Winners & Losers 2013

In Investing: Air Canada took off, income investors got burned, and bitcoin bubbled

Investors

The bull is back

2013 turned out to be an unexpectedly good year for the markets. But can the QE-lubricated party continue?

Investors partied like it was 1999 again

(Richard Drew/AP)

Given all the high-priced investment advisers, stock analysts, fund managers, books and blogs purporting to offer financial advice, you would think that investing is a complex, intimidating process. But this year, investing was dead simple: if you held some large company stock, you made money. You needn’t have concerned yourself with market timing, digging into quarterly reports, or poring over economic research. Most major stock indexes had a phenomenal year. With startlingly few exceptions, every sector advanced.

This year, the Dow Jones industrial average surged by 23% and the S&P 500 by 26%, leaving behind their pre-recession highs in the spring without stopping to ask for directions. The Nasdaq, meanwhile, is up 32% and touched its highest level since 2000, at the peak of the tech bubble. In Canada, the S&P/TSX composite proved to be a relative laggard but still grew by nearly 9%. The good results were not limited to North America, either. Germany’s DAX index rose 22%. Japan’s Nikkei, which has been an underperformer for decades, fared best of all with a 50% climb.

Few investors and prognosticators saw it coming. “The stock market has been much stronger than I thought at the beginning of the year,” says Brandon Snow, a portfolio manager with Cambridge Global Asset Management. But after a year of unrelenting gains, and with the world’s best-capitalized indexes sitting at record highs, surely stocks are due for a correction soon, right? Concerns are already brewing that stocks are running ahead of fundamentals and getting increasingly pricey.

To even attempt to answer that question (spoiler alert: no one really knows), it helps to understand the reasons for the stock market’s stellar performance. Low interest rates are a major factor. When the recession hit, central banks around the world co-ordinated interest rate cuts to juice the economy again. Rates are still at record lows, and the U.S. Federal Reserve’s aggressive quantitative easing program shows few real signs of abating—chairman Ben Bernanke’s June 24 guidance on plans to “taper” QE notwithstanding. One consequence is that bond prices are pushed higher, returns diminish, and investors are left to pile into equities if they want to grow their portfolios. Stock prices naturally move higher, even if the underlying corporate and economic fundamentals are nothing to cheer about.

Canadian stocks are a bit of an outlier. The TSX trailed its peers, largely because the index includes a large number of mining and precious metals companies, which are taking a beating amid softening demand for commodities. But Canadian companies with an international focus, such as Alimentation Couche-Tard and CGI Group, outperformed and surged more than 50% and 60% respectively.

Low interest rates are not the only factor in the markets’ rise, though. The global economy is improving, albeit slowly, and major risks appear to be receding. “The best way to say it is things haven’t gotten dramatically worse,” says Ian Hardacre, head of Canadian equities at Trimark Investments. Some investors believe the U.S. housing market, the cause of so many problems, is rebounding. As of September, the Case-Shiller index, which tracks home prices in 20 American cities, had increased 13.3% year-over-year. Even though the Federal Reserve recently noted the housing recovery slowed in recent months, some economists see that as a temporary phenomenon. U.S. banks, which were hammered by the housing crash due to their exposure to home mortgages, are on better footing. Outside of North America, the European Union, while still in a weak state, no longer appears to be on the brink of breaking up, and China has so far managed to avoid a hard landing.

These moderately positive economic developments, combined with a low-interest-rate environment, is a recipe for a booming stock market. “We’re in a sweet spot,” says Bill Webb, executive vice-president and chief investment officer at Gluskin Sheff and Associates.

Any number of events could cause stocks to reverse, but there appears to be momentum still. Interest rates don’t appear to be moving anywhere soon, for one thing. The Bank of Canada turned more dovish this year, and incoming Fed chair Janet Yellen has said she intends to continue the central bank’s massive bond-buying program. Webb believes that other factors will influence stocks beyond abnormally (and temporarily) low rates, too. “Earnings growth will supply the next phase of the bull market,” he says. During the recession, corporations cut back drastically on staff and froze wages. While damaging for workers, these cutbacks have turned corporations into lean operations. Even a slight improvement in the economy translates into a big boost in corporate earnings. “There’s enormous operating leverage, and margins have improved,” says Terry Shaunessy with Shaunessy Investment Counsel in Calgary.

Still, the strength of the market this year is making some people nervous. “While low interest rates justify higher stock values, the gains of the past year can’t be explained by improved fundamentals, as the economy has grown less than 2% year-over-year and profits have risen a pedestrian 4%,” wrote BMO senior economist Sal Guatieri in a recent note. Emotions are driving the market, and that can cause things to get out of hand. Jeremy Grantham, chief investment strategist at GMO, expressed his worries in a recent letter to investors. “I would think that we are probably in the slow buildup to something interesting—a badly overpriced market and bubble conditions,” he wrote. Activist investing legend Carl Icahn piped up recently too, saying he’s “very cautious” on U.S. stocks, which “could easily have a big drop” now that they’re repeatedly posting record highs.

For portfolio managers, even finding stocks to buy is becoming a challenge due to high valuations. “Everything is just going higher regardless of anything going on,” Hardacre says. “Our whole investment team is finding it very difficult to find new ideas.” Though many portfolio managers will say stocks are fairly valued for the most part, the gap between cheap and expensive equities is narrowing. Goldman Sachs tracks the price-earnings ratios of companies on the S&P 500, and found the disparity between inexpensive and pricey firms shrank to the lowest level since 1990 in June, and hasn’t changed much since.

Heading into next year, the question for investors is whether to hold on or take some chips off the table. “Probably the worst thing for the market is if we continue at this pace,” says Snow at Cambridge. “If stocks keep getting more expensive because people feel better about them, that sets us up for a significant pullback.” Snow says he and his team are still finding investment opportunities, but they’re waiting for the right price before buying. Hardacre at Trimark sounds even more cautious. “I don’t want to lose money, and I think we’re heading for a difficult time,” he says. Most Trimark equity fund managers are net sellers these days.

Shaunessy recognizes some investors will be hesitant leading up to 2014, but doesn’t expect them to stay that way. “Greed will overtake that caution,” he says. “Once they start to see the market moving, and they’re seeing their colleagues making big moves in the market, they’ve got to get in.” Even Grantham concedes stocks will likely continue their bull run into next year. He estimates U.S. stocks, particularly non-blue-chip firms, could rise another 20% to 30% next year on the back of low interest rates and investor zeal.

What equity investors choose to do next year is ultimately a matter of risk tolerance. “Be prudent and you’ll probably forego gains,” Grantham wrote. “Be risky and you’ll probably make some more money, but you may be bushwacked and, if you are, your excuses will look thin.” Indeed, while investors could sit back and watch their portfolios grow this past year, making money in 2014 without getting burned could require considerably more effort.

Joe Castaldo