Market Commentary
December 2011
Saturday, December 31, 2011
The prospect of a potentially darker chapter opening in the European debt crisis sent global equity markets on another wild ride in the fourth quarter. Worries that Italy would join Greece, Portugal and Ireland as the next debt victim fanned fears of a world without a Euro currency, a European Union and economic growth. Investors hung on every bit of news; buying in advance of an outcome and selling when it turned out to be less than expected. As difficult as the volatility may have been to live through it was surprisingly predictable. Announcements of new meetings, new policies and new approaches to tackle the sovereign debt problem were cheered by the market but in each instance the supposed solutions fell short, leading to quick sell-offs. This "buy-the-rumour, sell-the-news" pattern pertaining to Europe also extended to the U.S. where markets rallied ahead of U.S. Federal Reserve meetings and debt ceiling debates only to be disappointed.
Taking a step back from week-to-week market moves, the North American stock markets have held up remarkably well this year all things considered, with the S&P 500 index delivering a total return of 2.1% for the year and the S&P/TSX down 8.7%. We are certain that many investors feel much worse given the elevated level of volatility. In a non-policy-driven world, the chaos in Europe, slowing in China, concerns about the U.S.economy and oil prices rising over US$110 worldwide (Brent), one could well expect markets to be down more than 20%. But they're not, which says to us that investors are "looking through" these landmines and toward further U.S. Fed and ECB quantitative easing. We continue to believe that this is the most likely outcome over time, which would be positive for stocks and gold. Nevertheless we are still mindful of the potential for more headline risk in the short term.
As volatile as the period was, the S&P/TSX Composite Index notched a small 3.6% gain for the fourth quarter while the S&P 500 posted an 11.8% total return and the Dow a 12.8% rise. For the year, Canada's benchmark index is down 8.7%, the Dow rose 8.5% while the S&P, as mentioned, closed the year up 2.1% (total return). The Trust outperformed the S&P/TSX delivering a 5.7% rise in the 4Q reporting period. For the year, the Trust has also outperformed its benchmark posting a loss of 5.1%. Outperformance for the quarter primarily stemmed from solid stock picking in the Trust's three largest equity sector allocations: financials, energy and materials.
Of the three, energy provided the best returns powered by holding Canadian Natural Resources which delivered a 23% return over the reporting period. Imperial Oil Ltd., also performed well posting an 18% return as did Suncor Energy Inc. which rose 8% over the period. Energy service firms also provided the portfolio with some lift led by Black Diamond Group, up 26% and Northern Property, up 10%. The result was less forthright in financials. Royal Bank of Canada aided performance rising 7% while Bank of Montreal and Bank of Nova Scotia detracted. In general, we remain bullish on Canada's banking sector and feel it is a casualty of the European debt situation which casts a long shadow on global financial institutions. Royal Bank, while off its lows of the year, is still trading about $8 short of its $60.8 high for the year and offers a solid 4% dividend yield. This is an extremely attractive entry point for a high-quality company with a rock solid balance sheet. Exposure to materials, the Trust's third largest sector weighting, hurt the Trust with Barrick Gold Corp., a top holding being the biggest detractor to overall performance with it falling 4% on the quarter. Goldcorp Inc. also hurt portfolio returns as did Newmont Mining Company which fell 5% and 4%, respectively.
The recent downward move in gold deserves additional analysis, as it is one of the largest overweights in the Trust. While bullion has been trading as a "risk on" asset for quite some time, and some pullback with the overall market is logical, we were surprised at the speed and magnitude of the correction. From discussions with market participants, we believe a short-term buyer's strike occurred. Many institutional investors see no need to take risk on the long side with only two weeks left before year-end. At the same time, central banks are likely waiting for refreshed buying quotas in the New Year. We expect both conditions to reverse in early 2012. Furthermore, for the longer-term, gold remains the asset class of choice for those who think that central governments will ultimately monetize their debts away. We remain believers that this will come to pass despite the painful short-term hiccups last quarter.
In addition to delivering strong capital appreciation potential, the Trust is also focused on maximizing distributions. The current distribution stands at ten cents per unit and the Trust has derived the distribution from a variety of investment sources, including portfolio income. One of the ways the Trust has successfully generated income is through its covered call option strategy. The strategy allows us to hold a security in anticipation of future capital appreciation while 'writing', or selling, a call option on a portion of the security in order to generate additional income. Call options written are short-term, typically less than 30 days, retaining medium to long-term capital appreciation opportunities for the Trust. The portfolio management team has used this strategy opportunistically, particularly when the market is flat or downward trending. During weaker markets, a covered call option strategy will generally provide higher returns and lower volatility for a portfolio compared to one that does not utilize this strategy. We believe this strategy will help keep the distribution sustainable and we're pleased to report a successful options writing program for the quarter. This was particularly true for the month of November when the markets staged their second rally of the reporting period. We saw somewhat limited upside in the market then, but still wanted to hold our positions in case of surprise policy action so we were very active in overwriting. Furthermore, with volatility indexes close to extremes, the Fund was earning significant premiums for selling covered calls.
As we head into the New Year, we expect trading days to remain choppy and we will continue to use the increased volatility to take advantage of mispriced assets while selling when most advantageous. We continue to await some kind of co-ordinated global policy response to the European debt situation and if/when forthcoming there could be fireworks.