Newsletter July 2, 2007

InvestorsFriend Inc. Newsletter July 2, 2007

Do Not Fail to Invest in Stocks

In the next section I indicate that I am somewhat cautious, even slightly bearish about the near-term direction for the stock market.

But this does not mean that I would advocate that any long-term investor take the risk of having no investments in stocks.

Reports of losses and declines in stock markets often make for sensational news. Those with no stock investments may feel vindicated whenever there are reports of major declines in the market.

But is is an indisputable fact that over the long-run, those who invested in stocks and stayed with the broad market averages have done very well over time, in spite of the volatility.

Consider that the average annual gain on large U.S. stocks since 1926 has been 10.4% per year.

$100,000 invested at 10.4% for the long-term would grow to the following values:

30 years $1.95 million

40 years  $5.2 million

Sure, inflation would eat into these gains, but after inflation the real return has averaged, 7.17% and therefore even after inflation $100,000 still grew on average to $1.6 million in 40 years, which means you could at that point eat your original $100,000 cake and still have 15 more 100,000 cakes left over.

The surest way to benefit from the long term gain in markets is to get into the market and then hang on tight through the volatile periods, but always staying in the market.

In theory, successful market timing, jumping out when the market is over-valued and going back in when it declines would add dramatically to your returns. But given the risk of missing out as the stock market rises, it is probably wise to keep a significant portion of a portfolio in the market at all times and to only attempt to time the markets with a portion (if any) of a portfolio.

Nevertheless, most investors, being human, are overly fixated on where the market will go next week and next month and in the next year rather than being content to keep the faith that over the longer term the direction is clear – UP.

Short-term Stock Market Direction

I am cautious about the direction of stock markets in the near term. In the long-term I am highly confident that stock markets will continue to offer attractive returns. But the short-term is highly unpredictable.

At this time, there are reasons to fear that the market will fall temporarily.

The Canadian stock market has more than doubled since lows reached in late 2002. The U.S. stock market has not risen quite as much but is close to 100% higher than its late 2002 to early 2003 lows. Over that period there have been some “corrections” or set-backs but there have no really major declines. Typically markets do periodically have corrections in the range of 15% or more every few years, although not on a predictable time scale.

Perhaps a bigger worry in interest rates. Long-term interest rates had been trending down for almost 25 years since highs reached around 1982. Recently they have increased. Declining rates were one of the big factors that drove stock markets to higher-than-average gains most years over the past 25 years. Higher interest rates will all – else being equal – pull stock values down.   This is a mathematical fact, if interest rates go up, that (all else equal) pulls stock values down. Earnings growth and expectations of earnings growth can sometimes overcome the gravitational affect of higher interest rates, but still that gravitational pull exists.

Earnings growth has been higher than average and higher than growth in the economy most years for quite a few years. This will not last forever. At some point earnings growth will slow to or below the rate of growth in the economy.

A consumer recession could be triggered by high consumer debt levels and higher interest rates and/or lower home values or by other factors.

For all of the above reasons, I am cautious to slightly bearish on the short-term direction of stock markets at this time.

Tempering this, is the fact that price to earnings multiples do not seem excessive. As long as earnings do not decline, markets are not likely to fall precipitously. In addition corporate buyouts have continued place upward pressure on stock prices.

My own approach has been to selectively sell some stocks to raise my cash position to about 24%. This means that I will largely ride-out any market decline but I will have some funds available to scoop up bargains if a significant market decline does occur.

The Canadian Dollar – Winners and Losers

As of this Canada Day weekend (July 1, 2007), the Canadian dollar is worth just over 94 cents U.S. It therefore takes about CAD $1.07 to purchase a U.S. dollar.

This is a 30-year high for the Canadian dollar. This represents a steep jump in the value of the Canadian dollar. Just over five years ago the Canadian dollar was briefly as low as about 62 cents, meaning it cost a hefty $1.61 Canadian to buy a U.S. dollar at that time. As recently as early 2005, the Canadian dollar was worth only 80 U.S. cents or a cost of CAD $1.25 to buy the U.S. dollar. The recent huge increase in the value of the Canadian dollar in U.S. dollars affects different parties in different ways.

First I will briefly discuss how our higher dollar has hurt or helped various parties. Then I will discuss what I think should be done.

Ordinary stay-at-home Canadian

A Canadian family that does not ever travel outside Canada and which has no U.S. investments is not affected very much at all. The higher Canadian dollar has not had much if any impact on the overall average inflation rate in Canada. Correspondingly this family will notice little or no impact of the higher Canadian dollar. (Of course such a family could be hit hard indirectly if their employer was hit hard by the higher dollar).

Snow-bird or American-vacationing Canadian

It is suddenly a LOT cheaper to vacation or winter in the U.S. These Canadians benefit noticeably from our higher dollar. Expect to see more snow-birds and more U.S. vacations and expect Canadians to stay longer in the U.S. on these visits.

Cross-Border shopping Canadian

Back in the early 80’s Canadians would flock to the U.S. to buy electronics, cloths, gasoline and other items cheaper and then bring them back to Canada. Even after paying duties at the border this was worthwhile. But cross-border shopping became unattractive when the value of the Canadian dollar slumped first into the 80’s cents range then the 70’s and finally the 60’s cent range. These shopping trips will now likely return with a vengeance. I expect to see U.S. border hotels begin to accept the Canadian dollar at par as a further inducement to draw Canadians over the border.

American Tourists to Canada

Americans found Canada at least affordable and sometimes cheap when their dollar was worth over CAN $1.50. Now they will no-doubt find Canada to be expensive. I expect them to stay away in droves. This could decimate the Canadian tourist and convention industry.

Canadians with Investments in the U.S.

As the Canadian dollar plummeted under 70 cents U.S., Canadian investors were urged to invest more of their portfolios into the U.S. market. RRSP investors and Pension plans complained endlessly about low foreign content restrictions in these tax-assisted plans. The government finally relented and raised and then eliminated the restrictions. Oops, since then the gain in our currency has resulted in large losses in value when American investments are translated back into Canadian currency terms.

But, the good news is that it now seems much more affordable to purchase American investments at this time. Most Canadians who have American investments will likely be people who will eventually spend some of their money in the U.S. The value of their American investments in U.S. dollars did not decline as our dollar rose. Offsetting the loss on American investments is the fact that a Canadian’s home country investments are now worth a lot more in U.S. dollars. Overall the increase in the value of the Canadian dollar is a good thing for most investors in spite of the short-term pain some suffered.

Americans with investments in Canada.

Most American investors likely have few investments in Canada given that America is largely a self-centric country. In addition archaic rules make it expensive for Americans to buy stocks on the TSX. They can however easily buy those Canadian companies that trade on U.S. stock exchanges. Americans who bought Canadian stocks when our dollar was cheap have seen windfall profits as our dollar rose in value. This would apply particularly to those Canadian companies that have most of their costs and revenue in Canada. (A Canadian head-quartered company that actually has most of its expenses and revenues in the U.S. would not tend to rise in price as our dollar rises).

Canadian companies that largely exports its products to the U.S.

This is the “house of pain”. The much higher Canadian dollar has been financially ruinous for some companies in this position. Imagine in early 2002 a sale at U.S. $1.00 translated back to a fat CAN $1.61, and today it translates back to CAN $1.07.  Meanwhile wages and other costs are paid in Canadian dollars. Unless such a company was extremely profitable at the  2002 exchange rate, it would surely be losing money at today’s exchange rate. In most cases, no reasonable amount of technology improvements or cost-cutting or attempted price increases could overcome this type of reduction in the value of revenues.

Canadian importer/ retailer.

This type of company has benefited greatly from the higher Canadian dollar. Their expenses to import have dropped precipitously. Even after passing some of the savings on to customers, these type of companies will generally have done very well.

What about currency hedges?

Some companies will have hedged against the increase in our dollar. But in most cases hedges tend to be for only a year or a couple of years. It’s not realistic to think that Canadian companies or individuals would have or could have hedged against the rise in our dollar.

What should Canada do about the rise in our dollar?

As demonstrated above, major fluctuations in our dollar against the U.S. dollar cause major positive and negative impacts on various parties.

It may seem unpatriotic to suggest this on the Canada Day weekend, but Canada should seriously consider adopting the U.S. dollar or permanently fixing the exchange rate.

In 2002 as our dollar plumbed record lows, there were calls to adopt the U.S. dollar. That would have caused riots in the Streets. Can you imagine the howls if that had been done? Salaries and the value of savings and houses and everything would have all dropped by about 38% to reflect a 62 cent dollar.

Now, our dollar is tantalizingly close to being equal to a U.S. dollar. Many forecasters predict our dollar will get to parity and beyond. But as demonstrated above a rising Canadian dollar can do major damage. For the first time in over 30 years we have an opportunity to adopt the U.S. dollar at a level close to parity.

If we don’t adopt the U.S. dollar or fix the exchange rate, there is certainly a possibility that our dollar will return to the 80 cent range or below. Currency fluctuations will remain major risk factor for Canadians.

There would be some disadvantages, Canada would lose the ability to set its own interest rates separate from the U.S. I guess from a National pride and sovereignty point of view, that is bad. But I would point out that California has an economy that is larger than Canada’s any yet it thrives without its own currency or its own interest rates.

Canada is very much a global trading country and a huge majority of that trade is in U.S. dollars. The question of adopting the U.S. dollar is worthy of serious debate given the unusual opportunity to do so at or close to parity.

Pensions versus do-it-yourself retirement funds

Many investors are saving in tax-sheltered plans to create essentially a do-it-yourself pension. It’s useful to think about the value of a pension compared to the value of money accumulated in a tax-sheltered retirement account.

A pension plan will often show you a “commuted value” which in some sense is the current value of a pension. In some cases workers may have the choice of taking the commuted value or of taking the monthly pension payments starting at a certain age. At first thought, these might be considered to be equivalent. The pension plan has calculated that it is basically indifferent as to whether it gives you the lump sum or instead pays you the pension starting at a certain age and terminating on your death (or a smaller pension that reduces on the death of you or your spouse and terminates only after both have died).

However, while the pension plan may be indifferent as between the two amounts you will not be indifferent.

If the individual in this case is about start retirement and needs the monthly income, it will most likely be far better to take the pension rather than the commuted value.

Here are some considerations and comparisons between a Pension Plan and a tax-sheltered “pot of money” of the same commuted value.

Factor Pension Pot of Money in a tax sheltered Account
Flexibility Once a pension is taken there is typically no flexibility at all. You will have no ability to change the amount paid out. It’s usually not possible to change course and decide to take a commuted value, after the pension has started. In this scenario, you have some flexibility. You can spend the money as quickly or as slowly as you wish. After some years you could convert some or all of the money into a pension-like life annuity.
Risk of running out A pension by definition should last until the death of the pensioner No guarantees whatsoever on how long the money will last
Risk of Insolvency of sponsoring corporation or government While the existing pension assets are usually held separate from the corporation, there is a  risk that if the sponsoring corporation goes bankrupt and a pension deficit exists, your pension could be reduced.If you have earned a pension from a very weak company, you might want to take the commuted value if you have the chance, to avoid this risk Not applicable
Monthly Payment A pension of a given commuted value can likely initially pay out a higher monthly amount compared to an annuity purchased with that same commuted value or compared to someone managing a pot of money equal to that commuted value.The reason is that the pension can plan on you dieing at an average age. Some pensioners will die young, some will live past 100, but the pension plan can plan for the average. If you are managing a pot of money initially equal to the commuted value of a pension, you will have to assume the “worse” – that you will live to a ripe old age.You therefore will have to initially pay out to yourself a smaller monthly amount compared to a pension of the same commuted value.
Investment Management costs Pensions usually incur modest pension management costs because they pay wholesale rates for this service and benefit from their scale and purchasing power An individual managing their own pot of retirement money could incur high fees to have it professionally managed
Leaving an Estate Depending on the options selected a pension may be guaranteed to pay out for at least 5 or 10 years, and therefore in the advent of the early death of both the pensioner and spouse, there would be something left for the estate.However, after that (usually) short guarantee period, a pension usually simply terminates after both the pensioner and spouse have died. In that case the pension contributes nothing to an estate for inheritance. A self-managed pot of money will not be forfeited on the death of the pensioner and spouse. In Canada it will be taxed as income in the year of death (ouch!). But that could still leave a substantial amount for an estate.If a person facing the decision of taking a pension or a commuted value has reason to think that, sadly, they will die young and if there is no spouse or the thinking is that the spouse also will die young, and if leaving an inheritance is important then this person might want to choose the commuted value rather than the monthly pension.
Fraud Proof If you are managing a pot of money on your own then you would be at higher risk of losing the money to fraud compared to a pension recipient.
Creditor Proof In rare situations creditors might be able to “come after” a pot of money which might not apply to monthly pension amounts.
Inflation Protection Many pensions are partially indexed for inflation, but few are fully indexed. This can definitely erode your purchasing power over the years. A pot of money invested partly or fully in stocks will tend to grow with inflation over the long term. In the short term inflation can hurt stocks, but eventually corporate earnings tend to adjust for inflation.
Risk of senility Not a factor A self-directed investor who becomes senile certainly faces some risk.
Return A pensioner is usually indifferent to the amount of return that the pension fund earns. A pension is not typically ever adjusted up or down for strong or weak market returns. (In rare cases poor returns could eventually lead to pension cuts) A do-it-yourself retirement plan can benefit if higher returns are achieved but suffers if lower returns are achieved.

The bottom line is that a pension versus a individual retirement account of the same commuted value each have their own advantages and disadvantageous. If faced with a choice between the two, it is a complex decision and professional advice should be sought.

END

Shawn Allen, President
InvestorsFriend Inc.

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