Note: This interview was conducted on December 28th, 2010.
“Opportunities and risks arise because markets are prone to the excesses of crowd behaviour” says portfolio manager Jason Priest of J. Priest Investment Management. As a result the efficiency and rationality of capital markets is thrown out of balance creating opportunities for loss or gain. While portfolio managers like Jason get paid to have their finger on the pulse of the capital markets, they can’t always be right. In fact there probably aren’t too many professions that allow one to be wrong as often as portfolio managers, economists and analysts are. Cognizant of this Jason is very upfront in admitting that he can’t always be right but he is also adamant to add that his experience and training as a portfolio manager provide him with ample tools to protect a portfolio from massive losses even when he is wrong. To provide an example, recalling the market meltdown of 2008, when most markets around the world lost between a third and half their value, “no client portfolio under my management lost more than 3% and many had positive returns” says Jason.
To find out how he did it, carry on reading as we cover everything from interest rates to the dollar and everything in between.
Biography: Jason Priest is President and Founder J. Priest Investment Management Inc., a Toronto based portfolio management firm with a primary focus of protecting the hard earned assets of its clients. Prior to founding his own firm Jason worked for an Independent Portfolio Management Firm and one of the big five banks. Jason is a CFA Charter holder and a member of the Global Association of Risk Professionals.
Q: With Chinese gold imports surging in the aftermath of the government’s deregulation move (over 200 tons in the first ten months of the year or a five-fold increase from 2009) combined with the recurring themes of financial market instability in Europe, the price of gold hit a new nominal high at 1420/oz in U.S. dollars today. Given this backdrop, what is your outlook on gold going forward?
A: There are two sides to every story. The loosening of these regulations also makes exporting gold from China a lot easier. China is no doubt a major player in the global markets, but they are also leaders in excess capacity. They are known to have a full year’s supply of copper on hand at present. I am wary of gold at its current price. I fully acknowledge that its impressive rise can continue but I also know that gold prices can turn ferociously. At this point I think there could be more upside for gold prices, but the downside risks are just as great and are currently ignored by the markets. I choose to stand aside when the general investing population keeps throwing money at something believing it will never go down.
Q: The most recent U.S. jobless claims data can be argued as one of worst reports of the year: wages were flat for the first time since June, full-time employment has declined for six months in a row and the unemployment rate ticked back up to 9.8% from 9.6%. However, with Bernanke’s appearance on 60 minutes on December 5th hinting at more QE if necessary, what is your outlook on the U.S. equity markets going forward? Also, how have you positioned your client portfolios to take advantage of this view?
A: I believe that we will see increasing volatility in both U.S. and global equity markets. Mainstream economics would have us believe that there is a high probability that manipulating the money supply through campaigns such as Bernanke’s QE2 will spur growth. There are good reasons, however, to believe that these programs will not only not work but they will create greater imbalances and risks in the global economy. When the Fed’s Open Market Committee buys US Treasuries and other securities it creates reserves on its books for the member banks it buys from. These member banks can in turn lend out the majority of their new reserves to other banks, businesses or consumers.
The whole operation depends on willing borrowers to take loans from the banks at what are now very attractive rates and to invest them in such a way as to increase productivity, output, employment, or preferably a combination of all three. Unfortunately for the Fed, the borrowers they are looking for are not biting. Consumers are about as extended as they can be. Businesses are more interested in making enough sales to cover current expenses than they are in taking on more debt in an uncertain economy. Though we have modestly positive growth in GDP, we are again seeing inventories build; end demand is still weak. That leaves a small group of willing borrowers among the speculators, from hedge funds to banks, which either trade for themselves, or will use the additional credit to provide margin to investors willing to risk trading on borrowed funds. The Fed saw and acknowledged the same circumstances in the late 1920’s.
So far, QE2 has done little if anything for the economy but has provided a boost for equity markets for the past six months. The markets are overbought on most counts, sentiment has priced in a Goldilocks path for the economy, and I believe that any disappointment in economic news in the New Year will leave U.S. and global markets at risk of a significant correction, and a drop of 20% or more could come swiftly. I don’t know when it will come, but I suspect with the S&P500 above 1,250 that a 20% or larger drop from these levels is much more likely than a 20% gain.
Currently my portfolios are positioned with minimal exposure to stocks. There is one saving grace in US stocks - the fact that they are priced in US dollars, about which I am much more optimistic. With the Canadian dollar hovering at par, I think a significant correction in global stock and asset prices would be met with a rising US$/CDN$ rate, cushioning the drop I expect in stock prices for Canadian investors.
Q: If the jobless claims data doesn’t paint enough of a grim economic outlook, the price of oil is trading at near a 26 month high at $88/barrel. Despite what may seem like significant economic headwinds, the Dow has rallied almost 350 points in 2 days. Mr. Priest, why do you think the economic data is not being reflected in the performance of the equity markets? In addition, if you think the equity markets in the United States are not trading on fundamentals and are divorced from the economic situation, how do you manage the risk in your portfolios?
A: The recent rise in stocks does not mean the markets will continue to rise to the moon. In my experience large upward moves in short periods of time are more characteristic of bear market rallies than of sustainable bull market moves. As mentioned in the last question, I think that the easy money policies of central banks around the world are at the root of the rise in equity markets lately. Massive ongoing net withdrawals from equity funds month after month, reductions in risk holdings of pension funds are indicative that a part of the market is in step with economic reality. Volume in the markets is quite low compared to the last rally, and looks to be mostly driven by leveraged speculators and high frequency trading.
The only way to manage risk in an environment like this is to minimize exposure to the risky asset. As we saw in the crash of 2008/9, very few areas of the markets held up. There may be a few more places to hide in stocks should the markets drop again, but I don’t think there is a reliable way to know where they will be ahead of time. I hold a healthy amount of cash in my portfolios to manage the risk. This served me very well for the past few years, and I expect it will again. Others may complain that cash pays so little it is not worth considering. These same people are often heard saying that it pays to be in stocks for the long run and that waiting through crashes and corrections will pay off. If you can wait in a stock for five to ten years that has lost 20-50% to get back to even, waiting in cash for one or two years for equity prices to become reasonable is an attractive alternative. The return on most Canadian equity funds is still negative for the past three years, worse than cash, and it was a nerve wracking roller coaster ride for many investors – which doesn’t factor into the returns printed in the newspapers, but in my opinion that cost is also real.
Q: How are you allocating the assets in your (or clients’) portfolio - in terms of sectors? What are these allocations based on? Are you finding any sectors to be cheaper or more expensive relative to others?
A: I am a top-down stock picker. I don’t necessarily choose a sector or industry because its valuations are more attractive. If a sector looks like it will benefit under my macro view it will be weighted accordingly. Once I have set the sector weight it is generally easy to find individual names with relatively attractive valuations or growth prospects in that sector around the globe. Currently I have only modest overweight positions in telecom and info tech. I am significantly underweight financials and the energy and mining sectors as I think that these two sectors will be hit the hardest in a deflationary scenario, and given even a modestly positive outlook they are overvalued in my estimation.
Q: What is your outlook on interest rates (in Canada, the U.S. or elsewhere)?
A: Given the potential turmoil we could see across the global economy my views on interest rates are mixed. I can see rates moving significantly higher for poor credit risks while many central bank rates and some sovereign credit rates remain low and even head lower. I think the high-yield space is very vulnerable to a spike in rates should economic conditions deteriorate, both as the prospects for default increase and liquidity and volume of trading dry up. I am completely avoiding this space presently as I feel it is where much of the risk is concentrated. Sovereign debt of smaller countries is also a big risk, but there are opportunities on a case by case basis.
Q: What are your thoughts on the continued hunger and bullish action in fixed income investments, especially Treasury bonds. What do you make of the valuations? Do you own any bonds - if so which kind? What are the risks of a ‘bond bubble’ popping?
A: I am positive on the outlook for Canadian government debt. I think rates for Canadian Government debt will remain low, and that the recent rise above 3.25% presents a decent buying opportunity. I can see the 10yr Government of Canada bond making a new low in yield, below 2.5% at some point in 2011. I expect similar results from US Treasuries. One word of caution would be that like stocks, the volatility of these yields is likely to rise. I do not recommend buying to hold to maturity, nor for the mid to long term. Should yields drop as I expect, it would present a selling opportunity. As I expect volatility to increase I think we will get many such opportunities to buy when yields are in the mid to high 3% and sell as they come back down to the mid 2% range over the next several years. You can actually make decent gains off moves of that size.
In terms of a bond bubble, as I mentioned above, I think most of the risk lies in the high yield sector and I would include a good deal of corporate credit in that. I do not believe that low interest rates in and of themselves constitute a bond bubble. There is a significant chance of deflation in the global economy and rates are a refection of this. History is replete with examples of decade long periods where interest rates floated in the range we are in now. If you want to judge whether or not a particular asset may be in a bubble the thing to ask is if it is possible that the price of that asset could drop by 50% or more in the coming year. With treasuries I do not believe we are anywhere in that range. For the price of the 10 year Government of Canada bond to drop by 50% its rate would have to rise to 14%. Even a rise to 5% would take only 10% off the price for a loss of 7% over a year when you include the interest. What would it take for stock prices to drop by 10%, or even 50%? Where does it look like the risk really is? I am comfortable holding a healthy amount of 10 year Canada bonds.
Q: What is your outlook on the Canadian and U.S. dollar? Do you expect the Canadian Dollar to remain near parity for an extended period?
A: The rise back up to parity earlier this year from below 77cents U.S. in March 09 did not have the same momentum as the big push back into November 2007. I think this is evident in the way we have been flirting with parity since April without making a breakthrough. As much as the Canadian economy has some good things going for it, we have to keep in mind that as currencies go, we have a fairly small share of global funds, certainly in comparison to U.S. dollars and Euros, and that it doesn’t take as much foreign buying or selling interest to move our dollar as it does for the larger currencies.
The way our dollar has been trading since about late 2000 when it was becoming clear that the tech boom was crashing and the U.S was going into a recession looks like our dollar has been a risk trade ever since. As easy money flooded the global economy many investors outside Canada shied away from U.S. Equities, and the funds poured into the U.S. housing market, but also into commodities, and in many cases commodity proxies. Many large global pension funds, as well as scores of hedge funds began buying up Canadian stocks, bonds, companies, property and even currency outright. When the big crash began in late 2007 risk started to come off and Canadian assets and dollars started to sell off. This was especially evident in Sept/Oct of 2008 when our dollar dropped almost twenty cents in one month.
As I believe we will be in for a significant correction in global markets beginning at some point in the next 12-18 months, I think there is a definite possibility this pattern will continue. My best case for the Canadian dollar for the coming year would be a trading range between 90 cents and parity, if we get a correction I can see the dollar dropping below 80 cents, even into the low 70s quite easily.
Q: With the economies of the emerging countries showing no signs of slowing, in stark contrast to the economies of the developing countries, so much so that inflation in countries like China is at a 25-month high - are investors better off allocating a major portion of their assets to multinational companies that derive a large portion of their earnings from the developed countries or ETFs that allow exposure to these countries? Mr. Priest, what are your thoughts on the equity markets in Asia, both developing and emerging?
A: By now you know that I am anticipating less than favourable conditions for global equity markets in the near term. I did not subscribe to the decoupling theory back in 2008 where many thought that the problems in the U.S. housing market would be isolated and Chinese and other emerging markets would pass unscathed and I do not believe these markets will be spared should we experience another stock melt down. I do, however, think that these areas provide excellent long term potential. I would be a buyer in many of these markets on a decent correction in prices. Going forward this is an area that I think should be an overweight position for most investors.
As for how to gain exposure, I think holding some multinational companies is prudent. ETFs for specific countries and regions will give you the works, not just the best, so this is an option that is most suited to a time when the overall prospects for a bull run in those markets is likely – after a nice correction. Another option is to cherry pick individual companies. Many brokerages now have global trading on many exchanges, and there are also many good companies in the emerging markets that are traded as ADRs on the NYSE. Many of these companies have comparatively little debt, are gaining market share, and pay dividends in excess of 5% while maintaining a growth rate higher than that found in the average U.S. stock. There are a few actively managed mutual funds in this space that also offer good access to these markets with returns that have justified their fees.
Q: To wrap, if you could encapsulate your global macro views into a handful of cogent investment themes, what would they be?
A: First and foremost I would say investors need to be much more cautious than they have been. As I have outlined above, central banks around the world have brought significant distortions into the markets through poorly thought out monetary policy. There remains a lack of genuine stimulus in the global economy. By genuine, I mean organic and sustainable, as opposed to temporary and forced stimulus like the central banks are pushing. I do not believe that recent moves in equity markets reflect this reality and as such are ripe for a correction in the best case scenario and another significant crash as a worst case. I recommend that equity allocations be taken down at this point and that holdings of cash be increased temporarily.
Secondly, I believe there is still a very good opportunity in Canadian Government bonds. In this space, I like the 10 year bonds. With yields having come up in the past few months there is a good possibility that capital gains can be achieved to augment the admittedly low interest rates. I’m not looking for double digit returns here, but I think something in the 5 to 8 percent range for 2011 is possible. If yields were to decline again to around 2.5% of 2010 I would reassess the outlook at that time. Investors who wish to be a bit more aggressive could pick up mid-dated U.S. treasuries and look for both gains from lower yields and a stronger U.S. dollar.
Finally, I think even for optimistic investors this is a good time to take excess risk off the table. We saw back in 2008 how quickly liquidity in some sectors can dry up. Anywhere investors are reaching for yield is a good place to start liquidating. Trusts and high yield bonds with yields in the double digits are likely to be hit very hard. There is nothing wrong with having a decent amount of cash on hand.
Thank you, Mr. Priest!
Update: This post was included in the Totally Money Blog Carnival, the Carnival of Personal Finance, the Cavalcade of Risk and the The Wealth Builder Carnival
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