Our Library

December Market Commentary and Outlook December 3rd, 2010 By Kim Mailey, CFP

Send to a Friend Back to Our Library

Driving Home Using the Rear View Mirror

The logic of investors can at times be bewildering! Looking back at the last few years, the fact is that the stock market took a terrible tumble down and the bond market enjoyed a great jump up when interest rates were pushed to all time record lows. When panic and fear pushes stock markets to extremely oversold levels, it is logical to assume that they will recover with time. When interest rates are near zero, it is logical to assume that the only direction they can go is up - which can make bonds prices go down.

With this in mind, take a look at the purchases and redemptions of the entire Canadian mutual fund industry as gauge of typical investor behaviour.

	Net Sales ($ Millions)*
	September 210	October 2010	Year-to-Date
Equity Funds	($1,153.1)	($820.6)	($5,899.5)
Bond Funds	$1,675.2	$1,372.2	$8,509.8
* Figures from IFIC

What are "typical" investors thinking buying $8.5 billion of bond funds when interest rates are at all time lows? My guess would be because the bond funds have done well in the recent past - and moderate growth. Valuations appear reasonable but the gauge of sentiment is not showing a strong "wish-you-were-here" craving among investors. At least 1,500 Canadians investors in a recent survey reflected a rather gaping disconnect between the investment outlook and their investment decisions.

Surveys trying to gauge investors' attitude towards the equity market are generally finding that a majority of respondents are optimistic in their outlook for the equity markets and yet only 13% were somewhat or much more likely to invest in stock. Another disconnect!

Canada is witnessing a valuation pattern similar to that of the U.S. Canadian stocks are offering yields that exceed those of Canada bonds.

Markets have been extremely resilient since August 2010, despite lingering concerns over sovereign debt issues in Europe, conflicts in Korea, and fears of economic deceleration in emerging countries. From my perspective, these represent valid risks that will create tremendous volatility in equity markets over the next several months.

Aside from the above risks, I note that there are some supportive themes for the market outlook. To be sure, any recovery will likely be choppy as a number of risks still linger in the macro environment, but strong corporate balance sheets (supporting buybacks, M&A activity), stabilizing earnings, and low interest rates should present a stable foundation for stock markets.

Supporting factors for optimism:

• The Bureau of Economic Analysis (BEA) in the US announced that third-quarter GDP growth was revised higher than expected, to a 2.5% annual rate, up from an initial estimate of 2%. Higher consumer spending, business investment, stronger inventory growth and an improving trade balance all contributed to this upward revision in third-quarter GDP. Alan Ruskin, strategist at Deutsche Bank, said GDP growth could rise above 3% in 2011.
   
• The November University of Michigan/Reuters survey of consumer sentiment rose to 71.6, up sharply from 67.7 in October, reaching its highest monthly reading since June. The survey cited improving optimism in the job market as a key driver of improving consumer sentiment. Another possible reason for improving consumer sentiment is that personal income rose 0.5% in October, rising even more than most economists expected, giving merchants increased hope for improved holiday sales.
   
• To create real job growth, economists believe that the U.S. economy must grow at a 3% annual pace and that new weekly jobless claims must average less than 400,000, so the best economic news last week came on Wednesday, when the Labor Department reported that new unemployment claims in the latest week declined by 34,000 to 407,000, the lowest weekly level in more than two years! New jobless claims have now fallen in four of the past five weeks - the first time that that has happened since July 2008. The closely watched four-week average of new jobless claims fell by 7,500 to 436,000, also a two-year low.
   
• The Commerce Department announced that core inflation rose only 0.9% in the 12 months ending October 31 - a record low since this data has been collected (in 1960). Despite the fact that the cost of turkey and other food staples have risen significantly, the Fed now has sound data to support its deflation argument - justifying their $600 billion added to the U.S. economy via quantitative easing.
   
• U.S. online retail sales on Cyber Monday - the Monday after Thanksgiving - hit a record high, surpassing US$1-billion for the first time for a single day of Web shopping, up 16% over last year.
   
• December tends to be a seasonally strong month for returns. Dating back to 1980, the market as measured by the S&P 500 index has had a positive return 73.33% of the time.
   
• Shareholders of General Motors raised $20.1-billion in the largest IPO in U.S. history. Shares jumped 7% in the first day of trading before closing up 3%.
   
• Vincent Delisle, Scotia Capital's Portfolio Strategist, writes: "Although investors remain cautious, two straight years of positive equity performance, along with firming economic activity, may result in flows slowly coming back towards the equity market in 2011/2012. In the absence of sustained positive equity flows, and a reversal in bond flows, we see limited P/E multiple expansion."
   

Bottom line, stock markets don't typically fall in the midst of quantitative easing, record corporate earnings, improving consumer sentiment, an improving job market, and recent evidence indicating that the holiday shopping season is off to a strong start! The first phase of the "January effect" may have already started as we head into the traditional year-end rally. This is a seasonally strong time of the year, so I expect that the next several weeks could be especially pleasant for our portfolios.

I continue to believe that the core of one's financial assets (the "hub") should be invested in an actively managed and well diversified "pension type" of portfolio. For risk tolerant accounts, the addition of carefully selected individual equities can be added (the "spoke") for the opportunity of additional return with recognition of the additional risk. I identified in last month's commentary a number of candidates for this hub and spoke strategy I ascribe to, and I am now adding three additional candidates:

1. Barrick Gold Corp - an attractively valued senior gold producer with a strong balance sheet, strong free cash flow and low geopolitical risk. ScotiaMcLeod rates this company as a sector outperformer and has a one year target of $77 - approximately 40% higher than its current price.
    
2. Onex Corp - has very strong management, is diversified and debt-free. ScotiaMcLeod rates Onex as a sector performer with a one year target of $33.50 - approximately 17% higher than its current price.
    
3. Rona Inc. - the share price of Rona has drastically underperformed its peers such as Lowe's and Home Depot. ScotiaMcLeod rates Rona as a sector outperform and has a one year target of $16 - approximately 21% higher than its current price.
    

Investors must recognize that individual stock holdings have higher return potential than a broadly diversified portfolio but also have a higher risk. Suitability discussions should take place.

I always welcome and comments or questions about the material I have presented in this article. I wish you the very best for upcoming holiday season.