Defensive posture recommended

With the long-running bull market delivering healthy gains in the first half of the year, investors may want to adopt a more defensive position, according to a strategy note out of Richardson Partners Financial.

The S&P/TSX Composite Index turned in a six-month return of 7.7% at the end of June, despite some rough patches along the way. Gains were largely driven by announced mergers and acquisitions, and speculation that anything could be up for grabs next.

But the market could soon be facing headwinds, according to Andy MacLean, CFA, director, private client investing, and Clancy T. Ethans, CFA, senior vice-president and chief investment officer, both of Richardson Partners.

“A combination of low interest rates, increasing acceptance of alternative investing and an extremely competitive financing environment resulting in accommodative covenants has driven the trend,” the report says. “While there is no doubt that there is froth here, this trend could go on for some time.”

Interest rates are already on the rise in Canada, as the Bank of Canada finally followed the lead of its European counterparts. Tuesday’s 25 basis point hike was the first since May 2006 but still leaves the overnight rate at a rather accommodative 4.50%.

More importantly, the U.S. Federal Reserve is not expected to raise its key interest rate anytime soon, as the American economy remains on a knife’s edge. American consumer spending dropped 0.9% in June, compared to an expected slowdown of just 0.1%, according to RBC Economics Research, but the year-over-year rate “remained at a still-solid 3.8%.”

While the U.S. consumer has been showing signs of fatigue since 2006, the global economy could pick up even more steam. MacLean and Ethans predict growth could rise from 4% to almost 5%, which could help to prolong the period of strong demand for Canadian resources.

“By all measures, this bull market in Canadian equities is getting a little long in the tooth. What is remarkable is the uninterrupted upwards progression of this bull without any correction or extended period of consolidation. We noted at the beginning of the year the building enthusiasm for equities without any consideration given for the potential risks in the market.”

Despite the length of the bull run, MacLean and Ethans expect equities to continue to outperform both cash and fixed income securities. But they have cut their stock allocation to 55% of the portfolio, from 65%, citing “slowing profit growth, rising valuations and an overall building risk profile.” They have recommended clients redeploy that capital evenly between cash and bonds.

So far this year, they point out, cash has outperformed bonds, as rising interest rates have eaten into the capital value of fixed income securities. Holding a fair chunk of change will also allow investors to take advantage of any short-term drops in the equity markets.

“This is still a rather defensive tactical asset allocation and will, we feel, provide investors with a measure of protection should an equity correction occur, while at the same time providing a 15% cash reserve to take advantage of any excessive market volatility,” the note reads. “As for our 30% recommended allocation to bonds we recommend that investors keep maturities to less than 10 years as interest rate volatility is likely to continue.”

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com