QUARTERLY MARKET COMMENTARY – third QUARTER 2010

QUARTERLY MARKET COMMENTARY – OPTIMISTS AND PESSIMISTS

“Look at market fluctuations as your friend rather than your enemy, profit from folly rather than participate in it.” — Warren Buffett

Another rollercoaster ride!

The finish of the third quarter was the polar opposite of the second quarter. The S&P 500 posted the best September return since 1939 following on the heals of a positive move in July and a decidedly negative August.

The Toronto Stock Exchange reported a total return for the quarter of 10.3% of which 4.1% was contributed by the move in September. The US markets as measured by the S&P 500 Index posted a total return of 11.3% of which 8.9% occurred in September. Due to the 3.0% appreciation of the Canadian dollar over the quarter, the return as expressed in Canadian dollars was 8.1%. Global markets outside of the Americas were just as robust. The EAFE (Europe, Asia and Far East) index appreciated 16.5% in US dollar terms and 13.2% when expressed in Canadian dollars.

The appreciation in the equity markets appeared to have little to do with improving fundamentals in the economy. Investors drove stock prices up in spite of relatively weak economic releases, perhaps in the expectation of earnings greater than the current consensus.

Unemployment remains stubbornly high with little signs of improving. Capacity utilization is nowhere near levels to indicate any prospects of significant growth in the near term. In the US, home sales were at the lowest level in ten years. Cosumer confidence plunged as the US trade deficit widened. There was certainly enough pessimism to drive the bond market to higher levels as the DEX (Canadian Universal Bond Index) appreciated 3.2%. T-bills returned a miniscule 0.14% in the quarter. Gold was also propelled to record highs, reaching levels in excess of $1300 per ounce indicating that investors were hedging their bets on the equity market and the value of the US dollar.

The problems in Portugal, Italy, Ireland and Greece persisted and rating agencies downgraded several of these countries in the quarter which exacerbate their problems as debt becomes more expensive for them to raise.

So, what can explain the wild optimism that has propelled the equity markets higher?

Authorities have been doing their best to maintain confidence while investors grasp at any positive news that justifies some optimism. Different goverments are taking varying tactics to achieve this state. In Canada, interest rates have increased modestly, signalling that the economy is strong enough to absorb higher rates while at the same time bolstering the Canadian dollar. In the US, interest rates have not moved, leading many to believe that the economy remains very weak. On the other hand, Mr. Bernanke, Chairman of the Federal Reserve, stated that they are prepared to continue with monetary easing and even more stimulus if required, implying that the authorities will do everything they can to avoid another recession in such a short time period. On the positive side, this suggests that the authorities still believe that they have the wherewithal to spend more money on stimulus. On the negative side, the market would likely take it that the economy is really in dire straights should they actually resort to another large round of stimulus.

Efforts to arrest the large trade deficits in Europe and the US have so far taken the form of attempting to get the Chinese to allow their currency to appreciate against the other major currencies thereby stimulating demand for US and European exports. The Chinese have allowed some easing of their currency controls, but this has been very limited to date.

Financial reform continues on both sides of the Atlantic. In the US, the omnibus Dodd-Frank bill was passed but many of the controversial measures had been watered down giving hope to investors that the impact to profitability on financial instutions will not be as severe.

Earning growth projections in general have been quite strong helping to lift market optimism lately but perhaps setting the stage for some downside should those projections not be met. Reported economic growth as measured by GDP (Gross Domestic Product) has managed to stay positive thus far raising hope that another recession can be avoided for the time being. However, it is important to realize that this growth is coming off very depressed levels of a year ago and has primarily been confined to a few sectors such as automobile production in the US.

Hopes that the housing market will stabilize are also underpinning some optimism, but any material declines may well trigger some fear.

In conclusion, there remain good reasons to be cautious. Investors should be wary if any of the following occur:
• sudden announcements of new stimulus spending in the US;
• continuing declines in housing prices;
• significant lowering of earnings expectations;
• attempts to artificially lower currency values relative to the Chinese currency.

Although we hope that another recession can be avoided, any recovery in the economy is likely to be slow and setbacks are going to occur. Investors need to be vigilant in order to grasp any opportunities to purchase shares in firms that are in a strong financial position to last through a prolonged recovery.

THIRD QUARTER 2010 FIXED INCOME COMMENTARY

“Today, there are three kinds of people: the have’s, the have-not’s, and the have-not-paid-for-what-they-have’s.” — Earl Wilson

During the quarter markets were pummelled by a dizzying set of contradictory statistics. Seemingly moment by moment contradictory numbers appeared to indicate either a once again weakening economy or a modestly improving one.

No wonder investors on both Main street and Bay street were perplexed by the contradictory signals. Nevertheless, on balance it does appear that modest improvements carried the day. The interpretation of these statistics has led to a seemingly irreconcilable market reaction.

On one hand equities posted a solid performance over the quarter, indicating a positive interpretation of the data. On the other hand, declining interest rates seemed to suggest that the flight to quality and expectations of an extended period of low interest environment was also accepted by the market. These two interpretations are normally contrary and can only by reconciled in a scenario where markets are so perfectly balanced that ongoing low interest rates can be expected to generate non inflationary growth over an extended period.

We tend to be a bit more sceptical and fear that one of these two alternative scenarios will prevail at a cost to the other. Even a modestly improving economy can be used to validate the expectation of improved equity markets, however to believe that already low interest rates will continue to decline assumes a truly dire scenario.

The Governor of the Bank of Canada, Mark Carney, recently warned that Canadian household debt is high and financial conditions remain exceptionally stimulative. The Canadian economy’s resilience has given him the opportunity to raise interst rates by a quarter point twice over the course of the third quarter. His goal has been to help dampen the growth of household debt, increase the savings rate and at the same time give the Bank the ammunition to once again cut rates if it becomes necessary.

Clearly this interest rate policy is divergent from that of the United States. Differences in the depth of the recession, in the course of the recovery and perhaps most importantly, the much tamer impact on the financial system has given the BOC latitude in policy implementation. At the same time, the divergent interest rate policy cannot continue forever and it can be expected that further rate increases will remain on hold until more positive economic data materializes.

The total return performance of the bond market for the third quarter was an increase of 3.2%, largely as a result of the performance of long bonds. The ten-year Government of Canada bond yielded 2.7% at quarter-end, declining by a third of one percent during the quarter.

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