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Is The Recovery A V Or W?

The remarkable rise in the Canadian and American stock markets since they hit lows on March 9 raise the question: Where do they go from here?

Let’s consider the numbers. Major stock indices are reporting strong recoveries. For example, the S&P/ TSX Total Return Index, which includes dividends, was up 23.7 per cent for the eight months ended August 31, 2009. Meanwhile, the S&P 500 Composite Total Return Index, which is the index of large cap U. S. stocks and their dividends, is up a more modest but still respectable 15 per cent year in the same period. These are substantial gains, suggesting that investors expect a continuing or V-shaped recovery. That’s the conclusion of Yogesh Oza, an equities analyst at CIBC Wood Gundy in Toronto.

But there is a downside as well. Even though U. S. home sales appear to have begun a rebound with sales volumes and price rising slightly, U. S. retail sales continue to lag as American consumers try to dig themselves out of debt. Americans are saving more and spending a lot less on durable and discretionary goods — a trend that could, Oza notes, block the recovery south of the border.

Trying to predict the future course of the recovery has become an adventure in the alphabet. Not only is there a V-shaped rebound, there is also the W-shaped recovery that allows for a break in the rebound, the L-shaped non-recovery in which the economy flatlines for what could be years, as Japan has done since 1989, and the J-shaped recovery in which most components of the economy rocket ahead.

Jackee Pratt is one of the brightest stock pickers on Bay Street. A vice president and portfolio manager at Mavrix Fund Management Inc., in Toronto, she notes that the recovery in stocks was first driven by optimism that the global recession will end. That boost in confidence was reflected in increased price to earnings multiples for stocks. Then higher earnings expectations in analysts’ reports added fuel to the recovery.

“The easy money has been made,” Pratt says. “What happens next in the markets depends on the strength of the recovery and how companies translate that recovery into better earnings and cash flows.”

There are a few laws in stock markets that seem to work in every economic cycle: First and foremost, long-term averages rule. They tend to pull short-term averages back to the rates of returns over periods of years. That’s because markets tend to price capital correctly in terms of relative risk. An example to the point, Greater China equity funds produced a spectacular rebound in the last six months, rising 37.8 per cent as of August 31. Similarly, the NASDAQ Computer Index in U. S. dollars rose 56.3 per cent in the same period as investors chased recovering sales of software and hardware. What is clear in the recovery so far is that investors have chosen to buy into risk and to leave relatively safe investments. Thus fixed income mutual funds are trailing with gains of just 2.1 per cent for the six months ended August 31.

These very high and very low gains are exceptions to the long-term returns of the sectors. For the 10 years ended August 31, Greater China equity funds gained 11.7 per cent per year compounded annually. As the short average meld into the long run returns, highly charged Chinese stocks are likely to stagnate or run in reverse. Meanwhile, health care stocks, battered by widespread fears that U. S. medical insurance reforms will shrink profits in the sector, are likely to rebound. Indeed, health care stocks are up 15.9 per cent for the six months ended August 31, a 12.6 per cent leap in just the month of July.


Rather than try to estimate corporate earnings, which are the principal drivers of stock prices, investors can use index funds and leave the market to allocate investments and returns. Canada, a major exporter of commodities and energy, should benefit from the recovery, whatever form — or alphabet letter — it takes. For the six months ended July 31, Canadian natural resources mutual fund portfolios rose 35.5 per cent.

U. S. stocks are likely to be laggards on a currency basis. Why? The greenback is due to lose value against other G-7 countries’ money in coming years. One reason is because so much has been printed to prop up the banking system. Then the there is the balance of trade. The U. S. is a commodity importer, Canada is a commodity exporter. They lose, we gain in the trade.

Finally, there is the gigantic American federal deficit, which has soared from $11 trillion in mid-2008 to a widely estimated $21 trillion as U. S. monetary authorities have reflated the banking system. The U. S. does not have the ability to pay down those debts. What’s more, if China, now America’s biggest creditor, were to begin cashing in its trillions of U. S. Treasury bonds, the value of the American dollar would plummet. Chinese monetary authorities know this, so they are likely to be slow and moderate in switching from U. S. bonds to a blend of Eurobonds and Japanese yen bonds. In any event, the threat to the American dollar is distant. But any investor who wants to make a long term bet on American stocks will have to deal with this threat eventually.

For now, the 17 per cent gain of the loonie against the greenback since Dec. 31, 2008 has briefly halted and backed down slightly. But the power behind the loonie is strong. In July and August alone, the Canadian dollar rose 12 per cent against the American dollar. That turned the 38.8 per cent rise of the S&P 500 Composite for the six months ended August 31 into a more modest 19.8 per cent rise in Canadian dollars.


More currency-driven stock and bond returns are to come. The implication: If you want to buy a U. S. stock fund, pick one that is currency hedged. The cost of hedging is negligible and it provides insurance against value erosion by the continuing rise of the loonie.

Foreign stocks should do well. The Morgan Stanley Capital International (MSCI) World Index was up 47.2 per cent for the six months ended August 31. The MSCI Europe Australasia and Far East Index was up 54.1 per cent and the MSCI Emerging Markets Index in Canadian dollars was up 48.1 per cent in the period. But as long as investors select risk rather than safety, foreign stocks except American ones, appear to have a bright near term future.

Taking chances on stocks is not, of course, to everyone’s taste. The bond market was the place to be in the meltdown, but domestic bonds whether government or corporate have expected returns less appealing that those of stocks.

Randy LeClair is vice president and portfolio manager at AIC Ltd., in Burlington, Ontario. He’s a specialist in foreign bonds. “We are shifting to bonds for commodity-based currencies like the Australian and New Zealand dollars, which may appreciate more than the Canadian dollar,” he explains. “The Australian and New Zealand dollars are three times as sensitive to commodity price changes than the Canadian dollar. And when you consider that a 10-year New Zealand bond pays 5.9 per cent and the Canadian 10-year government pays just 3.5 per cent, the foreign bonds offer both some safety and a good potential return on the currency and on the yield.”

LeClair has put a third of his AIC Global Bond Fund into Canadian issued-bonds priced in Australian and New Zealand dollars, betting that high yields on the bonds, compounded with expected currency gains, will produce strong returns. Buy the bonds or buy his fund, which had a 5.4 per cent return for the 12 months ended July 31. You won’t get the kind of double digit returns stocks have been generating, but then you won’t have the risks either. And if the foreign currencies follow expectations, bonds issued in them could produce handsome gains in Canadian dollars.

Andrew Allentuck’s latest book, When Can I Retire? Planning Your Financial Life After Work, was published earlier this year by Penguin Canada

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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