Investment Commentary January 2024
US Yield Curve
The small inversion of the 10-2-year US Treasury yield curve stayed stable as of the end of December at minus 35 basis points.
US Corporate Debt Spreads
Investment grade US corporate debt spreads declined in December to 1.62% from 1.67% in November.
No changes from last month with the Chinese economy. Their economy remains weaker than the Communist Party wants and consequently additional monetary and fiscal stimulus is expected.
Equity Market Valuations
The forward PE of the S&P 500 rose to 19.80 times as of the end of December. The small drop in equity prices so far this year has reduced the forward PE to 19.2 times 2024’s projected EPS. The five- year average is only slightly lower at 18.9 times.
US Corporate Earnings
Projected EPS growth in 2024 for the S&P 500 is currently at 12%. Obviously 2024’s estimate is much too high, taking into account the possibility of a weakening economy. EPS are expected to grow by only 1.30% year over year for the 4th quarter of 2023 and by 0.80% for all of 2023
During December both Nike and Fedex reported their latest quarterly earnings and both lowered their revenue forecast based on weaker demand. It is too early to know for sure if these are company specific issues or larger macroeconomic ones.
Central Bank Monetary Policy
The latest Federal Reserve meeting saw some back pedalling on the number and timing of Central Bank’s interest rate decreases for 2024. This rhetoric is not surprising as it has happened throughout all of last year.
I am maintaining the same asset mix as last month for both the individual company portfolios and the ETF ones. However, assuming that this Thursday’s growth rate in US CPI continues to decline, I may increase overall equity exposure for both portfolios by 5%. Any backup in the inflation numbers may surprise investors and cause a short-term selloff.
Long term I remain positive on equity returns. Many companies will start reporting their 4th quarter numbers and will be adjusting their 2024 forecasts accordingly.
The recent US payroll number for December was better than expected, but there were some negative revisions from the previous month that make the employment numbers seem a little less rosy.
Currently 66% of money managers in the US believe the US economy will have a soft landing. This is a sharp reversal from one year ago when 68% of money managers expected a recession. Investors may be a little too optimistic today as they expect a 140 basis point reduction in the Federal Reserve’s policy rates this year. This is exactly twice what the Federal Reserve is projecting.
According to the American Association of Individual Investors, US bullish sentiment on equities rose to 48.6% last week, slightly less than from the recent peak in December. This number is well above the historical average of 37.5%.
Some strategists are now worrying that the market’s sunny outlook leaves little room for disappointment. If either the declining inflationary trend reverses or stalls somewhat or if the economy starts to weaken sharply, the equity market may experience more volatility.
However, as Jeremy Siegel recently pointed out, US growth stocks are trading at approximately twice the forward PE relative to value stocks. Obviously, this indicates that pockets of the equity market remain undervalued.
Equity Sector Recommendations
The only change I am making from last month is to reduce my Overweight in Energy to Market Weight. There are several headwinds currently keeping crude prices depressed. A closure of the US refiners for two months for annual maintenance takes the demand for crude a little lower. Secondly US production surprisingly continues to climb and OPEC production actually rose by 70,000 barrels per day. Saudi Arabia decided to cut its prices for its flagship Arab light crude to Asia. JP Morgan estimated that 26 oil rigs will be added this year, mostly in the Permian basin. Even though the current Palestinian War with Israel appears to be escalating, crude prices remain range bound. My Energy sector weight is now going down to 12.48% representing my North American benchmark weight.
The Materials sector continues to look interesting with a peaking of interest rates and the US dollar globally. As you all know, this is a very volatile sector. Nevertheless, the outlook for both gold and copper will help overall profitability for stocks in this sector.
Individual Equity Changes
In a portfolio blog dated December 22, I added Ivanhoe Mines, IVN.TO, to the Growth portfolio in the Materials sector. The positive outlook for copper will benefit Ivanhoe and its peers.
Ivanhoe owns a 39% equity interest in one of the fastest growing, highest grade copper deposits globally. This mine is located in the Republic of the Congo and is called Kamoa-Kakula. Ivanoe also has an equity interest in an adjoining copper deposit that may have similar mineral composition.
Despite all the problems with First Quantum’s Cobre Panama mine, Ivanhoe has a good relationship with the Republic of Congo. The expected mine life of the Kamoa-Kakula deposit is 42 years with a low unit operating cost based on the high ore grade.
While the shares trade at a higher valuation than many of its peers, it should be pointed out that Ivanhoe is a combination of a base producer and an exploration company.
In a blog dated December 29th I added Ag Growth, AFN.TO, to both portfolios in the Industrials sector. The company produces portable and stationery grain handling equipment that lowers the cost and improves the crop yields for farmers. The company has a free cash yield of 6.72% and is trading at the lower end of its 5- year range on an Enterprise Value to forward EBITDA level at 5.81 times The company is focused on increasing operating margins, lowering costs and reducing its leverage. Its dividend yield is 1.19%.
In a portfolio blog dated January 4th, I deleted Magna International from both portfolios in the Consumer Discretionary sector. The company is experiencing materially slower sales growth in the US than many of its peers. In addition, its higher than peer average exposure to Europe is not helping currently. I am recommending a switch into more shares of Martinrea, that is already in both portfolios. Martinrea trades at a significantly cheaper valuation than Magna both on a forward PE and on an Enterprise Value to forward EBITDA basis.
Please ensure that your exposure to new pro forma weight in Martinrea takes into consideration my overall Consumer Discretionary weight of 6.30% and that includes the other companies that include Dollarama, GM, Restaurant Brands, Lululemon and Ulta Beauty.
In the Reit sector, I am deleting Rexford from both portfolios. A recent industry study by Cushman & Wakefield revealed that US warehouse availability jumped to the highest level since the Pandemic with the 4th quarter’s 5.20 level. This is up from 3.10% last year. Retailers have retrenched over the last year from inventory re-stocking with rising rates and a more conservative consumer spending outlook. However, the availability of logistics space remains below historical standards of 6.40%. In light of this new trend, I am deleting Rexford while still keeping Prologis in my model portfolios. Rexford is trading at a much higher valuation than Prologis on a Price to trailing twelve- month FFO basis. In addition, Prologis has facilities throughout the US and internationally, while Rexford is only in Southern California.
Lastly, I am adding the US company, First Solar, FSLR-US, to the Growth portfolio in the Technology sector. It is interesting to note that this company is part of the Technology sector and not part of the Utilities sector. The company is a global leader in solar panels and its technology uses cadmium tellurite to convert sunlight to electricity. This is called thin-film technology and First Solar is the global leader in this area. Production facilities are located in the US, India, Vietnam and Malasia. First Solar’s thin film technology is considered a higher performance but lower cost alternative to the conventional crystalline silicon panels. The company has intentionally no production facilities in China, but has focused on India in particular recently as a much better alternative.
The company recently signed a 15- year power purchase agreement with Cleantech Solar, a company building a 150 MW of solar and a16.8 MW of wind capacity in India. Once operational, Cleantech will supply up to 70% of First Solar’s electrical needs in India.
First Solar’s revenues, EPS and EBITA are expected to grow by 31%, 64% and 71% respectively in 2024. Currently the shares trade on 2024 EPS at 12.80 times and 8.41 times Enterprise Value to 2024 EBITDA. This is quite reasonable taking into consideration the expected growth. It is important to keep in mind that this business is highly cyclical and dependent on government policies. The company has a strong balance sheet with Financial Debt only 0.422 of trailing twelve- month EBITDA.
While the company’s third quarter revenue growth was below expectations, the shares have declined 28% from their recent high. As a result of their high fixed cost operating structure, operating margins are expected to rise sharply over the next several years with the revenue growth expected.
Last year most renewable energy stocks experienced poor returns as higher rates provided a major headwind. Now that interest rates are expected to drop this year, this will greatly reduce this headwind. In addition, the US Inflation Reduction Act provides $370 billion in subsidies and tax credits for clean energy providers and users.
As the company’s share price is volatile and does not pay a dividend, I am only adding it to the Growth Portfolio.