifetime pre-tax monthly income of about $3,667 per month for $1-million of savings or principal. However, there are  numerous disadvantages to purchasing a life insurance annuity, including the inability to get out of the product, the inability to transfer the assets to an heir and the lack of  lack of upward adjustment to inflation.

A better alternative income stream comes from the preferred shares of Canadian corporations. As a result of the sell-off in Canadian preferred shares in late 2018, an investor can generate a pre-tax equivalent income stream of 6% to 8% from the most credit-worthy corporations in Canada. These include the Royal Bank of Canada, Toronto-Dominion Bank, Manulife Financial Corporation, TransCanada Corporation and Brookfield Asset Management Inc., to name a few. The preferred share coupon payments also protect against inflation indirectly through periodic coupon adjustments that are directly tied to Government of Canada bond yields. For $1-million of savings, the resulting pre-tax equivalent monthly income is roughly $6,000 in perpetuity to start, with periodic inflation adjustments in the future.

Current Canadian Preferred Shares Market Valuation is Attractive

The prices of Canadian preferred shares often move with the prices of the common equity of the same issuers. Prices also move with the level of 5-year Government of Canada bond yields, which are used as a benchmark when resetting coupon payments on rate-reset preferred shares (higher bond yields generally mean higher prices for the preferred shares).

The most widely quoted benchmark index for the Canadian preferred share market is the S&P/TSX Preferred Share Index. Most recently, the index has been trading at a level around 630, something unseen since July 2016. The 5-year Government of Canada bond yields roughly 1.70% in early 2019 or about three times the 0.60% yield prevalent in July 2016. Using this comparison, the preferred share market in Canada is significantly more attractive than it was in mid-2016. The asset class is yielding over 100 basis points more, despite the index value being at similar levels.

Chart of Canadian Preferred Shares vs Government of Canada 5-year bond yield

A return to the same interest-rate environment from mid-2016 is highly unlikely as that was the period when government interest rates bottomed in major markets and central bank interference in the bond market was at its peak. It was in that period when 40% of government debt globally had negative yields. Thus, the Canadian preferred share market currently appears to be discounting a scenario in interest rates we view as highly unlikely.

Canadian Preferred Shares Are an Attractive Income Option

An extended period of low interest rates has proven challenging for savers with a low tolerance for risk. Traditional bank savings accounts and money market funds have provided very little risk-free income. Life insurance annuities provide a higher income stream but are restrictive in many ways. While these may improve over time, they aren’t especially attractive at the moment. On the other hand, Canadian preferred shares provide higher income with the potential for capital appreciation, with low incremental risk of non-payment. The sell-off in late 2018 has made Canadian preferred shares particularly attractive, especially when viewed through the context of the history of the asset class. And, preferred shares offer further benefits, including seniority in the capital structure and inflation protection. Going forward, we see interest rates rising over time, which should provide a further tailwind for Canadian preferred shares.

— Sandy Liang, CFA is the Head of Fixed Income at Purpose Investments and Jeremy Lin, CFA is an Associate Portfolio Manager. Sandy and Jeremy manage Purpose Canadian Preferred Share Fund.

 

Note: Yields as at March 6, 2019. Payments calculated on a monthly basis for ease of comparison. Equivalent Monthly Income is the monthly pre-tax income on $1 million of savings. Tax calculations are based on the highest marginal tax rate in the Province of Ontario in 2019, 53.53%. Equivalent Monthly Income calculation assumes investor is in highest marginal tax rate and earns the full tax credit on eligible dividends.

All data sourced to Bloomberg unless otherwise noted.

The content of this document is for informational purposes only, and is not being provided in the context of an offering of any securities described herein, nor is it a recommendation or solicitation to buy, hold or sell any security. The information is not investment advice, nor is it tailored to the needs or circumstances of any investor. Information contained on this document is not, and under no circumstances is it to be construed as, an offering memorandum, prospectus, advertisement or public offering of securities. No securities commission or similar regulatory authority has reviewed this document and any representation to the contrary is an offence. Information contained in this document is believed to be accurate and reliable, however, we cannot guarantee that it is complete or current at all times. The information provided is subject to change without notice and neither Purpose Investments Inc. nor is affiliates will be held liable for inaccuracies in the information presented.

Commissions, trailing commissions, management fees and expenses all may be associated with investment funds. Please read the prospectus before investing. If the securities are purchased or sold on a stock exchange, you may pay more or receive less than the current net asset value. The indicated rate of return is the historical annual compounded total return including changes in share/unit value and reinvestment of all distributions and does not take into account sales, redemption, distribution or optional charges or income taxes payable by any securityholder that would have reduced returns. Investment funds are not guaranteed, their values change frequently and past performance may not be repeated

Certain statements in this document are forward-looking. Forward-looking statements (“FLS”) are statements that are predictive in nature, depend on or refer to future events or conditions, or that include words such as “may,” “will,” “should,” “could,” “expect,” “anticipate,” intend,” “plan,” “believe,” “estimate” or other similar expressions. Statements that look forward in time or include anything other than historical information are subject to risks and uncertainties, and actual results, actions or events could differ materially from those set forth in the FLS. FLS are not guarantees of future performance and are by their nature based on numerous assumptions. Although the FLS contained in this document are based upon what Purpose Investments believe to be reasonable assumptions, Purpose Investments cannot assure that actual results will be consistent with these FLS. The reader is cautioned to consider the FLS carefully and not to place undue reliance on the FLS. Unless required by applicable law, it is not undertaken, and specifically disclaimed, that there is any intention or obligation to update or revise FLS, whether as a result of new information, future events or otherwise.

The Fed Catches Up to the Market; What’s Next?

The Federal Reserve was already behind the market, prior to Wednesday’s meeting. The “dot plots,” the Fed Governor forecasts for future Fed Funds rate increases, are now closer to the market’s thinking. For now, the hiking cycle is done, with zero increases expected in 2019 and a median forecast for one hike in 2020.

What was more dovish than expected, and possibly more responsible for the 10bps decline in 10-year bond yields post-meeting, was the change in balance-sheet reduction. The run-off of Treasury and mortgage securities held by the Fed will slow its pace, starting in May. This is a total 180 from what Fed Chair Jerome Powell said in 2018, when he remarked that the balance sheet run-off was on “auto-pilot.”

Overall, the dovishness extended beyond the normal commentary on the short end of the yield curve. Accompanying the balance sheet and rate outlooks were growth rate forecasts for 2019 and 2020, which ratcheted down slightly. The median expectation for US economic growth in 2019 and 2020 is now 2.1% and 1.9%, respectively. That’s down from the previous forecasts of 2.3% and 2.0%.

Recall that the Fed is “data driven.” It now appears to be market driven as well. The “Powell Put” is firmly in place and he has now backtracked from previous comments on both the neutral rate and balance-sheet reductions, which is probably the single largest contributor to the market’s 180 since Christmas Eve. The monetary environment from global central banks can only be characterized as accommodative, with real interest rates back to just about zero, again.

Channelling the much-overused Gretzkyism, “skate to where the puck is going, not where it is right now,” our view has been and remains that the economy is slowing but a near-term recession is unlikely. We had been early in taking off our bond-market hedges, with the 10-year yield now at January 2018 levels, which hasn’t cost us much because risk assets have performed well so far in 2019. We don’t think it’s the time to re-hedge with long bonds and we are not calling for a return of the 2016 fixed-income environment.

Going the other way, there are some market trends that are worth watching closely today, with respect to inflation and growth. The implied inflation rate in TIPs (the difference between 10-year yields and inflation-protected bond yields) has already bottomed. It’s happened not just in the US, which is nearing 2% again, but also in Europe.

The most recent headline CPI number in the US is 1.5%, but core inflation (which removes food and energy) is 2.1% year-over-year, in line with the Fed’s target levels. Wage inflation is over 3% year-over-year and at cycle highs. Oil has quietly rallied back to almost US$60 per barrel, which means it will likely be a higher year-over-year number in the second half of the year, putting upward pressure on headline inflation. Copper prices have been firm and are halfway back to highs from a year ago. It doesn’t appear that US or global growth is in a downward growth spiral; if anything, there appear to be “green shoots.”

Chart of 10 year treasury yield versus TIPs B/E 10 year inflation rate

In summary, with quantitative tightening proceeding at a slower-than-expected pace starting in May 2019, it makes sense bond yields reacted to the announcement by going lower. The change is minor though, compared with the fact that US budget deficits are still $1-trillion (which must be financed) and the European Central Bank is no longer conducting quantitative easing. The bond bear market doesn’t go in a straight line, but for investors with a time horizon, it still makes sense to assume there’s a headwind in bond yields. Today, around 20% of the world’s government debt is back to negative yield. This isn’t a normal state.

 

— Sandy Liang, CFA, is the Head of Fixed Income at Purpose Investments. He is the lead portfolio manager for a number of funds, including Purpose Strategic Yield Fund, Purpose Canadian Preferred Share Fund and Purpose Credit Opportunities Fund.

All data sourced from Bloomberg.

The content of this document is for informational purposes only, and is not being provided in the context of an offering of any securities described herein, nor is it a recommendation or solicitation to buy, hold or sell any security. The information is not investment advice, nor is it tailored to the needs or circumstances of any investor. Information contained in this document is not, and under no circumstances is it to be construed as, an offering memorandum, prospectus, advertisement or public offering of securities. No securities commission or similar regulatory authority has reviewed this document and any representation to the contrary is an offence. Information contained in this document is believed to be accurate and reliable, however, we cannot guarantee that it is complete or current at all times. The information provided is subject to change without notice.

Commissions, trailing commissions, management fees and expenses all may be associated with investment funds. Please read the prospectus before investing. If the securities are purchased or sold on a stock exchange, you may pay more or receive less than the current net asset value. Investment funds are not guaranteed, their values change frequently and past performance may not be repeated.

Certain statements in this document are forward-looking. Forward-looking statements (“FLS”) are statements that are predictive in nature, depend on or refer to future events or conditions, or that include words such as “may,” “will,” “should,” “could,” “expect,” “anticipate,” intend,” “plan,” “believe,” “estimate” or other similar expressions. Statements that look forward in time or include anything other than historical information are subject to risks and uncertainties, and actual results, actions or events could differ materially from those set forth in the FLS. FLS are not guarantees of future performance and are by their nature based on numerous assumptions. Although the FLS contained in this document are based upon what Purpose Investments and the portfolio manager believe to be reasonable assumptions, Purpose Investments and the portfolio manager cannot assure that actual results will be consistent with these FLS. The reader is cautioned to consider the FLS carefully and not to place undue reliance on the FLS. Unless required by applicable law, it is not undertaken, and specifically disclaimed, that there is any intention or obligation to update or revise FLS, whether as a result of new information, future events or otherwise.

Green Shoots Amid Rising Cannabis Valuations

February was another positive month for the cannabis sector as the group continued to bounce from the December lows. While it seemed stocks were up every day in January, February was a different story. Volatility began to return to the group and there were more intraday swings, albeit with a positive bias.

With the positive sentiment around the group, financing activity picked up. American multi-state operators (MSOs) continued their ‘land grab’ by locking up capital. In February alone, we saw at least three MSOs raise capital to go public. Purpose Marijuana Opportunity Fund (MJJ) participated in two of these raises, Grassroots Cannabis and Vireo Health, Inc., getting in to ground-floor opportunities ahead of the passive indices. Additionally, smaller Canadian operators raised capital dedicated to premium grow operations. While appetite remains healthy in the group, it’s notable that not all deals are getting completed within the deal terms. This could be a signal of buyer exhaustion and maybe a near-term top for the group.

Valuations in the sector are close to all-time highs, propelled by the passing of the 2018 Farm Bill in the US and marijuana legalization becoming a ballot topic for the 2020 elections. We have become wary of the excessive valuations and investors that are beginning to price in expectations that may be difficult or impossible to achieve. As such, we maintained a 20% cash level in MJJ for most of February, eager to deploy at any downturn. Despite the heavy cash balance, the Fund was able to maintain a strong upside capture while minimizing volatility.

As for March, we remain more defensive than during other periods over the last year. We continue to deploy cash into promising private plays and saving our dry ammo for the next big down day. Exciting opportunities are emerging around extraction, branding and international opportunities, such as Mexico.

The Canadian LPs are reporting mixed results as many struggle to meet market expectations and their own targets. The delays in rolling out recreational retail stores in Ontario and BC are being used as an excuse for most of these misses, but at some point we must see profits. By the second half of 2019, there likely won’t be as much tolerance for earnings misses and we should start to see even more separation between winners and losers.

— Greg Taylor, CFA is the Chief Investment Officer of Purpose Investments and Nawan Butt, CFA is an Associate Portfolio Manager. Together, Greg and Nawan manage Purpose Marijuana Opportunities Fund.

All data sourced to Bloomberg unless otherwise noted.

Commissions, trailing commissions, management fees and expenses all may be associated with investment funds. Please read the prospectus before investing. If the securities are purchased or sold on a stock exchange, you may pay more or receive less than the current net asset value. The indicated rate of return is the historical annual compounded total return including changes in share/unit value and reinvestment of all distributions and does not take into account sales, redemption, distribution or optional charges or income taxes payable by any securityholder that would have reduced returns. Investment funds are not guaranteed, their values change frequently and past performance may not be repeated

Certain statements in this document are forward-looking. Forward-looking statements (“FLS”) are statements that are predictive in nature, depend on or refer to future events or conditions, or that include words such as “may,” “will,” “should,” “could,” “expect,” “anticipate,” intend,” “plan,” “believe,” “estimate” or other similar expressions. Statements that look forward in time or include anything other than historical information are subject to risks and uncertainties, and actual results, actions or events could differ materially from those set forth in the FLS. FLS are not guarantees of future performance and are by their nature based on numerous assumptions. Although the FLS contained in this document are based upon what Purpose Investments believe to be reasonable assumptions, Purpose Investments cannot assure that actual results will be consistent with these FLS. The reader is cautioned to consider the FLS carefully and not to place undue reliance on the FLS. Unless required by applicable law, it is not undertaken, and specifically disclaimed, that there is any intention or obligation to update or revise FLS, whether as a result of new information, future events or otherwise.

Markets March Forward as Central Banks Remain on the Sidelines

Fears of a retest of the December lows have seemingly been pushed aside for now, as global trade tensions have abated and interest rate hikes appear to be off the table for the year for the major central banks. Global equity markets continued to advance in February, lifting the year-to-date performance for most markets above 10%.

The shock of the sell-off that ended last year left many investors defensively positioned and holding more cash than normal. When cash levels are high and everyone’s waiting for an opportunity to get back into their favourite names, it’s often a setup for the opposite to happen; the market has a tendency to do what makes the most people wrong.

Corporate earnings came in as expected, but uniformly have been met with buying as investors cheered numbers that proved to be better-than-feared. Information technology has once again led the market higher with many software stocks up over 20% on the year. This market isn’t as narrow as previous markets, but those who called the end of the FANNG trade may have been premature. Defensive sectors are lagging and the long-suffering energy stocks are quietly up 15% on the year.

Geo-political risk remains elevated yet largely ignored. What will change that remains unknown as markets appear numb to crazy Trump headlines and events such as Brexit. With the Federal Reserve on the sidelines, largely attributed to slower global growth, it’s almost a case of bad global news is good for risk assets as it further extends the pause in rate hikes.

A skeptic would point to the fact these global fears were present all of last year but central banks remained hawkish until a dramatic selloff in equities forced Fed Chair Jerome Powell to change camps and back down. The S&P 500 was around 2,900 before the sell-off that took it down to 2,350.  With the rebound back above 2,800, you could be forgiven for wondering, ‘if the market returns to 2,900, do rate hikes come back to the table?’

If it all comes back to global growth fears, it’s always important to watch the metals. Copper is approaching $3/lb. and is above the 200-day moving average for the first time since last summer. There is a chance copper is saying these growth fears have passed and emerging markets may be starting to recover. It’s also important to note that the US 10-year Treasury yield, which started the year around 2.5%, is now over 2.75% and heading higher.

Higher bond yields, higher copper prices and higher equity markets may cause the market to question if central bankers really are on the sidelines for the entire year. Will markets handle a more hawkish Fed better this time around? It’s too soon to tell, but this is required watching.

Markets are off to their best start to the year since the early 1990’s. It’s hard to imagine it will be a straight line higher, but absent a major shock, we don’t expect a dramatic sell-off either. It’s prudent to take some risk off the table, but also important to keep invested.

Ideas with Purpose

Purpose Global Bond Fund (BND): While we think it’s advisable to take some risk out of portfolios, we also believe it’s wise to maximize returns as well. BND provides a higher yield than Canadian and US 10-year government bonds. It also yields higher than the US investment-grade corporate bond index with a lower duration. Diversification across a variety of regions provides further protection.

Purpose Multi-Strategy Market Neutral Fund (PMM): The investing environment is relatively uncertain right now, but we believe it is important to remain invested and diversify into alternative investments. PMM has the ability to source returns from multiple markets with low correlation to one another. The Fund has been firing on all cylinders so far this year, capturing a portion of the equity market rally while also generating meaningful returns from long and short exposures to commodities and currencies.

— Greg Taylor, CFA is the Chief Investment Officer of Purpose Investments.

All data sourced from Bloomberg.

The content of this document is for informational purposes only, and is not being provided in the context of an offering of any securities described herein, nor is it a recommendation or solicitation to buy, hold or sell any security. The information is not investment advice, nor is it tailored to the needs or circumstances of any investor. Information contained in this document is not, and under no circumstances is it to be construed as, an offering memorandum, prospectus, advertisement or public offering of securities. No securities commission or similar regulatory authority has reviewed this document and any representation to the contrary is an offence. Information contained in this document is believed to be accurate and reliable, however, we cannot guarantee that it is complete or current at all times. The information provided is subject to change without notice.

Commissions, trailing commissions, management fees and expenses all may be associated with investment funds. Please read the prospectus before investing. If the securities are purchased or sold on a stock exchange, you may pay more or receive less than the current net asset value. Investment funds are not guaranteed, their values change frequently and past performance may not be repeated.

Certain statements in this document are forward-looking. Forward-looking statements (“FLS”) are statements that are predictive in nature, depend on or refer to future events or conditions, or that include words such as “may,” “will,” “should,” “could,” “expect,” “anticipate,” intend,” “plan,” “believe,” “estimate” or other similar expressions. Statements that look forward in time or include anything other than historical information are subject to risks and uncertainties, and actual results, actions or events could differ materially from those set forth in the FLS. FLS are not guarantees of future performance and are by their nature based on numerous assumptions. Although the FLS contained in this document are based upon what Purpose Investments and the portfolio manager believe to be reasonable assumptions, Purpose Investments and the portfolio manager cannot assure that actual results will be consistent with these FLS. The reader is cautioned to consider the FLS carefully and not to place undue reliance on the FLS. Unless required by applicable law, it is not undertaken, and specifically disclaimed, that there is any intention or obligation to update or revise FLS, whether as a result of new information, future events or otherwise.

Q&A: why options should be in every investor’s portfolio

Options are a great way to add diversification and an alternative income stream to your portfolio, but the strategy can often be confusing for some investors. Between calls, puts and strikes, it’s easy to get lost in the terminology.

Frank Maeba is one of the portfolio managers at Neuberger Berman Breton Hill ULC who runs Purpose Premium Yield Fund (PYF). The portfolio uses a specific options strategy known as cash-covered put writing where puts are sold to other investors to earn a premium. We spoke to Frank about how the strategy works and why it’s a powerful tool every investor should consider.

Q: First off, what’s the difference between selling calls and selling puts?

When you sell a call, someone on the other side of the options contract has the right to buy stock from you at a higher price. When you’re selling a put, the person who owns that put has the right to sell stock to you at a lower price. That’s the main difference. Selling a put means you could end up buying stock. As a seller of calls, I could end up being short stock.

Q: How can investors use puts in their portfolios?

Probably the number one way to use a put as an investor is really to protect your portfolio from going down. If you’re long equities or long certain stock names and you’re worried that there are bad things happening in the world or that the market is topping out, and you want to protect against that kind of downside, you can pay a premium – basically a type of insurance that protects you against that stock decline. So, you’ll have the right to sell that stock at a pre-defined level, even if it’s trading significantly lower.

Q: How exactly does a put act as insurance for your stocks?

There are two sides of puts. Investors who are worried about a downward move generally will pay up for insurance to protect their portfolio [by giving them the right to sell stocks at a certain price even if they decline]. On the flip side, there are people who sell that insurance and they try to collect those premiums. They try to collect as many premiums as possible because over a long cycle in general, collecting premiums is a pretty healthy business.

Once every year or every couple of months, you might get impacted by a bad event where you have to pay out on that insurance claim, so to speak. Over a longer cycle, there are many businesses predicated on collecting those insurance premiums. The way we set up our own current portfolio in PYF is similar to that. We’re selling insurance or put premiums, collecting those premiums and generating a healthy yield. And hopefully we can risk manage the portfolio so we don’t really have a bad event happen across the portfolio.

Q: Is selling puts essentially applying the insurance business model to an investment portfolio?

That’s exactly it! You’re picking up small premiums. Think of it as earning maybe a dollar a month selling puts. Hopefully you can string together a lot of positive months where you collect a dollar every month for 11 months, and then on the final month something bad might happen. You’ve collected hopefully 11 dollars in premiums, and then you might actually have to pay out half of it to cover some bad event. But net-net over the course of the year, you get to keep more than you pay out. And that’s the gist of this strategy and of the insurance business.

Q: Insurance companies sometimes pay out huge amounts, yet they manage to operate in a fairly stable manner. Does selling puts add stability to your portfolio?

It’s a pretty consistent way of generating an income in yield that’s pretty diversified versus just owning dividend equities or fixed-income credit. It gives a very different risk profile that can be stable over time. When you’re dealing with options there can be two key things that help make it more of a steady ride.

First of all, it’s experience. At Neuberger, we’ve had a lot of experience managing these types of option portfolios going back decades. There are certain things you can do to help manage the risks of this kind of strategy so that when it does draw down and you have to pay out that insurance, maybe it’s not as deep a payout as you might expect.

The second thing for managing risk is just doing it consistently over time, diversifying the names of the portfolio and trying not to use too much leverage. [PYF] is an unlevered type strategy. These are the kinds of things that help minimize the risks of a big blow up.

Q: How much time and work have you personally put in to learning how to run an options strategy?

I started off my career on an options desk back in the mid-1990s. So, I have over 20 years of options experience. It’s across multiple markets: not only equities, but currencies, commodities, rates. All derivatives markets have certain basic construction blocks, so to speak. So, getting really good at currencies, for me, definitely applies over in equities or even fixed income and commodities.

I’d say there’s multiple learnings across a cycle. Over the last 20 years, we’ve seen ups and downs in markets; we’ve seen geopolitical events; good things and bad things happening in the [options investing] instruments. All of those learnings are really embedded in the current strategy to make it as smooth as possible.

In terms of the effort, there are two things I’d say. A lot of that experience helps us run the portfolio in a very efficient and cost-efficient way. The second thing is that we’ve built a substantial amount of technology around our options trading so that it can scale in a reasonable way to minimize trading costs and expenses. And also, [technology helps] just to manage the sheer number of options we’re trading each and every month.

The options market is still one of those markets that’s not as automated as equities or currencies. There’s still a lot of manual stuff in order to execute an options trade. So, we’ve built out quite a bit of technology to help us do that in a very efficient manner.

Q: What exactly are you looking for when you decide to execute an options trade?

First and foremost, it’s not really the derivative we’re looking at, especially in PYF. We start off with “are these stocks that we want to ultimately own?” The way to think about a lot of this strategy is you sell a put, you earn a premium, and if you happen to get put to, meaning exercised, and you end up owning that stock, that’s not necessarily a bad thing. Another way to think about it is that you’re earning a premium while waiting to potentially own that stock at a lower price.

We start off our analysis by saying “what’s a good group of stocks that have good value characteristics, good quality characteristics, good positive cash flows, et cetera that we would love to own just outright, but also would love to own on a dip if they pull back 5% or 10%?”

Once we identify that group of stocks, we do a secondary screen where we look at “do these have attractive volatility or option characterizes that we think are worth writing puts on?” The things in the secondary part of that process would be “do they exhibit high volatility?” That usually means they pay a higher premium, so you get to harvest that higher premium on that name.

Probably the biggest thing in running this type of program is that the names have to be highly liquid. We tend to really only write puts in the US market because it has the deepest options liquidity. In order to manage an ETF-mutual fund complex doing this type of strategy where there’s inflows and outflows, trading back and forth, you want very tight bid-offer spreads. And you want that kind of liquidity to manage the underlying instruments.

Q: How big of a role should this type of strategy play in an overall portfolio?

I think alternatives are definitely a very important part of any type of traditional asset mix; especially right now, with markets where they are. Bonds are probably at their all-time low yields and yields will likely rise going forward. Equities are at extremely high levels; potentially, on a valuation basis, at the top-end of the range. And we’re late in the economic cycle. So, that traditional 60/40 asset mix – you can’t really rely on it, I would think, to produce the same kinds of returns we’ve seen over the last decade going forward.

Really, the trick is finding what the alternative return drivers are. What are alternative-type risk profiles that I can put into my portfolio that can potentially give me the returns I’m used to but also mitigate the downside risks of equities selling off heavily or bonds selling off heavily? I think this type of product meets a lot of those desires.

If you’re trying to generate income in your portfolio and you’ve relied on credit, bonds or dividend-paying equities – those are all suffering right now with rates backing up. Whereas this type of product has a negative beta to interest rates. It actually performs well when interest rates are going up. It does have underlying equities that we write puts on, but these puts are 7-10% out of the money. And, it has much less direct exposure to markets than the alternative of just owning the long-only equity outright. The way we manage this strategy, it only has on average 10-15% exposure to the underlying equities. Significantly less beta is being held in this portfolio, but still pumping out a pretty healthy income distribution of 5-7%.

Q: What’s the worst-case scenario with this strategy?

Worst-case scenario is that you’ve written a lot of puts that are 7-10% out of money and then all of a sudden, the market just drops. We’ve seen examples of that across history. Think of the crash in 1987 where basically the market just dumped 20% in a straight line. That’s not great for this type of portfolio. Even in February, we saw a straight line drop where the markets fell 12% from the peak in quick order. That’s when these risk-management techniques come into play and are tested.

One of the biggest things we do is diversify the number of names that we write on, but we also diversify the types of puts. We will choose different maturities on the puts and different strikes. So, diversify as much as possible. The whole point of diversification in this type of derivative portfolio is to smooth out the path dependency of the overall portfolio. The more diversification you can embed in it, the more that risk is diffused across the entire portfolio. Since inception[1], the overall volatility of this portfolio has only been 3.5%. Equities normally exhibit anywhere from 15-20% volatility over a cycle, bonds anywhere from 4-5% volatility. The volatility of this portfolio is substantially less over a cycle so far.

In February 2018, PYF actually ended up on the month slightly. A lot of the risk-management techniques we’ve discussed about diversification, those are a lot of the reasons why it was able to dampen that impact despite February being [the kind of event] that can damage an options portfolio. We saw a lot of options portfolios blow up, but we were able to skate by relatively easy. It goes to show we construct these portfolios, we hand-hold them, we focus on managing risk around them, and that’s embedded in everything that we do.

 

[1] Inception of PYF is January 19, 2016; data as at May 31, 2018.

A visualization of how the put-writing options strategy in Purpose Premium Yield Fund works.

Disclaimers
Commissions, trailing commissions, management fees and expenses all may be associated with investment funds. Please read the prospectus before investing. If the securities are purchased or sold on a stock exchange, you may pay more or receive less than the current net asset value. The indicated rate of return is the historical annual compounded total return including changes in share/unit value and reinvestment of all distributions and does not take into account sales, redemption, distribution or optional charges or income taxes payable by any securityholder that would have reduced returns. Investment funds are not guaranteed, their values change frequently and past performance may not be repeated
Certain statements in this document are forward-looking. Forward-looking statements (“FLS”) are statements that are predictive in nature, depend on or refer to future events or conditions, or that include words such as “may,” “will,” “should,” “could,” “expect,” “anticipate,” intend,” “plan,” “believe,” “estimate” or other similar expressions. Statements that look forward in time or include anything other than historical information are subject to risks and uncertainties, and actual results, actions or events could differ materially from those set forth in the FLS. FLS are not guarantees of future performance and are by their nature based on numerous assumptions. Although the FLS contained in this document are based upon what Purpose Investments believe to be reasonable assumptions, Purpose Investments cannot assure that actual results will be consistent with these FLS. The reader is cautioned to consider the FLS carefully and not to place undue reliance on the FLS. Unless required by applicable law, it is not undertaken, and specifically disclaimed, that there is any intention or obligation to update or revise FLS, whether as a result of new information, future events or otherwise.

Oh, Canada! A plan for 2019

The Canadian economy is forecast to expand by 2.1% in 2018, which is pretty much in the bag. However, in line with most global economies, ‘moderation’ seems to be the popular term for growth in the coming years, with forecasts for 2019 sitting at 1.9% and 1.7% for 2020. Beneath this headline number, which don’t sound so bad, there are a few contributors and detractors that may prove more troublesome.

Before we jump into the negative signs, it’s important to understand that the Canadian economy would find it very difficult to fall into a recession with the US economy doing well. The old adage “when the US sneezes, Canada catches a cold” works both ways. Canada has a hard time catching a cold when the US is feeling healthy, which is the case today. In fact, the only time since 1960 that Canada suffered consecutive quarters of negative GDP growth with the US economy still growing was the energy-induced slowdown in the first half of 2015, which proved temporary on a national basis. Given US economic growth is currently forecast at 2.5%, things south of the border are looking pretty good.

Canadian economic woes

There are certainly some headwinds for the Canadian economy. Insolvencies among Canadian companies rose 4.6% in the third quarter, the fastest quarterly increase in over five years. If these were concentrated in Alberta due to soft energy prices and infrastructure bottlenecks, we could blame this rise on industry-centric factors. However, this trend was evident across a number of provinces, some of which have no material energy exposure. With our largest trading partner, the US, still doing fine and the overall Canadian economy still expanding, the culprit appears to be higher interest rates. Interest rates started moving higher in mid-2016, but remain low by historical standards. It’s too early to tell, but this could be evidence of just how sensitive our economy has become to changes in interest rates. Perhaps more sensitive than many currently already believe.

The Canadian consumer also appears to be feeling the pinch of higher yields. Canadian household debt reached a new record in November of over $2.15-trillion. Rising debt may sound negative, but changes in debt actually correlate very strongly with economic activity. It takes money to make money. So, a new record high is a positive for the economy; however, the growth rate in total debt continues to slow, down to levels that have only been seen during recessions (chart below). And this isn’t just attributable to the slowdown in home sales, as consumer credit debt growth has been slowing along similar lines.

Slow debt growth, the continued situation on the energy front, some softness in housing, plus an acceleration in the moderation of growth among developing economies (that tend to be source of marginal demand for resources); it doesn’t paint a great picture for the home team.

And if our economy really has become ‘uber’ sensitive to interest rates, there may be another issue. Say the US economy keeps performing well (our expectation), their yields will remain elevated. Even with a softer outlook for the Canadian economy, our yields will be dragged along for the ride. This would negatively impact the levered consumer and the interest-rate-sensitive housing industry.

But we have a plan

There is some good news. First, the economic headwinds for Canada may be largely evident in valuations. We have written in the past months about how much the price-to-earnings multiple (PE) for the US declined in 2018. Well, the TSX PE has fallen from 17.5x to 13.5x over the past two and a half years. With many companies trading so cheaply by historical standards, this clearly is reflecting to some degree the moderation in the Canadian and developing economies.

The other strategy that may benefit investors is once again focusing on Canadian companies that generate most their sales from outside Canada. Especially for those with more US exposure, you may be getting the benefit of a more robust US economy at a Canadian discounted valuation.

The first chart below is a breakdown of domestic revenue by sector for TSX members. Industrials and information technology jump out as potentially fitting this mold. The industrial average is 45%; however, when you get to the company level there is a large range. Names such as ATS Automation Tooling Systems, CAE Inc., NFI Group Inc. (New Flyer Industries), Bombardier Inc. and SNC-Lavalin Group Inc. are all much more global.

Financials tend to be more domestic focused, but again, this varies substantially across names. Bank of Nova Scotia, Toronto-Dominion Bank and Royal Bank of Canada among those with the largest non-Canadian revenue. The life insurance companies tend to have an even lower exposure to Canadian revenue. Certainly, a factor worth considering with ‘moderation’ varying from one economy to another.

— Craig Basinger, Chris Kerlow, Derek Benedet and Alexander Tjiang are members of Richardson GMP’s Connected Wealth team which manages Purpose Core Equity Income FundPurpose Tactical Asset Allocation Fund and Purpose Behavioural Opportunities Fund

All data sourced from Bloomberg unless otherwise noted.

The content of this document is for informational purposes only, and is not being provided in the context of an offering of any securities described herein, nor is it a recommendation or solicitation to buy, hold or sell any security. The information is not investment advice, nor is it tailored to the needs or circumstances of any investor. Information contained in this document is not, and under no circumstances is it to be construed as, an offering memorandum, prospectus, advertisement or public offering of securities. No securities commission or similar regulatory authority has reviewed this document and any representation to the contrary is an offence. Information contained in this document is believed to be accurate and reliable, however, we cannot guarantee that it is complete or current at all times. The information provided is subject to change without notice.

Commissions, trailing commissions, management fees and expenses all may be associated with investment funds. Please read the prospectus before investing. If the securities are purchased or sold on a stock exchange, you may pay more or receive less than the current net asset value. Investment funds are not guaranteed, their values change frequently and past performance may not be repeated.

Certain statements in this document are forward-looking. Forward-looking statements (“FLS”) are statements that are predictive in nature, depend on or refer to future events or conditions, or that include words such as “may,” “will,” “should,” “could,” “expect,” “anticipate,” intend,” “plan,” “believe,” “estimate” or other similar expressions. Statements that look forward in time or include anything other than historical information are subject to risks and uncertainties, and actual results, actions or events could differ materially from those set forth in the FLS. FLS are not guarantees of future performance and are by their nature based on numerous assumptions. Although the FLS contained in this document are based upon what Purpose Investments and the portfolio manager believe to be reasonable assumptions, Purpose Investments and the portfolio manager cannot assure that actual results will be consistent with these FLS. The reader is cautioned to consider the FLS carefully and not to place undue reliance on the FLS. Unless required by applicable law, it is not undertaken, and specifically disclaimed, that there is any intention or obligation to update or revise FLS, whether as a result of new information, future events or otherwise.

What Apple’s warning may tell us about the markets

Late yesterday, Apple refreshed its guidance, warning investors to expect lower sales from the holiday quarter due to a slowdown in iPhone sales in China. It will be very interesting to see how it affects the markets today.

This could be looked at as an Apple-only event. Given the stock was already down over 30% from its peak earlier in the year, you may look at this as something the market was expecting. The global cellphone market is very competitive and Apple has been losing share to Samsung and Huawei over the last few years. Add in the trade dispute between the US and China, and it shouldn’t be a shock to hear Apple say the bulk of their current issues stem from China.

What the bears will focus on is the fear that this is another sign of a slowdown in global growth. Names such as Caterpillar and Boeing are key indicators of this sentiment. But, with the US 10-year bond yield already falling from 3.2% to 2.6% in the last few months, the market may have already priced in a slowdown. This bad news could be the evidence the Federal Reserve needs to halt its interest rate hikes, which in the end, would be good news.

This could also lead to more rotation from growth to value, which looks like it may have peaked earlier this summer (chart right: Russell 1000 Growth Index vs Russell 1000 Value Index; click to enlarge).

What may be lost behind the Apple headlines this morning is the huge acquisition in the healthcare space, with Bristol-Myers Squibb buying Celgene for $74B. This is a reminder that corporate balance sheets are strong and some companies are viewing the recent pullback as a buying opportunity. Today’s trading could tell us a lot about how the markets will act in the next few weeks. With the recent sell-off, a lot of bad news has already been priced in. If markets think this is a one-off event and is isolated to Apple, value investors may come back to the market and move us higher. But, leadership could be coming from sectors that have been ignored for many years.

In Purpose Global Innovators Fund (PINV), we have been out of the cellphone names for the past few months in favour of the software group. We haven’t held shares of Apple since this summer.

— Greg Taylor, CFA

 

Chart sourced to Bloomberg.
Commissions, trailing commissions, management fees and expenses all may be associated with investment funds. Please read the prospectus before investing. If the securities are purchased or sold on a stock exchange, you may pay more or receive less than the current net asset value. The indicated rate of return is the historical annual compounded total return including changes in share/unit value and reinvestment of all distributions and does not take into account sales, redemption, distribution or optional charges or income taxes payable by any securityholder that would have reduced returns. Investment funds are not guaranteed, their values change frequently and past performance may not be repeated
Certain statements in this document are forward-looking. Forward-looking statements (“FLS”) are statements that are predictive in nature, depend on or refer to future events or conditions, or that include words such as “may,” “will,” “should,” “could,” “expect,” “anticipate,” intend,” “plan,” “believe,” “estimate” or other similar expressions. Statements that look forward in time or include anything other than historical information are subject to risks and uncertainties, and actual results, actions or events could differ materially from those set forth in the FLS. FLS are not guarantees of future performance and are by their nature based on numerous assumptions. Although the FLS contained in this document are based upon what Purpose Investments believe to be reasonable assumptions, Purpose Investments cannot assure that actual results will be consistent with these FLS. The reader is cautioned to consider the FLS carefully and not to place undue reliance on the FLS. Unless required by applicable law, it is not undertaken, and specifically disclaimed, that there is any intention or obligation to update or revise FLS, whether as a result of new information, future events or otherwise.

Is this a repeat of the 1998 correction?

We typically don’t put much weight on how one market period compares to another, especially when looking at price graphs. The market composition, the environment and the participants change too much over the years for us to give much weight to simple chart comparisons between the TSX or S&P 500. However, similarities in the market environments can make these comparisons more useful.

We considered the similarities between today’s market environment and that of 1998, and found a number of strong commonalities. Both 1998 and 2018 are roughly the ninth years of historically long bull market runs. That means both are clearly in the late bull phase of the market cycle. Both cycles had the US equity market as the clear leader compared to other developed and emerging markets. The US dollar was also one of the stronger performing currencies, similar to today. In 1998, a currency crisis started in Russia and spread to a number of Asian emerging economies, which triggered the correction and a global growth slowdown. It was notably less for the US and more for other economies such as Europe and Asia. This cycle, we have had crises in Argentina and Turkey, and now slowing economic growth in China weighs on global growth. Again, more for non-US economies.

Currently, the S&P 500 is down 11% from its late September high. In 1998, the S&P bottomed at closer to -20%. One could argue markets were a bit more inflated in the late 1990s, making the drop more painful. The P/E ratio for the S&P 500 dropped 4 points from 22x to 18x in 1998, compared to a drop of 3 points from 18x to 15x so far in 2018. The TSX, which started falling earlier than the S&P 500, is now down 12% from its high. The bad news is that in 1998 the TSX ended up dropping almost 30%.

The drop in global growth expectations was much more severe in 1998 relative to the current state, especially in the emerging markets (note we said ‘current state’ as things can change). This certainly weighed more on the TSX, given its resource tilt. In 1998, the BRIC (Brazil, Russia, India and China) nations’ GDP dropped from 2% growth into negative territory for two quarters. Europe was slowing and the US remained pretty resilient to the global slowdown (left chart below). Fast forward to today and we have the US remaining on a healthy growth path, Europe losing steam and the BRIC nations showing some signs of slowing. Clearly, the current situation is not nearly as dire as 1998 at this point. And if you believe current 2019 consensus forecasts (yellow bars in the right chart), there does not appear to be a sudden deceleration in the cards.

Long correction

The current spell of market weakness seems like it just keeps dragging along. It sure feels that way to us. The S&P 500 peaked on September 21, which means this correction has lasted +80 days. Given the current level is not far from the recent December 10 low, it’s hard to say if that was truly the trough or there is another leg down. If it was today, it would be the longest peak-to-trough among the last ten corrections. This isn’t one of the most severe yet, but relative to other corrections during the cycle, it is a big one. The average number of days from peak-to-trough has been 35, with an average decline of 10%.

The next chart shows all the past corrections for the S&P 500 during the current bull market and how they played out. The purple line is the average and the yellow line is the current market. The only two that were near these depressed levels after this amount of time was in late 2010 and 2011, during the European financial crisis.

Some encouraging signs

We need not be all down on the markets, as there are some positive developments, even as we watch the markets close the week near session lows. Today, the S&P 500 is trading below 15x, the TSX is below 13x and Europe is below 12x. That is cheap. Sentiment has turned very bearish, which has historically been bullish. The American Association of Individual Investors survey this week found only 21% felt bullish and 49% bearish about the stock market over the next six months. That is the highest percentage of bears since 2013.

Also, emerging markets are outperforming developed markets. Emerging markets started weakening quarters ago. Clearly, we all should have paid more attention to this canary in the coal mine. Emerging markets tend to be more sensitive to changes in sentiment and global growth, given the higher reliance on trade, less developed financial sectors and at times, a jittery shareholder base. The fact that emerging markets have been outperforming the developing markets in the past few weeks may be a sign the end of the corrective phase is near.

If none of those are right, Santa is coming soon…

 

— Craig Basinger, Chris Kerlow, Derek Benedet and Alexander Tjiang are members of Richardson GMP’s Connected Wealth team which manages Purpose Core Equity Income FundPurpose Tactical Asset Allocation Fund and Purpose Behavioural Opportunities Fund

Charts sourced to Bloomberg unless otherwise noted
Commissions, trailing commissions, management fees and expenses all may be associated with investment funds. Please read the prospectus before investing. If the securities are purchased or sold on a stock exchange, you may pay more or receive less than the current net asset value. The indicated rate of return is the historical annual compounded total return including changes in share/unit value and reinvestment of all distributions and does not take into account sales, redemption, distribution or optional charges or income taxes payable by any securityholder that would have reduced returns. Investment funds are not guaranteed, their values change frequently and past performance may not be repeated
Certain statements in this document are forward-looking. Forward-looking statements (“FLS”) are statements that are predictive in nature, depend on or refer to future events or conditions, or that include words such as “may,” “will,” “should,” “could,” “expect,” “anticipate,” intend,” “plan,” “believe,” “estimate” or other similar expressions. Statements that look forward in time or include anything other than historical information are subject to risks and uncertainties, and actual results, actions or events could differ materially from those set forth in the FLS. FLS are not guarantees of future performance and are by their nature based on numerous assumptions. Although the FLS contained in this document are based upon what Purpose Investments believe to be reasonable assumptions, Purpose Investments cannot assure that actual results will be consistent with these FLS. The reader is cautioned to consider the FLS carefully and not to place undue reliance on the FLS. Unless required by applicable law, it is not undertaken, and specifically disclaimed, that there is any intention or obligation to update or revise FLS, whether as a result of new information, future events or otherwise.

The biggest loser: behavioural hints from tax-loss selling

Along with some early holiday shopping, astute investors also get busy in November by selling off the ‘dogs’ in their portfolio. Ben Franklin might have been right when he said, “in this world, nothing can be said to be certain, except death and taxes.” However, planning now can certainly help minimize your capital gains tax come April, as long as you sell your stocks before or on December 27 (Canadian stocks sold after that date carry their capital losses forward to the 2019 taxation year). Depending on your returns for the year, your portfolios may have a few or several worthy candidates to sell off, crystallize the losses and hopefully offset some gains in other positions.

The annual tax-loss selling tradition has a seasonal effect on the underlying index. We looked back eighteen years at the TSX and TSX Small Cap Index and identified a prevalent pattern. As demonstrated in the chart below, markets on average tend to face increased selling pressure in November, driving indices lower. The selling pressure tends to abate midway through December, triggering a noticeable seasonal increase in stock prices during the new year. This effect has been well-studied and is aptly called the ‘January effect.’ While not a bias itself, this seasonal aspect of the market is certainly rooted in investor psychology.

The January effect seems to affect small caps more than large caps, likely because they are less liquid. You can see from the chart above that the TSX Small Cap Index experienced a larger sell-off in the tax-loss selling period and still managed to outperform the S&P/TSX Composite Index by the end of February. Tax-loss selling isn’t the only behavioural reason for this effect. In January, investors could also be putting cash bonuses into the market or perhaps buying their favorite Purpose fund. There may also be some window-dressing, as institutional fund managers shed losers to improve the appearance of their year-end holdings. It’s purely cosmetic in nature, but does add to the pressure for the year’s biggest losers.

Dogs of the TSX

We did some data-sleuthing to demonstrate this effect. For each of the past five years (2013-2017), we created a basket of the 20 worst performers on the TSX (as at November 1). We then measured their median performance from November to February. As these are the positions that fell the most during the year, they are likely at risk of “tax-loss selling.” As you can see from the chart below, selling pressure was strong in November and began to abate in mid-December, turning into strong gains heading into the new year.

Behavioural investing, in our opinion, moves beyond simply looking at individual company or market fundamentals to incorporate the behavior of other market participants. If you know there are going to be a bunch of sellers in the market for tax reasons, this gives you an advantage. In a highly competitive market, advantages are hard to come by and can be key to your success.

 

— Craig Basinger, Chris Kerlow, Derek Benedet and Alexander Tjiang are members of Richardson GMP’s Connected Wealth team which manages Purpose Core Equity Income FundPurpose Tactical Asset Allocation Fund and Purpose Behavioural Opportunities Fund

Charts sourced to Bloomberg unless otherwise noted
Commissions, trailing commissions, management fees and expenses all may be associated with investment funds. Please read the prospectus before investing. If the securities are purchased or sold on a stock exchange, you may pay more or receive less than the current net asset value. The indicated rate of return is the historical annual compounded total return including changes in share/unit value and reinvestment of all distributions and does not take into account sales, redemption, distribution or optional charges or income taxes payable by any securityholder that would have reduced returns. Investment funds are not guaranteed, their values change frequently and past performance may not be repeated
Certain statements in this document are forward-looking. Forward-looking statements (“FLS”) are statements that are predictive in nature, depend on or refer to future events or conditions, or that include words such as “may,” “will,” “should,” “could,” “expect,” “anticipate,” intend,” “plan,” “believe,” “estimate” or other similar expressions. Statements that look forward in time or include anything other than historical information are subject to risks and uncertainties, and actual results, actions or events could differ materially from those set forth in the FLS. FLS are not guarantees of future performance and are by their nature based on numerous assumptions. Although the FLS contained in this document are based upon what Purpose Investments believe to be reasonable assumptions, Purpose Investments cannot assure that actual results will be consistent with these FLS. The reader is cautioned to consider the FLS carefully and not to place undue reliance on the FLS. Unless required by applicable law, it is not undertaken, and specifically disclaimed, that there is any intention or obligation to update or revise FLS, whether as a result of new information, future events or otherwise.