October 2017


With this commentary, we plan to communicate with you every quarter about our thoughts on the markets, some snap-shots of metrics, a section on behavioural investing and finally an update on some of the people at MacNicol & Associates Asset Management (MAAM). I hope you enjoy this information, and it allows you to better understand what we see going on in the market place.


“Psychologists tell us that in order to learn from experience, two ingredients are necessary: frequent practice and immediate feedback.”                                                                                                   

–  Richard Thaler

The Numbers:

Melt Up

Investopedia has got to be one of our all-time favorite websites. Don’t have the slightest clue what a vague or new fandangled investment term means? No sweat. Investopedia’s website has you covered. This quarter, one term stood out to us more than any other: “melt up”. So, what exactly does melt up mean?

According to Investopedia a melt up is:

“A dramatic and unexpected improvement in the investment performance of an asset class driven partly by a stampede of investors who don’t want to miss out on its rise rather than by fundamental improvements in the economy. Gains created by a melt up are considered an unreliable indication of the direction the market is ultimately headed, and melt ups often precede melt downs”.

We would argue that given all the worry in the world, the definition for melt up should be amended. Specifically, we believe Investopedia might want to delete “partly” and supplant it with “mainly”. Between Catalan President Puigdemont’s refusal to clarify whether Catalonia has or hasn’t declared independence from Spain, the escalating conflict between Baghdad and Erbil, President Trump’s mixed gibberish on tax reform and healthcare, debt ceiling issues [remember this one], disdain over Federal tax proposals against small business owners here in Canada or North Korea’s insistence that diplomacy is the furthest thing on its mind, investors had a lot to worry about this quarter. While the 3rd quarter came to a conclusion on September 30th, October’s notoriety for one of history’s all-time great stock market plunges was something experienced investors were not oblivious to.

But you wouldn’t know it by flipping back to the lower right-hand table on the first page. To be clear, certain financial market observers are troubled by the daily new record highs in markets and a palpable absence of conviction in things like breadth and volume. Ultimately, for now though, the path of least resistance continues to be higher.

Jeff Saut of Raymond James believes the secular bull market still has years left to run. We don’t know what to make of the idea that the present bull market lasts another 7, 8 or 9 years, though we are big, big fans of Jeff Saut. It is important to separate the length of a secular bull run from the percent gains earned during a secular bull run. It is also important to understand the phases of a bull market. Bull markets have three phases: accumulation, mark-up and blow off (“mania”).  The main difference between phases 2 and 3 is the improvement in earnings for which the former is known. Phase 3 is associated with herd mentality, certain stocks taking on an almost biblical level of importance and your obnoxious brother-in law reminding you what a great stock picker he is. But individual phases of secular bull markets are not always cleanly separated. It would certainly be great if they were, but it doesn’t work like that. In the past 100 years investors have experienced a couple of secular bull runs.

The bull market of 1921-to-1929 was one in which a clear distinction between the three phases was obvious. The initial accumulation phase was met with skepticism yet marched onwards and upwards. A 7-month corrective bear market provided the transition between phase 1 and the phase 2 mark-up. In June of 1924 the market re-tested its previous low signaling that “the coast was clear” and that investors could re-enter the market, which set the stage for the roughly 40-month long mark up phase. The “blow off” phase of the 1929-1934 bull market occurred in two sub-phases from July-to-December of 1928 and then again from July of 1929 until the crash in October.

The bull market of 1949-to-1960 was different. In 1949 no one really cared much for the stock market. Sentiment was poor and daily trading volumes were low as many investors expected a lengthy post-war depression. This overt pessimism ended up setting the stage for one of the great bull markets of the last 100 years. Markets back then certainly climbed a “wall of worry”. History buffs will doubtless recall many of the shocks in those days such as the numerous recessions & Wars, Korea, Suez [Tripartite Aggression], Lebanon, Eisenhower’s heart attack and others black swan events of the day. In early 1956, the market would appear to have peaked out topping in April and August [and then once more in July of 1957] ahead of a severe secondary reaction bear market that lasted from August of 1957 until well into October. This bear was particularly ornery and convinced many investors that the bull market was over. However, the market did not yet show signs of phase 3. Those who bought on the dip in late 1957 we richly rewarded.

The last bull market ran from August of 1982 until 2000. Back in August of 1982 you couldn’t give stocks to investors, they were scared stiff. The powerful accumulation phase in this bull market was the reason behind the strength of its mark up run [phase 2] in which 3 full years went by without a 10% correction. Not having a 10% correction is such a lengthy period of time is all well and good, but it breeds complacency and sets the stage for a market to correction all at once which took place on Black Monday in October of 1987. Following Black Monday, the only notable pull back in markets came in late 1990 when Sadam Hussein invaded Kuwait, though markets recovered quickly as investors began discounting a quick victory early on. From 1991 until the end of 1995 markets moved gradually higher. This marked the 13th year of the secular bull run but also a change in the nature and scope of the bull’s temperament. Beginning mid way through 1996 the market began rising at an accelerated pace.
In his speech to the American Enterprise Institute in December of 1996 then US Fed Boss Alan Greenspan made the following statement:

“Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade”?

“Irrational exuberance” can actually be traced to Yale University Professor Robert Shiller [who was reportedly Greenspan’s source for the term] but the implication of the comment was that markets might be overvalued. Nevertheless, markets roared higher fueled primarily by the dot.com mania of the late 1990s. Back in those days not investing in high flying tech stocks didn’t make you foolish it made you an infidel. And investors continued to pile into tech stocks they knew nothing about. The markets continued higher following a brief pause caused by the collapse of hedge fund Long-Term Capital Management [LTCM]. LTCM lost $4.6 billion in less than four months in 1998 following the Asian Financial Crisis and Russian Ruble Crisis, and required a Fed bailout that included the participation of 16 other major global financial institutions. Though concerned about market valuations a year earlier, the notion that the Fed would “rescue” a troubled Hedge Fund in Greenwich, Connecticut helped fuel greater risk taking and moral hazard. The peak of this bull is generally regarded as the merger by AOL and Time Warner. Manic moral hazard punctuated phase 3 of the 1982-2000 secular bull run with a blow off that blew up when many companies like Pets.com failed completely and shut down. Other companies, like Cisco Systems, saw their stocks decline by 86%.

Returning to the issue at hand: is the present bull market we are in set to stampede higher or will it be slain in the very near future? Recent market action does provide some data points. Earlier, the S&P500 set a record for consecutive days of RSI [relative strength index] a measure of momentum. Typically, after over extended periods markets sell off.

But looking at the situation more holistically, one must ask what are the 5 key areas of concern for a bull market? They would not necessarily be things like North Korea or The President’s tweets or Catalonian secession vote. Those things are news and more event-driven risk factors. Rather, pay close attention to unemployment, inflation, the yield curve, ISM data and valuations.

Rising unemployment tends to be a good indicator of a looming recession: unemployment has risen prior to every post-war recession in the US. But it’s really the combination of low unemployment and high valuations that tends to precipitate negative returns. Rising inflation has been an important contributor in past recessions and, by association, bear markets because rising inflation tends to tighten monetary policy. We are not sure what to make of inflation. On the one hand, if you live in Toronto, life sure “feels” expensive even though most of us are not surrounded by “nice things”. On the other hand, market observers will note frustration on the part of Central Bankers at achieving mandated inflation targets. This is a challenge for future Monetary Policy and markets since we have inflation, yet we don’t. Related to the point about inflation, tighter monetary policy often leads to a flattening or even an inverted yield curve. Since many, although by no means all, bear markets are preceded by periods of tightening monetary policy, we also find that flat yield curves, prior to inversion, are also followed by low returns or bear markets. Typically, very high levels of momentum indicators, such as the ISM and PMIs [Institute of Supply Management and Purchasing Managers Indexes] tend to be followed by lower returns when the pace of growth starts to moderate.  The highest returns are when the ISM is low but recovering, while the lowest are when it is low and deteriorating. High valuations are a feature of most bear market periods. Valuation on its own is rarely the trigger for a market fall – often valuations can be high for a long period of time before a correction or bear market [as we commented on earlier]. But when other fundamental factors combine with valuation as a trigger, bear market risks are elevated.

The MAAM investment team has a proven, long-term track record. We continue to believe that market valuations are elevated, though may continue to be so for the foreseeable future. A “highlight reel” market crash so universally telegraphed by investors rarely makes it to the highlight reel. More importantly, rather that fretting over whether the next bear is lurking around the corner, or whether the bull run continues onwards, we feel that the best solution for today’s investor is a diversified, client centric approach. At MAAM, equities selected carefully with an eye towards intrinsic value and alternative investments will continue to provide client portfolios with important diversification when conventional markets correct. Our key mandate at MAAM is to ensure our clients can hopefully afford their lifestyle and that means taking advantage of the melt up and avoiding the melt down.


The Endowment Effect

In behavioral finance the endowment effect describes a circumstance in which an individual values something which they already own more than something which they do not yet own. The endowment effect was revealed by Nobel Prize winning Economist Richard Thaler [more on Prof. Thaler shortly] shows that investors tend to stick with certain assets because of familiarity & comfort, even if they are inappropriate or become unprofitable. The endowment effect is an example of an emotional bias. In practice, the endowment effect is one of the most pervasive errors investors make, and one of the costliest. The endowment effect centers on fear and afflicts successful stock pickers. My own father in law is a prime example. He buys a stock at $20, expecting it to go to $50. The stock reaches $44 or $45 swiftly, and then stalls out a bit, what portfolio managers refer to as consolidation. But he cannot bear to sell until the stock has gained its “full” value [in his mind].

The fear of embarrassment, of not getting full value for a good investment, fools even talented stock pickers into allocating too much capital in what has become “dead money”, when their skills would be far better put to work finding new stocks to buy. Recall that inflation, high or low, is a sort of pervasive destroyer of capital, overvaluing one’s winners does little to combat its deleterious affects.

Working with a registered Portfolio Manager is not your “in” to a world of clairvoyant, know-it-alls. We’re just regular people who have a passion for investing, but know that to do it successfully you need to take emotion off the table. If you or someone you know wants more information on how working with a registered Portfolio Manager can help you take the emotion out of your investing plan, call us today at (416) 367-3040 or visit our website at www.macnicolasset.com.


“That makes three of you…”

What is so amusing?

A short time ago, I was speaking with my 73-year old father. I often table political or quasi political questions to my father because I find his experience valuable. My father has also been retired for several years now and tends to tell it like it is, and yes that is a euphemism. My question to my father was this “Dad, I have to be honest, I do not I understand what Mr. Trudeau and Mr. Morneau are hoping to achieve by tinkering with the Income Tax Act”, to which my dad replied, “That makes three of you son”. At MAAM we don’t claim to be tax experts at all. In fact, we suggest you get tax advice from a competent tax professional that suits your needs and budget. Don’t have one? We can introduce you to many trusted tax partners we know. But some general comments one what is going on are timely.

That Mr. Trudeau and Mr. Morneau would consider making it more difficult [and expensive] to transition businesses from one generation to the next and alter the way passive income is taxed are indeed very touchy subjects for many Canadians. For a business owner to pay a family member that is not actively involved in the business is one thing. But extracting money from a corporation through a dividend payable to family members in a lower tax bracket was and is a huge benefit to those business owners who have that ability. Taxation of passive investment income was also “huge”. The government wants to prevent cash from being hoarded and contends is not being reinvested into the businesses or the economy. We will all know the official tag line from Ottawa soon enough. But the moral of the story is this: in some cases, the Government’s proposals would change tax legislation that has been in place for 50 years.

That’s a pretty big deal and so we hope these revisions were thoroughly thought out.


Richard Thaler

Richard Thaler is a famed Economist known for his work in the field of behavioral economics. Earlier in the month of October Thaler won the Nobel Prize in Economics for ‘incorporating psychologically realistic assumptions into analyses of economic decision-making’. By exploring the consequences of limited rationality, social preferences, and lack of self-control, he has shown how these human traits systematically affect individual decisions as well as market outcomes. Anecdotally Thaler is known as the “nudge” Economist. Thaler and co-author Cass Sunstein wrote a book called Nudge and defined it as a choice “that alters people’s behavior in a predictable way without forbidding any options or significantly changing their economic incentives.”

Gord Downie [6 February 1964 – 17 October 2017]

The MAAM family is extremely sad to have learned of the passing of Tragically Hip Frontman and Canadian rock icon Gord Downie. Disclosure is a big part of the investment business and we have no problem disclosing ourselves as big-time fans of Gord and “The Hip”. Gord was one of rock music’s greatest stars and he left a lasting, indelible mark on us and millions of fans. A Poet of our generation and far too young to have left us at age 53. He will be greatly missed.

Firm News: MAAM turns 17


MacNicol & Associates Asset Management recently celebrated its 17th Anniversary. We would like to take this opportunity to thank our dedicated staff, trusted partners and especially our valued clients for all their support.

Happy Halloween!

MacNicol & Associates Asset Management Inc. 


October 2017