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Determining Value Buys In A Turbulent World

We’re in the middle of a stock market boom. Stocks are up in the U.S. and Canada, the Euro has gained value as the world has come to realize that the European Union will remain intact in spite of debt management problems, and consumer sentiment is improving in what appears to be all major industrialized nations. Wall Street bonuses have hit an all time high, even as Americans unable to pay their mortgages continue to be thrown out of their homes at a near record rate, even though evictions, stalled by court orders not to carry out improper home seizures, have declined from their 2010 highs.

On paper, even if choppy, the recovery in financial markets in North America and Europe looks like it is accelerating. That suggests that it’s less risky to buy into major market stock indexes like the S&P/TSX. Investors evidently agree, for the market recovery has both breadth in many sectors and depth in the sustainability of rallies. But can it last?

Recoveries need two supports — one, a foundation of good economic news and a good outlook, and two, what John Maynard Keynes, the British economist whose theories are widely credited with bringing the U.S. and Britain out of the Great Depression, called, “animal spirits.” It’s worth noting that war preparations to boost industrial production and conscription to reduce unemployment helped too.


Today, the spirit of recovery is in place and internal market mechanisms to sustain rises in stock prices are in place. Investors have bought into the idea of the recovery, but the world is not quite as rosy as the forecasts assume. What investors are seeing is a rise in stock prices and jumping aboard that bandwagon. Animal spirits are strong. What investors do not weigh is the pit of problems that could derail the recovery: Middle Eastern instability, no small matter given that a third of the world’s oil comes from the region, the prospect that China will raise interest rates to slow down its recovery and, in turn, Canadian exports, and rising food costs that can eventually destabilize the governments of poor countries that can’t afford to buy more grain.

Part of the recovery is about bonds. Interest rates have risen dramatically in the last six months as investors anticipate recovery and rising inflation. Government of Canada bellwether 10 year bonds now yield 3.47 per cent to maturity, That’s a leap from their 3.2 per cent yield to maturity back in September, 2010. A comparable 10 year U.S. Treasury bond now pays 3.62 per cent, up from 3.35 per cent six months ago. What is driving up the yield is dropping bond prices (bond prices and yield move inversely, for old bonds with fixed coupons are less appealing when new bonds have higher yields). If yields on safe government 10 year bonds rise to four per cent, there is historical evidence that money will stampede out of stocks for the guaranteed return of investment grade debt.

So far, stock investors are following the lure of improving earnings and balance sheets. As I write this column phone company Telus Corp. has reported a 45 per cent jump in fourth quarter profits over the same period a year earlier. Stocks of energy producers like oil sands giant Suncor Energy, fertilizer maker Potash Corp., Canadian Pacific Railway, which ships commodities to China, are all thriving. The good news is palpable, but how long can it last?


Betting on rising price momentum in a rising market is a way to lose. It is the opposite of the idea of buying low and selling high. It has been compared to driving forward by looking backward. And it is a denial of the truth that in financial markets, few trends have staying power.

So what to do? Central banks continue to suppress short term interest rates. Short term rates strongly influence two-year bond rates and those rates strongly influence five and 10 year rates. The Fed and the Bank of Canada will eventually start pushing up short rates, making loans more expensive, reducing the willingness of businesses to borrow and discouraging consumers from putting more debt on their plastic.

That’s a recipe for stagnating stock profits, so when buying into stocks these days, it pays to have a backup of health dividends. Dividend rates of 3.5 per cent to 4.5 per cent on bank stocks and 5.5 per cent on BCE Inc., for example, are equal to the yields on many of their bonds and offer a dividend tax credit to boot. Long term investors in companies able to sustain dividends, as the chartered banks did during the 2008 to 2009 meltdown, in regulated public utilities that have strong payouts, and in financial services companies with strong and rising dividends, for example, can survive a lot of trouble. The combined financial services companies’ earnings and stock prices are leveraged on the underlying products and services they provide, so volatility is to be expected. This is no recommendation to buy or trade any of them, but it is an observation that if they continue to pay dividends, patient investors will not suffer.

There is still room for bonds in patient investors’ portfolios. If inflation in the U.S. and Canada holds in a range of 2.2 per cent to 2.8 per cent, as the economics department of the Bank of Nova Scotia predicts it will for the next several decades, and if 30-year Government of Canada bonds pay 3.8 per cent as they do now, then the difference, say one per cent to 1.6 per cent is a risk-free return after inflation but before tax. In an RRSP, they can stabilize volatile stock returns.


There is a lot more money to be made in provincial bonds, such as 20-year Ontarios that currently yield 4.5 per cent to maturity. The risk of default is negligible and it is easy to sell them at any time. The return after inflation adjustment is 2.3 per cent before tax.

In corporate bonds there is always the theoretical risk of default. But a Greater Toronto Airport Authority 23 year bond pays 5.23 per cent to maturity or about three per cent after inflation and before tax. The GTAA bond is premium priced at $116 per $100 of face value, guaranteeing a capital loss on paper — handy if you have capital gains to offset, but the yield to maturity is built in and the risk of default is very small.

Commodities are the last great standby for value investors in a turbulent world. Most commodities are industrial inputs. So copper depends on demand for building construction and wire production. Coal fires up steel plants. Only gold is theoretically immune from the worries of industrial production falling.

It’s not quite that simple, unfortunately. The world saw gold prices fall to US$723 at the bottom of the 2008 market collapse as investors rushed to sell anything they could to raise cash. Now that liquidity has been restored, gold is up to US$1,360. That’s not even double the price in January, 1981, when it hit US$860 for one day and, as the argument goes, gold would have to rise to US$2,400 per ounce just to catch up to three decades of inflation. That is has not done so yet implies that either the inflation theory is wrong or that the world needs even lower interest rates to make it sufficiently inexpensive to own gold that pays no interest.

The best strategy for the future remains to be diversified in stocks, bonds and commodities. Dividend-paying stocks, bonds with returns that leave a margin over inflation expectations and some commodity exposure are what is needed for times good and bad. Investors who bet on the theory that the world will be rosy or who say that the end is nigh and that stocks are doomed to collapse always run into the problem that the future may not cooperate with predictions. The diversified investor is ready for any outcome, even if spreading out capital means that there may not be any big kills. But the diversified investor will survive. And that is the most fundamental animal spirit of all.

AndrewAllentuck’slatestbook,WhenCan IRetire?PlanningYourFinancialLifeAfter Work,wasreleasedbyPenguinCanadaasa paperbackinJanuary

About the author


Andrew Allentuck’s book, “Cherished Fortune: Build Your Portfolio Like Your Own Business,” written with co-author Benoit Poliquin, was recently published by Dundurn Press.



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