A feeling of confidence and optimism


Equity markets ended 2003 like a lion. The S&P 500 index closed higher in six consecutive weeks, the longest such streak for the large cap benchmark since 1998. And the party goes on as of this writing.

There is a feeling of confidence and optimism in the air. Perhaps, the song “Don’t worry, be happy” might come back among the top ten of the pop charts again…

The following table summarizes the price performance of the main indices for the 4th quarter and the year of 2003.

  4th Quarter Year 2003
  In local Currency In Cdn Dollar In local Currency In Cdn Dollar
S&P/TSX (Cdn) + 10.78% + 10.78% + 24.29% + 24.29%
S&P 500 (U.S.) + 11.64% + 7.09% + 26.38% + 4.28%
Nasdaq (U.S.) + 12.11% + 7.54% + 50.01% + 23.78%
Europe (Euro) + 10.55% + 14.58% + 14.25% + 13.17%
Nikkei (Japan) + 4.48% + 4.21% + 24.45% + 13.77%

The US economy is recovering nicely since 2002, courtesy of the stimulative monetary and fiscal medicines applied by Alan Greenspan and his pals at the Federal Reserve. As a rule, economic trends do not change on a dime. Once an upturn takes hold, it sets in motion a chain of events that become self-sustaining. The cycle usually does not end before inflationary pressures surface, forcing the Fed to tighten its policies. Listening to the Fed recently, we believe that loose monetary policy will prevail for the foreseeable future in order to continue reflating the economy. In a sense, they are trying and succeeding, we might add, to avoid Japan’s policy mistakes.

Data also show that a broad-based economic upturn is underway. A very high percentage of economies around the world are expected to record growth improvement in 2004. This broadening out of the expansion is very healthy and should make it more durable. It finally looks like we have dug our way out and are moving into a pretty amazing synchronized global recovery.

The US dollar continues to decline against the Canadian Loonie and the Euro. Its long-term downtrend has further to go although the recent extreme pessimism could fuel a short-term rally in the coming weeks. As crazy as it might sound, the dollar weakness is a plus for the US economy. Coupled with the synchronized global upturn, US exports could be up nicely, narrowing the so-called trade deficits that most economists have been relentlessly criticizing.

Oil prices have gone up further, testimony of an economic recovery but also of a weak US dollar. If they were to honor their commitment, OPEC should be increasing production in order to lower and stabilize prices around US$ 28.00 per barrel. For now, they have decided not to. Then again, why should they? In fact, especially for the Middle East countries, they are being paid with an eroding currency (the US dollar) while their families are spending Euros buying consumer products in London and Paris. For the sake of comparison, oil price has gone up only 10% in Euro and Cdn dollar while it has gone up 35% in US dollar….

Which brings us to address investors’ concerns regarding several issues:

1. The decline of the US Dollar, its demise and the possible rise of the Euro as the global reserve currency

This will not happen anytime soon. The Euro is not without merit and global demand for it will probably rise in the medium term when countries continue rebalancing their reserves to better reflect with whom they are doing their business (for a long while, everybody just kept US dollars in their reserves because they had no confidence in any other currencies). However, Europe is a collection of disparate economic, social, cultural members sharing a single, and not always appropriate, monetary policy. The recent disagreement on the Stability and Growth Pact - between France and Germany on one side, and Portugal, Spain and Italy on the other - is testimony of more trouble and disparities to come, as several Eastern European countries join the Union. Let us not forget also that Western Europe, in particular, has a grim demographic profile that does not support exciting growth prospects while the US is still the land of opportunity, with the best demographic profile of any major country. It is still one of the most dynamic economies with the deepest and most liquid capital markets, coupled with an entrepreneurial culture and the least amount of government intervention.

Let us not forget another very important point: The US is the only country that can borrow and pay its bills in its own currency, i.e. all the currency risk is borne by foreigners. As long as they have the ability to force their creditors and trading partners to take US Dollars as payment, it will stay as the global reserve currency. That does not mean that it will be stable. Actually, it could even mean more extreme volatility as the US adjusts itself to the reality of globalization.

2. The debt bubble and the ultimate “day of reckoning”

It is true that US household debt has been climbing steadily since the post WWII period. On several occasions, economists were sure the debt load would create havoc on the US economy. Yet, it managed to defy expectations and keep growing from expansion to expansion. Ultimately, the doomsayers may be right but the fact is that, for the last 50 years, it has been a pretty dumb idea to bet that the American consumer cannot handle ever-larger sums of debt. We all know that debt cannot rise faster than income indefinitely. However, it is difficult to know where the limit is. Besides, rising debt levels do not mean the same consumers and companies taking on increasing amount of debts. Access to credit has become much easier over the last 50 years thanks to the development of more sophisticated financial system and products.

Loans and mortgages have become more widely available, thereby raising the ratio of debts to incomes. Low interest rates have also contributed their share in raising debt levels by making the carrying cost of a mortgage more affordable.

We are not saying that the household sector is in great shape. We are merely pointing that it is not Armageddon. Obviously, if a recession occurs for other reasons, then consumer indebtedness will worsen the situation. We believe that a debt problem can only be solved with time, and considering the size of the US debt load, it will need a long time.

3. The Real Estate bubble

House prices have definitely risen steadily in recent years. People have allocated more of their capital in real estate but that reflects their disillusion regarding the lousy returns on the equity markets over the last several years more that the wild speculation we witnessed in the late 80s when people were buying for a short-term gain. Even at these price levels, housing is still quite affordable in general thanks to low levels of interest rates.

It is always dangerous to generalize about real estate market because conditions vary so much from region to region. At any moment in time, there could be some “mini-bubbles” in the making. However, according to the Bank Credit Analyst, National house price index in the US has never recorded an annual decline since the 1930s. We venture to say that the Canadian situation is quite similar (except maybe Quebec that has had its own cycle mainly related to the separation issue).

4. The “sucking sound” coming from China this time, stealing manufacturing jobs from the US

For those who believe this is the case, let us dispel this nonsense through some data we have gathered in a study by the economic research department of Alliance Capital Management: from 1995 to 2002, China actually lost 16 millions manufacturing jobs, a 15% decline while during the same period, the US only lost 2 millions manufacturing jobs, or an 11% decline. Canada, on the other hand, has seen an increase of 20%.

Job losses in manufacturing are not merely a problem in the US but a problem for the entire world. Jobs were lost to better machinery, better computers, better robots and better productivity. Yet, output has risen steadily, rendering consumer products more widely available and affordable.

It is very likely that the manufacturing industry is following the footsteps of the agricultural sector in the early 20th century: the percentage of the working population in the agricultural industry has fallen steadily over the last 100 years from 30% to less than 2%. Yet, farm output keeps rising thanks to better equipment, chemicals and fertilizers and as Martha Stewart would say, “it’s a good thing”. This is the nature of progress. Thank god because the alternative is not so appealing: would anyone like to go back 200 years, when hunter gatherer societies offered full employment for all, devoting all the resources toward providing barely the basic necessities of food and shelter?

5. The corporate scandals in the US are undermining investors’ confidence in the financial markets

We, like most investors, find appalling the fact that some corporate executives had, fraudulently or not, amassed such big fortunes to the detriment of shareholders and got away with it. We also find that in the case of fraud, the punishment inflicted on the criminals is not commensurate to the crime committed. However, let us not fool ourselves into believing that corporate scandals are the main culprit here. Greed is the single most important factor for the tech bubble of 1999-2000 and its ensuing collapse. The same is true for any other bubble in market history. Scandals are actually the offspring of such euphoric periods. Investors lost trillions of dollars when the market collapsed compared to a few billions of dollars on some corporate scandals (by the way, 1 trillion is equal to 1,000 billions, to put things in perspective). While we should not dismiss all these scandals as a non-event, we believe that, in general, investors have themselves to blame for their greed during those euphoric periods.

As you know, the year-end comments always include some of the extracts from our readings throughout the year that we find enlightening and we quote them as they are written by their authors. This year, we found one that really stands out. Here it is:

Regarding the stock market

[Herb Stein was probably the nation’s most influential Republican economist back in the 1970s. One of his famous quote eventually became Stein’s law that says: “If something can’t go on forever, it will eventually stop”.]

“…most days we can observe in the market what at first looks like the opposite principle at work: “Whatever has been happening for a while is likely to keep on happening a while longer, even if it no longer makes sense”. One reason for this is that lots of market phenomena are driven by positive-feedback loops…[lower interest rates improves borrowers’ financial conditions which in turn allows them to borrow more]…So things go on longer than they should, but, as Stein points out, not forever. Make money cheap enough and any bad idea can look good enough to fund…

“…The market abounds in these positive-feedback loops. They are a thing of nature, rather more to be expected than not…The market’s natural inclination is not to moderate itself but to run on headlong until it finds a brick wall, a.k.a. Stein’s law.

“…market behavior is terribly difficult to predict in detail, or with any precision as to timing. And yet it is often surprisingly easy to see that a market trend is pushing the limits of Stein’s law. Markets may be hard to parse, but brick walls stand out like, well, brick walls. Equilibrium may be a myth, but severe disequilibria are easily observable.” (A. Redleaf & R. Vigilante)

The Claret Team

N.B.: As you know, we don’t make forecast on the market because we always believe that selectivity is more important. We use a bottom up approach to choose the securities we invest in and let others read the tea leaves. But if we have to make a comment on the outlook for 2004, we would say that it is difficult to find bargains these days. As an analogy, we would say that we are still dancing at the party but we are doing it close to the exit.