What I do at the start of every year is go back and remind myself that each individual year has its own particular story, in preparation for the 12-month period that lies ahead.
For example, 2007 taught everybody that it never hurts to take profits after the market doubles and that if something is too good to be true, as was the case with the housing and credit bubble, it probably is.
The lesson in 2008 focused on capital preservation strategies and the urgency of managing downside risks.
Then, in 2009 it was vital not to overstay a bearish stance in the face of massive fiscal and monetary stimulus, even if the economy was in a deep recession for half the year. Last year’s lesson was on how to handle the many post-stimulus market swings that are inherent in a post-bubble credit collapse.
It is very tempting to look back at the past year and conclude that it was a great year for the markets because the S&P 500 rallied 13% point-to-point, but that is about as relevant as the fact that by the end of August, the S&P 500 was off 14% from the nearby peak and the TSX was down 6%. But the year 2010 was most noteworthy for intense financial market volatility — there were no fewer than six mini-bull markets and six mini-bear markets (up or down at least 6%) in what was truly a roller coaster of a year.
And we head into 2011 much the same as 2010 — with plenty of optimism and growth priced into the U.S. equity market and facing a year chock full of “event risks” thatwill likely produce some very nice trading opportunities. We must be very well prepared to take advantage of volatility this year. Last year, we concentrated on mitigating downside risks and preserving capital at the expense of capitalizing on all the moodswings that took place. In 2010, the concerns were over Greece, health care, the end of QE1, and the mid-term elections.
In 2011, the “event risks” that we expect to generate the volatility and periodic spasms that create significant buying opportunities are even larger in number and more diverse. These range from Ireland, Portugal and Spain, to the U.S. debt ceiling file, to the U.S. state and local government turmoil, to another down-leg in U.S. home prices, to surging food and energy prices, and to heightened inflation pressure. The threat of policy tightening in the emerging markets (especially China) continues, and with the end of QE2 in June, Fed Chairman Ben Bernanke will again have a tough choice to make between unwinding the bloated balance sheet or reinforcing speculative behaviour in risky assets by embarking on QE3.
In this light, we fully anticipate another roller coaster ride in the markets this year, and we intend to be more pro-active at the intermittent lows with a continued eye towards limiting downside risks to our portfolios. The heightened volatility means extra reliance on our hedge funds, to mitigate the market volatility by focusing primarily on ‘relative value’ trades. This means essentially going long on undervalued high quality assets and going short on overvalued, lower quality assets.
While we are still cautious on the overall equity market, we do see a silver liningin the energy sector and in large-cap and mid-cap companies that have lagged the upturn this cycle and are relatively inexpensive. Here, we focus on large cash-flow generators with strong balance sheets that pay out a reliable dividend stream. So despite our concerns over complacency among U.S. equity investors, there are still needles in the haystack — in oil, in large-cap tech and the defensive dividend paying stocks within health care and consumer staples.
The recent backup in bond yields sets up potential decent returns in fixed- income markets, as the hiccup we saw this time last year provided. Corporate balance sheets are in terrific shape on both sides of the border and we see market interest rates trading in a tight range through most of 2011; therefore, credit strategies are going to be an area of focus. The secular bull market in commodities is one reason, though not the only one, why we also remain long- term positive on the outlook for Canada relative to the United States, especially with regard to the Canadian dollar.
I think it pays to focus on three interesting market developments here. First, the Canadian dollar towards the end of last year re-attained par against the U.S. dollar and I recall that when we saw this unfold in 2007 and 2008 the oil price was on its way to $145 a barrel, not $90, and this tells you that this latest leg-up in the Canadian dollar is more than just a commodity story.
Second, look at the bond market and you will see that the yield on a 2-year Canada bond trades at a 100 basis points premium relative to U.S. Treasuries, which tells you something about the relative strength of the Canadian economy. Furthermore, the 30-year Canada bond trades at a 90 basis points discount to long U.S. Treasuries, which is unprecedented. This is a huge anomaly but one that carries a very important message because the further you go out the yield curve the more the market tells you about its view of long-term fiscal and inflation risks, and again, this is being transmitted into growing global confidence in the Canadian dollar relative to the U.S. dollar. Finally, keep in mind that the Canadian dollar didn’t just rally 5½% against the U.S. dollar last year but also rallied 5½% against the basket of non-U.S. dollars, which is added confirmation that this is as much about a strong Canadian dollar story as it is a weak U.S. dollar story.