I spoke with John Rovansek recently about his opinions on the current investment climate in the US. Here are some of his comments.

On Wednesday, September 7, Mark Carney, the governor of the Bank of Canada, decided to hold rates steady at 1%, declaring the need for rate hikes has “diminished.” In his speech he said, “in light of slowing global economic momentum and heightened financial uncertainty, the need to withdraw monetary policy stimulus has diminished.” He cited a deeper US recession and shallower recovery as one of the reasons for the decision.

Over the past few months, I have been laying out a case for considering US and global equities for your portfolios, as part of a strategy to build positions in an asset class that has been somewhat out of favour. With this in mind, along with Mr. Carney’s interest rate decision and commentary, it made me think about corporate earnings, particularly in the USA, P/E ratios and what could impact future earnings. I asked myself this question: Are equities/stocks still cheap? The answer: That depends if you believe the numbers.

For particular stocks, the numbers look good, but for the market as a whole, it’s not so clear. Wall Street strategists have provided all kinds of models and forecasts. The crux of the mainstream bullish argument is that stocks are inexpensive based on standard measures such as price-earnings (P/E) ratios as well as the equity-risk premium. Both measures depend on corporate profit forecasts, which are open to uncertainty. As we know, the problem with forecasts is that they are about the future, and the future is unknown.

A recent report from Societe Generale’s lead global strategist, Albert Edwards, highlighted several key issues. In his report, Mr. Edwards pointed out how corporate profits were terrific in 2010, but have become less so in 2011. Labour costs are surging, which is slashing margins. Mr. Edwards thinks we are at a “tipping point” at which companies can no longer pass cost increases to a low-demand world. While this may be true, we have seen corporations respond to higher expenses by trimming all types of costs, including labour. In the US, an example of this effect and reported in late August, is zero jobs growth. Mr. Edwards also points out that the pace of unit-labour costs is a key driver of inflation and coupled with deteriorating trends in productivity suggests that earnings recovery, based largely on profit-margin expansion instead of top-line growth, is coming to an end.

Back to my question: are stocks cheap? The S&P 500 trades at approximately 13 times consensus estimate of $90 earnings per share and just 11.5 times the $102 forecast for 2012. The equity-risk premium, calculated by comparing stocks earnings yield (the inverse of the P/E) to the 10-year Treasury yield (assumed to be the risk free long term interest rate) indicates that equity asset class prospective returns should vastly exceed those of government bonds. Some stocks already sell at extremely low P/Es (10 or less), despite massive earnings growth over the past 10 years. What has this left? A group of large, global blue chip companies with rock-solid balance sheets, high dividend yields and significant cash generation potential to expand payouts selling at low valuations. An opportunity, in my opinion, worth exploring, particularly if you believe the numbers.

Photo credit: “Sale Sticker (Vector)” by Vectorportal on Flickr

This month I’d like to present a letter from John Rovansek of Great-West Life:

Over the past few weeks, I sent out correspondence on a couple of themes. The first theme focused on building a case for considering, or re-considering, US investments and the second theme built a case for consideration in adding global fixed income exposure to client portfolios. Based on recent financial data, articles & interviews, I thought I would ponder the question – are we headed for another recession?

Since the end of May a number of headlines have made their way to the front pages of financial publications. One prominent headline on May 30 featured Mark Mobius, executive chairman of Templeton Asset Management’s emerging markets group. Mr. Mobius postulated that another financial crisis is inevitable because the causes of the previous one haven’t been resolved. His thesis focused on the derivatives market, and specifically, the effect the volume of derivative “bets”, in different directions, will have on volatility in the equity markets. He also cautioned that the largest US banks have grown larger since the financial crisis as has the number of “too big to fail”. If his prediction proves correct, the US taxpayer will once again be forced to protect those deemed “too big to fail”.

A second headline was the hawkish tone that Mark Carney, governor of the Bank of Canada, signaled when he delivered his May 31 speech to hold the line on interest rates. Mr. Carney pointed to continuing global threats & the dampening effect of the strong Canadian dollar on exports for keeping rates steady. He also indicated he is worried about a slowdown in spending by US consumers but also acknowledged inflation is hotter than was anticipated in Canada, and this could be interpreted as a sign the central bank will raise rates before the end of the year.

Do these headlines indicate we are headed for another global recession? I suggest we look to yield curves for guidance. Yield curves are leading indicators. Let’s examine the US yield curve to get sense if a return to recession is on the horizon in the US. Why? For several reasons. One, the US is the largest economy on the planet. Two, economic expansion has been increasing, albeit at a morbid pace. Three, the Federal Reserve has been steadfastly accommodating on its monetary policy.

With the Federal Reserve’s benchmark rate at zero to 0.25% & the 10-year Treasury note yielding approx. 3.06%, the spread between the two interest rates is among the widest in history. It’s when we see an inverted yield curve – short rates above long rates, that recession takes hold. The spread derives it predictive ability from the simple fact that one rate is artificially pegged by the central bank while the other is determined by the market. When the yield curve is steep, as it is now, it induces banks to expand their balance sheets – borrow short, lend long & increase the money supply. That US bank credit isn’t growing is more a reflection of the lessons learned during the period of excess leverage & in part to the new lending standards imposed by banks.

The time to worry about recession is when the Fed raises the funds rate to the point where the yield curve inverts. The yield curve is one of 10 components of the US Index of Leading Economic Indicators. Historically, the yield curve has been the first of the leading indicators to signal a turn in the business cycle. With the spread currently about 300 basis points & the Fed in no hurry to raise short-term rates, recession doesn’t appear to be on the horizon any time soon. In the recession that we just completed, the fed funds rate rose above the 10-year Treasury yield in June 2006. The US recession started on or about December 2007. Over the past seven expansions, they lasted, on average, 71 months. The current one is not quite 24 months old, and by some metrics, it has yet to get going. The US $15 trillion economy won’t, & doesn’t turn on a dime. While the possibility for a recession may still exits, the probability remains small. Things don’t change that quickly.

For the time being, being contrarian and looking at the aforementioned themes of US & global opportunities may prove to be correct after all.

If you would like to talk about John’s comments and how they might affect your investments, please give our office a call and make an appointment to speak with one of our financial advisors.

From smallbizadvisor:

Shortly after the election was called the Canadian Federation of Independent Business (CFIB) asked the federal party leaders to provide their ideas on how they would help small businesses if elected.

…

As a strictly non-partisan organization, CFIB has highlighted elements of the platforms to help business owners make their own decisions:

Commitments for Small Business (in alphabetical order by party):

• Bloc – a tax credit for small firms hiring youth
• Conservative – an EI hiring tax credit for small firms
• Green – cutting payroll taxes by one-third
• Liberal – an EI hiring credit for youth and the amalgamation of programs for entrepreneurs
• NDP – a cut to the small business corporate tax rate to 9% and hiring credit

Ideas to Small Business the CFIB does not support (in alphabetical order by party):

• Bloc – an increase in CPP premiums
• Conservative – no plan on unfunded public sector pensions estimated at $200 billion
• Green – a hike in CPP maximum pensionable earnings
• Liberal – an increase in CPP payroll taxes and corporate tax hike
• NDP – a massive increase in payroll taxes and expansion of EI benefits

You can read the full article here. Find out more about the Canadian Federation of Independent Business on their website.

**REMINDER: Monday is Election Day**

Don’t forget to vote!

Photo Credit: “don’t be late” by haven’t the slightest on Flickr