The Quarterly:

April 2017


With this commentary, we plan to communicate with you every month about our thoughts on the markets, some snap-shots of metrics, and a section on behavioural investing.


We hope you enjoy this information, and it allows you to better understand what we see going on in the market place.


“The key to money management is making a lot of money when you’re right, and minimizing when you’re wrong.” –

Stan Druckenmiller

The Numbers:



A Market at Odds


Almost all major stock markets, including the TSX, started off the year red-hot; markets rallied on promises of lower taxes, stronger GDP growth, and more infrastructure spending, with the common underlying theme being a rally suspended by optimism and rhetoric. We discussed our belief that the current market rally was driven by market optimism in our last monthly. However, for various reasons, optimism seems to have cooled recently, as all major markets have moved either sideways or slightly down since their late-February peaks, indicating a sentiment that we also believe to be true – that the market has gotten ahead of itself.


In addition to optimistic expectations, the so-called ‘Trump Bump’ rally was also driven by a massive inflow of retail investment, or, the ‘average investor’. Unfortunately, it is a typical axiom of market analysts to treat this surge in retail participation as a contrarian indicator.  Over the quarter, stock and bond ETF and Mutual Funds recorded $162 billion in net inflows, the largest quarterly inflow figure in four years. Most these purchases were funneled into general market funds tracking the performance of the S&P 500 in its entirety or a specific sector of the S&P 500.


At the same time, corporate insider sales have reached six-year highs in both February and March, which is also considered a contrarian indicator. Corporate employee stockholders sold $10 billion of stock – or $500 million worth per day –  in February, and $9.7 billion worth – or $450 million per day – in March, according to Investment Research Firm TrimTabs.


Inside the indices, the underlying businesses themselves are seeing a continued improvement in performance, albeit muted and, in many cases, below previous expectations. According to Factset, with ~5% of S&P 500 companies reporting actual results for the quarter, 74% have ‘beat’ their respective earnings per share forecasts, while 57% have ‘beat’ their sales targets. However, Factset also notes that earnings growth expectations for the index have dropped significantly in relation to forecasts which were made in December. In addition, 71% of companies who have provided earnings guidance have issued a negative forecast. It should be noted that corporate earnings have been notionally disappointing for some time, and indices have continued to climb, so these statistics are not necessarily death knells for the market.


For example, despite downward revision, a positive earnings growth result for the S&P 500 this quarter would mark the third consecutive quarter of growth, a streak not achieved since 2014. Despite this volatile slate of earnings results since 2014, the index itself has risen almost 30%. In fact, earnings of S&P 500 companies have been largely treading water since 2014, which can be seen below in Chart 1.


Chart 1



This chart shows that, despite accounting tricks and share buy-backs, ‘adjusted’ Earnings Per Share has only barely risen above its 2014 reading. In conjunction, it is also notable that earnings have been falling since the end of 2014, despite a market rally of ~18% since the peak.


In lieu of earnings, this has lead the market rally to be driven by multiple expansion, which essentially means investors have placed a higher ‘value’ on each dollar of corporate earnings. A more pessimistic verbiage would be to say the ‘cost’ of a dollar of earnings – as an investor – has increased significantly over this period. Stock valuation multiples are ephemeral concepts, with no true ‘right’ answer; however, the farther they drift from historical averages, the larger the risk of reversion to the mean. Chart 2 below shows the expansion of the S&P 500’s most commonly-quoted valuation multiple, the Price-to-Earnings ratio.


Chart 2


As can be seen, since 2014 – which was the period referenced previously – the market’s key valuation multiple has expanded by 47%, despite Earnings Per Share remaining flat. The causes of this phenomenon are hotly debated, with the key points often revolving around rock-bottom interest rates, Quantitative Easing and the lack of other viable investment vehicles.



Road to Ruin


Aside from aiding the general stock market rally, low interest rates have also been a major boon to one specific market – the auto industry.


At the depths of the Great Financial Crisis, there existed a legitimate possibility that some of America’s largest auto manufacturers – GM, Ford, and Chrysler – would not continue to exist in their current forms. This threat was extinguished, however, by an explicit bail-out from the Federal government that allowed them to survive. Slowly, these companies recovered, and with the help of zero percent interest rates, they have been able to thrive.


Since the depths of the Crisis, the auto sector has added more than 650,000 jobs, produced profits and sales increases for seven consecutive years, and rocketed total vehicle sales to more than double the level they experienced in 2009. The resurgence of the American auto sector has truly been the narrative of a decade; however, we may now be approaching its final chapter. Chart 3 below details the skyrocketing vehicle sales of the past 7 years, including a foreboding dip at present.


Chart 3


In short, the growth of vehicle sales over the past 8 years or so has been significantly aided by low interest rates and creative financing strategies.


Cheap leases and auto loans have required almost or literally zero deposit, and creative incentive schemes such as ‘no money down’ or ‘no payments for 18 months’ have enticed buyers into the market who wouldn’t have been able or willing to purchase a new vehicle otherwise. This has helped create a boom in vehicle sales, while also creating a mountain of auto loan debt, which has been packaged and sold as credit products, similar to the mortgage-backed securities which gained notoriety during the Financial Crisis. Chart 4 below visualizes the amount of new auto loan debt which was created over this period in order to create the trend illustrated in Chart 3.


Chart 4



Now, contextually, we believe it is important to note that we do not believe this to be the precursor to another financial crisis. Much of the securitized Auto Loan securities themselves are held by hedge funds, rather than individuals, and the bulk of the un-securitized auto debt is held by the finance arms of the manufacturing companies themselves. This does, however, carry significant implications towards the future of the Auto industry itself.


For example:

  • This level of accommodative financing has acted to ‘pull forward’ future demand, and has served to entice those who would have otherwise been unwilling or unable to purchase vehicles into doing so now. This means that there will be less individuals available in the future looking to purchase vehicles.
  • This surge in vehicle sales has resulted in commensurate rapid growth in manufacturing to meet demand. At cycle peak, as demand declines, this often results in building inventories. Based on corporate performance reports, this seems to be the current situation American manufacturers find themselves in.
  • The debt-fueled auto sales boom has also created an inflated used-car market, which puts downward pressure on the prices manufacturers are able to charge for new vehicles, and thus negatively affects margins.

According to TrueCar Inc., an Automotive Pricing and information website, American manufacturers are offering their most lucrative incentive packages in history, with an average value of $3,587 per vehicle. They are desperately attempting to maintain the sales growth rates experienced over the last decade, and it isn’t working. Over the first quarter of 2017, every major auto manufacturer missed sales forecasts, except for Nissan. Ford’s sales were down 7.2% year-over-year, Chrysler’s were down 5%; stated new car inventories of America’s top auto companies were at an all time highs.



In a new report, Morgan Stanley notes that, due to off-lease used car supply doubling since 2012, it is possible that used car prices could collapse by as much as 50% over the next 4-5 years. This sort of activity would be devastating to the performance of auto manufacturers, as well as their related suppliers.


The market has largely recognized the current danger of the auto market, as Ford and GM currently trade at P/E multiples of 9.8 and 5.7 trailing earnings, respectively. However, we thought that the story was important to detail as it is an example of how exuberant debt-fueled purchases can distort and harm the long-term prospects of a market structure; eventually, the chickens come home to roost.


The American auto stocks also represent an apt example of what is known as a ‘value trap’. This describes a stock which trades at a notionally low multiple, drawing the attention of bargain-hunters, who subsequently discover the stock was priced accordingly to significant risks or clearly definable performance declines. These sorts of scenarios are a needed reminder that, sometimes, stocks trade at low multiples for a reason.


Growing Pains


One of the quintessential features of economics is the existence of growth cycles; these exist within sectors, products, commodities, and entire economies. The auto sector, discussed previously, is nearing what would be known as a contraction phase. This period is often difficult for investors, constituent business, and employees, but it is also important to realize the necessity of such a phase to the long-term viability of the market itself. To explain, we would like to quickly reference the oil market.



It should come as no surprise to most Canadians when we say oil prices have collapsed in recent years. From a peak of nearly $140 a barrel in 2008, to $100 a barrel as recently as 2014, to below $30 in 2016. This volatile price action has had a significant affect on oil and gas producers, who have had to re-engineer their business models out of necessity to survive. Businesses have cut costs, increased productivity, utilized new technologies or software, and basically made every attempt to make a profit with a lower value given to their product. This is why a true ‘break-even’ figure for oil producers is difficult to arrive at, and has also been the primary driver towards oil and gas development companies severely reducing their cost structures, at times by as much as over 50%. Chart 5, created by consultancy IHS Markit, breaks down these savings by category.


Chart 5

Some of these costs – specifically installation and equipment costs – will rise again during the next boom market, as rig and vessel owners are able to charge more for their equipment; however, many of the other cost savings will remain, resulting in a leaner and more efficient structure moving forwards. Businesses do whatever it takes to survive and profit, which, in the long run, makes them better at their job. It is the optimistic silver lining to discern from any turbulent period, and serves to cushion the negativity of the prior piece on the auto industry; in the long run, pain is growth, and the consumer and investors end up long term beneficiaries of an improved entity.


Behavioural Investing: Framing, Data Mining, and Confirmation Bias


This commentary’s Behavioural section is an amalgam of many biases, some of which we have touched on in the past.


While reading a news piece, Chris MacIntosh of Capital Exploits came across a surprising headline, indicating that, apparently, living next to a busy road increases your chances of developing dementia by 12%. Startled by the figure and apparent non-sequitur, Mr. MacIntosh researched the development further. After locating the study, he found that living near a busy road, in fact, increases your chance of developing dementia to 12%, from a base rate of 11%. So, a 1% total increase or an 8.3% increase over the base-case scenario, neither of which were quoted in the original story.


A similar story emerged recently regarding bacon, with the headline proclaiming that bacon consumption increases the risk of colon cancer by 18%. In reality, the study found that eating two pieces of bacon per day would increase your chances of colorectal cancer from a base of ~5% to a rate of ~6%. An overall increase in probability of ~1%, an increase in base of about 20%. We reminisce over the package of crackers which states they have ‘50% less fat’, when they only had 2 grams of fat per serving in the first place. For context, smoking increases your chances of lung cancer by 2500%.



These stories are excellent real-world examples of common behavioural biases which affect investors and individuals. Framing is important to consider when analyzing any data, stock, or opinion. Be sure to research the context from which the data was obtained, as well as any historical or contextual trend data, in order to properly discern importance. Data mining references obsessively searching for data which confirms your initial opinion. It is vitally important in all aspects of life to actively seek out data which disagree with or challenge your beliefs, in order to strengthen your overall final viewpoint. Finally, confirmation bias, while similar to data mining, is more over-arching in respect to the other two behaviours; individuals typically perform actions which help translate to a final opinion which ostensibly justifies their initial bias or opinion. This behaviour can include data mining or framing, but is representative of an entire process of behaviours. Overall, when analyzing data sources or information, it is important to actively seek dissenting opinions, raw research, and context, in order to avoid forming or supporting these behaviours.


MacNicol & Associates Asset Management Inc. 

April 2017