Welcome to Views from the Crow's Nest for April, 2010.

Most stock valuations are stretched, GDP and profit growth projections are laughably high and sovereign debt issues continue to rumble. Yet, here we are in mid-April 2010 and markets just seem to keep grinding higher, with the TSX just above 12,000 and the S&P 500 just under 1,200.

It’s been said that politicians and logic have never been caught in the same room together; the same is true about the investing public. During rising markets we commonly observe that investors ignore bad news and focus only on the good stuff, leading to the expression “climbing the wall of worry.” The brilliant investment pioneer James Dines   catalogued his accumulated market axioms, the first of which is “A trend continues until it actually changes.”Such is the behavior of today’s investors and the mainstream media. The only people with shorter memories than voters are investors…until there’s an election. Trends trump reason every time.

There are glimmers of economic hope emerging from some sectors. What we find amusing is that bad news is ignored, and when current data is compared to horrible one year old numbers my mind flits to Shakespeare, specifically “Much ado about nothing.” There are some positive shifts showing up in some regions and countries, including Canada. What is often forgotten is that markets are leading indicators of economies, i.e. they anticipate what will happen. The glimmers of hope that many investors are pointing to today as reason to finally get back in now have been priced into the markets for 6 to 9 months.

In modern culture, optimism and pessimism have taken on a certain moral character-optimism is good and pessimism is bad. We strive to approach things in a state of objective observation, being neither Bulls nor Bears. We prefer to be realistic about the future and seek to understand what is driving current trends, leading to clues of what might be the catalyst for a genuine trend change. We recognize and embrace the longer term opportunities in various sectors including commodities, precious metals, Emerging Markets etc., but resist being rigidly fixated on these themes because of short-term risks. Timing is everything.

For the short term at least, markets are trending higher and that matters most. Client portfolios are mostly invested, with some cash at the ready to pounce on emerging opportunities while being vigilant for the early signs of important inflection points that lead our portfolio managers to reduce exposure to market risk. Ride the Herd but don’t become one of them.

It’s the early stages of earnings season and some positive results could drive equities higher, possibly through May or June. As always, our portfolio managers have tight stops under all positions and are happy to go to cash or even go short temporarily with portions of capital in Growth mandates if that’s what markets dictate. We prefer to flow with the markets rather than delude ourselves into believing we can make them do what we want.

Governments, households, and many corporations are over-burdened by a massive amount of DEBT. Unfortunately, politicians who are NOT financially independent seem to want two things for themselves: 1) to get elected, and 2) to get re-elected. Without the tether of a Gold Standard, governments have been borrowing without material restraint to finance the present-day needs and desires of the voter. The rationalization has been the false assumption that steady economic growth would continuously expand the tax base and allow these debts to be paid off DOWN THE ROAD. Where are the brakes?

And now, most major economies have rapidly aging populations, which will reduce their future growth, leave the ongoing structural burden to be financed by a shrinking workforce, while increasing demands from healthcare. This will necessitate cutbacks to Canada’s programs, resulting in a dramatic increase in the importance of being proactive in managing one’s own health, and taking important steps to maintain independence and dignity as we age.

“Obamacare” Meanwhile, Barack Obama et al have managed to push through his legacy issue before the November Mid-Term elections shift the balance of power in Congress. U.S. politics is becoming radically polarized over this issue, with intensifying ideological rhetoric on both sides. When we dig in our heels, we also dig a hole for ourselves. What are the relative costs of publicly funded wars versus publicly funded healthcare? If the Americans pull in their military horns, who becomes the world’s unpaid police force? Do we really need one? These are big questions to ponder, with no easy answers.

Easy Money? “Quantitative Easing” is central banker code for expanding the money supply, now facilitated by simple electronic journal entries by central bankers, and serves to dilute the value of every fiat currency on the planet. Today we’re in the midst of competing currency devaluations, with governments pushing their own currency down in order to make their exports attractive to foreigners, and imports unattractive to their own citizens. We already have trade wars by “currency stealth” and as investing legend Jim Rogers says, “No one has ever won a trade war.”

Eventually all systems run their course, and unsustainable models implode. As far as government debt burden goes, we’re much closer to the breaking point than most people realize…not just Emerging Market countries, Greece or the other “PIIGS” countries in Europe.

This is a major problem for the entire European Union including Germany, the U.K, U.S., and Japan. Canada’s fiscal situation isn’t good, only less bad. The risks previously detailed in this newsletter continue to worsen, and the list expands daily. Why does this go un-reported by the mainstream?

“Credit” derives from the Latin word credere –to believe. Lenders must believe the borrower will repay interest and principal in a sound currency. Government over-spending can’t continue indefinitely because investors eventually reach a tipping point and stop believing in the borrower. Lenders demand more return for the increased risk, forcing increases in interest rates beyond the control of central bankers, putting even more pressure on governments’ ability to re-finance maturing debt while higher interest rates slow domestic private sector prosperity, reducing the very income tax base that governments need to service their debt.

This vicious circle of historic magnitude is just getting started, and it will devastate those who simply hold bonds and Preferred Shares (for their tax-efficient yield) because they continue to believe they are “safe.” We believe that sovereign debt defaults by some of the riskier borrowers are likely in the next year, but hope we’re wrong. When (not “if”) this happens, it’ll start the domino effect and could be the emerging seeds of serious price inflation.

With this global debt burden as the backdrop, we do not view the market meltdown and partial recovery of the last 21 months as being a short-term crash before a speedy return to the halcyon growth periods of past decades. We are not – in our opinion – in a new bull market. We view the last 21 months as the early visible stages of a global “economic right-sizing” which has not yet fully run its course. Looking back, the major peaks in the US occurred a full decade ago, but have been masked by rapid credit expansion and the very real distractions of terrorism, overseas wars, political turmoil and our busy daily lives.

The terms used by mainstream media to describe our current situation have not yet started to include “Depression,” and in fact have recently shifted back to “Recovery” because they have the attention span of hummingbirds and understand almost nothing about economic realities. In direct contrast to this “Happy Days are here again” mentality, we believe that we are in the early stages of “The Second Great Depression.” This is not necessarily bad news for investors because all crises also contain opportunity. Awareness and agility are the critical factors that can turn this into a good news story for you.

One of the most obvious signs of a Depression is massive price deflation, recently visible in shrinking stock markets globally and real estate values in the U.S. and parts of Europe. Here in Canada we also face significant risk to real estate values precisely because so many people are in a frenzy to buy it, especially in Vancouver, Toronto and Calgary. To think that Canada or specific cities are immune to the realities of houses becoming unaffordable is wishful thinking. We all eventually feel the effects of our decisions, good, bad or neutral.

No one can know with absolute certainty exactly how long the deflationary cycle will last, but we believe this could take between 5 and 12 years to fully correct. Japan is in year 20 if its deflation, with no end in sight. Along the way there will be pockets of safety and prosperity, and significant opportunities created for those who do not ride these markets down again.

In our opinion, this recently started structural deflation will be followed eventually by significant inflation, possibly a hyper-inflation when we eventually see the Velocity of Money cycle back upwards, with mountains of newly created currency chasing a finite number of goods and services. Surviving and prospering in this environment will be challenging to say the least and only time will tell for sure.

We hope we’re wrong about the potential for a hyper-inflation, but the very fact that we are aware of its possibility allows our portfolio managers to actively shift allocations to take advantage of such adverse conditions, instead of being victimized by them.

Past manias and financial crises have shared many common characteristics. In my daily research I recently found an interesting list on Mish’s Global Economic Trends Analysis about the great bubbles over the past three centuries, condensed below.

1. • Great investment debacles generally start out with a compelling growth story
   

2. • A blind faith in the competence of authorities
   

3. • A general increase in investment activity
   

4. • Great booms are invariably accompanied by a surge in corruption
   

5. • Strong growth in the money supply leads to financial fragility
   

6. • Fixed currency regimes often produce inappropriately low interest rates, which are liable to feed booms and end in busts
   

7. • Crises generally follow a period of rampant credit growth
   

8. • Moral hazard
   

9. • Financial structures become precarious
   

10. • Dodgy loans are generally secured against collateral, most commonly real estate.
    

Does any of this sound familiar?

It would be naïve to believe that we will be buffered against future destruction of financial wealth, unless we actively do something about it.

Those who emerge from this period with their purchasing power intact (or better) will be set for decades, precisely because they won’t need to start over in their wealth accumulation. Don’t ride the next downturn, and get your assets positioned to prosper before you miss the next rise.

 

That's all for this issue of Views from the Crow's Nest. Please forward this newsletter to anyone you think might benefit from the information. 

 

If you're not already a member of our Client Family and are curious about how we might be able to serve your family, please call us at 403-517-2234 or click here: andrew@integratedwealthmanagement.ca

 

Cheers,  

 

Andrew H. Ruhland, CFP, CSA

Wealth Management Advisor

President, Integrated Wealth Management Inc.