Investment Compass - Quarterly Market Commentary - Q3 2009

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the NVESTMENT

COMPASS

Quarterly Market Commentary

Fall 2009

Suite 213 5455 152nd St. ● Surrey BC Canada ● Tel (604) 576 - 8908 ● [email protected]

Are We (Half Way) There Yet? - A look at the stimulus paved road to recovery Economic Stimulus still remains a crucial element to ensuring the sustainability of the economic recovery.

Inflation isn‟t proving to be an immediate concern as deflationary pressures remain stubborn. A Jobless Recovery appears to be on the horizon as the economy strengthens.

Corporate Earnings are the key - the big question is if earnings can meet the optimistic outlook that has been priced into the equity markets.

Media W atch Pacifica Partners appears on BNN and writes for the Financial Post. Interviews and commentaries are available on our website and now via Twitter.

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xactly one year ago, we had sent a note to clients stating that the “bottoming process” had begun and that as best we could tell March 2009 would complete this process. During that six month period, a few times we doubted the validity of our thesis and thought “Perhaps the crowd is right this time”. The sheer violence and turmoil of the market bottoming process was masking the internal repair going on throughout the economy. We saw China‟s stock market bottom in November, the tech stock laden NASDAQ bottom next and by March we heard favorable comments from the executives of some of the large US banks that set the underpinnings for the current strength in the market.

Cartoon courtesy of BlueWire Studio.

However, it is estimated that about 80% of the rebound in economic growth has come While it is always easy to fall into one about due to the impact of the government extreme camp or another when it comes stimulus. Some elements of the investment to offering prognostications on the econcommunity are pointing to this fact as their omy and the markets, proof that the economy is too history shows that it is “... about 80% of the weak to stand on its own and best to remain objective rebound in economic therefore the stock market as possible and look at rally will peter out. They also growth has come the facts from all sides. point to the return to promiBy now, most investors about due to the im- nence of the Keynesian have come to the realizapact of the govern- school of economics in tion that the recession which government spending ment stimulus. ” has all but officially and rising budget deficits are ended. The unpreceused to help the economy as justification to dented coordination by the G-20 nations become ever more vigilant for outbreaks of has resulted in the stabilization of interinflation. They believe that the rise in gold national markets and by most measures prices is due to the debasement of paper the markets are once again functioning currency. In short, the sanctity of paper curas expected. rency has been degraded by governments. Continued on page 2

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We are also witnessing an especially loud chorus of investors who continue to champion the idea that all of this government stimulus will unleash a torrent of inflation sooner rather than later. At this point in time, the proponents of the “inflation is coming” scenario are in a “Show Me” kind of mood. They want to be reassured that central banks will not

only have the conviction to stand up to political pressures and turn off the monetary spigot but also be able to show enough good judgment to be able to do so in a timely fashion.

Currently, it is not inflation that seems to be showing itself in the economic data but deflation. Most statistics that measure inflation show that prices are falling in some cases and price pressures are virtually dormant. There is significant excess industrial capacity in North America and unemployment rates are expected to continue to rise. Most economists expect that like the last two recessions this will be a “jobless recovery”. In addition, bank lending has been falling despite the c e nt r a l b a nk s around the world injecting massive quantities of money into the system. This is where the inflation argument tends to weaken.

One of the best analogies to date about the effect of the tidal wave of money being injected into the system is to think of a gas barbeque. If someone turns on the gas but there is nobody there to push the igniter button, there will be no flame. Thus, if the Federal Reserve is injecting fuel (money supply), the banks have to do their part to ignite it for the economy (lending). In the US, the Federal Reserve is doing its part to help the economy but the money supply is shrinking as banks reign in their lending as the chart below shows. It is difficult to tell if the Federal Reserve is even concerned as they standby and watch the US dollar depreciate. However, many argue that the money supply growth is necessary to prevent deflation. Currently, investors around the world are borrowing US dollars and buying assets in commodity producing and the emerging markets economies, as well as raw commodities themselves such as gold, oil and copper. This has created a vicious cycle of a steadily declining US dollar and appreciating commodity prices. If we take a look at oil prices, for example, it is hard to justify current levels based on supply and demand. Instead, it seems that the speculators are out in full force once again.

With respect to the labor force, there has been a structural realignment and many of the jobs that have been lost are not going to come back as the economy gets rolling again. There will be some adjustment required of labor. One of the strongest propellants of the global economy for the balance of the year will be the huge levels of inventory that need to be rebuilt. In the third and fourth quarters of last year, global trade ground to a virtual halt. The collapse of Lehman Brothers locked up the financial markets and a globally synchronized trade collapse ensued. During the months of Dec „08 and Jan „09, it is estimated that industrial production fell an astonishing 30-35% in Japan and Taiwan, and about 10% in North America. As fears arose about the economy, Continued on page 3

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many companies ratcheted production down quickly and chose instead to work down their inventories. In the US alone, the emphasis on inventory destocking over the production of new goods accounted for about 40% of the shrinkage in the US economy. While inventories are decreasing and new production of goods is gradually rising, it is far from normal in the US as the chart to the right shows. The US consumer accounts for about 16% of the global economy and almost 70% of the domestic US economy. As long as unemployment continues to rise in the US and income growth is negligible at best, we can expect to see continued sluggishness in the pace of the economic rebound.

This brings us to the stock market. Where to from here? As the title of our newsletter suggests, some investors are asking if the run is over while others are asking if we are just half way yet. By looking at the bond market we see that it is more preoccupied with the possibility of battling deflation and that the economic rebound will be slow and tepid. Since early June, the 10 year Treasury yield has declined by almost 20% to 3.20%. In other words, investors are willing to buy a US Treasury “...companies have rebond that matures in 10 ported earnings that years and willing to achave been on balance cept a humble 3.20% as an acceptable rate of better than expected.” cash return. In contrast, equity investors are betting that the economy has bottomed and is in the process of beginning a self sustaining rebound. Many pessimistic investors would contend that the market is no longer attractively valued on a number of metrics. Based on last year‟s earnings, the market is valued at about 20x (i.e. investors are paying about $20 for every dollar of 2008 earnings). But if the optimists are correct and

earnings rebound as the consensus expects, the market is attractive at only 15x (i.e. investors are paying about $15 for every dollar of next year‟s earnings). The consensus analyst expectations are for a rebound in corporate earnings of approximately 25%. At this point, some caution is warranted in that the markets are pricing in a fairly robust earnings rebound. Anything less than that will serve to set up a reaction of disappointment from the markets and that would be one of the most likely reasons for the “pullback” that many are waiting for. This is an important point that we should take on in more detail. Only four times in the last twenty years have earnings growth of this level occurred. We would need to see economic growth in the US come in well north of 4% to produce that sort of earnings growth accompanied by interest rates that stay at about current levels. Thus far, companies have reported earnings that have been on balance better than expected. A great deal of this has to do with three factors:

1. The aforementioned inventory restocking 2. Government stimulus programs helping to kick start demand 3. Rising corporate productivity through cost cutting and corporate cutbacks What has been missing up to now is any indication that corporations are seeing their “top line” revenue grow through improving sales. There are some glimmers of improvement but it is slow in coming. The irony is that if we do see a “V-shaped” recovery and corporate earnings do come in at the levels the most optimistic forecasts are calling for, then we should see interest rates begin to rise and that will take some of the luster off of investing in commodities and emerging markets. That in and of itself will be a fairly strong vote of confidence for the North American economy and the US dollar. Continued on page 4

pg 4 One of the strangest set of events we are seeing has to do with how investors are reacting to positive economic data from the US. If positive data is released, we see the $US sell-off and a corresponding buying spree into the currencies of commodity producing countries. These investment flows are not entirely being directed by fundamental issues such as commodity supply and demand but rather based on movements on the currency market frontier. As a result, for Canadian investors, it is hampering their The stock market is ability to buy backing the optimistic into US equioutcome of a sharp ties because the g ains economic rebound and would be offthe bond market is sayset or even ing “not so fast” negated by the fall in the US dollar. At this point in time, the bond market is skeptical of the economy‟s rebound. This is a significant discrepancy that seems to be going on between the bond market and the stock market. All too often, stock market investors are worried about missing out on the gains and are sometimes clouded by visions of short term gain. The bond market is the much more measured of the two markets. It tends to be a sober deliberator and is not prone to wild gyrations.

That in a nutshell is where we are at as investors. The stock market is backing the optimistic outcome of a sharp economic rebound and the bond market is saying “not so fast”. Given the turmoil that was unleashed over the last couple of years, it is safe to say that investors should have learned some lessons on risk management. The more we look around however, the more we would have to say that many investors seem to be back to the same old game.

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The information in this newsletter is current as at Oct 1, with their legal, investment and/or tax advisor. Pacifica 2009, and does not necessarily reflect subsequent Partners Inc. is not liable for any errors or omissions in market events and conditions. the information or for any loss or damage suffered. This newsletter is published for information purposes only and articles do not provide individual financial, legal, tax or investment advice. Past performance is not indicative of future performance.

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Graphs and charts are used for illustrative purposes only and do not reflect future values or future performance. The statements and statistics contained herein are based on material believed to be reliable, but are not guaranteed to be accurate or complete. Particular investments or trading strategies should be evaluated relative to each individual‟s objectives in consultation

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