Nicola Wealth Management

By Rob Edel, CFA

November was another fine month for the capital markets with the S&P 500 increasing 5.7% and the S&P/TSX increasing 4.9%. As of the end of November, the S&P 500 has rallied over 60% off its March 9 lows while the S&P/TSX has added just over 50%. The effective default of Dubai World, an investment company that manages investments and projects for the government of Dubai, caused some angst in the markets during the month and served to remind investors that credit issues still remain. The impact of the lesson was short lived, however, as the capital markets soon recovered with the situation contained to a small number of lenders.

Generally good corporate earnings and increased conviction that the recession is over were the main drivers during the month. As of mid-November, with 93% of S&P 500 companies having reported Q3 earnings, 370 had beaten estimates; much higher than the 61% average over the last 15 years. While earnings are still 14% lower than last year, they are substantially higher than the negative 25% growth analysts had predicted. As for the economy in general, the timing of the official proclamation signaling the end of the recession is left to the National Bureau of Economic Research's (NBER) Business Cycle Data Committee (we don't know why, it just is, that's all). And while they are still collecting data, it seems likely they will indicate the recession ended some time this past summer. The NBER are a very deliberate group and it's not unusual for them to take 6-18 months to declare the start or end of a recession.

Despite still posting strong returns, equity markets were showing some signs of tiring in November. While the big-stock indexes like the S&P 500 and the Dow Jones Industrial Average were pushing to new highs, the leaders in the recent rally have remained more subdued. Small and medium-cap stocks were among the earliest and strongest movers since the market bottomed on March 9, as is typical of rallies based on economic turnarounds, but were mainly unchanged in November. Other market leaders, such as the financial and energy sectors, have also failed to continue their torrid pace. Instead, more defensive sectors such as health care and telecommunication, more or less forgotten in the run up since March 9, have gained more attention from investors. Even more disturbing, trading volume has declined sharply and the ratio of advancing stocks versus declining stocks has decreased - common signs of a market topping out.

Certainly seasonality could be weighing on stocks as investors typically reposition portfolios for tax purposes and lock in gains before year end. The fact that investors have liquidated $14-billion from U.S. equity funds since October 21 while increasing their demand for risk-free government debt, leads one to conclude that at least some investors have become concerned about the short-term sustainability of the current rally. Demand for 3-month treasury bills has been so intense, in fact, that yields on some bills went into negative territory for a short period of time in November.

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Given the magnitude of the rally in the capital markets and present valuations, we think it is more than understandable that the markets take a bit of a breather. While we believe the recession is over, we don't think the recovery will match expectations set by the strong equity markets. We also believe that there is a fair chance the economy will go back into recession once the central banks inevitably start removing fiscal and monetary stimulus next year. Low interest rates are one of the primary drivers behind the recent rally as speculators are able to borrow money to invest in risky assets at practically zero interest rates, while savers are forced to move out on the risk curve in search of returns. Ironically, an improving economy could hurt investment returns by accelerating the Fed's timetable and force them to raise interest rates earlier than previously anticipated. After the strong November employment report, for example, futures markets were indicating a 68% probability that the Federal Funds rate would raise the overnight rate to 0.50% by June and to more than 1.0% by next December. It's not a question of how the Fed will take away the punch bowl, but when. And the markets won't react well when they do.

THE U.S. ECONOMY

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Economic indicators in November continued to signal that the recession in the U.S. has indeed ended. The magnitude and sustainability of the recovery, however, remains very much in doubt. GDP growth in Q3, while still in positive territory, was revised lower in November and manufacturing activity, while still showing growth, was weaker than previously indicated in October with only the Chicago PMI (Purchasing Manager's Index) higher than the previous month. The continued slow drawdown in business inventories and negative sales growth seem to confirm a generally sluggish manufacturing sector. Better than last year, but certainly not a strong recovery. The services sector is in even worse shape, with the ISM (Institute for Supply Management) non-manufacturing index contracting below 50 and thus indicating contraction in the service sector. This is not good news, given the services industry makes up approximately 90% of the U.S. economy.

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With a sluggish economy and downward momentum in job growth, the markets braced for another negative employment report in November. Even President Obama, in a speech the night before the non-farm payrolls were released, warned that the unemployment rate could continue to move higher. He, and everyone else, was pleasantly surprised when it was disclosed that only 11,000 jobs were lost in November versus expectations of -125,000. Even better, October's losses were lowered from the previously announced 190,000 to only 111,000 and September's losses were lowered to 139,000 from 219,000.

While we are skeptical of such a dramatic turnaround given jobless claims remain high and the ADP National Employment Report (private employment based on ADP's business payroll clients) came in at nearly -170,000, all indications are that the number was fairly clean with no seasonal adjustment trickery. Temporary workers added 52,000 and the service sector hired 58,000 workers while manufacturing and construction detracted 41,000 and 27,000 respectively. Even hours worked increased to 33.2 from 33.0, indicating that companies are finding more work for existing staff. One month doesn't make a trend, however, and even though 11,000 jobs lost was a pleasant statistical surprise, it was still negative and extended the monthly job-loss streak to 23 consecutive months. Let's wait to see what December brings before becoming too optimistic.

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Move along folks, nothing to see here. Inflation continues to remain under control, for the time being. Headline CPI declined for the eighth month in a row on a year-over-year basis, and while core inflation moved up slightly from last month, it is still well within the Fed's 1.5% to 2.0% target range.

We would like to point out, however, that just because CPI remains low, it doesn't mean that there is no inflation in the marketplace. Students of the University of California would certainly argue that inflation is alive and well and living in Southern California given the University's Board of Regants recently voted to hike student tuition 32%. The increase will take place in 2 steps and eventually increase an undergrad's fees for a semester to $10,302 next year versus $7,788 this year. While this is just one example of price pressure, we continue to keep a close eye on inflation as it could have dramatic implications for interest rates and investment returns.

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Despite the better employment numbers, consumer confidence continues to struggle. The Conference Board's index suggests a slight improvement off fairly depressed levels while the University of Michigan index continued to slide lower.

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Poor consumer confidence usually translates into poor results at the cash register, but October treated retailers pretty well with retail sales in positive territory for the month (though still down from last year). The good news for retailers is unlikely to continue, however, as November same-store sales came in below expectations of 2% growth, despite annualizing some pretty poor results from last year. Thomson Reuters estimates that 81% of retailers missed estimates in the month of November.

What's more, the all-important Black Friday shopping weekend (the Friday and following weekend after the Thanksgiving holiday that is traditionally the start of the Christmas shopping season) looks to be on balance, disappointingly. The National Retail Federation estimates that while 195 million consumers shopped over the Black Friday weekend versus 172 million last year, they spent only $343.31 per person versus $372.57 a year ago. They estimate that a total of $41.2-billion was spent over the 4-day weekend versus $41-billion last year. While this is a small increase, it should be pointed out that the economy was basically frozen last year due to the credit crisis. The good news for retailers is that they entered the Christmas shopping season with low expectations and low inventories. This should translate into better profit margins as they will hopefully need to discount fewer goods to clear their shelves.

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While consumers may be saving like Scrooge this Christmas, they are opening up their wallets for the housing market. Existing and new home sales continue to move higher and prices look to have bottomed. Pending sales recorded their highest year-over-year increases ever and closed October at a 43-month high. The bad news, however, is that homeowners continue to run into problems with 1 in 7 households behind on their payments or in foreclosure versus only 1 in 10 a year ago. First American CoreLogic reports that 23%, or 10.7 million, households had negative equity in their homes in Q3 and 5.3 million are estimated to have mortgages at least 20% higher than the value of their homes. First American CoreLogic estimates that home owners who owe more than 120% of the value of their homes are likely to default, even if they can afford the payments. In 2008, for example, about 588,000 borrowers defaulted even though they could afford to continue making payments. Luckily, nearly 24 million owner-occupied homes do not have any mortgage at all.

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Perhaps the fate of the Pontiac Silverdome in Pontiac, Michigan best epitomizes the issues faced by the real estate sector. Built 35 years ago at a cost of $55.7-million, this 80,300 seat stadium was home to the NFL's Detroit Lions until they left for Ford Field in 2002 (many fans wish they would have just left….period) and has been sitting vacant ever since. Hoping to unload the annual $1.5-million maintenance costs, the city recently sold the stadium and adjacent 127 acres of land for a mere $583,000. The buyer was Canadian real estate developer Andreas Apostolopoulus, who, while pleased that he made the winning bid, didn't expect to prevail and doesn't seem to have any firm plans on what to do with the stadium.

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With the U.S. dollar weakening and the U.S. consumer on a spending strike, one might naturally assume that the U.S. trade deficit should continue to decline. Apparently not the case in September, as the trade deficit ballooned to its widest level of the year with its largest month-to-month increase since February 1999. Energy imports were the main culprit with the realized price of oil increasing $3.42 to $68.17 and more than compensating for a 2.9% increase in exports.

The trade deficit with China also widened, leading to further rhetoric regarding the Chinese Yuan and the need for China to let the Yuan appreciate. Clearly, global trade needs to be more balanced in the future. As President Obama was quoted in September "We cannot go back to an era where the Chinese… just are selling everything to us, we're taking out a bunch of credit card debt or home equity loans, but we're not selling anything to them." It's not clear, however, that a weaker Dollar (or stronger Yuan) is the short-term answer. In fact, the U.S. trade deficit with China increased 33% from 2005 to 2008 even though the dollar fell 18% against the Yuan.

World Bank Chief Economist Justin Yifu Lin, the first Chinese national to act as the World Bank's chief economist (and perhaps not the most impartial commentator on this subject) argues that a stronger Yuan won't help rebalance global trade and might even hinder global economic recovery. Mr. Lin points out that a stronger Yuan would increase the cost of Chinese imports to the U.S. that are not domestically produced. This would result in an even higher trade deficit and less money in consumer's pockets. In economic jargon, this is referred to as the J curve effect. While Mr. Lin might be correct from an economic perspective, he has failed to consider the political value (from an American perspective) of a stronger Yuan and the perception (however ludicrous it may be) that it is solely to blame for the current U.S. trade deficit.

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THE CANADIAN ECONOMY

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While less than expected, GDP was up in the third quarter, thus increasing confidence to predictions that the recession in Canada is indeed over. Forecasts remain conservative, however, with the OECD (Organization for Economic Co-operation and Development) estimating GDP growth of 2% in 2010 and 3% in 2011. Both leading indicators and the Ivey Purchasing Managers Index were headed in the wrong direction in November.

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While the U.S. October non-farm payroll report was a pleasant surprise, Canada's results were nothing short of stunning, with gains more than offsetting September's weak results. While still 1.9% below peak employment levels in October 2008, October saw a healthy balance of 39,000 full-time and 40,000 part-time jobs created in October. The only negative in an otherwise spectacular month was wage growth of only 2.3%, the lowest since March 2007. In fact, 19.6% of employees were subject to a wage freeze in Q3. A few more months like October and the Bank of Canada is going to be under serious pressure to raise rates, despite reiterating that no rate hikes are in the cards at least until the Spring.

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Like the U.S., inflation in Canada continued to be well controlled in October. Core CPI moved up slightly to 1.8%, but is still well within the Bank of Canada target range.

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Consumer confidence may have been weaker in November, but September retail sales were stronger than expected and in the black for the seventh time in 9 months. Canadian consumers continue to outspend their American cousins.

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If the October job market didn't get the Bank of Canada thinking of raising interest rates, the housing market certainly should. The Canadian Real Estate Association boosted their sales forecast for 2009 by 6.6% and expects average prices to rise 4.2% in 2009 to $317,900, a 1.5% increase over previous estimates. Current sales estimates put the housing market on track to match 2004 levels, though still below levels seen in 2005-2007. With just over a 4-month supply of unsold homes on the market, bidding wars are again becoming the norm. Could a housing bubble be forming in Canada? We think so. The Royal Bank recently commented that home ownership costs in Q3 increased in Canada for the first time in 6 quarters and believes that affordability will continue to deteriorate in the coming months. How long can the Bank of Canada stay on the sidelines? If not for the Canadian dollar, they probably would have followed Australia's lead and raised rates already. Australia, for the record, raised their overnight rates a third time on December 1 to 3.75%.

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Canada's trade deficit narrowed in September due to stronger auto exports and lower imports.