The Fundamental Case for the 20,000 Dow

Tuesday, August 14th, 2012

by Seth Masters, Chief Investment Strategist, AllianceBernstein

While some people deem stocks expensive relative to 10-year trailing earnings, we take a forward-looking approach. It starts with the premise that the stock market is not a casino and stock prices are not pulled out of thin air: they reflect the intrinsic value of companies’ future earnings.

Let’s start with basics. Stocks represent an ownership claim on a share of company earnings. Hence, stock prices reflect (imperfectly, of course) the value of companies’ current earnings and potential earnings growth. In computing the expected returns for stocks, what matters is the starting price, earnings, dividends (the portion of earnings distributed to shareholders), earnings growth and changes in P/E. As you might expect, low starting prices, high earnings and dividends, high growth, and P/E expansion are all good for future stock returns.

The models we use when investing are complex, but a simple argument makes the point. The expected return for a Treasury bond held to maturity is equal to its yield. Similarly, the expected return for a stock equals its earnings per share (EPS) divided by its price—its earnings yield—if the company has no growth prospects and therefore returns all of its earnings to shareholders. If the company does have growth prospects, it would retain some of its earnings to fund growth. In that case, the expected return equals the dividend yield plus dividend growth. If the company pays out a constant share of earnings as dividends, dividend growth equals earnings growth.

Let’s apply this framework to the S&P 500 Index’s price level of about 1,300. Consensus forecasts call for the index to have $104 in earnings per share this year. If the companies in the index didn’t xpect any growth, they would pay out all their earnings as dividends, and earnings and dividends wouldn’t grow. The S&P 500’s dividend yield would be 8%, as the first row of the display below shows.

If the P/E remained unchanged, the total return would also be 8%, but both the S&P 500 and the Dow would stay at their current level. While a flat index price might be disappointing, we think most investors today would probably welcome an 8% return on investment.

Of course, the companies in the S&P 500 do retain a portion of their earnings to finance growth, so the index’s dividend yield is slightly above 2%, rather than 8%, as the second row of the display shows. What kind of earnings growth should we assume?

What About Growth?

Historically, earnings and the stock market have grown with the economy over time, although they can diverge for several years at a stretch, particularly if market euphoria drives stock prices to very high multiples of earnings or if gloom drives stock prices to low multiples. Nominal US GDP, which includes inflation, has grown 7% a year on average since 1947—and so have the S&P 500’s earnings and price. (GDP growth is more commonly quoted in real, or inflation-adjusted, terms. We use nominal growth here to match data for earnings growth and the stock market.)

The three key variables that drive both economic growth and earnings growth over the long term are inflation (which increases the nominal value of economic output), population growth (which boosts the number of people consuming and producing goods) and productivity (which increases the output per person or per unit of capital).

Inflation is widely expected to average about 3% over the long term; population growth, to average about 1%; and productivity, to continue to rise about 2% per year. Since 3% + 1% + 2% = 6%, 6% is a plausible long-term economic growth forecast; it is actually below both the postwar average and the International Monetary Fund’s projections for the next five years.*

So let’s assume 6% economic and earnings growth. With a constant dividend payout ratio, this would lead to 6% dividend growth. Eventually, this growth rate would probably make investors less gloomy, and the market would rise from its current low level of 12.5 times earnings.

If the S&P 500’s P/E rose to 15—halfway back to its average of 17.6 since 1970—the index’s expected return would be 9% per year. At that rate, the S&P 500 would reach 2,000 in five years. The Dow, which typically trades at about 10 times the S&P 500, would reach 20,000 in about five years.

But as discussed above, the market should arguably be trading at an above-average multiple, since bond yields are so low. If the S&P 500’s P/E rises to 20 times earnings as sustained growth in a low-interest-rate environment makes investors more confident, the Dow could reprice to 20,000 immediately, as the third row of the display shows.

Since most investors today would probably welcome an 8% or 9% return for the next five to 10 years (let alone an immediate market revaluation), the current limited appetite for stocks suggests that investors don’t believe in these scenarios. Most likely, they don’t believe in the consensus forecast of $104 in earnings per share this year or 6% economic growth. So let’s examine the implications for stock returns of lower earnings and slower economic growth.

What If Earnings Fall or GDP Growth Slows?

Many people expect earnings to decline because margins are far higher than usual. If corporate spending picks up from the unusually low levels of recent years, margins would fall, and that could drive down earnings.

We think it’s reasonable to expect margins to decline somewhat—although not necessarily to their historical average. But for the sake of argument, let’s look at what would happen if margins declined from 9.5% today to their long-term average of about 6.75%.

Even in this scenario, the S&P 500 would reach 2,000 and the Dow would reach 20,000 in about 10 years. Applied to current revenues, 6.75% margins would reduce S&P 500 earnings by about 30%—to $74, as the fourth row of the display shows.

While there would likely be a severe market pullback initially, if normal economic growth resumed and P/E ratios normalized, the S&P 500 would have a 5% total return and reach 2,000 in 10 years.

But the global economy is now weak, and the European sovereign-debt crisis could end up being a drag on economic growth for years. What if Europe and theUSenter a lengthy period of disinflation? That’s possible, particularly if policymakers are unsuccessful at addressing the world’s serious macroeconomic problems.

So let’s perform a stress test and assume inflation of only 1%, population growth of 1% and no productivity growth at all. That would give us nominal GDP growth of just 2%. A recent survey of professional forecasters said there’s less than a 10% chance that economic growth will be that slow over the next three years.**

What would these dismal economic forecasts imply about future earnings growth and stock returns? If we assume the S&P 500 earns $74 per share this year, 2% growth would still get us to a 4% annualized market return if the market P/E ultimately returns to average, as the fifth row of the display shows. At that rate, it would take 20 years for the S&P 500 to reach 2,000 and the Dow to reach 20,000. Such returns are hardly enticing, but they are still likely to exceed bonds.

Of course, stock-market returns could be worse than 8% (or 4%), particularly in the short term. S&P 500 earnings could fall below $74, and anxiety could cause market valuations to drop even further below normal; both happened in early 2009. Other market shocks are also possible. For example, very high inflation with slow growth could cause price-to-earnings multiples to contract.

But market returns could also be better. Our stress test incorporated draconian assumptions—a 30% drop in earnings plus no productivity growth at all, a very rare occurrence over a 10-year period. Human ingenuity has led to remarkably persistent and steady productivity growth in the postwar period. In recent years, new technology and globalization have driven productivity growth. In the future, these trends and others not yet imagined are likely to continue to drive it.

Faced with uncertainty and traumatized by losses in recent years, investors who are avoiding stocks appear to be assuming that the worst outcomes are highly likely to occur. Or, perhaps, they’ve just lost their stomach for market volatility and are prizing near-term stability over potential long-term gains.

In my next post, I will compare the likely range of outcomes for stocks and bonds.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Seth J. Masters is Chief Investment Officer for Asset Allocation at AllianceBernstein and Chief Investment Officer of Bernstein Global Wealth Management, a unit of AllianceBernstein.

Tags: Alliancebernstein, Chief Investment Strategist, Company Earnings, Consensus Forecasts, Dividend Growth, Dividend Yield, Dividends, Earnings Growth, Earnings Per Share, Future Stock, Growth Prospects, Intrinsic Value, Premise, Price Earnings, Shareholders, Stock Market, Stock Prices, Stock Returns, Thin Air, Treasury Bond
Posted in Markets | Comments Off

Pivotal Point for Bonds…and Friday Rallies

Sunday, August 5th, 2012

The TLT ETF is one of the most watched in the market, since it’s the easiest way for institutions to quickly move in and out of U.S. Treasury bond exposure.   For many months during these rallies the fly in the ointment has been the U.S. dollar and Treasuries which constantly had a bid.  The TLT had not been below its 50 day moving average since early April which is just about the time the equity markets began weakening materially.  This instrument is now sitting on it for the second time in just over a week so it is at an important juncture.

As for the market as a whole you just have to tip your hat – I went back to review and 4 of the past 6 Fridays have seen monster moves up negating most/all of the moves down earlier in those weeks.  The Friday after the Euro summit, last Friday after Draghi’s comments, this Friday, and one other Friday that I don’t recall the reason for the big move.  Strangely each of the past 9 Mondays has seen markets close in the red.

However each time the market has been on a cusp like this of a breakout, the next few sessions have led to serious selloffs.  We’ll see if this time around it is for real.  This market is very similar to last summer/fall’s market in that the moves are violent and gaps are constant, but that market had a sideways to down bias whereas this one somehow has been going up with most of the gaps being to the upside instead of balanced between up and down (since June).  To put into perspective 15 of the past 22 sessions (68%) have been selloffs in the S&P 500 – but the 7 up sessions (4 of them on Fridays) have been so ferocious, the market is actually up 20 S&P points over those 22 sessions.  There is certainly little memory from day to day as each day’s headlines or rumors take everything with it.

Today the money is moving back into the pro cyclical areas which was another sign one would want for a sustained move.    The euro is also strong today and that inverse trade has been the key one for markets.

Copyright © Market Montage

Tags: Bias, Bonds, Breakout, Cusp, Draghi, ETF, Fly In The Ointment, Fridays, Gaps, Juncture, Last Friday, Moving Average, Pivotal Point, Rallies, S Market, Second Time, Selloffs, Trad, Treasuries, Treasury Bond, U S Treasury
Posted in Markets | Comments Off

Dividend vs. Treasury Yields

Friday, June 8th, 2012

by Econompic Data

The dividend yield of the S&P 500 is above that of the ten year Treasury for the first time since the financial crisis. Before that we have to go all the way back to the 1950′s to find a time when this was the case.

The kicker… stock dividends have only made up about 45% of total S&P composite stock returns over the past 100 years, while Treasury bond coupon payments have made up north of 96% of Treasury bonds returns over that same period (see below). What this means for an investor is unless you think dividends will be cut and/or capital appreciation will be negative (i.e. corporate America will shrink in terms of nominal value), stocks are poised to outperform.

My take… stocks appear to be very cheap relative to bonds for investors with a long-term investment horizon, while near term investors need to be careful as we seem to be in a world that is likely to have binary outcomes (i.e. either a boom or an absolute collapse).

The remaining 55% of S&P stock returns have been in the form of capital appreciation, which has become increasingly important since the 1950′s (see above), as corporations reinvested earnings back into their businesses / bought back shares (vs paying out dividends), while investors evaluated the relative merits of equities relative to bonds (see the much tighter relationship to bonds, which ratcheted up P/E multiples).

Source: Irrational Exuberance

Tags: Capital Appreciation, Composite Stock, Corporate America, Coupon Payments, Dividend Yield, Financial Crisis, Investment Horizon, Irrational Exuberance, Kicker, Long Term Investment, Nominal Value, Relative Merits, Stock Dividends, Stock Returns, Term Investors, Treasury Bond, Treasury Bonds, Treasury Yields, Value Stocks, What This Means
Posted in Markets | Comments Off

Drop the Inflation Concerns

Friday, June 8th, 2012

by Econompic Data

As I’ve outlined before, wages tend to be the one of the better predictors of inflation (or deflation) out there as wages tend to be very sticky and stable (so when they move, it tends to mean there is a new underlying trend).

So how are wages currently holding up?

Well, earlier this week, the BLS released compensation figures for Q1 and even with negative real interest rates and multiple quantitative easings, there is absolutely no wage inflation in the pipeline. In fact, the year-over-year change in nominal wages came in at just 1.3% at the end of March and 0% over the last six months, the lowest since the crisis and below the rate of inflation.

Even more concerning (to me) is that these figures are as of March, before business sentiment took a turn for the worse on renewed European concerns.

With no inflationary pressure and limited growth potential, a low yielding Treasury bond almost appears justified.

Source: BLS, BEA, Fed

Tags: Bea, Bls, Business Sentiment, European Concerns, Inflation Concerns, Inflationary Pressure, interest rates, Pipeline, Q1, Rate Of Inflation, Six Months, Treasury Bond, Wage Inflation, Wages
Posted in Markets | Comments Off

Treasuries Currently Overbought: Relative Performance of Stocks vs. Bonds

Thursday, June 7th, 2012

by Tiho Brkan, The Short Side of Long

Topics Covered

• Global economic data worsening towards a recession
• Treasury Bond sentiment is extremely optimistic

Overview

The selling pressure has stopped. It seems that the S&P 500, Crude Oil and Gold are now recovering somewhat. Sentiment reached extreme negative levels on all of these asset classes over the last couple of weeks. 30 Yr Long Bond has paused its vertical rise on top of extreme bullish sentiment, while the US Dollar posted a reversal also due to extremely bullish sentiment. It seems we are entering a period of mean reversion but the bottom line still remains the same: investors have been selling risk due to possibility of a disorderly default in Eurozone, triggered by Greece as the first domino. At the same time, Asia and especially China is slowing down meaningfully. Nothing has been done, announced or hinted by authorities yet and risk off trades are very crowded.

Economic Data

Last week was one of the worst ever data release weeks for the US economy. Out of 21 releases throughout the week only 1 was better than expected, 2 came in at their estimates and a staggering 18 releases (including the important employment figures) all came in below economist expectations. I am pretty sure that the authorises, politicians and central bankers around the world are watching this with a magnifying lens right now. The question is what will they do next and will it even matter?

The overall Developed Markets Citigroup Economic Surprise Index has completely collapsed in recent weeks, so it should not be surprising at all that Bonds have outperformed Stocks again in the first half of 2012. While majority of analysts, economists and investors continue to put all of their faith towards the Federal Reserves ability to re-stimulate the economy through further QE, contrary to that I personally think it will not have too much of an effect, apart from a short to medium term sugar high rally without any new highs. In other words – a bear market rally!

Economic data is negatively surprising economists, not just in the US, but all over the world including the darling favourite of the investment world – Emerging Markets. As we can see in the chart above, the Emerging Market Citigroup Economic Surprise Index has completely collapsed for the first time since 2008 and with it GEM equities plus the global economic barometer – Dr Copper. This leads me to believe that not all is well in Asia and especially China.

While I believe all risk assets are currently oversold and due for a rebound, if the weakness continues again in repaid fashion, it will most likely lead me to a conclusion that we are entering a global recession. Chinese equity market, the Shanghai Composite, is still struggling to break upward. While this is a very bad sign, I am still willing to give it a bit more time to prove itself, as it struggles with a cluster of resistance points around 2,400 to 2,450 level. However, a proper breakdown will most likely signal a hard landing scenario for the Chinese economy. The crisis started in the US in 2007 and spread to the EU, but if we move towards a Chinese hard landing scenario, the final economic crash will most likely occur in Asia, where the boom has created over capacities in all economies from Indonesia to Korea and Australia.

Equity Markets
Nothing new to report.

Bond Markets
The second part of an article is a slight conundrum to the first part above. Here I focus on overbought Bond prices and extremely bullish sentiment that accompanies this assets. Therefore, one major problem when discussing a possibility of a recession, from a contrarian point of view, is that majority of market participants are already overweight Bonds as a fear trade. So the question is, if things get worse, will these safe havens go even higher?

Focusing on the current outlook, be it German Bunds or US Treasuries, prices have gone almost vertical in recent weeks and yields have dropped to 200 year plus record lows. While the uptrend is still intact for the 30 Yr Long Bond and the bull market is still posting new highs, currently the Daily Sentiment Index is showing readings of 97% bulls as of Friday last week. These types of readings usually do not offer too much further gains and most likely signal that we could at least suffer a correction / pullback from current levels.

This view is also confirmed by the Mark Hulbert service of tracking Bond newsletter exposure recommendations. Consider that at present, Bond newsletters are recommending 40% plus long exposure towards this asset class. This a very dramatic switch from March 2012, where these same “gurus” were recommending 40% net short exposure (and got it completely wrong). Historically, readings of 40% plus on each side have been very extreme and usually signalled that Bond prices reversed in some type of a counter trend rally.

Personally, I do not own any bonds in my fund, because I think they are a major major major major bubble! To led money to the US government at 1.5% over the next ten years is a total robbery when adjusted for true inflation figures, in my opinion. Therefore, I am waiting to short these assets, together with the Japanese Yen, at some time in the future.

Having said that, that does not mean prices cannot go higher from these levels, as overvalued bubbles can turn into manias and totally insane buying frenzies. Remember Nasdaq in 1999? Therefore, I am still reluctant to call a final top on the Treasury bull market, until the final EU crisis resolution and some type of a major default occurs to create a capitulation.
Currency Markets
Nothing new to report.

Commodity Markets
Nothing new to report.

Credit Markets
Nothing new to report.

Recommandations

• Summary: my further action depends on political and central bank intervention. During market panics, authorises also panic. It is not until they start to panic, that they actually do something about current problems, which usually take form of some type of reflation policy. However, weak action will make me reduce my longs substantially and rebalance my portfolio towards net short exposure. Italy and Spain are once again moving towards the edge of the cliff, which is a real worry while Asia is now in a meaningful slowdown.
• I still own SPY Calls purchased in middle of May, and today I purchased some more Calls on the SPY ETF. I do not own any other equity positions in my portfolio.
• I also still own SLV Calls purchased in middle of May, and I also added to that by buying some more SLV ETF positions today (only a small trade). I am also still holding onto that core Silver position from late December 2011 bottom at $26.
• I bought a very small position in Agricultural commodities through RJA ETF today. I’m expecting the Agricultural bull market to resume eventually (best fundamentals of any asset class right now). But, I haven’t done anything major just yet.
• Other assets on my watch list for some shorter term bullish rebound trades include Australian Dollar (FXA), Russian / Brazilian equities (RSX & EWZ) and Continuous Commodity Index (GCC).
• It is too early to talk about shorting anything yet, as I am waiting for a market rebound first.

Tags: agricultural, Asset Classes, Brazil, Bullish Sentiment, China, Citigroup, Crude Oil, Economic Data, Economists, Employment Figures, energy, ETF, ETFs, Eurozone, Federal Reserves, Gold, Magnifying Lens, Mean Reversion, New Highs, Qe, Recession, Relative Performance, Stocks Bonds, Tiho, Time Asia, Treasuries, Treasury Bond, Vertical Rise
Posted in Markets | Comments Off

Corporate Bonds: Figuring out a Fair Price (Koesterich)

Monday, November 14th, 2011

Last week we argued that corporate bonds look reasonably priced and appear cheap relative to Treasuries. Now, I want to address the logical follow-up question: How do you know what a fair price is for corporate bonds?

One way to think about corporate bond valuations is to consider the spread. Investors in corporate bonds are assuming credit risk – the risk that the issuer won’t repay the principal or make good on an interest payment. Investors are arguably not subject to that risk with a Treasury bond (for all its troubles, the US government has never defaulted).

As investors are taking on marginally more risk, they should be compensated in the form of a higher return. The spread between the interest on a corporate bond and a Treasury obligation of a similar duration is one way to assess how much investors are being compensated for taking on additional risk.

In general, when the economy is stronger, spreads tend to contract as investors are less worried about companies defaulting. Conversely, when the economy is weaker investors should receive a higher return to compensate for the risk of increased defaults (as you would expect, defaults rise in recessions).

So when it comes to evaluating how wide the spread should be, start with your view on the economy. By comparing your view of the economy to current spreads, you can get at some rough measure of “fair value.”

Today, spreads are wide relative to their historic average – but they also appear wide given the state of the economy.

The spread between an index of Baa corporate bonds and the 10-year US Treasury note is approximately 3.30%, nearly twice the historical average. In other words, investors are sufficiently worried about the state of the economy that they are demanding twice the premium relative to Treasuries they normally receive (another interpretation is that Treasury yields are artificially low because the Fed is buying up a good chunk of existing supply).

But when we compare the current level of spreads to a measure of leading economic indicators (see the chart below), spreads also look too big. Based on this analysis, spreads should be about 1% tighter than they currently are, meaning that either Treasury yields should rise or corporate bond yields should fall.

Either way, corporate bonds look better than Treasury bonds.

Source: Bloomberg

Tags: Chunk, Corporate Bond, Corporate Bonds, Credit Risk, Duration, Economy, Interest Payment, Investors, Obligation, Recessions, Rough Measure, Treasuries, Treasury Bond, Treasury Note, Treasury Yields, Us Government, Us Treasury, Valuations, Wh
Posted in Markets | Comments Off

Corporate Bonds: Figuring out a Fair Price (Koesterich)

Tuesday, November 8th, 2011

by Russ Koesterich, Chief Investment Strategist, iShares

Last week we argued that corporate bonds look reasonably priced and appear cheap relative to Treasuries. Now, I want to address the logical follow-up question: How do you know what a fair price is for corporate bonds?

One way to think about corporate bond valuations is to consider the spread. Investors in corporate bonds are assuming credit risk – the risk that the issuer won’t repay the principal or make good on an interest payment. Investors are arguably not subject to that risk with a Treasury bond (for all its troubles, the US government has never defaulted).

As investors are taking on marginally more risk, they should be compensated in the form of a higher return. The spread between the interest on a corporate bond and a Treasury obligation of a similar duration is one way to assess how much investors are being compensated for taking on additional risk.

In general, when the economy is stronger, spreads tend to contract as investors are less worried about companies defaulting. Conversely, when the economy is weaker investors should receive a higher return to compensate for the risk of increased defaults (as you would expect, defaults rise in recessions).

So when it comes to evaluating how wide the spread should be, start with your view on the economy. By comparing your view of the economy to current spreads, you can get at some rough measure of “fair value.”

Today, spreads are wide relative to their historic average – but they also appear wide given the state of the economy.

The spread between an index of Baa corporate bonds and the 10-year US Treasury note is approximately 3.30%, nearly twice the historical average. In other words, investors are sufficiently worried about the state of the economy that they are demanding twice the premium relative to Treasuries they normally receive (another interpretation is that Treasury yields are artificially low because the Fed is buying up a good chunk of existing supply).

But when we compare the current level of spreads to a measure of leading economic indicators (see the chart below), spreads also look too big. Based on this analysis, spreads should be about 1% tighter than they currently are, meaning that either Treasury yields should rise or corporate bond yields should fall.

Either way, corporate bonds look better than Treasury bonds.

Source: Bloomberg

Bonds will decrease in value as interest rates rise.

Copyright © Russ Koesterich, iShares

Tags: Bonds, Chief Investment Strategist, Corporate Bond, Corporate Bonds, Credit Risk, Duration, Economy, Interest Payment, Investors, Obligation, Recessions, Rough Measure, Russ, Treasuries, Treasury Bond, Treasury Note, Treasury Yields, Us Government, Us Treasury, Valuations
Posted in Bonds, Brazil, Markets | Comments Off

Canada Market Cheat Sheet (February 22, 2011)

Monday, February 21st, 2011

TSX and Subgroups Week Ending February 18, 2011

TSX and Subgroups YTD

TSX and Subgroups 1-year Ending February 18, 2011

Strengths

Carney Says `Possible’ Canada Fourth-Quarter Growth Faster Than Projected

Bank of Canada Governor Mark Carney said it’s “possible” the economy grew at a faster pace in the fourth quarter than the central bank projected last month. [Bloomberg]

Canada defies global trend with tame inflation

Canada’s annual inflation rate slipped to a relatively tame 2.3 percent in January as a strong currency helped it buck a global trend that has seen several major nations struggle to control rising prices.

Canada’s January inflation rate edged down to 2.3% [RBC]

In January, Canadian consumer prices increased by 0.3%, which was in line with market expectations. The annual inflation rate, however, eased to 2.3%, lower than December’s 2.4% pace. Core inflation, which excludes the eight most-volatile items and the effect of changes in indirect taxes, was unchanged in January and below expectations for a 0.1% rise. The annual rate edged down to 1.4% from 1.5%. [RBC Economics Research]

U.S. Fed members more confident about sustained economic recovery [RBC]

The minutes of the January meeting show a modestly upgraded forecast for the U.S. economy in 2011 although with the expectation of slow progress toward the Fed’s dual objectives of price stability and full employment. The minutes indicate that incoming data “would need to be solid for a while longer to justify a significant upward revision to their outlook.” As such, we see no need to change our view that the Fed will complete its current round of U.S. Treasury bond buying and maintain the Fed funds target in its current range. [RBC Economics Research]

Banking on a business-led recovery

As the country’s major banks get ready to report earnings this week, investors are taking a closer look at two areas of the balance sheet – commercial loans and consumer lending. Each will have something to say about what kind of a quarter it was in banking, but the real value of the data will be the statement it makes about the Canadian economy in the year ahead. {Globe and Mail]

Canadian new home prices rose to highest level on record in December [RBC]

Statistics Canada’s New Housing Price Index rose 0.1% on a month-over-month basis in December 2010 following the unrevised 0.3% advance in November. While the increase was slightly below expectations (market expectations were for a monthly increase of 0.2%), the rise in home prices moves the index to establish a new record high for the second consecutive month. On a year-over-year basis, the pace of growth in new home prices decelerated for sixth consecutive month, slipping to 2.1% from 2.3% in November. [RBC Economics Research]

Weaknesses

A merger that will only bring mediocrity

The executives of the London and Toronto exchanges are pumping their proposed merger so hard that you wonder how either bourse managed to survive on its own. Together, apparently, they would be a world-beating marvel. Left to their own inadequate devices, they would fade away like old soldiers, or simply get squashed by the new breed of monster exchanges like the baby deer in the classic Bambi Meets Godzilla cartoon. [Globe and Mail]

Canadian December manufacturing sales show disappointing increase [RBC]

Manufacturing sales in December 2010 managed to rise only 0.4% in the month. This increase failed to reverse the 0.6% drop recorded in November 2010, even with the decline lessened from the 0.8% decline previously reported. The volume of sales unexpectedly dropped 0.5% in the month. Expectations were for a much stronger increase in December of 3.0%, on a nominal basis, in the face of an earlier reported 9.7% surge in December merchandise exports and indications of the completion of auto sector retooling by the end of November. [RBC Economics Research]

Opportunities

U.S. retail shakeup will spread North: Desjardins

The U.S. retailing scene has been whipped into a frenzy, as activist investors and private equity players take a shining to the sector at a time when companies are reviewing their strategies.

And it’s only a matter of time before there’s a spillover effect in Canada, contends Desjardins Securities Inc. analyst Keith Howlett. [Globe and Mail]

Threats

RBC: U.S. January inflation rate rose more than expected

U.S. consumer prices increased by 0.4% in January 2011, thereby beating market expectations for a 0.3% increase, although in line with RBC’s forecast. The annual inflation rate rose to 1.6% as a result, slightly faster than December 2010′s 1.5% pace. Core inflation, which excludes food and energy prices, posted a 0.2% monthly gain, also beating expectations for a 0.1% rise, and the annual rate rose to 1.0%. The rise in the core inflation rate marked the third consecutive increase from October 2010′s 0.6% all-time low. [RBC Economics Research]

TSX sells, Canada sold down the river

Diane Francis states: The proposed takeover of the TSX Group is unacceptable and would injure Canada’s competitive advantages. [Financial Post]

Tar sands row threatens Canada-EU trade deal: sources 2:31pm EST

BRUSSELS (Reuters) – Canada has threatened to scrap a trade deal with the European Union if the EU persists with plans that would block imports of Canada’s highly polluting tar sands, according to EU documents and sources. [Reuters]

Canada PM Stephen Harper says no budget “horse trading” 4:44pm EST

VANCOUVER (Reuters) – Canadian Prime Minister Stephen Harper said on Monday he is not “horse trading” with opposition parties over the budget, but that does not mean he is trying to force an election this spring. [Reuters]

Stock trading patterns prior to mergers raise more red flags

A super-sized rally preceding the public announcement of a takeover raises difficult questions: Was the run-up in Norsemont shares simply a case of traders realizing the company was a likely takeover target and bidding up its price? Or did word of the pending deal leak out, allowing unscrupulous investors to take advantage? [Globe and Mail]

Tags: Annual Inflation Rate, Bank Of Canada, Bank Of Canada Governor, Canadian Market, Commercial Loans, Core Inflation, Currency, Dual Objectives, Economics Research, energy, Global Trend, Indirect Taxes, Inflation Canada, Mark Carney, Market Expectations, Quarter Growth, Rbc, Taking A Closer Look, Tame Inflation, Target, Treasury Bond, U S Treasury, Upward Revision, Week Ending February
Posted in Canadian Market, Markets, Outlook | Comments Off

2011 Outlook: Should Bond Investors be Bracing for a Bubble?

Tuesday, January 18th, 2011

2010 Review/2011 Outlook

by Capital International Asset Management

Please click on images for video

1. A look back at history can offer investors much-needed perspective

Kevin Clifford: Hello. This is Kevin Clifford, president of American Funds. I’m here with three of our senior portfolio [managers] to take a look back at the developments that shaped the investment landscape in 2010, as well as discuss the outlook for global equity and fixed-income markets.

Joining me for today’s discussion are Jim Rothenberg, Rob Lovelace and Jim Mulally. Jim, Rob, Jim, thank you very much for being with us today.

You all have just come back from some time in the field talking to advisors. In reading the notes, one of the themes that just runs through this is how do you explain to advisors that it’s safe to go back in the water – that this is the time to be thinking seriously about building globally diversified, balanced portfolios. What did that discussion sound like, Jim, from your perspective?

Jim Rothenberg: One of the messages we heard loud and clear out there in the field is many of the clients have been frightened. They were frightened by what happened in 2008-09, how much money was lost. They were frightened by the flash crash in May. So I think there is a really pervasive and deep concern on the part of investors, which is manifested where the flows are going in the industry.

But I think it’s important to take a step back. There have been some other times when the world looked pretty ugly. When I started in the business, we had two recessions: 1969-70 and 1974-75. We had two big jumps in the price of oil, from $3 to $12 to $36. I bought my parents a 14.75%, non-callable, 30-year U.S. Treasury bond. You had 22% short rates at a moment in time. And we lost the war in Vietnam. And the president [of the United States] was impeached.

So all of that – when you think about it – was a pretty ugly time. And by the way, [it] was long – it wasn’t short. It was about 12 years, the time frame I’m talking about. And yet, at the end of that time frame, if you went back and looked at BusinessWeek or The Wall Street Journal, nobody was forecasting what then unfolded in 1982-2000, which was one of the better market periods that we’ve seen in history, with a compound growth rate in the U.S. equity market in the high teens.

So I think that perspective – what I tried to convey to some of the advisors that we visited – is that, no, this game is not over, in the sense that everything we read is pessimistic today. And it is. It’s mostly about pessimism. But again, I go back to individual companies. There are many companies who are growing their earnings streams, growing revenues, finding places around the world where they can see growth and who are doing a good job. So, to me, that creates a lot of opportunity, and that’s the pitch that I really was out talking to people about. We see opportunity to invest.

Kevin Clifford: Rob?

Rob Lovelace: Jim emphasized what I feel very passionately about, which is that there are a lot of companies out there that are doing well that trade at attractive valuations. And we’re seeing that.

When I spoke to advisors in the field, it was interesting, because a lot of people were talking about doing exactly what we’re already experiencing, which is focusing on companies that also have pretty good dividend yields. So being able to invest in high-quality companies that pay a good dividend, often in excess of the bond yield – with the potential that things will turn out better than people are worried about – is a pretty sound investment thesis. In fact, I would say, it’s the roots of our company.

If you go back to the 1930s, in the depth of the Depression, ICA, The Investment Company of America® [Capital's flagship fund for U.S. mutual fund investors; not available in Canada] was rebuilt as a growth-and-income fund. And a funny story about growth and income, even as a concept – we tried to get that name listed in Europe: Growth and Income. And they said you can’t have both of those in the same fund. They’re two separate things.

So it’s a purely American concept, and it came at a time much more serious than what we have now – much more difficult than what we have now. But it came at a time when people were scared of the stock market. And to get them to invest in equities, you had to say, “We’re going to give you income higher than the bond yields. We will have an eligibility list in which we screen for quality companies based on the balance sheet. We’ll show that they haven’t lost money over a certain period and they’ve been consistent about paying that dividend, so that you can have the income side to be sure of and growth may come over time.” That was just sort of a bonus if it worked out that way.

So the core of our DNA – the core of our growth-and-income business – comes from a period that’s challenging like this, where people are worried about the equity markets. So not only do I see it as a signal of why investing in these quality companies is a good thing, but I think it’s very particular to Capital Research and Management [Company]SM and our roots and how we’ve focused on investing in these types of funds for our history.

***

2. U.S. corporations benefit from overseas growth, despite economic woes

(Click on image for video)

Kevin Clifford: 2010 has been a most interesting year. Looking forward to 2011, could you spend a few moments talking about the macroeconomic environment that we’ve experienced this year and some thoughts for next year?

Jim Rothenberg: Kevin, I think most of us who read the newspaper have observed that the economic recovery has been quite slow by historic standards and unemployment has stayed high – much higher, certainly, than the Democrats had hoped – and it presents a continuing challenge.

The other thing I think that’s true is that this recovery, while slow, is still proceeding along. But it’s also different than the recoveries we’ve seen the last couple times around, perhaps for quite some time. And that is, this recovery’s not being led by the U.S. consumer – in fact, not being led by the U.S. It’s really being dominated by the developing countries, who now represent, collectively, more gross domestic product than the U.S. does in the world. And I think our economy [and] particularly our politicians are having a great deal of trouble adjusting to that.

But corporate America, I think, has adjusted fairly quickly. Certainly, those corporations who can benefit from overseas growth – wherever those growing markets are – I think have done remarkably well. And corporate America has also done a good job of cutting back where it had to, of trimming its cost structures – and, of course, that’s contributed to unemployment on the one hand but pretty good earnings on the other hand.

So I think you’ve seen this sort of standoff, if you will, between an environment that is fragile, where the Federal Reserve is keeping interest rates quite low, [and one] where corporate profits have been pretty good. And the result has been an S&P 500 return, at least so far, that probably is a little better than people thought it would be.

Kevin Clifford: OK. Rob, let’s shift to you. You spend a lot of your time focused on the world outside the United States. Can you take us around the world quickly?

Rob Lovelace: Sure. I think Jim alluded to the main part of the story right now, which is that the U.S. economy is not the driver in the recovery. We had an inventory cycle, but we really haven’t had the traditional consumer recovery or the capital spending that would normally come with the return in demand. And most of the demand we’re seeing is driven in developing or emerging economies.

Europe is kind of a mix. There are parts of Europe that are similar to the United States – periphery Europe that you hear a lot about: Greece, Spain, Ireland, Portugal and the U.K. But there are other parts of Europe. Sweden had a very V-shaped recovery – pretty traditional. Germany has been helped by its export position and a pretty austere fiscal policy that they’ve had for quite a while. So it’s a very mixed story – very country-specific. In aggregate, Europe is not recovering quickly – but doing better than, I think, some people might think here because of the Greek and other headlines that make it feel like Europe’s in big trouble. It’s very patchy, and Germany’s one of the bigger economies there, as are some of the Scandinavians, in terms of the contributions. So it’s important to realize that there are good things happening in Europe, especially, as was said earlier, on the corporate level. Many European corporations are quite healthy and doing well because of their position in the worldwide scene.

The positive stories are China, India, some of the other developing countries, and even there it’s still a bit mixed. I think everyone realizes that it’s positive – that they’ve gone from purely export-driven economies to much more domestically driven economies – and that’s absolutely true of India, which wasn’t as much of an export-based economy to begin with. But even in China, it’s encouraging to see consumption improving and domestic construction and government spending driving consumption there in a way that’s positive for all of the world.

I think there’s a competitive spirit that gets people worried about that, but if you had to look at what you’d want to have happen while the U.S. is recovering, it’s that someone out there is doing well and is able to keep the global economy moving.

***

3. Should bond investors be bracing for a bubble?

(click on image for video)

Kevin Clifford: Jim, global fixed-income markets: What would you like to talk about?

Jim Mulally: Well, the most important point is how healthy they are now. And when you consider that 18 months ago credit markets were in chaos, now there are amazing amounts of liquidity; credit markets are open to borrowers. Mortgage-backed markets are still dependent on agency guarantees; there really hasn’t been a recovery outside of that. But generally, they’re in very, very good health.

Now, there are some people who argue that we’re in some sort of a bubble as far as bond markets go, and I’ve really resisted using that term. The reason is, to me, words matter – and most people really do know what a bubble means. A bubble typically has certain aspects to it. It’s assets rising in price without any particular fundamental backing to their rise. Secondly, people think they can get rich on those assets. And third, it usually includes some aspect of leverage. If you take the [U.S.] housing bubble, that’s just by definition, since people are taking mortgages to purchase houses that, in many cases, they really shouldn’t have purchased.

Bond funds aren’t like that. It is true: A lot of money is flowing into bond funds. But that’s largely because people can’t really live with virtual 0% short-term rates. Whether they’re in CDs or money market funds, they’re being forced out into the longer end of the curve. And that means that they are taking some price risk; there’s no question about that. And eventually, interest rates will rise – they always do. It’s a cyclical phenomenon. And when that happens, some people, I’m afraid, will be disappointed; they will realize that this was not a cash fund and the price will go down if interest rates rise.

But the fact is, the possibility of losing tremendous amounts of money, to me, is quite low. So it’s not really fitting into what people would traditionally call a bubble.

***

4. China trip expanded meaning of “global research”

(click on image for video)

Kevin Clifford: Rob, you were just in China with a large group of your colleagues. Can you give our viewers some flavor of what that trip was all about?

Rob Lovelace: We had slightly over 80 investment professionals. We visited four cities in Asia – Beijing, Shanghai, Taipei and Hong Kong – and then reconvened in Hong Kong after having visited more than 90 companies. That in itself probably doesn’t surprise people, because we pride ourselves on having global capacity. We have a major office in Hong Kong, and we visit companies all the time.

I think what really highlights the difference in what we do and how we do it is that in addition to our folks based in Asia and our folks based in Europe and our folks based in the U.S. who look at global companies, we also had a number of people who basically spend most of their time looking at only U.S. companies, and maybe don’t necessarily invest in companies, certainly, based in Asia, but they need to understand what’s happening in the world.

So, while I know a lot of our competitors have offices abroad, my exposure to them has shown that they tend to have people based in Asia who invest in Asia and based in Europe who invest in Europe, and they maybe talk to each other in a conference call. But it’s pretty rare when you take the U.S. team over to Asia to have them understanding what’s happening not just in China but in the region – we had companies from India come up, for example – to then understand the knock-on impact on companies that are doing business mainly in the United States. I think that’s pretty unique.

***

5. Investment team continues its global expansion

(click on image for video)

Kevin Clifford: Rob, let’s start with you. I think it would be important for the advisors to understand how we think about, and have thought about, growing the research organization through this very volatile period over the last three years.

Rob Lovelace: We have always had a philosophy – I think it was really crystallized in the 1970s – that we should always be growing our investment professionals, in part because the world’s always shifting and you want to make sure you’ve got people looking at what’s important now, but also because, generationally, you want to make sure you’ve got a strong group of people at all phases of their careers in an organization like [The] Capital Group.

So we have continued to hire through this period in our investment team. Most of those people will spend a period of time in one of our larger research offices in the U.S. and Europe, and many of them then end up in places like Asia, where they’ll spend a good part of their career.

But that pattern, in and of itself, speaks to the global spirit we want in every analyst: often with multicultural backgrounds, speaking multiple languages, understanding that companies rarely do business anymore in only one country. And so we want our people to have that global flexibility wherever they go, and we’re looking for people with interesting backgrounds. In environments like this, you often get to hire some people that not only have those backgrounds but maybe have a little experience and that will fit in well with the team. So we continue to try and hire opportunistically.

Kevin Clifford: Jim, how’s this playing out in our fixed-income group?

Jim Mulally: Well, very similarly. Fixed-income, of course, has got a component of both a top-down and a bottom-up part of it. That’s just the nature of investing in bond markets. So, in addition to consistently hiring people who are doing research on, whether they’re credits or structured bonds, doing individual bond analysis, we also have a whole group, Capital Strategy Research – which we continue to add people to – who are doing economic analysis, accounting analysis, even political analysis and that sort of thing. And the combination of those two in the research group really adds to our capability in the fixed-income management.

Kevin Clifford: Jim, four decades of experience. How unique is this approach to doing global research?

Jim Rothenberg: We have been at this for all the time that I’ve been here and before – continue to expand, have expanded – in every type of market environment. And we have really emphasized people on the ground in the local markets. A lot of folks do global investing or non-U.S. investing, but they really do it from a U.S. base, and they don’t necessarily have as many people out there in the field in the local markets, as familiar with the local markets, as I think we do.

So from my perspective, it’s all about hands-on, being there, seeing companies, getting to know those companies as well, if we can, as the ones we’ve been following in the United States for years.

Kevin Clifford: I’m going to let that be the last word. Thank you all very much for joining us today. This has been terrific. We certainly appreciate you taking your time to share your thoughts with us. And for you, our audience, we hope you found this information to be helpful.

***

Commissions, service fees, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated.

The statements included here are the opinions and beliefs of the speaker(s) expressed at the time the commentary was recorded and are not intended to represent the opinions and beliefs of the speaker(s) at any other time. This content is for informational purposes only and is not intended to provide any tax, legal or financial advice. Capital International Asset Management (Canada), Inc. or its affiliates assume no liability for any inaccurate, delayed or incomplete information, nor for any actions taken in reliance thereon. The information contained about each product or firm, as the case may be, has been supplied without verification by us and may be subject to change. The Capital International portfolios are available through registered dealers. For more information, please consult your financial and tax advisors for your individual situation.

Capital International Asset Management (Canada), Inc. is part of The Capital Group Companies, Inc., a global investment management firm originated in 1931. The Capital Group Companies, Inc. includes two of the world’s largest providers of global/international equity investment services: Capital Research and Management Company (U.S. mutual funds) and Capital Group International, Inc. (global institutional), which also includes Capital Guardian Trust Company. Our funds are subadvised by our affiliates, Capital Research and Management Company and Capital Guardian Trust Company. These groups manage equity assets independently from one another.

Tags: American Funds, Balanced Portfolios, Bond Investors, Canadian Market, Clifford, Crash, Emerging Markets, Fixed Income Markets, Global Equity, India, International Asset Management, Investment Landscape, Lovelace, Moment In Time, Mulally, Portfolio Managers, President Of The United States, Price Of Oil, Recessions, Rothenberg, Time Frame, Treasury Bond, U S Treasury, Ugly Time, War In Vietnam
Posted in Canadian Market, Credit Markets, Energy & Natural Resources, India, Markets, Oil and Gas, Outlook | Comments Off

Economy and Bond Market Diary (November 8, 2010)

Saturday, November 6th, 2010

The Economy and Bond Market Diary (November 8, 2010)

The Federal Reserve implemented phase two of its quantitative easing program this week, announcing an additional $600 billion of Treasury bond purchases. The surprise to the market is what the Federal Reserve will be buying. The Fed is focusing its purchases primarily in the 2 to 10-year Treasury range and less on the long end of the market. The bond market reacted accordingly with 5 to 10-year Treasuries rallying as yields fell as much as 12 basis points. Meanwhile the 30-year bond sold off, pushing yields up by 14 basis points.

Strengths

• The Federal Reserve followed through on the much anticipated quantitative easing program, more or less meeting investor’s expectations.
• The October employment report was much better than expected. The economy created 151,000 jobs and the prior two months were revised higher as well.
• The ISM Manufacturing Index unexpectedly rose to its highest level since May.

Weaknesses

• Retailer’s same store sales for October were generally disappointing, rising a modest 1.5 percent.
• The housing crisis continues as Standard & Poor’s estimated that the total cost for the bailout of Fannie Mae and Freddie Mac could be $685 billion. Standard & Poor’s also reported that large U.S. banks could experience losses of up to $31 billion if forced to buy back mortgage securities.
• Central bankers around the world are taking a different approach than the Federal Reserve as the Bank of England and the European Central Bank both kept monetary policy unchanged. In addition, Australia raised interest rates this week.

Opportunities

• Inflation is unlikely to be a problem for some time and this gives central bankers and other policy makers around the world room for expansive policies.

Threats

• Inflation expectations as measured by Treasury Inflation-Protected Securities (TIPS) spreads have risen sharply this month. Inflation expectations will be key data points to drive Fed policy changes going forward.

Tags: 10 Year Treasury, 30 Year Bond, Bailout, Bank Of England, Basis Points, Bond Market, Employment Report, Fannie Mae, Fannie Mae And Freddie Mac, Fed Policy, Freddie Mac, Inflation Expectations, Inflation Protected Securities, Ism Manufacturing Index, Key Data, Market Diary, Mortgage Securities, Phase Two, Treasury Bond, Treasury Inflation Protected Securities
Posted in Markets | Comments Off