I've been warning about the growing risks to the Canadian dollar, China, and resource stocks for about a year and advocating conservative U.S.-denominated assets. Now, with the emerging markets growth story crumbling, and the greenback surging past the loonie, the question is what next? In looking for the next big investment theme, the biggest danger is impatience. Uncovering the next market sector that outperforms will be of little use if the stocks get swamped by the death of the previous era's dominant themes.
In almost 20 years of providing investment advice, the feeling after getting a macro call right is always the same: relief. Watching it happen now, mostly I'm just happy that anyone who accepted the advice, maybe someone close to retirement who couldn't afford to lose, might be marginally better off.
Writing about the potential decline in emerging markets is one thing, but it's only begun to play out in the markets and is likely to continue for a long time. Goldman Sachs, for instance, predicts the "Fragile Five" emerging markets economies won't regain stability until 2015.
I think the best portfolio strategy for Canadian investors should be designed to weather the storm first, and eke out decent returns second. As someone who made the painful mistake of "buying the dip" on Oracle Corp. in 2001, only to see the stock crater another 58 per cent, I'll suggest that trying to catch the bottom in market sectors that have outperformed over the past decade is probably the last thing you want to do.
If we're going to play defence, it's helpful to identify what we're defending against. In general, my assumption is that the investment trends of the 2002-to-2012 decade – a weak U.S. dollar, strong emerging markets, strong Canadian dollar, S&P/TSX outperforming S&P 500 – are now heading in reverse.
All of these trends point to higher portfolio allocations to U.S.-dollar-denominated equities and lower weightings in Canadian stocks, particularly materials stocks. A heavier cash weighting also makes sense.
The simplest way to add U.S. equity exposure is to reduce resource holdings, particularly mining (yes, even if you take a loss) and buy an S&P 500 index ETF. For the more ambitious investors that want to pick U.S. stocks, Goldman Sachs strategist Ben Snider notes that consumer staples and health care stocks have historically outperformed during periods of emerging markets weakness.
Other than increasing U.S. equity weightings at the expense of commodity stocks, I don't think there's a lot to do here yet. All the signs of a secular shift are there, but we need to confirm the temporary halt in the emerging markets growth miracle. More confirmation of the U.S. economy's resurgence would also be welcome.
Federal Reserve monetary policy, credit stress in China, a fragile economic recovery in Europe and the rapid spread of currency devaluations through the emerging markets are four reasons why playing defence is warranted.
Sometimes, the smartest thing to do during market volatility is to wait and watch how things unfold. This looks like one of those times.