FIRST QUARTER 2009 – RETROSPECTIVE AND PROSPECTIVE

WHERE’S THE BOTTOM?

“Facts are stubborn things, but statistics are more pliable.” — Laurence J. Peter

“People who always try to play the market to its lowest point, always miss it.” — Earl Peattie

“Where’s the bottom?” “Are equities cheap?”. Pundits love these questions because there is no answer, at least until long after the moment has passed. It is a question that can induce anxiety, create uncertainty, sell newspapers and fill airtime, day after day. When financial markets are trending up, it is rare that the question is framed as: “Is this the top?”.

Given the state of the savaged economy, it is easy to exploit investors’ fears. Investors were pummeled last year. The Toronto index recorded a loss of 33% and the US market as measured by the S&P 500 was even worse with a decline of 37%. Pension funds in Canada recorded negative returns of 18% on average while some of the largest sophisticated funds reported declines of nearly 30% (Caisse de Depot, University of Toronto Asset Management) or more (Harvard University down 48%).

The capital markets continued to decline in the first two months of this year. In Canada, the TSX declined nearly 3% in January and plummeted over 6% in February. The US markets were off over 8% in January and over 10% in February. Mr. Obama failed to generate an inaugural rally. Incessant negative news plagued investors during the period. Corporate earnings continued to decline and disappoint. AIG, one of the world’s largest insurance companies recorded a $61.7 billion dollar loss; the largest corporate loss in history! Nortel, once Canada’s star technology company, filed for bankruptcy. Job losses continued to mount as many companies announced layoffs in the thousands and the unemployment rate approached and surpassed 8%. Auto sales continued to be in free-fall, raising concerns about the inevitable bankruptcy of GM, Chrysler, or both, and the spin-off effects such a bankruptcy would have on allied industries and communities.

Finally, in March, some respite. The Toronto Stock Exchange was up nearly 8% and the S&P 500 increased by even more. In the US, the treasury announced that that they would support the market for Treasury securities by purchasing up to $300 billion in the open market. Commodity markets recovered some lost ground as fears about the severity of the recession seemed to dissipate. Investors took note that some firms with the wherewithal to finance an acquisition were stepping up and making opportunistic moves. During the quarter, Merck, a large pharmaceutical concern, announced that it would buy a smaller rival, Schering Plough. Roche, a Swiss biotechnology concern, purchased the remainder of Genentech that it did not already own. In March, Canadian investors were pleased to see Suncor make an opportunistic offer for Petrocan in the energy field. These, and other, acquisition activities helped investors achieve some solace that business leaders are looking out to better economic conditions.

So, “Is this the Bottom?” or is the recent move up just a temporary rally?

Although equities are less expensive than they were before the market collapse, that does not necessarily mean they are cheap. Professional investors look at many metrics in making determinations over valuation levels. One such indicator is the level of yields on common stocks. When yields are high, stocks are considered to be inexpensive. Yields fall as stock prices rise. At this time, yields on the S&P 500 are around 3% which is much higher that they have been in over ten years. However, it is nowhere near as high as the early 1950’s when yields got close to 9%. Another cause for concern is that many companies have been slashing dividends which is another manner in which yields decrease.

Another factor to consider is price to earnings ratios (P/E’s), or how much you are paying for earnings. The first problem here is to define what you mean by earnings as there are many ways they can be measured. Furthermore, a low P/E does not necessarily mean stocks are cheap. In a recession, earnings tend to go down, particularly in commodity and cyclical industries making the ratios look high. Smoothing earnings over time can help. The current ration of around 10.5 based on historic earnings is below what many may consider to be a long term average but with a range that can go from 6 to over 40, it is hardly a reliable indicator.

Other investors may turn to relative valuation techniques, but that also opens up a host of questions as to what underlying assumptions are being made over the discount rate being used as a basis of valuation. Low discount rates imply higher valuations. Today, using the current low rate environment should be good, relatively speaking, for equities compared to bonds. However, the current low rates on bonds may be reflective of a poor economic outlook which would not be so good for stocks.

We could go on discussing other methodologies, but the point is that nothing should be taken at face value or in isolation. So, where does that leave us? Is this the bottom?

We do not know! It is and remains our contention that our time is better spent analyzing individual companies seeking the the best prices for the most risk adjusted return potential that we can identify over the investment time horizon under consideration. Recently, some new investments have been added to our roster. As companies are identified that meet the characteristics that we desire, others will be cautiously included in portfolios where appropriate.

FIRST QUARTER 2009 FIXED INCOME COMMENTARY

The relentless intervention of central banks around the world appears to have been having a positive effect on markets as the bleakness of winter seems to have been transformed into the thaw of spring. And yet, much needs to be done.

It would be foolish to assume that the worst recession in living memory coincident with the near meltdown of the world financial system could be undone in the space of a couple of months. Job losses are past the five million mark in the United States, resulting in a reduction in consumer spending, tax receipts and eroding the ability of overextended consumers to pay the grab bag of debt payments that they carry. The initial phase of the current difficulties was related to the sub-prime housing meltdown in the United States. However much of this had occurred before the current tsunami of layoffs. The recently unemployed have until now been paying their mortgages and taxes. Now they are heading towards significantly constrained lives.

As far as the Government is concerned, it is facing reduced tax revenues at a time when it is not only committed to massive stimulus spending aimed at jump starting a stalled economy, but also to recapitalizing and bailing out the financial system. All of these efforts will require a torrent of money that would make King Midas blush.

We agree that the speed and severity of the credit meltdown coincident with the slide into recession, calls for decisive measures. There are divergent opinions on the precise remedy for the financial debacle. While economists and pundits have the luxury of debating aspects of the various proposed remedies, governments and central bank governors have been forced to act quickly.

The amount of money that is being spent to try to jump start economic activity around the world will have monumental consequences for the future. Governments are now issuing budgetary forecasts that are calling for huge deficits for years to come. These deficits when combined with the various bailout packages will result in dramatically higher borrowings. This will place increased pressure on the bond market in the form of higher interest rates. Furthermore, as the economy gains traction, corporate borrowers will also be competing with governments to raise funds, both for operational and investment needs. This will create further upward pressure on rates.

The recent establishment by the Federal Reserve of a program to purchase long-term securities, thereby supporting low interest rates, clearly indicates a reluctance by market participants to buy long-term bonds at these low rates.

The total return performance of the bond market for the first quarter was an increase of 1.8%. The ten year Government of Canada bond yielded 2.8% at quarter-end, essentially unchanged over the course of the quarter. The difference between corporate and federal issues moderated slightly over the course of the quarter, signaling an easing in credit concerns.

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