Outlook 2014: look to the future, learn from the past

The MoneyLetter, MPL Communications Inc.
133 Richmond St.W., Toronto, ON, M5H 3M8. 1-800-804-8846

- Keith Richards

As we begin the New Year, many of us find ourselves reflecting on past decisions we’ve made for our portfolios – both profitable and not – and the events that led to those decisions.

It’s also a time to look to the future and keep an eye on emerging trends, as well as taking lessons from past mistakes to avoid any future pain. In this article, I’d like to take a look at some of the events and trends of 2013, and share with you my outlook for the coming year.

Equities

I’ve been focusing on a key thesis of a rotational market lately. That is, we at ValueTrend expect the broad markets to do “okay” over the winter, but nowhere near as well as the past few years.

This is because we believe that markets will likely have a normal healthy bear market correction (but NOT a crash!) later this year – possibly as early as the second quarter.

Various technical, seasonal, cyclical and fundamental factors come together in and around the spring of this year to suggest the risk profile may change for the markets, albeit temporarily.

Rest assured that I will be taking evasive action to mitigate as much risk as possible when the timing looks best, and I will make those actions clear through the articles you read in these pages as well as my blog (www.smartbounce.ca).

As markets approach that potential correction, it is typical for the leaders to slow down in velocity, and new emerging stocks to take their place.

I call this the “Great Rotation” – institutions and “smart money” seem to be gradually rotating out of yesterday’s winners into emerging and defensive stocks. Equities that we hold at ValueTrend that fit the “emerging” category are Texas Instruments (NASDAQ-TXN, $43.67), American International Group (NYSE-AIG, $51.18), Enerplus Corp. (TSX-ERF, $19.57), and CAE Inc. (TSX-CAE, $13.74).

Defensive stocks we hold include the pipelines and consumer staples, which are also seeing positive inflows right now.

The second theme we watch for is “a stock pickers market.” As the market enters its final bullish phase before a potential normal, healthy correction, we believe that it has become far more important to own the right stocks at the right time.

In other words; it’s now more important to uncover overlooked and undervalued stocks, rather than just own the broad markets. For example, we hold Parkland Fuel Corp. (TSX-PKI, $18.45), Brookfield Infrastructure Partners L.P. (TSX-BIP.UN, $41.97) and Chemtrade Logistics Income Fund (TSX-CHE.UN, $19.45).

These stocks were originally overlooked by investors, and presented unique value opportunity when we bought them. We plan on rotating into a few other underappreciated stocks that are emerging from consolidation patterns. Stay tuned for those in my upcoming articles.

Fixed Income

It’s been a rough year for fixed income portfolios. The suggestion in June of the U.S. Federal Reserve slowing their bond purchases in the marketplace caused bond prices to fall last summer.

Investors who had grown comfortable watching the value of their fixed income securities (bonds, preferred shares and income stocks) rise each month were surprised when their statements arrived in the mail over the summer, showing losses in almost all fixed-income classes.

Headlines such as “Bond bull is dead” started appearing in the financial media.

There are those who say sell bonds and move into dividend stocks. With dividend stocks you can achieve a three to five per cent yield. However, the potential loss of principal that comes with over-weighted stock investing is too much to handle for most conservative investors.

If I am right about a market correction in 2014, you will be grateful that you did not “chase yield” through carte-blanch replacement of fixed income securities with stocks.

While I don’t mind adding an element of equity dividend payers within a fixed income portfolio, I do not endorse an outright change in strategy from bonds and preferred shares to stocks. Further, in the past I have written on creating fixed income portfolios and recommended investors position their holdings very conservatively.

Further, in the past I have written on creating fixed income portfolios and recommended investors position their holdings very conservatively. For example, I’ve focused on very short termed maturities, and floating choices such as Horizons Active Floating Rate Bond ETF (TSX-HFR, $10.13) and Horizons Active Floating Rate Preferred Share ETF (HFP-T, $10.01)

This way, you will have experienced a much smaller drawdown on your fixed income holdings than most income managers this summer during the “Bernanke tapering scare”.

You must view fixed income holdings as just that: they are investments that pay an income. Investors should not spend much time worrying about the up and down price movements of these securities like those experienced in 2013.

Over the long run, they tend to return to their “normal” values. Meanwhile, they continue to pay income to your portfolio.

A short-termed performance blip on the radar should never influence an investor to change their asset allocation strategy.

My view is that fixed income is part of a properly diversified portfolio for both risk reduction and liquidity needs, especially in years where stock markets decline.

When I structure a client’s portfolio, these three core principles of investment discipline remain in place:

* Conservative asset allocation model. I tend to emphasize asset allocation with a focus on capital preservation, especially for conservative investors.

As a result, I recommend conservative investors hold a conservative portfolio weighted in short-termed bonds and floating rate securities  as mentioned above; they are ideal for turbulent times, yet still offer steady reasonable long-term performance. * Twin disciplined stock screening process. By combining a fundamental and technical analysis approach to buying and selling stocks, you will end up owning stocks held at the right time for the right reasons. Further, I am a firm believer in following a disciplined approach incorporating fundamental, technical, and seasonal sell patterns. A blanket “buy and hold at all costs” mentality is actually riskier than a carefully planned system of buying and selling assets. ValueTrend’s sell process actively responds to market shifts – particularly during bear markets. * Diversification and contrarian approach. Ultimately, you want to create a diversified portfolio of 20 or so carefully chosen securities, and sell them when either the fundamentals or the investment tides change. And it is important to avoid “herd mentality” when buying securities. Many investors are enticed to overweight sectors or industries that appear to be unstoppable, only to learn the hard way that they were participating in an investment bubble. For example, many investors were heavily weighted into interest-sensitive stocks in early 2013 in pursuit of high dividends. These stocks, such as REIT’s and certain pipelines and utilities, were crushed last summer.

I always emphasize underweighting those sectors. Twenty-four years of trading stocks and bonds through two major bull and two major bear markets has taught me (often the hard way) to spot the potential signs of a bubble.

I recall my cleaning lady (and other fairly unsophisticated investors) asking me about technology stocks in 1999, prior to the tech bubble implosion of 2000-2001. I was reminded of this last winter while overhearing the daily banter in my gym locker room between obviously retired investors.

These folks were enthusiastically discussing their REIT’s, income trusts, high-yield energy stocks, and utilities. It was at that time that I knew the party would have to end for the interest-sensitive stocks sooner rather than later.

In other words, learn to identify a bubble by noting the conversations of the least informed investors you know. That can be an excellent sell signal by itself.

I wish you trading success in 2014, and look forward to sharing my thoughts with you over the coming year. Happy New Year!

Keith Richards, Portfolio Manager, can be contacted at krichards@valuetrend.ca.  He may hold positions in the securities mentioned. Worldsource Securities Inc. – Member: Canadian Investor Protection Fund, and sponsoring investment dealer of Keith Richards. The opinions expressed are those solely of Keith Richards and may not necessarily reflect that of Worldsource Securities, its employees or affiliates. The contents are for information purposes only and do not represent investment advice. ETFs may have exposure to aggressive investment techniques that include leveraging, which magnify gains and losses and can result in greater volatility in value, and be subject to aggressive investment risk and price volatility risk. ETFs are not guaranteed, their values change frequently and past performance may not be repeated. Please read the prospectus before investing.

 

The MoneyLetter, MPL Communications Inc.
133 Richmond St.W., Toronto, ON, M5H 3M8. 1-800-804-8846