How to benefit from stock market setbacks...

It has not been a good month for sure. As of last Friday, the S&P 500 is down 6% so far this month, and the S&P/TSX is about 4% down. Both indices are now almost 12% off their highest level for the year. As it stands, we are currently in a serious corretion. And, with the S&P 500 closing last Friday just below the critical 2600 support level, we feel that the market is now in need for one or two pieces of good news in order to rebound from here. Regardless of what happens next though, every market setback offers an opportunity and there are at least two things you can do to benefit from the current setback. But before we get to that, let's take a look at what happened last week.

There are reasons cited behind the current correction (or may be bear market, who knows), if that at all matters. Often when the market wants to fall (or rise), it looks for any reason to do so. Still, the ones cited for the ongoing weakness are at least three:

First: shrinking liquidity. The US Federal Reserve continues to raise interest rates, with at least one more raise expected this week (the market seems to be pricing in at least one more raise next year; some even predict a third one from by the middle of 2019). At home, The Bank of Canada seems to have temporarily stalled its tightening cycle for at least one round, but could very well resume it if economic growth prospects improve. More importantly, the US Federal Reserve continues to normalize its balance sheet, by re-selling bonds and other financial assets in the open market, thus sucking significant amounts of liquidity. In Europe, the ECB has re-confirmed the end of its quantitative easing program this month, which will also deprive the market from an important source of liquidity.

We have always argued that shrinking liquidity would be a game changer. Back in June, as part of our update on The end of quantitative easing and what it means to the market" we outlined in detail how quantitative easing worked, and tried to quantify the amount of liquidity injected by each central bank, just to give a sense of magnitude of what we would be missing come next January (versus 2016).

Second: late cycle issues: the US economic boom, and with it the bull market, have had a good run and there are ligitimate concerns that we are approaching the end of the cycle. Although there is nothing to indicate that US growth is weakening, news from China and Europe came out quite negative last week. That was compounded by specific company news such as Johnson and Johnson dropping more than 10%, Costco missing on earnings estimates and Apple iPhone sales estimates in China being slashed. All that converged to cause a 2% drop in US equities on Friday. Just as we thought that the market was forming a base within a certain trading range, with the S&P 500 forming a crititcal support point at 2600, the market closed just below that support line!

third, trade war rhetoric: enough is being said about that, but whatever the outcome will be, this is going to be a tortuous road with lots of bumps on the way, even if an agreement is eventually reached.

Where do we go from here? As we said, the market now probably needs some good news in order to rebound. But regardless of where it goes next week, there is a couple of silver linings within all of this negativity. One, the market is selling off, but it is doing so on normal, if not slightly below average volume. In other words, while the sell off is significant in magnitude, it is not heavy in terms of volume, and that could be a positive. What's happening is somewhat reminiscent to what happened in other Decembers (e.g. 1987 or more recently 2016), when sell off on relatively moderate volume in December was followed by a massive rally in the following year.

The other silver lining is valuation: the combination of lower equity prices and better earnings has now resulted in much more reasonable valuation metrics. Based on forecasted earnings of 178 for 2019, the S&P 500 is now trading at a forward P/E ratio of less than 15, which is not outrageous. Aside from a handful of technology stocks, most equity sectors are now trading at even lower multiples, which raises hopes that any further downside would at least be contained. For Canada, we discussed equity valuation in detail as part of our last week update.

The third silver lining is credit pricing. Last week, junk bonds closed slightly higher, which could be a sign that credit investors are diverging from equity investors. Equities and high yield bonds often move in tandem so such divergence, if it continues could signal that the credit market sell off is tapering, and that in itself could be a precursor to an equity rally. Fingers crossed.

Back in May this year, we wrote an update entitled: "Five things to do in preparation for the next bear market". We encourage you to review that note, because we continue to stand by the five things we said back then, even though we've already had a 12% correction. But if you feel there is more to do to benefit from this setback, here are two things to consider:

First, tax losses: following a drop of this magnitude, you may well have a couple of losers in your portfolio. There is nothing wrong with that. It happens to the best investors, and the damage ought to be limited as long as you never bet the farm on any single investment, and as long as you look at your results on a portfolio basis, not in terms of individual holdings. So if you hold any of your losers outside a tax sheltered account (higher risk or volatile investments should always be held there), now is a good time to sell you losers and realize a tax loss. However, this suggestion comes with a major, major caveat. Please read on....

Sellig when the market is down is never a good idea. So if you ever want to realize a capital loss for tax purposes, you need to replace the investment you sell with something similar, otherwise you would be converting a temporary loss into a permanent one. This is where one has to be careful. CRA has strict rules about "superficial losses". If you sell something at loss and buy it again within a month, CRA will consider that a "superficial loss" and will deny you the advantage of applying it against capital gains. Thus to realize the capital loss benefit, you need to replace the fund you sell with one that is very similar, but not exactly identical. In otherwords, you replace your losing fund with one that belongs to the same category, which has similar, or quasi- similar holdings.

In addition to the ability to scrutinize fund holdings, FundScope offers two fantastic (and very exclusive) tools for managing capital gains taxes. The first one is the ability to rank funds based on their sector holdings. So if you sold a fund that has high exposure to certain sectors, and you would like to find alternatives with similar exposures, you can rank your funds based on their exposure to your sector(s) of choice. The other tool is similarity analysis. This tool calculates the correlation factor between different funds (up to 30 funds in one porftfolio) and can show you, based on historical behaviour, which funds are similar. With your advisor's help, you can use our tools to identify which funds are most similar to the one you want to sell. If you replace your fund with a similar one, you can realize your tax loss while staying fully invested. In other words, you can eat your cake and keep it.

The other thing you can do to benefit from this setback is to buy more equities. Stock market corrections, or bear markets, are like goods going on sale. They offer you an opportunity to buy good investments at a cheaper price. Again, this is a very delicate operation that requires a lot of courage but also an extremely long-term oriented approach. This is not about timing the market or catching the next rally. It is meant to capitalize on an opportunity to rebalance your portfolio and load up on sound investmens at a cheaper price, for the long term. You may not get it at the bottom of the cycle (you rarely will) and your purchase may very well be followed by further market setbacks, so you have to be prepared for that. Most importantly, you need to stick to the golden rule of never biting more than what you can chew. In other words, never buy equities with money that you might need in the short term. That said, at today's prices, there are some interesting opportunities. Canadian banks are trading at attractive yields of 4% or higher and so are utilities and pipeline companies. Some insurance companies are trading at yields of 6% or higher, and so are some foreign oil majors. So here you have a golden opportunity to load up on high yielding equities to boost your dividend income. For that, we strongly urge you to work closely with a profession al advisor, to determine which funds or companies to choose, based on your risk tolerance and individual circumastances. We can only offer you the tools to do it properly, but the final decision is yours to make, in conjunction with your advisor.

Finally, remember one thing: markets are getting choppier but there is nothing new or surprising here. Market jitters are normal and nothing goes up or down in a straight line. The only thing that matters is to be prepared for such normal jitters and to have the financial ability and the moral acumen (e.g. patience, courage and confidence) to wait for the market to rebound. It always does.

December 17, 2018

