Markets started with a choppy uptrend

Quarterly Letter

Markets have started with a choppy uptrend and ended the quarter up 5%, despite a sharp correction in January. Our outlook has not changed. We still expect a moderately good year for the stock market punctuated by a correction sometime during the year. The earlier the correction comes, the stronger the recovery will be before the end of the year.

Our road map has not changed. We still favor equities and shun long term government bonds. Most of all, investors should stick with the asset allocation that keeps them in their comfort zone. Volatility creates high emotional shifts, which might be good in love but not in investing.


We rarely talk politics in our quarterly letter because it is a sensitive topic. Our clients hire us to make money. They do not necessarily share our vision of the world and might not agree with our political opinions. Besides, we sometimes act against our own opinion in the name of returns. For example, we agree that smoking is harmful to our health, yet if tobacco stocks get too cheap, we certainly will buy them.

Since the beginning of the financial crisis, we have noticed that governments around the world, taking advantage of populist ideology among the people, have moved in to regulate the private sector.

The world’s financial industry is facing a plethora of new regulations with the objective of trying to avoid the next disaster.

The health care industry in the US is slowly being nationalized in the name of universal coverage. President Obama and the democrats are trying to make the American People believe that their health care reform will cut the deficit in 10 years. Yet, they can’t even forecast next year’s deficit…

Through fiscal stimulus, spending from governments is taking over those of the consumer, whom are so stretched in their own finances that they are forced to save. Consequently, public debt has ballooned to levels never seen before, in absolute terms and, in some cases, relative terms.

Despite all the hiring by governments (the US government has hired 1.2 million workers for the census) and a slow recovery, most analysts believe the unemployment rate will stay high for many years to come.

So, in this letter, we will try to address some of these public concerns and/or policy debates that you have undoubtedly read in the newspapers over the last couple of years. As we give you our “two-cents-worth”, we would like to remind you that you don’t have to agree with us. After all, it is only AN opinion.

Are the investment bankers to blame for the financial meltdown?

Partly, but bad government regulations are also responsible.

We don’t believe that investment bankers purposely operate outside the laws. However, they do lobby congressmen and politicians to get what they want. It is actually the regulations from congress that set the stage that eventually led to the financial meltdown. Moreover, by keeping interest rates low, the Federal Reserve also ended up encouraging speculation in real estate. The investment bankers are basically greedy opportunists (and that is not illegal).

However, when speculation leads to mortgage brokers helping potential borrowers lie about their income to get their mortgage approved, and investment banks taking on debt to an obscene leverage ratio of 40 to 1, we can safely say that the main culprit here is the compensation system across the financial industry. Mortgage brokers are compensated on getting mortgage approved. Investment bankers are paid by getting more mortgage deals done. Securities brokers are getting paid by selling mortgage related securities (CDOs, CDSs…). Proprietary traders within banks are getting their bonus by using leverage to speculate.

Leverage is a time bomb that eventually blows up. Yet, leverage is to some investment bankers what performance enhancing drugs are to some athletes. They can’t help it. It is ultimately up to each company, supported by its shareholders, to set a compensation system that includes “financial punishment commensurate to the crime”.

Why is government to blame in this mess?

Campaign lobbying contributed greatly to an environment where regulations become lax, setting the stage for questionable policies (or lack of) during the first half of the decade. Stealth leverage ensued, aided by complex legal jargon and accounting rules that allowed companies to hide their debt and/or its quality from their shareholders and regulators.

Can government involvement help fix the system?

Yes, but only by setting strict capital requirements for the banks and harsh punishment for bankers who break the rules. Furthermore, government should focus on better regulation and not more regulation. Unfortunately, we don’t think the political will is there, especially in the US Congress.

In the financial reform debate, democrats want to impose a fee on large financial institutions for being covered under the government’s “too big to fail” policy. It looks to us like a government backstop policy. Wouldn’t this be an invitation to recklessness and overleveraging, the same behavior that brought us to the current sorry state in the first place?

The US government therefore is introducing a new array of regulations that give it oversight on different banking businesses, their size and pay packages. The irony is the following: if regulators couldn’t see what was coming in 2005 with the real estate bubble, what makes them more visionary when the next disaster hits?

Politicians like regulation in general because it gives them power. We are not against the rule of law because we truly believe that a capitalist society only exists because of the rule of law. However, when regulation goes overboard, innovation ceases and fosters a stagnant economy. In general, too much regulation increases the cost of doing business for the small and medium entrepreneurs who make up the bulk of economic growth. It discourages hard work and encourages bureaucracy.

Will deficits and debt sink the US economy?

Not necessarily. In order to answer this question, we have to think in terms of balance sheet: assets, liabilities and equity. High deficits and debt are manageable if income and assets are growing. For a country, income means its GDP. Therefore, high deficits and high debt problem can be fixed by encouraging growth, in other words, by implementing pro-growth regulatory and fiscal policies. On the other hand, policies that do not foster growth lead to stagnation like Japan and California.

The US needs a better balanced congress and senate in order to move the country in the right direction. As surprising as it might sound to you, the US still has the benefits of positive demographic trends, strong entrepreneur spirits, innovation and creativity.

Will the Loonie stay strong?

For now. We are a “petro-dollar” country, after all. As commodities prices stay strong, so will our Dollar. However, we should not loose sight of the cyclical nature of commodities prices.

Recently, the world has embraced our financial system model for its solid state. Our 6 banks stood the test of a financial meltdown and came out well capitalized. Consequently, there is a flow of institutional money into Canadian Dollars to purchase our bank stocks.

Ultimately, a stable Dollar is better for our economy than a volatile one, as we are recently witnessing. Volatility increases the cost of doing business for manufacturing companies in general. Let us not forget that we can’t build a solid country by selling all our resources. In accounting terms, it will be like selling assets and book them as revenues. Eventually, it will catch up with us.

Is inflation or deflation a greater threat?

Unfortunately, we believe that we are stuck in a confusing period for some time. On one hand, we know every country has printed too much money and it is inflationary. On the other, advances in technology have driven consumers’ products prices down by improving production efficiency, globalizing manufacturing facilities and benefiting from low wages in developing countries.

This may be the reason why the Consumer Price Index barely nudged over the last decade while commodities, relatively untouched by all these technological improvements, have soared.

As no one can predict the end of technological innovation and creativity and as governments have a bias toward printing money (to lower the cost of paying back their debt), we actually do not have an answer to this question.

Is China a friend or a foe?

Mostly friend, but…

China’s main concern is “internal security”. In order to keep its people employed, China needs a GDP growth rate of 5% or more. Its political leaders understand that disruption of growth could spur social unrest, a potentially uncontrollable situation not to be underestimated, especially in a country of 1.2 billion people.

In its quest to become a world power, China is trying to strike the right balance between keeping a low profile and exerting its growing influence. As a result, Chinese leaders will fumble from time to time in their policies. As Dens Xiaoping summed up the US-China relationship in an epigram in the 1980s: There are inherent limits to better relations and inherent limits to bad relations.

The fundamentals of the two countries’ strategic interests will prevent the complete severing of cooperation. China needs the US export market, investment and technology; America needs the low cost daily necessities made in China to fill the Wal-Mart stores.

Cooperation will continue regardless of periodic conflicts. Besides, what will newspapers write about if there are no bad guys to beat on?


We welcome your comments and questions at all times and we will try to address them in the next quarterly letter.

The Claret Team