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October in Review November 1st, 2011 By Kim Mailey, CFP

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October in Review

After a punishing decline in market values in the third quarter, the month of October has provided some relief with the anticipation of, and ultimately in response to a substantive agreement for the Eurozone. The U.S. markets had their best month since December 1991.

	October 2011	Year-to-Date	One Year	Three Year	Five Year	Ten Year
S&P/TSX 60 Index	+5.40%	-8.86%	-3.35%	+7.86%	-0.15%	+5.93%
S&P 500 Index (C$)	+ 6.00%	- 0.26%	+ 3.59%	+2.36%	-4.21%	-2.95%

Many details are yet to be finalized, but the broad agreement includes three key features:

1. Greek bondholders will "voluntarily" write down the value of Greek debt by 50% which will help reduce Greece's debt load from 150% of GDP down to 120% by 2020.
    
2. The European Financial Stability Fund (EFSF) will be expanded to one trillion Euros from the current 440 billion Euros through a combination of additional funding from the IMF and possibly a capital injection by China and/or other nations. .
    
3. European banks will be recapitalized to offset the impact of the haircut on Greek bonds.
    

Although U.S. equities delivered their best monthly performance in October since December 1991, trading volumes were below average, signaling a further absence of investor conviction.

As encouraging as this European agreement is in principle, it is clearly just the first step in a multi-step program to resolve the European debt crisis.

While investors were primarily focused on Europe in October, U.S. corporate earnings remain strong and third quarter U.S. GDP growth was reported at a solid 2.5%, up from 1.3% in the previous quarter. With 331 members of the S&P500 Index having reported Q3 results to date, 70.1% have reported positive earnings surprises. Third quarter earnings are on track for a 14.4% increase over third quarter 2010. This is significant!

Outlook

It took just five days for the wheels to come off the euro plan. Greek Prime Minister George Papandreou has surprised everyone by calling for a referendum on the deal which would have significantly reduced the country's debt burden in return for cuts in Greek government spending. The prospect of an angry Greek electorate voting down the latest EU deal is clearly a concern for investors and follows harsh criticism of the plan from all over the Greek political spectrum. This obviously disappoints those who hoped last week's Euro deal would allow the market to focus on some signs of a rebound from the U.S.

Bank of Canada governor Mark Carney says Greek plans for a referendum on its austerity measures may be a good thing. The central banker told the Commons finance committee that plans to get Greece out of its deep debt hole will need broad democratic support in Greece if they are to work.

"It is imperative that there is widespread support, broad democratic support for these measures because they will unfold over a period of time," Carney told the committee.

"If this is a judgement of the Greek government that this is the best approach to validate that support, we fully respect that."

Despite the significant stock market rally in October, equities remain the favoured asset class versus bonds. Credit Suisse's Global Equity Strategist Andrew Garthwaite is raising the one year-end target for the S&P 500 to 1,270 (from 1,180) for the following reasons:

• US macro surprises are positive for the first time since April and their lead indicators are now consistent with 1.9% US GDP. The probability of a U.S. recession has fallen from 35% to 25%.
   
• The European deal - though problematic on details - has shown that Europe is able to come up with credible policies when forced. Most importantly, the Draghi-led European Central bank seems willing to continue to buy peripheral European debt, which will be critical in the process of mutualising European debt. In consequence, Garthwaite thinks the risk of another Euro-area crisis has fallen;
   
• Tactical indicators are still mildly supportive despite the recent rally: equity inflows are still very depressed, equity sector risk appetite is still one standard deviation below average and corporate net buying is still twice the historical norm. (This is buying done by corporate insiders - those that have the best idea of their company's worth!) .
   

While touring Europe in the late 1800s, American author and humourist Mark Twain attended several productions of Richard Wagner's opera, including Parsifal and Tristan and Isolde. He famously declared Wagner a composer whose music is better than it sounds.

Twain's take on German romantic opera could apply to the current investment climate. There is much doom and gloom out there, from the European debt crisis to the weak U.S. economy and fears of a global recession. I truly believe it's better than it sounds.

No doubt you have read some of the alarming headlines comparing the current U.S. malaise to the Great Depression of the 1930s. This is completely off base. Consider some of these stats:

• Between 1929 and 1932, a staggering 5,000 U.S. banks went out of business. Today, corporate America is awash in money and U.S. banks are sitting on about US$2-trillion in cash.
   
• U.S. corporate profits plummeted from about US$10-billion in 1929 to about US$1-billion in 1932. In contrast, Wall Street today is in a golden age of profitability. Profit margins have averaged 8.4% for the past 30 years and in 2010 hit a record US$1.68-trillion in the fourth quarter.
   
• The U.S. unemployment rate peaked at a staggering 28% in the 1930s. Some cities were economically devastated. In Toledo, Ohio, for example, unemployment peaked at 80%. Today, the U.S. unemployment rate is 9.1%. There are some signs of optimism. Jobless claims are declining and the unemployment rate continues to fall in U.S. cities.
   

I am not trying to make light of the current U.S. economic downturn. Federal Liberal leader Bob Rae recently described the U.S. economy as "flatter than a pancake," a colourful assessment that is not far from the truth. But Wall Street is fine, thank you very much - it's a political crisis that needs to be fixed. Together, Democrats, Republicans and taxpayers must harness the spirit of American ingenuity and effectively tackle the US$14.7-trillion debt. Decisive action cannot wait until January, 2013 when either President Obama or his successor takes the oath of office.

Meanwhile in Europe, Greece is at the eye of the storm. Its debt-to-GDP level is an eye-popping 149%; it has a coddled civil service and a long and storied tradition of tax revolt. Every day the city of Athens is the scene of violent protests. There is increasing negative sentiment that, sooner or later, Greece will default on its debt.

It's important to put the Greek crisis in some context. Greece is a tiny nation in the euro zone, contributing only 1.8% to the economic bloc's annual GDP. Yes, the banks of Europe that hold Greek debt will take a hit if and when the Mediterranean nation defaults, but much of this bad news is already accounted for in the markets.

Widespread fears of contagion across Europe are overdone. In September, Italy passed a sweeping €54 billion austerity plan that will balance the budget in 2013. Growth may slow, but the country has taken necessary measures to stabilize its debt. The economies of Germany, Denmark, Norway and Sweden are strong and poised to lead Europe out of its current crisis.

Salvation is possible for Europe. Consider Ireland, an extraordinary example of how a troubled economy can quickly turn its fortunes around. A year ago, Ireland faced a grave banking crisis, rising inflation and debt downgrades.

The European Union and the International Monetary stepped in, providing nearly US$113-billion in return for cuts to the minimum wage, tax hikes and spending caps. After three years of contraction, the Irish economy is growing again. Labour and rent costs are falling, foreign investment is up and exports growing. Yields on 10-year Irish bonds sunk below 8% in September, making it easier for the nation to finance its debt.

The Irish experience shows us that economic recovery through painful deleveraging is possible. It can be done with a deft mix of political will and public support-sadly, the two key ingredients sorely lacking in Athens and Washington D.C.

Beyond the U.S. and Europe, a very different economic story is playing out in the emerging markets, especially in the fast-developing economies of Asia. Many countries like China, India and Indonesia managed to avoid the recession of 2008-2009. This resiliency speaks to the strong fundamentals driving their economies going forward.

The IMF expects Asia's new economies to grow at 8% or higher through 2016, a tremendous growth advantage over the rest of the world.

Readers of my past updates will know that I recommend a "hub and spoke" strategy for some investors. This is where the core of the growth portion of the portfolio is invested in a conservative globally diversified pension portfolio using third party money managers carefully selected and monitored by a third party pension manager (Summit, Pinnacle, and Russell portfolios). Those tolerant of a slightly higher risk level in return for higher returns can consider having a small portion of the growth portion of their portfolio being exposed to high quality individual securities. In my past two updates I have recommended some specific securities and the table below will provide an update of those recommendations. I believe all of these recommendations continue to offer considerable upside over the coming months.

Summary:

For investors, the good news is markets will recover. The best investors will stay focused on long-term objectives and be opportunistic in their outlook. Having the correct asset allocation will ensure money that you need in the short term is available to you when needed with no market timing risk, money is needed in the next three to five years is set aside in laddered guaranteed investments, and the only money that is exposed to the multitude of opportunities that I believe the stock market currently offers is the money that is not expected to be needed for the next three to five years.