A review of 2013
As we look back at 2013, we should all be thankful for a year of great markets. We saw significant returns in the U.S. with the S&P 500 Index up 26.6% year-to-date. In Canada, the market performed reasonably well with the S&P/TSX Composite Index up 7.4% year-to-date. The Canadian dollar, however, had a tough year (-8%).
When you dissect the performance of the markets this year, we have seen significant multiple expansion (as discussed in my November 5 blog). It’s clear that investors are feeling more confident in the outlook today than they were at the beginning of 2013. We also saw a significant divergence of the market in Canada with resources companies declining by 7% (materials -32%, energy +9%) and non-resource companies up 22%. We have definitely seen the excitement in the U.S .markets reflected in non-resource Canadian names.
Outlook for 2014
Looking at current valuation levels over the long run, equities tend to deliver returns in the high single digits. Our job as active managers is to do better. However, as we enter 2014 there is a very interesting set of circumstances which could cause an explosive move in the markets. Investor confidence is high, the Fed is tapering but guaranteeing low rates for a really long time, and we have seen the 30-year bull market in bonds seemingly come to an end. While equities are fairly valued, they are still cheap compared to bonds and we could see a rush into equity markets. Of course, there is potential for bond money to move into equities but when you look at the amounts of cash on the sidelines a sell down of bond funds really isn’t necessary.
Although it would be a profitable ride, a large asset allocation shift like this could drive markets to uncomfortable valuation ranges. To appropriate valuations relative to the bond market, stocks could trade up to 18-20 times forward EPS, which is 25%-35% upside from multiple expansion alone. At that level, you really only should only expect 5% +/- returns over the long run – and this doesn’t compensate for the volatility in the equity market. If that happened, coupled with a slightly higher 10-year bond yield, you would likely see us raise cash in the Cambridge equity funds and rotate back into bonds in our asset allocation and income mandates. Again, this isn’t our base case but it is a risk we see as a probability.
With that potential in mind, I want to remind everyone that we are investors not speculators. In a momentum driven market focused on multiple expansion, we likely will not perform as well as we have over the last few years when fundamentals really stood out. As the rewards shrink and risks increase, expect us to reduce exposure to the market rather than chase returns. This is the importance of downside protection in tough times. The Cambridge funds performed adequately during the volatile years of 2011 and 2012, so do not feel any pressure to make up for losses in what could become an overexcited market driven by speculation rather than fundamentals.
Our philosophy remains the same. Our core names continue to be significant portions of the funds and we continue to identify pockets of the market where risk-reward is skewed in our favour. Our list of potential investments continues to build but we remain patient purchasers. The cash positions of our funds currently sit in the 10%-12% range, down from a month ago, but still enough to react to any pullback in the markets. As discussed earlier in the year, we have made a significant effort to find ideas in Europe and you will continue to see our portfolios reflect the global opportunities we uncovered.
In closing, we wanted to thank everyone for their support this year. We wish you a happy and healthy holiday season.