For our 2023 Q2 portfolio we wanted to take a different approach. In this quarter, we will discuss the macro positioning and views we have in relation to the overall market, then individually touch on the movements that have been made in both the Alpha and NA Core portfolios. The reason for this is that there are some very large forces that we thought were important to discuss.

As a starting point, the S&P 500 has had a tremendous start to 2023 with a YTD performance of 14.5%. This headline number does not paint the whole picture as we have never seen such dislocation in the market. Passive investments and the proliferation of 0 day to expiry options (0DTE) have caused a significant disconnect between certain segments of the “index” with the 8 largest companies essentially generating 100% of the “index” return. This has caused a distinct break between the “index” and the economic conditions we are experiencing. I will try and keep this as out of the weeds as possible and apologize if it gets a little technical, but we believe it is very important to help explain what is currently happening regarding your hard-earned capital. I want to preface all of this with we will get to the positives by the end of the commentary.

Let’s start with the composition of the S&P 500. According to https://www.slickcharts.com/sp500, Apple and Microsoft combined now make up 14.5% of the S&P 500. Add in Nvidia, Alphabet, Tesla and Meta and you’re up to roughly 26%. Berkshire Hathaway is the next largest company at 1.65% but roughly 40% of Berkshire’s stock positions is in Apple, so as Apple goes so does Berkshire. Why is the composition of the market so important in 2023? The proliferation of passive investing has completely changed the way the markets behave. If you were to start studying to become an investment analyst, one of the first lessons you learn is that a company is the value of all its future cash flows. You must try and deduce what those future cash flows will be and then bring them back to present value with a suitable discount rate. In times of low interest rates, or falling interest rates, the discount rate used drops, which means all those future cash flows are worth significantly more. One of the first calculations I memorized while studying was that Present Value = future value/(1+r)to the nth power. With r being the discount rate and N being the time. Let’s make it simple and say a company will generate $1000/yr for 10yrs and the discount rate is 3%. The present value of those cash flows should be $744.09. 1000/(1.03) to the power of 10. What happens if the rates go up to 5% keeping all else equal? The present value decreases to $613.91. This is one of the reasons why when interest rates go up higher growth companies tend to underperform. So typically you add 3% to the risk free rate (RFR) to get an appropriate discount rate, so if the RFR has been 0% but is now 3% then your discount rate has gone from 3% to 6% which should have a dramatic impact on the value of a growth company. So for a great company like Apple to be trading at all-time highs. In fact while Apple has slowing revenues, growing at roughly half of what it was last year and has guided down for the coming quarters the company added $1T in market cap. At $3Trillion dollars every 1% move in the market equates to $30B of market value. Nvidia is trading at roughly 40x revenue adding $400Blm to their market cap on roughly $3.5B increase in guidance. Yes AI will drive substantial revenue growth for them but at 40x revenue they are priced for perfection. We must be in a great economic cycle since clearly the move in interest rates doesn’t matter to their valuations. So why are fundamentals not playing as important part of this current market rally?

What happens when passive investing takes on more and more market share? Passive investing has taken more and more market share over the past number of years. As you can see here, just the three largest passive S&P 500 ETFs have over $1T in assets. https://etfdb.com/compare/market-cap/. This is not a knock on passive funds, in fact, we have used them and will continue to use them to access certain sectors when we are looking for sector exposure. They are a great tool that should be part our toolbox. However, with passive, you have less people doing the “math” on what a company is worth. So as more money flows into a passive ETF, that ETF then, must allocate that cash equal to the market weight of the underlying companies. So for every $1 invested into a passive S&P 500 ETF .145 cents goes to Microsoft and Apple, whereas the two smallest companies Dish Network and New Corp have a combined .01% weighting and would only get .001 cent. You can see how this can become a self-fulfilling prophecy. The more money that flows into the passive ETF space the more money gets invested into the top stocks, thereby driving the performance of those top market cap stocks and which thereby increases their share of the market which then causes the ETFs to buy more of the company and the cycle continues. The big question comes, what happens when the music stops and we see outflows? The opposite must happen. For every $ removed from the ETF 14.5cents must be sold out of Apple and Microsoft.

In the intro we mentioned the proliferation of 0 Day to expiry options. Call and put options have been tools that have been used for decades to allow someone to invest a smaller amount of money to make a directional call on a company or for an institutional investor to help hedge out risk. The longer the time frame to expiry the more opportunity you have for your call to play out. As an example, if you thought during the great financial crises of 08/09 that there was no way Bank of America was going down, you could invest the same amount of money in a 2 year call option and get about 10x the upside exposure. The downside however is that if the call doesn’t work out you lose it all. This was always a relatively small part of the overall market conditions typically reserved for very sophisticated institutional investors as they can become quite complex and can lose it all if not used properly. During the COVID lock downs however, we saw the ”gamification” of investing with the likes of Robinhood taking off. According to Robinhood https://www.nytimes.com/2020/12/24/style/robinhood-2020-recaps.html, they added 3M new funded uses in 2020, a year when most American’s were stuck at home with stimulus cheques and nowhere to spend it. In my role I had to pass many exams and courses to get the qualifications that I have. In order to add the potential of using options I then had to pass what was arguable the toughest course I had yet to take. Unfortunately, apps like Robinhood brought option trading to the masses and as the retail traders started using more and more options that drove the proliferation of 0DTE. These options literally expire within 6 hours. To make an “investment” decision that must come to fruition within 6 hours or you lose all your money sounds more like going to the casino and gambling but we are now, according to Bank of America, seeing these options as taking more than 50% of all daily option volume. Why this is important is that it dulls volatility. As volatility gets suppressed, this forces more asset classes, such as the $1.5T invested in volatility target and risk parity funds to buy more equities and decrease their volatility hedges, which continues the cycle.

So how does this end and when does the reversal happen? That is anyone’s guess, but we think the economic cycle will help guide us there which takes us to the consumer and commercial real estate. You might be asking what commercial real estate and the consumer have in common. Normally, not much, but in the face of ever higher interest rates a lot.

We have started to see cracks in the commercial real estate market. This market of course is very different then residential or industrial. Think of downtown office towers and shopping malls. There is $1.4T in commercial mortgages coming due in the next two years. https://www.politico.com/news/2023/06/05/mortage-interest-rates-property-values-00094969

As more and more workers have been given the flexibility to work remotely or some form of hybrid the vacancy rates in towers has gone up. https://www.cbre.ca/press-releases/canadas-office-vacancy-rises-further-in-first-quarter, this in turn has caused the value on those properties to at best, stay steady and at worst, start to fall. If a company has too much leverage and the building isn’t of economic value to them, we have started to see companies walking away. Whether it’s Brookfield walking away from buildings in LA https://financialpost.com/fp-finance/brookfield-defaults-2-office-towers-los-angeles or companies defaulting on hotels in San Francisco https://www.bnnbloomberg.ca/owner-stops-debt-payments-on-two-large-san-francisco-hotels-1.1929031, this is a concerning trend that we believe is just getting started as higher interest payments make it harder to justify the debit levels that were taken.

Which takes us to the consumer. We are also dealing with these same higher interest rates and has the old saying goes; as the consumer goes, so goes the economy. So how is the consumer doing? Well, we are experiencing some records. We have had a record 25 months and counting of negative real wage growth. Although wages have been going up they have not kept pace with inflation for over 2 years, meaning even with a bump in pay, you still have less for discretionary purposes. According to the NY FED, we are seeing the highest year over year growth in credit card balances at just over 17%. This number bottomed out and was negative in Nov 2021 and has been rising ever since. Unfortunately, the interest rates on those balances have also increased from roughly 16% in Nov 2021 to 21% today. In the United States most mortgages have 30-year rates, so the rapid rise in interest rates doesn’t have as much of an impact on your bottom line but it does mean that you will most likely not move anytime soon which has decreased the supply of real estate and help to keep prices more elevated. In Canada however most of our fixed rate mortgages are revolving every 5 years, meaning you need to renew it for a new term. Essentially, we have 20% of our mortgages being renewed every year so the longer the rates stay elevated the harder it is. Let’s say you have a $500k mortgage, which with the average Canadian house price being over $700k isn’t an unrealistic number, https://wowa.ca/reports/canada-housing-market, With simple math, if you had locked that $500k mortgage 5 years ago at 2%, then you would have had a $2117 monthly payment and your balance today would be down to $418,851 https://www.cibc.com/en/personal-banking/mortgages/calculators/payment-calculator.html#resultsFirstHeading. Which means you’ve paid almost 2x more principal then interest payments. Now put that $418,851 balance in with a 5.75% 5 year fixed rate and keep your same amortization period your payment increases to $2925 but you’re paying roughly 70% more in interest then principal over those five years. So most Canadian would need to have seen their income go up by roughly $20k over the previous 5 years just to be able to cover that extra payment. With the rising cost of living in all aspects of our lives this means that the consumer has significantly less cash flow for discretionary spending, which is why most consumer facing companies have been lowering expectations for the coming quarters.

The real question becomes as the consumer starts to increase their credit card debts and delinquencies at what point do they start tapping into their savings to help pay their bills and if this occurs what will that do to the passive investment fund flows? As you can see from the above we are skeptical on this “market” rally and believe it behooves us to continue to be cautious but that doesn’t mean we aren’t finding opportunities to take advantage and position ourselves for the future.

We are seeing certain individual companies and sectors do very well in this type of an environment and we have been and will continue to position ourselves to take advantage. Visa, Mastercard and Fiserv are all companies that facilitate payments. As cash transactions continues to go the way of the dodo and as consumers tend to rely on their credit cards for more of their daily spending these companies will continue to make significant progress. As we are seeing almost daily there are new cybersecurity penetrations that make national and international news. That is one sector where the demand for security continues to increase and if the “bad guys” continue to try to infiltrate companies and governments the need for cybersecurity will only continue to increase. We currently have Canadian energy companies trading at 1-2x cash flow and are paying out significant dividends and buybacks. The move to electrification of the western world will continue to drive demand for the resources and the “picks and shovels” that are needed to make that transition. Defense also makes sense, with gold trying to reach all-time highs and cash paying north of 4%, dividend names such as the banks and pipelines paying 5-7%. So, although we have concerns about the broader market we are seeing fantastic opportunities. Our clients have always told us to try and protect their hard-earned capital so with the current environment we are going to continue to err on the side of caution and look to deploy into areas that have more favourable risk/rewards.

 

As always, please feel free to reach out with any questions or concerns you may have.