SECOND QUARTER 2010 – RETROSPECTIVE AND PROSPECTIVE

MIXED SIGNALS

“A smooth sea never made a skilful mariner.” — English Proverb

The tepid advance of the first quarter gave way to near panic in the second quarter as fear overtook greed in the world stock markets; particularly in the final month of the quarter.

Canadian investors got off relatively “light” as the Toronto Stock Exchange total return suffered a loss of 5.5% in the quarter (a 6.2% loss before dividends). Two-thirds of that total return loss, or 3.7%, occurred in the month of June. Our neighbours to the south got smacked harder with the S&P 500 total return declining 11.4%. As investors around the globe fled to a perceived safe currency (or at least a fungible currency), the US dollar appreciated from $0.96 to 0.94 against the Canadian dollar or about 2%. This appreciation was enough to reduce the S&P 500 total return to a loss of 7.5% in Canadian dollar terms. Other global markets followed a similar pattern as measured by the MCSI EAFE (Europe, Asia and the Far East) Index that recorded a total return loss of 13.8% in US dollar terms or a decline of 9.9% in Canadian dollars.

Bond investors love misery and as the fragility of the recovery became more apparent, concerns of any substantial interest rate increases in the near term dissipated. As investors dumped equities, the price of bonds were bid up and the DEX (Canadian Universal Bond Index) appreciated 2.9%.

A number of events dominated investors’ concerns as the quarter unfolded.

The sovereign debt crisis in Europe worsened as the size of the deficits and the required amounts of bailout funds escalated. Although Greece and Spain were at the forefront of the news, concerns with respect to Portugal, Italy, Ireland and Hungary also made headlines. Fitch, a well regarded rating service, downgraded the credit quality rating of Spain and issued a warning to Britain. The Credit Default Swaps (CDS) of the affected countries ballooned in price. Rather than addressing the underlying problems, many governments are attempting to mask the problems by curtailing or restricting the trading in CDS’s and short selling.

The threat of pervasive regulatory reform added to investors’ anxiety in the capital markets. In the US, the Dodd-Frank bill on financial regulatory reform was passed and it represents the greatest incursion into business since the 1930’s. The costs and ultimate restructuring of the regulatory framework have yet to be determined. However, little solace could be garnered from observing the government representatives grill members of the financial community in the US capital. If this is indicative of the financial knowledge of the rule makers, we have good reason to be concerned.

The April 22nd sinking of the offshore BP oil rig further destabilized the market. In addition to the uncertainty this tragedy has caused for the oil industry and the effect that this will have on supply, the cost and devastation of the environmental impact are unimaginable.

Confidence in the market took another hit on May 6 when there was a “flash crash” as US market fell by over a thousand points in a few minutes. It appears that a number of factors coalesced to cause this event. In response to this freefall circuit breakers have been put in place that will presumably shut down the trading in any security that falls by more than 10% in a five minute period.

Where do investors turn in this sort of calamitous investment environment?

Benjamin Graham is considered by many to be the father of value investing. Warren Buffet, one of the greatest value investors of all time, studied under Benjamin Graham at Columbia University and he describes Graham’s book “The Intelligent Investor” as the best book on investing ever written. In 1963, Graham delivered a speech titled “Securities in an Insecure World”** in which he specifically emphasized three guiding principals that investors should keep in mind, particularly in troubled periods.

The first principal was “Invest in bonds and stocks only so far as you can live with fluctuations in price.” This statement is the reason that investment counsellors spend the time they do determining their client’s ability to tolerate risk and devise investment policy statements that balance this tolerance with investment objectives.

The second principal is “The price you pay when you buy stocks is key.” This statement is the fundamental underpinning of value investing. In periods of uncertainty, you want to own the stocks of companies that are well managed and have the financial capacity to ride out the storm. In fact, it is during such volatile periods that portfolio holdings can be upgraded as the prices of good companies come under pressure. Investors must have their homework completed and be prepared to seize these opportunities.

The third, and perhaps the most difficult principal is “Have a sound plan and stick to it.” Most investors have the most difficulty in the “sticking to it” part. It is very easy to be influenced by the short term gyrations in the markets. Reacting impulsively can lead to getting whip-sawed by changes in market sentiment as all too many people have learned to their peril. It is for this reason that many investors turn to professionals for their expertise in keeping a steady hand on the investment plan.

We anticipate that there will be opportunities in the next number of months as events continue to unfold. As always, we appreciate your confidence for the continuing opportunity to work together and welcome your calls and questions at any time.

** For those interested, the complete Benjamin Graham 1963 speech can be found in this PDF document: [www.jasonzweig.com/documents/BG_speech_SF1963.pdf]

SECOND QUARTER 2010 FIXED INCOME COMMENTARY

“I had plastic surgery last week. I cut up my credit cards.” — Henry Youngman

The second quarter was characterized by concerns regarding sovereign debt quality, primarily concentrated in Europe, and signs of a weaker than expected economic recovery.

The potential of a slowing recovery increased fears of a double dip recession and the perceived risk of deflation. While various economic indicators have come in weaker than expected, on balance they remained positive on both sides of the border. A modest, but continuing growth scenario is further supported by the fact that long term interest rates are higher than short term ones. Generally this is a sign that investors expect higher rates in the future, a view consistent with improving economic performance.

As far as deflation is concerned, much has been made of the fact that consumers are paying down debt and corporations are hoarding their cash, “just in case”, as opposed to ramping up their spending and thereby contributing to the recovery. Despite this background, one has to note that inflation measures in both the US and in Canada, while remaining modest, are definitely positive. Other countries, with the notable exception of Japan, are in a similar situation.

At the same time, it is worthwhile to remember that a tried and true method for countries to deal with overwhelming debt burdens is to inflate their way out of it. Therefore US policy makers will do whatever is required to maintain positive inflation.

Despite ongoing debt issuance by the US, investors when faced with ongoing sovereign credit concerns, continued their unabated purchase of Treasury securities. When taken in context of other nations’ debt burden, the US continues to maintain the dubious distinction as the “least ugly” bond market. It is worth noting that the difference between a piece of paper and currency is confidence. For the moment at least, there is continued confidence in the greenback.

In a widely expected move the Bank of Canada raised its trend setting overnight rate in early June by a quarter point. Nevertheless, in an announcement the BOC noted that future increases will be considered in the context of both domestic and global economic developments. This provides a clear indication that even at the highest levels, policy makers are finding the economic signposts hard to discern.

The total return performance of the bond market for the second quarter was an increase of 2.9%. The ten-year Government of Canada bond yielded 3.1% at quarter-end, declining by half of one percent during the quarter. Interest rate relationships between federal, provincial and corporate debt issues started to normalize with the corporate bond index yielding more than the provincial one. Given the inherently higher credit risk of corporate debt issues, this is to be expected.

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