The month of June saw North American stocks end up in slightly positive territory. On a total return basis, the S&P/TSX Composite Index gained 0.3% and the S&P 500 Index was up just 0.2% .

However, volatility in the C$/US$ exchange rate was a big story yet again as the return on the S&P 500 in C$ terms was 6.6%. The story was similar for international equities. The MSCI EAFE Index (Europe, Australasia and Far East) was down -0.8% in US$ terms but up 5.6% in C$.

In June, the C$ lost ground against the US$. This was in stark contrast to May when the loonie posted its biggest monthly advance versus the US$ since 1950. We expect currency movements to continue to be hot topic in the weeks ahead.

Energy and Materials were a drag on performance for the S&P/TSX last month dropping 2.2% and 6.6% respectively (these two sectors represent 46% of the index currently). Even with the 2.2% pullback in Energy, the sector still posted an almost 22% gain to close the second quarter.  Solid gains in Industrials, Consumer Discretionary and Financials (in particular banks which were up 9.8% this month) were sectors that kept the S&P/TSX in positive territory in June.

Key Messages

While uncertainty still looms, the data suggests that the worst of the economic and credit crisis appears to be behind us. Although U.S. consumer confidence numbers released earlier this week fell to 49.3 from 54.8 last month, the confidence index remains well above February’s low of 25.3. Many other indicators are now suggesting an easing in the pace of economic contraction in the aftermath of the deepest, most synchronous recession in the world economy in 60 years.

Most analysts expect continued volatility in stocks, currencies, and economic indicators as, although many agree we have embarked on some type of recovery, the timing and pace of that recovery may prove to disappoint investors.

For investors this means that our balanced, long-term view is as important as ever.  There is still value to be found in dividend growth stocks.

Dividend Money purchases in the past month include:

Transcanada Pipeline (TRP)
Sun Life Financial (SLF)
Royal Bank (RY)
Bank of Nova Scotia (BNS)
Power Corporation (POW.TO)

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We are accustomed to thinking of asset allocation in the context of individual portfolios, but the snapshot below looks at investor’s current allocation to stocks, bonds and cash on a global basis and compares today’s situation with historic norms.

The chart shows that the world’s allocation to equity investments is at the lowest level in 20 years, with fixed income picking up the bulk of the weighting and cash also representing a significantly higher weighting relative to equities. In short, investors the world over are underweight equities relative to the long-term historic average and significantly so.

Clearly, the chart above shows that over the past year, many investors around the world have gravitated towards “safer” asset classes, namely cash and fixed income. But, over time, this is likely not an effective investment strategy. By contrast, professional money managers use asset allocation models built on fundamental investment theory and research to achieve their investment objectives. These tools take emotion out of the equation.

It is important to note that no asset strategy will be ideal during all market conditions, it is the managemetn of emotions and the use of rationale thought and research that will help you understand the market.

Many investors say they recognize that they can’t participate in a market recovery if they’re sitting on the sidelines yet the chart above suggests that for most, their fears get in the way of making disciplined, rational decisions. Most people need some exposure to equities in order to achieve their long-term financial goals.

Here are two recent examples:

• Global credit markets continue to thaw as government cash injections and interest rate cuts kick in. Last Friday, the London interbank offered rate (Libor) – the interest rate banks charge each other for loans – fell the most in eight weeks to 0.85% for three-month U.S. dollar loans. Libor, which determines rates on everything from car loans to mortgages, peaked at 4.82% at the height of the financial crisis last October. Last Friday’s fall in three-month Libor was the 33rd consecutive day of declines – the longest stretch dating back to January 2008.
•  Last Friday also marked the 10th consecutive day of gains for the Baltic Dry Index, which tracks ocean shipping rates for commodities. This was the longest advance in three months and the index hadn’t been that high since last October. The index is followed by economists since it can provide insight into the level of demand for raw materials in global markets.

Whether it’s banks starting to lend again, demand for raw materials picking up around the world, improved housing affordability in the US or the fact that the stock market rally since March 9th is now the largest and second-longest rally in the past 18 months, it seems step by step the pieces required for recovery are falling into place (albeit baby steps).

That said, the recovery path could still look like “one step forward, two steps back” for a while as we were reminded last week by weaker than expected April retail sales in the US and soft Q1 manufacturing sales data in Canada.

However, we can see that the LIBOR rate, the key indicator for credit movement, has decreased drastically.  By all economic measures, this is a great sign for business and as such, a good sign for investors!

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Below are a few summary points including a couple of references to the ‘less bad’ concept.

U.S Housing

Real estate, which has been at the root of the credit crisis, needs to stabilize before a sustainable recovery can happen. Here are some things to consider with respect to the current situation:

• Housing to Income ratio: At its peak, the ratio of house prices to household incomes in the U.S. was 27% above its long-term average. It is now down 30% from that peak. While seemingly ‘ugly’, this has brought housing prices back to their equilibrium level. That in itself doesn’t generate new buying, but it does create “capacity” – something that’s important for recovery. With housing affordability at its best level in a generation, once household balance sheets are restored and confidence returns, people will then take advantage of this more ‘normal’ house price to income relationship and go back to buying houses.
• Housing Sales: Although existing housing sales are still falling – they are falling at a much slower rate compared with last year, which suggests that the situation is getting ‘less bad’.

Corporate Balance Sheets

One of the bright spots in the decline of the economy until now has been the health of corporate balance sheets – things like corporate debt to equity ratios and ability to cover interest payments on outstanding debt. With continued contraction in the economy, we are now starting to see meaningful erosion in corporate balance sheets as business profits continue to come under pressure. However, despite this erosion, corporate balance sheets are still relatively healthy.

Manufacturing

The U.S. manufacturing index (ISM) tends to respond favorably six months after interest rate cuts. This is because manufacturing orders are dependent on consumer demand, which is stimulated by low interest rates. Although possibly a long way off, there’s some evidence that we may be seeing a positive response to historically low interest rates.

Earlier this year, the manufacturing index in the U.S. (the ISM) was moving sideways instead of falling and yesterday, data showed that the ISM improved modestly in March. While the ISM data was still weak, recent trends suggest that the health of manufacturing is not getting any worse (i.e. the situation is ‘less bad’ than has been previously been the case).

Inflation

Although inflation may likely have to be dealt with longer-term, it’s not a near-term issue for policymakers. There is risk of “transitory/temporary deflation” (the opposite of inflation and a situation where prices of goods are declining over time) but we believe it is unlikely to develop into a sustained period of falling producer/consumer prices. As the credit crunch and deepening recession continue to dominate policy, rates are expected to hold at rock bottom levels.

Some Important Stats on Stocks

Here are some current relevant statistics for those who want to know if they should be investing in stocks right now:

• 30, 19 – Since 1950, the average U.S. bear market has lasted about 13 months and on average, has declined 28%. At the end of February, we were 18 months into the current downturn and U.S. stocks were off by more than 50% from their October 2007 peaks. On average, when bear markets end the return on U.S. stocks 12 months later has been about 30% and investment losses through previous bear markets were typically restored an average of 19 months thereafter (although it’s important to keep in mind that the breadth of the current decline has been worse than the average).
• 80, 16 -When the S&P 500 is trading below fair value and inflation is at or below its long term historical average of 4.2% (conditions that exist today), the return on stocks is positive more than 80% of the time. The average one year return during these periods is about 16% versus an average loss of 7% during instances where returns were negative (less than 20% of the time).

• 30 – On North American exchanges, more than 30% of stocks are currently trading below book value.

What These Statistics Mean

No, these statistics are not the be all and end all of investing. Nor are they to be used as a roadmap for your own investing decisions. However, they are useful in illustrating the fact that bear markets end just as our last bull market ended.

The climb will not be as drastic or sharp as the fall, but there will eventually be another bull market and stocks are surely closer to a bottom now than they are to a top.

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