First Quarter Wrap-up
After a very strong start for global equity markets in the first few weeks of the year, markets hit a wall and a steep correction ensued the last week of January. The correction took markets down approximately 10% over the course of just two weeks. In terms of corrections, it was not the percentage term that was alarming; it was the swift move it made, causing volatility measures to rise to extreme levels. The CBOE VIX Index, also known as the 'fear index', which measures volatility of U.S. equity markets, rose above 50 for just the third time in its history (typically resides between 10 and 20). The other two times being the Great Recession of 2008-9 and August 2015. Markets then recovered about half of that drawdown into mid-March, but since then have come back down to test those lows. Depending on which market you look at, some have slightly broken the February low by the end of March, some have not. As we stand here in early April, most markets have recovered a bit, showing resiliency with the long-term trend still positive.
Looking at Canada, our market has continued last year's trend of underperforming the U.S., with the S&P/TSX Composite falling 5.2% in the first quarter. Our counterparts in the U.S., the S&P 500 and Dow Jones Industrial are down 1.2% and 2.5% respectively. In international markets, the MSCI EAFE Index declined 4.9% in local currency terms. With the Loonie depreciating to most other currencies in the first quarter, some of these global returns have been cushioned by a few percentage points. The Loonie fell 2.4% to the Greenback, 5% to the Euro and 8.1% to the Yen.
In the bond markets, the FTSE TMX Canadian Bond Universe was up 0.10% and the Bloomberg Barclays U.S. Aggregate Bond index declined a rather large 1.64%. Interest rates have been rising at a more rapid rate down south where that has been stronger economic growth and inflation. Bond prices move inversely to interest rates, and it is becoming clearer that we are now in a rising rate environment. However, from a very long term perspective, rates have not risen high enough to provide enough evidence that a secular change is at hand. The current environment is making it difficult for a balanced portfolio. Typically, when we get a steep correction like we’ve had, interest rates decline showing risk aversion, and conversely bond prices rise, whereby the fixed income allocation of a balanced portfolio offsets some of the decline of the equity allocation. This is not the case currently.
Lastly, commodities in general had a positive quarter, with the price of gold rising 1.7% and WTI crude oil advancing 7.5% to finish the quarter at just under US$65/barrel. This is a 25% increase over the past twelve months, but it has yet to translate in performance for energy stocks in Canada. The S&P/TSX Energy Index was down 8% in the first quarter and over 11% in the last year. Of interest, one area of great strength has been the price of lumber, up 35% over the past twelve months.
Milestone strategy and outlook
Since the second quarter of 2016, we have had a constructive view of markets due to a positive fundamental backdrop based on solid economic and earnings growth. Our view has not changed and will not change until these fundamental drivers, in aggregate, turn negative. At present, our Milestone Recession Risk™ Composite is still showing a relatively low risk of recession for the U.S. market over the next six to twelve months. Two other third party risk gauges we follow are in the same situation with relatively low probabilities. When you cut through all the noise, which admittedly there is a lot of lately (trade wars, NAFTA, pipelines, Russia, Syria, etc), we come to the following conclusion that forms the basis of our longer-term positive fundamental thesis. We have solid global synchronized growth, still positively sloped yield curve, robust credit markets, capital spending improvement, positive domestic activity driving earnings growth (EPS), U.S. tax cuts tailwind, strong employment and rising median household incomes, historical strong consumer confidence which usually leads consumer spending, low core inflation, neutral fed policy, and solid domestic demographic trends. Even though we are likely moving into the later stages of the current cycle, we believe there is still plenty of room to run.
Do we believe that markets will quickly recapture new highs? Probably not, which is normal, it is important to remember that bottoms (and tops) should be considered a process and not a price. The current two and a half month correction has relieved an overbought market, with sentiment and valuations at a much more attractive level now. The Q1 earnings season is fast approaching, and earnings growth is expected to be in the 15-20% range, best in seven years. We believe the tactical backdrop sets the stage for the next leg higher. With our core fundamental thesis of higher EPS driving markets, we feel that the market direction will be resolved to the upside, and that the current correction is ultimately a result of correcting an historical level of optimism rather than a change to the fundamentals.
Courtesy of Canaccord's chief market strategist, Tony Dwyer, their favorite tactical signal suggests 15% upside over the intermediate-term (see chart below). This signal recently hit an extremely oversold level of 23. Since the current secular bull market began in 2009, this has proven to be a reliable signal indicating minimal downside but strong upside potential. On average, over the past seven occurrences, the drawdown and upside following this signal has been roughly -2% and +23 (median 15%) over the next nine to ten months (median 142 trading days).
Source: Bloomberg/Canacord Genuity
After an extremely long period of low volatility (in fact, last year was the lowest on record for the S&P 500), we have now seen extreme volatility the last couple months with wild swings on both price and volume. One naturally assumes this is negative long-term, but that is definitely not always the case. Another positive tactical signal comes from Sundial Capital Research's publication sentimentTrader. At last week's close, the NYSE's upside volume of shares traded has been either greater than 80% of the total volume or less than 20% in eight out of the past eleven trading days dating back to the last week of March. In the eight previous times this has occurred since 1962, the median return for the S&P 500 one year later has been over 22%, with a worst case occurrence of 11%. Even over the shorter-term, the signal has had an 88% positive occurrence with a median gain of over 6% three months out. The following chart shows the points where this signal was triggered.
Source: Sundial Capital Research, sentimenTrader.com
Last quarter, we highlighted a couple myths or perhaps misconceptions that many people perceive as big risks to the current market (flattening yield curve and high small business optimism), and backed them up with facts showing quite the opposite. This quarter, we would like to highlight credit markets, which is one of the positive drivers we mentioned above that form part of our core fundamental thesis. Credit markets have been robust, and past recessions have generally not occurred without serious breakdowns in the credit market. Based on research from Canaccord analyst Brian Reynolds, public pensions (also known as the smart money) and institutions have "continued to put more money into the credit market, fueling stock buybacks." This is in complete contrast to late 2007, prior to the Great Recession, "when they received margin calls greater than their cash balances, prompting the financial disaster." These institutions continue to allocate fresh new tax money to credit, which indicates to us that this correction will likely be brief like those of the past few years. Until we see much more stress in the credit markets, we don't see recessionary risks rising to a concerning level.
As always, we continue to monitor our long-term leading indicators for recession risk, as well as some of the risks that could put a ceiling on equity markets like escalating trade wars, accelerating near-term inflation and Fed policy mistakes. However, we remain positive in our intermediate to longer-term outlook based on the core drivers that we still see in place today.
Here is our Milestone Market Report on economic data, capital markets, commodities and currencies through March 30th, 2018: (click for PDF version)