Investment Compass - Quarterly Market Commentary - Q1 2009

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the NVESTMENT

COMPASS

Quarterly Market Commentary Spring 2009 Suite 213 5455 152nd St. ● South Surrey BC Canada ● Tel (604) 576 - 8908 ● [email protected]

Debunking the Hype – misled by headlines

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In this issue Debunking the Hype - misled by headlines pg 1

Is it Time to Buy Junk?

- a look at high yieldbonds

pg 4

Uncovering the future

- Inter-market insights pg 5

Media watch:

Pacifica Partners has appeared on BNN and the Financial Post. Interviews & published commentaries are available online at:

ecord unemployment, unprecedented stimulus packages, and “bleak” economic reports top the headlines of even the most respected newspapers across the globe. It‟s no surprise that many investors feel impending “doom and gloom” when it comes to their investments. Fortunately, we can find comfort in knowing that newspaper headlines are often a poor indicator of where investments are headed and are in fact better indicators of where investments have been. This may seem counterintuitive, but the fact is that investors often incorrectly infer that the past or even current economic environment will dictate market returns over the coming periods. History has shown that this is the case. In fact, once either economic dread or market euphoria hits the main stream media, the end is usually close at hand. To understand why, it is important to recognize that the stock and credit markets are forward looking entities. In simple terms, they provide positive returns if the future economic outlook becomes brighter than the current economic outlook. In that regard, when the economy is already viewed by the masses negatively, the only real investment concern is “can the economy get any worse?”

Summary: 

Headlines aren‟t a good measure of future market performance as has been demonstrated over many decades.

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High yield bonds could be preparing for a significant rally, but it still looks early.

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 nter-market relationships (between

Stocks, Bonds, Currencies, and Commodities) can provide insight into how markets are poised for future moves.

Recent unemployment headlines, as sampled below, demonstrate the dreary outlook that highly regarded mainstream publishers are presenting.

“Job Fair Offers a Glimmer of Hope Amid the Gloom” – April 1, 2009 The Toronto Globe & Mail

“Euro Jobless Rate Surges to 8.5 pct” - April 1, 2009 Forbes

“ADP Sees Another Steep Drop in Jobs” – April 1, 2009 Wall Street Journal

From the perspective of the investor, what should be kept in mind is that phrases like “amid the gloom”, “jobless rate surges”, “steep drop” are only intended to entice readership. However, the reader often infers that the increasing number of jobless individuals implies a doomed stock market. Yet, this is not the case. (continued on page 2)

pg 2 (continued from page 1) To demonstrate, we look to Time magazine‟s February 8th 1982 cover entitled, “Unemployment, The Biggest Worry” (top of page3). Over the one year period prior to the issue hitting print, the S&P 500 had already lost 12%. However, one year after the issue was published, the S&P 500 index gained 27%, 5 years later it gained 144%, and 10 years later it gained 259%. Even in annualized terms the gains were impressive, with gains of 27%, 19.5%, and 13% per year for each of the periods respectively Unemployment may be a recurring economic theme in every generation; however the current financial crisis is of course unique. It turns out that this may not be true either. The financial crisis of 2008/2009 that has origins in sub-prime mortgage lending and the securitization of these mortgages, is on some levels not that different from the Savings and Loan Crisis of the „80s and early „90s. In both cases, weak regulatory supervision resulted in banks (and savings and loan associations) becoming increasingly involved in speculative real estate and commercial loans. Without conducting an in depth comparison of either crisis, it is sufficient to say that the headlines weren‟t that different than those currently being depicted:

500 index gained 23%, 115%, and 178% in the respective one, five, and ten year periods immediately following the publication. Again, once concerns over the banking crisis hit mainstream media the market recovery had already begun. Inflationary concerns are no different than any other mainstream economic fear. And, with record stimulus packages put forth by governments and central banks, inflationary pressures may indeed arise. However, many investors have already flocked into gold based investments in order to hedge their risk to a potential inflationary environment. In response to this move, gold climbed to over $1000 USD / ounce in February of 2009. Fortunately, we felt that the Gold story was over-bought and chose not to take our clients down that road. Subsequently, gold prices corrected sharply. In essence, the market has already accommodated for the possibility of inflation by adjusting its valuations accordingly. In the mean time, the headlines of mainstream publications read as follows:

“Some see Inflation as Key Threat” - London Free Press March 29, 2009

“Inflation Fears Grow After Fed Prints $1.2 Trillion” – CBS News March 20, 2009

”Georgia Bank Failure is 21st of 2009” – March 30, 2009 BankInfoSecurity.com

”Wall Street Slides on Worries Over Bank Failure Risks” – March 20, 2009 News.com.au

“Community Banks Caught in Sins of Bigger Banks”

“US Inflation Threat Worries Chinese Too” – Dallas Morning News March 24, 2009

Time magazine once again allows us to put these inflationary concerns into a historical context with their October 22, 1979 issue entitled “The Squeeze of ‟79 – Tighter Money, Higher Prices, Wall Street Woes” (bottom of page 3).

– March 30, 2009 Seattle Times

Again, the US stock market returns immediately following the publication date were impressive. In fact the annualized returns over the period were more than 12% per year.

As indicated in the first headline, it is true that 21 US banks have failed up to the end of March of this year. It is also a fact, however, that an additional 25 US banks failed in 2008. As concerning as these facts are, 1984 witnessed more bank failures during the early stages of the Savings and Loan crisis. 106 banks failed in 1984 despite the fact that 99 US bank had already failed in 1983.

The lesson of all of this is that investment decisions built from extreme emotional responses to such things as irrational fear or market euphoria do not serve investors well. A good gauge of consensus opinion comes from the headlines making the mainstream publications. It is a reminder that the doom and gloom present in the media today is likely already reflected in the valuation of the market. Market sentiment usually sours or improves faster than that of the main-stream. This is what often creates opportunities for profiting from excessive fear.

How did the markets and the media respond? Using the December 3rd 1984 cover of Time magazine entitled, “America‟s Banks – Awash in Troubles” as a marker (middle of page 3), the S&P

The headlines on the right side of page 3 are a sample of what we see in newsstands today – fortunately, they too are bleak.

pg 3

Today’s Headlines

pg 4

Is it Time to Buy Junk? - a look at high yield bonds

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s market uncertainty now begins to show signs of subsiding and investors begin to shift out of bonds and cash and enter back into the relatively risky equity markets, shifts within bond holdings themselves are also taking place. In fact, investors are now shifting from treasuries (government bonds) which represent the lowest risk bonds, to the relatively risky side of the bond market, corporate bonds. As the economy continues to further strengthen, investors will also return to buying high yield corporate bonds, also known as “junk” bonds. Although the term “junk” can be unsettling for any investor, high yield bonds are simply bonds that aren‟t considered „investment grade‟ because they don‟t have BBB- or higher ratings (as per S&P bond ratings). However, high-yield bonds possess higher yields in order to compensate investors for their higher default risk. The title „junk‟ itself is also bit of a misnomer, which dates back to the early 1980s when Michael Milken, a pioneer in the high-yield bond market was ironically convicted of securities fraud. Today, however, the US high-yield bond market is almost $1 trillion in size and its Canadian counterpart is over $50 billion, with institutions such as pension plans and mutual fund investors as major participants. Since investor demand for high yield bonds is closely tied to global risk appetite, the yield spread (difference) between treasuries and high-yield bonds, called the high yield “credit spread”, is thus a key indicator of economic health. Note that at the height of the bull market, high yield bonds paid in roughly 8%, compared to 4% from US Treasuries (a 4% credit spread), but today that spread is closer to 18%, a sure sign of market fear. Much like equities, high-yield bonds have historically achieved outstanding returns in recovery phases of economic cycles, as

depressed high-yield bond prices rebound with improving economic outlook. In addition, since debt holders possess “senior” claims to a firm‟s assets over that of its equity holders, the high-yield bond space can at times pose a better riskreward profile than equities. In order to demonstrate the potential upside that high-yield bonds possess, the chart to the left (bottom) compares the returns in the high-yield bond space (HYB) to the S&P 500 index. Default rates are a key risk factor in determining the safety level and the timing of when to invest in high yield bonds. The downside of investing into a high-yield bond mutual fund or ETF can be quantified from the percentage of high-yield bond holdings within that portfolio that default on their debt obligations. Generally, a “good” fund will have a default rate of approximately 1-2% or less, which is usually a fraction of the percentage of total defaults in the high-yield market.

Historically, high yield bond investing has been safest when default rates are declining from their highs. As the chart above shows default rates can be tracked but we are not yet at the levels seen in previous recessions. At this point, patience and careful observation is warranted as the worst is likely yet to come.

How should I invest? High yield bonds are difficult to buy as they trade in large lots ($25k to $1million). In addition, the task of finding the best opportunities is best left to an experienced high yield bond manager, preferably one with a measurable long-term track record. Furthermore, a high-yield bond fund is best suited as part of an actively managed portfolio. At some point in the future, the portfolio manager should be able to gauge when to take a position within a highyield bond fund, and also when that position should be scaled back or even eliminated.

pg 5

Uncovering the Future Inter-market insights

The US dollar has a strong effect on commodity prices. For example, a strong US dollar impacts capital flow into commodity stocks and the currencies of commodity producing countries. Likewise, the converse is true.

n surging economic environments the most common explanation for a robust economy almost always includes some form of overconfidence in which runaway price trends are explained away by a newly discovered universal “truth”.

This relationship is encapsulated in the chart below entitled “$US influence on Commodities & Emerging Markets” – showing how copper (perhaps the most economically sensitive of the base metals) acts relative to the $US and in turn, how the emerging market economies‟ stock markets move quite tightly with copper.

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For example, the reason given for the commodity boom in recent years was that China and India were moving into the industrial age. In turn their vast populations would continue to consume commodities at a rapid pace. However, we took a different view in that we examined the commodities boom by looking at it from another perspective. In particular, we examined inter-market relationships, or relationships of seemingly unrelated asset classes. Of specific importance was the relationships of gold to the US dollar, and the Japanese Yen versus the Euro.

Gold and the US Dollar Gold and the US dollar both tend to move in opposite directions from one another. This relationship hit extremes in 1985 and 2001 in which the US dollar began two separate multi-year declines with gold moving in the opposite direction. As a result, investors – recognizing this change over time – began shifting their investment focus into gold and the mining sector. It is, however, important to note that even prominent relationships like the gold-USdollar trend will sometimes deviate from the norm. Take the recent occurrence of both rising gold prices and a rising US dollar which occurred after markets bottomed in late December. With investors afraid of the potential of rising inflation amidst the uncertainty in the US economy, they bought gold. But while some investors were rushing into gold, other investors who invested abroad were buying US Treasuries (US dollars) – an investment considered by many to be the safest investment in the world.

The Euro € and the Yen ¥ How does the Yen and Euro relationship come into play? The relationship between the Japanese Yen and the Euro is an important barometer of international risk appetite. For years, investors have been taking advantage of near 0% interest rates in Japan to borrow capital. Borrowed Yen is converted to Euros in order for investors to take advantage of opportunities in Europe. In turn, during this conversion process, the Yen is sold (it depreciates) and the Euro is bought (it appreciates). This Yen “carry trade” (money borrowed cheaply in Japan and invested elsewhere in the world) provided the market with excess liquidity during the boom that helped launch stock and real estate markets skyward. When the run-up eventually collapsed, these borrowers began to pay their debts back to Japanese banks. In order to do this, they had to buy back Japanese Yen and sell their Euro denominated holdings. Hence the recent strength in the Yen has coincided with weaker stock markets. The stronger the Yen became, the more investors had to sell international assets to stem their losses. (continued on page 6)

pg 6

(continued from page 5)

Pacifica Partners featured by Segal School of Business

Prior to the recent market rebound, we noted that the Japanese Yen was weakening indicating a coming rebound in markets. Notice, that this led the stock market‟s advance by several weeks.

Why are these two seemingly unrelated relationships important? Movement of the Yen/Euro cross will help us confirm if markets are ready to break out and continue a strong, sustained rally. This is one of the first places analysts will look in order to determine the level of risk investors are willing to assume. Thus, in order for us to discern future market direction, we do not look at economic forecasts with too much enthusiasm (as an aside – the closest the official score keepers of the US economy have ever come to calling a recession was six months after the fact). In fact, the S&P500 actually topped out early in 2007 – at least a year before the recession was deemed to even exist. In general, inter-market relationships are real time forecasters for the direction of the markets and provide a better look into the future.

The information in this newsletter is current as at April 1, 2009, and does not necessarily reflect subsequent market events and conditions.

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