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Stock Market Should Reward The Prudent

Where are markets going? It’s a perennial question, but at the moment there is anything but clarity. The U. S. Federal Reserve Board has given a hint of what is to come by raising interest rates from 0.25 per cent to 0.50 per cent for overnight loans to banks by the Fed. It’s a token, a gesture, that shows the Fed isn’t going to provide free money to the banking system much longer. It’s also a signal that interest rates will rise further, but nobody expects big increases to happen very soon. The U. S. economy is still too wounded from the great meltdown in 2008 and 2009. The Bank of Canada (BoC) has adopted a wait and see posture and is holding its overnight rate at 0.25 per cent. The BoC has promised not to raise interest rates until July, but could change its mind if inflation perks up. There seems little chance of that at the moment, however. High unemployment in the U. S. and Canada is likely to keep wages down. Indeed, as one commentator said, “if you’re looking for a job, the recession isn’t over.”

Low interest rates help stocks, for bank deposits and bonds earn little. Investors who can stand a little risk prefer to put their money into stocks that can generate higher returns. Even bank stocks pay three per cent to five per cent dividends these days. It seems no contest. But wait — if the central banks take back their loans to banks, especially in the U. S., the banks’ balance sheets will weaken, their bond prices will drop and their stock prices should follow downward.

The stock market has other issues. The big question is what will happen to the U. S. economy. Already, there are abundant caution signs. Investors worry about what will happen when the Federal Reserve Board, which now has about $1 trillion of housing loans — more than it has Treasury bonds — starts to clean up its balance sheet. The quality of assets in the banking system is still not what it should be. Those who worry that the subprime loan crisis that triggered the meltdown in 2008 could reappear in the form of a new crisis with other kinds of fancy loans have a lot good sense on their side.

Investment banks are now selling longevity risk, that is, the chance that folks with pensions will live longer than expected, dragging down the net worth of the pension funds. Note that fancy assets are not necessarily sound assets. That’s what the subprime crisis was about. Wait a few years and the bankers may yet produce another meltdown and get big bonuses for having done it.

The saving grace of the Canadian stock market is the soundness of our banks and the profitability of our resources. We mine money in the form of gold, energize the world’s transportation fleets with our oil, heat homes with our gas and make construction materials with wood from our forests and copper from our mines. That’s my patriotic speech and it is correct.

That is not to say that a market stressed by risk could not decline. And that is

precisely what worries analysts like David Rosenberg, chief strategist for Gluskin Sheff Associates Inc. in Toronto, a money management firm.

Rosenberg points to China, where banks have been told to increase their reserves (this cuts their profitability because they can lend less when their money is tied up). So much depends on China and, these days, when the Bank of China sniffles, the rest of the world seems to get a hacking cough.

STOCK SELECTION FOR GROWTH

For now, with interest rates low, Canadian, U. S. and global stocks continue to beckon. “The markets are just waiting for more direction from corporate earnings,” says Tony Warzel, president of hedge fund manager Rival Capital Management Inc. at Winnipeg. “The year-over-year returns will be positive and most companies will show good earnings growth for the first and second quarters because last year we were still mired in the recession. But the returns could sag in the third and fourth quarters when the numbers are compared to earnings that were already getting better.”

In a market in which there is not much direction, successful investors have to be good stock pickers. That means research, exploring advice from financial planners and portfolio managers and looking beyond last year’s performance. In finance, the past may be prologue, but the truth is that things change. One year’s terrific performance in one sector is unlikely to be repeated. The market rotates to something else, eventually evening out the performance of all stocks and sectors and rewarding those who buy cheap and punishing those who buy dear.

The stock market will eventually climb out of its present doldrums marked by weeks of aimless wobbling. But along the way, the world will have to confront and solve the crisis brought on by the potential default by Greece on its government debt.

There is nothing good about it. Greece’s public debt is 100 per cent to 120 per cent of its gross domestic product, the gap due to what appears were books deliberately fudged to get it into the European Community and onto the Euro. In the past, countries with public debt problems could devalue or let the market do it for them. That no longer works, for Greece has given up the drachma. Germany may loan Greece money at the risk of riots in it’s the streets of Berlin and Dusseldorf by workers who protest aiding Greece, a country with more generous social benefits and earlier permitted retirement than its own. Then other marginal European economies, especially Portugal and Spain could ask for handouts. No matter what happens, either taxes in Germany and France will have to rise or all the countries on the Euro suffer what amounts to the devaluation of their economies. Bottom line –Greece and much of Europe has been living above the standard of living its economies support. Their comeuppance is due. For now, European money is gushing into American Treasury bonds, supporting a ship that, on the basis of government’s ability to fix its deficit, ought to be sinking. U. S. stocks, too, are getting support from the Euro’s crisis.

PREPA RE FOR A BUMPY RIDE

Over the next couple of years, the Toronto Stock Exchange should perform well, rising to 13,000 within 12 to 18 months from a current level 11,526 at the time of writing, says Jackee Pratt, vice president and portfolio manager at Mavrix Fund Management Inc. at Toronto. “It could be a bumpy ride getting there, for we are due for a 10 per cent correction to the market,” she says. “The TSX has risen 62 per cent since its bottom on March 9, so there has to be a correction. The markets dropped five per cent in January and have another five per cent to go. So holding some cash and moving into carefully selected dividend-paying stocks is opportune

No one ever said that investing would be easy or without tough moments. In this market, holding Canadian dollars in preference to the weakening Euro or the deficit-damaged U. S. dollar is prudent. Wait for market downturns, get advice from your

financial counselor and seek stocks with dividend support. That’s a middle course between the pessimism of the worsening recession school and the optimism of those who believe we are in a prolonged economic revival.

Andrew Allentuck is the author of When Can I Retire? Planning Your Financial Life After Work, published in 2009 by Penguin Canada

About the author

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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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