Newsletter January 15, 2006

InvestorsFriend Inc. Newsletter January 15, 2006

Performance of our stock picks continues to be outstanding. While there can be no guarantees, we will be using the same diligent approach to attempt to pick stocks which can beat the market return – as we have been able to do each of the past six years since the inception of this web site.

Strange Interest Rate Levels and their Implications

Long-term interest rates are an exceptionally important factor in driving up or down the prices of  investment assets including stocks, bonds, houses, commercial real estate and other assets. Therefore investors can benefit from being aware of the level and direction of interest rates.

In the United States, short-term daily interest rates set by the Federal government have increased in 13 steps from an amazing low 1% about two years ago to 4.25% today. Meanwhile long-term interest rates have remained stubbornly low and have even been falling despite the rise in the daily interest rates. In the U.S., the 10-year government bond yields 4.44% and the 30-year yields 4.65%. This is strange because usually investors expect to earn much higher interest on a 10-year investment compared to a daily investment. (Note, a yield is an effective interest rate)

In Canada, the situation is just as strange. The Bank of Canada daily rate is 3.50%, the 10-year yield on government bonds is 3.99% and the 30-year yield is 4.10%.

It seems strange that investors are willing to invest for 30 years at a locked in rate of just 4.10%. In Canada the real-return bond yield is just 1.48%. Apparently investors are willing to invest for many years with expectation of receiving a gain of 1.48% in real purchasing power plus an implied (4.10-1.48) = 2.62% to cover inflation. And investors in the government bond at 4.10% are also taking on the risk that inflation will be higher than 2.62% per year over the 30-year period. This suggests that these investors do not expect long-term interest rates to rise and they do not fear higher inflation.

These incredibly low interest rates are part of the reason that the price/earnings (P/E) ratio of stocks has stayed relatively high. A dividend yield of even 2% seems attractive compared to bonds that are priced to yield around 1.48% plus an expected inflation compensation of about 2.6%. After all, most dividends can be expected to rise at at least the rate of inflation. And at a P/E of 20 a stock has an earnings yield of (1/20) = 5%. Again that appears to compare favorably to bonds. That is, with bond interest rates near 4.0% we don’t need the P/E ratio to be much lower than 20 to attract investors to stocks.

Looking at these very low interest rates it seems like it is a better time to be a borrower than to invest in fixed income. Certainly many corporations and individuals are taking advantage of low interest rates by  borrowing for many purposes.

One of the age-old debates in investing is what percentage of a portfolio to keep in cash, versus bonds, versus stocks. Bonds have been good or even great investments for the past 25 years. At first this was because they offered high interest rates. On top of that as interest rates fell, the bonds enjoyed capital gains.  Even bonds purchased a few years ago providing say a 6.5% interest rate have proven to be unexpectedly good investments as lower interest rates caused unexpected capital gains on these bonds.

Investing in long-term bonds now involves a low interest rate – for example around 4.5% on a 10-year Bank of Montreal Bond and around 5.13% on a riskier 10-year Bond issued by Yellow Pages. There is some chance for a capital gain if interests rates decline but also a chance for capital losses if interest rates rise. To my way of thinking, this is not an attractive alternative to stocks at this time, given that many stocks can be found with dividend yields of 2 to 3% and stocks can generally be expected, on average to grow in value with the economy say 5% per year (3% GDP plus 2% inflation). While some investors choose bonds for diversification, my own strategy is to avoid bonds in favor of stocks. I also like to keep some funds in cash in order to hedge partially against a decline in stocks.

The amount of funds which should be devoted to cash versus stocks versus bonds depends very much on an investor’s particular situation. For more information on this asset allocation decision see my articles on asset allocation.

As documented above, long-term interest rates are currently not much above short-term interest rates. This is known as a relatively flat yield curve. If this trend continues and the short-term interest rates become higher than long-term interest rates, then we would have an inverted yield curve. Unfortunately inverted yield curves are known to be highly predicative of recessions. Some analysts have explained that in this particular case an inverted yield curve might not signal an imminent recession. Still. it is definitely a point to worry about.

Mortgage Strategy

It’s always difficult to know if home owners should float with a lower interest mortgage rate or lock in a longer-term rate.

Normally, in stable times interest rates are expected (but certainly not guaranteed) to be stable. Therefore normally we would expect to pay a premium by locking in a longer term mortgage rate. Essentially the homeowner expects to pay more but is willing to pay that extra, as insurance against the risk that short term interest rates could increase sharply.

For the past 25 years or so homeowners who chose floating rates have been the winners. They should have expected to “win” even if rates had remained stable. But they received an additional large benefit when interest rates declined fairly steadily over the past 25 years. It hurts to be locked into a 7-year mortgage when rates fall continuously over that period! Those with floating rate mortgages benefited immediately from the lower rates and would have felt pretty smart.

Right now we are in an usual period where the premium for locking into a longer-term mortgage is lower than normal. For example ING Direct is offering a floating rate of 4.20%, a three-year rate of 4.90%, a 5-year at 4.99% and 10-year at 5.34%.

If a home-owner has a large mortgage and expects to continue to owe a large balance in ten years time, and if that home-owner is nervous about the risk that interest rates could rise, then I believe that the opportunity to lock in for ten years at 5.34% would be attractive. Of course they might regret that somewhat if rates were to fall over that period. However, they would have the peace of mind of being protected against a rise in rates.

I find it difficult to imagine that the rate on a five-year or a ten-year mortgage is going to fall from today’s levels. Given the steep rise in shorter-term government interest rates I suspect that there is a higher chance that long-term interest rates would rise rather than fall. However, I  would have said the same thing several years ago and long-term rates confounded myself and most people by continuing to drop.

In the final analysis each homeowner has to decide if they should go with a floating rate rather than locking in. And this depends on many factors including their ability to take the risk of higher rates and their outlook for interest rate changes.

Will the Overall Stock Markets Continue to Rise?

Canadian stock markets have done incredibly well over the past three years and now continuing into 2006. Investors need to consider whether the markets can continue to rise.

The market can be expected to rise as long as earnings are expected to rise at an acceptable rate AND as long as the Price / Earnings ratio on the market remains constant or rises. (If one these factors, earnings or the P/E ratio fall then the other factor would have to rise a lot in order to keep the market up on its own)

It is instructive to review the recent market gains on the TSX and Dow Jones Industrial Average (DJIA)

Here are the gains on the TSX and the DJIA for the past three years:

TSX Earnings Growth TSX Index Gain DJIA Earnings Growth DJIA Index Gain
2003 no data 24% 35% 25%
2004 no data 13% 20% 3%
2005 no data 22% 5% -1%
3-year compounded 71% 70% 27%

In regards to earnings gains for 2006, my understanding is that there is little reason to expect any more than quite modest gains. The North American economy has done very well in recent years fueled partly by lower interest rates. By most accounts, interests rates are now expected to rise. Canadian manufacturers and tourism will suffer from our much higher dollar. High energy prices are hurting consumers and businesses. In Canada, this scenario suggests flat or lower earnings for most sectors, except for oil and gas and resources which are very unpredictable.

Similarly in the U.S., earnings gains in the overall economy are likely to be hard to come by. However, figures on the Dow Jones site indicate that analysts are expecting the DJIA stocks to exhibit 19% earnings growth – which to my mind is too optimistic.

Longer term, the North American economy should continue to be healthy and (in the long term) deliver earnings gains per share of perhaps 5% annually (3% real GDP growth plus 2% for inflation).

So, overall, for 2006 the earnings outlook would suggest a flattish year for stock market indexes (at best).

The other factor to consider is whether or not the P/E ratio can be expected to rise or at least remain stable.

The current P/E on the TSX index is 20.6. On the face of it that is a fairly high P/E that may be difficult to sustain. The current P/E of the DJIA is 17.7. which may be a sustainable number.

A fair and sustainable level for the P/E ratio on a major stock market index is difficult to calculate and depends on assumptions. Clearly the sustainable P/E ratio level rises with lower long-term interest rates. And long-term interest rates remain at very low levels. Therefore we might expect the P/E ratios to remain above historical long-term averages of about 18. If interest rates remain low, I suspect the P/E on the DJIA could increase somewhat. In Canada , long -term interest rates are near 4.0%. Therefore a stock index with a P/E as high as 1/0.04 = 25 might be justified. But I would rather be more conservative and suggest that P/E ratios on a market index that are above 20 is getting perhaps dangerously high.

If long-term interest rates rise noticeably, then the market P/E ratios would likely contract which would drive the stock indexes down unless earnings growth was very robust.

So.. the 2006 outlook  for Canada based on the P/E ratio would be that we should not expect an increase in the P/E ratio to add to whatever stock gains earnings growth gives us. In fact there would be more danger of a decline in the market P/E ratio. For the U.S. the outlook appears somewhat better. The P/E there could rise there to give a boost to 2006 returns and should only fall if interest rates increase noticeably.

My overall conclusion for the Canadian market as a whole is that it does not look to be a strong year in the markets. I believe caution is warranted particularly for manufacturing sectors and sectors that might suffer in a consumer-slow-down. Despite unexciting outlook, if oil  and gas and other resources continue to rise then 2006 could be another good year for Canadian stocks, on average.

Market timing can be a difficult game and so one does not necessarily want be out of the market. Individual bargains can still be found. But a higher than normal allocation to cash might be wise.

Sector Valuations

I recently updated an article that looks at the P/E ratios of the various segments on the TSX.

Financial Engineering

One of the great themes of the past 25 years or so in the markets has been the rise of various forms of Financial Engineering. This can involve restructuring companies to in such a way that a given stream of cash flows can be repackaged in such a way that the valuation of the cash flows can be increased substantially.

For example a conglomerate might be broken up into several separate trading companies. In this scenario we may find that 3 divided by 2 is 2 instead of 1.5. A company worth $3 billion is split into two pieces worth $2 billion each. This can happen because markets tend to put a discounted valuation on conglomerates. Pure-play companies in a single industry tend to be more valued in the market, partly because they are easier to understand and predict.

In the debt markets a process called “securitization” has made it possible to lower overall borrowing costs in many cases.  For example, instead of borrowing all funds on its general credit, a company pledges its accounts receivables as security and may be able to borrow very cheaply based on the security that the lenders receive. Somewhat strangely, the company finds that the rate it pays on the remainder of its debt on its general credit may not have gone up much and so its total borrowing costs go down. So, simply slicing up the debt in a different way can lower the total borrowing cost.

In Canada the Income Trust phenomena is an example of financial engineering. Clever people figured out a way to avoid corporate income taxes by converting into a Trust. In addition to the valuation increase driven by tax savings, by keeping their dividend pay-outs constant even as their earnings fluctuated, the market perceived a lower risk and the valuation of the original stream of cash rose again.

I believe that Financial Engineering is one of the contributors to stock market returns over the past decade. However, I worry that this is largely a one-time event. In the past there may have been many opportunities to apply financial engineering. But at some point all the easy fixes are done, the valuations for various cash flow streams have been pumped up and there are few opportunities left. Whatever return boost has been provided to the markets by financial engineering, it is not something that we could expect to continue for very long. However, in Canada I believe there are still quite a few opportunities left in the area of Income Trust conversions. Therefore we may have a few more years left where financial engineering will boost returns.


I’m going to vote conservative, largely because that party is most friendly to economic development and least likely to allow government spending and waste to continue to increase.

Unfortunately though the conservatives will not exactly end government waste. In fact it has been suggested that in order to get elected a party almost has to promise to take money away from “the rich” and give it to the poor and middle class. The reality is that most of the money will be taken from the middle class and then redistributed perhaps mostly to the middle class. For example the middle masses clamor for publicly paid daycare, forgetting that they are the same group that would ultimately pay for that in their taxes.

At this point the conservatives seem to be ahead in the polls. However, this does not seem to be because people are drawn to Stephen Harper. Rather it seems people are rebelling against the liberals. If the conservatives win, it will be a more a case that the liberals lost then that the conservatives really won.

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