Condor in the News - Commentary on EBAY

EBay Bets PayPal In-House Beats Pop From Icahn Plan: Real M&A
2014-01-24 21:26:02.824 GMT
     (For a Real M&A column news alert: SALT REALMNA .)
By Brooke Sutherland, Brian Womack and Tara Lachapelle

Jan. 24 (Bloomberg) -- EBay Inc. is willing to forgo a
possible 26 percent stock pop by rejecting Carl Icahn’s proposal
to split off PayPal, banking instead on the promise of longer-
term rewards by keeping its online payment unit in-house.

Shareholders including Sterling Capital Management LLC and
Kornitzer Capital Management Inc. are, so far, backing the
stance of Chief Executive Officer John Donahoe, who says that a
unified EBay helps fund PayPal’s expansion. Activist investor
Icahn called a separation of PayPal, one of EBay’s fastest-
growing businesses, a “no-brainer” that would improve value.

While EBay’s breakup value is pegged by analysts and
investors at about $69 a share, compared with $54.94 yesterday,
investor Condor Asset Management Inc. said the stock will rise
as it expands PayPal to more vendors. Sharing risk management
and transaction data helps the $71 billion company’s online
marketplace and payment units better compete against rivals such
as Amazon.com Inc. and payment processor Square Inc., said
Susquehanna International Group LLP.

“We can all come up with a higher number than $55 for EBay
shares, but that’s why we own it,” George Shipp, a fund manager
at Sterling Capital, which oversees more than $45 billion, said
in phone interview from Virginia Beach, Virginia. “I don’t know
that it’s such a significantly higher number that it means the
EBay team is doing a lousy job, or that I have a burning desire
to light a fire under the board for some sort of short-term pop.
This is not a broken company.”

Icahn Stake

EBay, whose online marketplace sells everything from
motorcycles to golf clubs via auctions and at fixed prices,
acquired PayPal in 2002 to add online-payment services. The unit
almost tripled sales in the five years ended in 2012 and now
accounts for about 40 percent of revenue at the San Jose,
California-based company.

Icahn, who took a 0.82 percent stake in EBay and is also
seeking two board seats for his employees Jonathan Christodoro
and Daniel Ninivaggi, said this week that the company “hasn’t
done as well as it should have” and spinning off PayPal would
unlock value for investors. Icahn didn’t respond yesterday to a
request for further comment.

“We have been successful exactly because PayPal and EBay
are together,” Donahoe said during an earnings call with
analysts this week. “No other payments competitor has achieved
PayPal’s success, because no other competitor has a commerce
platform like EBay.”

Amanda Miller, a spokeswoman for EBay, declined to comment
yesterday.

Better Together?

Sum-of-the-parts estimates from six EBay analysts and
shareholders ranged from $60 to $75 a share. That tops EBay’s
record high of $58.89 in December 2004, and it implies the
company should be valued as much as 37 percent more than its
closing price yesterday.

Since EBay disclosed Icahn’s stake and also reported
holiday quarter sales that missed analysts’ estimates, the
company’s shares have gained less than 1 percent.

Today, EBay fell 1 percent to $54.37.

Even though a split may deliver returns for shareholders,
PayPal is in a better position to grow as part of the combined
company, said Stephen Kahn, a Toronto-based fund manager at
Condor Asset Management.

As EBay seeks to increase PayPal’s use by other vendors,
both online and in stores, “staying together is not a bad
thing,” Kahn said in a phone interview. “Until PayPal payments
broaden significantly beyond EBay e-commerce, I think it makes
sense.”

Funding Expansion

EBay can use the free cash flow from its marketplaces
business to fund the expansion and innovation, Matt Nemer, a San
Francisco-based analyst at Wells Fargo & Co., wrote in a report
yesterday. Having PayPal integrated with EBay’s marketplace also
helps build the payment service’s customer base, said Josh West,
an analyst for Kornitzer in Shawnee Mission, Kansas.

EBay’s marketplace makes up about one-third of PayPal’s
revenue and more than half of its profits, according to CEO
Donahoe. EBay also contributes more than 30 percent of PayPal’s
new customers.

“PayPal definitely benefits from being a part of EBay, and
the distractions around trying to spin off part of it or the
whole thing could certainly hinder its long-term growth
prospects” said West, whose firm advises the Buffalo Funds,
which oversee about $8 billion including EBay shares.

Sharing data between the services makes both the e-commerce
and online-payment businesses more competitive, Susquehanna
analysts Brian Nowak and James Friedman wrote in a report
yesterday.

Nothing New

Icahn isn’t telling shareholders anything new by
highlighting the potential benefit of a PayPal split, said Shipp
of Sterling Capital. Even so, Shipp said he prefers the long-
term rewards of keeping the company together to the short-term
boost that a breakup might bring.

“PayPal could trade at a higher multiple -- we know
this,” Shipp said. “There may come a day when it makes sense,
but I don’t know that we’re close to that day. It looks to me
like the integrated company is doing well.”

While there are some advantages to keeping EBay and PayPal
together, the manager of shareholder Jacob Internet Fund said
the case for splitting up is stronger. Retailers that may be
hesitant to use PayPal because it’s owned by their competitor
could choose to adopt the service if PayPal were independent,
Ryan Jacob said in a phone interview.

Win Faster

Investors will eventually give EBay credit for the value of
PayPal, though a breakup would accelerate that, said Daniel
Johnson, a Louisville, Kentucky-based money manager at River
Road Asset Management LLC, which oversees about $10.3 billion,
including EBay shares.

“We think we can win if it stays together, but we can win
a little faster if it gets split up,” Johnson said in a phone
interview.

Even if Icahn fails to spur a transaction, the added
pressure on EBay’s leadership benefits shareholders, according
to Sean Sun, an analyst at Santa Fe, New Mexico-based Thornburg
Investment Management Inc., which oversees $94 billion including
EBay shares.

"Having this activism is good because it probably gets
management more focused and brings to light the fact that the
company is undervalued,” Sun said in a phone interview. “I
don’t think the spin is going to happen without management’s
support, but just having Icahn in there can get them thinking.”

For Related News and Information:
Icahn at EBay Shows Boards Learning to Listen to Activists
NSN MZV5B76KLVR6
EBay Says Icahn Proposes PayPal Spinoff After Taking Stake
NSN MZV1QO6KLVSU
PayPal Increases Mobile Investment as Smartphones Replace Cash
NSN MXL7666S972A
EBay deal news: EBAY US TCNI MNA
Real M&A Columns: NI REALMNA
Top deal news: DTOP

--With assistance from Beth Mellor in New York. Editors: Beth
Williams, Sarah Rabil

http://www.bloomberg.com/news/2014-01-24/ebay-bets-paypal-in-house-beats-icahn-s-plan-real-m-a.html

US $ Strength to persist vs. CDN $

The US Dollar gained 7.2% over the Canadian Dollar during 2013. The Canadian Dollar weakness is a function of both a strong US Dollar and a weakening Canadian Dollar.

When the Chinese economy was growing in excess of 10%, it was buying commodities in record quantities. This translated into currency strength in commodity oriented economies such as Canada, Australia and New Zealand. As growth in the Chinese economy slowed, their purchases of resources declined. This resulted in declining Commodity prices, along with the resource based economies currencies.

The US economic recovery is slowly gathering steam. Rates in the US have already moved up and the bias is clearly to the upside. With Canadian economic growth slowing, interest rates in Canada are unlikely to rise as quickly as in the US. Higher yields on US assets make holding or buying the US Dollar a more attractive proposition for investors. Money on the margin migrates to where it can earn the highest risk adjusted return.

The US Dollar has been and remains the world's reserve currency. None of the events over the last six years has changed this. If anything, events have transpired to solidify the US Dollars position as the global reserve currency. This is especially true as it becomes increasingly evident that there is currently no credible alternative. Part of the reserve currency's functions is to provide stability for global investors. Post the financial crisis, governments around the world mandated that their banks invest in safer and more liquid bonds. US government bonds, and the highest grade US corporate debt fit this better than non-investment grade or illiquid foreign bonds. The US bond market is deep, providing ample liquidity for investors to get in and out of at a moment's notice.

Many countries around the world are incentivized to depress their currency to ensure the competitiveness of their export oriented industries. This is accomplished by countries selling the local currency and buying the US Dollar. This results in upward movement of the US Dollar which translates into a lower Canadian Dollar.

Q4 AND 2013 IN REVIEW

Condor Asset Management is celebrating our fourth anniversary. We have consistently matched or outperformed comparable stock indices. Over the last year we also achieved stock returns in excess of 30% while maintaining our commitment to solid conservative investment profiles, as per the request of the majority of our clients. We are proud of our track record and appreciate the trust our clients have placed in us.

Over the last 3 months North American equity markets continued their winning ways. The S&P/TSX index gained 6.5% and the S&P 500 increased 9.9%. The full year was even better with the S&P /TSX gaining 9.4% and the S&P 500 increasing 29.6%. When factoring in the movement of the US Dollar relative to the Canadian Dollar, the US market provided Canadian investors with a gain of 38.9%. Contrary to some predictions, US Dollar strength relative to most major currencies persisted throughout 2013. We see few near term reasons why the Canadian Dollar will recoup these losses (vs. the US $). See our next blog entry.

Positive economic data is a catalyst for the upward movement of the stock market. The final revision to third quarter US GDP growth was +4.1%, partially boosted by an inventory build. Businesses typically build inventory when perceptions regarding the economy are positive. The employment data also highlighted a growing economy. Jobless claims dipped below 300,000 while November non-farm payrolls increased by 202,000. The unemployment rate declined to 7%, which is The Fed’s originally stated target for reducing the quantitative easing program. One of the bright spots was auto sales hitting levels which have not been seen since the financial crisis of 2008. Another highlight was the ISM (Institute of Supply Management) survey which yielded positive results of greater than 50% (which signify expanding demand). The ISM manufacturing survey was 57.0% while the comparable data for services was 53.9%.

This abundance of positive economic data has resulted in rising interest rates. Investor anticipation of a taper announcement pushed US bond rates to 3%. At the conclusion of The Fed's Open Market Committee meeting in December, The Fed announced that they would reduce bond purchases by $10 Billion a month starting in January. They further stated that depending on the data, they would continue reducing purchases throughout 2014.

Canadian bond returns during the past year were -1.2%. This is only the third year of negative bond returns since 1979. Bond returns over the last two years were a miniscule +1.2%. With current rates being as low as they are, rate increases will likely result in bond returns similar to the last two years. We currently prefer short term bonds so our clients are positioned to take advantage of potential reinvestment opportunities presented by higher interest rates.

We do not subscribe to the theory that rising interest rates will be negative for stock markets. An increasing interest rate environment accompanied by a growing economy is typically positive for stock markets. These conditions are currently present in the US and to a lesser degree in Canada. The US economy is forecasted to grow 2.5% - 3.0% in 2014, with Canada facing more modest growth of 2.0% - 2.5%. Both growth forecasts are an acceleration from the 2013 GDP growth rates. The US stock market surged with the Feds announcement of its reduced bond purchases. The Fed also surprised the market by promising to keep interest rates at current low levels for "an extended period of time". While this appears to be positive in the short term for financial markets, an accelerating US economy will probably make this a short lived promise.

There has been a fair amount of discussion concerning the potential of a stock market crash. We believe this is unlikely to occur. The crash argument hinges on the stock market being in an asset bubble created by low interest rates. It is extremely rare that so many pundits correctly call a bubble in a timely manner. When looking at the fundamentals compared to prior bull markets, stocks are not overvalued. Stocks on average trade at 15 times earnings, which is close to the historical average (Chart 1). Stocks are neither historically expensive nor cheap. With 8% earnings growth forecasted for 2014 (and 2015), there is still upside embedded in individual stocks.

Chart 1: S&P Trailing P/E

Source: Deatsche Bank

We did see a minor stock market correction (around 5%) near the end of September. We expect there will be at least one, if not more, corrections in 2014. This does not change our belief that equity markets offer reasonable returns for the foreseeable future.

Our discussion up to this point has been predicated on a reasonable US GDP growth rate. To date, growth has been somewhat tepid. Having said that, all the variables are in place so that 2014 might be the year where growth accelerates above 3%. Contributors to this would be improved employment rates, a better than expected housing recovery, growth in auto sales and the wealth effect.

2013 US GDP growth was depressed by approximately 2% in part due to higher taxes and reduced government spending. This follows two years of fiscal spending dragging down growth by about 1% per year (light blue line in Chart 2). US Government spending has been declining since 2009, while private sector GDP has grown at a 3.3% pace during the same period. Most of this fiscal spending handicap will disappear in 2014. State and local governments are beginning to invest in long delayed infrastructure projects. The Federal government recently passed a two year budget with less severe spending cuts than originally planned. The budget deal also reduces uncertainty by lowering the risk of a government shutdown due to legislative dysfunction. This is positive for the stock market, as investors dislike uncertainty and try to avoid. With government spending not impeding GDP growth, the US economy has potential to grow at something closer to 3.5% in 2014.

Chart 2: Real GDP

Source: BEA, Haver, Deatsche Bank

The wealth effect may also lend some support to accelerating growth in 2014. The consumer has been deleveraging (by increasing their savings rate) over the last few years in order to reduce debt levels. This growth impediment was necessary to repair the damage from the financial crisis. Consumer’s financial balance sheets have significantly improved. Less consumer debt combined with low interest rates have resulted in the household debt servicing ratio (Chart 3) currently being at the lowest level in 30 years. The lower income necessary to service household debt suggests that consumers will have more money available to spend.

Chart 3: Debt Service Ratio

Source: The Federal Reserve, J.P. Morgan

Bull markets typically do not end unless there is a recession. Based on the abundance of positive economic indicators, a recession is not in our near term forecasts. If anything, we see an economy that is slowly gaining momentum. The biggest surprise for 2014 could be an economy that returns to normal. We define a normal economy as one that has a healthy employment market, buoyant housing and auto sectors and no fiscal drag from government spending. This would increase the probability the economy would grow in excess of 3%, which is has not done since before the recession.

Stocks are currently more attractive than bonds. While bonds are an important part of a diversified portfolio, their returns will be below historical levels. We see positive returns for both the US and Canadian stock markets but not to the same degree as 2013. Going forward, stock selection and being in the right sectors will be an increasingly important part of generating above average returns. Condor Asset Management has demonstrated that we can navigate the market risks and provide superior returns. Please contact us at Condor to see how we can aid you in designing a portfolio to help you achieve your financial goals.

WILL CHINESE AND EUROPEAN ECONOMIES HAVE A SIGNIFICANT INFLUENCE ON GLOBAL MARKETS?

The answer to the title is a resounding yes. The strong North American stock markets during the third quarter (S&P 500 in Canadian dollars + 2.5%, S&P / TSX Composite +5.4%) were related to improving Chinese and European economic data. As a reminder, the 2012 economic data showed signs of a Chinese slowdown (due to declining exports) and a continuing European recession. Recently, reports have highlighted stabilization in the European economies and acceleration of the Chinese economy. This renewed acceleration of global growth is positive for equity markets.

The recent Purchasing Managers Index (PMI) reports lead us to conclude that the European economy is bottoming and the Chinese economy is growing again. The PMI is a leading indicator for what is transpiring in the manufacturing sector. A PMI above 50% indicates that manufacturing sentiment is growing, while a reading below 50% implies that manufacturing is contracting. The blue line in chart 1 demonstrates the European Purchasing Managers Index (PMI) crossing above 50%. The black line in chart 1 tracks the growth of the Euro zone economies. This line is approaching zero, indicating that Europe is finally recovering from a deep and protracted recession.

Chart 1: Leading indicator (PMI) points to improving domestic demand growth in Europe 

      Source:  Thomson Reuters, Credit Suisse Research

Chart 2 is the data set for Chinese PMI. The PMI New Orders Index is popping above 50%, implying that manufacturing sector activity is accelerating. Both the stabilization of the Euro zone economy and the economic growth acceleration in China (world’s second largest economy) are positive for global economic growth and stock prices.

Chart 2: Recent PMI new orders suggest improvement in Chinese GDP growth

 

Source:  Credit Suisse

For this quarter’s commentary I was tempted to repeat last quarter’s title, “It’s all about the Fed, again”. The Fed continues to influence North American markets. The Fed's commentary four months ago hinted that they would ease their bond buying program. Most investors expected that this would occur at the September 18th Fed meeting. Bond prices declined significantly as interest rates shot up in anticipation of a change in Fed policy. Yields on ten year government debt rose from 1.6% to 3.0% in just four months.

At the September 18th meeting, The Fed surprised the financial markets by announcing that there would be no changes in their quantitative easing program. They re-iterated that any pullback in bond purchases would be data dependent. The Fed Chairman opined that the data did not support a taper at the current time. When mentioning data, they are specifically referring to employment data, as the Fed has a dual mandate that takes into consideration both growth (which has been ok, but not great) and employment (improving but still tepid as of the August report). Some investors speculated that The Fed did not want to taper the bond buying program in advance of the looming debt ceiling debate in Washington.

Whatever the reasons for their inaction at the September meeting, it resulted in interest rates declining across the yield curve. Ten year government bond yields backed off to 2.6% and bond prices recovered some of their summer losses. Low interest rates will continue to provide support for rate sensitive portions of the economy such as autos and housing.

Another benefit of the Fed's ongoing quantitative easing program and continued low interest rates is the positive influence on stock and house prices. When asset prices increase in value, consumers feel more confident about their financial well being, even without an increase in income levels. With the stock market indices hitting record highs and housing prices in most markets recovering to pre recession levels, consumers are feeling wealthier. This positive confidence ultimately translates into increased consumer spending, providing a boost to the economy. This "Wealth Effect" creates a positive feedback loop. Heightened economic activity translates into higher incomes, increased consumer demand and business investment.

The US economy continues to grow. While 2.0 - 2.5% growth does not appear to be strong relative to prior recoveries, the private sector is growing in excess of 2.5%. A shrinking government sector is holding back the growth numbers for the overall economy. Stabilization of the government sector of the economy should result in higher growth rates for the entire economy.

We anticipate with a strengthening economy, The Fed will begin tapering their bond buying program at some point in the near future. Even with the recent rise in interest rates, the bond markets remain in a low rate environment, with yields of less than 3%. The bottom for interest rates in this cycle is behind us. We are transitioning from a declining rate environment to a rising rate environment. This means that bond returns are likely to be less than the current meagre dividend yields. The bond market will be a tough place to make money and invest over the next few years.

In our last commentary, we discussed plausible year end targets for the S&P 500. After a great third quarter, we are over half way to our December 2013 target. While upside of 3% may not appear material, it is still attractive compared to 2.6% bond yields. The potential exists for more gains in 2014 based on the same exercise we did last quarter. An S&P 500 target of 1880 for year end 2014 is achievable if we assume the index trades at 16 times trailing earnings, which is its historical average. This implies US stock market returns in excess of 10% between now and the end of 2014.

Clearly we find stocks more attractive than bonds, especially when considering that we are nearing the end of the current interest rate cycle of declining rates. Interest rates have begun to moving up, and will continue rising over time. In this scenario, bonds are likely to have a difficult time returning much more than their current low single digit yields. Stocks on the other hand offer potential for double digits gains over the next five quarters, with dividend yields that are similar to bond yields. Dividend payouts should continue rising as company profits are at record levels and corporate balance sheets are flush with cash. This will provide further support for continued stock price gains.

The most important factor for our conclusion that stocks will outperform bonds goes back to the rising interest rate scenario. Rising interest rates are typically bad for bonds but good for stocks, especially if the rate increase is due to an improving economy. While the Fed might not have enough data at the current time to support pulling back on their bond buying program, the financial markets are anticipating that it will occur. The other key factor is the improving economic data from Europe, China and the improving US auto and housing markets. Our conclusion is economic growth is picking up, which will result in a cycle of rising interest rates and stock prices.

INTEREST RATE AND BOND PRICE PRIMER

Understanding stock movements is relatively straight forward. Rising earnings, dividends and stock prices is generally considered a good thing for equity investors. When considering bonds, the first thought would be that rising interest rates would be positive for bond investors as they would be paid higher interest rates. The reality is a little different in that rising interest rates results in declining bond prices. Bond prices and interest rates have an inverse correlation. So why is it that rising interest rates is negative for bond prices and bond holders?
The easiest way of explaining this is by example. If you buy a ten year bond at $100 that has a 2% coupon, you will earn $20 in interest over the life of the bond. Assuming rates never change and ignoring interest com-pounding (for simplicity), the price of the bond will remain at $100 till the $100 principle is repaid in ten years.

Bonds, like stocks, do trade on a secondary market. You can buy ten year bonds when they are issued (which we will call "new" bonds for our example) or you can buy "used" ten year bonds on the secondary market. For our example, a "used" ten year bond will be considered any ten year bond that has less than ten years to maturity. A "new" bond will turn into a "used" bond the day after they are issued.

Buying a "used" bond with a maturity of ten years less a day is virtually identical to a "new" ten year bond. For our example, we will assume that they are equivalent. If we buy a "new" 2% ten year bond, and the following day interest rates for ten year bonds pop to 3%, "new" bonds issued after the change in interest rates would be priced to yield 3%. These "new" bonds would pay $3 of interest per year or $30 over the ten year life of the bond. Since the bond we bought yesterday (with a 2% coupon) only pays $20 interest over its ten year life, it is obviously less attractive than a bond that pays 3%. There needs to be another mechanism to entice buyers to buy our now "used" 2% ten year bond on the secondary market. This mechanism is price. For buyers to get a 3% equivalent yield from a "used" 2% coupon ten year bond, the price of the "used" 2% bond would drop from $100 to $90 at the same time that interest rate rise to 3%. A buyer (but not the initial holder) of the "used" 2% bond would then realize interest of $20 and capital gains of $10 over the ten year life of the bond (assuming the bond is held to maturity). This is the same as a buyer of a "new" 3% bond receiving interest of $30 over 10 years with a return of principle that is equal to what was paid for the bond. Of course, the initial buyer of the 2% bond (when it was considered "new") would realize a capital loss of $10 / bond when interest rates rose from 2% to 3%. This is why bondholders lose when interest rates rise. Their bonds are re-priced to reflect the higher interest rates.

What happens to the "used" 2% bond over the intervening years? Assuming interest rates remain at 3%, the price of the 2% bond will rise approximately 1% per year. This means that the bond holder will receive both 2% of interest plus 1% in capital gains each and every year. The math also means that the further out the maturity for any bonds held, the larger the loss on the price of the bonds when rates rise, all else being equal. We have already seen an example of what happens when rates rise and how it impacts a ten year bond. If the same example is applied to a five year bond, a rise in interest rates from 2% to 3% will result in the price of a "used" five year bond dropping to $95. The reason the bond price only drops $5 (vs. $10 for the "used" ten year bond) is because buyers of the bond need only a 5% discount to offset the five years of receiving a 2% coupon, in-stead of 3% for the more recently issued "new" bonds.

These examples are extreme, as bonds rarely have such big overnight moves (2% to 3%). While rapid and significant decreases in bond prices do happen, they tend to play out over a number of days and weeks rather than overnight as we have illustrated. While rising interest rates are positive for prospective bond purchasers (as they receive higher rates), they are negative for existing bondholders due to bond price declines.

ITS ALL ABOUT THE FED (Again)

This quarter’s newsletter will focus exclusively on the US markets. The European and foreign markets have remained relatively stable. The key influence on the US markets are the recent statements by Federal Reserve Board Chairman Bernanke. His remarks, which are typically cryptic, leads to a positive “read” on the US economy.

The financial markets saw a marked increase in volatility during the recently completed fiscal quarter. The quarter began on a strong note with a strong upward trend. Mid-quarter comments from The Federal Reserve Board (the Fed) Chairman Bernanke concerning a sooner than expected end to the Fed’s easy money policies resulted in a sell off in all asset classes. Both stock and bond markets posted significant declines in a relatively short period of time as investors adjusted to the prospect of higher interest rates. The US stock market (as measured by the S&P 500) gained 2.4% during the quarter, while the Canadian Market (as measured by S&P/TSX 300) declined 4.9%. Exposure to resource and gold stocks weighed heavily on the Canadian market. The Canadian bond market declined 2.4% as yields on the benchmark five year bond increased from 1.2% to 1.8%.

Chairman Bernanke’s comments signalled conditions for a change in monetary policy. He reiterated that the Fed would not remove the excess liquidity previously injected into the financial system thus avoiding the risk of creating a tighter credit environment. The Fed has no interest in contracting credit conditions and potentially choking off the fragile economic recovery. The Fed would initially reduce bond purchases prior to commencing a money tightening policy. A 1% rise in interest rates from current historically low interest rates, would be unlikely to hinder economic growth.

Any discussion of an impending transition from an “easy money environment” of low interest rates to a more neutral policy will result in heightened investor anxiety. We believe that the Fed's exiting its ultra low interest rate policy should be viewed as positive. It reflects the anticipation by the Fed of a sustainable, improving US economy. Make no mistake about it, the US recovery is happening. US Auto sales growth remains healthy while housing activity is red hot. The excess supply of housing inventory of two years ago has reversed and there is now an under supply of homes for sale. The result is new home starts reaching post-recession highs and rising home prices. These positive trends have translated into improved employment data.

Over the last couple of years, we have witnessed low interest rates driving stock market gains. This is not sustainable over the long term. A strong, growing economy fuelling growing corporate earnings is needed to support rising stock prices over a longer period of time. The fundamental underpinnings are in place to enable a healthy stock market over the next couple of years. The stock market will not rise in a straight line without corrections. Volatile stock markets have typically been the norm, unlike the relatively calm markets of the last nine months. The stock market is in a choppy consolidation phase, which is likely to persist through the summer. Stock price fluctuations are currently reflecting the tug of war between an improving economy and the prospect of rising interest rates.

We believe that the Fed has the best view of the economy. When investors come around to the concept that rising interest rates is a positive read for economic and corporate outlooks, the stock market will resume its upward trajectory. With the recent bond market decline, we continue to believe that bonds are not a profitable near-term investment. Our concern remains that a stronger economy will result in higher interest rates, even if the majority of the near-term increase has already occurred. From a historical perspective, a move from 1.6% to 2.5% for the US ten year bonds is a big move. While 2.5% is still considered low, it does not provide enough of a cushion to reflect the risk of another big rate increase sometime over the next year.

Our bullish view of the stock market has been based on attractive stock valuations. After the sizable US stock market gains over the last year, it is increasingly difficult to call the market cheap. The US stock market currently trades at 16 times trailing earnings, which is more in line with its historical fair value. As such, we would characterize the stock market as reasonably valued. We prefer not to assume that valuations will rise in excess of fair value when analyzing future market trends. We maintain this conservative approach in order to more realistically determine asset allocations. Future stock price gains are likely to come from earnings growth than from increased valuations. Applying a 16 multiple on 2013 S&P 500 estimates ($108), yields a target of 1730 by the end of this year. This results in a potential 8% return by year end.

Since the recession of 2008-2009, investors have flocked to bonds due to their perceived safety and income orientation. Chart 1 highlights that only in the last year have investors begun to put money back into the stocks. Equity markets inflows have been inconsistent and still represent only a fraction of the money that has poured into bond funds over the last four years. As a significant amount of money remains sitting in cash accounts or bonds, stock market inflows could persist for a number of years. The great rotation from bonds into stocks has barely begun.

Chart 1: Cumulative Fund Flows

Source: BMO Capital Markets Strategy Group


We remain positive on the US stock market due to an improving economy, increasing corporate earnings and relatively low interest rates. We believe that the US stock market offers the best potential risk adjusted returns. Valuations rising to something closer to fair value have made individual stock selection increasingly important in generating positive returns.

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.