The Canadian stock market rallied again in the last week of December to finish the month with a total return of 1.9%, leading to a 4th quarter gain of 1.7% and a full year gain of 7.2%.  Bonds went in the other direction in December as long-term interest rates rose slightly; for the month, the Dex Bond Index fell by 0.1%, but was up 0.3% for the 4th quarter and generated a 3.6% return for the full year 2012.  Looking more closely at stock attribution for the past year, most of the gains came from the larger stocks in the index as the S&P/TSX60 Index gained 8.1% while the S&P/TSX Small Cap index fell by 2.2% over the same period.   Sector selection was also of key importance in the Canadian stock market last year as the Financials gained 17.6%, representing basically the entire gain for the market as this sector accounts for over 30% of the index.  The 3 largest contributors to the index gain last year were 3 banks (Royal, Scotia,TD) followed by Nexen due to its takeover offer from CNOOC.

Resource stocks were a drag on the index last year as the Energy sector fell 7.6% while the Basic Materials dropped by 6.9%, driven in large part by a 5.9% drop in the Gold sub-index.  Leading stocks on the downside were Barrick Gold and Goldcorp as well as the large energy companies such as Canadian Natural Resources.

Stocks in the U.S. had a very strong year as the S&P500 stock index had a total return (including dividends) of 16.0%, the Dow Jones Industrials climbed 10.2% and the Nasdaq Composite Index jumped 15.9%.  Bonds did well also, especially riskier ones. The Merrill Lynch index of junk bonds rose 15.6%, helped by defaults of just 2% of issuers, despite the sluggish U.S. economy.  Behind the gains was continued action by the Federal Reserve to keep interest rates low, revive the economy and encourage investors to shift into stocks and riskier investments.

In the U.S., financial stocks led the way, another big surprise given the continued concerns about the health of many financial companies. Financial shares in the S&P 500 rose about 25%, with Bank of America jumping more than 100%.  Housing-related stocks scored among the biggest gains, as the real-estate market showed new vigor, surprising some who thought the housing decline would continue. Shares of home builder Pulte Group soared 179% in 2012, making it the top gainer in the S&P 500.  The housing rebound has helped improve consumer confidence, another reason for the market’s strength.  Consumers are much more confident now that their home prices have stabilized and may start to grow again, one reason consumer-related stocks have risen about 20%.

Outside of North America, one of the biggest winners was the German stock market, which gained 31.1%.  While bets on broader stock and bond markets did well, the best investments were riskier ones.  Among the best performing markets globally were the Greek, Portuguese and Irish stock markets, which were euphemistically referred to as the ‘PIIGS’ the prior year;  looks like some ‘pigs could fly’ in 2012!   Emerging markets gained over 15% in 2012, another sign that investors are starting to believe that the worst is over for the global economy and the trend is to start to increase the economically-sensitive or ‘risk’ trade.  Overall, the MSCI Global Stock index gained 13.2% in 2012.

As we enter 2013 it is worth putting aside some of the headline political bickering and look at some simple comparisons as to where the best potential financial market returns could come from over the next few years.  While many investors (especially individuals) have spent most of the past five years taking money out of the stock market, we believe that stocks offer the best potential return of any asset class.  While the return on cash remains negligible, investors have been shovelling money into the bond market, believing that the current global market is much like the Japanese market of the 1990’s, where stocks continued to fall on slow economic growth and bonds yielded the only positive returns.  We would argue that the ‘bubble’ today is in bonds! 

Looking back at the stock market back in the year 2000, the biggest company (by stock market capital) in the world was Cisco Systems, with a market cap of over US$500 billion.  It traded at over 70 times earnings and paid no dividend while the return on 10-year government bonds at that time was 6.5%.  That was the height of the technology bubble and, in retrospect, a good time to get out of stocks as they yielded very little return over the subsequent 12 years.  Fast forward to today and we find Cisco trading at a meagre 10 times current earnings, it has over 40 billion of cash on the balance sheet and it pays a dividend that gives it a yield of 2.7%.  Compare that to the 1.7% yield on 10-year government bonds and you can see how the scales have tipped in the other direction.  In fact, with inflation running close to 2.0% today, the ‘real’ (or ‘inflation-adjusted’) return on bonds is actually negative.  This, in our view, should lead investors to shift more money back towards stocks, particularly if the current recovery stays on pace and the political issues in the U.S. and Europe reach some conclusion.

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