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Dances With Bulls


Highlights This Month

The NWM Portfolio

It was once again a “risk on” month in November, though the market appeared to be losing a bit of steam as we moved into December.

Interest rates were mainly unchanged in December with 2-year Canada yields ending the month at 1.10% versus 1.11% at the start of the month. 10-year Canada’s backed up a little, ending the month at 2.56% versus 2.42% on October 31. NWM Bond was flat during the month.

Credit spreads provided positive returns in November, as NWM High Yield Bond increased 1.1%.

Global bonds were also higher, with NWM Global Bond increasing 0.4%. A weak Canadian dollar was a positive contributor to these results.

Mortgage returns were slightly higher than previous months, with NWM Primary Mortgage and NWM Balanced Mortgage returning 0.3% and 0.5% respectively.

NWM Preferred Share returned 1.1% for the month, outperforming the index by approximately 20 basis points. The strong performance for the preferred share market for the month was primarily driven by narrowing credit spreads.

Canadian equities were moderately stronger in November with the S&P/TSX gaining 0.5% (total return, including dividends), while NWM Strategic Income and NWM Canadian Tactical High Income were up 2.7% and 3.7% respectively.

Foreign equities were also stronger in November with NWM Global Equity up 2.6% versus 3.8% for the MSCI All World Index and 5.0% for the S&P 500 (all in CAD). All our external managers were up, led by Edgepoint +3.7%, Carnegie +3.2%, Cundill +3.1%, Templeton Smaller Companies +2.4%, and Guardian Asia Growth and Income +0.2%.

NWM U.S. Tactical High Income returned 0.8% (approx. 2.6% in CAD), lagging the market due to the large percentage of the portfolio allocated to put writing, which capped the performance of the fund.

The REIT market was flat during the month with NWM Real Estate down 0.1%.

NWM Alternative Strategies had another good month in November, increasing an estimated 2.1%, thanks mainly to our trend following CTA strategies (estimated, pending confirmation of Altegris fund results).

Unfortunately, it was another rough month for gold, with bullion down 3.6%. Gold stocks fared even worse, with NWM Precious Metals declining 10.2%.

November In Review

By Rob Edel, CFA

U.S. equities continued to power global capital markets higher in November with the S&P 500 and Dow Jones Industrial Average up 5.0% and 5.8% respectively (in Canadian dollars).

Part of this strength was due to a weak Canadian dollar, which lost almost 2% during the month, but even measured in local currency terms, U.S. markets were clearly stronger.

In Canada, the S&P/TSX only managed a 0.4% increase while the Euro Stoxx 50 increased 2.7% and the MSCI World Index was up 3.8% (all in Canadian dollars).

Asian exchanges were the lone exception, outpacing U.S. stocks in November with Japan’s Nikkei 225 rising 6.4% and China’s Shanghai Composite up 5.6%.

Year-to-date, however, only Japan’s Nikkei has been able to keep pace with the surging American exchanges as the Nikkei 225’s 37% gain year-to-date narrowly underperformed the S&P 500’s 38% increase.

It’s a risk on market, with U.S. equities the place to be. But can it continue?

MMC-2013-11-US market has provided strong leadership

At almost 60 months and counting, even though the current rally is getting a little long in the tooth, investors are only now starting to take notice.

Morningstar estimates only $111 billion have been allocated to U.S. stock mutual funds and ETFs year to date (as of October 31) versus $134 billion in withdrawals since 2009. In the four years previous to the Tech Bubble bursting in 2000, investors purchased $471 billion in U.S. stock funds.

Valuations are also not stretched. Factset estimates that based on trailing 12-month earnings, price earnings multiples on the S&P 500 are only 15.8 times versus an average of 16.9 times since 1999.

MMC-2013-11-Surprise Ending

Now the bear argument is that profit margins are unusually high, thus inflating earnings and underestimating trailing P/E multiples. However, even Robert Shiller’s cyclically adjusted price earnings ratio only (average of the last 10 years earnings per share, inflation adjusted) returns a P/E ratio of 25.2 versus the average since 1881 of 16.5.

Yes, Mr. Shiller’s model pegs the market at almost 50% above the long term average, but it is still considerably below the Tech Bubble peak of 44 and the 28 multiple the market reached just before the financial crisis.

MMC-2013-11-Bubble Watcher

So there is room for markets to move higher? Yes, but not much according to most forecasters.

Wall Street strategists are forecasting mid-to-high single digit gains on the S&P 500, which is pretty low given Wall Street tends to be an optimistic bunch. They don’t typically make money, scaring investors away from stocks.

Their forecasts are also pretty realistic, however; as Birinyi Associates points out, the S&P 500 has averaged only 5.5% since 1927 and only 6.4% in the year following a 20% or greater increase in the S&P 500 (which has occurred only 23 times).

Not only are returns likely to be lower next year, but expect volatility to increase. Intra-year, the S&P 500 was, at worst, only 6% in the red during 2013, the smallest intra-year drawdown since 1995.

It’s a lot easier on investors’ stomachs when the market goes up in a straight line. Expect sales of Gaviscon to do better in 2014.

MMC-2013-11-Trading on Fed Expectations

The biggest threat to the market in the near term remains a change in monetary policy, namely an end, or at least a reduction (aka tapering), in the Federal Reserve’s bond buying program (aka quantitative easing).

Despite the Fed’s attempt to convince the street that tapering doesn’t mean they will raise interest rates anytime soon, the market has been selling off on good economic news, fearing higher interest rates are soon to follow, and rallying on bad news.

This is not the way it’s supposed to work folks.

The reality, however, is the economic recovery is tenuous at best and the Fed really doesn’t want to raise interest rates. The yield curve has steepened (as longer-term interest rates have increased), but the increase in bond yields will likely slow from here.

The bond market has corrected based on the news that the Fed will taper at some point, and a further sell off in the near term would require much stronger economic growth than many expect. Also, inflation remains dangerously low and until wage rates begin to climb, will likely remain so over the short term.

We believe wage rates, and inflation in general, are going to be key indicators to watch in 2014.

If the economy can continue to slowly improve and inflation remains well below 2%, the equity market will do just fine. The problem is, how likely is that in the medium-to-long term? Growth without inflation sounds great, but truly would be an example of “this time it’s different.”

MMC-2013-11-Print Faster

The best thing equities have going for them right now is they are not bonds. Bonds yields are low and have only one way to go but up (meaning prices will go down). Stocks out-yield bonds in almost all major markets.

MMC-2013-11-Stocks are outyielding bonds globally

So, not sure about investing in the U.S.? Worried about interest rates and equity valuations? Well, why not invest in the Euro-zone, because the economic conditions in Europe are so much better (read with more than a hint of sarcasm).

Of course economic growth in the Euro-zone is non-existent, with GDP up 0.1% in Q3. Like the U.S., inflation continues to trend lower and the unemployment rate remains disturbingly high.

Yet the Euro is soaring. What gives?

MMC-2013-11-Ascending

Part of the reason for the strength in the Euro is a result of traders exiting bearish bets against the currency based on increased confidence that the Euro-zone will survive.

But also putting a bid under the Euro is the knowledgement that, for all the trials and tribulations endured by the European Central Bank (ECB) over the past year, the ECB has actually followed a more conservative monetary policy than other developed country central banks and has actually shrunk its balance sheet.

Yes, the ECB cut interest rates in early November and threatened more unconventional methods (code for quantitative easing), but everyone knows the Germans loathe the idea of using monetary policy as a means to stimulate the economy.

Most Germans believe interest rates should be moving higher, not lower. Germans, you see, are savers, putting aside about 10% of disposable income a year, versus Americans who save about 5%.

Germans see today’s artificially low interest rates as what a recent headline in Der Spiegel magazine described as “The Expropriation of the Savers.” The ECB’s move to cut interest rates was seen in Germany as a transfer tax from hard working middle class Germans to the free spending southern European economies.

Business magazine WirtschaftsWoche recently argued the ECB rate cut was less about preventing deflation and more about stabilizing troubled economies with cheap credit and worried that such moves jeopardized necessary debt reduction and risked new asset bubbles (thus the headline Tanz mit dem Bullen, or “Dance with the Bulls”).

MMC-2013-11-Super Savers

In fairness to the rest of Europe, however, Germany can afford to take a more conservative stance in regards to monetary policy. Even with the strong Euro, Germany is running a healthy current account surplus.

With a high-end manufacturing niche and the above-mentioned passion for saving, Germany is able to deliver consistent trade surpluses and has drawn much criticism from their Euro-zone partners.

Germany isn’t profiting at the expense of the rest of the Euro-zone, however. Their trade surplus with the rest of the Euro-zone has actually fallen during the financial crisis, going from 5% of GDP in 2008 to about 2% presently.

MMC-2013-11-Trade Off

It’s a bit of a head scratcher, but the Euro and European stocks could continue to gain traction.

Don’t focus on the problem countries (like Greece, Italy, Spain and Portugal), have a closer look at the northern European countries and the companies in these countries that are leaders in their industries.

All of Europe sold off during the financial crisis and not all deserved to.

The U.S. Economy

MMC-2013-11-Economic Growth-Table-US

Q3 GDP was revised higher and grew at its quickest pace since the first quarter of 2012, though most of the positive revision was again due to inventory building. Excluding the change in private inventories, GDP grew a much more modest 1.9%.

Consumer spending, in fact, grew only 1.4%, the weakest showing for the consumer since the recession ended.

There’s two ways to look at the increase in inventories. Either it means companies have borrowed growth from future quarters and GDP growth will slow in Q4, or they see a recovery coming and are stocking up. We hope the latter, but fear the former.

On a positive note, the fiscal drag from budget cutbacks and the payroll tax increase should ease next year.

MMC-2013-11-Not as Good as It Looks

MMC-2013-11-Slower Than Meets the Eye

MMC-2013-11-Employment-Table-US

The unemployment rate in November fell to its lowest level in five years as the U.S. added over 200,000 new jobs for the second month in a row.

At 7%, the unemployment rate is getting close to the Federal Reserve’s 6.5% target, after which they would begin the process of raising interest rates.

MMC-2013-11-Monthly Change in Nonfarm Payrolls

Many believe the Fed could actually push this target lower, however. Wage and job growth remain very uneven. The unemployment rate has been coming down, but it is partly because workers have stopped looking for work and have left the labour force.

High wage earners are able to demand wage increases, but most of the new jobs being added to the economy are in lower paying industries and dominated by younger workers. As a result, the middle class remains under pressure as real incomes have stagnated.

Hardly an environment in which to tighten monetary policy.

MMC-2013-11-US Recovery Leaves Some Behind

MMC-2013-11-Inflation-Table-US

It doesn’t matter which index one uses to measure it, inflation is low – and going lower. It is also not just a U.S. phenomenon.

Most of the developed world is experiencing an environment of low inflation, with only Iceland, Norway, Australia, and the United Kingdom experiencing inflation rates over 2% and rising. In the U.S., clothing, cars, and gasoline have been keeping a lid on prices.

MMc-2013-11-Two Under Target

As with the employment market, however, inflation appears to be working at two different speeds, one for the rich and one for the, well not so rich.

Luxury items remain in demand and prices have been strong. Artwork, for example has been on a tear, with Francis Bacon’s “Three Studies of Lucian Freud” recently changing hands for a cool $142.4 million, the highest price ever paid for a work of art at auction.

In early December, Norman Rockwell’s “Saying Grace” fetched $46 million, a record for an American painting. Looking for a diamond? Sotheby’s recently auctioned off a 24.78 carat pink diamond for a record $83.2 million.

Or how about the Bitcoin phenomenon? I don’t understand them, but the price has exploded.

MMC-2013-11-Bitcoin Price Chart

MMC-2013-11-Bitcoin Activity Stacks Up

Inflation will be one of the key variables to watch in 2014.

If it continues to decline, expect central banks to ramp up monetary policy. If it starts to move higher, look out. No one is expecting or prepared for this and capital markets would become an unfriendly place very quickly.

Two areas to watch: wage increases and medical cost inflation. Both have been unusually low, but may be starting to move higher. We have added the Federal Reserve’s favorite inflation index to our list (PCE) and continue to look for any sign that inflation is making a comeback.

MMC-2013-11-CPI

MMC-2013-11-Consumer Confidence-Table-US

Consumer confidence continues to trend higher, most likely due to an increase in household wealth.

U.S. household net worth increased 2.6% in Q3, which, adjusted for inflation, is only 1.4% below peak levels. Rising stock markets certainly have helped, as have the rebound in house prices.

As a result of believing Scotiabank when they say “you’re richer than you think,” Americans have started to borrow again. Household mortgage debt grew 0.9% in the third quarter, while other consumer credit increased 6%.

MMC-2013-11-Full House

MMC-2013-11-Taking On Debt Again

As with employment and inflation, there are two speeds when it comes to household wealth and consumer confidence.

Income and wealth continues to become less evenly distributed in America. Pew Research estimates net assets of the top 7% of American households averaged $3.2 million versus only $133,817 for the remaining 93%.

MMC-2013-11-Latest Share

MMC-2013-11-The Consumer-Table-US

Despite the partial government shutdown, retail sales were decent in October.

Auto sales were particularly strong, a trend that continued on into November. In fact, Autodata Corp. estimates sales in November were up 9% versus last year and, at an annualized pace of 16.4 million, were growing at their strongest pace since early 2007.

Other retailers are finding consumers a little thriftier and the holiday selling season has gotten off to a slow start. The National Retail Federation estimates 141 million shoppers hit the stores over the Thanksgiving holiday weekend versus 139 million last year, but they spent less, averaging only $407 per shopper versus $423 last year.

Expect a flurry of sales over the next few weeks.

MMC-2013-11-Diminishing Returns

MMC-2013-11-Housing-Table-US

Existing home sales fell for the second month in a row and sluggish pending sales indicate a turnaround is likely at least a few months away.

Prices, however, continue to trend higher and inventories of new and existing homes remain lean. Most encouragingly, building permits moved higher in October, and this is a good sign for the economy.

Yes, higher interest rates took a bit of the wind out of the housing market, but we still think the recovery is intact.

MMC-2013-11-Permission Granted

MMC-2013-11-Trade-Table-US

Not only did the trade deficit narrow in October, but it did so with both imports and exports rising. This is a good sign for both U.S. and global economic growth.

MMC-2013-11-US International Trade in Goods and Services

Overall, the U.S. economy is moving in the right direction and a Fed tapering in either January, or March at the latest, is in the cards.

The Canadian Economy

MMC-2013-11-Economic Growth-Table-CAD

Canadian GDP in Q3 grew at it fastest pace in two years, though like the U.S., most of the upside was due to inventory building.

Also, the third quarter most likely benefited from some catch up from the second quarter Quebec construction strike and Alberta floods. Consumer spending was solid, as was construction and business investment.

MMC-2013-11-Employment-Table-CAD

Canada’s job market nearly matched the strength seen south of the border in November as almost 22,000 jobs were added during the month. The quality of the gains were low, however, as almost all were part time.

As with the U.S., the official unemployment rate in Canada probably understates the true employment picture. If one were to add workers who were involuntarily working part time or discouraged and no longer looking for work, the unemployment rate would jump up to 9.3%.

For an apples-to-apples comparison to the U.S. (because we use a different definition and calculation), Canada’s unemployment rate in 2012 would have been 14.2% versus the official 7.2% using the U.S. U6 calculation for involuntarily part time and discouraged.

Canada, however, does have a much higher labour participation rate than the U.S.

According to TD Securities, currently 86.4% of Canadians between the age of 25 and 54 (referred to as the core participation rate) are either employed or are actively looking for a job versus only 80.5% of Americans.

The 5.9% gap between the Canadian and U.S. core participation rate is at its highest point since 1976. If the U.S. had the same core participation rate as Canada, meaning many of the workers who have given up looking for work were still actively looking, the unemployment rate in the U.S would soar to 11.3%.

Alternatively, applying the U.S. participation rate to Canada would result in our unemployment rate plummeting to a mere 2.5%.

MMC-2013-11-Inflation-Table-CAD

Headline inflation moved lower in October mainly due to lower gasoline prices. Core inflation, however, remains well below the Bank of Canada’s 2% target, removing any concerns that the Bank of Canada will raise interest rates any time soon.

A future cut in rates is a possibility, though unlikely.

MMC-2013-11-Consumer Confidence-Table-CAD

MMC-2013-11-The Consumer-Table-CAD

September retail sales grew at their fastest pace in four months, led by a 5% increase in new car sales.

Given consumer debt levels in Canada, we question the sustainability of the recent surge in retail spending in Canada, but we’ll take it as long as we can get it.

MMC-2013-11-Housing-Table-CAD

Existing home sales declined in November, though this is hardly surprising given the recent strength in the market and the fact this is only the second monthly decline this year.

With interest rates remaining low and the employment picture continuing to brighten, we don’t see a major selloff in the near term. Flat prices, perhaps, but no big decline.

Where we are more concerned is with housing starts and new construction, which has a bigger impact on economic growth. Housing starts also declined in November, though permits increased in October.

Fitch Ratings estimates construction represents 7.1% of the Canadian economy versus only 5.2% in 2000. A normal reversion to the mean might be in order.

The Canadian Association of Accredited Mortgage Professionals estimates a 30,000 to 50,000 reduction in housing starts could directly impact 100,000 workers.

MMC-2013-11-Trade-Table-CAD

Canada’s trade deficit turned into a trade surplus in October, though the fact both imports and exports declined is hardly a reason to celebrate.

Lower prices were largely responsible for the decline in imports as volumes were stable. Exports, while down on the month, are still up more than 5% versus last year with exports to the U.S. up nearly 10%.

Canada needs U.S. buying to continue in order to drive economic growth higher.

What will definitely help the cause is the recent weakness in the Canadian dollar. The loonie recently hit a three-and-a-half-year low against the U.S. dollar and looks to be heading lower.

Goldman Sachs, in fact, is advising their clients to short the Canadian dollar, believing the loonie will fall to $1.14 (or about 88 cents) over the next twelve months.

Why? Many believe the Bank of Canada could actually cut interest rates given the recent weakness in the Canadian economy, particularly in the manufacturing sector, which experienced a 30% decline in foreign demand during the financial crisis.

The Canadian economy recovered from the financial crisis much more quickly than most developed nation economies and our currency reflected this strength. Canada, along with other hard asset currency countries like Australia, was considered a safe haven.

It was generally considered a given that the Bank of Canada would raise interest rates before the Federal Reserve. Now, as mentioned above, the unemployment rate in Canada is nearly the same as in the U.S. and GDP growth in Canada is falling behind.

Many now believe that not only will the Fed end up raising rates before Canada, but Canada might even have to lower rates. Its likely Canada would have already cut interest rates if not for fear of stoking an already red hot housing market.

A lower dollar might be bad for those looking to travel abroad, but it might be just what the doctor ordered for the Canadian economy.

MMC-2013-11-Limping Loonie

The key for Canada continues to be stronger economic growth south of the border. If U.S. economic growth continues to recover, Canada is well positioned to take advantage.

Let us know your thoughts on November’s market activity in the comments below!

This material contains the current opinions of the author and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information presented here has been obtained from sources believed to be reliable, but not guaranteed. NWM fund returns are quoted net of fund level fees and expenses but before NWM portfolio management fees. Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value.