July Market Update from Kelowna

We are increasingly confident that the 2007-2009 bear market lows reached on March 9, 2009 will hold. Usually, if a bear market low is tested it happens within six months. We are already four months off the March 9 lows and it looks doubtful that these levels will be retested. Most of the world’s leading stock indexes have increased 40% or more from March 9 to June 12. The S&P 500 increased 39.9% and the S&P/TSX increased 41.6%. Since June 12, the stock market has experienced a mild correction of between 7% and 10% thru July 10. The S&P 500 has dropped 7.1% and the S&P/TSX has declined 9.9%. We believe that this correction phase is likely over now that we have entered the second quarter earnings reporting season. As in the first quarter, we believe that corporate earnings reports for the second quarter will be better than expected. This should propel the market higher as investors gain confidence that the worst of the profits reports are behind us.

Investor and consumer confidence is gradually returning. We have noticed a positive change in sentiment. While there are still perma-bears and disbelievers out there, they are increasingly becoming a minority, sort of like Gov. Sarah Palin supporters. They are not yet ready to accept defeat. As the markets move higher, corporate profits improve, and there are more signs that the recession is coming to an end, we think market sceptics will eventually throw in the towel. We still believe that the recession in Canada and the U.S. will be over by October.

With both Chrysler and General Motors now out of bankruptcy, we think that auto sales will start to improve soon. With mortgage rates still near record lows, the housing market is starting to improve in a number of locations such as California, Florida, and Arizona. Substantially lower home prices also helped attract buyers who could get financing. There will likely be more home foreclosures (but the new supply is being absorbed).

The financial crisis also appears to be over. Interest rate spreads on corporate bonds have come down, the LIBOR rate is back to near normal levels as is the TED-spread. Financing is available to qualified borrowers, and the prime rate is still very low in Canada (2.25%) and in the U.S. (3.25%). Almost all major banks say that they have increased lending in recent months. While there are corporate borrowers who say that money is still tight, we believe that the banks are lending money to most borrowers. Certainly, investor concerns about the health and viability of the major financial institutions have ended. While there are still reports of small regional banks in the U.S. failing, there have been no major financial institutions that have failed or needed to be rescued by the government.

The U.S. bank stress test seems to have done its job in getting all the major banks to strengthen their capital bases. We think this phase is now complete and the banks will resume their normal business models and gradually restore profitability as the recession ends. The worst is clearly over for the major Canadian and U.S. financial institutions.

After this current stock market correction is over, and it may already be over, we think that the stock market will continue to move higher over the remaining six months of the year. We think there are five good reasons why this should occur. First, we will see more evidence that the recession is ending over the next six months. Fiscal stimulus efforts (i.e. increased government spending) and easy monetary policy (i.e. low interest rates) will eventually end the recession. Second, corporate profit comparisons are gradually improving and will continue to improve in the third and fourth quarters. Third, stock valuations are still attractive with most stocks having anywhere from 50% to 100% upside potential just to get back to their former highs. Fourth, right now there is no viable good alternative to stocks with government bond yields extremely low compared to stock dividend yields. And fifth, there is still a lot of money sitting in cash, T-bills, and money market funds looking for the right time to get back into the stock market.

Eventually, most of this cash will find its way into the stock market as investors seek higher investment returns. We are confident that investor psychology has only just begun its shift away from extreme fear levels and is gradually moving to more neutral levels before it once again moves into its extreme greed levels likely by 2012. We still believe that stock market returns in both Canada and in the U.S. will exceed 20% for the full year of 2009. Such returns are not uncommon coming out of a major bear market. However, we also expect to see a couple more corrections (pull-backs of 7% to 10%) before the year is over.

In the meantime, our stock portfolios are still structured defensively. We have very low exposure to the consumer and reasonable exposure to the industrial and transportation sectors. Our biggest exposure remains financials and energy sectors. We believe energy prices will move higher in the next few years as the major global economies renew their growth. If the global recession carries into the first half of 2010, we think our portfolios will still do fine given the conservative nature of our stocks and the heavy emphasis on dividends.

10-year government bond yields in Canada and the U.S. trended almost straight up from the end of March to mid-June and then fell until early July. To be more specific, the yield on the 10-year Government of Canada bond rose from 2.78% on March 31 to 3.65% on June 10 and then fell to 3.27% on July 10. Bond yields on 10-year U.S. Treasury notes rose from 2.7% on March 31 to 3.94% on June 10 and then fell to 3.29% on July 10. With inflation rates running near zero in both countries it is no surprise that government bond yields are this low. However, large fiscal budget deficits and large increases in the money supply inevitably mean higher inflation within two years making 10-year government bonds at these low yields seem a bit risky and not that attractive.

We believe bond yields are headed higher over the rest of the year and therefore, we are keeping our bond portfolio duration levels below six years. The Canadian dollar rose 16.7% from $.7928 U.S. on March 30 to $.9251 on June 2. It then fell back to $.86 U.S. as of June 30. The rapid rise coincided with the steep increase in crude oil prices. With oil prices falling from $72 U.S. a barrel to $60 U.S. a barrel, the Canadian dollar has also fallen. We are still long-term positive on the Canadian dollar expecting it to rise back to the $.92 U.S. to $.94 U.S. range by year-end.

Market Submission from Tim Burt - Cardinal Capital