Personal Finance 101

3 Key Issues That Influence the Stock Market

As we head into the fall and we look forward toward next year, it is important to take a look at the general econimc landscape, assess the data that we have access to, and develop our views on the performance of our investments going forward.

The following are three high-level economic data points that we can use, along with our other tools, to further assist us determining our views on equity market investments.

1.) U.S. Housing

As the root of the credit crisis, healing in the U.S. housing market is a precondition for sustainable recovery. Recent data has confirmed that the worst is behind us and the residential real estate market is stabilizing.

The inventory of unsold houses while still high is heading in the right direction towards clearing and sales of existing homes have recently turned positive on a year-over-year basis. And an index which measures year-over-year price changes of houses in 20 major U.S. cities (the S&P/Case-Shiller Home Price Index) plunged 33.6% from its June 2006 peak to the April 2009 trough, but has now climbed 1.9% over the past two months.

2.) The U.S. Consumer

The resurgence of the U.S. consumer will be key to watch as recovery unfolds since consumption is 70% of the American economy. Despite the ‘hit’ that the housing crisis has exacted on their net worth, American household balance sheets are still in relatively better shape than they’ve been in the past due to the tremendous growth net worth over the last decade.

However, the process of deleveraging (winding down debt) has begun and this will impact spending patterns in the near-term.

3.) The U.S. Manufacturing

The level of manufacturing has historically followed an inverse path to the Fed funds rate but on a 6-month lagged basis – as the fed funds rate drops, six months later, manufacturing activity picks up.

However, in fall 2008, although rates declined to historically low rates, the credit crunch intensified and that typical relationship between low interest rates and increased manufacturing activity did not materialize. More recently, credit channels have opened up and the ISM (gauge of manufacturing activity) has improved, indicating the economy is finally responding to massive stimulus after a long lag.

And further improvement just yesterday with the latest ISM level better than expected at 52.9 – the first reading above 50 since January 2008 and hit the highest level since June 2007. This is further indication that while not yet normal, the economic environment is normalizing.

These are three key areas of the market to watch when assessing the high-level economic situation and it’s relationship to the stock market trends and valuations.

Of course this isn’t the be all and end all of data you should include in your due diligence, but it certainly plays a role as you calculate your risk tolerance moving forward.

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A Look at the Market’s Big Picture

Just a few days into August and markets seem to have picked up where they left off in July.

Here’s a summary of market action and key developments from last month, including monthly benchmarks.

• Investors saw more data indicating that healing is underway in the global economy. Increased optimism paved the way for a fifth consecutive month of gains across world markets.
• International stocks advanced. The MSCI World Index returned 8.4% (in $US terms). Since March 9th, the MSCI Asia Index has risen about 58% in local currency terms.
• Commodity prices rose. Copper is up more than 80% year-to-date supported by increased demand from China. The S&P/TSX Composite Index benefited, adding 4%. The S&P/TSX has climbed 45% since hitting a five-year low on March 9th.
• In the U.S., stocks made up more ground. The Dow Jones Industrial Average (DJIA) had its best month since 2002, up 8.6% . The S&P 500 Index advanced for the fifth consecutive month (the longest streak since 2007) gaining 7.6% . The S&P 500 is now up more than 40% since March 9th and Monday, it closed above the 1,000 level for the first time since November 2008.
• Volatility continued to be a key theme in currency markets. After falling more than 6% against the U.S. dollar in June, the Canadian dollar appreciated by 7.4% versus its U.S. counterpart in July. This cut into returns on investments denominated in $US. Case in point, the 7.4% gain on the S&P 500 was essentially wiped out when converted back to C$.

With much of the latest economic news continuing to look less bad (over 70% of companies beat expectations last quarter and it appears US housing may have found a bottom), the economy looks to be on the mend.
However, we must realize that the rate of recovery that we are seeing is not normal and likely cannot be maintained long-term. That said, as an investor looking out 5+ years I belive valuations in the equity market are still low and the potential remains for double-digit returns heading forward over a 5+ year horizon.

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Summer 2009 Stock Market Evaluation

With the end of June comes the start of summer: warm air, hot beaches and, sometimes, choppy waters. The following is a recap of last month’s market action and key developments from “30,000 feet” .

The month of June saw North American stocks end up in slightly positive territory. On a total return basis, the S&P/TSX Composite Index gained 0.3% and the S&P 500 Index was up just 0.2% .

However, volatility in the C$/US$ exchange rate was a big story yet again as the return on the S&P 500 in C$ terms was 6.6%. The story was similar for international equities. The MSCI EAFE Index (Europe, Australasia and Far East) was down -0.8% in US$ terms but up 5.6% in C$.

In June, the C$ lost ground against the US$. This was in stark contrast to May when the loonie posted its biggest monthly advance versus the US$ since 1950. We expect currency movements to continue to be hot topic in the weeks ahead.

Energy and Materials were a drag on performance for the S&P/TSX last month dropping 2.2% and 6.6% respectively (these two sectors represent 46% of the index currently). Even with the 2.2% pullback in Energy, the sector still posted an almost 22% gain to close the second quarter.  Solid gains in Industrials, Consumer Discretionary and Financials (in particular banks which were up 9.8% this month) were sectors that kept the S&P/TSX in positive territory in June.

Key Messages

While uncertainty still looms, the data suggests that the worst of the economic and credit crisis appears to be behind us. Although U.S. consumer confidence numbers released earlier this week fell to 49.3 from 54.8 last month, the confidence index remains well above February’s low of 25.3. Many other indicators are now suggesting an easing in the pace of economic contraction in the aftermath of the deepest, most synchronous recession in the world economy in 60 years.

Most analysts expect continued volatility in stocks, currencies, and economic indicators as, although many agree we have embarked on some type of recovery, the timing and pace of that recovery may prove to disappoint investors.

For investors this means that our balanced, long-term view is as important as ever.  There is still value to be found in dividend growth stocks.

Dividend Money purchases in the past month include:

Transcanada Pipeline (TRP)
Sun Life Financial (SLF)
Royal Bank (RY)
Bank of Nova Scotia (BNS)
Power Corporation (POW.TO)

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Invest Now When The Odds Are In Your Favor

As an investor, you come up with an overall approach to meet your objectives and then bring in the stocks, bond, real estate etc. to your portfolio to execute the plan. Of course you expect that there will be frustrations along the way – just like we can’t control the weather, we can’t control the markets. But, if you are willing to put up with the frustrations, by the end of your investment time horizon, you should be able to enjoy the retirement you’ve always dreamed of.

Historical Statistics

Anyone investing for a long time should expect markets to go down sooner or later, but the long-term trend has always been up. In 183 years of equity markets in the U.S. performance was positive 70% of the time and negative only 30% of the time. Years like the one 2008 is shaping up to be are extremely rare. In fact, the only complete calendar year that lost over 40% was 1931. Conversely, the market improved by more than 40% ten times.

The chart below shows the frequency of positive and negative calendar year returns in the U.S.

There are two key messages to take away from this chart:

1. The market performance of 2008 is well outside the norm. Looking at history, it seems unreasonable to expect such negative returns to keep recurring.
2. Investors often focus on average returns, but the long-term experience of the market is very different from the average. The average U.S. equity calendar year return is approximately 8%, but in any given calendar year there’s less than a 25% chance of a return in the range of 0 to 10%. Returns outside that range should be expected – both positive and negative.

Additionally, what you can’t see in the chart is that four of the five best years (over 50% return) occurred immediately following a negative year.

With 2008 being the worst calendar year in recorded history for equity returns, do you think that the possibility is increased for history to repeat itself with 2009 rebounding with a potential 50%+ return?  While we have history as a guide, only time will tell if these statistics will hold true in the future.

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Why Don’t We Buy Stocks When They Are On Sale?

As I came into the office today, I was reminded of what time of year it is. Every year a very large tree is set up and decorated in the lobby of the building. Years ago it was a Christmas tree but as times changed it became known as a holiday tree. This year, in order to spare the slaughter of an innocent tree, it’s a 10 foot steel cone covered in green, prickly plastic. So, as I walked past the holiday cone I was reminded about what’s coming later this week in the U.S. – Black Friday.  

Black Friday

Black Friday is so named because it’s the day that retailers finally move into “the black” for the year and it’s the day that marks the unofficial beginning of Holiday shopping. It’s also the busiest day of the year for most retailers in the U.S. and a day that many items go on sale as businesses compete for those gift shopping dollars. Seasoned shoppers will do their research by scouring through local papers then line-up early in order to get the best deals – after all, if you can get the same item at a lower price, why wouldn’t you?

Strangely, when it comes to investing it seems that people want to pay more. Mutual fund sales show this time and time again. When markets are close to their peaks, mutual fund sales are strong, but when markets are close to their bottoms, mutual fund sales are weak. But who can blame investors? If we look at markets in the U.S., the S&P 500 Index is currently at levels similar to 10 years ago and while Canadian markets have faired somewhat better, it’s still been an ugly 10 years.

A Lesson In History

In 1974 the S&P 500 Index dropped from a closing value of 99.74 on March 13 down to a closing value of 62.28 on October 3 losing over 37% of its value (note that the index is based on price only and does not include dividends). And much like today, there were several events that were weighing on the minds of investors, such as:

1. The energy crisis following the OPEC oil embargo
2. The resignation of President Richard Nixon following the Watergate scandal
3. The loss of Vietnam war
4. An economy in recession

What investor would want to be in the market at a time like that?

Well, as it turns out, a very astute one. The table below shows the returns of the S&P 500 Index following October 1, 1974.

S&P 500 Index

The most important thing an investor can do right now is to learn from history. Although there are some differences between any two periods of time, there are examples of times in the past with many similarities to what we are seeing today.

Those past times represented outstanding investment opportunities in equity markets. No one knows exactly when the market will be at its bottom, but if you’re buying right now, you know for fact that it’s not at its peak. And, like many consumer goods, the market is on sale.

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Using Historical Averages Can Make You Money In Stocks

A concept that I’ve explored lately in this recent volatile market is reversion to the mean, which suggests that prices have a tendency of eventually moving back towards their long-term historic averages.

A good example of this could be the price of oil. After rising 47% in the first half 2008 and hitting a record high of $147 per barrel on July 11, the price of oil has dropped more than 20% in less than eight weeks as supply-demand dynamics adjusted (Not including the speculative bounce last week). Albeit $120 oil can still be considered high by historical standards, the point is that dramatic increases over short periods of time represent imbalances that are likely to self-correct.

Using The Reversion Theory In Your Portfolio

Within the context of recent history, many people might associate reversion with a downward movement so the first thing that comes to mind is something that’s overpriced. However, if we turn this concept over in order to highlight value as well. For example, while oil has soared to new heights, at the other end of the spectrum global equities have been punished and U.S. stocks in particular have struggled amid the credit crunch and a deteriorating economic backdrop.

Over the last 12 months, the return on the S&P 500 Index has been about -11%. Consider however that the average annual return on U.S equities over the past 25 years is 11.4%. On this basis, investors (especially those sitting on the sidelines in cash) might want to ask themselves whether they think stock prices in the world’s largest and most diverse economy will stay at current levels indefinitely, or whether it’s more reasonable to think that at some point, they’ll revert to more historically normal levels.

Analysts spend many hours and a boat-load of money determining what they perceive as fair value for equity markets. Their valuation models incorporate long run averages for inflation, interest rates and growth and based on current levels for these factors, U.S. equities appear to be trading below fair value. Another way to interpret the reversion theory essentially is a version of the “stocks on sale” message.

Reverting To Positive Returns

If U.S. equities are trading below where they should be based on historic averages for similar environments, then it follows that at some point, they should move back towards fair value, meaning stock prices should eventually rise.

Now, I am NOT forecasting what the price of oil will be or where U.S. stocks will be trading six months from now or when reversion will happen – I’ll leave that to the “experts” . The message to take from this is that amid 200 point swings in the stock market or $10 spikes in oil prices, it’s prudent to think about where prices are in relation to historic long run averages.

In a volatile market it becomes very difficult to predict which individual stocks are going to be most successful. However, buying a broad index such as the S&P 500 will offer significant exposure to a US equity market that has become oversold and is valued at well below historical averages. Not to mention that the S&P 500 has a dividend growth rate of about 11%. So, buying this index offers you an average of 11% raise each year while we wait for valuations to return to the mean.

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