FOURTH QUARTER REVIEW AND 2006 RETROSPECTIVE

“What, me worry?” — Alfred E. Neuman, MAD Magazine

The fears that were highlighted in our third quarter comment were all but ignored in the fourth quarter. It wasn’t that the factors driving those fears entirely dissipated, but investors chose to ignore those factors and focus on weaker energy prices, combined with massive liquidity, as an excuse to “damn the torpedoes” and pile into the market. Many of the concerns pervading the market at the end of last quarter still persist: slowing global economies, weak US housing prices, consumer debt levels, massive US deficits (trade and current account), a floundering North American automotive sector precipitating large layoffs, etc.

Investors shrugged off any concerns and the market advance was very strong in the Fourth Quarter. The S&P/TSX advanced 10% while south of the border both the Dow Jones and S&P 500 advanced 12% and 11% respectively. Other world markets also advanced with the EAFE (Europe, Asia and Far East) Index up 15% (Note: All foreign exchanges expressed in Canadian dollar terms). The biggest shock to Canadian investors occurred on October 31, as the Federal government reversed its stated intention not to tax income trust distributions. The S&P/TSX still managed to produce a positive return despite the fact that trusts, impaired by the change in tax policy fell precipitously ending the quarter down by over 10%.

For the year, all the North American markets advanced by over 15%, the best showing since 2003. The S&P/TSX advanced 17% for the year while the Dow Jones and S&P 500 were both up 16%. The global markets, with few exceptions, also reported strong returns. The EAFE Index was up 23% for the year. With the exception of the US dollar, the Canadian dollar was weak against most of its global counterparts. The US/Canadian dollars started and finished the year at almost precisely the same exchange rate, despite the fact that the Canadian dollar spent almost all the intervening period trading at a premium to the $0.86 level. This fact will distort some of the reported returns for the year that fail to account for this phenomena (Actual returns reported by Canadian investors in the US will be less than stated in some cases). Globally, the Canadian and US dollar did not fair as well. Relative to the Euro, both currencies declined around 11%.

As stated, massive liquidity chasing financial assets appeared to be the driving force behind the market appreciation throughout the quarter and the year as a whole. This liquidity stemmed from a big year in M&A (mergers and acquisition) activity. Internationally, the metals sector had the best year in decades as demand for copper, zinc, nickel and uranium was strong given the fast paced growth in the global economy. Consolidation in the metals sector continued as the large global firms sought surety of supply. In Canada, the sale of Inco and Falconbridge to foreign firms was completed. Canadian investors saw other takeovers of note as Fairmont Hotels, Intrawest, Sleeman Breweries and Vincor were sold to foreign firms. In the US, some major M&A activity took place in media firms. Google paid $US1.65 billion for You-Tube, a relatively new internet site. Despite concerns for traditional advertising, many newspaper chains in the US have also been pursued by deep- pocketed investors. Some of the largest M&A activity is coming from private equity firms that can amass billions of dollars in cash and credit to pursue large targets thought too big in recent years. Since the Federal Reserve stopped increasing rates in August as economic slowdown appeared probable, the US market took off as the benign and low interest rate environment made credit appear easy. The market increase was also stoked by investors’ sense of wellbeing from advancing valuations in stocks, bonds, commodities and property.

Corporate malfeasance continued to be highlighted throughout the year as some high profile stories came to light. Patricia Dunn was forced to resign as Chair of HP. Kenneth Lay (Enron) died of a heart attack before he spent any time in jail, but his compatriot Jeffery Skilling started serving his sentence. Option backdating has become a major issue in North America, particularly in light of the widening gap between CEO and average employee pay. Conrad Black continues to protest his innocence to any wrongdoing while trying to reinstate his Canadian citizenship, just in case jail time becomes unavoidable.

On a happier note, philanthropy has taken front stage with Warren Buffet combining forces with the Gates Foundation, making many billions of dollars available to tackle large, global problems. It is hoped that their example will create a chain reaction in the business community, thus enhancing the public personae of business leaders while benefiting society in a manner more efficient than government has been able to deliver.

Investors enter 2007 with price momentum on their side. Energy prices remain low due to inclimate warm weather patterns throughout a large part of North America and Europe. Interest rates are stable going into the year as the Federal Reserve is caught between a slowing economy and inflationary pressures seeping through the economy as a result of high commodity prices. There is also a dilemma between the desire of the US to see competing currencies appreciate to mitigate their competitive advantage (especially China) and the need to keep foreigners holding massive amounts of US currency. This past year, even Japan was forced to give up a 0% interest rate policy as evidence of recovery begins to surface.

In 2006, the US witnessed a dollar decline of 11% against the Euro, 8% against the Australian dollar, 14% against the pound and 9% against the ruble. Foreigners have been happy to finance much of the US debt, so long as dollars were perceived as a secure place store wealth. Given the rate at which US debt is accumulating and given the uncertainty of the spending increases that may result from the Democrats taking the house and senate, foreigners are unlikely to remain complacent without being paid more to hold US dollars. In fact, several large holders of US currency, such as Iran and China, have stated their intention to diversify although these pronouncements may well be politically motivated.

Adding to the uncertainty, early evidence suggests that the unseasonable weather and a tiring, indebted consumer will result in lackluster retail sales in the final quarter. Walmart had a major system failure on the Monday following US Thanksgiving, one of the biggest shopping days of the year, that will inevitably effect sales.

From a Canadian point of view, things are not as bad. Commodity prices continue to linger at high levels and our housing market is not as leveraged as that of the US. Energy prices appear to have stabilized in a tight range, but pressure could cause energy prices to increase as the year progresses. One of the positive fallouts of the change in the income trust taxation may well be more M&A activity in this area. However, it must be remembered that over three-quarters of Canadian exports go to the US. Furthermore, central Canada still depends largely on the strength of the automotive and housing sectors. If the US has problems, Canada will have problems.

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. We see many of the stocks in the materials sector priced for perfection, and as a result we have taken profits in many holdings. Cash positions are high and we are content to stay on the sidelines looking for opportunities. The bond market is not currently paying us to go out into longer maturities. Credit spreads are also tight, giving little incentive to look at corporate bonds. Our search for value may take us farther afield this year, but we will, as always, remain risk averse.

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