Summary

  • The stock market in Canada had another positive month despite some mid-month weakness due to European debt fears and weakness on the Chinese stock market.  The main Canadian index was up 2.2%, lead by a resurgence in the resource sector.
  • The Canadian bond market struggled in November as interest rates were pushed higher on the outlook for stronger economic growth in North America and some fears about the return of inflationary pressures.
  • Commodity markets edged higher last month with silver and uranium the standout performers, gaining 13.5% and 14.1%, respectively.  Gold and oil prices were also stronger while most base metals weakened slightly.
  • The Economic data remained positive and appears to be gaining some momentum again in North America.  Employment levels in the US appear to be strengthening at last which could increase consumer confidence.  Chinese manufacturing also came in above expectations again, showing that growth continues despite higher interest rates.
  • In terms of stock sectors, the Basic Materials group lead the overall gains once again with an increase of 4.9%, followed by Energy with a gain of 3.6%.  Strength in Research in Motion helped push the Technology sector to a 2.9% monthly gain while the Financial sector once again trailed the overall market, gaining only 0.7%.
  • Our Stock Market Outlook is still bullish over the medium-term as economic growth is recovering, profits continue to improve, interest rates remain low and stock valuations are reasonable.  Stocks have had strong gains since the recent lows in August and are always at risk of a short-term correction, particularly since investor sentiment levels have gotten somewhat bullish lately, as often seen at short-term market highs.  But we view that only as a short-term risk.  The overall fundamental outlook argues for higher stock prices over the next few years in our view.
  • J Zechner Associates is launching a new pooled fund product on January 1, 2011.  The JZAI Global Hedged Growth Fund will be available to all qualified investors through an Offering Memorandum that can be obtained by contacting us.  There is an attached file with this letter outlining the strong 3-year performance history of this Fund, some information about the investment strategy of the Fund as well as administrative details.  Please have a look and feel free to contact us to find out more about it. 

Financial Markets: Monthly Review and Outlook

Investors were given plenty of reasons to take some money off the table in November, with tumultuous headlines about debt default issues and ratings downgrades of sovereign debt in Ireland and Portugal, new worries about similar developments in Spain (which is twice the size of Portugal, Ireland and Greece combined!) , the sudden military engagement involving North and South Korea  and an FBI investigation into three large hedge funds in the US as part of a widening insider-trading investigation.  Despite all of this, stocks snapped back from mid-month losses to once again head higher.  The S&P/TSX Composite Index in Canada gained 2.18% in November, its 5th consecutive monthly advance. US stocks also improved late in the month but came in around break-even for the month as Financial and Technology shares were somewhat weaker.  European stocks fared the worst with the DAX index in Germany and the CAC40 in Paris each down over 5% on a US dollar basis (due to the weakening of the Euro).

Stocks started last month strongly on the ‘much anticipated’ announcement on November 3rd of a US$600 billion Quantitative Easing plan by the US Federal.  They outlined how they would be spending about US$80 billion a month through to the end of the first half of 2011 buying long-term government bonds in order to keep interest rates low and further stimulate US economic growth.  But this news had been so well telegraphed that the stock market fell back on the old ‘buy on rumour, sell on news’ pattern with stocks falling 3-5% over the following week and then drifted lower through the middle of the month.  Stocks rallied towards the end of the month as investors rushed back to the resource sector, helped in large part by the pick-up of takeover activity in the sector as well as further gains in commodity prices.  Basic Materials and Energy stocks lead the Canadian advance while the so-called ‘defensive’ sectors of the market (Health Care, Consumer Staples and Telecom stocks) all suffered monthly declines as investors opted for the ‘risk on’ trades once again in November.  One of the biggest positive impacts last month came from the increase of over 20% in the stock price of Research in Motion, where some optimism about both the sales of the new BlackBerry Torch as well as the introduction of the Playbook in 2011 (to compete against the hugely popular iPad from Apple), lead many analysts to upgrade their earnings outlooks as well as their price targets for the stock.

In last month’s comments, we noted that after substantial price gains in September and October, stocks to us looked ready for another pullback, similar to what we had seen multiple times since the stock market bottomed in March of 2009.  We thought that a correction of anywhere from 5-10% looked like a good possibility, especially given the ‘giddier’ level that investor sentiment levels had risen to very recently.  Although we remained very bullish for the medium term we were somewhat concerned that, over the short-term, stocks might have gotten a bit ‘ahead of themselves’.  It was almost the exact opposite of what we saw back in August when we moved the stock positions in our Balanced Funds close to the maximum level.  So in early November, we reduced our Balanced Fund equity positions from 120% of the benchmark weight to around 80%, looking to re-enter the market on some expected weakness.  At that time, the markets were also facing US mid-term elections and had already rallied sharply on the prospect of more quantitative easing (QE2) from the US Federal Reserve.

But stocks are proving to be highly resilient as substantial cash levels of investors is providing support to any pullback.  Given our very positive outlook over the medium term, we began redeploying our excess cash back into the stock market on the weakness in mid-November.  We added back to many of the same sectors that we had sold, including Energy and Basic Materials in Canada as well as Industrials and Financials in the US market.  There is still a risk of a correction in prices but the economic data continues to get better, earnings growth is strong and, most importantly, corporate takeover activity is starting to pick up again, with companies starting to put their substantial cash balances to work buying up smaller competitors at attractive valuations.  In Canada, zinc producer Farallon Mining received a 25% premium on an ‘all cash’ bid from European metals firm Nyrstar. Then Western Coal received a substantial premium on a bid from Walter Energy.  This was followed by another deal in the fertilizer industry with Potash One receiving a bid for the company from German potash producer K+S.  The deals weren’t limited to the resource sector either as the Bank of Nova Scotia stepped up to buy the 80% of Dundee Wealth that they didn’t already own and AGF Funds bought Acuity Management for over $300 million.  Similar activity was also taking place in the US.  Caterpillar expanded through the purchase of Bucyrus while retailer J. Crew and consumer products company Del Monte Foods are both being bought by a private equity groups.

This type of activity should continue as companies still have substantial cash balances, they are looking for new areas of growth and are becoming more confident that the economy is on a sound economic footing.  The upper panel on the chart below shows that corporate cash levels as a percentage of total assets in the US remain at the highest levels since the early 1960’s.  Up until recently, these companies have felt more comfortable holding onto that cash given that debt markets and bank financing had been less accessible for them to secure funds and they were somewhat uncertain about the economic outlook.  But the bottom panel of that chart shows how business confidence has been improving as global economies exit the recessionary conditions of 2008 and the first half of 2009.  With lots of cash and a higher degree of comfort, it’s no surprise that corporate takeover activity has picked up the way it has.

Despite some shorter-term concerns about high levels of investor sentiment and excessive expectations for the benefits from QE2, the bullish case for the stock market over the next three-year period remains in place in our view.  In fact, the stock market could easily be back at record highs within twelve months and the rationale for this is fairly straight forward.  After experiencing the sharpest recovery in any ‘post recessionary period’, corporate earnings in the US are now within 10% of the peak levels reached back in early 2008.  U.S. pre-tax corporate profits rose 28% year-over-year in the third quarter, and have now made their way back above pre-recession levels.  Additionally, profit margins still appear to be expanding, as the profit share of GDP (Gross Domestic Output) rose to 11.2% (the recession low was 7%) and is closing in on its pre-recession high of 12.3%.  With earnings expected to continue to grow at least 10% over the next year and with interest rates at substantially lower levels than they were back in 2008, there is no reason for the stock market not to go back to the valuation levels at the prior peak on a similar earnings level.  This would put the entire market more than 20% above current levels! Clearly there are no guarantees that the earnings will continue to grow at over 10% and that valuation levels will move back to 2008 levels, but it doesn’t take much optimism to envisage such a scenario.  In fact, with interest rates at such low levels it’s easy to argue for a higher level of valuation on a similar earnings base which would put stocks well above the old highs.  This scenario could also get a boost from a greater sense of urgency from investors who don’t want to continue to sit on money market funds with almost no yield or investments in fixed income securities, which have been under pressure for the past month.  If these funds start to flow back into stocks, then the upside move would be amplified even further.  Although many investors have benefited from the strength in stocks over the past 18 months and have been taking some profits on those gains, the reality is that the majority of investors have missed out on this rally given that it followed so quickly on the heels of the devastating downturn in 2008.   There is a substantial amount of cash still ‘on the sidelines’ with very few alternatives to look at in this environment of low fixed income yields.  These funds will almost certainly start heading back into stocks at some point, particularly if economic growth and corporate profitability continue to improve as they have.  We have seen some early indication of this recently in the US where inflows to equity mutual funds have turned positive again in 5 of the last 6 weeks.  Also last week, we saw the first net outflow from bond funds in the US since December of 2008.   So the tide may in fact be turning when it comes to investment flows as well!

The most important part of this story, though, is a continued recovery in the global economy, with the US once again joining the party.  We continue to see indicators that suggest that economic growth is recovering at a modest pace. Overseas growth continues to be exceptionally strong, even in Europe which is dealing with specific sovereign debt issues.  The U.S. consumer is also starting to have a stronger outlook as recent employment gains are helping to boost consumer sentiment.  The Conference Board’s confidence index climbed to 52.6 this month from 50.2 in October.  The improving spending outlook has helped boost retailer shares. The S&P Retailing Index, which includes Amazon.com Inc. and Macy’s, has climbed 6.9 percent this month and reached a three-year high on November 24th, just before the US Thanksgiving Weekend and ‘Black Friday’.  Manufacturing, the industry leading the U.S. recovery that began in July 2009, expanded in November for a 16th consecutive month, according to a report from the Institute for Supply Management (ISM).  The group’s factory index this month was little changed at 56.5, with readings greater 50 signaling expansion.  The ISM’s gauge of services, which represent almost 90 percent of the economy, climbed to 54.3 in October, the highest level in six months.

The big event that investors and consumers have been waiting for in the US, though, is some sign that employment levels are starting to pick up again, especially since almost 8 million jobs were lost in the US economy during the recession in 2008-09.  Things seem to be improving on that front as well though as can seen in the chart below which shows the Weekly Jobless Claims figure in the US.  After peaking at levels near 650,000 in early 2009, weekly claims dropped steadily and have held in the 450,000 range for most of this year.  Last week they dropped down to 407,000, the lowest level since mid-2008, and close to the key 400,000 level which is generally associated with stronger levels of employment growth.  This week’s US employment report for November will shed further light on the situation.  Expectations are for a gain of 150,000 jobs in November, similar to the report in October that set the groundwork for the stock market’s subsequent gains.

Economic activity appears to be picking up again in Canada as well.  The action of the fixed-income market in the past month, considered among the best of forward-looking indicators, suggests the economic recovery is picking up steam in Canada and the central bank may deliver another rate hike as early as March of next year. Yields across the curve have reached levels last seen in June and July when the Bank of Canada commenced a short-lived rate-hike campaign.  At that time, there was no talk of the U.S. Federal Reserve needing to inject hundreds of billions of dollars of additional liquidity into the U.S. economy to jump-start the recovery.  Two-year bond yields, a great indicator of where the Bank of Canada’s benchmark rate might be headed, have jumped nearly 40 basis points in barely a month since the last central bank decisions.  This dip in bond prices over the past month could also end up accelerating investors switching from bonds to stocks.  When both were rising, the urgency to switch was less emphatic.  But if bonds continue to deliver low or negative returns, then investors could become even more likely to switch over to stocks where dividend yields remain high (bank dividend yields in Canada are still almost 50% higher than 10-year government bonds) and earnings are growing to support higher stock prices.

As a final point on a potential positive move in stocks, you really need also to look at the seasonal period we are heading into now.  There is a recurring history of strong stock markets heading into this time of year that has often been dubbed the ‘Santa Claus Rally.’ Birinyi Associates calculated the return of the S&P 500 between US Thanksgiving and New Years Eve for each year since 1945.  Over the past 65 years, the market is up 72% of the time for an average gain of 1.92%.  When the market is up, the average gain is 3.38%, while the average decline during down years is 1.88%.   The best year was 1971 when the S&P 500 rallied 13.02%, and the worst was 2002 when the market lost 6.29%.

Canadian investors have rightfully felt very good about the performance of our economy through the last recession.  Our banking sector proved more resilient in the downturn since it didn’t have the same degree of loan exposure to bad real estate as many of the US banks and our government didn’t have the same deficit funding issues that have plagued many smaller European economies.  The strength of the resource sector has also provided an added impetus for stronger stock market performance in Canada, as evidenced by the 35% gain for the Canadian stock market in 2009 versus 23.5% for the S&P500.  Similarly in 2010, the Canadian market is us 11.5% versus a 5.9% gain in the US.  But before we get too smug about this we should be careful to look at the numbers around the consumer debt levels, one of the key suspects in the problems and excesses that helped drive the US into the last recession and almost brought the global financial system to a collapse.  While the extravagant lending and questionable funding of the US housing boom are well known now, the thinking from most is that Canada is somewhat more immune from these problems due to more conservative financing.  But, as shown in the chart below, Canadian household debt has been rising consistently over the past 30 years.  Household debt as a percentage of disposable income has risen from a very manageable 60% in the early 1980’s to over 140% today, with little indication that this trend is reversing.

Levels near 150% have been associated with many of the problem economies in the past that have suffered financial market contagions.  With interest rates still exceptionally low, the servicing of this debt has been less of a problem.  But it certainly makes the economy much more susceptible to running into problems if interest rates start to head higher.

One of the pillars of strength in the recovery has been the performance of the Chinese economy, as well as many of the other emerging market countries that are in the long-term process of moving from agricultural-based economies to industrial-based economies.  Their demand for basic materials has fueled the huge resurgence in the resource sector while their growing demand for consumer goods is supporting the growth of many of North America’s larger multinational businesses, particularly in the technology and pharmaceutical businesses.  Investors here are therefore closely watching the economic numbers in those economies, particularly China, to make sure that those growth rates remain intact.  In the case of China it certainly still looks like the worries are ill-founded as they have really come through the recent downturn in exceptionally good shape.  The chart below shows the annual real economic growth in China, quarter by quarter, for the last four years.  While growth did drop below the policy target of 8% for three quarters during the financial crisis, it didn’t ever drop below 6% and has recovered quite sharply since then, peaking out at nearly a 12% annual rate in the first quarter of this year.  While this growth may indeed start to slow down at some point as infrastructure and capital spending get ahead of actual global demand for the products they produce, the economic outlook for now still looks strong.

 

That takes us back to Europe, where the headlines have been the most negative recently and where many believe the source of the most stock market risk is emanating from.  But our contention all along has been that these are more ‘headline’ than ‘real’ risks.  The stock market had shown sharp gains and, in our view, was ready for a bit of a correction and was just looking for some excuse to support it. A year ago at around this same time stocks sold off briefly on worries about debt defaults in Dubai, which was looking more and more like the US housing market supplanted onto a Middle East economy, ripe with excessive spending, over-valued real estate and questionable financing sources and structures.  But the problems of Dubai were never going to add up to be enough to bring down the global economy.  They were more in the ballpark of a mid-sized US regional bank.  In the end the market resumed its upward trend and the problems of Dubai disappeared from the headlines.  The same could be said for Greece in the spring of this year when the stock market also experienced a 10% correction while the headlines went on and on about the debt ratios and funding requirements of the Greek economy.  In the end, the European Union was able to put together a rescue program for Greece, helped in large part by a falling Euro which actually provided additional gains for the northern European economies, particularly Germany.  Stock investors ultimately stopped paying attention to the problems in Greece, recognizing that they had little impact, if any, on the global economy, and stocks eventually resumed their uptrend.

We think that Ireland is much the same case.  Early in this decade many economists and others praised the economic growth rates and strength of the Irish economy and dubbed it the ‘Celtic Tiger,’ in reference to its ability to grow like the emerging Asian economies (often referred to as the ‘Four Tigers’).  But, in the end, it wasn’t really a new or particularly insightful economic model that was being implemented in Ireland.  It was just growth that was being amplified by an excessive level of government spending (which rose to over 30% of Irish GDP) and was being funded by aggressive borrowing from foreign investors, which ultimately had to be repaid!  The only lesson in all of this should really be taken by the Americans.  Here is an example of an economy that appeared to be doing exceptionally well but was doing so on excessive levels of spending, borrowing and huge growth in the money supply.  Not unlike what is happening in the world’s largest economy today.  The lesson is that these debts ultimately do have to be repaid and if this can’t be done through regular channels, then debt defaults and further currency depreciation are the inevitable result.  That’s probably the simplest reason why the US dollar continues to be under downward pressure and why the gold market just doesn’t seem to want to stop moving higher.  Not all that illogical if you think about it.