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Making big bets on economic cycles

These days, it’s hard to find a place where your investment will be safe, let alone lucrative. It helps to make the right choices

There is an economic recovery brewing. Every cycle of boom to bust to boom again is a little different, but the broad patterns are much the same. What counts when economies make their turns is to be in the right type of asset, then the right industry and finally in the right companies.

Setting the scene

We are coming to the end of one of the biggest bond booms in history, the almost uninterrupted decline of interest rates since Federal Reserve chairman Paul Volcker and Bank of Canada governor Gerald Bouey broke the back of double digit inflation in 1982.

At that time, interest rates were 12 per cent for federal government bonds, 15 per cent for provincials and 16 per cent and up for corporate bonds. Since then, bonds have produced immense gains. A 30-year strip bond, which pays no interest until maturity, purchased in 1982 for $1,000, would have had a value at maturity of $30,000.

The bond boom is ending because there is nowhere for interest rates to go but up.

It has to be admitted that if deflation broke out, long government bonds would still be valuable and could gain in market price. But the distance from 12 per cent in 1982 for a Government of Canada 30-year bond down to 2.8 per cent today is a lot more than from 2.8 per cent today even to zero.

Looking to the future

Investors with long horizons need to look at the big picture. In the event of rising interest rates driven by economic recovery and mid inflation, stocks should thrive.

A modest increase in earnings compounded by a small increase in the ratio of price to earnings will push up stock prices handsomely.

Commodity prices should also do well with the return of inflation. The problem, of course, is to pick the right commodities.

Energy is too abundant to produce rising market prices. Many crop prices are already at historic peaks. A broad cyclical push upward of commodity prices is not yet in view.

Real estate prices are headed down in many markets — B.C., Ontario, and Alberta — as a result of steam running out of their booms. Bank of Canada policies restricting the terms of first time buyers’ amortization periods has made entry level housing harder to afford. The effect ripples upward throughout the housing market.

Canadian house prices are still high in relation to rents. Speculators are leaving this market — the wise investor can wait on the sidelines for a few years.

In this broad survey of investment markets, stocks are the winners. Next problem? Which sectors to buy.

Choosing a sector

With rising interest rates, life insurance companies should show better earnings.

The underlying mechanism of life insurance pricing — how much it costs to buy a given death benefit — is interest. As interest rates rise, life insurers can sell a given benefit for a lower premium or, for a given premium, provide a higher death benefit.

Insurers like Manulife Financial that sold segregated funds and other guaranteed payout products and then took a huge hit on their prices when stocks collapsed and they had to make good on their guarantees, should do better in the future. Likewise, Canadian insurers that bought major mutual fund vendors just as capital markets collapsed should find that their mistimed purchases begin to pay off.

Global banks are coming out of a deep slump. Many have shed a lot of their derivatives trading business and want to concentrate on wealth management. After numerous missteps including trying to fix the global short-term bank reserve lending market, massive fines levied by regulators, and other regulatory actions just short of criminal prosecution, European bank recovery is in the offing.

Canadian chartered banks are expensive by global standards. None of our banks have had to pay large fines for misconduct for, in fact, they have been angels in a garden of temptations. Their reserves are strong, defaults on loans are small, their management is reliable and their dividends solid and rising. Money invested in a chartered bank or an exchange traded fund of chartered banks should return an average dividend of 3.5 to four per cent plus a three to five per cent annual price gain. Telecoms like BCE Inc. are mature and strong dividend payers.

Global consumer products companies such as Unilever PLC, Procter & Gamble, Kraft Foods, and Walmart Stores should be good recovery bets. The big soap companies expand sales with growing consumer purchasing power in China and southeast Asia. Kraft controls markets by sheer marketing power.

Walmart’s expansion cannot be stopped. Its biggest risks are unionization, which can only happen in one jurisdiction at a time, and a rising exchange value of the Chinese yuan. Walmart is expanding in China, so some of the rising cost of goods it buys in China would be offset by rising China sales. Walmart’s move to groceries insulates it from much of the China yuan/dollar exchange problem.

Global transportation that brings all these markets together is problematic. One would say that with more global business, there should be more shipping. The problem is that the ocean freighter market is oversupplied with vessels, the global airline business oversupplied with planes and railroads in Europe are running light as a result of the seemingly endless continental recession. A broad sectoral expansion in global transport awaits the end of the global recession. Investing selectively in Canadian and American railroads is not too risky. Putting money into any major airline is a risk I would not take.

Technology investments have been fabulous winners in the last 30 years and horrible failures too. Apple has gone from boom to bust and boom again.

Compaq? Dot com mania? Recall Facebook’s recent and, said the market, overpriced initial public offering. The biggest winners have been IBM and Microsoft, but even they could falter again. If all software is available by rent — cloud computing — then Microsoft would be in trouble. In short, technology investments are for the knowledgeable and the swift. For major bets for the long term, it is not a good place to be.

Funds with reasonable fees

With all of this said, broad stock exchange traded funds and mutual funds with fees in the reasonable range of 1.2 per cent per year or less are still reasonable investments.

You can buy global stocks in the MSCI Index, the S&P 500, the S&P/TSX total return index, and global consumer product stocks.

Being in the right asset class, which is stocks, the right sectors such as consumer products and Canadian financial institutions, and the right companies in that order will position non-farm investments for gains in the next few years.

By the same token, staying out of airlines, cell phones, social network companies and government bonds should reduce the risks of off-farm investments. The future is not kind to those who forget the lessons of history. †

About the author

Columnist

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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