Geo-Political Risk, Rising Oil, Double-Dip?

A sustained and significant rise in oil prices could derail the global economic recovery by stirring inflation and putting the brake on spending. What's going on in the Middle East is driving oil prices higher, which have risen 7.35% since the start of the year. The worry is whether or not there will be supply disruptions like the ones that came with the 1973 oil embargo and the 1979 Iranian revolution.

Most economists reckon that the price of oil would have to rise to at least $120 a barrel and stay there to threaten the recovery. Past price hikes have fed recessions. In this case, however, because the rising price is not demand driven, Central Banks are unlikely to raise rates, unless higher oil begins to feed into the prices of other goods and services; that's uncertain given high unemployment in developed countries along with idle manufacturing capacity.

So buying opportunity or time to sell? That begs the question: Can the Middle Eastern people be bought, or is it more than just sharing the wealth?

GB

Return on Equity

Warren Buffett believes that the return that a company gets on its equity is one of the most important factors in making successful stock investments. Benjamin Graham defines stockholders equity as: "the interest of the stockholders in a company as measured by the capital and surplus."

A high return on equity means that surplus funds can be invested to improve business operations without the owners of the business (i.e. stockholders) having to invest more capital. It also means that there is less need to borrow. On the subject of borrowing, debt can increase the return on equity, provided the return on capital from the debt is greater than the interest paid on the debt.

What kind of returns on equity should investors be looking for? Benchmarks could be the return on investment grade bonds or the average rate of return of companies in the market. In 1972 Mr. Buffett identified the average rate of return on equity of corporate America was 14%; in 1981 it was 11%. This past decade the average return on equity was north of 20%, thanks to all the cheap debt financing which was readily available. We all know how that turned out. That's why Mr. Buffett prefers to own companies with little or no debt.

GB

Oil

US crude futures hit a 2 1/2 year high, touching $94.49 a barrel, it's highest since October 2008. On Monday, Brent crude prices hit a 2 1/2 year high of $108.70. It's all due to geopolitical risk in the Middle East, including more recent events in Libya. Looking to possibly take advantage of the instability in some way, Iran sent two naval vessels through the Suez Canal to the Mediterranean. This obviously has Israel concerned which depends on a long-standing peace agreement with Egypt for regional security.

The oil markets are concerned about possible contagion and supply disruptions, especially out of Saudi Arabia, where protests so far have been low key; and Saudi Arabia has said it won't necessarily increase production to offset supply disruptions elsewhere. From a technical perspective, US crude prices were also boosted as traders rushed to cover the short positions in the Brent/WTI spread which had blown out to a record $16 per barrel last week.

GB

Inflation

From The Economist:

"China's inflation rate has become one of the world's most closely watched numbers. Last weeks release showed that inflation rose to 4.9% in January, up from 1.5% a year earlier. The increase was smaller than expected, but has not quelled fears that as inflation creeps up the government will need to slam on the economic brakes. Some economists, however, believe that China should welcome higher inflation as a more effective way to re-balance its economy than a currency appreciation.

Wages are increasing at a faster rate - If higher inflation reflects faster wage growth, this will help China, not hurt it. Some of the ways in which inflation is thought to be harmful to growth, such as discouraging saving and investment, hardly matter in China, where both look excessive. Its biggest imbalance is too little consumption. When wages rise more slowly than productivity, an economy produces more than it can consume, resulting in a current-account surplus. If wages now outpace productivity, workers' share of the cake will rise, boosting consumption and helping to reduce China's external surplus.

GB

Gold

Q: Gold in 2010 reached a 10 year high at over $1400. What do things look like moving forward?

According to the World Gold Council,the main trends for gold in 2010 were:

- Jewelry was very strong, led by Chinese and Indian consumption. Annual jewelry demand rose by 17% in 2010.

- Investment demand remained stable in 2010,

- Central banks shifted from net sellers to net buyers in 2010, the first time in 21 years.

- As demand for technology increased in 2010, so did the demand for gold in electronics, increasing 41% to $17 billion.

- Total supply increased about 2% from 2009 due to a number of new projects.

- Scrap supply fell slightly compared to 2009 by 1%

We find it particulary interesting that both Indian and Chinese investment and jewellery demand continue to grow. This is extremely bullish in Scotia's view.

Another indicator is the gold/silver price ration. Today the gold/ silver ratio Is reaching new lows at about 42.7. This is propelling silver equities higher. Can silver keep this pace up? Will the ratio dip below 40 and if it does will it then correct where gold makes it's move or is this a new base level for the gold-silver relationship? All are difficult questions to answer, but we would think that prudent profit taking on spikes and buying on dips is the only way to play this trend.

Investor sentiment

Q: We've been through some pretty big ups and downs in the last few years. What is the current feeling with investors?

A: Some Investors appear to have forgotten the downs. According to morningstar US equity Mutual funds investors are returning in full force. Long-term flows roared back in January with nearly $30 billion in estimated inflows, reversing December's $10.6 billion outflow. This is the biggest haul for open-end U.S. stock funds since February 2006 and the best January since 2004. It also reverses eight consecutive months of outflows. Conversely, nearly $76 billion fled money market funds, the majority of which left taxable funds. This was the largest money market exodus since April 2010. It appears investors are favouring equities at this point.

High Yield Bonds

High-yield bonds have acted a lot like stocks over the past two years, but unlike stocks, bonds eventually have a pull-to-parity. So how much more can high-yield bonds run?

Credit Suisse's fixed income research team highlight that the average yield on the Credit Suisse High-Yield Index is a record low 6.89% (since at least '86). The average high yield bond is now trading at nearly 104 compared with an average dollar price of about 56 in December 2008. They calculated a theoretical lower bound for yields by adding the treasury yield and the historical average default loss rate. At this lower bound, investors leave no cushion for any liquidity or credit risk premium. The overall average default loss rate has been fairly stable over time, ranging from 1.91% to 3.11%, and the premia have historically averaged 322 basis points. With the 5-year treasury yield at 2.4% and the long-term high yield default loss rate at 2.73%, 5.13% is roughly the current floor for yields.

GB

The Oil Winter/Spring strategy is one of the strongest seasonal out-performance trends according to Thackray. From 1984 to 2008, the two-and-a-half months starting on February 25 and ending May 9, the energy sector has outperformed the S&P500 23 out of 25 times, and by an average of 6%; also impressive is the positive performance 23 out of 25 times.

As the winter progresses, refineries start to convert their operations from heating oil to gasoline. During the switch-over time, low inventory levels of both heating oil and gasoline can drive up the prices of a barrel of oil and oil stocks. In early May, before the kick-off the driving season, the refineries have finished their conversion and the price of oil and oil stocks tend to decline.

Turning to the markets, as of February 15th, 386 companies in the S&P500 had reported fourth quarter results, and of those 69.7% reported positive earnings surprises. So far, adjusted earnings are tracking towards $22.72US per share, a 35% YOY increase.

GB

Economic Data

Last week we had some economic data that moved the markets: America's unemployment rate fell to 9% in January from 9.4% in December. The number of unemployed people fell by about 600,000 to 13.9 million, while the size of the labor force did not change. In Canada, employment rose by 69,00 in January, but the number of those searching for work also increased. The unemployment rate went up by a fifth of a percentage point to 7.8%.

The news to today is China's reported CPI was weaker than expected; however, the weighting of the their CPI index had been tweaked with housing being raised and food being reduced. If you listened to my story yesterday, food prices are on the rise. Bottom line, these figures have done little to dissipate continued inflation concerns, so further rate increases in the near term shouldn't come as a big surprise. Last week, China's central bank raised interest rates by 25 basis points for the third time in less than four months.

GB

Wheat Prices

Few commodities are impervious to the 'China effect' - the upward pressure on prices from rampant demand in the world's bounciest big economy. Coffee is one - few Chinese drink the stuff. Wheat has been another - China is the world's biggest producer, remaining largely self-sufficient. That could be about to change.

The UN Food and Agriculture Organization reported that rain and snowfalls were well below average in eight wheat-growing regions. The current drought could be the worst in 200 years. The International Grains Council estimates world wheat production in 2011 will be 647 million tonnes, much lower than in the two years before. If China starts buying, importers may step up efforts to secure wheat and exporters may impose more bans.

Wheat prices in Chicago jumped nearly two percent last Tuesday when the UN FAO issued an alert that China's crop was in trouble, and prices remain near their highest level since 2008.

GB

Trade Surplus

Our trade surplus moved into positive territory in December. That's important because it suggests exports are improving for Canada. This is a good thing because to a large extent Canadians rely on supplying our resources to the world market to fuel our domestic growth and standard of living. A word of caution is that one explaination for the surge in exports is explained by increased demand for energy. Since energy is priced in US dollars and the US dollar has been falling of late increased demand for energy could be partly explained by a falling US dollar relative to other currencies around the world.

6-Step Retirement Income Strategy

I thought I'd share a retirment article by Betty Meredith and Kevin Seibert, which was featured on advisoranalyst.com:

"Building a retirement plan is far different from creating a standard financial plan. Not only do you have to extrapolate your needs for the next 20-30 years, but you also have to convert assets, allocate income, and optimize taxes. Retirement requires a process, not just products. There is no 'magic bullet' that can be applied to every situation. Here's a six-step guide to building a retirement plan:

Step 1. Estimate duration of retirement assets - Success or happiness in retirement requires integration of three major life areas: wealth, engagement, and health;

Step 2. Identify and manage retirement risks, such as : longevity risk, inflation risk, health care and long-term care risk, and investing risk;

Step 3. Identify distribution, tax and estate issues, and opportunities - Deferring an reducing taxes over time can have a substantial impact on the duration of a retiree's assets;

Step 4. Identify options for addressing gaps (i.e. postpone CCP, work part time, or create additional lifetime income);

Step 5. Convert resources into income;

Step 6. Maintain and update the plan - The plan should be reviewed at least annually. Several events can trigger a revision to the plan, such as: death of a family member, change in health, or actual spending differing from planned spending.

Remember - Retirement is a process.

GB

Stats

As of Tuesday, 332 companies in the S&P500 had reported Q4 financial results; and of those, 70.5% reported positive earnings surprises. So far, adjusted earnings are tracking towards $22.98 per share, a 38% year-over-year increase. There are 20 companies in the S&P500 reporting today, and so far, five of the six that have reported already have beat expectations.

According to Standard & Poor, there is $1.1 trillion in cash sitting on the balance sheets of the top 50 corporate cash hoarders: Toyota with $48 billion; China Mobile with $47 billion; Petrobras with $35 billion; and Microsoft with over $40 billion. Other companies with a huge stash of cash include Total, Volkswagen, and Vodafone. Cash is a drag on returns and yields on short-term paper are low, so there is incentive for these companies to invest, make acquisitions, or return capital to shareholders through a rising dividend or share repurchase.

In the month of January, large-cap stocks outperformed small-cap stocks. Stocks typically have positive returns during the month of January with small-caps outperforming. This trend seems to be diminishing.

GB

Outlook still positive for markets

Is the outlook still positive?

From a technical perspective markets appear to have momentum at their backs. North American markets are all trading above their 50 day moving averages and have been for some time now despite some disruptive geopolitical and economic setbacks. We still expect markets to produce positive returns in north America in 2011 but not as inspiring as 2009 and 2010. Dividends will likely make up a meaningful contribution to total returns.

Buy The Close?

Interesting research out of Credit Suisse this morning:

"In today's markets, where thousands of participants compete for an edge, no statistical analysis is overlooked. This is also an era where holding periods for some can be measured in microseconds. With an eye towards intraday, statistical trading, as opposed to fundamental buy and hold, are some time intervals more profitable than others?

Looking at median returns of the S&P500 in 30 minute intervals, and despite an overall up-and-down market for the year, nearly every interval had a positive median return in 2010. In January 2011 however, the picture was more mixed, with ups and downs throughout the day.

Something consistent between the samples though; both were strongly positive going into the close.

GB

Canadian Jobs

According to Stats Canada, over 69,000 jobs were created last month, which is a pretty strong number, raising hopes that a labor market recovery may finally be taking hold. In contrast, while the US jobless rate declined from 9.4% to 9%, that's largely due to people dropping out of the job market.

The 69,200 gain far outpaced consensus of between 15,000 and 21,000. Now it's not so much the absolute number that matters, because these numbers can fluctuate a large degree from month-to-month; it's the trend that matters, and the trend is up. According to economists, Canada has recouped all of the jobs lost in the recession that began in 2008, though a net loss persists in manufacturing.

On this strength, the Canadian dollar continues to rise against the Greenback.

GB

Inflation

(from The Economist)

Continuing on with the inflation theme the past couple of days, it seems inflation is in the news everywhere. The big worry is that global monetary conditions are far too loose, thanks to rock-bottom interest rates, bloated central bank balance sheets in the rich world, and to emerging economies' inability, or unwillingness, to tighten policy enough in response; however, much of the recent rise in inflation is driven by one-off factors. In no big economy, emerging or rich, is inflation at the peaks reached in 2008; core inflation is still quite modest.

Over time, temporary price pressure can become entrenched, through either consumers' expectations of future inflation or workers' demands for higher wages. That does not seem likely to happen. In developed economies, unemployment and unused capacity are high, which would suggest lower, not higher inflation down the road. The loan exception is Germany.

It's a different story in emerging economies, but even there, the dangers can be exaggerated. In China, for example, rising wages and prices can help re-balance its economy towards domestic spending.

Inflation is always a cause for concern; but today, not for panic.

GB

The McFlation Index

Inflation is creeping up around the globe, but economists disagree on the best way to measure consumer-price inflation. In many countries, ordinary folk as well as investment analysts suspect that governments are fiddling the figures for political reasons, and the true inflation rate is much higher than the officially reported one. If you find the theory of price indices hard to digest, why not rely on simple bugernomics?

The Eonomist's Big Mac Index was devised as a lighthearted gauge to whether currencies are under-or-overvalued, but it can also be used to cross-check oficial inflation rates. Consisting of food, materials, wages and rent, the McDonald's Big Mac offers a handy consumer-price basket, whose composition has hardly changed over time.

The Economist compared prices late last year with those ten years earlier in a selectin of countries. There are discrepencies between the Big Mac Index rates and the officially reported rates, but the differences aren't much and can be partially explained by food inflation being generally higher than overal inflation. The only country where it can't be explained away is Argentina, where burger inflation is at 19% vs. its officially reported rate at 10%.

GB

Payment of Expenses by the Higher Income Spouse

Generally speaking it can be tax effective for the higher income spouse to pay all the family's expenses, while the lower-income spouse invests as much of their income as practical. The investnment income earned will be taxed at a lower rate than if it were earned by the higher-income spouse. This assumes the higher income spouse is not incurring these expenses to earn an income and can't write off the expenses. This arrangement will allow the lower-income spouse to generate investment income that otherwise would have been used to pay off personal debt.

Income Splitting in Retirement

There are advantages to income splitting in retirement. For example, the tax on 2 $50,000 incomes is less than the tax on one $100,000 income. If you are age 65 and over Canadians receiving "qualified pension income" will be entitled to allocate (or split) up to 50% to their spouse. This means RPP payments, RRIF payments and RRSP annuity payments qualify. In addition, spouses can share their CPP retirement pensions.

If you are under the age of 65 qualifying pension income is limited to RPP payments only. Withdrawls from RRSPs, and OAS, GIS, CPP payments do not qualify.