The worst return since the fourth quarter of 1987

Quarterly Letter

The bear market continues its ravage and delivered the worst return since the fourth quarter of 1987.

The following table summarizes the price performance of the main indices for the third quarter of this year.

Indices In local Currency In Canadian Dollars
  3rd Quarter 3rd Quarter
TSX (CAN) -13.51% -13.51%
S&P 500 (U.S.) -17.63% -13.86%
Nasdaq (U.S.) -19.90% -16.23%
Europe (Euro) -23.17% -20.04%
Nikkei (Japon) -11.66% -9.39%

The underlying economy starts showing signs of weakening, albeit very little. Interest rates are stable. Unless consumer spending falters rates will likely stay at the same level.

The Canadian Dollar has given up more than half of the gain acquired in the second quarter while the Euro has been fairly stable around parity. We do not have any insight regarding these currencies except to say that it is not wise to bet against the U.S. Dollar for the foreseeable future.

Oil price went up to US$ 30.00 at the end of the quarter but has receded toward US$ 27.00 as we write this comment. Cheating among the OPEC nations has become endemic again…or should we say cheating is the norm again. Saudi Arabia is quietly but consistently increasing their production. Their problem is that as they increase their production capabilities, they are not able to sell the oil they can produce as the other OPEC members cheat even more openly.


The natural question that stems from such a bad quarter return is how did the market perform after such a poor performance? Statistical research indicates the market has tended to outperform strongly after an extremely poor performance. In fact, since World War II, the market has never failed to be higher one, two, three, four or eight quarters after a 15% decline. One could take this to mean that if we are not entering a period of sustained deflation, the market could be near a cyclical bottom.

We do not pretend to know what the market will do over the next few years. However, we would like to point out several observations over the last few quarters that are of interest to investors:

  1. With all this hostility to corporate leaders, we believe that the stock market has already priced in most of the bad news. Today’s anti business reactions parallel that of the 1903 bear market, known as the Rich Man’s Panic. Then, Teddy Roosevelt lectured business on integrity. Today, very ironically, our politicians are lecturing business about ethics.

  2. Although profits seem to still be falling, what most analysts overlook is that operating income is rising. The operating margin is the most basic efficiency ratio for a company. Without write offs, earnings would rise nicely now. Profits are about the past. Operating margins are about the future.

  3. Insider transactions have shifted from bearish to bullish. Earlier this year, insiders sold about 4 shares for every one bought. In July, that reversed itself to two shares purchased for every one sold.

  4. We all know small investors exit near market bottoms and they are exiting in droves judging by the mass redemptions of equity mutual funds in July, August and September of this year. They also typically purchase real estate when they get out of the equity market.

  5. Almost never is a “third year” of a president’s term a down year. The last time it happened was 1939 and then the Standard & Poor’s 500 was down a mere 0.4%. The median “third year” return of the S&P since inception is 22.8%.

  6. We have been told that profits are declining in the US, have been doing so for years and will continue to do so into the future. Yet, after having analyzed profits as a percentage of GDP since 1946, we note the cyclical nature of this number. It varies rather materially from 13% in the early 50’s to 6% in the early 80’s. Presently, it is at 7.6% and rising towards the mean of 9%. We would argue that not only is the US economy not heading toward some sort of deep crisis, it is actually behaving normally through its cyclical nature.

  7. Over the last few months, companies have been criticized for playing with pension fund accounting to smooth out their reporting income and meet analyst’s forecasts. In the past several weeks, a number of companies have warned that they will take charges to cover pension plan shortfalls or inject more cash into under funded plans. This move in turn will lower earnings and stock prices, as we are told. We cannot agree more with the need to revise downward the actuarial forecasts for pensions. However, we believe the effect upon share prices should be minimal. Although the doomsayers would like you to believe that the earnings diverted from company balance sheets will simply be lost, the reality is that they will not. Instead, they will become investment in pensions and find their way into debt and equity markets.

Do we look for a return of the raging bull of the late 90’s? Very unlikely. Instead, we look for a market with wide trading ranges for the next few years as the economy repairs itself from the excesses of the bubble of 1998-2000. As portfolio managers, this is the best market scenario we can hope for because it will definitely favour fundamental analysis over indexing strategies, which, over the last 2 decades, have made life difficult for the stock-pickers. From 1982 to 2000, interest rates were the main factor driving stock prices upward. In the coming years, we venture to say that sales, operating margins and cost controls will likely be the “things to watch for”, and we are watching them closely.

The Claret Team