Back to Basics
December 28, 2023
At the end of 2022, when we were looking out to 2023, we told clients the future was not bleak, nor was the economy sliding into a deep, dark recession, or about to fall off a cliff. We said that 2023 would be a year of recovery. A year where interest rates would stabilize. A year where inflation would settle down and economic growth would be flat, but generally positive. And a year in which companies that the market unfairly punished would recover. This is exactly what we got. In our last newsletter of 2023, we will look at what all this means, where we are heading and how we have been managing our clients’ portfolios during this time.
Where we are:
As we mentioned above, 2023 unfolded very much according to our expectations: it was a year of recovery. Both companies and individuals adjusted to the new reality in which money, goods and services are all more expensive and growth in both the economy and the markets is slowed. From an investment performance standpoint, “recovery” really is the best word to use. What got beat up in 2022 had a great year in 2023. What didn’t get hammered in 2022 traded sideways in 2023. This can be seen quite clearly when we examine the U.S. indexes.
In 2022 the Dow Jones Industrial average, which is the 30 largest industrial stocks in the U.S., faired relatively well, only losing about 8%[i] of it’s value. In contrast, the S&P 500 (the largest 500 companies measured by market cap) lost over 18%[ii] of its value in 2022 and the Tech heavy Nasdaq lost over 33% of its value in 2022. This year, the numbers are similar, but on the positive side. The Dow Jones is finishing the year gaining 12%[iii], the S&P 500 is up 25%[iv] and the Nasdaq is up 41%[v]. While these end results are similar, the ride or volatility in each area has been dramatically different. We must remember that while the numbers for 2023 sound impressive, they come on the heels of a rough 2022. The caveat to remember is that when you invest $1, and you lose 50% you are down to $0.50. If you made 50% back the next year you are only back to $0.75. In other words, you need a 100% gain to make up for a 50% loss. So, while the 40% that we have seen in the Nasdaq sounds impressive, a gain of almost 50% is required to recover 2022’s losses.
Here in Canada, the Canadian stock market looks a lot more like the Dow Jones than the Nasdaq 100. In 2022 the TSX Total Return Index was down about 6%[vi] and in 2023 it is up about 10%[vii]. One of the major sectors that held back the Canadian stock market in 2023 is banking. Our major banks, combined with our other big financial companies, make up the largest part of our stock market and 2023 was not kind to them.
There is a misconception out there that higher rates are good for banks; they are not. All you need to do is compare the profit of any of our major banks from 2022 to 2023. They are all down. This happens for a few reasons. First, when interest rates go up quickly, as they did in 2022, banks cannot start charging all their clients more right away. Only clients with variable rate loan products feel the pinch right away. It takes years for the banks to get caught up. But the banks are paying the higher rates right away for the money they owe. Also, when higher interest rates slow the economy, the business that banks rely on also slows down, which further drags down profit. Finally, there is wealth management, which represents a larger and larger part of a banks’ business every year. Given the fact that higher interest rates typically weigh on markets, revenue from this business line falls too. The combination is not a great recipe for banks to make money.
Bonds were also an interesting storyline in 2023. Bonds are used in portfolio construction for three main purposes. First to provide safety and stability, as historically they have performed in this way. Second, to provide a fixed, consistent income stream. And last, bonds offset the volatility of equities as typically they have done quite well in years that equity markets have dropped. In 2022 none of this conventional wisdom held true. Bonds had one of their worst years on record and that came after one of the worst decades for bonds ever. This did not occur because bond markets were broken; companies or countries were not going bankrupt and defaulting on their payments. The problem in 2022 was that interest rates and bond prices are negatively correlated. When interest rates go up, bond prices go down and as we all know, interest rates went through the roof and bond prices went through the floor. When the dust settled on 2022 the Canadian Corporate Bond index was down over 12%[viii] on the year. Going into 2023 some had speculated that bonds would come roaring back—that it would be the year of the bond. This prediction was based on the idea that interest rates would be slashed in 2023. While we never understood why some believed this, there is little use in speculating now. Plainly, that didn’t come true. But what did come true is that bonds had a very decent year. With the reality of higher interest rates now baked in, many bonds now pay 4-6% interest payments. As we look ahead to 2024 there is evidence we might start to see a few small cuts to interest rates, which is helping push the price of bonds up a bit. At the time of writing, the Canadian Corporate Bond index is up about 8%[ix] in 2023; earned the yield plus a little bit more as they outlook for interest rates looks brighter in 2024.
Given all of the above, the portfolios we manage for our clients continue to behave according to our expectations. Our balanced individual security models that participated in the strong markets in 2021 held up extremely well in the rough waters of 2022 so that in 2023 they have erased almost all of their loses. Our equity or stock allocations only participated in about half of the greater market volatility in 2022 and recovered in 2023. Our fixed income and bond allocations in client accounts are also posting strong results. While the speed of the interest rate increases surprised us slightly, we were well prepared for rates to rise last year, which put us in a great position to seize the opportunities that presented in 2023. As you have heard many times before, capital preservation is at the heart of all of our investment strategies and our risk controls are working.
Where we are going:
This is the question that every investor is asking. As we mentioned at the start, we still do not see a deep, dark recession in our future, nor do we see a troubled economy ahead. Yes, the economy is slowing. In fact, we seem to be just hovering above zero growth. If we drop below zero, we will be in a recession. But if the question is will there be a recession our answer has to be “maybe”. That might sound vague but whether we stay above the zero line or slightly below it, we believe the result is the same: slow growth. This doesn’t mean that the investment outlook is bleak, in fact we see the opposite. Right now, we see businesses that are correctly priced for the current market environment and the math behind a classic portfolio construction is great. If we examine the traditional 60/40 portfolio (60% equities/stocks 40% fixed Income/bonds), we are set up for what might be the best 2-4 years in recent times. Here is why. Currently, fixed income or bonds are paying about 4-6% per year. So, the safe secure part of your portfolio should earn you a 4-6% minimum rate of return for the next few years. That number could edge higher when interest rates revert. As for the equities or stocks, good dividend paying companies are currently paying a 5-6% annual dividend[x]. Therefore, even if markets never recover, as long as these companies don’t cut their dividends (which we believe is very unlikely) investors will have a rate of return of 5-6% per year. As markets recover over the next few years you can add 2% to 4%+ on to that return for capital appreciation. It is this combination of factors and market conditions that gives us confidence our clients will see the rate of returns outlined in their investment policy statements. At the end of the day, we do believe that there are many reasons to be optimistic that 2024 will be a fruitful year for investors.
For more insight, please click here to read Scotia Wealth Management’s Global Portfolio Advisory Group’s latest report, “Here’s what we’re thinking”.
What are we doing?
As the title of this newsletter states we are “back to basics”. For our team of portfolio managers, we see the future as relatively simple. First is asset allocation. With higher interest rates guaranteeing returns, no one should be taking more risk than they are comfortable with. You can earn 4-6% return with low- to no-risk investments. GICs, for example, are still paying over 5% on the short end. Now is the time to ensure that you are comfortable with the asset allocation in your account. Next is equities or stocks. We also believe that for the next 2-4 years our equity trading will be relatively straight forward. As we mentioned above, good, high-quality companies are paying a 5-6% dividend annually and there is room for the value of these companies to go up. We are focused on doing our job correctly by ensuring that each and every company that our clients are invested in is profitable, paying a dividend and in a position where they will be able to continue paying you that dividend. As our clients know, each and every day this is what we are doing. We are examining every business and every investment in our portfolios. It bears repeating that we follow this extremely disciplined process because it has rewarded our investors in the past and it will continue to deliver in 2024.
Trades and portfolio actions
Rebalancing & Trading:
When markets turn and go through gyrations, we view it as our time to shine. Over the past year our trading activity has dramatically increased. Over 50% of the investments that we owned at the beginning of 2023 are no longer in our portfolios. We have been rebalancing portfolios, locking in gains, and allocating capital to areas of the market that have been depressed for the wrong reasons. If you have any questions about what we are doing or why, please reach out. We welcome questions and love going deep with clients to explain our investment methodology in greater detail.
Canadian Holdings:
Our Canadian portfolio has changed dramatically in 2023. Over 70% of the stocks that were in the portfolio on January 1st are not there today. We also started the year owning four of Canada’s major banks and today that number is only one. As we close out 2023 our Canadian portfolio looks to finish the year relatively flat. But flat is not bad, as we are not climbing out of a big hole from 2022. In fact, our Canadian stock portfolios traded sideways and held on to the amazing gains from 2021 all through this period of volatility. This sets us up for a great 2024.
In the second half of 2023, seven companies were exited from our clients’ portfolios: TD Bank (TD), SSR Mining Inc. (SSRM), Newmont Corporation (NGT), Canadian Utilities (CU), Vermilion Energy Inc. (VET), Osisko Gold Royalties (OR), and National Bank (NA). The seven new companies that entered our portfolios are: Parkland Corp. (PKI), Vermilion Energy (VET), Kinross Gold (K) North West Company Inc. (NWC), Peyto Exploration and Development Corp. (PEY), Power Corp of Canada (POW), Fairfax Financial (FFH).
U.S. Holdings:
Our U.S. holdings held up well in 2022 and resumed their climb in 2023. In our U.S portfolio, our Tech stocks have been by far our shining stars this year with our investments in Microsoft (MSFT) increasing in value by over 55%[xi] in 2023.
We had one stock leave our U.S. portfolio in the second half of 2023 and one stock enter our portfolio. The stock that we exited was the Exxon Mobil Corp. (XOM). The company that replaced it was Illinois Tool Works Inc. (ITW)
ETF Portfolios:
Our tactical managed ETF portfolios, held in many of our client’s TFSA accounts, are built using smart indexing ETFs, which have naturally tracked closer to market returns. As a result, as markets rebounded this year so did our ETF portfolios. The shining star of our index portfolios was the Nasdaq 100 Index, which is up over 40%[xii] in 2023.
Private Equity and Alternative Investments
Currently, in our managed accounts we have a small allocation to some alternative investments, mainly in the fixed income space. We recognize that private equity and alternative investments have the opportunity to provide returns that are above what traditional equity investments can offer and in many cases with reduced volatility. In 2024, we look forward to launching alternative portfolios for clients who are wishing to add this asset class to their overall asset mix. We will be talking to clients about this as we do our annual reviews but please reach out to us if you want to learn more.
FHSA (First Home Savings Account)
Quite simply this is the best way for any Canadian to save for their first home. This account offers the tax deductibility benefits of an RRSP and the tax-free growth and tax-free withdrawal benefits of the TFSA (if the funds are used to buy a first home). If you or anyone in your circle is saving for a first home, they really should be opening an FHSA, and we would love to be the ones to do that for them. Please contact us to learn more.
Team Update
Our team continues to evolve. Cody Faber who has been an investment associate on our team for five years has left our team to pursue another opportunity within Scotia Wealth Management. Myself, Danielle, Ingrid and Jenisha all look forward to continuing our relationship moving forward. If you have any questions about his departure, please reach out to me.
On a personal note:
We hope that, regardless of what you are celebrating this holiday season, you get some time to slow down and be with the important people in your lives. From the COVID pandemic to the rocky markets of 2022 to conflicts erupting around the world, the start of this decade has been turbulent and unsettling. We want to take this opportunity once more to express our deep gratitude to such a remarkable community of clients and friends. Serving you is a privilege, and we are genuinely grateful to be a part of your journeys. Please accept our heartfelt appreciation as well as our wishes for a wonderful and safe holiday season. All the best for a happy, healthy and prosperous 2024!
If you have any questions or if there is anything that we can do, we are here and we want to help.
Sincerely,
Christopher Le Roy and the team
The Le Roy Financial Group
[i] Morningstar Direct
[ii] Morningstar Direct
[iii] Morningstar Direct
[iv] Morningstar Direct
[v] Morningstar Direct
[vi] Morningstar Direct
[vii] Morningstar Direct
[viii] iShares Canada
[ix] iShares Canada
[x] Thompson One
[xi] Morning star Direct
[xii] iShares Canada
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