Trapeze Asset Management commentary for the third quarter ended September 30, 2016; titled, “Bizarro World.”

Q3 2016 Hedge Fund Letters

Everything feels a little backwards. President Trump getting more unsavoury in his behaviour yet managing nonetheless to win the election, despite polls to the complete contrary. The Chicago Cubs winning too. U.S. stock markets hitting all-time highs and, though fully valued, active investing being completely shunned in favour of passive. Many bonds carrying negative yields. Relative debt levels surpassing those prior to the Great Recession yet the volatility index, a measure of fear, near its lows.

Trapeze Asset Management

Trapeze Asset Management

And in the financial world, the most bizarre occurrence recently has been the rally in the stock markets post election. The market suffered 9 consecutive down days through early November as it dealt with rising interest rates and the uncertainty around the election results. Why the run-up post election when so many forecast a rout? Likely, for a number of reasons. What financial markets despise more than just about anything is uncertainty. With the outcome known, the markets readjusted. Furthermore, Trump’s initial comments were somewhat conciliatory, tempering nervousness. But the primary driver of the market boost came from rising interest rates—a result of foreigners selling U.S. government bonds and rising inflationary expectations. The rate of 10-year U.S. Treasuries rose from a multi-year low of around 1.3% in July to 1.8% pre-election and then post-election have jumped further to 2.4%. This is a boon to financial service companies whose earnings are dependent on higher rates on their float. So most financial stocks rocketed ahead, as did health care stocks that had previously fallen in anticipation of a Clinton win. The contribution of these 2 sectors set the tone for the overall market where gains have been relatively widespread. The spectre of lower corporate tax rates has helped too, especially for small caps—mostly domestic companies—where the Russell 2000 recently completed a 15-day consecutive winning streak.

At the same time, growth in the world economy seems to be accelerating again. Even in the Eurozone. China is in faster growth mode too.

In the U.S., new orders for manufactured goods improved recently as did consumer confidence, housing and retail sales, and importantly, unemployment continues to decline, now at 4.6%, a 9-year low, and wages generally have been rising though they declined unexpectedly in November. In light of this, and the bullishness post election, with promises of stimulus from large tax cuts and infrastructure spending (not to mention rising interest rates), the U.S. dollar has risen to a 13-year high. The stimulus should bolster growth and raise inflation but bring an accompanying rise in the deficits—the trade deficit from rising imports and declining exports as a direct result of a high dollar, and the budget deficit from rising government spending and declining tax receipts.

A rate hike this month by the Fed appears to be a mere formality—market driven rates having moved well in advance of administered rates. And more hikes thereafter are likely. Rising interest rates may be good for banks, but not necessarily for the overall economy. Mortgage rates are rising, and so are house prices, making affordability more difficult.

And as this bull market has risen since ’09, one of the longest cycles, it is no longer a bargain, trading in line with our estimate of fair market value. Bonds could once again create competition for stocks, although money has recently been pulled out of Government bonds at a record pace, and into stocks. Rates have likely moved too far too fast. So it wouldn’t surprise us to see rates actually fall temporarily, though Trump’s plans, once implemented, will likely increase the federal debt from an already extended $20 trillion, ultimately causing inflation and interest rates to rise more rapidly.

O Canada

In Canada, however, progress is slow; consumer confidence has declined and unemployment stuck at 6.8%. The Canadian dollar is down, likely a result of the wide negative spread between Canadian and U.S. interest rates. Though the lower Loonie should ultimately stimulate Canadian exports. Indeed, Q3 growth was up an annualized 3.5% from improved exports. And now that energy prices are rising, we should see some further improvement. With Canada’s total government debts now in excess of 110% of GDP (versus 90% in ’07) this could weigh on the exchange rate.

A falling CAD is positive for Canadian resource companies whose costs are in CAD but whose prices are in USD. We continue to prefer our domestic resource companies for this reason, especially since our proprietary work is calling for higher commodity prices and a still lower exchange rate. If inflation picks up and global economic growth accelerates, then Canadian stocks could outperform.

Trapeze Asset Management – Still A Bull Market

While many countries around the world continue a policy of monetary easing, the monetary aggregates in the U.S. have begun to shrink. While this is an indicator that the economic growth will ultimately be reigned in, that’s still not the case today.

Our own Economic Composite (TEC™), designed to alert us to recessions in various regions around the world, is not forecasting a peak in the business cycle. Though equities have lifted to all-time highs, and are trading at fair value in our work, bear markets rarely occur without a recession. Our TRIM™ stock market indicators, which warned earlier in the year, are back on buy in most regions. Though, after the recent market run-up, we are on the lookout for a market correction, which in a bull market has averaged about 6%. While a correction could start at any time, we continue to scour for bargains. Our own screens, where we look for stocks trading for 85 cents-on-the-dollar or less, are providing the least number of potential investment opportunities in some time—another reason a correction could be close. Meanwhile, with an earnings yield of 6%, even with 10-year Treasuries up to 2.4%, stocks are relatively more attractive than bonds. Albeit, should rates rise much above 3%, without a meaningful boost in corporate earnings, the relative attractiveness of stocks would dissipate. While a stock market correction could occur at any time, we still believe any decline in the near term will likely be modest and that growth and equity prices should continue higher, although likely at a below average pace.

Our Strategy

As value investors we look for bargains, and in the large cap arena they have become scarcer. There are some unpopular sectors, such as precious metals, but one has to have a positive forecast for the underlying commodity—which we do. We remain bullish on oil too which recently jumped on planned production cuts by OPEC. Natural gas prices have been stronger and look to move higher. Many commodities, such as copper, are at their best levels since the crash. With the recent rise in interest rates, a rotation toward financial services and away from other sectors is creating potential investment opportunities.

We continue to buy shares that pass our due diligence process when we can find them at a wide enough discount from our estimate of their fair market value (FMV) and assuming our earnings outlooks are favourable. Our objective is to continue to add more large cap positions to our All

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