As we move forward, we remain steadfastly committed to continual improvement. In this spirit, we have introduced a survey tool that we will send out prior to each Wealth Road Map Review Meeting – the objective is to allow for reflection and the construction of an agenda based on your areas of interest. Continued feed back on this tool is greatly appreciated!
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For those that believe “brevity is the soul of wit”, here is the Quarterly Compass Newsletter in five key points:
- Q4 2023 is exactly why we do not try to time the market. A substantial portion of portfolio returns for 2023 occurred between November 1 and December 31.
- Our outlook remains positive for 2024. This is supported by qualitative and quantitative factors. Examples are below.
- The market correction seen in September/October seems to have been exaggerated, normal seasonal volatility.
- For the time being, we want to continue to overweight the U.S. vs. Canada.
- We are witnessing the start of an adoption/acceptance cycle with blockchain. This has the potential to be a profound shift.
Quarterly Compass Newsletter – December 31, 2023
The events of Q4 2023 remind me (ironically) of a quote from Lenin who once remarked that “there are decades where nothing happens; and there are weeks where decades happen”. Although we did not see “weeks where decades happen”, we saw weeks where the year happened. Missing any of those weeks would have meant missing out on a substantial portion of your annual return. This is exactly why you want to be, with extremely rare exceptions, fully invested inline with your objectives and risk tolerance. Market turns have always come quickly and the current trends towards algorithmic trading and using exchange-traded funds (ETFs) in place of individual stocks has made the pace of reversals truly stunning.
Key North American markets provided the following returns for Q4 2023: the NASDAQ 100 and S&P 500 gained 14.65% and 11.65% respectively (in USD) and the Canadian S&P/TSX Composite rose 8.11%. International markets were also positive, with the MSCI EAFE Index up 10.72% (in USD). Q4 started on a weak note in October but turned up substantially in November and December. Tame U.S. inflation data, strong economic data, the containment of the Israel-Hamas war and the pivot by the U.S. Federal Reserve (The Fed) all provided tail winds. The recovery was broad based and, in the U.S. led by the real estate, technology, financial, and industrial sectors. Only the energy sector posted negative returns. All figures are per Refinitiv.
Per Refinitiv, key global fixed income benchmarks, such as the Bloomberg U.S. Aggregate Bond Index posted positive returns as key yields fell substantially during Q4. In its December meeting, the U.S Federal Reserve maintained it key overnight rate but hinted very strongly that rate hikes are now at an end and that cuts are now possible. In Canada, the Bank of Canada (BoC) maintained its key overnight rate and maintained its bias towards hiking. The maintenance of the hiking bias was a bit curious as the economic/inflation data coming in has not been strong and Canadian debt/GDP is amongst the highest in the developed world. It is worth noting that the BoC’s own data shows that a significant percentage of Canadian inflation is being driven by higher mortgage finance costs – i.e., rate increases causing inflation.
During Q4, commodity prices declined per the Bloomberg Commodity Index. Furthermore, as per Refinitiv – market-based expectations of inflation remain well-contained with longer-term inflation “break-even” rates ranging from 5 to 30 years, all remaining near or below 2.30% at the time of writing.
Based on questions from clients I have collected a few thoughts:
First and foremost – there continues to be a lot of questions about the market volatility that we saw in September and October. Historically, September and October are amongst the weakest months of the calendar for stock markets. There are many theories for this phenomenon including investor uncertainty about the next year’s earnings, final summer holidays and the fiscal year end for many financial sector businesses. It is usual to see some sort of market pause or temporary reversal during these months. This is especially true in recent years – as pointed out by Fundstrat – the last few Septembers have been more down than the average. In addition, this year, I believe we saw an exaggerated seasonal weakness this year because the Israel-Hamas war drove fears about a wider Middle East conflict.
The correction was also likely attributable in part to what seems to be a reaction pattern from “investors” who have very fickle macro-economic outlooks and who have adopted the habit of viewing the world through a “glass half empty” lens. Bad news is bad news and good news is viewed as a chance to sell. This can be seen in the fact that, per Bloomberg, U.S. mutual funds and ETFs suffered almost US$240 billion of redemptions in the 12 months ending October 31st 2023 even though the S&P 500 was up by more than 20% in that time period. Money market and bond ETF/mutual funds saw inflows of US$1.2 trillion over the same time period. This is the exact opposite of what usually happens as good returns typically attract funds to an asset class and speaks to the profound skepticism and “negative reaction function” of many “investors.”
Bull or positively trending markets are said to “climb a wall of worry,” or put another way by John Templeton, “bull markets are born on pessimism, grow on scepticism, mature on optimism and die on euphoria”. There is a laundry list of worries out there (inflation, valuations, investor flows, financial conditions etc.), as such I believe that in John Templeton’s frame we are somewhere between pessimism and scepticism – which implies that this bull market likely has a long way to go.
This phenomenon is very counter intuitive which is why I have shared a “filter” on the markets that can be useful in thinking about potential outcomes and why frames like Templetons are useful. The idea is to imagine that the market is a machine that wants to create the greatest amount of psychological “pain” for the largest number of “investors”. If “investors” are overly positioned in cash/near cash investments, then (barring a collapse of the financial system) one of the best ways to create “pain” is to have markets move substantially higher. When the market you sold (or did not buy) goes up much more that what you own – that hurts. The opposite is also true, when “investors” are overly optimistic and are invested as such, then the most “painful” thing that can happen is for the market to drop substantially.
Looking forward, I remain optimistic about the year ahead but want to be direct in stating that we will likely see several corrections along the way. Examples of data points that are contributing to my belief that a positive 2024 is highly likely include:
- From a qualitative perspective – as was the case through all of 2022 and 2023 – both individual and institutional investors remain underinvested and generally negative on the markets. Examples of this negativity include (but are not limited to) money market balances which in the U.S. are nearing US$6 trillion and the investor redemptions in an “up market” mentioned above. This negativity has been and remains a significant contrarian positive – history is clear that extremes in sentiment and positioning in either direction usually resolve in the market moving in the opposite direction vs. expectations.
- From a quantitative perspective: Ned Davis Research did a look back and found that as of December 14, >40% of the S&P 500 stocks were “overbought” – although this has only happened 4 other times in history, the average return 1 year later was +27.5%. Similarly, Rich Ross of Evercore ISI pointed out that markets have broadened out significantly. On December 18 alone, 27 new stocks hit new 52-week highs. The broadening out of a bull market has almost always led to very positive results in the year ahead. For example, a study by the Finom Group found that since 1957 the average annual return following the type broadening out we have seen is ~20%.
Another question that came up frequently in the quarter was related to our clear overweight of U.S. equities in the equity allocations of portfolios. This decision comes down to where your capital will likely be treated best. As inflation and interest rates continue to drop it is likely that we will continue to see companies with strong secular growth profiles continue to perform well. These companies typically belong to sectors such as technology, communications, industrial or consumer discretionary. Unfortunately, the S&P/TSX 60 index is dominated by sectors that do not fit this “blue chip growth” profile. There will be a time when Canadian equites become more appealing, but this does not appear to be that time. This is not to say that the TSX will not appreciate if equities rise in general – just that the best chance for the best possible return lies elsewhere right now.
The last thought I would like to share in this piece relates to the evolving world of blockchain and digital assets. Blockchain technology and crypto tokens (Bitcoin, Ethereum etc.) are being brought from the fringes of the financial world into the mainstream by U.S. regulators and large U.S. asset managers such as Blackrock, Fidelity, JP Morgan, Franklin Templeton and State Street Global Advisors to name a few. In addition to Bitcoin ETFs, these Wall Street institutions have been investing heavily into blockchain technology to facilitate trading, administration, and a host of other functions. Some large global banks have begun to issue bonds on blockchain and asset managers like Templeton have launched money market funds using blockchain.
There were times where one could easily ignore this space as a “scam” or “playground for criminals” – I humbly opine that those times have now likely passed and that even if only partially adopted, the impact of these technologies will be profound. Like the internet in 1994 before Netscape went public in 1995, blockchain is being brought to the fore and will likely continue to become more mainstream as the months and years go by. In fact, the mass marketing has begun – here is a link to a recent ad on YouTube and the X platform (former Twitter): https://x.com/bitwiseinvest/status/1736755061127020794?s=12&t=ra0LDTyCVn28mWO1v67AqA
This does not mean that we should run headlong into the space – but it does mean that it is likely that these technologies will start to impact our daily lives and having some familiarity with the space would be useful. To that end, please find below a link to an Introduction to digital assets by Fidelity Digital Assets: Introduction to Digital Assets (fidelitydigitalassets.com)
We have taken several actions in the portfolio entrusted to us since our last update. First, we have conducted our routine quarter-end review of all holdings and will be adjusting the names in the portfolio – we have pushed most rebalancing into 2024 to defer capital gains. As previously discussed, a key part of our process involves profiting from our successful names and looking at the worst-performing stocks with an eye to reduce or remove them in favour of stocks with a better fundamental and technical profile. We also conducted a review of our alternative strategy holdings and replaced one manager and switched products with another. With client input and where client objectives and risk tolerance aligned, we also introduced a 1% weight in the Canadian traded Fidelity Advantage Bitcoin ETF to take advantage of the adoption cycle and supply/demand dynamic that is evolving.
As always, the focus of the Kluge Wealth Advisory Group is on preparation and not prediction. Irrespective of any views, we always acknowledge and prepare for a wide range of events and outcomes. As we move into 2024, the picture painted by my Risk Dashboard remains optimistic about the path forward. As a result, we recommend that investors consider reducing cash and investing in both high-quality equity and fixed income, to the extent that risk tolerance and objectives allow.
