2014 Federal Budget: Underfunded Pension Plans in Canada - A greater opportunity!

The 2014 Federal Budget was announced this week with no new surprises… But the one that has us very interested is in changes to the Pension Transfer Limits coming from Underfunded Pension Plans! Under the Income Tax Act, the pension transfer limit formula determines the portion of a lump-sum commutation payment from a defined benefit Registered Pension Plan (RPP), received by a plan member who is leaving the plan (I.e. Retirement), that may be transferred to a RRSP on a tax-free basis. The amount in excess is taxable in the year it is received. In 2011, the government introduced a special rule that provides relief to members leaving a pension that is underfunded. Essentially the transferable amount is calculated in certain circumstances to allow a member leaving an RPP whose estimated pension benefit has been reduced due to plan underfunding. This allows for a greater amount to be transferred to an RRSP. (Budget 2014 proposes to allow this rule to apply in additional situations, including the windup of individual pension plans.) Why should you care? A quick look at the DBRS website will give you a list of the "worst-funded defined-benefit pension plans" in the country: Some quick examples: Ontario Power, Air Canada, Hydro-Quebec, Bombardier, Imperial Oil, BCE, Hydro One, Telus, Suncor Energy, Sask Power, Bank of Nova Scotia, CP Rail, CN Rail, Manulife Financial, ATCO, RBC. ----We have developed a unique team of experts who specialize in stress-testing underfunded pension plans for clients across the country. We run multiple opportunity-cost analyses to provide you with the best information possible to answer the question: Do I take the pension or take the commuted value?---- The more information you have, the better off you will be. Best Regards and Safe Investing! Eric

Equity pullback may be overdue, but piles of cash on the sidelines should provide downside support.

Equities

: Even as more and more Wall and Bay Street strategists wave cautionary flags about the near‐term prospects for equities, the most common question the PAG Equity desk receives these days is “My client’s cash weighting is too high… what stocks would you be buying right now?” Strong YTD performance and a lack of investment alternatives continue to drive funds flows toward the equity market, the U.S. in particular. We’re seeing “frothy”, “bubble”, and “overvalued” more frequently in the media nowadays, but these are not adjectives we would ascribe to equity markets because all of these imply that a sharp correction is in the offing.

Equity markets may indeed be overdue for a pause, but with the outlook for global growth improving, tail risk declining, and headwinds facing most other asset classes (such as fixed income and commodities), we expect any pullback to be modest and relatively short

‐lived. Capital markets will remain focused on Fed tapering, with November’s employment report (due Dec. 6) being a critical piece to the tapering timetable. Investors with

short investment horizons should consider selective profit‐taking with an aim of reinvesting after a modest pullback.
Regionally, we continue to view the risk ‐reward proposition offered by European equities as

attractive. To our U.S. neighbours, we wish you a happy Thanksgiving and we give thanks for a spectacular performance YTD! Looking ahead to 2014, we aren’t expecting an encore performance… U.S. equity returns will likely come solely from earnings growth (consensus forecast calling for 11% YoY earnings growth for S&P500 next year).



Fixed income: We continue to see merit in our broader macro view, namely that bond yields will likely rise but that the pace will likely be more steady and incremental, with smaller bouts of data dependent volatility. Our view is predicated on (1) that the Fed is now likely to have greater continuity with the general tone of a Bernanke led Fed as Janet Yellen’s confirmation was referred to the Senate, (2) any asset paring will likely be met with other accommodative action, whether that be a change in forward guidance or other market operations, (3) broader macro growth although tepid, seems likely poised to gain some traction in 2014, and (4)

the more recently dovish BoC tone will continue to figure prominently in market sentiment. Although key risks remain, particularly in relation to U.S. political developments, bond yields seem increasingly likely to remain range bound but with a modest upward bias in the near term. As well, the front end of both US and Canadiancurves have been demonstrating more buoyancy which we believe will continue for the foreseeable future.



Preferreds: The preferred share market has found its groove as it has started to trade in a sideways fashion.  With two rate reset redemptions occurring Dec 31, 2013 (GWO.PR.J and IAG.PR.C), the search for reinvestment ideas continues as investors flock to the good quality (Pfd ‐2L and above) rate resets with attractive spreads as well as bank perpetuals, which is keeping the market well bid. We are anticipating that this trend will continue as we get through tax loss selling and into 2014 when there should be further redemptions in the rate reset space.

Capital Markets

: Is quantitative easing the next step for the ECB; How about them banks, eh?



After unexpectedly cutting interest rates to 0.25% on Nov 7, economist Nouriel Roubini (a.k.a. Dr. Doom, famous for predicting the U.S. housing collapse and ensuing worldwide recession) recently suggested that the European Central Bank will soon resort to quantitative easing as Europe flirts with deflationary risks. Combined with an inflection in some economic data, the potential for quantitative easing further supports our interest in European equities.



Strong share price performance by the Canadian banks is threatening to overtake hockey as the most popular armchair sport in Canada. Driven by increasing comfort in a soft landing scenario for housing, forward P/E for the bank group has expanded by 1.8 multiple points since June to 11.5x. Under normal conditions, Cdn banks have traded in the 12x ‐13x range. All you kids out there, stay tuned for Earnings week in Canada that kicks off next week; current consensus is pointing to 9.8% YoY earnings growth for the group.

 



Bank of America is the latest to forecast further downside risk to gold in 2014. BofA sees gold hitting US$1100/oz next year as the Fed begins to taper and the U.S. dollar appreciates. BofA expects oil, copper, and natural gas to remain range bound. UBS cut its one ‐ and three‐month gold price forecast to US$1180/oz and US$1100/oz, respectively.

Economics

: Recent data supports early‐2014 Fed tapering; Canadian economy moderating



Recent U.S. housing and employment data continue to point to possible Fed tapering decision in January or March 2014. While November’s jobs report (due Dec 6) will be the most important data point between now and the next Fed meeting (Dec 18), weekly initial jobless claims have shown promising trends in recent weeks  (4‐week avg declined to 332k vs. 358k at the end of Oct).



U.S. Housing data has been mixed, with October existing home sales continuing to slide (5.12M vs. 5.14M est 5.29M in Sep) and the mood of U.S. homebuilders remains below the peak in August. Average home prices, measured by S&P/Case Shiller, continue to show strong uptrend (Sep +13.3% YoY vs. +13% est). October’s building permits, which tend to foreshadow housing starts, reached a five ‐year high (1034k vs. 930k est). There are two ways to interpret this strong reading: there is pent up housing demand from ongoing employment

gains, or that the drop in mortgage rates after the September FOMC meeting spurred activity. Unfortunately, the most important housing data, housing starts, has been delayed until Dec 18 due to the Oct government shutdown. In our opinion, the U.S. consumers’ ability to cope with higher mortgage rates is critical to the tapering equation.



Canadian data showed moderating consumer trends, with Sep home prices gains slowing (+1.6% YoY vs. +1.7% est and +1.8% in Aug), decelerating Sep ex ‐auto retail sales (0% MoM vs. +0.2% est and +0.5% in Aug), and Oct headline inflation slowing further (+0.7% YoY vs. +0.8% est and +1.1% in Sep). Weaker data has contributed to a 1.5% drop in the C$ so far this month. We expect headwinds for the C$ will likely extend into 2014.

Geopolitical

: Tentative breakthrough with Iran; China trickling out reforms



Western nations reached a six‐month interim agreement with Iran regarding the latter’s nuclear program. Under the terms of the agreement, Iran has committed to stop enriching uranium beyond 5% and grant access to inspectors. In return, no new nuclear ‐related sanctions will be imposed on Iran for six months and Iran will receive up to $7B of relief on existing sanctions. Should Iran live up to its commitments under this confidencebuilding first step, further relaxation of sanctions are likely, including a possible loosening of oil export restrictions. After an initial knee ‐jerk reaction, Brent crude oil prices have recovered as traders take a wait‐andsee

approach.



China has started to trickle out reform decisions reached at its recent planning session. While precise details have yet to be disclosed, easing of the controversial one‐child policy, dismantling of some state‐owned entities, removal of roadblocks for capital raising, and liberalizing the financial system’s ability to set interest rates are among the reforms announced to date.

(Portfolio Advisory Group - 2013 Year End - Here's What We're Thinking - Forum) - E

The "Great" Rotation into Fixed Income?

I wanted to share a recent article covering Barron's recent round table discussions on Fixed Income and investment trends.

An even greater rotation into fixed income? Quite a thought, as we're constantly being told that the opposite is occuring... But let's look at the bigger picture.

Every day, more than a thousand Canadian boomers turn 65. The trend is expected to continue for the next 17 years. And as they enter into the drawdown period, they're looking for ways to turn their nest eggs into retirement income.

This has resulted in the need to fundamentally shift their asset mixes, Rick Headrick, president of Sun Life Global Investments, told a lunchtime audience at an advisor event recently.

"In 2000, 70% of portfolio holdings were sitting in equities, while only 14% were in the income categories," he says. "Today 44% is allocated to fixed income."

The other major investment trend, he adds, is corporate-class bonds. For non-registered assets, it's a tax-efficient way to draw income out. In fact, last year, the bulk of net flows into corporate class were allocated to fixed income.

So for all the talk of the great rotation into equities, current flows suggest if there's any rotation, it's into fixed income.

"Equity funds have been in net redemption each of the last four years," says Headrick. "Certainly there's been a flight to safety as well, but it's also because of that thirst for yield."

Corporate class' first major advantage is the ability to switch between funds within the structure. If you wanted to trim your Canadian equity weighting, and move more into emerging markets, you could do that within corporate class without triggering a tax event.

Another big advantage: efficient taxable distributions. A corporate mutual fund company can pay out Canadian dividends, which are taxed more favourably than interest income or foreign dividends. Also, on redemption, only 50% of capital gains are taxable.

The structure can cancel out gains and losses for tax purposes. (If you have one fund sitting in a gain position and another in loss, they offset each other.)

But these advantages can come at a cost.

Corporate class fixed-income funds have higher fees relative to the mutual fund trust version. But that's ok because tax efficiencies more than offset those higher fees.

Headrick notes another wrinkle in the form of the disconnect between investors' risk appetite and their return expectations:

"Currently only 22% of investors are willing to take on more risk to get a higher return, yet 40% expect their investments to yield 5% to 7%, he says.

That means the traditional asset mix of fixed income and Canadian equities won't cut it.

"Investors need to diversify into infrastructure (toll roads, airports, etc.), real estate, emerging market debt and other non-traditional asset classes to create sustainable income in retirement," he asserts.

Something that we tend to fully agree with.

Please give me a call/email if you would like to discuss your current asset mix, investment policies, or to review what options in the non-traditional space are available to you.

Best Regards and Safe Investing!

Eric

Recent market volatility isn’t necessarily all bad news…

Recent market volatility isn’t necessarily all bad news…

With the end of quantitative easing in sight, we remain optimistic on equities and concerned about bonds:

• On June 19, Ben Bernanke and the members of the Federal Open Market Committee (FOMC) signaled the tapering of bond purchases by the U.S. Federal Reserve.
• The statement triggered the biggest two‐day decline in stocks in the last few years. However, in our view, the tapering of bond purchase means that the economy is improving. If the economy is improving then that will be good for corporate earnings and therefore good for stocks and commodities, and bad for bonds and gold.
• We believe the correction we have been expecting is currently underway and this will soon represent a good buying opportunity. We remain optimistic on the outlook for equities, continuing to prefer the U.S. over Canada for the balance of 2013.

Tapering is coming:

• The increase in bonds yields after the June 19 FOMC statement was no surprise as one of the largest buyer of bonds since the recession has just signaled their intentions to slow down the purchases and possibly end the purchases in 2014. With increased borrowing costs due to higher interest rates, the cost of borrowing is outweighing the benefits of holding stock positions with borrowed money and therefore funds that buy stocks with borrowed money decided to sell their stock positions and payback their loans.
• Global equity markets have been declining since Fed Chairman Bernanke’s testimony to Congress on May 22. In this testimony, Bernanke made it clear that the FOMC “is prepared to increase or reduce the pace of its asset purchases to ensure that the stance of monetary policy remains appropriate as the outlook for the labor market or inflation changes.” This 1‐2‐3 punch triggered sharp declines in virtually every asset class, except the U.S. dollar.
• Broadly speaking, improving economic trends bode well for corporate earnings growth, and with valuation still attractive, U.S. equities remain our favourite asset class. In this environment, our preferred U.S. sectors remain Financials, Industrials, Technology, and Healthcare. We expect some additional softness for Telcos, Utilities, REITs, and Consumer Staples.
• Gold has succumbed to the fact that inflation around the world remains subdued and that the U.S. could soon stop “printing money.” Copper and other base metals are flirting with technical support levels as investors re-evaluate China’s economic growth.

U.S. still on recovery path; China’s recovery may be delayed

• Recent U.S. economic data has been mixed but still supportive of an improving trend. Retail sales for May, which provide tangible evidence of improving consumer confidence, were better than expected. In sharp contrast to the U.S., Canadian April retail sales were weak and declined when auto sales are excluded. Headline inflation for May was also lower than expected.
• After weak trade data earlier this month, Chinese manufacturing activity showed further contraction. Based on recent commentary from the new leadership it appears that they are comfortable with the current level of economic growth (7%‐8%). Furthermore, the new leadership has voiced a preference to move the country toward a sustainable growth model by focusing on financial, social, and environmental reforms, and a gradual transition away from an export‐centric economy to a domestic‐centric economy.

Risk on / Risk off...........

Summary of FOMC statement: Bernanke hinting that QE nearing an end, but action remains data-dependent

1.       Change in statement:

a.        Previous: “The committee continues to see downside risks to the economic outlook.”

b.       Today’s statement: “The Committee sees the downside risks to the outlook for the economy and the labor market as having diminished since the fall.”

2.       Key Bernanke sound bites relating to tapering of QE:

c.        “If the incoming data are broadly consistent with this forecast, the committee currently anticipates that it would be appropriate to moderate the pace of purchases later this year,”

d.       “And if the subsequent data remain broadly aligned with our current expectations for the economy, we will continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around mid-year.”

e.       “If you draw the conclusion that I just said that our policies -- that our purchases will end in the middle of next year, you’ve drawn the wrong conclusion, because our purchases are tied to what happens in the economy. If the economy does not improve along the lines that we expect, we will provide additional support.”

I wanted to share some of our Chief Investment Officer's comments regarding the current market reaction to the above:

After yesterday's press conference from Mr. Bernanke it is clear that the market is back in risk-off mode but we ask the question why are all asset classes moving in the same direction and on the surface the only safe place to be looks like cash????

  

Mr. Bernanke signaled that should the economy continue to improve then the Federal Reserve will start to taper the Quantitative Easing that we have seen over the past few years or in other words they would slowdown their $85 billion per month bond buying and eventually end the buying sometime by mid-2014. This potential tapering has been talked about since Mr. Bernanke mentioned it at the Senate and Congressional hearings in late May and the markets have seen a pull back since that meeting especially when we look at 10 yr bonds in the US. With his confirmation of such at yesterday's press conference the markets have continued their risk-off activity. However, we ask the question if the economy is improving why are the stock markets declining rapidly???

  

As we are all aware the High Frequency Traders control the markets these days and with stocks in a selling phase these High Frequency players exaggerate the problem. So why the sell-off at all?? Well it's called the carry trade and for those of you that have been around long enough I am sure you will remember the great unwind of the Yen carry trade. Basically Investors borrow money at low interest rates and buy stocks, as interest increase the cost of the carry increases and therefore investors are forced to sell stocks and payback the loans. We expect this unwind to continue for the next few days!!!!!

  

So what is going to happen over the next few months?? Volatility and lots of it!!! What Mr. Bernanke has done here is increase the odds of extreme volatility around economic releases as he clearly noted tapering will be data dependent. We expect that the market is going to be thrown around on a regular basis here as Housing and Employment numbers are improving yet Manufacturing and overall Growth remain subdued. -SJ.

This correction was an overdue and welcome event in my opinion. We've been watching the margin levels of investors continuously increase over the last year, mostly on the back of continued QE... The forced covering will bring asset prices back to more normalized levels, and the potential for long-term fundamental investing can resume.

Hold firm to your disciplines. Be proactive, not reactive. Conviction is key.

Regards.

E

"Since WW2, investors have endured a total of 56 pullbacks, 19 corrections and 12 Bear Markets."  (S&P Capital)

Selling Your Business? Planning is key........

One of the core pillars of our practice is in working with business owners in and around Calgary. We have been assisting them with proper succession planning, valuation, tax savings strategy, pension and income planning, family security, and eventual estate optimization for a number of years now. In preparation for our fall series for business owners, we will be posting articles and tips that cover some of the key aspects of a succession plan, starting today with Estate and Tax:

In many cases, the owner of a small business wants to pass the business on to succeeding generations, typically children. This can be done through a Will when the person dies but the person may want to do this while they are still alive. There can be compelling tax reasons to do this. An 'estate freeze' is a mechanism where ownership passes to the next generation while the owner is still alive. Here are the different types of estate freezes:

Paying Tax Now

Under tax law, if an asset such as a company is transferred to another party, either to family member(s) or another arm's length party, it is considered to be a sale at the fair market value. This can result in substantial capital gains tax in the year of the transfer if the company has increased in value. However, if you transfer now, any subsequent growth is attributed to the new owners.

Use of Trusts

One way to do an estate freeze is to have the shares of a company transferred into a trust with family members as the beneficiaries. You may be able to establish yourself as the trustee and retain control but if the beneficiary of the trust is not your spouse, you will have to pay capital gains tax since the transfer will be as if you sold the shares. Again, tax on any subsequent growth in the shares is the responsibility of the trust and/or the beneficiary.

Section 85 Rollover

In the previous two examples, there may be immediate tax implications by transferring a company to your family now. A further issue that can arise is that the owner will lose control of the company. The Income Tax Act provides a mechanism that allows an effective change of ownership while still enabling the original owner to maintain control of the corporation. This is the Section 85 rollover.

The Section 85 rollover can be a very practical and tax efficient strategy. However, it can also be rather complex in the details and is another area where professional advice is highly recommended.

Situation:

Lori Strong wants to pass her wholly owned company, Lori Inc. to her two children, Sarah 34, and Chris 32. Her shares of the company have a cost of $1 million. A qualified business valuator has determined the current fair market value to be $5 million so the shares have increased in value by $4 million.

Setting up a Holding Company

A Holding Company, Holdco Inc, is set up. Sarah and Chris are equal shareholders and they each buy 100 common shares for $1 per share.

Using Section 85, the shares of Lori Inc, are transferred into Holdco. In return Lori receives preferred shares of Holdco worth $5 million, the fair market value of the Lori Inc. shares. These preferred shares have voting control over Holdco and are retractable at Lori's discretion, which means she can redeem them for $5 million. Lori can choose a transfer value for the shares of $1 million - her cost. Lori will not have to pay any tax on the preferred shares until she eventually sells them.

Since the preferred shares have a set value of $5 million any subsequent increase in the value of the Lori Inc. shares will accrue to the two common shareholders of Holdco Inc., Sarah and Chris.

By doing this, Lori has managed to keep control of the company, deferred any immediate gain, and has passed on any subsequent growth to her children.

One of the important features of the Section 85 rollover is that Lori will have discretion in regards to the transfer value of the Lori Inc. shares. For example, although the shares currently have a fair market value of $5 million, under Section 85 she may be able to transfer the shares at their cost of $1 million, avoiding any immediate tax since the transfer amount chosen ($1 million) is the same as her cost. The children would have a tax cost of $1 million for the assets (the shares transferred) and the owners of Holdco Inc. shares (Chris and Sarah) will not have to pay any tax until they dispose of the Lori Inc. shares in the future.

Your advisor will be able to provide you with additional general information on Section 85 rollovers and how to proceed if it appears that this strategy would be right for you.

Be sure to update any other documentation that may contain information related to your company, such as the information contained in this personal record keeper and personal and financial log book. Share your personal record keeper with your loved ones including your Executor or Executrix. Provide a copy of your personal and financial log book to your financial advisor so that he/she can have a better understanding on how your financial situation is changing.

Once a month I will be putting up key articles on Business Succession Planning in preparation for our fall series of luncheons on the subject.

*Please forward this on to anyone you know who may be going through the motions of selling or succeeding their businesses in the coming years. (*Early planning is key.)

Or, if you have any questions, or if you would like to meet personally to have a discussion, shoot me a message.

Best Regards.

Eric

Private/Public Capital Trends in Oil and Gas...

I want to share with you some key thoughts from our friends at Arc Financial. They are an energy group we work with from time to time, and they put out some very good commentary on energy markets. I felt that their most recent publication warrants some consideration, as it mirrors comments made by the CEO of Pengrowth during a boardroom meeting we had 2 weeks ago: The trend of US private equity and pension funds moving to acquire small-cap public oil and gas companies.

"A Privileged Trough of Capital Reflects Change"

They say, "you can lead a horse to water, but you can't make it drink."

There are exceptions to this proverb, notably for oil a nd gas companies. We know if you lead them to capital they will always drink. Unless the trough is dry.

Right now there is unprecedented scarcity of public capital available for oil and gas companies. Year to date Canadian financings for the industry are at a 10-year low, and probably at an all time low if the data is adjusted to reflect a growth metric, for example dollars available per unit of output. The dearth of dollars is, in part, due to the mood of the capital markets, but mostly the situation speaks to the changing structure of the industry.

After flipping the 2013 monthly calendar twice, year over year public company financings to date are tracking around 20% of normal. As of early March, total equity raised is at $345 million, which is a mere trickle. Usually by this time of year new equity issues are indicating one and a half to $2 billion, well on the way to the 10-year average of about $10 billion per year. Debt too is lagging: only $275 million has been issued this year.

It's not unheard of for the debt and equity spigots to be shut. It happened in 2002 after Enron imploded. IT also happened on rare occasion in the 1990s, but back then the industry was one-fifth the size that it is now on a cash flow basis. Also, since then, acute inflation in the mid-2000s devalued the purchasing power of an investment dollar.

Today the capital markets are demonstrating extreme discretion. ALthought broad equities have perked up recently, risk aversion is still top of mind among investors. IN Canada, intertwined macro oil and gas issues like price differentials, low prices and access to markets are also causing reticence to finance public companies in the industry.

WHile debt and equity are important lifelines, the dominant source of investment capital is cash flow. Unless dividends are being paid out, oil and gas companies typically reinvest every dollar of cash flow back into the ground. But on the natural gas side of the business this source of capital is also scarce due to low continental commodity prices. On the oil side, cash flow is compromised due to deep price discounts. Historically, this three-way choking off of industry capital - equity, debt and cash flow - would reflect negatively on the industry, leading to a serious contraction of field activity and ultimately production declines.

Drilling activity is somewhat muted this year, but not proportionally to the dearth of public capital. Our estimates suggest that the industry will still spend $54 billion in 2013, this despite a forecast of only $36 billion from cash flow. How is this reconcilable; in other words, how can the industry as a whole be spending 1.5 times its cash flow without help from public capital markets?

The gap is explainable by prevailing structural changes. First, private equity capital has stepped in to fill in for some of the public market shortfall, but not all. Globally, the institutional investors bias is leaning toward private company investment. Private equity has financed several hundred million dollars already in 2013, but this quieter source of capital is highly selective and doesn't serve up growth capital to the broader industry.

Selectivity and discretion is a big theme in today's investment landscape. Only a handful of high-growth, darling companies are able to raise money; for example, two-thirds of the $345 million in equity this year was raised by one public company - Tourmaline OIl Corporation.

The loudest statement about structural change comes from the patient and deep pockets of large multi-national companies, there the bulk of the industry's growth capital is coming from right now. None of these participants need to depend on public market financings to further their interests. Shell, Chevron and PETRONAS are declared long-term players in the LNG game, spending money from wellheads to the coast, regardless of current market conditions. Overseas JV money targeting resource plays also continues to be an alternative source of capital. Notable, big oil sands companies are tracking spending levels in the low-$20 billion level this year, with no hiccup relative to prior years.

Massive up front investment into big resource development is how the industry will end up spending significantly more than its cash flow this year; the oil sands sector will spend 250% more than it takes in, and non-oilsands 120%, for a weighted average of 150% as a whole.

Structurally, the selectivity of capital and shift in its sources means that the oil and gas industry has become a cloistered business that favors few. In fact, there is lots of water at the trough. But for now only big, sophisticated or privileged horses are able to drink. ( Peter Tertzakian - March 22, 2013 - Arc Financial Corp.)

Eric Bennett_Wealth Advisor by

An Ever Changing Industry....

Potential Headwinds!!? Caution in the wind for 2013.....

Back in the saddle!

It's been a while since my last post... But with the market rally we've been experiencing I felt it prudent to share some cautionary thoughts as we head into 2013.

Starting with a great article I received from our friends at Bloomberg which details some key factors that have been fueling the rally and why we may want to proceed with caution from this point:


The US stock market rally that kicked off the New Year continued last week, and after only two weeks, US stocks are up around 3% for the year. European stocks have posted similar gains and equities in Japan have advanced even further. What’s behind this rally – and more importantly, can it continue?

In my view, the rally can be attributed to three factors. The first is obviously relief over the fiscal cliff deal. Also, some investors sold winning investments in December in an attempt to generate capital gains in 2012 before capital gains taxes in the U.S. were scheduled to increase in 2013. Because capital gains rates did not change for most Americans, however, many investors are now buying back the stocks they had sold.

Second, stocks are benefiting from a normal period of seasonal strength. While the so-called “January effect” may not be as significant a trend as some would believe, there is a modest historical tendency for stocks to advance in the first month of the year.

Finally, economic data has generally been better than expected, not just in the United States, but also globally. Manufacturing data from China is confirming that an economic hard landing has been avoided and there are also some similarly positive signs from the US financial services sector. The global economy is starting 2013 with some momentum.

But it is important to remember that at least the first two of these factors are likely to be temporary. True, I expect equity markets to continue to advance and to outperform bonds for the year as a whole, with the best performance likely coming in emerging markets. But I believe the current pace of gains will slow—if not immediately, then probably by February. Here are three reasons why I remain cautious in the near term:

1. Expect a good deal of headline risk coming in the next couple of months. Investors should expect continued dysfunction from Washington as lawmakers wrestle with the debt ceiling, scheduled spending cuts and the need for continuing budget resolutions. Not only are the odds of some sort of “grand bargain” diminishing, but the current bickering raises the possibility of another last-minute showdown and a potential debt downgrade.

2. There is political risk coming out of Europe, with Italian elections approaching in February. Should the election fail to produce a clear result, or should the voters choose a less market-friendly government than the one currently headed by Prime Minister Mario Monti, markets would likely react negatively.

3. There are lingering concerns about the US economy. Once we get a look at January month-end data, we will see the first clues about how higher taxes are impacting the economy. Notwithstanding some of the stronger data cited earlier, I expect the first quarter to show relatively soft economic data. In particular, I’m concerned about consumption levels weakening in January as people come to grips with smaller paychecks.

Moreover, while these risks are clearly evident, investors seem to be overly complacent.  The VI X Index (a widely followed measure of stock market volatility that is also known as the “fear index”), fell last week to its lowest level since June 2007, suggesting that there is not much bad news priced into market right now. That means any negative shock would have the potential to drive markets lower.

The bottom line is that while stocks are reasonably valued (particularly outside the United States), expect tougher going as we head into February. Source: Bloomberg, L.P.

Best Regards and Safe Investing!

E

September (make it) Rain... (kinda sounds like a G&R song)

So here we are, half way through September, and the markets continue to show us that we like the feeling of quantitative easing... So much so, that all other equity indexes are showing the immensely positive shock these programs have on our psychological beings. So away we rally....

My friend over at Qwest Investment Management had a terrific "trend watch" report out last week. The following utilizes some excerpts from this letter which I think hit the nail on the head for the economic environment we are in...

September is turning out to be “stimulus month” for the global economy. First, the European Central Bank announced a program of unlimited buying of peripheral country debt under certain conditions. Their actions have temporarily put a floor on eurozone risk.

China followed by announcing a series of infrastructure spending initiatives designed to stimulate the economy. Measures include plans to build 2,018 kilometers of railroads, as well as spending on sewage treatment plants, port and warehouse projects and waterway upgrades.

And then last week the Federal Reserve joined the party by announcing further stimulus for the American economy.  
Stock and commodity prices have soared on news of these pump priming measures. While our Trend Model was prescient enough to spot this rally early, we believe that this is a rally to be “rented and not owned”. Longer term problems remain and the global economy still has to deal with the longer term problem of a debt overhang, which ultimately translates to slower economic growth.

They went on to utilize a chart from HS Dent Research which adds to the the story. It demonstrated the correlation of US age demographics to stock market returns. Baby Boomers are nearing retirement and until the next generation, who are aptly named the Echo Boomers, start to hit their peak savings years, stock prices will continue to face some real headwinds. (I haven't included the chart in this blog entry, but instead have added a great chart showing the "expansion and contraction" cycles in the markets (Dow Jones back to 1900). One can easily spot the population "boomers" cycle from start to current retirement.)      

 As this rally continues, look for opportunities to take profits off the table and reallocate towards uncorrelated asset classes. - For many of us who have been holding throughout the cycle, this may prove an excellent time to do so.   Best Regards and Safe Investing!   E

Realized Canadian light crude prices have improved significantly; will the equities follow?

My friends at GMP recently reviewed the price trend of Canadian light crude, and the potential this will lead to upward momentum in the small/mid caps in this space.

The WTI price has strengthened in recent weeks but there have been wider CDN price differentials periodically throughout 2012 which have negatively impacted Canadian wellhead prices. We note that the light differentials have narrowed substantially in the last couple weeks results in significantly higher realized oil prices for producers.


· The graph shows that the Canadian light Sweet Price (Net Energy) was trading at a of discount to WTI of $11.50/b or a CDN realized price of ~$65.00/b in late June.

· The discount in the couple weeks has narrowed significantly from $11.50/b to only $1.00 - $3.25/b currently. This narrowing combined with the improvement in WTI has significantly improved the realized price in Canada. The implied CDN light price as of last night was ~$85.00/b a $20.00/b improvement in the last 2.5 weeks.

· This trend is also seen in other light crude products. For example, Bakken crude at Clearbrook MN has increased from US$63.69/b on June 28th to ~US$88.50/b this morning.
 

The oil weighted equities have not reflected this realized price improvement


· No surprise but there is a strong correlation between the light crude price and oil weighted producers in our coverage universe. We have included a graph going back from March which shows that the two often move in lock step (corr. of 85%)
 
 

·

However, the recent strengthening in Canadian pricing has not been reflected in the share prices of the oil weighted producers and the relationship has diverged. The E&P’s that would benefit the most from the stronger pricing and sentiment would be the oil weighted producers.Cheers
 
E

Dont forget about..........

The Search for Yield - Dividends & Payout Ratios

In an era of historically low bond yields and zero percent benchmark interest rates,
the thirst for income has rarely been so hard to quench. Since 2009, the yield on 3-
month Treasury Bills has averaged 0.65% in Canada and 0.10% in the United
States. From 1954 to 2007, U.S. 3-month yields averaged 5.2%. Investors have
been fleeing pure equity investment vehicles for years and flocking to income
products/bond mutual funds in search of income and lower volatility. The latter is
likely to prove elusive in coming years as monetary policy normalizes higher. The
traditional high dividend paying sectors such as Utilities, Telecom, and REITs have
benefitted the most from income oriented flows in recent years, but other areas of
the market may now attract some attention. U.S. Banks that have cleared stresstests
will start raising dividends and Technology behemoth Apple announced
yesterday that it would re-introduce a dividend. The S&P 500 dividend currently
stands at US$27.53 and its dividend yield of 1.95% had until recently surpassed the
U.S. 10-Yr bond (2.38% yesterday, 1.88% last 3M average). In Canada, the TSX's
dividend yield (2.85%) still edges 10-Yr Canada bonds (2.29%). Both for the TSX
and S&P 500, a positive dividend yield-to-bond yield spread is a first since late
2008-early 2009. Dividend growth has lagged the profit recovery since 2009 and
the S&P 500's payout ratio of 28% is the lowest since 1871. Equity flows could see
a positive reversal if bond returns start to disappoint. Should this happen, we
believe companies offering high yields and the ability to raise dividends will benefit.
Non-traditional dividend areas are likely to join the dividend party as well. Our Chart
of the Day highlights the S&P 500 and TSX index/sector dividend yield and payout.

Strategy Corner....Dividends and Share Buy Backs. (It's been a while)

Keeping in line with our strategy to look for new and innovative investment ideas, I bring you the following:

Dividends and Share Buybacks

Over the years, companies have created shareholder value through share repurchase programs and/or dividend increases. By share repurchase program we are referring to companies that buy back their stock in the open market. Both policies can create value for shareholders although there is an ongoing debate as to how much value is created, and which is the better use of free cash flow.

Certainly, the permanence of a dividend increase tends to be a better indicator of financial health and investors like to see dividends credited to their accounts. That said the return of cash to shareholders through share repurchase programs also benefits shareholders by reducing the number of shares outstanding, boosting earnings per share, and providing support for the share price. In this report, we have attempted to identify companies that have a history of consistently delivering on both shareholder friendly policies.

U.S. Corporations Flush with Cash

U.S corporations are sitting on record levels of cash with non-financial corporate businesses holding U$2.12 trillion in liquid assets at the end of the third quarter of 2011. High free cash flow yields combined with low returns generated on cash holdings should lead to increased dividend payments to shareholders and share buyback activity. In 2011, S&P 500 companies paid U$256 billion in dividends to shareholders, or about 29% of earnings. That’s well below the long-term average payout ratio of 47%. In 2011, U$530 billion worth of share buybacks were also authorized, up nearly 45% from 2010.

16 Companies with Investors’ Interests in Mind

We screened the S&P 100 Index of U.S. mega cap stocks, looking for companies that consistently repurchased shares and increased dividends over the past five years. To qualify, a company must have repurchased and reduced its common shares outstanding, and increased its dividend in each of the last five years without exception.

When creating our list, why did we not simply look for cash-rich companies with high free cash flow yields? Far too many management teams have destroyed shareholder value with poor investment decisions. Share buybacks and dividends put cash directly back into shareholders hands. However, these shareholder friendly policies should not come at the expense of strategic investments that could positively impact a company’s long-term growth and financial health.

There are 16 companies in the S&P 100 that met our selection criteria. Industrials, in particular defense companies, large retailers, and health care companies dominate the list. The stocks on the following page are ranked based on yield, decline in shares outstanding, and growth rate in dividends. On the basis of these three equally-weighted factors, Lockheed Martin (LMT) tops the list. On average, over the last five years, this defense company has reduced its shares outstanding by 5.3% per year while increasing its dividend annually by an impressive 21%. The shares currently yield 4.8%. Runner-up Texas Instruments (TXN) repurchased a similar amount of shares, but its Board was more aggressive in terms of annual dividend increases. However, the chipmaker’s shares yield only 2.1% at their recent quotation.

*Call or send me an email to discuss the companies that passed the test, and how this strategy may be a possible addition to your current investment policy.

Best Regards and Safe Investing!

E

Upcoming Seminars:

WHY?

Reduce your financial burden.
Maintain your independence.
Access cutting-edge medical services.
Assist in your recovery any way you choose.

Strategy Time... (a revisit to high yield corp bonds)

High yield bonds offer investors attractive income in the current environment, with an average yield of more than 600 basis points greater than the yield on government bonds.

So, why is it important for investors to include an allocation to high yield bonds in their portfolio?

1. Enhanced Diversification - High yield bonds are often considered a distinct asset class, as they involve different return characteristics and have a lower correlation to traditional asset classes such as Government bonds and equity. For this reason, adding high yield bonds can increase portfolio diversification, and potentially reduce risk and enhance returns.

2. Attractive Income Potential - With interest rates at low levels, most investors cannot generate the income they require by investing in government bonds alone. Generally speaking, high yield bonds pay higher interest rates than investment-grade and government bonds to help compensate investors for the additional risks of investing in lower quality bonds. Over the life of a bond, those higher coupons provide a higher rate of return than higher quality (investment grade) bonds.

High yield bonds offer investors attractive income in the current environment, with an average yield of more than 600 basis points greater than the yield on government bonds.

3. Capital Growth Potential - In a recovering economy, companies who issue high yield bonds can see their debt rating upgraded due to improved cash flow, offering investors the potential for capital appreciation from the associated increase in the bond’s price. Historically, high yield bonds have tended to provide equity-like returns, but with much lower volatility – a characteristic that many investors are currently looking for.

4. Less Sensitivity to Interest Rates - High yield bonds tend to be less sensitive to interest rate fluctuations than most fixed income securities, primarily because they carry a higher coupon and have terms of 10 years or less. In addition, high yield bond prices react more to credit spreads and changes in credit quality than interest rates.

What’s the outlook for high yield bonds?

We believe conditions remain extremely favorable for high yield bonds. Weak demand, particularly from consumers is providing an environment of slow but positive economic growth, low interest rates and low inflation. Corporations, having cut costs and delevered balance sheets during the credit crisis, are showing strong profit growth but only marginal revenue growth. As a result, leverage across the corporate sector remains low, and cash has been building to record levels. Credit quality, as measured by balance sheet strength is at record levels and corporate default rates are headed towards new lows.

With yields on traditional income producing investments at record lows, investors are increasingly looking to high yield bonds to provide steady, sustainable cash flows. In addition, many investors have been unnerved by the extreme volatility of equities in recent years, with high yield bonds offering an attractive, less volatile alternative. As a result, flows into the sector from both institutional and retail investors continue to grow, putting downward pressure on spreads.

How are we incorporating them in our client’s portfolios? (A study)

All portfolios reflect the clients individual risk tolerances, goals and requirements, so we sit with each and build out a strategy on a case-by-case basis. However, from a macro view, parts of client’s portfolios that are focused around a 100% equity mandate have benefitted greatly from scaling back (say 25%) and reallocating to High Yield.

The chart below shows the 15 year return of the S&P 500 along with the 15 year return on the US High Yield Index. Interestingly, High Yield outperformed by over 8%, but with substantially less volatility during that period.

For clients scaling back to a 25% High Yield / 75% Equity portfolio - the average annual return bettered the 100% Equity portfolio by around 2.2%. ***And it did so at 25% less volatility.

How does one best invest in this asset class?

It is important to view High Yield Corporate Bonds in a similar risk category as equities. (I commonly refer to them as a “stock in bonds clothing”.) So, I do not look to include them in the Fixed Income portion of client’s portfolio profiles, but rather towards the overall equity portion.

There are a number of ways to participate in High Yield: directly buying the bonds from the issuer, buying the index through various ETFs, or buying units of a High Yield fund. All 3 are great ways, but are unique and dependant on the requirements of the client. **Questions such as Cost, Liquidity, Diversity (market and sector), and Manager Risk are all part of the decision process.

Here are some examples:

iShares IBOXX Hi Yield Index ETF (HYG)

Costs 0.5% MER
The 3 year return 9.36%
The 3 year index return was 10.41%
Small tracking error for this ETF
Current Yield: 8.17%

Marret High Yield Fund (MHY.UN)

Barry Allen – Fund Manager
Costs 1% MER
Average duration – 3 yrs.
Since inception (June 2009) return 10.51%
Current Yield: 7.34%


The High Yield market in Canada is quite small, with most new issue allocations going towards the institutional investor, so looking towards a managed or indexing approach would provide access to much broader markets for the individual investor.

As always, contact your investment advisor to see if this asset class is an appropriate fit in your current portfolio.

Best Regards and Safe Investing.

Eric.

Market Update.... Emphasis on the Pro's not the Con's

So here we are...

It's been entirely too long to go without an entry to my blog. Albeit, my weekly Market Watch newsletter has refocused my attention, it is now time to place some very serious thoughts into perspective.

I've lost all craving for houmous, grape leaves and spanikopita. Probably for ever...

Here's a summary of the expected Euro plan for Greece:

1. Greek bondholders will “voluntarily” write down the value of Greek debt by 50% which will help reduce Greece’s debt load from 150% of GDP down to 120% by 2020.

2. The European Financial Stability Fund (EFSF) will be expanded to 1 trillion euros from the current 440 billion euros through a combination of additional funding from the IMF and possibly a capital injection by China and/or other nations.

3. European banks will be recapitalized to offset the impact of the haircut on Greek bonds.
As encouraging as this European agreement is in principle, it is clearly just the first step in a multi-step program to resolve the European debt crisis.

Despite the significant stock market rally, equities remain the favoured asset class versus bonds. That said, we expect equity market volatility to continue and recommend profit taking to lock in recent short term gains. For buyers building longer term portfolio positions, we expect the market will provide yet another lower entry point so there is no rush to buy at current levels.
One of a few exceptions would be gold which has pulled back almost US$200/oz. since the highs reached in August. Both gold bullion and gold equities should perform well in the current environment.

Commodity cyclicals and industrial stocks offer the most upside potential in the event equities rally again, but they also will likely continue to exhibit the greatest volatility.

Many high quality dividend paying stocks at current levels do not offer much capital appreciation potential but will provide investors with the most downside protection if the market retreats, and the steady dividend income generated remains an important component in portfolio total returns.

Given our outlook for an extended period of slow economic growth, whether falling into outright recession in North America or not, equities are expected to trade in a range for the next several years. We are inclined to trim some profits on holdings that have performed well. In turn, emphasizing the need to be more tactical in the current environment, this capital could be selectively rotated into stable names that are more reasonably valued.

We place particular emphasis on the word "selectively" given the fragile situation in Europe and we continue to encourage a focus on larger-cap companies with sound balance sheets.

Stick to your knitting....

There are indications of a Bullish time for equities ahead.... Why?

1. Systematic/mechanical devaluation of the US$

*Global Commodites/Resources priced in USD.

*Forecasting of some substantial falls in commodity prices over the next few years.

*Which will lower Inflation pressures in global Markets.
(I.e. A $10 fall in the price of a barrel of oil would transfer an amount of income equivalent to around 0.5% of world GDP from producers to consumers.)

*Eventually drive resurgence of demand.

*Good for Canadian resource heavy economy which some argue could overheat and (as we've seen in the past) fail to diversify.

2. The death of Defined Benefit Pension Plans.

*Larger institutional money must be reallocated away from risk-free assets towards stronger blue-chip portfolios.

*Equities will benefit from this "refocus" by pension plans and other large institutional players.

3. 100 Years of Expansion and Consolidation Trends.

*As per the chart at the top of this entry, there are very interesting themes that have taken place throughout history of the stockmarkets (in this case, the Dow Jones Industrial Average).

*After expansionary periods in the markets (which last on average 20 years), there are contractions/consolidations that last around 15 years.

*Roughly putting the next 20 year "up" period at a start date of around 2015... (Almost there)

The key of course will be to find ways to continue to navigate the turbulent waters ahead. It is paramount that we tailor our investment policies to reduce volatility and ensure a certain margin of safety is built in, should the macro-economic environment take a turn for the worse.

Best Regards and Safe Investing.

How interesting... All out sector correlation (again)

The S&P 500 sector correlation is at its highest level since '89.

With Global macro-economic factors continuing to drive equity markets, generating alpha (I.e. beating the market) is getting much harder. With the intensification of the Euro debt crisis and the U.S. credit rating downgrade, the correlation amongst S&P 500 sectors has increased rapidly. With sectors (and stocks) moving in lock-step, the average correlation among S&P 500 sectors has exploded, giong from 68% in eraly June to 90% currently, the highest level since at least 1989.

In comparison, the 22-year average sector correlation stands at 57%. The current sector correlation is surpassing the levels hit last summer (87%) and during the 2008/2009 crisis (89%), as illustrated in the chart above.

From a contrarian perspective, however, the last two peaks in sector correlations provided good entry points in the equity market.

Could ETF's be adding to this all out "unification"?

ETFs account for more than 30% of volume in U.S. stock markets, compared with just 2% in 2000. It may be reasonable to expect ETF trading to drive correlation higher because many of the vehicles are tied to stock indexes.

For example, the 10 different industry sectors of the S&P 500 show well over a 95% correlation over the last month, and a low of 72% in February 2011. High yield bond prices are at a 93% correlation to stocks, which is another multiyear record.

This is unusual for U.S. equity markets, which have tended towards lower correlations in rising markets and clustered returns when things get ugly.

It may not mean that we are necessarily in for tougher markets from these points, but it does make the decision about asset allocation more important than sector or stock selection. (At least for the time being)

Best Regards and Safe Investing.

E