Almost all the indicator individual components moved lower; with QE program on the verge of winding down we reduced the Monetary Conditions to +1, the first reduction in five years.  Sentiment moved down from +1 to -1, not due to public participation in the market but more because the advisory services and strategists have become more complacent about the outlook, suggesting higher short-term risk.  Corporate Profits were also reduce to neutral (0) from +1, as profit margins are at record highs, input costs are rising and profit growth has slowed to low single digits.  Economic recovery in Europe and stabilization of growth in China keeps the Economic Growth indicator at +1.  Finally, we can no longer argue that stock valuations are historically cheap, at least not in the U.S.  While stocks remain under-valued relative to bonds, rising interest rates are starting to erase that advantage.  Now we need continued economic expansion to fuel further earnings growth in order to make stocks more attractive again.  However, this is not a very bearish call as we would see a 5-10% correction in U.S. stock prices as adequate to move back to a fully invested position.  Meanwhile, growth-oriented stock markets such as Canada do look relatively under-valued and we continue to see good buying opportunities in the basic materials, industrial, technology, energy and financial service sectors.

With all the concern about the tapering and eventual end of QE, we have to keep in mind that stocks can still rise along with interest rates, as long as corporate profits are growing.  The chart below shows a few periods when interest rates were rising and stocks were also showing gains, including the late 1990’s and from 2004-07.  Eventually the rising rates do their job in slowing down economic growth and reducing inflationary pressures.  Then stocks head into a bear market.  Clearly we are nowhere near a point right now where central banks are about to start raising interest rates though.  The Fed continues to state that “a highly accommodative stance of monetary policy will remain appropriate for a considerable time after asset purchase program ends and the economic recovery strengthens”, suggesting that this sweet spot of the Fed policy cycle for stocks could run longer than normal this time around.   All the U.S. Federal Reserve comments are indicating is that it will “slowly start removing the monetary stimulus” by reducing the monthly purchase of treasury bonds (again we refer to our headline letter two months ago “Easing Up On Accelerator Not Same as Hitting the Brakes”).  However, interest rates will have to head higher at some point once economic growth is firmly established. Again looking at the chart, there is no more room for rates to go lower and they remain far below historical levels.Interest Rate Trends

Finally, how much upside is there left in the gold stocks?  After falling by over 65% from the September 2011 high to the late June low, the TSX Gold index has now risen 40% from that low two months ago and has been almost solely responsible for the 5.6% gain for the Canadian market so far in the 3rd quarter.  Sentiment and valuation had gotten so extended to the downside in June that it was basically looking like a repeat of the 2009 stock market lows for this sector.  Investors wanted nothing to do with gold stocks, most of the advisory services were calling the sector a sell, institutional investors were at less than half of index weight in the sector and the common theme was that the bull market in gold was over and the gold miners never make money anyways!  That is typical of what happens at market bottoms.   On the other side, physical demand for gold, particularly from the Far East, had surged due to the weaker prices.  The stronger economic growth from Europe and China also put downward pressure on the U.S. dollar, another developing plus for gold.  Also, the July-October period is typically the strongest seasonal time for gold stocks as it coincides with the Indian wedding season.  Gold mining companies were helping their cause as well by announcing cancellations of higher cost projects, pushbacks in capital expenditures and more focus on profitable growth.  We had increased our gold weight to about 150% of the index weight at the lows.  Given the strength over the past two months we have reduced the exposure back to an index weight of approximately 8%.  Our focus names continue to be the mid-sized growth companies that have adequate financing in place to meet all their capital needs.  Detour Gold, Osisko Mining, Kinross Gold, Yamana Gold and B2Gold Corp remain our core positions in the sector, although we have recently reduced positions in all of those stocks.

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