Market Risks Prompt Shopping For Lagging Stocks

Markets are soaring and investors, especially those who have waited on the sidelines for an opportunity to buy into recovering American banks or hot Canadian commodity producers, are frustrated. Halted only by the Japanese nuclear reactor explosions in early March that scraped a few hundred points off the S&P/ TSX Composite (now fully recovered) equity markets have charged ahead seemingly oblivious of what could be hard times to come.

Pushed to back-of-mind neglect are the following issues, each of which could derail global markets. Interest rates are rising around the world, partly as a reflection of the global recovery, partly to cover the risks of massive sovereign debt default.

Greece is near default, Portugal is not far behind and Spain could follow. Investors will be much poorer if the Athens government restructures its debt and forces bondholders to wait a decade or two before they can collect not the 11 per cent the bonds now yield, but perhaps four per cent. That could be a model for the other troubled Eurodebtors.

There are other worries. The Middle East is in turmoil, which is almost normal, but if Libya’s Muammar Gaddafiwere to burn his oilfields, as Iraq’s Saddam Hussein did to Kuwait’s oilfields in 1991, world energy supplies would be crimped. The Japanese disaster has cut several per cent out of the nation’s electrical grid. The country will have to buy more fossil fuels to make up some of the loss, which will only push high oil prices even higher. They will import more and export less. Japanese debt, now 200 per cent of gross domestic product and the highest level in the G-7 will no longer be financeable domestically. Japan will have to borrow in global markets and pay global rates of perhaps four per cent to five per cent for 10 to 30 year bonds. That will be a vast markup over current mid to long rates. Japanese stocks will have to face strong headwinds.

Finally, there is the problem of rising energy prices. The more people have to spend on energy, the less than have to spend on other things. For Canada and other energy exporters, high energy prices are fine. But we won’t be able to thrive in a global economy that is mired in

high interest and energy costs.

More worries: The American housing market is getting even deeper in the hole as more house prices fall below what their owners owe to lenders. Homeowners have less equity and less wealth. They are less able to stabilize the American economy in downturns. Meanwhile, all eyes are on China. The question, of course, is whether they can sustain their insatiable demand for basic resources including iron, steel, coal, oil, fertilizers and grains.

BUYING LAGGARDS

The stock market has followed the trends. Investors have been

chasing winners. Yet that behaviour is not the way to play. Investors who put their money on winners either directly or through mutual funds are setting themselves up to sell low when the market turns south. And it will, for there has never been a trend in history that has not reversed itself. That is why they are called trends, after all.

Mutual fund investors who chase last year’s hot performers are in effect preparing themselves to lose. Mutual fund managers, especially those who have had a good year, try to invest the money that rushes in after their performance numbers are published, tend to buy more of what they already have. New investors and existing investors tend to insist on a “more of the same” strategy. Unfortunately, that means buying on price momentum, picking up recent winners at ever higher prices. Index investors get the worst the deals because most market index funds just replicate capitalization- weighted indices. So if Bank A or resource company B starts the year, each with 10 per cent of the index and their stocks are up 30 per cent, they are 13 per cent of the index in December. In bull markets, index investors in particular wind up with a lot of expensive stock. If you recall Nortel Networks when it accounted for a third of the TSX, you will understand the problem of buying winners.

The wiser thing is to buy stocks that are down. Energy markets are a good place to look for them, and there are many candidates. Natural gas has had two terrible years. Gas futures are down as much as 75 per cent from their 2008 levels. Natural gas is the cleanest burning fossil fuel. Gas-fired electrical generators are quick and easy to build, at least compared to nuclear plants that take as much as 20 years for political approval and construction.

Uranium mining companies are suffering. Shares of Cameco Corp., the biggest uranium producer in the world, are down 35 to 40 per cent from before the Japanese disaster. New reactor construction in a few places will be delayed by safety reviews, which are essential in this dangerous business, yet uranium stocks will eventually recover.

Making electricity from nuclear power is ecologically wise, for uranium does not put carbon into the atmosphere. Moreover, uranium is a fuel source entirely separate and different from fossil fuels that heat homes. If there were no nuclear power, world carbon emissions would rise by what has been estimated at eight per cent per year and fuel would become prohibitively expensive for the masses in developing countries. Already, nuclear plants supply 20 per cent of America’s electricity, 75 per cent of France’s electrical needs, and 26 per cent of Germany’s requirements. Power from windmills and tidal flows is marginal. New reactor construction may slow in the wake of the Japanese disaster, but uranium is here to stay. Indeed, China has 80 nuclear generator projects underway. There is no doubt that management and means for storing spent fuel have to improve, but a return to 100 per cent fossil fuel source electrical power is no longer possible.

Another bet is Main Street Canada. Retailing suffered in the meltdown, but retail stocks such as Canadian Tire Corp. with a price to sales ratio of 0.58, a 1.7 per cent dividend and an 11.6 per cent return on equity are downright cheap. It is not alone. When the recovery of the financial sector and commodities eventually gets to average folks, their retailers will thrive.

THE RETURN OF INFLATION

All that leaves the biggest question: will we have a return to inflation? For now, annual inflation predictions remain modest at 2.2 per cent or so on both sides of the border. For 2012, Scotiabank’s Economics Department predicts core inflation — that’s without food and energy price changes — running at 1.9 per cent. If the Federal Reserve lets short term interest rates rise over the approximately zero level it has held them at and other bond yield rise accordingly, we’ll return to a natural investment environment rather than one resuscitated back to life by central banks. And all that means that sectors far from banks and commodities will find it easier to get loans, easier to sell stocks, and easier to make sales. That’s what’s ahead if the recovery proceeds.

The problem is that the recovery is far from such a sure thing. If interest rates rise ahead of corporate profits, business investment will fall. If stocks soar to unreasonable markups over expected earnings, there will be a correction. For now, investing in the recovery seems to makes sense. And if one buys into companies with good free cash flow and reasonable valuations, it is not unreasonable. Yet in six to nine months, enough time for a market pullback, stocks could be a lot cheaper.

So buying today’s slugs remains a good alternative to going with the flow. Most of all, the less you pay for a stock, the less you have to lose. Hotshot bank recoveries and commodity plays are old news. Sluggish sectors like big pharmaceuticals in the U.S. and consumer products in Canada still have low multiples of price to earnings. Finally, the easiest play of all — ladders of bonds in exchange traded funds run by Claymore Investments and others offer the strong prospect of rising income. The ladders just pay a few per cent per year right now, but payouts will rise along with climbing interest rates. The five year terms and rollovers to rising interest rates are insurance against losses.

AndrewAllentuck’slatestbook,WhenCan IRetire?PlanningYourFinancialLifeAfter Work,waspublishedinJanuarybyPenguin Canada

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Investors that bet on winners set themselves up to sell low when the market turns south

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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