DAVID DRISCOLL’S MARKET OUTLOOK

In just over three weeks of market action, we’ve seen:

• The S&P 500 Index up 7.45 per cent. According to the Stock Traders’ Almanac, how January goes, so goes the year. This would imply that we have positive returns on the stock market in 2018.
• Stock-based funds overall have brought in just shy of $77 billion in 2018 with the lion’s share of $59.2 billion going to passively focused exchange-traded funds. By comparison, equity funds across all classes took in a net $278 billion for all of 2017 according to Morningstar, meaning that last week alone equated to 12 per cent of flows for the entire previous year.
• Bank of America Merrill Lynch’s “Bull & Bear” indicator is sending a sell sign, which has been accurate 11 straight times since the firm started tracking it in 2002. The indicator points to a technical pullback for the S&P 500 to 2,686, which would be about a six-per-cent drop from the current level.
• Thanks to U.S. tax cuts, American companies are thinking of closing down or selling Canadian assets and taking the cash back to the U.S. to re-invest there as the corporate tax rate is now lower than Canada’s (21 per cent vs.30 per cent).
• Bond prices have fallen 1.8 per cent on the Government of Canada 10-year bond. For the 10-year U.S. Treasury, its price has fallen 2.1 per cent.
• And thanks to a falling U.S. dollar, commodity prices (priced in U.S. dollars) have jumped across the board except for coffee and sugar. Natural gas prices are up 18 per cent, West Texas Crude (WTI) is up 9.5 per cent and agriculture prices are up two to three per cent for corn, wheat and soybeans.

So, what to make of all this? Do we continue to melt up to 3,700 on the S&P 500 (the equivalent of the market peaks in 1929 or 1999) or, as speculated above, suffer a six-per-cent correction and then continue higher?
With stocks at high historical nose-bleed levels investors have to seriously consider how much they can afford to lose and decide on how much to invest in each instrument, whether or not they’re stocks, ETFs, bonds, cash, etc.
When buying a stock, you should always ask yourself these questions:

1. Why am I buying the stock? You should have at least five reasons why you wish to own the company. Otherwise, don’t buy it.
2. How does it fit in my portfolio? Avoid the most common mistake investors make: correlation risk. One company from a particular sector only.
3. What are the risks? The risks should be well understood and each company’s risks should be different than other names in an investor’s portfolio.
4. How much cash do I wish to own in the event this market sells off more than six per cent?
5. At what point do you wish to enter the market again? After a 10 per cent, 20 per cent or 50 per cent correction? That discipline can help you avoid buying too soon and force you to think about entry prices on stocks you wish to own or add to a position.
6. Are your dividends growing and at what rate? Is it greater than the historical norm of seven per cent? Is the growth rate offsetting inflation?

If you can answer these and prepare ahead of time, you’ll be ready for whatever comes our way.

DAVID DRISCOLL’S MARKET OUTLOOK

Are we in for a wild ride in 2018? With the S&P 500 Index currently trading at 23.14x earnings and its historical average at 16.2, one may surmise the market is 43 per cent overvalued. However, according to history, the largest market peaks in 1929 and 1999 suggest we could go another 40 per cent higher – the “melt-up phase.” Unfortunately, the ride down to its historical norm after such a peak would be about 50 per cent.

So, what to do? Here are some ways to deal with today’s markets:

• Re-balance positions when necessary – if you own a 30-stock portfolio and one of the holdings becomes greater than six per cent, sell half and allocate the cash to those positions with a weighting less than three per cent. This avoids any emotional struggle – instead it’s mechanical.
• Pay attention to the stock’s beta – if you own stocks with betas over 1.50, it’s important to either sell outright or re-balance. That’s because if the market drops 50 per cent, these stocks could drop 75 per cent (50% x 1.5). That could destroy your capital quickly and the return to break-even could take decades.
• Keep some money in cash. We hold 20 per cent times the equity weighting of a client’s portfolio. If the portfolio is 100 per cent equity, then we’re 80 per cent invested with 20 per cent in cash. If the portfolio is 50 per cent stocks and 50 per cent fixed income, we’d have a 10 per cent cash weighting (50% x 20%).
• Diversify globally. If the market drops 50 per cent, the Canadian dollar will come under pressure and a global portfolio would help ease the pain. In 2008, the Canadian dollar fell 22 per cent as investors flocked from minor currencies like the Loonie to the more liquid currencies of the U.S. dollar, euro and the Japanese yen.
• Avoid correlation risk – don’t own multiple stocks in the same industry. In 2008, it wasn’t one Canadian bank that fell 40 per cent, they all did. If you’re living off the capital and it falls 40 per cent, you could run out of money before markets recover.