January 9, 2019

 

2018 Q4

Overview & Outlook

With the market turbulence being on everyone's mind, the following report will be more of an in-depth analysis on the Q4 2018 market sell-off and understanding what happened and what is to come. Along with that, briefly touching on our real-estate market here at home, and a follow up on China.

 

October's Sell-off

From peak to trough we saw the month of October return -11.41%. That's one single month and over a 10% drop in the S&P 500. I speculate that as the market began to drop, many margin calls were triggered, thus causing even more forced selling. With such a drastic drop some stocks were down enough to justify buying the dip. Well, while that might have seemed to be the case, the market grew weaker with more intense selling pressure coming from high trading volumes. Now, generally, during times of market turmoil we see money flood out of equities (stocks) and into fixed-income (bonds). However, if we look at the 10 Year Treasury Bond Yield, it was still sitting at its highs - suggesting that money did not flow into fixed income during the sell-off. [Money usually leaves equities (when people sell stocks) during market downturns and flows into fixed income (buying bonds) since it's seen as lower risk.] This time money didn't flow into bonds - perhaps because the cash that was amassed from selling equities went towards paying down leverage and margin debt.

December's Sell-off

As December hit, the market selling pressure got worse; confirmed by an increase in trading volume. Generally, this happens during December as fund managers commonly sell their worst performing stocks at the end of the year. Except, a lot of stocks were performing poorly, so even more stocks were sold off, which led to a large market decline. December's peak to trough was a near -17% fall. However, if we take a closer look at certain stocks, specifically the big tech names, it becomes very clear which stocks were sold off the most .

Percent Decline of Stock Price Since its Highs

fang stocks decline

As the year came to an end, the US market closed down -6.24%, while from its highest point this year to its lowest it was down -19.8% (-0.2% shy of being considered a bear market). Now while that's the US, if we look at the entire world - the total market cap (value) of all companies together - they were totaled at $87 Trillion. However, nearing the end of December we saw it tumble down to $67 Trillion; a 23% drop. Yes, that's $20 Trillion wiped off the globe - definitely creating some exceptional investment opportunities.

Source: YCharts

Triggers

If we look at the reserves on the US FED's balance sheet, then it is clear that they have been selling off their assets into the open market; approximately $400 Billion worth thus far. As the FED sells assets in the market, the money they receive as payment from selling those assets gets pulled out of circulation; this means there's now less money in the system, which pulls liquidity from the market. As the FED has been selling its reserves, the FED has also been increasing interest rates, which makes money more expensive to borrow. This means a tighter monetary policy and has the same effect of taking liquidity from the system. How? Because as interest rates increase, less people borrow money and more people are pressured to pay back debt. Both cases reduce the amount of money available for investment in financial assets, and thus leads to market sell-offs. This should serve as a reminder that the market is powered by more than just valuations. Macro economic cycles and changes need to be taken into account when positioning your portfolio.

 

Outlook

Unfortunately no one (that I know of) has the crystal ball to predict the future, however, looking at the facts gives us the opportunity to think objectively about investment positioning. What we know is that the central banks (FED, ECB, BOJ, etc.) were net buying $100 Billion a month in Q4 2017; no doubt that acted as a major support in the financial system as they bought up financial assets. However, in 2018 net buying dropped to approximately zero, suggesting there was no excess liquidity being pumped into the system from central banks around the world. As a result, we were left with volatile conditions and a down year in the market. Now this coming quarter net buying is expected to hit -$20 Billion a month, better said as net selling, and drain on global liquidity. While having cash in your portfolios helped in 2018 allowing you to buy up certain stocks at a cheaper prices, 2019 will also be a year to keep a reliable cash position on standby. This will help ensure you can buy up other equities as they become depressed in expected volatile markets. Additionally, something critical to watch out for is going to be whether or not the FED will increase interest rates again. If they do, we may see equities get further punished through increasing discount rates (lower valuations), capital flowing into fixed income (from out of equities), and tighter money (borrowing to invest becomes more difficult). An exciting year of selective opportunity lies ahead.

Note on Toronto Housing Market

While we see the prices continue to increase in some areas, and stagnate or fall in others, one thing is clear; it's expensive to live home. As it stands, the percentage of one's income that is needed to cover the costs of home ownership in Toronto is at 74.9% and Vancouver at 88.5%. This means for every dollar you make, 74.5 cents goes towards expenses on your home. Owning a home is becoming financially overwhelming and increasing rates will make this worse - leaving people in a position of needing to sell. Should the Bank of Canada further increase interest rates, Canadians will struggle tremendously. I have been warning about this since early 2018: If real-estate is in anyway at risk, it will continue to damage Canadian banks who have unparalleled exposure to our real-estate market through lending. For people I speak to who are not clients, I find that many like to own Canadian Banks; some of which will only buy Canadian banks as investments. This creates concentrated risk exposure that can damage your life's savings, especially in a down market. Take a look at Canadian bank stocks since the beginning of 2018. Ouch.

Percent Decline of Stock Price Since its Highs

canadian bank stocks

Source: YCharts

A Quick Follow Up on China

As China's market began to tumble in the beginning of 2018, we saw short-term lending rates in China come down quickly to help provide easier money to stabilize and stimulate their market. The circulation of new easy money takes time to get back to boosting earnings and increasing stock values in China. Since they continued to lower rates until September 2018, we might see the stimulus of lower rates trickle back into the Chinese market and help maintain it within the next few months; assuming a slowing global economy doesn’t drag everything down.

Thanks for reading.

Your Financial & Investment Advisor,

Gianluca Folino