It’s summer and world stock and bond markets are in the doldrums again. As I write this column, the S&P/TSX Composite is flirting with a 10 per cent decline year to date, the point at which a slump takes on the title “correction.”
The problems driving down the world’s markets are real: the tsunami and nuclear power disasters in Japan that will take seven per cent out of that economy this year and pull down global stock market averages as a consequence. The housing market in the United States continues to be wretched with prices down to where they were in 2002. Net household wealth has shriveled and American consumers are neither able nor in a mood to spend and rescue their economy.
In Canada, Canadian household debt is soaring. Statistics Canada recently measured it at 147.3 per cent of disposable income. That means consumers must at some point rein in spending and, if interest rates rise, cut spending and pay their bills. More problems are on the horizon.
Greece totters on the brink of default. European finance ministers meeting in the third week of June resolved to do nothing until the Greek parliament agrees to pass drastic pension and spending cuts demanded by the recently deposed minister of finance. Ireland, Portugal, Spain could also default and then, if enough sovereign bonds fail, the banks holding those bonds, even the powerhouses in Germany, could crumple. The potential mayhem is enough to scare even sober long term investors. No wonder markets are in fright mode.
THE IMPACT OF GREECE
Let’s focus on the Greek mess. Greek state 10-year bonds have recently traded to yield an astonishing 17.34 per cent. They yield 14.41 per cent more than German state bonds, which are the European benchmark. Recently, Standard &Poor’s downgraded Greek state bonds to CCC from B, pushing them deep into junk territory. Greece has proposed that holders of its national bonds voluntarily agree to roll over the bonds for new ones when they mature and not seek to cash them in for some indefinite period. This is like agreeing to let somebody rob your house. You may not be able to prevent it, but to agree is nuts. Still, the voluntary rollover, which is a polite way of avoiding the moment that Greece runs out of Euros, which could trigger other defaults, is a diplomatic way of avoiding outright collapse. On the other side of the equation, a poll of Greek voters taken in mid-June found that 47 per cent oppose government austerity proposals and want early elections. The solution sought by Europe’s financial wizards in June is far from a certainty.
The flight from risk is not mere nervousness. The problems of Greece are spread throughout Europe’s peripheral states. On June 16, The Economist, a British financial journal, added up who owes what. Ireland’s national debt has soared from 25 per cent of its gross domestic product in 2007 to 112 per cent of national output, the result of decisions to bail out two large domestic banks that added 42 per cent to the national debt. Portugal’s national debt will rise above 100 per cent of GDP while the national debt of Greece has reached an terrifying 160 per cent
Just earning money to pay bills doesn’t look like the solution, at least not in the short term. The International Monetary Fund lowered its forecast for major global regions and economies. In a mid-June report, it said that U.S. GDP would grow at 0.2 per cent less than its estimate in April, Central and Eastern Europe 0.8 per cent less, and Brazil 0.5 per cent less. The IMF’s outlook for Canada was unchanged: GDP should grow at 2.9 per cent in 2011 and 2.6 per cent in 2012. These are not big changes, but, as the IMF said, there is a heightened potential that the situation in Europe could spread through the financial system. “If these risks (Greek and other bond defaults) materialize, they will reverberate across the rest of the world.”
THE IMPACT ON FARMERS
What should a Canadian farmer do with his off-farm investment dollars? The biggest global economic problem driving down markets is government debt. Banks are stuffed with it. Rates on national bonds set the rates for most other loans. So when sovereign bonds are no longer trustworthy, each country’s system of lending goes into the twilight zone. In that underworld where government bonds are chancy but utility bonds are golden, stock prices collapse in the face of uncertainty, and the fearful and the prudent flee to cash and the strongest bonds they can find, U.S. Treasuries.
The U.S. has its own massive debt problems, but the idea that it would fail to pay its bonds is considered remote. The rush to U.S. debt has pushed down yields on 10-year Treasuries to 2.93 per cent, a massive 0.40 per cent drop in yield in just three weeks. Treasuries are still regarded at the best looking horses in the glue factory. Government of Canada 10-year bonds have recently been priced to yield 2.95 per cent per year. Canada bonds are the better investment, for our government debt is better managed than that of the U.S. and our inflation prospects lower.
Investors willing to take on some risk can buy beaten down stocks. In the midst of gloom, investors should be able to find good value stocks that have fine prospects in spite of the market. Still, there is the old saying that a falling tide lowers all ships. Moreover, some fine companies like Blackberry phone maker Research in Motion, which has been trashed by the market for weeks, threaten to be value traps in which low prices cannot convince investors to buy. RIM’s price has recently been just four times next year’s earnings per share. That would be a giveaway at the corporate candy store, but investors fear worse news from the once-dominant smart phone maker. Apple has taken RIM’s growth and RIM, for its part, has failed to dazzle the market with new technology. The future is bleak, says the market. RIM is just one example of stocks whose growth has been embalmed in bad news.
Canadian bank shares have gone on sale. Across the TSX, there are bargains to be had. The problem, of course, is that the apparent bargains today may seem overpriced in a few days or weeks. Bank earnings are forecast to fall with the worsening economy.
OVER DONE PESSIMISM?
Yet the pessimism may be overdone. In the U.S., Standard &Poor’s predicts that the companies in its bellwether index, the S&P 500 Composite will earn 18 per cent more in 2011 than they did in 2010. The index is now valued at 8.7 times the composite’s cash flow, which is cheaper than it has been 81 per cent of the time since 1998.
The problem, of course, is the other 19 per cent of the time. If we are in correction territory, then it is possible that averages will go down and that 8.7 earnings multiple will become 7.7 per cent. In the near term, the end of the bailout program called QE2 on June 30 is likely to reduce bank lending and trigger near term contraction. There is an absence of good news that can propel the market upward.
For now, it pays to avoid excessive risk. Buying dividend rich stocks is a way to weather the storm. CIBC is selling for $77 as I write this, down from a 52-week high of $85.56. At that price, the $3.48 annual dividend represents a 4.50 per cent yield. Regulated utilities are also a buy. Shares of Emera, the holding company for Nova Scotia Power, have recently traded at $31.64, slightly off their $32.83 52-week high. Its $1.30 annual dividend amounts to a 4.10 per cent yield. Adjusted for the dividend tax credit, yields are 5.76 per cent and 5.25 per cent, respectively. The risks are not too great, for even if either company stumbles, its history of raising dividends will eventually pull up the stock price.
The cautious and the crafty can cut their costs and generate premium income by writing covered calls on market exchange traded funds or stocks. The strategy works until the stock or ETF soars. Then the investor, having given up future profits, has to walk away. It’s always possible to buy back in, of course.
Finally, there is the tried and true strategy of staying on the sidelines. In bad markets, cash can be king. After all, making a miserable one per cent or so in a savings account looks good compared to losing 10 per cent on the market or 50 per cent in Research in Motion. Modest goals are not always the craft of cowards — sometimes they can be downright reasonable.
AndrewAllentuck’slatestbook,WhenCan IRetire?PlanningyourFinancialLifeAfter Work,waspublishedearlierthisyearby PenguinCanada.
There is the tried and true strategy of staying on the
sidelines. In bad markets, cash
can be king