DOW HITS RECORD ALL TIME HIGH, NO ONE CARES

Stock markets rocketed upward during the recently completed quarter with both the Dow Jones Industrial Average and the S&P 500 gaining in excess of 10% to close at record levels. The Canadian stock market as represented by the S&P / TSX index gained 2.5%.

This is one of the quietest, most unloved bull markets we have witnessed. The stock market is at record highs, but no one seems to care. Where prior market records were met with euphoric investors clamoring to invest in stocks, current highs are being met with apathy. Instead of headlines trumpeting investor optimism, we find investors and media pundits are questioning when the market "bubble" will burst. The concern is that the Fed Reserve Board (The Fed) will end the liquidity induced party. The Fed's low interest rate policy is pushing investors towards stocks, given few alternatives that provide attractive returns. After 4 years of steady outflows from stock funds, money is beginning to flow back. This movement towards stocks has the potential to continue for an extended period of time. We recognize that the Fed will have to raise interest rates at some point but we do not believe this will occur in the short-term. The impact on stocks from the inevitable rise in interest rates will be mitigated by both a strengthening economy and improved corporate outlooks.

The Fed's easy money policy is not the only factor driving stocks higher. Concerns weighing on markets in 2012 are beginning to recede. Despite last year's negativity influencing the markets, North American economies still managed to grow. Last year's fiscal crises will not materially impac the global economy going forward as sufficient progress has been made towards resolution.

The US economy appears to be gaining momentum aided by rising auto production and housing activity. We have spoken of the virtuous cycle of increasing activity in these sectors fueling employment growth which cycles back into further demand for these economically important sectors.

These trends should continue for the remainder of the year. The continuing positive data points from the purchasing managers index (an indicator of manufacturing strength) highlights the growth of the manufacturing sector. Buoyed by household wealth recovering to near all time highs, we are also seeing increasing levels of consumer confidence.

While the private sector of the US economy is relatively healthy and gaining strength, the public sector (government) is not as healthy. Federal and State Governments are facing growing deficits and are beginning to restrain, and in some cases, cut spending. As politicians in Washington were not able to reach a deficit reduction agreement, sequestration was implemented to force a reduction in government spending. Sequestration will constrain economic growth, but not enough to offset the positives or damage the recovery.

Stock prices tend to move in sync with earnings. Earnings continue to increase, achieving record levels. With a positive economic outlook, earnings growth should persist. Stock valuations are at a slight discount compared to historical levels based on the Price/Earnings ratio (Chart 1). Stock prices have the potential to increase due to both continued earnings growth and reasonable valuations.

Chart 1: Forward Price / Earnings

Source: JP Morgan

US stocks should continue to outperform Canadian stocks as they have heightened growth opportunities. The US economy appears to be accelerating, while the Canadian economy is slowing. Part of the slowdown is fueled by a pause in the already overheated real estate market. Canadian consumers are more in debt than US consumers were at the beginning of the financial crisis in 2008.

A significant portion of the Canadian stock market is exposed to commodity stocks. These companies benefited from the Chinese infrastructure boom which led to a commodity super cycle. With a pull back in Chinese investment spending, the commodity super cycle appears to have concluded. The next leg of the Chinese growth story is more likely to be led by consumer consumption (where a large number of US companies are well positioned) rather than investment and infrastructure spending.

As previously discussed, we are not overly excited about the bond market. So far this year, this has been the correct call as bonds have returned less than 1%. Assuming GDP growth in North America remains above 2%, bond holders will at best only make the current coupon of 2% - 3%. The risk to bond prices is ultimately to the downside as a strengthening US economy will eventually lead to higher interest rates.

The stock market has moved up almost in a straight line this year. This is obviously not the norm. Typically, there are corrections even as the stock market moves to higher levels. We cannot predict what will precipitate a correction, or even when it will occur, but we assume that the next downdraft will be a short term event. The stock market should continue to move up. We based this on: continuing low interest rates, an improving economy, increasing corporate earnings and undemanding stock valuations. We continue to believe that the US Stock market continues to offer the best potential risk adjusted returns for the remainder of 2013.

Q4 2012 Commentary

The US election and the fiscal cliff dominated financial headlines over the last three months of 2012. The bitter election campaign ended with the re-election of President Obama and preservation of the status quo in both the Senate and the House of Representatives. Despite daily fluctuations there was little overall market movement as most investors concluded that there was a strong incentive for politicians to reach a settlement on the fiscal cliff issue. The US stock market was down slightly during the quarter, while the Canadian stock market was up fractionally.

While US politicians debated government spending and taxes, sluggish US economic growth persisted. As the American politicians were successful in negotiating a deal, we remain guardedly optimistic for growth prospects in the US economy in 2013. Recent economic indicators provide a hint of a more robust economy in the near future. The first signal is a continuation of the trend toward increased auto sales. Home starts and prices also continued to rise up from historically depressed levels. While both auto and real estate activities do not have a direct influence on US stocks, they do impact the economy and employment numbers. As we have previously discussed, growth in auto sales and housing creates a virtuous cycle of increased employment feeding into increased consumer spending providing the seeds for further growth in housing, autos and the economy in general.

Although the fiscal cliff was averted, the negotiated deal primarily addressed taxes by making the “temporary tax cuts” permanent. Spending issues were not addressed in this version of the deal; however this is unlikely to influence the short-term economic prospects in 2013. Alternatively a near-term austerity program (that would cut spending this year) may negatively impact the fragile economic recovery currently taking place. The key to maintaining the economic recovery will be to put in place a long-term economic framework that will address the growth in spending and debt accumulation.

US companies are in better shape than they were 4 or 5 years ago. The average corporate balance sheet has either excess cash or has significantly reduced its debt loads. The past few years have seen companies streamlining their operations in order to yield more efficient operating structures that result in higher profit margins. The combination of wary investors and increasing corporate earnings will provide an opportunity to obtain stocks at attractive valuation levels (Chart 1). In light of the lifting of the most recent macro concerns (fiscal cliff), we see stock prices continuing to move upward in 2013. We believe it is increasingly unlikely that valuation will contract from current levels, and if anything, there exists the potential for valuations to rise as consumer confidence increases.

            Chart 1

         Source: BMO Capital, Factset, IBES, Compustat, Federal Reserve

A number of macro factors have impacted investor confidence and investing patterns. These concerns include, but are not limited to: The European debt crisis, the toxic US political environment, uncertainty over higher tax rates and continued deficit spending. When we look at these concerns we see: a stabilization of the European debt crisis, a recently completed US election and a stabilization of the tax rate for 98% of the US population. The US deficit stills needs to be addressed, but it can be dealt in the future. From an individual American perspective, more people are employed and the value of their homes and stock portfolios are rising. It is anticipated this will lead to increased confidence in their individual financial situations. These rising confidence levels could result in cash inflows into the stock market leading to stock valuations moving back  their historical levels. Individual investors remain skeptical that stocks are a better investment than bonds. Their focus remains on yield and income rather than capital appreciation. Any change in investor attitudes to risk would be positive for stocks.

While the Canadian economy has been one of the brighter spots in the global economy, there are some future challenges. Recent Canadian economic forecasts have been slightly downgraded. Canadian household debt to disposable income ratios (Chart 2) are currently above where US household debt to disposable
incomes ratios were in 2008. There are signs that the Canadian housing market is slowing down, in part related to a change in government mortgage regulations. The critical question will be whether this housing slowdown is just a temporary pause or the beginning of a slide in home prices with consequent negative implications for the economy.

              Chart 2: Canadian Debt to Disposable Income

              Source: Statistics Canada

A large portion of Canadian stock markets gains have been fueled by gains in commodity stocks. As emerging market economies experience slower growth rates and a de-emphasis of infrastructure spending, it is uncertain whether the super cycle for commodity stocks will continue. While we expect the Canadian market to achieve positive returns over the next few years, the gains will not of the same magnitude as experienced before the onset of the 2008 financial crisis. If anything, stock selection will be even more critical.

Bond yields remain near historic lows. The slow pedantic rate of economic growth suggests that bond yields will remain relatively stable, albeit with low rates of return. We believe that we are the point in the cycle where the 10 year rates are goo proxies for the expected long run rate of return. This is similar to what was achieved in 2012. We continue to appreciate the relative stability of bond investments in an environment of flat interest rates. We remain concerned that as interest rates rise, bond prices will decline. For the income portion of our portfolios we have been employing a strategy that provides superior yields
over 10 year bonds while at the same time hedging the risk of rising long term rates. Call or email me to find out more about this strategy.

As we look into 2013, stocks should continue to outperform bonds with US stocks outperforming stocks in other regions. While we prefer companies that pay decent dividends, we will not pay up for high dividend payers where there is little likelihood for dividend growth. We remain focused on companies where positive sustainable trends will contribute to continued sales and earnings growth.

Tax Policy And Competitiveness Of US Based Corporations

Listening to the Presidential debates and reading the platforms of the 2 candidates, there is a lot of noise, truths and half truths related to what should be policy to ensure that the US corporations remain competitive in a global economy.  In my usual reading of corporate proxy material and other filings, I came across this in the S-4 filing related to the Eaton Corp acquisition of Cooper Industries.  It states that to grow in todays economy, Eaton Corp has to move their incorporation offshore to both grow faster.

".....Eaton’s proposal assumed that the transaction will be structured such that the surviving parent entity would be incorporated outside the United States. The decision that the parent company would have a non-United States location was made because the transaction was not economically feasible without incorporation outside the United States due to material competitive advantages currently enjoyed by Cooper as a result of its non-United States incorporation. Amongst those advantages are greater flexibility and lower cost of cash management, an enhanced ability to grow faster through organic growth and acquisitions, as well as a lower worldwide effective tax rate. Loss of these existing Cooper competitive advantages would have caused a large dis-synergy that would have prevented the acquisition from occurring."

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Don't Fight The Fed

Speculation regarding the US Federal Reserve Board's Open Market Committee (The Fed) quantitative easing program was the dominant theme impacting financial market over last three months. The Fed ultimately signaled that until the unemployment rate was reduced to more reasonable levels they would continue to be accommodative. This accommodative policy combined with the belief in the old adage of "Don't fight the Fed" fueled stock market gains. In a similar vein, the European Central Bank (ECB) President also provided soothing commentary to the markets by stating that he would do everything within his power to prevent further deterioration in Europe. The probability of any of the member countries exiting the Euro decreases with this reassurance. In a bid to reignite a sluggish economy, The Bank of China also began a new round of accommodative monetary policies. With the availability of “easy money”, a number of investors were caught chasing a rising stock market. In light of the current round of global synchronized easing, perhaps the new mantra for investors should be "Don't fight the Feds".

With mediocre economic growth, bond yields remain near historic lows. The slow pedantic rate of economic growth suggests that bond yields will remain relatively stable, with low rates of return.

The official US government data continues to show lackluster US GDP growth, even though there are pockets of strength. Both US auto sales and retail sales data came in better than expected. In our April quarterly commentary, we discussed our belief that housing was close to a bottom. We have increased confidence that not only has housing seen the bottom, but we are now starting to see resurgence in housing and remodeling activity. While we still do not want to make any sort of call on a significant increase in housing prices, rising housing activity is positive for both future employment growth and US GDP growth. The US Consumer Confidence Index surpassed expectations in September producing the best data point since the beginning of the recession.

A wise market pundit once told me that the better we can define the problem, the closer we are to the bottom. There is a high level of awareness of these fiscal problems across all segments of the population. Issues such as the Euro crisis, the slowing Chinese economy, the US political gridlock and the potential fiscal cliff in the US are discussed over dinner in many homes. With everyone able to accurately describe in exacting detail these potential risks, one must conclude that these concerns are largely reflected in current stock valuations and prices.

Investors are tired of the never ending discussions of an impending recession, the financial crisis, and housing troubles. They would like to move on. Europe has not blown up, and investors are beginning to believe that it is unlikely to happen. The big question plaguing investors has morphed from “how will we handle the crash” to “what would market valuations be if there is no European crisis ?“ If we believe that the crisis can be contained, and the three most important central banks in the world continue to ease, then we can make a case for valuations (and stocks) being higher than their current position.

We meet a lot of Canadian investors who want to avoid US based investments. These investors feel more secure allocating their entire stock portfolio to Canadian equities. Their assumption is that as long as the Canadian economy continues to chug along, they are insulated from what is occurring outside our borders. We believe that this could not be further from the truth.

Canadian Commodity producers (metals, energy and agriculture related companies) sell the majority of their products to other global companies. Sales prices (typically denominated in US dollars) are determined by global forces that are largely influenced by the American, European and Chinese economies. Owning primarily Canadian stocks will not insulate investors from events outside our borders. Furthermore, they are at increased risk due to a lack diversification within their portfolios. Most Canadian companies in the same sector are typically correlated to the same macro factors. An example of this is the energy and gold producers' fortunes are tied to the price for oil, natural gas or gold.

The advantage of investing in US stocks is the ability for true diversification. The Canadian market is based primarily on financials and resource stocks whereas the US market has a both a depth and breadth both within and between the various sectors. The Canadian market has a relative paucity of choices, thus narrowing the possible candidates that could be considered for an individual’s stock portfolio.

Concerns in regards to a weak US dollar negatively impacting US stocks may in fact represent an advantage. US companies that are international players may benefit competitively from a devalued US dollar due to their US dollar based costs falling lower than their foreign competitors. To complete this cycle, the foreign income may translate back into US dollars at a higher rate thus providing a further lift to earnings.

We continue to recommend a balanced portfolio, with a bias towards conservative stocks. Equities are likely to be the primary financial beneficiary of the current global synchronized easing. We do own bonds, but due to their low yields, we are relatively underweight this sector. In the fixed income sector, our preference is for high grade corporate bonds. On the stock side, we are investing in high quality, dividend paying companies that have the continued ability to grow both earnings and dividends in the current sluggish economic environment. 

The US Deficit: How and when does the US get out of this mess?

The US Deficit was greater than $1,000,000,000,000 in each of the last 4 years.  I have written the number in its numerical form, and not in its abbreviated form ($1 Trillion) to highlight how large a number that is.  The US government debt has increased from $9 Trillion to over $14 trillion in 4 short years, currently representing 70% of US GDP.   Without a change to taxation or spending, the debt will continue to rise.  When the debt/GDP ratio gets to unsustainable levels, interest rates will begin to rise.

The question that needs answering is how did we get here? The first side of the deficit equation is about taxes. Historically, US spending have averaged 20% of GDP while taxes have run at the 18% level.  This 2% annual deficit was considered sustainable by a majority of economists.  During President Obama's term, US tax revenues have averaged 16% of GDP.  This is related to a combination of the recession and a gradual decline in the number of US citizens paying taxes.  Current figures estimate only 50% of the US population pays taxes as compared to 66% 10 years ago. (See Chart below).                                                                                                                                                           

Source: IRS, Heritage Foundation

The other side of the deficit equation is about spending, which has averaged 25% of GDP over the last 4 years.  This is related to the combination of a weak economy and an increase in social programs and regulations. The latter suggests that a portion of the spending increase is structural rather than cyclical.

From a simplistic perspective, we need to see a decrease in spending and an increase in tax revenues, in order to drop from the current 9% gap to the historical 2% gap. Republicans and Democrats have not come to terms on how to achieve a more balanced budget.  The philosophical questions that the 2 political parties are debating is not should we reduce the deficit, but how should we close the gap between spending and revenues?  The democrats on the far left would like to close the gap entirely through increased taxes while the right wing republicans would like it to do it entirely through spending cuts.  The most practical method of bridging the gap is via a combination of spending cuts and increased revenues so that they move closer to their long term averages.

While both parties recognize what is necessary to reach a negotiated agreement, neither side wants to overtly yield in an election year.  Until we have one party firmly in control of the White , the Senate and the Congress or increased willingness to compromise between the parties, the risk remains of continued inaction.

Implications of the US Election

During the second quarter, Mitt Romney won enough delegates to lock up the Republican nomination for the US presidency, effectively signalling the start of the US presidential race. As we write this commentary, President Obama has a slight lead, but the election is still too close to call.  We do not profess to be smart enough to pick the winner, but we can discuss the implications of a democrat or republican victory.

If President Obama wins another four years in the White House, we can expect more of the same; a continued push for higher taxes, increased spending for social programs and increased regulatory oversight.  The success of his agenda becoming law will depend on the makeup of both the house and the senate.  We presume that if President Obama retains the Senate, he would still have to deal with a Republican majority in the House of Representatives.  This would lead to continued gridlock with little progress being made on deficit reduction.  Corporate spending would also be constrained due to the uncertainty related to future tax levels and regulations.  Which party controls the Senate remains a tossup, but it is unlikely significantly impact the balance of power in Washington.  If current spending patterns continue apace, further rating downgrades of US debt should be expected. The first rating cut last summer had minimal impact, but a second or third rating cut has the potential to damage the US economy.

On the other hand, a victory for Mr. Romney and his platform would be looked on more favourably by US investors.  Mr. Romney is talking about scaling back US government spending to levels that are closer to the historical norm of the last 50 years (see box on page 3).  While we are not certain that there would be a significant reduction in taxes, we are confident that there would be more certainty related to the level of taxation and regulations faced by companies.  Mr. Romney understands that US spending is pushing the cumulative debt load of the country to a level that is ultimately unsustainable.   Hard decisions need to be made now or the country will be faced with even more difficult choices in the future, akin to what Europe is currently facing.  If Mr. Romney is leading in the polls heading into the fall, stock markets are anticipated to react favourably to the perception of a changing of the guard.  If Mr. Romney wins the fall presidential election, supported by Republican majorities in the House and the Senate, he would be able to fulfill his promises.