For me, a cold, dark and gloomy February winter day is a great time to reflect on 2011 and sneak a peek toward the remainder of 2012.
I, and most other equity investors, are happily waving good bye to 2011.
Unforecasted events like the Tsunami earlier last spring, the European Sovereign debt repayment and bank quality concerns unsettled world wide equity market and churned investor’s stomachs.
The results were particularly painful for Canadian equity investors.
The S&P/TSX Composite index was down 11% versus an approximately flat performance for the U.S. S&P 500 index. This was the first time that Canadian equities have under performed the U.S. since 2003.
However, as much as it’s results were disappointing, the TSX actually held up reasonably well, when compared to the emerging Chinese and Indian markets, where their equities declining 20% and 25%, respectively.
High volatility and correlations were the dominant characteristics of the equity market in 2011, which implied that stocks were being driven more by macroeconomic issues rather than by company specific news.
On the bright side, fixed income assets once again, had very strong years with Canadian and U.S. Government debt, as represented by the DEX Universe Bond Index and the Barclays Capital U.S. Bond Universe Treasury Index, respectively, delivering almost 10% total returns.
For me, this once again reinforces the critical importance of regular rebalancing, which forces us to buy low and sell high, and properly diversifying investment portfolios.
Not everything is doom and gloom. When I look forward, though, there are some positive signs for the equity markets.
Equity market volatility is decreasing. Since peaking in early October, volatility has steadily retreated in both the Canadian and the U.S. equity markets.
It is now in the low 20% range, which is a more normal and healthy level. This is encouraging as declining volatility has historically been associated with stronger equity markets.
Another positive factor is that stocks are inexpensive, not only in absolute terms given robust corporate earnings (approximately 12x forward expected earnings) and cash flow trends but also relative to government bonds in Canada.
The TSX dividend yield is considerably higher than 10 year government bond yields, which again something that we only saw during 2008 going back to 1994.
More important still, is that behind the doom and gloom of the newspaper headlines, lurks a quiet re-acceleration of U.S. economic momentum.
Specifically, the ISM New Orders Index, which is one of the best economic data series to track the economic cycle, has been steadily creeping upward since July.
This is particularly important, since over the last 10 years, TSX monthly returns on a year over year basis, have been 80% correlated to this data series.
Since 2001, the median performance of the TSX when the ISM New Orders index is above 50 and rising has been greater than 16%. Historically, cyclical sectors, especially Materials and Energy, have significantly outperformed in this environment.
Yet, given the still elevated level of global political and economic risk, I am still advising investors to avoid moving too far up the equity risk spectrum and advocate a focus on higher quality names with great balance sheets and revenue visibility at the right valuation.
