FIRST QUARTER 2007 – RETROSPECTIVE AND PROSPECTIVE

“Worry is the interest paid on trouble before it falls due.” — W.R. Inge

The financial markets went on a roller-coaster ride in the first quarter of 2007.

The S&P/TSX Composite managed to produced a total return for the quarter of 2.6% in a roundabout and volatile fashion. After starting the quarter out with positive momentum, the index touched gains in excess of 2% plummeting quickly to a loss and then regaining all of the lost ground in the final few weeks. South of the border, the picture was more subdued as the S&P 500 posted only a modest gain of 0.6% in US currency. In Canadian dollar terms, the S&P 500 was in loss territory of -0.4%. The Dow Jones Industrial Average recorded its first quarterly loss in US dollar terms of 0.9%; the first quarterly decline since April 2003! Global markets as measured by the MCSI EAFE index were stronger than the North American markets reporting total return of 3.0% in Canadian dollar terms. In Canada, fixed income markets as measured by the Scotia Capital Markets Universe Bond index returned 0.9%. The Canadian dollar gained almost one cent on the US dollar in the three month period.

During the quarter, the financial markets were extremely reactive to economic and political news. Daily fluctuations in commodity prices resulted in exaggerated movements in stock prices. Why are the markets so jittery? In our opinion, the markets are jittery with good reason.

Since 2003, the financial markets have been buoyed by massive liquidity, financed by funds borrowed at low interest rates and supported by growing global trade initiatives. Much of this liquidity has been achieved by leveraging investments through borrowing against assets (asset backed loans). Those very loans have in turn been bundled, packaged and sold as securities (e.g. Mortgage Backed Securities). Hedge funds have grown precipitously as many lenders have been willing to allow funds to borrow against investments in extremely high ratios. Consumers, previously unable to qualify for mortgages, purchased homes with little to nothing down and without the obligation to pay off principal for a few years.

Starting last year, creeping interest rates began to bite into some of those housing loans in the US. Late last year reports of a growing sub-prime loan problem began to make headlines. These problem sub-prime loans started to throw housing inventory on the market when already stretched consumers could ill afford to see the decline in the value of their homes. The result of course is falling prices which in turn undermine the securities issued that have been based on those assets.

Exacerbating the situation, commodities which have been on the run the last five years are beginning to falter as demand has become tepid in the face of a possible global slowdown. In our opinion, after such a great growth spurt, the industrial markets need a period to digest and adjust to some of the rapid changes that have occurred. Naturally, this is unsettling in the financial markets where many of the securities have been priced for perfection with little contemplation of a slowdown.

The political climate has also contributed to worries of investors. Troubles in the middle east play havoc with daily energy prices. Just at the end of the quarter, Iran took 15 British sailors as hostage for a claimed breach of their sovereignty.

So, where do we go from here?

Mr. Greenspan has increased his probability of possible recession (See our Fourth Quarter 2006 write-up; “It is our view that the probability of a recession, or at least a harder landing than many of the pundits are forecasting, is going up.”). His replacement at the Federal Reserve, Mr. Barnanke, immediately tried to downplay Mr. Greenspan’s comments in order to reassure the fragile financial markets. Articles suggesting the possibility of stagflation (increasing price inflation with little or no growth) have begun to surface.

Fortunately, we take a long term view. We are resisting the fads of the day. Many pundits are getting air time with themes such as “all you need are bank stocks” just as cracks begin to appear in the financial markets. A diversified portfolio remains your best defense in rapidly changing markets.

Today’s uncertainties present opportunities for long term investors. As prices have fluctuated, we have purchased selectively in companies with the financial strength to endure a period of unease and that have fallen to prices that we feel are more reflective of the value inherent in companies under consideration.

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