Investment ideas in a volatile market

Key Concepts

• Market Breadth: The extent to which a market rally is supported by a large number of stocks, as opposed to a few dominant ones.
• Sector Rotation: The strategy of shifting investments between different market sectors (e.g., energy, technology, financials) based on economic conditions and market trends.
• Inflationary Environment: An economic condition characterized by rising prices and a decrease in the purchasing power of money.
• Discount Rate: The interest rate used to determine the present value of future cash flows, often influenced by long-term interest rates.
• Value vs. Growth Stocks: Value stocks are typically considered undervalued by the market, while growth stocks are expected to grow at an above-average rate.
• Dividend Growth: An increase in the regular payments made by a company to its shareholders.
• Backlog: A list of orders or projects that a company has secured but has not yet completed, indicating future revenue potential.

Market Leadership Narrowing and Sector Rotation

David Burrows, Chairman and Chief Investment Officer at Barometer Capital Management, observes a narrowing of market leadership, indicating that fewer stocks are driving market gains. This contrasts with a healthy market where more companies typically participate in a rally. Over the past three months, this trend has become more pronounced.

Key Points:

• Canadian Market Focus: Burrows highlights that certain sectors crucial to the Canadian market, but less significant in the US market, are performing better.
• Crowded Areas Under Pressure: Conversely, more popular or "crowded" sectors are experiencing difficulties.
• Investor Strategy: Barometer Capital Management has been focusing on Canadian and international markets, as well as assets that perform well in inflationary environments.
• Risk of Early Fed Cuts: There's a concern that the Federal Reserve might be cutting interest rates too early, potentially leading to a resurgence in inflation.

Canadian Energy Sector Performance

Despite a consensus expectation for declining oil prices in 2026 due to anticipated oversupply, the Canadian energy sector, represented by ETFs like the XEG (ETF for major Canadian oil and gas producers), has shown remarkable performance.

Specific Examples:

• Companies like Imperial Oil and Tamarack Valley are advancing despite weak energy prices, which are currently in the high $50s.
• Context: While energy constitutes only about 2% of the S&P 500 index, it holds significantly more weight in the Canadian market. Historically, energy's share in the S&P 500 was much higher, exceeding 20% in the early 1980s.

Federal Reserve Policy and Inflationary Risks

The possibility of another rate cut by the Federal Reserve in December is being considered, following indications from the New York Federal Reserve. Burrows expresses caution regarding this potential move.

Key Arguments and Evidence:

• Inflation Ahead of Target: Inflation has been coming in below the Fed's target, but 72% of CPI components were still above the 2% target in the most recent measure.
• Historical Inflation Patterns: Historically, inflation has sometimes seen a surge, then moderation, followed by a second surge.
• Market Perception: The market appears to be pricing in the risk of resurgent inflation.
• Inflationary Sectors Outperforming: Sectors that tend to perform better in an inflationary environment, such as financials, energy, materials, and industrials, have been leading the market.
• Defensive Sectors Underperforming: Defensive sectors, which often behave like bonds, have generally underperformed over recent months.
• Gold Strength: The strong performance of gold is cited as evidence of investors seeking certainty in an uncertain market and potentially hedging against inflation.

Impact of Long-Term Bond Yields on Equity Markets

The behavior of long-term bond yields has a significant impact on equity markets, particularly on high-multiple growth stocks.

Step-by-Step Process/Explanation:

1. Discounting Future Cash Flows: When valuing growth stocks with high multiples, investors discount their future cash flows back to the present value.
2. Discount Rate Influence: This discounting process uses a discount rate, which is generally based on long-term interest rates.
3. Higher Yields, Lower Valuations: When long-term yields remain high, it makes it more challenging for high-multiple growth stocks, as their present valuations are negatively impacted.
4. Last Year's Anomaly: Last year, when the Fed cut rates for the first time in 40 years (in September), long-term rates actually rose, not fell. This was interpreted as bond investors anticipating that inflation would remain higher for longer and demanding compensation for that risk.
5. Value Outperforming Growth: Consequently, value stocks have been outperforming growth stocks over the last five months.
6. Value and Inflation: Many sectors currently considered "value" are less owned or have a more inflation-leaning profile.

Burrows' Perspective: Burrows believes inflation poses a greater risk to investors than disinflation or falling prices.

Barometer Capital Management's Portfolio Strategy

Barometer Capital Management currently holds a slightly higher cash position than usual, reflecting a strategic shift in their portfolio.

Key Themes and Focus Areas:

1. Reduced Tech Exposure: The firm has reduced its technology exposure by approximately two-thirds over the year, seeking other opportunities.
2. Cash Generation and Shareholder Returns: Focus is on companies that generate substantial cash and return it to shareholders through dividends and share buybacks. This strategy is less sensitive to financing costs if a company has significant excess cash.
3. Dividend Growth: Emphasis on dividend growth is crucial for offsetting the rising cost of living, a strategy that proved effective during past inflationary periods (e.g., the 1960s and 1970s).
4. Long Backlogs: Investment in companies with very long backlogs provides predictability of future business, even in the event of an economic slowdown.

Conclusion/Synthesis:

David Burrows of Barometer Capital Management suggests that the market's narrowing leadership and the outperformance of certain sectors, particularly in Canada, signal a shift in investor positioning. He emphasizes the risks associated with potential resurgent inflation, driven by factors like early Fed rate cuts and the historical patterns of inflation. Consequently, his firm is focusing on companies with strong cash generation, dividend growth potential, and long backlogs, while reducing exposure to crowded tech sectors and favoring assets that perform well in inflationary environments. The impact of higher long-term bond yields on growth stock valuations is also a key consideration, leading to a preference for value-oriented investments.