2007 : A year marked by high volatility

Quarterly Letter

2007 was a year marked by higher volatility than investors were accustomed to since the beginning of the current bull market of 2003. Particularly, Canadian investors had to contend with the combined effects of a strong Canadian dollar, a decline in the US housing market, credit market turmoil, falling metal prices and the prospect of slower global economic growth.

Moreover, all the appreciation in the Canadian market was concentrated in just a few stocks. In other words, if investors did not have Research in Motion, Potash Corp. and Alcan in their portfolio, their returns would have been substantially lower than the benchmark index.

The following table summarizes the price performance of the main indices for the fourth quarter and the year of 2007.

  Fourth Quarter Year
  In local currency In Canadian Dollars In local currency In Canadian Dollars
S&P/TSX (Cdn) -1.89% -1.89% +7.16% +7.16%
S&P 500 (US) -3.82% -3.24% +3.53% -11.34%
Nasdaq (US) -1.82% -1.22% +9.81% -5.96%
Europe (EUR) -3.14% -0.34% -0.09% -5.43%
Nikkei (Japan) -8.80% -5.71% -11.13% -18.89%

Adding insult to injury, since the Canadian economy is a mere 3% of the world economy, most Canadians have been conditioned to diversify their portfolios geographically, mainly by buying US and international stocks. 2007 was a difficult year to be outside of Canada mostly due to exceptional appreciation of the Loonie (a gain of 15%). As the table above shows, most markets had a negative return in Canadian dollar terms.

Oil finally surpassed the US$100 a barrel milestone on Wednesday, January 3rd, creating front-page headlines warning of trouble ahead. The obvious question that comes to mind is: “will the economy falter because of high oil prices”?. Common sense tells us that higher oil prices are an economic drag and when oil prices rise, stocks fall. But is this in fact correct?

It turns out that historical data on oil and stocks prices are not correlated, i.e. one being up does not send the other up or down. In fact, we cannot find any long-term meaningful relationship between the two variables. It is like stating that any given year that the NFC wins the Super Bowl, the market will go up more often than not. It is in fact true but cannot be explained.

As for high oil prices being an economic drag, there will be a level when it becomes one but we are nowhere near there yet. We are actually less energy dependent today than decades past. In fact, only approximately 5% of disposable income goes toward energy expenses versus 8-9% back in the early 80s. The way we see it, strong demand for oil reflects a strong global economy whereas radically decreasing oil prices would be a sign of weakening demand, which is not necessarily a good thing.

The price of gold has been on a tear lately and conventional wisdom dictates that gold is a good hedge against inflation, recessions and bear markets. Yet, over the last several years, inflation has been tame, stock prices have risen steadily but so has the price of gold …a hedging instrument does not behave in this manner.

Our read is that as the global economy grows, nations get wealthier and demand for gold as a commodity, strengthens. Since the supply of gold is relatively fixed and predictable -- new mines are difficult to discover and build -- excess demand could very well be the reason the price of gold is so strong and thus, not necessarily impending inflation.


As 2008 begins with a 16-day US stock market decline of close to 9%, there is a growing concern that the US economy is entering a recession, if it is not already there. Words and sentences like stagflation, credit crunch, the sinking US housing market, federal deficits, foreign creditors buying America, a weak US dollar and its effect on global economies and stock markets fill our daily newspapers and spreads fear among investors. Let us play the devil’s advocate and give you our point of view.

Stagflation was a term invented in the 70s to describe runaway inflation and stagnant economic growth. Despite what you read, inflation remains relatively low and contained. In general, we tend to only notice items that cost more today than they did a year ago whereas we disregard those that actually cost less, such as electronics, clothing, shoes etc… If inflation is currently a concern, it is certainly not showing up in the rate of return on long-term bonds, which has been sliding steadily lower. The way we read it, the market is telling us that it does not expect runaway inflation.

However, if agricultural commodity prices get out of control, it can lead to inflation in food prices. That would be troublesome as interest rates have little effect on taming food price inflation. For example, if wheat was to reach its level of 1970, it would have to rise by 60% from today’s price. To reach its all time peak, it would have to rise by more than 500%....

As far as growth is concerned, every quarter’s GDP growth was positive. The US economy is expected to have grown 2.2% last year. For the record, a recession is marked by 2 consecutive quarters of negative growth. Our guess is that the pessimists will have to wait for at least 6 more months to see if their dire prediction comes true. In the meantime, as for stagflation, let us say the facts do not confirm the media hype.

Now let’s discuss the credit crunch. We acknowledge that the US subprime market has been quite damaging to the financial sector, especially the banks involved. It is estimated that by the time this whole mess is over, it will cost the global banking system anywhere from US$ 250 billion to US$ 600 billion. While this is a huge figure in absolute terms, let us put it in perspective: the equity base of the top 100 banks in the world is close to US$ 6 trillion. This fact means that at worst, banks will lose 10% of their equity. To put it differently, banks certainly have caught a cold but nowhere near pneumonia.

If this credit crisis happened 30 years ago in the US, it would have probably created a widespread recession. Fortunately today, thanks to globalization, US banks have been getting capital infusions from home as well as from overseas while others are being acquired by much stronger rivals.

An interesting feature of today’s credit problems is that as of yet, no major player has declared bankruptcy, which was usually the case in past financial crises. But is being acquired a disguise of bankruptcy? The conclusion is the same: the troubled bank’s stock price collapses, an acquirer comes to the rescue, buys the troubled bank’s assets for a huge discount, hopefully fires the incompetent management team and redirects the operations on the right path. Just the fact that banks are able to buy each other is a testament that they are not in as bad a shape as you’d gather from media headlines. As for the capital infusion from overseas, why should one care who is putting the equity in banks, as long as banks fulfill their first and foremost responsibility of providing credit?

How about the sinking US housing market? You would not believe it but the aggregate value of real estate assets were actually slightly up according to the Federal Reserve’s latest report. While prices were down, new construction won the day, boosting the growth rate into just positive territory.

Let’s take a look at the US federal debt problem. Apparently, it is growing at US$ 1 million a minute. So, who owns this debt anyway – US$ 9 trillion and counting? About US$ 4 trillion is held by US government agencies like Social Security. Of the remaining US$ 5 trillion, US$ 2.9 trillion is held by the American public and the balance by foreigners. In sum, American individuals, corporations or government agencies hold 76% of the government debt while foreigners hold 24%. Now consider this: if the US level of debt was truly problematic, would interest rates on US government bonds remain so low? If investors saw risk in lending to the US government, they would be demanding much higher rates. The reality is that there is no safer place to invest than US bonds. While interest payments for 2007 amounted to US$ 430 billion (big scary number), total tax receipts were US$ 2.6 trillion – giving the government a very healthy debt service ratio of 6 to 1. One day, America might indeed have too much debt but that day has not yet arrived.

As far as foreigners buying America, we are still not sure why people would worry about high demand for US assets. On balance, foreign investment helps strengthen US financials when it is needed (like now) – a wonderful example of globalization of capital markets functioning properly. Similarly, the US is also investing all over the world and in gigantic proportions. In the end, protectionism, whether in trade or capital markets, is bad for an economy. Politicians should refer back to their history books to revisit the actual outcome of the disastrous effects of protectionism.

Finally, the weak US dollar has worried a lot of Canadians recently, especially after 20 years of being told to diversify internationally and reaping the profits of a weakening Canadian dollar. Let us not forget that the Loonie is a cyclical currency, highly sensitive to commodity prices. Therefore, to focus solely on the Canadian dollar vs. the US dollar is misleading (in 2007, the US dollar depreciated 15% versus the Canadian dollar). Against a basket of major currencies, the US dollar is down approximately 8% for 2007, a far cry from 15%! Currencies bounce around all the time. What is weak today may be strong tomorrow for no other reason than normal market volatility.

Trying to pin currency movements on deficits, economic growth or other causes is extremely difficult and may lead to inefficient asset allocations. In any case, we should remember that US dollars are still the global currency standard. Foreign investors now hold US$ 2.25 trillion, mostly in public debt, of this amount, foreign central banks hold US$ 1.25 trillion (Japan holds $582 billion, followed by China with $400 billion and Britain at $266 billion). The most fundamental reason for holding the greenback is stability and there is no other country that provides a similar capital friendly environment for investors. You can be sure China does not hold all its US dollars because they are making a currency bet. It is all about stability and strength.

Some believe the Euro will eventually replace the US dollar as a reserve currency, we think their enthusiasm is a little premature. It is still unclear how effective monetary policy among a group of culturally different member states will prove to be anyway. If push came to shove and a global crisis ensued, we are not sure the EU would stay together and support a common currency. Then what would happen? In fact, we believe the Euro will not exist in its current form within the next 20 years.

Although we might sound a little off the wall in terms of optimism, our main goal here is to put things into perspective for you so that you will not be influenced by the media. The main weapon used in this fight against headlines is the principle of Market Efficiency: if a news’ story – no matter how good or bad it may seem – is already widely known, it no longer has the power to move stocks much. This is not to say, however, that market efficiency is absolute. Markets are efficient only in intermediate and long-term horizons but in the short-term, fluctuations (sometimes quite violent), can be driven by sentiment having little to do with fundamentals.

Always remember that the media’s goal and yours are quite different. Reporters are paid to report, not necessarily analyze. More importantly, media outlets make money by selling news. They compete to get your attention with sensationalized, eye-catching headlines (sometimes quite misleading). Which emotion gets your attention the most if not the fear of losing money?

In conclusion, let us refer you back to the last quarter end comment regarding the market. Every couple of years, a major event happens and captures the attention of the media. It spreads like wild fire and everybody has an opinion on it (or has read an opinion that they decide to adapt for themselves), going from recession to major economic collapse. Yet, if you had invested 40 years ago in the Dow Jones index and fall into a deep coma until today, you would have skipped at least 16 major events and made roughly a compounded annual rate of…10%. Not bad for having slept through it all! Then again, maybe investors are not looking for returns, maybe they are looking for excitement, which the media gladly provides … for a fee …

Happy New Year from the Claret team!