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Ryan Modesto, CFA, is Managing Partner at 5i Research, a conflict-free investment research provider for retail investors offering research reports, model portfolios and investor Q&A. 5i Research provides content under an agreement with The Globe and Mail, which receives royalty compensation. Try it.

As 2016 has come to an end and investors have taken some gains from a strong year in Canadian and North American markets off the table along with locking in some tax losses, cash will be looking for a home in 2017. But where will investors be looking?

As tax losses crystallize and professional and retail investors/managers perform reviews on portfolios, outlooks, and strategies, a common theme emerges. That theme is rebalancing, which, simply put, means that investors sell some of their winners and move that money to the losers. It is a pillar of portfolio management if there ever was one and follows the old adage of buy low, sell high. But what happens when almost every sector sees strong returns in a given year? Where does the money for rebalancing go?

Materials and energy both have had a nice run-up, between roughly 12 and 14 per cent, depending on which sectors one looks at. However, with the strength in the U.S. dollar, as well as inflation still not making a major impact in the data and a slow-growth environment, it is tough to get too excited about precious metals and materials to a degree that warrants overweighting a portfolio. A continued resurgence in oil names could be in the cards, but this likely requires further output restrictions from OPEC. Given how closely energy stocks have followed the actual price of oil, even if oil is able to reach the $60 level as seen back in June 2015, it leaves roughly 10 per cent upside for the sector. That's nothing to bat an eye at, but it's reliant on an unpredictable commodity moving favourably.

Turning to more blue-chip industries, utility, consumer staples and telecommunications stocks are an important part of anyone's portfolio, but most investors are well aware of the 'reach for yield' trade that has occurred. Concern over higher dividend payers being weak in a rising interest rate environment is fair. There are definitely interesting stocks in all three sectors, but it is not an easy place to look to put money to work given valuations (in the range of 18 to 20 times next years earnings). Consumer discretionary stocks in Canada do have a cheaper valuation than many other names, but the Canadian economy continues to slowly drag forward, debt continues to climb, and whether the retiring baby boomers spend money in retirement on discretionary items is up for debate. This is all to say that while these sectors have a place in a portfolio, they are not without higher-level concerns that could trip up any strength in the sectors. Portfolio managers would have a tough case to make for their clients if adding money to these areas.

Technology and industrials are likely a good place for stock pickers, as they are sectors that on average have valuations in line with the broader TSX while showing some upside opportunities. A technology company like Shopify or Kinaxis could continue to see strong growth, regardless of the broader economy or market drivers. An industrial name like Magna or Exco Technologies could see the trading multiple expand just on a change in investor sentiment. Similar to the issue with energy though, this is more likely an area that an investor would adjust around the margins, as it is hard to make an argument for any material increase in portfolio weighting from a sector perspective.

With rising interest rates, an improving energy sector and knock-on impacts from a strengthening U.S. economy, financials will probably be an area of focus as Canadian investors look to rebalance their portfolios. There are two problems here, though. First, this theme we have referenced is not really 'new' by any means, so while there would be nothing overly concerning with increased financial exposure, the degree to which the theme driving financials has been priced-in leaves some uncertainty. A second, more interesting problem is that most Canadian investors will already have too much financial exposure in their portfolio whether they know it or not. Are you a passive TSX investor? You already have close to a 35 per cent position in financials. Is your portfolio professionally managed? You are still more than likely benchmarked to the TSX to some degree and have, again, around a 35 per cent weight in your portfolio toward financials. To put this in perspective, over one third of an individual's liquid assets could be concentrated in a single sector! Even if financials continue to perform strongly, it is difficult from a portfolio management perspective to justify adding much more exposure to a single sector.

While every sector contains stocks that can outperform their peers (which is why we far prefer simply owning good companies over trying to predict which sector, market or geography will outperform), the only clear option from a sector rebalancing point of view is that of health care. The segment has performed terribly over the last year, down roughly 45 per cent, thanks in large part to Valeant and Concordia, the latter of which is no longer in the health care index. With the U.S. elections behind us, there are still concerns regarding potential changes in the industry, but a great deal of uncertainty has been lifted.

However, what is most interesting is the lack of options in this sector. The Canadian health care index has five constituents: Chartwell Retirement, Valeant Pharma, Prometic Life Sciences , Knight Therapeutics and Extendicare. If you are a money manager looking to increase health care exposure, what options is one left with? Valeant, while making up around 51 per cent of the index, is probably not on the top of anyone's list. This whittles the options down to four stocks. If investor money is moving from winners and into losers, and one wants to stick to the TSX sector indices, there is a potential for a lot of money to be chasing very few stocks, of which many are on the smaller side to begin with. So not only does the health care sector offer some growth potential along with attractive valuations depending where one looks, it is at the top of the list of sectors that investors would look at when rebalancing and holds a low-depth index structure that could lead to demand for the stocks outweighing supply.

We are not big fans of annual predictions and would not really consider this to be one. We do not know when and how often interest rates will increase. We also do not know whether the President-elect will make good on many promises or if inflation will take hold. We also generally don't care, as the preference is to own companies that will continue to generate cash flows regardless of the multitude of factors out of their control. From a rebalancing standpoint, we think many investors will be scouring the beaten up health care sector in the New Year, whether it is by choice or due to investors being'offside on investment mandates and policy statements. While there is no guarantee that money will flow into Canadian health care stocks, we think it is the first place investors will look at when putting money to work in 2017. The arguments for health care exposure are compelling but far from risk-free, and as the old saying goes, markets can remain irrational longer than you can remain solvent.

Readers can follow @5iresearchdotca on twitter to get timely updates on dividend initiations, increases and cuts in Canadian markets.

Please perform your own due diligence before making investment decisions.

In order to remain truly conflict-free, the writer and employees of 5i Research cannot take a position in individual Canadian equities.

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