With US industrial production numbers for October coming in at a 4 month low of 0.1% versus expectations of 0.4%, investors managed to drive up the major averages to end Tuesday in positive territory. The Dow closed up by 30.46 points or 0.3% at 10,437.42, the Nasdaq advanced by 5.93 points or 0.3% to 2,203.78 and the S&P 500 rose by 1.02 points or 0.1% to 1,110.32. Before jumping into these markets, one must ask the question: are the markets overvalued? When considering investing in turbulent times such as these, how does one manage risk?
These are a few on the questions I posed to portfolio manager, Craig Stanford of TriVest Wealth Counsel. His responses are presented below.
Q: Mr. Stanford, in the face of the recent volatility in the stock market, a number of commentators are citing the over-valued nature of the markets based on the economic realities – what would be you’re view of the market (Canada and U.S.) right now?
A: At TriVest, we see the equity markets starting to look a bit stretched and are finding it more challenging to find opportunities that are not fully valued. Overall, there are still a few individual securities that appear attractive from a bottom up basis, but as a whole the markets currently look fairly valued. The U.S. market, for example, is up 60% from its March lows and trading at approximately 16X forward earnings. This is not only above historical norms of nearly 15X, but is also predicated on a more than 30% growth in corporate earnings in 2010. We consider this to be tad optimistic considering the overall health of the US economy and the double digit (and climbing) unemployment.
Q: What is your near and long term outlook for the Canadian Dollar with respect to its fundamental value and its impact on the earnings of Canadian companies?
A: We believe the current strength of the CDN dollar is a more a function of a weakening US dollar. In the short term, we think the CDN dollar could easily go to par. The U.S. government needs a low U.S. dollar to stimulate its economy and deal with its massive debt load. It was fairly clear from the recent OECD meeting that the U.S. intends to keep interest rates low and is (not so secretly) supporting a low dollar policy. This clearly hurts all of their trading partners and especially Canada. China is avoiding this pain by keeping its currency pegged, but is currently under a lot of pressure by the U.S. to allow its currency to appreciate. In regards to CDN corporate earnings, obviously the manufacturing business is hurting as the industry can no longer rely on a weaker dollar to offset poorer efficiency. It also doesn’t fare well for the energy business given cost structures are in CDN dollars and revenue in USD.
Longer term, it is always difficult to predict currency movements. We’ve never found anyone or any institution that can do it consistently or accurately. Ultimately, we think the U.S. dollar will appreciate when the current U.S. dollar carry-trade unwinds. There are currently huge net short positions in zero-cost U.S. Treasuries right now with offsetting long positions in higher yielding equities and commodities.
Q: Given that cyclical stocks have outperformed defensives in this rally since
March 2009, can you please highlight one sector among Canadian stocks (e.g. can be financials, energy stocks, technology, resources etc.) that you believe to be overbought and due for a correction and one sector that you believe to be oversold and due for a bounce and why?
A: We believe that the financial sector is fully valued, especially in the U.S. The next shoe to drop is likely defaults in the commercial mortgage area with U.S. $2 trillion of maturities over the next 15 months. A few large cracks are just starting to appear in the U.S. commercial property sector already, and it would not be prudent to believe Canada wouldn’t be impacted in some fashion. For example, despite the stronger positioning of the Canadian banks, many are trading near record levels reached in 2007.
When we screen for relative value, Utilities and Telecommunications are trading below historical valuations and have not participated to the same extent as some of the other sectors in the recent run up. On a bottom up basis, there are still some attractive stocks in the energy sector trading at reasonable cash flow multiples but it is very selective. As for example, we believe many of the gas-levered stocks to be trading at multiples greater than what is being implied by the forward curve for natural gas.
Q: With regard to risk management, which I see is one of your founding principles, how do you recommend investors approach managing their risk? Can you please elaborate on one or two methods utilised by TriVest in current times to 'protect and grow' assets?
A: At TriVest we utilize a three step process for stock selection. A formalized approach to risk management is included in each step. From a 30,000 foot view, we begin with a quantitative model that we have developed to screen the market for relative valuation and risk metrics that we deem important. We then follow this up with intensive fundamental research further screening our target opportunities by ranking of their management track record, the quality of their assets and/or business with a subsequent outlook for growth or sustainability of dividends, and lastly their overall relative value. To supplement our own research we also have considerable access to institutional equity research.
As a last and important step, we then take our equity model portfolio and apply an option overlay. This is our final level of risk control and can be tilted to match our views of an individual stock or the market in general. Options are a very powerful risk management tool that aren’t traditionally utilized by the Investment Counsellor community. As an example, you can buy a Put to hedge a particular exposure or implement a costless collar strategy (buy a Put and sell a Call) to set a floor and a ceiling on an investment.
We would not recommend that the individual investor utilize options unless they have some education in that area. There are publicly traded ETFs that can be utilized to hedge a sector or market exposure. However, we would caution against the average investor utilizing double or triple leveraged ETFs as they can lose market tracking over a relatively short period of time.
Q: Lastly, can you please highlight 1 stock/theme that you think offers the best value moving forward and your reasons for liking it?
A: Two very different themes that we would recommend looking into further would be Telecoms and Energy. Telecoms are currently trading at low valuations and we do see good future growth prospects in the cellular area in Canada (the U.S. market would be a different story given a more competitive landscape). Long term, oil prices should rise as cheap conventional reserves continue to decline and demand from countries such as China and India continue to rise. Short term, oil prices could be quite volatile in both directions with issues such as the large U.S. carry-trade, fear of future inflation etc.
Thank You Mr. Stanford!
Disclosure: No Positions
