Canada’s main stock index slipped on the last trading day of 2017 as some energy and mining stocks pulled back, but the index notched a 6% gain for the year, underperforming the three main U.S. indexes as its large energy component dragged.on the Canadian market.   Other key global indices surged higher throughout 2017 as continued low interest rates and growing belief in the global economic recovery supported the view that earnings will continue to grow in 2018.  The biggest winners were outside of North America though as global stocks gained over 21%, led by a sharp recovery in emerging markets. Not since 1993, when most Asian markets nearly doubled, have the region’s stocks had a better year. The MSCI Asia Index surged 47%, compared with 20% for the S&P 500 index, and 29% for the MSCI Emerging Markets Index.  Stocks have been on a tear going back to Election Day, reflecting investors’ optimism over the U.S. economy, tax cuts and the broader Trump agenda.  The Dow had its strongest first year post-Election Day since 1945, soaring over 25%.  Based on the Wilshire 5000, U.S. stocks have gained approximately $6.6 trillion in value since Trump’s victory.

Synchronized global recovery helped lift Asia, where gross-domestic-product growth surprised to the upside along with growth in trade, a particular boon for the export-dependent region. That helped lift Asian currencies, enabling investors and non-dollar indexes to benefit from foreign-exchange gains on top of their capital gains. A year ago, we were faced with huge uncertainties on the political and economic front, but corporate earnings gained by 23% in 2017, meaning that despite surging share prices, Asian stocks are still reasonably priced at 13.5 times 2018 estimated earnings. That bodes well for 2018.

Commodity prices also recovered in the 2nd half of 2017, helped both by global economic strength and a weaker U.S dollar, which had its worst year since 2003 despite repeated increases in interest rates by the U.S. Federal Reserve.  U.S. oil prices closed above $60 a barrel on the final trading day of the year, the first time since mid-2015, as the commodity ended 2017 with a 12 per cent gain spurred by strong demand and declining global inventories.  International benchmark Brent crude futures ended the year with a 17 per cent rise, supported by ongoing supply cuts by top producers OPEC and Russia as well as strong demand from China.

Copper markets were also strong in 2017, with the commodity rising over 33% on stronger global demand, some supply outages and optimism about a substantial new market in copper for its use in electric vehicles.  While adoption of electric vehicles, or EVs, is minimal to date, that could change quickly.  If EVs replace fossil-fuel vehicles at the expected rate, then a decade from now, 30% of vehicles will be electric, according to a recent analysis from the International Monetary Fund. By the early 2040s, more than 90% of cars and trucks would be EVs.

The passage of the tax bill in the US has increased that optimism as companies now see themselves generating higher profits on a lower tax rate.   The big question remains as to whether they will use this windfall to increase capital spending and hiring or whether they will continue to plow the excess funds into share buybacks.  The surge in stocks this past year was fueled by an increase in the purchase of ‘index funds’ by individual investors.  Stock picking has become far less important than the decision of how much to haave in stocks at any one time.  The chart below shows that $1.5 trillion of investor funds have gone into passive investments (index funds) in the past 15 years while over $1 trillion has moved away from active (stock picking) funds.   The big risk of course is we have no idea how committed those passive funds are to the market if and when we finally get a downturn in the market.  Since a lot of passive investing is based on quantitative strategies, which doesn’t use an active decision maker, we could see widespread redemptions of these funds if markets start to go lower.  The ability of the market to absorb large redemptions in index funds could strain the liquidity of the stock market.   No matter how we look at it, it is a substantial unknown new risk without any proven history.

Investor Fund Flows: 2002-2017
Passive vs Active Fund Flows

Seventy per cent of the global growth acceleration in 2017 is owed to a rebound in the commodity cycle. Because the rebound was concentrated in commodities, it helps explain why manufacturing sectors only partially participated in the rebound, and why import volumes in developed markets have not kept pace with the headline GDP growth improvement. Almost all of the bounce-back in US investment in 2017 appears due to the recovery in the oil sector and oil rigs coming back on line. In other words, excluding energy, there was no acceleration in US growth this year, and a significant rotation towards non-energy investment is required to sustain those growth rates. Although this pivot hasn’t happened yet, surveys suggest it will, but they have materially diverged from manufacturing output three times in the last seven years. The U.S., thanks to shale’s recovery, contributed 20% to the global growth acceleration this year.  China was a major driver of the rally in global trade this year (accounting for about 30% of the improvement in global import volumes) as the recovery in its property sector spurred stronger imports, not just of housing materials but also of all ancillary products (cars, white goods etc.). That property sector is now slowing sharply, however, and floor space sales have dropped from an average of 21% in the fourth quarter.

What to expect in 2018

Almost all stock market professionals, ourselves included, underestimated the strength in stock markets in 2017.  Positive money flows, optimism about the potential benefits of the Trump agenda, a strong pickup in global economic growth and a total lack of fear from investors about the geo-political and other risks all lead to an uninterrupted rise in global stock prices unlike anything we had seen since the market lows back in 2009.  While the global economy has clearly established strong momentum, the stock market has not had a serious correction in over six years, far longer than average and the longest uptrend since the 1990s.  However, stock volatility is at record lows while valuations remain at the upper end of historical levels.   While those facts alone don’t mean a pullback is imminent, the risks have clearly increased.   The other headwind that markets face in 2018 is the fact that global interest rates have started rising again after being at record low levels for most of the past eight years.  The market’s relatively high valuation isn’t enough to turn bearish. A strong global economy in 2018 is good news for Corporate America. Tax cuts will help the bottom line of domestically focused companies. I’m not a bear, but cryptocurrency trading looks like the leading edge of euphoria.

Rather than the top, mass public stock buying seems a signal that the bull market is securely in the exhilaration stage. The despair of March 2009 has come almost 180 degrees, passing through relief, hope, optimism, and now exhilaration. Next and last stop: euphoria.Since those low interest rates were one of the key reasons we have seen such a flood of money into financial assets, rising rates could put those flows at risk.   The logical trade for 2018, in our view, is a shift into the stocks that benefit from stronger global growth and are less at risk from a period of rising rates.   That group is the cyclical/resource sector, which has actually been a market laggard since 2011.  We have added to positions in the basic materials sector (particularly the copper stocks), energy (oil prices have recovered to over US$60 per barrel), industrials with global exposure, large technology and financials (which will benefit from higher interest rates).  We are avoiding the interest sensitive sectors such as utilities, consumer staples and REITs as they have all been the prime beneficiaries of the low interest rates over the past six years.

We wrote last month about the mania in cryptocurrencies (i.e. Bitcoin), how irrational it was and how we expected it to come to a sharp and ugly end at some point, probably sooner than later.   We saw a bit of that in late December as Bitcoin fell by over 40% in one week.  Unlike a stock, bond, or real estate, a cryptocurrency has no intrinsic value, with no cash flow or future streams of income. The value is simply what the next buyer is willing to pay, otherwise known as the greater fool theory. This isn’t investing. It’s speculation. Most investors aren’t nimble enough to avoid a battering.  The real risk is regulatory. Governments around the world will gradually see the cryptocurrencies as a threat to their fiat currencies and policies. Which government will stand by as untaxed money flows out of its country under its very nose?  It’s not hard to imagine the U.S. government telling banks they cannot transact business in such currencies.  Last week, the Securities and Exchange Commission halted trading in the Crypto Co. (CRCW), pending an investigation of “potentially manipulative transactions.”

Fairfax & Torstar

Fairfax Financial Holdings Ltd. has paid nearly $11.8-million to increase its holding of Torstar Corp.’s non-voting shares to 40.6%  Torstar is the owner of the Toronto Star, the Metroland group of newspapers and other digital and print media businesses.  Fairfax says it acquired the shares for investment purposes but, in future, it may discuss transactions with management or the company’s board of directors.  The company has gradually increased its stake over the recent years. Prior to the most recent transaction, it owned 27.3 per cent of the media company’s non-voting shares

What does the company see in Torstar that they like?  Probably the same thing as we do!  The valuation is ridiculously low and basically attributes a value of much less than zero for the entire newspaper business.   When we add up the pieces we see about 75 mm (fully diluted) shares outstanding so it has a market cap of about $100mm    ….they have about $30mm net cash on the balance sheet so the enterprise value is about $70mm…..two years ago they paid $200mm for Vertical Scope….you can argue that maybe they overpaid for that in order to diversify away from newspapers but the asset has done fairly well.  Even if you assume it’s only worth half of what they paid then it’s still $100mm.  All of that adds up to a negative value BEFORE you even get to the newspapers.   No argument that the EBITDA for Metroland and Star have been getting squeezed in recent years, but I have seen plenty of transaction for US newspapers in the past few years that have known brands…..witness Amazon’s Jeff Bezos buying the Washington Post.

Analysts are too focused on negative trends in newspaper advertising and ignoring the company’s shift to digital media.  I’m sure that this is where Fairfax sees the value and they are very patient investors.  The real problem is the unfunded pension fund which they have to contribute another $10mm into this year and next.   Analyst questions should be focused on the structure of that fund…..if results get better and interest rates rise then that deficit could disappear, but I haven’t heard a single question about the structure or management of that fund on any quarterly conference call.  Management has been abysmal but I’ve been hoping that recent changes there at the top could be the beginning of some needed restructuring.