Q3 2010 Quarterly Commentary

Global stock market returns were very robust during the third quarter as concerns about a "double dip" recession faded.  The US stock market (as measured by the S&P 500) returned +10.7%, pushing the year to date return into positive territory.  The Canadian dollar gained 3% against the US dollar resulting in the S&P 500 in Canadian dollars returning +7.0% .  The Canadian stock market (as measured by the TSX Composite) gained 9.5%.

 During Q3 it became increasinly obvious that the deleveraging of US consumer blance sheets would cap the growth prospects for the US economy for a number of years.  While the US housing  has not declined further,  it also has not provided any additional stimulus to the economy.  Housing starts remain at depressed levels and housing prices have flattenned out even though a significant number of homes are valued at less than the mortgages asssociated with those homes. 

The biggest concern about the prospects for the US economy has been the stickiness of the unemployment rate at historically elevated levels. Job growth is resuming, but not at a rate quick enough to absorb all the new entrants to the job market and bring down the unemployment rate.  Current job growth is not at the pace that the US has experienced in prior recoveries.   

 The sluggish recovery and its impact on job creation has become the key issue in the upcoming midterm elections.  Republicans look poised to gain control of the house and make gains in the senate.  This development is being warmly received by the markets as political gridlock will limit new spending programs and reduce the resulting business uncertainty. There is also optimism that the anti-business rhetoric emanating out of Washington over the last 2 years will dissipate.  A more balance tone out of Washington can only add to investor confidence and halt the slide in valuations related to the uncertainty and fear that currently pervades the market.

Having highlighted a lot of the negatives, all is not gloomy. The rest of the world continues to grow at healthy rates. Globally focussed companies, like industrial and technology companies, continue to exhibit robust growth.  The recently released Chicago PMI (pointing to healthy manufacturing  in the Midwest) and the ISM Manufacturing Index all show that while US manufacturing is slowing, it continues to grow.

Our portfolios are structured to focus on companies that have greater than average exposure to international markets.  Just because a company is domiciled in the US, does not mean that it is overly dependent on the US economy for its sales growth.  Over 1/2 of the companies in the Dow Jones Industrial Average have greater than 50% of their sales outside the US.  There is a strong proven correlation between non-US sales as a percentage of total sales and overall enterprise sales growth.   A slow growth US economy coupled with significantly faster growth in the rest of the world will lead to decent revenue and earnings growth for those companies well positioned.  The stocks that we own on behalf of our clients that are in the Dow Jones Industrial Index tend to fall into this category of having a high percentage of their sales outside the US.

A final point related to the US market is about valuations.  US stock valuations are at historically low levels, as can be seen in the following chart showing the price to book ratio on a 20 year basis.

The next chart shows the equity risk premium for the US market, which is a way of measuring the risk tolerance associated with equities. The higher the risk premium, the less risk tolerant equity holders are, and the cheaper the stocks are.  We are currently in a period with an elevated risk premium, which is a fancy way of saying that stocks are cheap.  The current low stock valuations are currently related to investor fears related to deflation, which is similar to what the Japanese began experiencing 20 years ago.                                                                                           

The most interesting charts were those charts comparing stock market valuations vs. bond market valuations.  The chart on the left shows the free cash flow yield of the S&P 500 being at its cheapest level vs. the BAA corporate bond yield.   When comparing the earnings yield of stocks (blue line) vs. High Yield Bonds (the red line), we get a similar looking chart. We would expect high yield bonds to have higher yields than S&P 500 stocks as they are generally perceived to be riskier assets.  Again the current relationship (similar yields) makes little sense, unless we are in, or investors believe we are in a deflationary environment.

While deflation is a risk and a concern of investors, we do not believe there is material risk of this occurring.  Recent data points from both the CPI and PPI provides scant evidence that we have entered a period of deflation.

We are still in the camp that says US growth will remain slow and uneven.  Growth prospects for US companies remain positive. There has been little change in sales growth or earnings growth expectations since the beginning of the year.         

 While Canada was the first G7 country to raise interest rates, recent signals from the Bank of Canada indicates that they will pause and not raise rates further till at least next year.  Canada's GDP, for the first time in almost a year, shrank in July. Other reasons for the pause include slowing housing activity, declining retail sales and the US economy being weaker than expected.

We are firmly in the glass half full camp when it comes to the outlook for the stock market. We are cognizant that all is not great in the US or the world, but believe that there is sufficient global GDP growth for stocks to continue to make gains.  Expectations remain conservative, and valuations are at multi-year lows. These all should lead to equities providing decent returns over the next few years and their outperforming the returns of bonds.

Global stock market returns were negative during the second quarter of 2010. The market's volatility increased as a number of issues led investors to question the sustainability of the global economic recovery and the potential for a double dip recession in the US.  Concerns about fiscal deficits in Greece, Portugal, Spain and Italy and the potential for debt contagion negatively impacted the Euro and the returns from European stock markets.  China's tightening of interest rates and the lending rules related to real estate also impacted global markets.

The US stock market (as measured by the S&P 500) lost 7.6% during the quarter, more than negating the gains from the first quarter.  As concerns increased about the pace of the global economic recovery (especially in Europe), The US dollar continued to strengthen against the majority of currencies. The US dollar gained 9.6 vs. the Euro, and 1.3% vs. the Canadian Dollar.           

Due to the recent damage to American personal balance sheets, consumer spending patterns in the US will remain more muted during this expansion than in prior expansions.  While the recession did not significantly impact the wealthy, it did have a big impact on the middle class.  The US savings rate is rising as consumers begin the process of repairing the damage incurred to their personal finances during the last few years. This increased savings is dampening the recovery vs. prior recoveries.  The continued stickiness of the unemployment rate near the 10% mark has led to concerns about the sustainability of the US recovery. 

Typically, at this point in a recovery, double dip recessions becomes a concern as the inventory led rebound slows and investors question what the next driver will  be to sustain the expansion.  While we currently do not believe that the US will experience a double dip recession, it remains a slight possibility.  We assign the highest probability that the US economy will continue its recovery, but at an anaemic pace with fits and starts. 

All signs point to the recovery continuing in US Manufacturing.  Readings from the Empire State Manufacturing survey and Philadelphia Fed survey both continue to be positive.  The ISM Manufacturing Index continues to read solidly above 50%, indicating that US manufacturing continues to experience growth.                                                                                                                                             

Recent data from the service sector also indicates that the US economy continues to expand.  The following chart demonstrates the positive readings since February (above 50), even though they have recently slowed.  The Non-Manufacturing Index tends to give a better reflect the state of the economy (vs. the ISM Manufacturing Index) as manufacturing only represents 10% of US jobs with the remainder being in the service sectors.

We are at the halfway point of 2010 and we still believe global growth will be in excess of 4% for 2010 and 2011.  Europe is forecasted to account for only 0.3% and 0.5% of that growth in 2010 and 2011.  While the southern European countries are taking drastic austerity measures to deal with their fiscal woes, these countries are largely immaterial to the overall European growth rate.  What really matters in Europe is Germany, and right now its export oriented economy is benefiting from the weakening Euro.  Over the last few weeks, companies that have reported earnings or spoken at investor conferences have all uniformly stated that while they are cautious on Europe, none of them have seen any significant change in their demand patterns.  The Euro zone will continue to experience positive growth benefits from their weakened currency.  

When breaking down the 4% global growth rate, it is apparent that almost half of the global growth is coming from non-Japan Asia, with almost 30% of the total growth originating from China. China growth has slowed as the infrastructure build out winds down.  This is being supplanted by Chinese consumption growth beginning to accelerate.  This combination of market changes has led to the leading indicators index suggesting that the Chinese economy is nearing the trough of its growth cycle. Chinese growth continues to remain at lofty levels relative to the rest of the world. We believe this acceleration in the Chinese economy is sustainable as the consumer share of Chinese GDP is only 32%, as compared to 71% in the US.  Other emerging markets in Asia will also continue to benefit from the strength being experienced in China. 

We continue to think that the best way of getting exposure to these growth markets is through US companies that sell into China and other emerging markets.  We do not like investing directly in emerging markets due to the immaturity of their compliance and regulatory environments, their lack of transparency and in some cases questionable management. We believe that investing in companies that are based in developed countries with significant sales outside North America and are focusing a meaningful portion of their investments on these growth markets is an excellent, low risk method of capturing these opportunities. These global multi-nationals have above market dividend yields, less stock price volatility than the overall market and the ability to grow earnings at least 10%.  An additional bonus is that many of these companies are trading at a 20 year valuation lows.

As expected, the Bank of Canada was the first G7 nation to raise interest rates.  With the markets being as unsettled as they have been recently, The Bank of Canada stated than nothing is pre-ordained (vis-vis continued interest rate hikes) and they struck a more cautious outlook. We expect further tightening this year, but the timing will be more measured than is typically seen in a rate tightening scenario.  Canadian housing is beginning to enter the corrective phase as housing sales have been down four of the last five months on a month on month basis and are down for the first time on a year over year basis.

While we are cognizant of the macro risks that are out there and the fragility of the global economic recovery, we continue to believe that the equity markets are poised for continued growth.  It appears to us that we are experiencing a correction in a bull market.  After the huge run up from the bottom in March 2009, it should not be a surprise that stocks need to consolidate their large gains.

Although investors remain pessimistic about markets continuing upward, the global economy continues to experience growth.  Valuations are at historically low levels and we have just come out of a deep recession.  All these provide a solid foundation for the markets to continue grinding upward.

We entered the year believing that economic growth in the developed markets would be good, but not great, with better growth in the developing markets.  We positioned our portfolios accordingly and as such have not made any major changes to our portfolios since the beginning of the year.   Our portfolios are positioned in companies that will continue to achieve their growth targets in a sluggish, yet steady upward US GDP growth environment, and are also exposed to the faster growing emerging markets.

Europe Is Not The Problem!

In my last post I talked about why I think that Europe is not that big a deal to us in North America. That does not necessarily mean that I can sleep with not a care in the world. I just feel that everyone is focussing on Europe and they are potentially missing the big picture, which is China.

Economists are projecting around 4% global growth for this year and next year, or at least they were till Europe blew up. That is a pretty good growth number. We do not believe that the problems in the European periphery will materially impact these numbers. Continental Europe remains in decent shape, and its contribution to global GDP growth will not change materially.

Its China that has us questioning our global growth assumptions for the next 2 years. It feels to us that everyone (including the press) is looking to the right, when the real game is to the left. While everyone is trying to decide how real a Euro contagion scenario is, few are paying as much attention to what is going on in China.

While North American markets are in a correction phase, Chinese markets are in a full blown bear market. The Chinese stock market is already down 20% this year. The markets are telling us that something is wrong in China. The commodity markets provide further confirmation of this concern. Oil is off 12% from the beginning of the year. Copper is down 18% from its highs just 1 month ago. These are some of the commodities that China inc has been buying in large quantities to fuel their building boom.

China is in the midst of a tightening cycle. They have raised interest rates numerous times and they have tightened credit standards. The government is trying to cool the real estate market before it turns into a property bubble. One might question whether the government will be successful or whether they are too late.

The problem in China is that a lot of the real estate development is being done on spec. Sound familiar? Real estate is not being built for buyers who will occupy them, but for speculators who are buying them on leverage. This game of musical chairs continues until the speculators cannot unload the properties at ever higher prices or their loans get called.

The real question is, can the Chinese government slow the property market down without killing their economy (and the growth prospects for the global economy)? Not sure what the answer is, but that is what I believe is going on in the markets this week.

I have heard a lot of questions of why the markets are selling the Canadian dollar when the US Dollar is strengthening against the Euro? Seems counter intuitive that investors would sell Canadian Dollars when they are worried about countries with large fiscal deficits (Europe). Canada is actually in way better fiscal shape than the US. But, it makes perfect sense if one considers that that the Canadian Dollar is weakening along with commodity prices and a potential weakening of global growth prospects. Canada sells a lot of commodity stuff to China and if China slows, they will be needing less of the raw materials we sell to them (and at lower prices).

This thesis is also corroborated by the performance of the industrials and technology stocks over the last few days. These companies are most exposed to global growth and they have been the poorest performers over the last week.

In my next post I will talk about how we are investing in this climate.

Bear Market? Correction in a Bull Market

Riots in Greece, the Euro falling off a cliff, Oil trading below $70 and Gold on a tear. The headlines are ugly. It is all bad, or so we are led to believe. If only the media were able to predict the last bear market!

That bear market only ended 14 months ago. As tends to happen, current predictions are based on the most recent past. We tend to use the events of the last few years as a playbook for how the current news will impact financial markets. While few people were able to predict the severity of the bear market just 3 years ago, it seems as if everyone and their cousin can predict the next bear market, which is just around the corner. Financial markets do have a tendency of repeating history, but not with such a short lag between events. Very few people are willing to go out on a limb and say what is happening in the context of the current environment. It is easier to frame events from today in what happened over the immediate past.

So, should our economic and market assumptions be any different from our assumptions a month ago? Nope. Huh, did I just say no? Yup. What about all the bad stuff that I mentioned in the first paragraph? Greek riots are bad for Greeks, not sure it will have that big of an impact on North American consumer. The Euro is bad for European consumers and North American exporters ( but good for European exporters). Oil prices declining is a negative precursor to economic growth, but effectively puts more money in the pockets of consumers.

Do not get me wrong, things are not great. The US consumer is in trouble, but we know that. US real estate recovery has stalled, but it is not getting any worse. The US recovery is still in place and the problems on the periphery of the Euro zone are unlike to change that.

We continue to believe that the recovery will continue, but maybe at a slower rate than we thought a month ago. North American companies sell very little to the Southern European economies. Most US-European trade occurs with the Northern European countries, which remain in better shape than their southern brethren. The reality of what is going on with Greece, is that global growth will be a little less than originally thought, but growth will still be solidly positive.

Can you guess what the S&P 500 has done since it reached its peak in late April? It is down around 8%. That is solidly in the range of a typical 5 - 10% correction. After the run-up from the March 2009 lows it is not surprising that we were due for a correction. We believe that this is nothing more than a cyclical correction in a bull market.

Stocks (and the market) are not expensive based on historical standards. Earnings will continue to grow and we will wake up at some point and find out that Europe is not that big a deal (from a global growth perspective).

Our investment strategy remains unchanged, which is to buy large cap stocks with growing earnings that have attractive valuations. At the current time, we are finding lots of stocks that meet this criteria.

who am I

This is my first blog entry. Over time, I will try to share my opinions about the markets, stocks and the financial business. Updates will occur on a semi-frequent basis as I have things to discuss. Would love constructive feedback so I can provide more useful comments.

Who am I? I am the founder of an investment counsellor in Toronto. We provide money management services to our clients through segregated funds. Our aim is to preserve capital while trying to grow assets by buying conservative, growth stocks. Prior to this, I spent over 20 years with large institutional firms. I have predominately participated in the US Markets. I have managed institutional, private and mutual fund mandates.