The stock market has continued to show gains so far in 2012 as investors have a greater sense of calm about the European situation and have also been encouraged by the strong economic data that continues to come out of the U.S.  The world’s largest economy has been showing renewed vigor since last fall, just as investors fears about imploding global economic growth were reaching a crescendo due to the Euro-Zone financial crisis and it’s impact on China, given that a large percentage of their exports go to Europe.  But you can’t keep the U.S. consumer down too long, and strength in retail sales, housing and employment have all lead to a resurgence in U.S. consumer confidence.   With recovery apparent in the world’s largest economy, fears about global growth have receded.  Recent corporate earnings reports were in line with expectations and still showed low double-digit year over year growth.  Investors had braced for something more dour than that.  On top of all this, there continues to be the commitment of central banks to keep interest rates low for an extended period of time and the fact that stock valuations are at historically low levels.   Given that bearish sentiment among investors had been at record highs going into last fall, the reversal of these conditions seems to have given the stock market a decent ‘tailwind’ behind it this year.

The strength of the rally in the last five months has been impressive, stalling out at times but never pulling back enough to give those who missed it a great opportunity to jump back in.  Bull markets typically “climb a wall of worry” and the rally since last fall has played out as just this kind of scenario.  The chart below shows the gains from various global markets as well as selected sectors of the Canadian stock market since the lows set on October 4, 2011.

Index % Gain Index % Gain
U.S. –  Dow Industrials +21.9 Canada – S&P/TSX Comp +14.1
U.S. –  S&P 500 +24.4 TSX – Financial Services  +9.9
U.S. – Nasdaq Composite +27.0 TSX –  Energy +28.8
German DAX Index +31.6 TSX – Basic Materials +10.3
Emerging Markets Index +28.1 TSX –  Telecom +7.8

While markets have rallied nicely off those October 4th lows, it is clear that Canada has lagged the moves in the U.S. market.  Germany has been the strongest of the larger industrialized markets, partly because it dropped more than most in 2011 due to fears about economic conditions in Europe and partly because that same economic data has done better than expectations recently.  Emerging markets have also been strong since those economies have higher inherent growth rates and were less impacted by the financial crisis in Europe.   Typically the Canadian stock market trades more in line with the emerging economies since it has a larger resource base and is therefore a larger beneficiary of growth in those regions.  But is has lagged in the recent advance for a few reasons; Canadian financial stocks have not rallied much off the lows, gaining under 10%.  But Canadian bank stocks did far better than any of the other global financial indices last year and consequently ended up having the highest valuation of any other bank stocks, thereby limiting their potential for much further upside as stocks have recovered.  Contrast that with some of the money-centre U.S. banks, which dropped by over 40% in 2011 and were trading at less than 50% of book value.  Also, the Basic Material sector, which usually rallies strongly in this type of advance, has lagged because the Gold sub-sector is up only 2.2% from the October lows.  The Energy sector has really been the key area of strength for Canada as crude oil prices broke through the US$100 per barrel level.  That could turn into a bit of a ‘double edge sword’ though since higher oil prices flow through to higher gasoline which, in turn, takes more money out of consumers’ pockets that they could be spending elsewhere.  Higher oil prices are one of the risks to the economic recovery taking place as well as the current stock market rally.  In the past week the Canadian market has started to gain some relative strength, though, powered by further gains in the Energy sector as well as stronger gold and metal stocks.  In order for Canada to out-perform global markets over the balance of the year, though, we are going to have to see some acceleration in the global economic numbers.

With slightly more certainty in the European financial situation due to the recent successful 2nd round of ‘bailout financing’ for Greece, the microscopes now will probably start to focus more on China to see how well they are doing in achieving their ‘soft landing’ and whether economic growth will stabilize.  The economic data for China in January and February does get distorted by China’s New Year Holiday.  The data is not racing to the upside but it has stabilized at lower growth levels.  The preliminary data for February shows that consumer spending is now growing at an accelerating rate in China, which seems to be more than offsetting the slowdown in exports to Europe.  Moreover, the fall in inflation is allowing the central bank in China to lower reserve ratios and expand credit, which should also start to reverse the growth slowdown.

With interest rates low all over the globe and money supplies expanding, many investors are worrying about potential inflationary pressures as economic conditions improve.  This has moved investors back into gold as a hedge against inflation and falling currency values.  Gold prices reversed their downtrend in December and are now close to the highs reached last August.  Speculators in U.S. gold futures are now their most bullish since September after the Bank of England and Bank of Japan said they will buy more assets and the Federal Reserve said it was considering purchasing more bonds. Central banks are also expanding their bullion reserves, adding 440 tons last year, the most in almost five decades.  They may buy a similar amount in 2012, according to the London-based World Gold Council.  The chart below indicates that gold stocks are starting to break out of a downtrend.  Gold stocks have lagged the move in gold bullion as more investors played the gold ETF directly rather than the stocks.

Gold Stocks Rise as Gold Recovers

We have increased our gold stock allocation recently to a slight overweight as bullion prices are moving higher and the stocks are at the lowest valuation levels seen in decades, with most trading below their net asset value.  Yamana, Barrick Gold, B2Gold, New Gold, Kinross and Osisko Mining are the key names in our portfolios.

While stocks have grinded to the upside since the lows last October, many market strategists are concerned that the recent rally has pushed stocks ahead of fundamentals.  One of the indicators of this could be a substantially higher level of stock sales by the folks who own and manage these companies.  Insider selling has increased substantially recently and remains high; there are now 6.8 company officers and directors selling stock in their own firm for each buyer. The ratio is still at levels that suggest firms may disappoint in their earnings projections or that they feel shares are simply over-valued.  A question that is frequently asked is – are insiders truly knowledgeable of their firm’s near term prospects? Their track record is very good – insiders were aggressive sellers in the second half of last July just as government agencies were cancelling orders because of worries that an agreement on the debt ceiling would not be reached. And insiders turned insistent buyers in the autumn as consumption recovered. But another way to illustrate their knowledge is to look at corporate guidance.  On that measure over the past 8 weeks, an average of 2.7 firms have guided lower for each firm that has guided higher, the ratio is up from just over 1.0 in the 4th quarter of 2011 and is above the historic average.  There is always going to be some fodder for both the bulls and the bears in the market statistics, but certainly it would not surprise us to see some pullback in prices over the near-term given such indicators.

1 2