Bull Market?

The headlines have finally turned in a positive direction. European stability has been enhanced by the restructuring of the Greek debt and the promise of additional short-term financing. Spain and Italy have taken steps to improve their financial situation leading to lower yields on their government debt.  Although Europe is in a mild recession, the US economy is experiencing growth. Employment, industrial production and housing data are all moving in the right direction.  The combination of the resolving Greek debt crisis and US economic growth has led to cautious optimism on the part of investors. In turn, this has resulted in a strong first quarter with the US market appreciating 12% in US dollars and 9.7% in Canadian dollars.

The Canadian stock market also experienced growth, albeit only 3.7%. This is in part related to fiscal interdependence on Chinese economic growth, which declined to 8%. Canadian stocks which are exposed to the commodity sector were impacted by a concern about a progressive decline in the Chinese economy. We continue to believe that Chinese economic growth of 8% will be the norm for the next few years, with a shift away from infrastructure spending to consumer led spending growth. Financial stock strength related to an easing in the European debt crisis and strengthening of the US economy provided some support for the Canadian stock market.

As the US economy accelerated, bond prices experienced a small decline. Bond yields compensated for the price declines, leading to flat total returns. Bonds remain a relatively safe investment, however in light of the current low interest rate environment and the strengthening US economy, we would not be aggressively investing in bonds.

Our last quarterly commentary cautioned that investors may find themselves in the position of chasing a rising market. The last 5 years have seen investors moving into more conservative assets (such as cash or bonds) leaving themselves underweighted in equities. Despite the recent run in stock prices, market valuations remain relatively inexpensive.  We believe the current upswing is likely to continue. This is supported by a reduction in the severity of the global financial crisis, slower but continued growth at 8%  for the world’s second largest economy (China) and a strengthening US economy.

                     S&P 500 Multiple is Still Below Long Term Average

The S&P 500 has increased by over 10% in each of the last two quarters.  While the media remains skeptical,  we believe that we are in the early stages of a bull market for stocks.  Most bull markets tend to climb a wall of worry and there is a multitude of issues for investors to fret about.

It has been a long time since investors experienced a bull market.  The new crop of relatively inexperienced investors may not recognize its return. There has been a notable decrease in both market and individual stock volatility since the beginning of the quarter. The only tell tale bull market characteristic currently missing is a full blown public euphoria.  The longer this bull market remains in stealth mode, the longer the current uptrend can quietly progress.  While we currently do not see anything to derail the continued upward long term movement of the market, we do recognize that there will be corrections.  As the market has largely been a one way trade up over the last 6 months, it would not surprise us if there was a pull back in the short-term.  As short and rapid corrections are all part of an uptrend, a short market decline will not change our preference for stocks over bonds for 2012.

US Housing Market

American home values have declined by $6.5 trillion since 2008. The housing market remains depressed despite the current economic recovery.

New home starts and increased renovation activity typically provides the biggest boost to job creation after a recession. The almost non-existent housing recovery (chart 1) is atypical for this stage of an economic recovery. This has resulted in a lower level of job creation and a subpar economic recovery.

Chart 1: New Home Starts

There are signs that after 4 years of historically low levels of housing activity, we may be nearing a bottom. Recent delinquency reports (households delinquent on their mortgage payments) have fallen to their lowest levels since 2008, potentially signalling that the housing market is stabilizing. The rate of home price declines is showing signs of moderation, providing another hopeful sign. During January, half of the cities surveyed showed flat or sequential prices increases on a seasonally adjusted basis. Sales of previously owned homes (chart 2) rose to their highest levels in almost two years in January. This activity was sustained through February.

                                  Chart 2: Existing Home Sales

Homes listed for sale (Grey line in Chart 3) is also declining as is the inventory of unsold homes (blue line in Chart 3) which fell to a 5 year low at around six months supply of existing homes for sale. A reading of 6 months or less is generally considered an indication of a healthy housing market where there is a balance between supply and demand.

                   Chart 3: Inventory of Existing US Homes

It is increasingly likely that a bottom for both home price and housing activity will be achieved sometime in 2012. This does not necessarily mean that home prices will materially appreciate for a number of years or provide near term relief for the millions of home owners who owe more on their mortgage than their house is worth. With the enormous backlog of bank foreclosures (2 million loans), there is still an ample supply of homes waiting to come to market that will limit a rebound in prices this year. Even though we are discussing national trends, real estate remains a local market. While home prices will bottom nationally sometime in 2012, prices will vary locally with the bottom occurring at different times in different markets.

China Growth

2011 was the year the Chinese economy slowed to under 10% for the first time in a decade. The Chinese government is attempting to address this by instituting steps to stimulate the economy. The size of the Chinese economy precludes a sustainable return to 10% plus GDP growth. Structural growth of 7-9% makes more sense to us when looking at the next 5 years.

We also see a change in the composition of the growth rate for the economy. Chinese growth has been driven by infrastructure spending that was focussed on real estate and exports. The government’s latest 5 year plan has emphasized domestic consumption growth over export led infrastructure growth.

This has implications in the type of companies that will benefit from Chinese economic growth. While the capital equipment and commodity companies were the big beneficiaries of this investment led boom over the last few years, going forward it will be the consumer products companies that benefit most from this growth in consumption. Companies with strong brands that have been investing in China will benefit from this growth trend.

The Continuing European Debt Crisis and its impact on North American Stocks

The ongoing saga of the European debt crisis was the big story of 2011 . This prolonged uncertainty resulted in higher than usual stock market volatility. The US market emerged as a relatively safe haven, finishing roughly flat for the year.

The Canadian Stock market declined by 11.3%, doing better than most European and Asian markets. Investors are waiting for a clear buy signal before they fully commit to investing in the equity markets. Unfortunately, the market never gives a clear signal as to when or what direction its next move will be. As we have previously discussed, stock markets are most likely to do what will cause the maximum pain for the majority of investors. As investors hesitate, in fear of a repeat of the 2008 market decline (which we do not think is a likely occurrence), investors may be caught chasing a rising market.

The worldwide media has been focusing on the negative impact of the European debt crisis; they have not focused on reasons to be optimistic on the North American stock markets. American corporate profits remain strong and are demonstrating growth. Valuations are definitely on the cheap side when compared to historical levels. Interest rates remain low and the Federal Reserve board has signalled that rates will remain low for the foreseeable future. Companies are sitting on a pile of cash; these strong balance sheets will provide flexibility in tough times.

Concerns remain that European negatives may overwhelm all the positives and bring down the global economy. We think that Europe will continue to make the tough choices necessary for long term financial stability. Both Italy and Greece have new governments, which are already implementing austerity programs.

The US economy remains plagued by a lack of a strong fiscal direction. The debt is growing at a frightening rate as Washington remains in political gridlock. Economic growth is tepid (2-3%) with little real movement in unemployment rates or real estate prices. Real estate, typically a driver of economic recoveries, is not adding to American GDP growth. The upside is that a combination of cheap American currency, labour and land is contributing to American competitiveness on a global scale.

In my 25 years of investing, this is the first time I have seen the US stock markets so dependent on events that are external to the US. The merging of the European economies means that one country's woes could potentially bring down the European system. Both individual stocks and markets are demonstrating a greater tendency to move up and down as a group than observed in previous cycles.

A deep European recession has the potential to impact growth worldwide. It is this uncertainty that has placed US stocks in a historically cheap position (see chart on previous page). Although the US would not experience anything as severe as the 2008 and 2009 declines, it would not escape unscathed. From an investor perspective, these low valuations provide selective buying opportunities. Alternatively, if Europe gets their act together and formulates a credible plan, stocks are a screaming buy.

The Canadian equity markets have been further hurt by concerns about a Chinese economic slowdown (see China on Page 2) and its impact on commodity stocks. With household debt levels in Canada above US household debt levels and with the potential for a cooling in housing activity, the Canadian equity Market is not for the faint of heart.

Bonds were again the best performing asset class for 2011, as they benefited from their relative safety as investors fled risky assets. While it is impressive that bonds have continued to exhibit such strong performance, we do not believe that this performance is sustainable from a longer term perspective. 10 year government bonds are currently yielding less than 2%. As the European crisis uncertainty diminishes, for good or bad, investors will be more willing to move assets away from the safety of bonds into the relatively cheaper and high growth potential of stocks.

The beginning of 2012 is a world where Europe is in recession and emerging markets have slowed. The resiliency of US economic growth at 2-3% is one of the fastest growth rates in the developed world. Despite the relative safety of bonds, we remain unenthusiastic as yields are at historical low levels. We prefer companies that will be able to grow through these challenging times and are exposed to the growth markets of the developing world. Companies with growing dividends which are higher than their own bond yields provide an attractive place to invest.

Bond Alternatives

The 10 year US Treasury bond currently yields just below 2%. This compares to an inflation rate that is currently running at just above 3%. If current interest rates and inflation do not materially change, investors will earn a negative real rate of return on their bonds. If interest rates rise, bond investors will experience capital losses on their bond investments. Long term oriented government bonds are unlikely to provide positive real returns with a risk of capital losses if interest rates rise.

So where does one go for a relatively safe, income oriented investment? Corporate bonds are one alternative to government bonds as they typically pay higher interest rates. These higher interest rates are paid to compensate one for the increased risk of default. If one is buying highly rated corporate bonds, the additional interest is usually more than sufficient to compensate for the slightly elevated risk. When implementing this strategy, attention has to paid to the credit risk of the bond portfolio. Buying poorly rated bonds to reach for higher interest rates increases the risk of a credit default in your portfolio.

Another strategy would be to invest in a portfolio of blue chip, dividend paying stocks instead of a portfolio of government bonds. A number of companies have dividend yields that are in excess of 2%. Balanced against the greater volatility of stocks is the potential for dividend increases combined with a more favourable tax treatment. A number of blue chip investment grade companies also have dividend yields that are higher than their own 10 year bond yields. A few examples include TransCanada, Microsoft and Abbott Laboratories.

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.