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Market Commentary & Outlook October 3rd, 2011 By Kim Mailey, CFP

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Upside Down

Following the worst quarter of stock market returns since 2008, investors are consumed with fear and the markets are experiencing a high level of volatility. Over half of the trading days in the third quarter saw the Dow Jones Industrial Average change by more than 100 points up or down.

The markets are primarily focused on the European sovereign debt problems and secondarily concerned about the US level of indebtedness. How have the markets responded to many of the world's Governments inability to balance their cheque book for many years - they flock to the US currency and push the US government guaranteed bonds to high prices and record low yields. Ten year US Government guaranteed bonds yield 1.8% and 30 year US Government guaranteed bonds offer yields of 2.77%!

In contrast to the Government's fiscal mismanagement, many corporate balance sheets have seen significant improvement. On September 16th the Federal Reserve reported corporate cash balances grew to $2.05 trillion -- a 4.5% increase over last quarter -- representing a $648 billion increase since the first quarter of 2009. This cash will be used for strategic mergers and acquisitions, share buy backs, and dividend increases. In this fear-crazed environment, corporately issued bonds and stocks have had their security prices pushed down resulting in higher yields.

Above all of today's "noise", the risk/reward pricing of the capital markets is upside down! Fundamentals have taken a backseat to US and European political posturing since July, but the gloomy headlines do not correlate with actual economic/earnings damage. Scotia Capital Portfolio Strategist Vincent Delisle says: "Investor sentiment has collapsed in recent weeks, but our view is that perceptions are currently overshooting the actual damage to the economy and earnings."

The major North American market returns:

	August '11	Year-to-Date	One Year
S&P/TSX 60 Index	- 8.39%	- 13.21%	- 6.27%
S&P 500 Index (C$)	- 1.20%	- 5.91%	- 0.17%

The exchange rate plays an important part on internationally diversified portfolio returns:

	9/30/10	12/31/10	8/31/11
Canadian / US Dollar Exchange Rate	$0.97	$1.00	$1.02	$0.95

Oh yes, let's not forget the price of gold:

	9/30/10	12/31/10	8/31/11	9/30/11
Gold (US$)	$1305.25	$1419.95	$1823.30	$1623.25

Santa Claus Rally:

100% of the time since 1939, the third year of the US Presidential election cycle has produced positive calendar year returns. For that track record to remain in tact there needs to be a significant rally in the final three months of 2011. Here are four scenarios that could spark a year-end rally.

1. Europe solves its problems

I believe that it will take many years to address the sovereign debt problems in Europe. However, with capital markets fixated on every piece of news regarding this situation, if the "Euro Nation" continues on the path they have followed in recent weeks and show they are committed to finding a long-term solution through decisive action and careful monitoring, this could allow markets to rally. If you remember it wasn't that long ago that Ireland was the focus of financial collapse and tough medicine and "Euro Nation" support has improved that country's fiscal stability significantly.

2. Government action

If the special deficit reduction super committee tasked with reducing the deficit by $1.2 trillion is successful, investors may become confident enough in the economy to once again purchase riskier assets like stocks. There are many other strategies being discussed including Congress rolling out a year-end tax break to reduce or eliminate capital gains taxes, or allowing investors to avoid taxes on dividends. Another idea was for a massive mortgage refinancing to give underwater homeowners-and their banks - an opportunity to work the debt off their respective books. This option, at least from the White House's perspective, could be done without congressional approval and might earn the votes of millions of grateful homeowners.

Usually when presidents fail to bring prosperity, they are voted out. So the re-election of Obama depends largely on how well the economy and stock market does this year. If it turns out that the US economy falters back into recession, the presidential election cycle is in no way a guarantee of higher stock prices.

3. Companies spend their cash

Companies are sitting on a record amount of cash -- those in the Standard & Poor's 500 stock index have a whopping $976 billion in cash and short term investments, estimates Standard & Poor's. If they were to spend some of that cash on expanding their businesses or rewarding shareholders, it would likely cause the market to rally. An increase in mergers and acquisitions, for example, would likely lead to stock gains as investors load up on shares of smaller companies they believe are good acquisition targets. The current high level of market uncertainty however has made companies reluctant to acquire.

A more likely scenario is for companies to start using their cash hoards to buy back their own shares or increase their dividend payouts. Consider Berkshire Hathaway's recent announcement to buy back what could amount to tens of billions of dollars' worth of the company's shares was followed by a 272-point gain in the Dow Jones Industrial Average.

4. Strong corporate earnings

With investor sentiment already at record lows, any piece of good economic news could have an outsized effect on stocks. One possible spark could be corporate earnings, which are expected to increase by 15% from last year. While that's less than the 19% seen in the second quarter, it could be enough to provide a surprise lift to stocks. If companies were to follow those strong reports with a positive outlook for their businesses in the fourth quarter, it could alleviate investors' fears of a double-dip recession: Many investors wait until the end of the third quarter to rebalance their portfolios for the coming year. Many investors who pulled back on stocks in August may wade back in to take advantage of cheaper shares.

However, if consumer spending sinks lower and unemployment remains high, experts say companies could have a tough time increasing their profits. Without some improvement in the economy and job creation, it will be difficult for companies across the board to maintain the robust pace of earnings we've seen.

What to do?

While being surrounded by negative news and pessimism, it is easier than ever to make emotional decisions in your portfolio. The value of having a financial plan and having it dictate the asset allocation in your portfolio has never been more evident.

While admitting that there might be a slight tint to my rose coloured glasses, I do believe for investors with the right time horizon and risk tolerance, there are very attractive opportunities being presented from the current crisis. A couple of examples are below:

1. Canadian Banks: ScotiaMcLeod's Portfolio Advisory Group's top three picks for Canadian Banks are CIBC, TD and Royal. These are companies that have consistently paid dividends for upwards of 100 years - never having missed a payment and never decreasing the dividend. With borrowing rates lower than the dividend yields - these jump out as an opportunity for long-term growth and tax efficient income.

   	Current Price1	1 Year Target	Rating2	Risk Rating	Target One Year Return	Current Dividend Yield
   CIBC	$71.44	$93.00	1-SO	Low	30%	5.03%
   TD	$71.67	$93.00	1-SO	Low	30%	3.79%
   Royal	$46.78	$57.00	1-SO	Low	22%	4.62%

   ^{1 as of October 3, 2011
   2 SO - compared to the other Canadian banks is rated sector out-perform}
   

2. With world food shortages, demand for fertilizers should be strong. ScotiaMcLeod's Portfolio Advisory Group's believe that fertilizer stocks are oversold - down 25% since September 13th. Their top pick is Agrium.

   	Current Price1	1 Year Target	Rating2	Risk Rating	Target Rate of Return
   Agrium	$67.41	$109.00	1-SO	High	62%

   ^{1 as of October 3, 2011}
   

3. Those wanting a more diversified method in participating in the recent sell off in high quality Canadian companies may want to consider participating in an investment that is coming to market that will hold an equally weighted and diversified portfolio of 15 large Canadian companies and provide a targeted 6.5% yield paid on a monthly basis. I would be happy to discuss this opportunity in greater detail and send you a preliminary prospectus.
   

Summary:

The downturn which began in April and was somewhat expected after a period of strong growth, has clearly been steeper and longer than expected. For investors, times like these underscore the importance of employing a time horizon that is appropriate to your objectives, implementing an appropriate asset allocation and maintaining a disciplined approach to portfolio rebalancing. Most of all, volatile times provide a reminder that your investment strategy should be driven by your needs, not by market movements. If short-term market movements cause you to panic, it may be time to reevaluate your investment strategy to ensure that it remains aligned with your goals and time horizon. We are here to listen to your concerns, please call us if you have any.