It’s been awhile since I last wrote a blog on markets, but I thought year-end would be a great opportunity to do so. With 2017 nearly in the books, we can look back and describe it as the least volatile market we have seen in a very long time. We have seen significant gains across markets and asset classes, while experiencing very little volatility as markets continue to grind higher through the year. Having entered 2017 with a conservative bias across our portfolios, we missed some of the returns that were available.
What was most surprising about 2017 was how willing investors were to take on speculative risk—a complete reversal after how concerned markets were in 2016, which was a difficult year for most. Stock markets began that year with one of the worst sell-offs in history amid concerns around the stability of China's economy. Commodity-related companies and European banks bore the brunt of the sell-off as volatility rose and credit spreads widened, driving equities lower. Around mid-year we had the announcement of Brexit, and shortly thereafter Donald Trump was elected. (What a great year for us to invest!)
The past 12 months have been the opposite. Spreads are at or near all-time lows, equity markets are hitting all-time highs, and volatility has been compressed and is reflecting one of the lowest levels of expected risk in the history of the markets. This environment has made it very difficult for our risk-adjusted opportunistic style of investing.
One of my favourite movies of all times is O Brother, Where Art Thou, which is set during the Great Depression. Three escaped convicts attempt to return home to collect a treasure (the story is a modern adaptation of Homer's Odyssey). At one point they come across a river baptism ceremony. Delmar, one the escapees, jumps in the water, bypassing the others waiting in line to be baptized by the priest, believing it will wash away all his sins…including his criminal record. As he is returning from his holy dunk, he says, "Come on in, boys, the water is fine."
I feel like this is the market today. People have taken the plunge, and with big speculative gains and they now feel like all their problems are gone. Those participating are happy to discuss their success (and the media is certainly happy to focus on these rare cases):
- Risky Business? How a Pole Dancing Instructor Found Success with Bitcoin
- A former manager at Target became a millionaire using one of Wall Street's favorite trades
Some may perhaps assume that with all the positive media coverage, making money is easy! Low volatility and high returns can’t be beat—take the plunge and feel the relief…“Come on in, boys, the water is fine.” And for many waiting skeptically on the shore, there is a palpable tension in the market, even anger: the dreaded FOMO (or fear of missing out, which Geoff Scott mentions in his November 24th blog.)
As I reflect on 2017, we may have been too cautious coming into the year, especially relative to the positive shift in investor sentiment. In addition to this, the market decided that some of the companies we own (Walgreens) and owned (Kroger) would be disrupted by the likes of Amazon, compressing their multiples below our expectations. Consequently, we missed some opportunity for returns for our clients. That said, it is important to keep in mind that while we have not offered the excitement many have craved this year, our cautious approach has served us very well over the last 10 years. We have built Cambridge on a promise to long-term clients that above all else we will focus on risks and capital preservation first—this has not and will not change.
With that, I will provide some context around the market as I see it today:
From risk aversion to the dreaded FOMO
At the beginning of 2017, global stock markets were already up 250% from the lows, with the US market up 330% from the 666 lows seen on the S&P 500 in March 2009. 2017 has also represented the first year over that span that investors have been frustrated if they are not keeping up with market returns. Across the board, they have been more focused on the potential gains, even as they recognize the significant risks they are taking to get them.
What’s interesting about today is that investors know they are speculating, but the returns are so good they feel the need to be involved. A recent survey of global investors demonstrates this phenomenon. Bank of America Merrill Lynch found that an unusually high number of respondents agree equities are overvalued, while at the same time cash positions at the same time are falling:
Source: BofA Merrill Lynch Global Fund Manager Survey
Also, a record number of investors are taking higher-than-normal risks in their portfolios:
Source: BofA Merrill Lynch Global Fund Manager Survey
And the ratio of bullishness to bearishness by investors is near all-time highs:
Most professional investors believe they will be the first ones out when sentiment shifts, and while I wish them well, I know it is impossible for all of them to be ahead of the herd running for the exits! This is a classic example of overconfidence leading to increased risk taking late in a cycle.
I have had many conversations with advisors this year about their clients calling to complain about returns, with specific questions about cryptocurrencies and marijuana stocks. Clients hear the media is touting all-time highs for stock markets, so how can their conservatively positioned portfolio only be up 3%–5% this year? It may seem like the right decision to invest more heavily when everything is good, but we know from history (and psychology) that this is not the best way to compound returns over the long run. Nonetheless, your average investor today has more interest in stocks than they have had since the bull market really began in 2011:
Source: Google Search Trends, "How to Buy Stocks"
As we always say, it is more important to understand what is being discounted in prices than knowing what will happen (which is impossible anyway). By investing during uncertainty, volatility and periods of heightened risk aversion, we earn better returns for our clients over the long term. Neither credit nor stock markets are reflecting much risk these days, so we will have to be patient.
Focus shifts to returns from risk
As investors become return-seeking, they tend to increase their risk profile and speculative exposure. This is because in order to stay invested in a market they believe is overvalued, they need to expect higher returns to justify the increasing risk they are taking on. Across many industries we have seen a huge divergence in performance by growth vs. value and disruptors vs. established companies this year:
A few of our companies have been impacted this year by the threat of disruption, compressing their multiples and providing opportunities to add to our positions. This is not to say that disruption will not occur, or is not occurring, but rather to point out that when a narrative builds in a speculative market about one or two companies destroying entire sectors, it tends to result in opportunities. This disruption is providing investment opportunities over the long term, even though we have no way of knowing when the market will reflect the value we see.
What does this mean for 2018?
Fundamentals have been strong, with decent earnings reported and continued economic momentum. But it seems to me that “price” has become the news, and high asset prices are being used to justify whatever views you hold (bond investors are bearish, low yields justifying their view—or equity investors are bullish, high stock prices justifying theirs!).
I do not know what will derail this optimism; it could continue for another year or even two. However, with history as our guide, we know it will be impossible to achieve our client's long-term goals if we simply buy the market now and wait. Expected returns for both equities and fixed income are near the lowest in history (rates, equity multiples and spreads are all at the 90th percentile historically):
Source: Philosophical Economics
Additionally, we do know a tailwind for asset prices over the last five years is about to become a headwind. Peak liquidity is behind us as central banks globally respond to improving economic conditions and unwind their respective quantitative easing programs:
Bottom-up analysis still works: Lots of opportunities at the company level
We are laser-focused on what we can control—executing our process and uncovering investment opportunities around the world. Throughout the year, Cambridge did many research trips in this pursuit. We were able to find opportunities in companies and sectors without clearly bullish stories that were cast aside. Our research team—the gears of the Cambridge Machine—did much of the heavy lifting as the breadth and depth of our research coverage continued to expand. This allowed us to deploy capital into new ideas as our cash position declined across the firm from 17.5% in January 2017 to 11.5% by November 31st.
As we continue into 2018, we will keep digging for those long-term opportunities where we find company-specific drivers to deliver the returns our clients deserve, while being vigilant of the risks we feel are out there. We will NOT put client capital at risk by participating in the speculative areas of the market, and as always, the Cambridge team, our families and friends remain invested alongside you.
On behalf of everyone here at Cambridge, I would like to thank you for your continued support and wish you and your family a joyous holiday season.
Brandon J. Snow
P.S. The Cambridge blog will resume in the new year, with Greg Dean’s semi-annual letter focused on the Small & Mid-cap Suite.
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