Nicola Wealth Management

December 2009 Market Commentary

By Rob Edel, CFA

The markets were in full Santa Claus rally mode in December with the Dow Jones Industrial Average increasing 0.80% and the S&P/TSX up 2.6%. For the year, the Dow gained a very respectable 18.8% while the S&P/TSX climbed 30.7%. Since the market troughed on March 9, the Dow has rallied nearly 60% while the S&P/TSX has gained just over 55%. While these are record-setting returns, the Dow still ended the year 26.4% below its all-time high and a disappointing 9.3% lower than levels seen 10 years earlier. In fact, the first decade of the new millennium saw the Dow deliver its weakest performance since the 1930s when it dropped 39.5%. If a broader index that included all stocks traded on the NYSE (New York Stock Exchange) were measured, investors would have suffered an average annual loss of 0.32%, or just over 3% over the last 10 years, making it the worst calendar decade for the NYSE since the 1820s. And that's including dividends. Even worse, if returns were inflation adjusted, the S&P 500 would have recorded an average loss of 3.3% a year. This is in stark comparison to the 1990s, which delivered the best calendar decade in history with an average annual gain of 17.6%. Timing is everything, isn't it? The best returning asset class over the past decade? Ibbotson Associates reports that it was gold, returning 15% over the past 10 years, though it did lose 3% a year in the 1990s.

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So that was last decade. What about this decade, or more precisely, 2010? With corporate earnings expected to increase nearly 30% (based on bottom up analyst estimates) and valuations close to long-term averages (around 15 times earnings), the markets would seem to be nicely positioned to continue their strong performance of last year. In order for this to happen, however, the U.S. and world economies will need to exhibit strong and sustainable growth. We don't think this is in the cards. While the U.S. economy has stabilized and the worst of the credit crisis looks to be behind us, we don't think the magnitude of the recovery will mirror those of past recessions. Sure, we might get stronger growth in the first half of 2010 as the bulk of the $787-billion fiscal stimulus is spent and businesses replenish their depleted inventories, but is it sustainable? The unemployment rate in the U.S. is reported to be 10% with the real rate probably closer to 17%. Consumers are not in a spending mood. A recent Michigan Survey of Consumers found that 37% of households plan to postpone purchases because of uncertainty. This is the highest figure reported since 1960 and it hasn't budged since Q2 2009. Consumers are scared. Scared about losing their jobs and scared about losing their houses. Even children get it. A recent Wall Street Journal article detailed how shopping mall Santas reported that fewer children were asking for Xboxes and iPods and more were requesting basics such as shoes, library cards and eyeglasses. Christmas retail sales may have been okay compared to last year, but they are far from recovering to pre-recession growth levels.

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Another concern we have for the coming year is the amount of fiscal and monetary stimulus that has been needed and what is going to happen when the stimulus is inevitably removed. The U.S. government plans to add more than $10-trillion to the national deficit though 2019. University of California economist Alan Auerbach fears that in 15 years, U.S. public debt will top the record 108.6% of GDP level set in 1946. While other countries, such as Japan, have carried debt higher than 100% of GDP, the U.S. is heavily dependent on foreigners to finance their debt. In order to continue to attract capital, the U.S. may be forced to raise interest rates, even if the economy is not ready for it. In order to reduce its debt over the long term, many economists estimate that the U.S. will need to raise taxes or cut spending by as much as 9% of GDP. To put this in perspective, this is about twice what the U.S. currently spends on Defense. Cut spending or be forced to raise interest rates... Neither are great options and both will provide a headwind to any economic recovery.

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The U.S. isn't the only country with financial woes. In fact, one of the strongest arguments against a weakening of the U.S. dollar is that other countries are in even worse shape. Case in point: the so-called PIIGS nations of Europe. "PIIGS," of course, being an acronym for Portugal, Italy, Ireland, Greece and Spain and a reference to the weak economies and high-debt levels of these countries, NOT a comment about their fine citizens. Greece was under the most scrutiny during December after their debt was downgraded to just above investment grade by Fitch. Simon Tilford, chief economist at the Centre for European Reform commented that "this raises question marks over the long-term viability of the euro's current membership." While the "PIIGS" might be under pressure today, Moody's recently commented that the U.S. and U.K. are at risk of losing their triple-A credit rating if they don't take action to reduce their deficits. Expect governments around the world to be under pressure to keep their spending under control in 2010 or risk creating a new credit crisis.

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THE U.S. ECONOMY

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With the exception of Q3 GDP being revised lower again this month, the economy continued to show signs of recovery in December. Even business inventories were higher in October, giving some hope that the inventory draw down cycle had run its course and companies would soon start to rebuild inventories and boost activity in the manufacturing sector. This effect was clearly evident in December with the New York area being the only weak spot in manufacturing. While the Empire State Index moved lower, it was still above zero, thus indicating growth.

While the manufacturing sector is no longer the heavyweight it once was in the U.S. economy, it is still important and highly sensitive to changes in the overall economy. A recovering manufacturing sector improves visibility for Q4 GDP growth and reduces the odds of a double dip recession. As Morgan Keegan consulting economist Don Ratajczak recently commented, "The odds of a double dip recession have gone from 1-in-3 to 1-in-5." With even the services sector stronger in December (the ISM Non-manufacturing Index increased above 50, though just barely), estimates for Q4 GDP growth have gone from 2% at the end of August to 3.9% today. While we agree the prospects for the economy do indeed look better, with the 1-in-5 odds that Mr. Ratajczak is giving, we might be inclined to wager a few dollars with him that there will be no double dip recession. Even the Fed is estimating GDP growth of only 2.5%-3.5% for 2010 and the employment and housing markets still look problematic.

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Click images to enlarge.

After last month's positive surprise reporting that a mere 11,000 jobs were lost in November, many were expecting continued positive momentum and an actual increase in employment in December. Alas, this was not to be as the U.S. reported that 84,000 jobs disappeared. There was a monthly increase in jobs, but it was from November being revised up to +4,000 versus the previously reported 11,000 loss. The good news is that jobless claims continue to trend lower and this is usually considered to be the best leading indicator of a turn in the unemployment rate. While the steadily declining continuing claims data would seem to reinforce the positive trend, the decline is more likely due to workers exhausting their regular benefits and claiming extended emergency benefits. Disturbingly, emergency unemployment claims increased from 4.2 million to 5.1 million over a two-week period in late December. Bottom line: layoffs may be easing, but workers aren't finding new jobs any time soon. We expect that unemployment rates will stay stubbornly high for at least the next few quarters, if not longer.

High unemployment and a weak housing market is also having a profound impact on migration patterns in the U.S., as the movement of workers from the Northeast and Midwest to the sunbelt States has slowed. A lack of jobs in former boom states such as Florida and Nevada and the inability to sell their existing homes has resulted in people staying put. A flexible and mobile labour market has traditionally been a key factor in making the U.S. economy so resilient.

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Last month saw a slight increase in inflation, particularly in Producer Prices which increased 1.8% versus October. Core PPI's increase of 0.5% was the largest increase since October 2008. While the inflation indices continue to indicate inflation is well contained, a recovery in global economic growth could reignite the food and commodity inflation issues seen before the global recession hit in late 2007. While most commodities (gold excluded) are still well below their 2008 peaks with the UN food-price index 21% below its June 2008 high, prices have started to move higher. In fact, the United Nations Food and Agriculture Organization reported that global food costs were up 7% in November, the most since February 2008. The Food and Agriculture Organization estimates that food output will need to increase 70% over the next four decades as the world population increases from 6.8 billion to 9.1 billion. Given these supply/demand dynamics, it's a matter of when, not if, inflation again becomes an issue. The only factor preventing us from becoming more bearish is that high unemployment rates should keep wage inflation in check.

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Nothing like the Christmas spirit to get everyone feeling jolly. Both consumer sentiment indices pointed toward increased consumer confidence.

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Improving consumer confidence usually translates into improving retail sales, and that's generally what we saw in November and the all-important Christmas shopping season in December. Merchants kept a tighter reign on inventories heading into the Christmas season to avoid having to slash prices in order to clear shelves. Consumers, on the other hand, delayed shopping as long as possible in hopes of taking advantage of last minute blow out sales, as experienced last year. In fact, a survey by the National Retail Federation reported shoppers had only purchased 47% of their expected purchases as of December 9 and only 70% the week before Christmas. Based on preliminary same-store sales results, it would appear that the consumer blinked first as MasterCard's SpendingPulse unit reported total retail sales between Thanksgiving and Christmas Eve increased 3.6% versus last year, despite some pretty poor weather on the East Coast. This is a little better than expected and very welcome after last year's 3.6% drop. What's more, sales during the week after Christmas were also strong, with the International Council of Shopping Centers reporting that sales for the 7-day period ending January 2 were up 2.5%. So far so good. The question is, however, whether the Christmas spirit will carry forward into the rest of the year. We suspect not.

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The housing sector continues to be volatile. While existing home sales remained strong in November, pending sales were weaker, indicating sales in December and January could slow. New home sales were also disappointing in November. Housing starts and building permits were stronger, though they are still down considerably from year-ago levels.

While the housing market seems to have stabilized, it's taken extremely low mortgage rates and huge price reductions to steady the market. With the Federal Reserve recently announcing plans to cap purchases of mortgages at $1.25-trillion near the end of March, mortgage rates will at best remain at current levels, but will more likely begin to move higher.

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Another concern is the increase of "strategic defaults," where homeowners who can afford to pay their mortgage default because it is in their best interests. Deutsche Bank Securities expects 21 million homeowners will end up owing more on their mortgages than their homes are worth in 2010. First American CoreLogic estimates that 5.3 million are presently 20% under water and 2.2 million are 50% under water. Unless prices increase dramatically, many of these homeowners will decide to turn their keys over to the banks. The downside of doing this? A default stays on a home owner's credit record for 7 years, making it expensive or impossible to get consumer loans or credit cards. Forget about buying another house for at least a few years. Also, while states such as California and Arizona generally prohibit lenders from seizing other assets, other states, such as Nevada, are less restrictive - debts can be sold to collection agencies that can dog a person for up to 20 years after foreclosure. Georgetown University business ethics professor George Brenkert points out the moral argument, believing that borrowers who were not deceived about the nature of the loan and are able to pay, have a moral obligation to pay and that the implications to the economy would be disastrous if Americans concluded they are free to walk away. Mortgage Bankers Association chief executive John Courson agrees (of course he would, wouldn't he?), pointing out that defaults can hurt neighbouring property values and sends a negative message to family and friends. The other side of the argument, however, is that defaulting borrowers can substantially reduce their monthly expenses by renting, thereby increasing their financial flexibility as well as their geographical mobility. As University of Arizona law professor, Brent White says, "Homeowners should make decisions on whether to keep paying based on their own interests, unclouded by unnecessary guilt or shame." Sounds like a lawyer, doesn't he?

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The trade deficit improved in October driven mainly by an increase in exports and lower energy imports. This bodes well for Q4 GDP as the trade deficit detracted 0.8% from Q3 GDP. While imports were up only 0.8%, they were still at their highest level since December 2008, providing another sign that the economy has started to recover. At $22.7-billion, the trade deficit with China was at its highest level since November 2008. Not a good thing, especially in an election year.

THE CANADIAN ECONOMY

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While the Canadian economy continues to outperform the U.S. on many metrics, GDP growth is not one of them. Manufacturing also appears to be sluggish given the decline in the Ivey Purchasing Managers Index below 50 in December. The strong Canadian dollar is killing the manufacturing sector, especially in Southern Ontario.

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Similar to the U.S. employment report, Canadian payrolls disappointed in December as the momentum from November could not be maintained. While we would expect some volatility in the monthly numbers, we would also expect a generally positive trend over the next several months.

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Inflation in Canada remained very well contained in November.

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Consumer confidence continues to move higher and retail sales maintained their positive trends with retail sales in October increasing for the eighth time in 10 months. According to online credit and debit processor Moneris Solutions, Canadians' Christmas spending increased 3.44% by volume, with Prince Edward Island leading the way with a 13.8% increase. December 23 was the busiest day with 16.9 million transactions worth $891.7-million, a 3% increase versus the busiest day last year. Of some concern, however, is the fact that shoppers were utilizing their credit cards as much as their debit cards as the year wore on. Rising consumer debt prompted Bank of Canada Governor Mark Carney to warn Canadian borrowers in December that the low interest rates enabling consumers to take on more debt would not remain at current levels in the future and consumers should anticipate increased carrying costs when deciding to incur more debt. We couldn't agree more. Canada has so far avoided most of the problems that befell the U.S. No need to follow suit now.

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The housing market cooled slightly in November with existing sales and average prices declining versus October. With only a 4.0 month supply of inventory available, however, it is no wonder sales declined in November. We remained concerned that a housing bubble may be forming in Canada and higher interest rates may be needed to burst the bubble. As Gluskin Sheff strategist David Rosenberg points out, Canadian home prices have recovered to record highs at a time when personal income has declined. Mr. Rosenberg estimates that in relation to personal incomes or residential rents, home prices are 15%-35% overvalued and residential mortgage balances have risen 7% over the past year. With 40% of the mortgages issued in Canada last year having short maturities, new home owners are very vulnerable if, or more correctly when, interest rates start rising.

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Canada's trade deficit turned into a surplus in October with stronger exports outweighing weaker imports. With the continued resurgence of the Canadian dollar, we suspect this surplus could turn back into a deficit in the near future.