Markets are really amazing things. Millions of people buying and selling different securities each day, determining the price of an asset in real time. Meanwhile, the vast majority of investors are not transacting at all, simply holding on to their portfolio and ideally watching their wealth grow. Some years, markets are extra kind to investors, such as the last couple of years, which had strong double-digit returns for many markets. Some years, markets are kinda cruel, like in 2022 when stocks and bonds both went down together.
The challenge is that the art of investing, with the objective of earning a return to fund some future goal, is dealing with uncertainty. Will tariffs, or the threat of tariffs, trigger more inflation or cause markets to fall? Or will broadening economic growth prevail, helping improve earnings growth, which is the ultimate driver of market performance? Much of the time, the outcome may be closer to a coin flip – thankfully with a slightly loaded coin that favours a pleasant outcome. The equity market goes up 70-75% of years looking back a long time.
But the market is not a coin flip because coin flips are independent; one flip has no impact on the next. If you flipped a fair coin five times, showing heads each time, the next flip still has a 50% chance of coming up heads. If the market goes up or down five years in a row, the probability of it reversing course continues to mount. This creates opportunities and increased risks. Successfully identifying when the odds are sufficiently tilted in your favour, well, that’s what makes a successful investor. However, this often requires a more contrarian mindset, which can be challenging and is often lonely.
Example of a Past Opportunity – Preferred Shares
In the summer of 2023, we took a positive view on preferred shares (prefs), a narrow asset class in which many investors have endured a painful experience. Prefs have many positive attributes, but they’re often viewed as part of a bond allocation while carrying equity-like volatility.
In 2023, prefs had been crushed for many reasons. Bond yields and short-term rates had risen sharply, which weighed on the value of both perpetual and rate resets. Perpetuals because, well, they are perpetuals; they carry a longer duration, so the price has to adjust for a competing asset class. Rate resets because they don’t reset often, meaning they would not be paying enough until they reset, so the price adjusts.
In a higher yield environment, there were simply more options for yield than before, so prefs suffered. Add to this the potential change in bank capital allocation rules, and there was a risk that banks would hold less prefs on their balance sheet.
Add this all up, and the space got crushed. From the start of 2022 till Q3 2023, the TSX preferred share index fell -27%, including dividends. It was that drop that loaded the preferred share coin with a higher probability of rising. The average discount to par across the entire Canadian preferred share market rose to -30%.
Of course, prices could have kept going down; that is how probabilities work. But they didn’t. Companies started calling their prefs at par instead of paying dividends that would reset at higher levels. And yields came down somewhat, providing more relief.
Preferred shares still offer very attractive yields, especially on a tax-adjusted basis, and can provide a portion of a portfolio’s yield providers. There are still more prefs that could be called at par as reset dates near. With yields coming back down, companies may not be as motivated to call in their issues. Still attractive, but in our view, the coin is much more neutral today.
2025 Opportunity?
The S&P 500 rose +26% and +25% over the past two years, the TSX +12% and +22%, and global markets +20% and +16%. Given that the average annual return for equities is in the high single digits, perhaps one could argue that the coin is a bit loaded on the bearish side. Or take a longer view of things. The chart below is the S&P 500 rolling two-year price return. The past two years of strong gains are not unprecedented, but they are rare. And you may have noticed that many of those spikes up are followed by a rather quick spike down.
There are positives and negatives at this point for the market. Trailing returns, being so outsized, is a negative. As are valuations, especially in the U.S. Credit spreads and volatility are low. On the flip side, many other markets are not expensive, economic growth appears to be broadening, and there is no shortage of liquidity. Let’s say the coin is not fair. Perhaps it’s slightly tilted towards the bearish side, just a bit. The chance of outsized returns from this point is probably lower than normal.
In fact, we could be in store for a normal year, even with all the noise out there. At this point, we believe this year will be a more normal one from a performance perspective, perhaps something in the single digits. But we also believe there will be some pretty big swings along the way. This kind of market, if it goes as we think, creates a few portfolio considerations:
1. Avoid Emotional Mistakes – bigger swings may result in emboldening investors on the upside and an increased risk of poorly timed capitulations on the downside. The amount of noise (much of it from the U.S. political system) increases this risk.
We have already experienced some of this with the recent tariffs that were turned on and then delayed. The TSX opened on that Monday down 3%, then largely recovered as tariffs were delayed. Some reduced Canada months ago, and yet today, it is sitting at its high. As we have highlighted, this is not the year for making rash or sudden changes.
2. Being Active – no denying that if markets are going straight up, it is best to just own beta. However, given the past few years and the backdrop, we do experience bigger swings this year, in both directions, with a flatter finish. That increases the benefit of being more active. Taking advantage of market drops, perhaps harvesting some gains on market pops.
This could be manifested in being more active with your asset allocation. Of course, we have our preferred strategy to be tactical, but regardless of how you implement it, a flatter and bumpier year augurs from being tactical. Plus, with market breadth improving, this also favours active equity management over passive.
3. Harvesting Volatility – a flattish year with bigger swings should help strategies that harvest volatility. While the VIX remains on the lower side these days, individual company volatility is rather high. This may prove to be a good year for option strategies that harvest yield.
While there are many iterations in this space, given higher short-term rates and our expectation for flatter markets and bigger swings, we believe cash-covered put writing is well constructed. The cash holding earns a decent return, plus the put premiums. And if we get a downswing in the markets, the strategy automatically does some equity buying. As long as the market doesn’t drop too far, it becomes an automatic buy-the-dip strategy.
Final Thoughts
Don’t make rash decisions, try to control emotions and survey the land for pockets where there may be a mispricing or overreaction. And most the time, do nothing. Opportunities in the market often cluster at certain times, and this is not a time that is rich with mispriced assets or opportunities. Maybe it will be a boring year… with a lot of noise.
— Craig Basinger is the Chief Market Strategist at Purpose Investments
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Sources: Charts are sourced to Bloomberg L. P.
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