The purpose of this quarterly commentary is to communicate with you about our thoughts on the markets, provide some snap-shots of market metrics, and provide an overview of topical issues; however, it will also be married with some aspects of our recently initiated monthly commentary, in order to provide you with a succinct update of our views on the market, without the need for two separate communications.  I hope you enjoy this information, and that it allows you to better understand what we see going on in the market place.

“Alpha is not generated from being up more, but mathematically from being down less. The vast majority of outperformance over time comes from missing large downdrafts in equities.” – Michael A. Gayed

At the onset of 2014, general market consensus was to expect a continuation of the environment experienced for the majority of 2013. Economic growth would likely remain subdued, as well as inflation; the U.S. would remain the center of attention, and Quantitative Easing (QE) would still be around for the majority of the year, likely keeping volatility in check. Despite the mundane market outlook, however, the end of the QE program in October was viewed as a potential catalyst for erratic market activity, with few analysts positing arguments with any conviction as to how they believed the market would react. This general consensus proved fairly correct for the first three quarters of the year, with the fourth quarter proving to be much more tumultuous.



The previous chart shows both the fourth quarter and full-year return for all major Canadian and U.S. indices in 2014, as well as oil prices. With the exception of the venture, all major markets were able to squeak out further gains on the year, however, the manner in which these returns were achieved were a far cry from a straight line.  Oil prices fell dramatically – almost by half – over the fourth quarter, resulting in a rout on oil and gas equities. Due to our skepticism regarding the industry leading into the second half of 2014, we were relatively underweight this sector, and therefore able to shield our clients from the brunt of this decline. For more information on the developing situation in the oil and gas sector, see our comments later in the letter.

While volatility – as measured by the VIX – was relatively subdued for the first three quarters of the year, rapidly falling oil prices, slowing global growth, and the conclusion of the QE program proved enough to re-introduce volatility to the market. The VIX peaked at 26.25 during the quarter, and reached points above 20 four times. For context, over the previous three quarters of the year, the VIX reached levels above 20 only once. This quarter also included two pull-backs to the S&P 500 of over 5%, although subsequent rallies allowed the index to re-gain its losses in a timely fashion.

Prevailing ambiguity, slow growth and end-of-year volatility resulted in typically defensive sectors performing the best over 2014. Utilities, Healthcare and Consumer Staples were the top performing sectors in the U.S., as investors funneled funds into ‘safe’ equities and chased dividends as treasury rates fell even further.

As stated previously, one of the major reasons for the spike in market volatility was a crash in global oil prices. This is an issue which is of paramount importance to the Canadian economy, and stands to remain an integral aspect of the economic environment moving forward. Below is an overall description of what is driving oil prices downwards, and implications moving forward.

Oil: Fueling the Volatility

Without a doubt, the most important story of the last six months has been collapsing oil prices, with the price of WTI oil falling over 50% from a high of $110 in July 2014, to a current price of under $50 a barrel. One of the primary effects of this price movement has been a crash in energy-related equity prices, leading many investors to wonder where the bottom is. At some point in time, there will be massive amounts of money to be made on a rebound in oil prices, however, nobody wishes to jump in too early and attempt to ‘catch a falling knife’.  In order to form our own personal plan of attack regarding the oil sector, it is our belief that the first important step is to gain an understanding of what is causing the current situation; in order for any sustainable recovery to occur, it seems likely that  at least some of these trends must reverse.

The primary driving force is an imbalance of supply versus demand. Currently, there is much more global supply of oil than there is demand. Previously, oil prices remained high as strong demand from countries such as China served to outpace growth in supply, and turmoil in the Middle East constrained output from that region.

However, high oil prices and newly created ‘fracking’ technology fostered a boom in oil production in the U.S., while at the same time, European economies showed weakness, China’s growth slowed, and some Middle Eastern countries started to increase their oil exports. During 2014, it became clear that global supply was surging strongly at a time when global growth – and therefore energy demand – was slowing, and prices started to collapse.  The chart below, obtained from the International Energy Agency, shows how demand and supply began to diverge in 2014. The bar chart represents the amount of excess supply, essentially.


Due to global over-supply and falling prices, all eyes turned to OPEC, the world’s largest oil cartel, as many expected them to cut their supply in order to support prices. As several of OPEC member countries rely heavily on oil revenue, a cut in production was somewhat expected, however, the organization announced during a November meeting that they would maintain their current production levels. This was a signal to the market that the over-supply would persist, which led to an increasingly steeper decline in oil prices. This maintenance of production levels has been viewed by some as a direct attempt to pressure U.S. fracking producers and gain global market share as the Americans scale back their production.  In addition, it has also been put forth that Saudi Arabia wishes to keep prices low to pressure Iran and Russia, who derive most of their fiscal revenue from oil exports as well, but have much higher costs than the Saudis.

Moving Forward:

The recent movement in oil prices is vitally important to analyze and understand due to the integral role the commodity plays within the global economy. Although lower energy prices have squeezed energy equities as of late, it also translates into lower gasoline prices and therefore savings for consumers and also certain industries such as industrials and transportation stocks.  The net effect of these two movements will be the primary trend to monitor moving forward, and will largely determine the economic environment in 2015.

It goes without saying that low oil prices will have a negative effect on oil producing companies.  The issue is, however, that nobody knows exactly how much trouble this will cause.  Due to receiving less money for their product, some producers will likely slow production and cut capital spending, hamstringing future growth. That being said, many of these companies are fairly highly leveraged with debt, and will need to keep the pumps going in order to make their debt payments. Many of these companies have taken out high yield debt with local banks, and any debt servicing issues that may arise from this low price environment would cause a contagious reaction in the U.S. economy.

On the positive side of the development, for once, are consumers, who are currently experiencing the lowest retail gasoline prices since 2009.


The Energy Information Administration (EIA) estimates that U.S. drivers will spend about $550 less on gasoline in 2015 than they did in 2014, assuming prices remain low. The hope, from an economic standpoint, is that this additional money will end up being spent, which will have a positive effect on the U.S. economy. Since 70% of U.S. GDP is driven by consumer spending, this extra $550 per citizen is not an immaterial amount.

It is difficult to predict whether the positive economic effect of retail savings will trump the negative effect on oil companies in 2015, as the development is complex and most analysts are issuing conflicting opinions. For this reason, we are preparing to remain actively informed on the developments, in order to stay ahead of the trend. In order to do so, we recently enlisted the help of Martin Roberge, the Managing Director of North American Portfolio Strategy for Canaccord Genuity Corp.

Regarding the recent move in oil prices, Mr. Roberge believes that the depression of prices will result in a net positive effect on the global economy. In short, he believes that these lower prices allow for a lower level of risk in regard to areas such as China, India, the Eurozone and Japan, who are currently all undergoing economic uncertainties in their own right, and are all also among the top oil importers in the world. This means that they will be paying much less for one of their largest imports, hopefully improving their government fiscal budget. With an improving fiscal situation in troubled nations, it is hoped that international investors will be able to invest their money with increased confidence, and be less concerned about any economic collapse in these areas.

In terms of the actual companies which produce oil, Mr. Roberge shares our mandate of caution, and recommends keeping a ‘shopping list’ of companies which would be attractive buy candidates once the environment changes. In order to monitor the market, Martin recommends two primary areas of focus: the current price of oil, and the number of drilling rigs currently operational.

The first aspect of analysis is fairly straight forward, as it is quite obvious that the price level of oil must be monitored constantly. One nuance which is important to note however, is how correlated the movement of oil prices and the market are. This is especially true for the Canadian market. Over the fourth quarter, the sharp slide in oil prices sent oil stocks plunging across the board, and rightly so. Volatility in all oil-sensitive sectors has continued ever since, as market participants jump at every move in either direction, attempting to gamble on either higher or lower prices. This type of activity is a symptom of oil prices being the headline attraction at the moment, and will likely continue to result in high volatility within the oil and gas sector for the near term. Once small fluctuations in oil prices result in less volatile activity in the equities, we will be less worried about this phenomenon.

The other indicator that Mr. Roberge suggests monitoring is the international level of oil rigs currently operational. The logic here is simple, and draws on the previous idea that the global economy is currently over-supplied with oil; the more rigs operational, the more likely there will be persistent over-supply and therefore downward pressure on prices. Once oil rigs reach a period where they are stabilizing, we would be more comfortable jumping into oil and gas stocks, and more comfortable in the stability of oil prices. Below is a chart, taken from Raymond James’ commentary, which displays the historical growth of oil rigs in operation.

The red lines simply illustrate the periods in time where rig counts fell at least 15%. As you can see by the end of the chart, although rig counts have already fell over 15%, they still have a long way that they could possibly fall before returning to any historically reasonable level. We believe that this will be an incredibly useful indicator to monitor, and will assist us in entering into the oil and gas names at a safe, informed level with high future prospects.


The Golden Rule:

Although we have touched on it many times in the past, we thought that today’s volatile markets have provided a telling example of gold’s role in the portfolio as insurance. As stated previously, the recent plunge in oil prices has resulted in a significant correction in many markets, as well as a decent level of volatility. One sector which has flourished thus far, however, is gold.

The gold sector has been much maligned over the past few years, as dropping bullion prices resulted in the abandonment of the sector’s equities in the eyes of investors. In conjunction, traditional equity markets were taking off with strong rallies, leaving little interest in gold investments.

From this previous observance, together with recent outperformance, it is easy to see how an allocation to precious metals serves as insurance; it tends to have a negative correlation with traditional equity markets. Despite reigning volatility and turmoil in traditional equity markets, gold equities have outperformed lately, and we believe this to be a perfect illustration of its value in a portfolio. The chart on the top of the next page shows the year-to-date returns for several industries.


This chart shows that, although many equity groups have underperformed as of late, gold and silver equities have rallied almost 18%. This typically negative correlation, in our opinion, is an important aspect to have when building a portfolio aimed to minimize volatility.


Behavioural Bias: Cutting Your Losses, and Letting Your Profits Run

When investing in an uncertain market, such as the energy sector currently, it is important to remember to cut your losses early and to let your profits run. This is a behavioural investing concept which is firmly rooted in value investing. If your investment thesis remains intact, and the stock is going up, there is little reason for a long-term investor to liquidate his or her position. This does not mean that they should not consider taking profits, but remaining invested in the company is important. On the flip side, if the company continues to perform or execute poorly, and this has materially affected your investment thesis in a negative manner, then you should cut the stock loose.

Everybody has fallen victim to either side of this dilemma at some point in their career, and legendary investor Warren Buffet is no exception. In 1966, he bought a significant amount of Disney, which at the time was trading at a deep discount and had numerous rides near completion. He bought in at $0.31, and the stock currently trades around $66. This could have been the pundit’s most successful trade of all time; however, he took profits early and sold out at $0.48 in 1967.

There are a few traditional mindsets that typically cause investors to fall victim to this phenomenon:

  • The belief that the stock ‘always’ bounces back. Indexes typically do, in the long-run, but this same logic should not be applied to individual stocks.
  • Investors do not like admitting they made a mistake.

Listed below are a few ideas to consider regarding how to avoid this pitfall:

  • “Hope is not a strategy”; you need a logical reason to hold on to a losing position.
  • What you paid for the stock is irrelevant to its future direction.
  • Set boundaries and criteria for when to buy a stock, but also for when to sell it.


MacNicol & Associates Asset Management Inc. January 2015