By John Nicola, CFP, CLU, CHFC
Ouch! It is customary to consider the start of a New Year as being one full of hope and promise. A new start where we can experience unrequited resolutions that were well-intended.
Someone forgot to tell Mr. Market that.
Last week, global markets had their worst start in decades led by the imploding and highly manipulated Chinese Shanghai Index. Even a diversified equity portfolio made up of 50% Canadian stocks, 25% U.S., and 25% Global would have lost more than 5% last week.
To make matters worse, the same portfolio would have earned just over 2% for all of 2015, so as of Friday January 8 it was in negative territory for all of 2015 and the start of 2016.
A Few Questions
This less than auspicious beginning to 2016 begs a number of questions:
- Are we experiencing the start of a bear market? (Technically the Canadian market and a number of others are already more than 20% below their peaks for this cycle.)
- Given interest rates are still at record lows, commodity prices have fallen dramatically, and Chinese growth is slowing (and may drop considerably more), are there any safe havens for investing in a long term portfolio that should ideally provide you with an inflation adjusted return of 4% net of fees?
- As you all know, we believe strongly in a truly diversified asset allocation approach that derives a significant portion of its annual returns from cash being earned and distributed on those assets. That cash can be in the form of interest on fixed income assets, dividends on both public and private equity and rents on real estate. How did our strategy perform last year and what might we want to be doing differently in this highly volatile environment?
I will come back to these questions at the end but first I would like to provide some information that we have presented to a number of audiences over the last six months concerning both past returns and future expectations.
Historical Context And Future Projections
Let’s examine historical returns since the turn of the century. Equity returns have been below historical levels for more than 15 years. Below is a composite made up of 25% MSCI World Index (global stocks), 25% S&P 500 (U.S. stocks) and 50% TSX (Canadian stocks) with returns measured from January 2000 to November 2015 (all returns in Canadian dollar terms). Returns are net of fees assumed to be 1% annually including all costs.
As you can see, the results are a very disappointing 3.3% per year, or less than 2% per year after inflation. Considering that the returns for S&P 500 have been about 6% annually after inflation for the last 100 years or so, the results for the last 16 years have been well below that norm.
Even when we reduce the equity exposure by 40% and replace it with bonds, the returns only increase to a nominal 4.1% annualized or just over 2% annually after inflation.
If those results represent past performance, then what might we reasonably expect to earn going forward? The two charts below come from the following sources:
1. The first chart is the quarterly summary of 7 year expected returns that GMO (a very well respected asset manager in the U.S. with about $140 billion of AUM) produced for a number of asset classes. The bottom line is that they expect to see 2% real returns over the next 7 years based on a balanced portfolio of the asset classes noted below.
2. The Economist magazine presented the chart below recently, showing expected annual returns for 10 years going forward for a typical U.S. based portfolio. As you can see from the chart, 10-year the inflation-adjusted expectations as of 2016 are similar to those from GMO at about 2% annually.
Is It That Bad?
There are good reasons for taking both a pessimistic and optimistic view of equity markets. Here are just some:
- Very few equity markets have Price Earnings (PE) ratios at low levels, so current prices are not that inexpensive.
- Low growth is impacting all economies globally. If that continues, then where will increases in future earnings come from?
- Low inflation also means low nominal growth in GDP, which is a longer-term drag on future earnings.
- Aging populations for the entire developed world, and many of the developing countries, suggests increased savings rates and lower spending. This will also slow economic growth.
- We have had a good run in stocks since the last bear market ended in early 2009. Is it now time for a reversion to the mean, and thus lower future returns?
- Low interest rates may be here for a long while. If one looks at what is called the “earnings yield” of the S&P 500 it is almost 6%. At the same time the ten year government bond rate is about 2.2%. In this environment perhaps PE ratios are not that high.
- Low energy costs benefit both consumers and many industries positively. It has the same impact as a major reduction in taxes.
So, in response to my very first question: are we entering a bear market? Overall, I would say that the Nays have the better of the arguments, but as we showed above, they have had that for the last 12 years. That is only one reason why we take a different approach to traditional asset allocation and to how we manage each underlying asset class.
The Outcome Of A Different Approach
1. How has NWM’s approach worked historically?
2. What are we planning on doing differently (if anything) going forward?
Our NWM Core Composite model earned those returns with about 20% less volatility than the 60/40 equity/bond portfolio.
We were able to deliver a net return last year of 6.9% over inflation and since 2004 about 4.6% annually after fees.
However, given how equity markets have performed during the first week of 2016 and the very low expectations from a number of sources for future returns, some reasonable questions arise:
- As I asked in my second question at the beginning: are there places where good value for assets can be found?
- How do we plan on investing in the future to deal with this challenged return environment?
We presented the slide below at the recent annual investment seminar held for the Chartered Professional Accountants (CPAs) of BC. It outlines the approach we have been taking and will continue to take with some modifications.
- We will continue to keep publicly traded equity positions under 35%. In addition, we will hedge part of that overall risk by using covered call and put options that also increase current cash flows on portfolios with favourable tax treatment.
- Whether we use third party managers or internally manage asset pools, we take the position that our clients are better off with an active asset management approach vs. passive index based models. History and common sense tells us that this is a strategy we want to continue to execute.
- Markets such as this can sometimes test one’s resolve to continually re-balance and add to asset classes that have under-performed and reduce positions in better performing assets. Last year weak performers included Canadian equities (energy and commodities in particular), preferred shares and high yield bonds. Over any length of time good investors know that you make your money by how well you buy assets vs. how well you sell them. As long as we are adding to our asset base over time we want to have opportunities to acquire more of them at lower prices. This opportunity now exists in a number of areas. There is no way to easily determine when a market has bottomed but it is not difficult to know when you can add to your positions for less money than would have been the case months or even years ago.
- We must continue to look for areas where we can add value to an existing asset. Whether that is getting better rents or lower vacancies in a building, investing in private equity at much lower earnings multiples than public companies, or improving fixed income returns by making direct loans to lenders such as commercial mortgages or corporate lending, those opportunities exist.
The fall in equity markets we experienced this last week may well continue and inflict some short-to-medium-term pain. But, as long as we focus on our plan and execute our strategy, our portfolios will continue to deliver sustainable cash flow. When that is combined with a truly diversified asset allocation model, then markets such as this eventually become the buying opportunities we are continually searching for.
It is perhaps an ideal time to recall the words of Rudyard Kipling:
This can be our New Year’s resolution for 2016.
JOHN NICOLA, CFP, CLU, CHFC
Chairman & CEO
Nicola Wealth Management
Notes: The NWM Core Composite returns represent the total returns of Canadian dollar denominated accounts of all fee-paying portfolios with a NWM Core mandate. The composite includes clients who are both fully discretionary and nondiscretionary. Historical net of fee composite performance returns are calculated using individual realized money-weighted client returns net of fees and is presented before tax. The NWM inclusion policy is based on clients weights at calendar year end and only clients with a full year performance are included. The composite returns are asset-weighted based upon ending calendar year market value. The NWM Core mandate may change throughout time. Additional information regarding policies for calculating and reporting returns is available upon request. The composite returns presented represent past performance and is not a reliable indicator of future results, which may vary. NWM Core Portfolio past performance is not indicative of future results. Returns are net of fund expenses. Please refer to the NWM Funds Offering Memorandum for additional details and important disclosure information. The NWM Core Portfolio Fund Asset Mix takes into consideration only the primary asset class of the aggregated funds but does not take into consideration the underlying fund’s holdings of other asset classes. For example, the NWM Primary Mortgage Fund is allocated in its entirety to “Mortgages” even though it holds some “Cash.” NWM is registered as a Portfolio Manager, Exempt Market Dealer and Investment Fund Manager with the required provincial securities’ commissions.
This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Please speak to your advisor regarding your unique situation and investing needs. Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value.