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2011 Mid August Review August 16th, 2011 By Kim Mailey, CFP

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Continued European sovereign debt concerns, the ridiculous lack of compromise demonstrated between the two US parties in addressing their debt ceiling followed by the somewhat irresponsible timing of the S&P credit downgrade to the US resulted in a week of extreme volatility in global stock markets. Agitation in the markets is evident, and emotional overshooting has driven global risk appetite to panic levels.

Many unanswered questions remain and, while difficult to do, I will take a step back from the minute-to-minute whipsaw in the markets and focus on the facts and fundamentals. While I hope to bring a greater sense of clarity and understanding in the face of today's extreme volatility, additional developments may impact the conclusions I set forth.

Probability of a Recession:
Credit Suisse uses a probability model using stocks prices, payroll momentum, jobless claims, housing permits, the relative price of energy, consumer expectations, and the "TED spread" - a proxy for financial stress. Their model indicates a 30% probability of recession occurring over the next six months. A US GDP growth of less than 2% would cause concern as it would not create the necessary job growth or assist with the housing problems.

How is today's environment different than 2008?
Banks and businesses have much larger cash buffers than they did in 2008. Businesses have exceptional profitability (albeit at the expense of job growth). With the second quarter earnings season behind us the number of companies exceeding analyst's expectations was impressive, and a year-over year comparison of a 15% average increase was also impressive.

With monetary and fiscal policy easier now than it was in 2008, with no more room to lower interest rates, the challenge will be on how to tighten budgets and increase tax revenues, not how to provide fiscal stimulus.

Market Trends and Outlook:
The safe haven assets that have become home to those panicked have been US Treasuries, German and Swiss bonds, and gold.

While very reluctant to call market tops and bottoms, there are signs that the move to safe haven assets may be in the late stages. The risk appetite indicators used by Credit Suisse indicate that equities are now in deep panic and bonds are in euphoria. These indicators have historically been good predictors of near-term reversals.

How much further can gold run?
One of the primary beneficiaries of the renewed bout of financial panic has been gold, with the price increasing from $1500 in early July 2011 to its current level of almost $1800.

It is notable that over the very long run, the real price of gold has shown no clear trend. It has been stationary with long periods of sideways movements punctuated by two spikes - one in the 1970's and one in the past decade. Both of these spikes occurred during periods where investor faith in the global financial system and western political system were under severe pressure. In the 1970's it was specifically to do with the breakdown of the Bretton Woods system of exchange rates and the oil shocks, and over the past decade the bursting of the tech bubble, the great recession and its aftermath.

With the US Federal Reserve issuing statements that they expect the US economy to be so weak as to need near-zero interest rates for the next two years, gold will likely remain the safe haven of choice for at least that long and may well trend higher over this time.

Summary:
On paper, stocks look like bargains in the wake of their recent selloff. The question is whether, given the latest threats facing the market, those cheap valuations are worth the paper they're written on.

Following the two week plunge in late July 2011 and early August 2011 that shaved 14% off the S&P/TSX composite and 17% off the US benchmark S&P 500, stocks are in recovery as investors continue to be drawn back to the market by what look like highly attractive stock valuations.

Even with the gains of the past few sessions, the S&P 500's "forward" price-to-earnings (P/E) ratio based on earnings forecasts for the next 12 months is around 12 times well below the historical norm of about 15 to 16 times.

"[The recent market slide] did leave the valuations looking more attractive," said George Vasic, chief strategist at UBS Securities Canada Inc.

However, the current circumstances suggest that valuations need to be taken with at least a grain of salt, if not a spoonful or two.

Citigroup equity strategist Tobias Levkovich suggests following the recent sell off that the S&P 500 has largely already priced in the risk of another recession. He said "barring a credit implosion and some form of global economic meltdown, stock prices at current values seem very reasonably priced".

Equities are expected to provide the best return to investors over the next few years. North American equities are preferred over European, and dividend supported equities are a defensive way to participate in the expected market growth or at the every least be paid to wait for the growth. The Canadian banks are attractive at their current prices. ScotiaMcLeod analysts rank TD, Royal and CIBC as "1 sector outperform" and Canadian Western Bank, Scotiabank and BMO as "2 sector perform". There are also some attractive opportunities within the REIT (real estate investment trust) universe.

I believe the recent panic was driven by two fears:

1. the US sliding back into recession, and
2. the US and European authorities being unable or unwilling to make the right policy changes.

I don't believe in either hypothesis. The usual indicators of an impending recession are not visible. The interest rate yield curve is not inverted, the leading economic indicators are not declining and copper prices have not corrected significantly. I also believe that the crisis in policy credibility will pass. Solutions do exist, and the failing markets are actually positive in a sick sense, in that they will motivate the politicians to do the right thing.

Going forward, I will continue to guide you to be positioned conservatively. However, valuations are becoming increasingly attractive and therefore remain diligent for an opportunity to increase our exposure to quality opportunities.

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