As the auto and housing sectors return to more normal growth rates, there should also start to be a further pick-up in job growth in the US which, in turn, will lead to higher consumer confidence levels and a recovery in spending.  As shown in the chart below, Hiring Intentions by US companies started to turn higher following the end of the recession in early 2009 and have continued to gain since then.  This is logical as companies were reticent to add to payrolls aggressively following the end of the recession since capital markets were still not functioning properly and companies were more likely to hold onto their cash positions in case they were needed for business operations or other capital needs.  Expansion wasn’t really an issue as much as survival!  But as the recovery has moved ahead corporate balance sheets have become more flush with cash (current cash levels of the S&P500 companies is at its highest level ever, slightly above US$900 billion).  These companies are now starting to feel better about starting to deploy these excess funds.  Business confidence is returning and the companies are using the cash to fund stock buybacks, increase dividends, buy competitors or just start to expand again, which includes adding to their payrolls.  All of these outcomes are positive for the stocks of the companies involved.

Our outlook for the stock market in 2011 is still positive and we remain with overweight positions in stocks in all of our balanced funds.  One of our main indicators for deciding the Asset Allocation is our proprietary Five Conditions Monitor (table shown below).  We evaluate five key conditions and assign a rating anywhere from ‘-2’ to ‘+2’ for each.  The total of all five will give us a number in the range of ‘-10’ to ‘+10’.   Anything above zero will generally mean conditions are good and we will be overweight stocks relative to bonds or cash.  The Indicator was as high as +7 last August but was recently pushed back to +4 as the Sentiment/Technical indicators have gotten somewhat extended (we had that indicator at +2 last August).  However, an overall score of +4 is generally enough for us to be overweight stocks with our average equity allocation being about 110-115% of the benchmark level.

Five Conditions Monitor Currrent Level (Range of -2 to +2)
Monetary Conditions +2
Economic Growth +1
Corporate Profits +2
Stock/Sector Valuations +1
Sentiment/Technical -2
Asset Mix Indicator – Equities (-10 to +10) +4

One of the reasons we are positive on the overall outlook for stocks is due to Corporate Profits (+2 rating).  As shown in the chart below, profits have made one of their sharpest recoveries on record following the collapse in 2008.  The financial crisis forced companies to cut costs, scale back operations, conserve cash and improve business productivity in order to ensure their survival through the worst downturn seen in over 70 years.  The result was that profits began to improve dramatically once the economy stabilized and have continued to grow.  The profit for the S&P500 companies are now within 10% of their all-time highs again and are still growing at double-digit rates, suggesting that profits will be back at their best levels ever within a year. If profits recover to their old highs, then it’s logical to expect that stock prices could also return to their prior peaks.  Since profits have grown faster than stock prices since the recession ended, stocks are effectively still cheaper than they were prior to the downturn.  With interest rates remaining near record low levels and economies expanding again, we could easily argue for higher valuations today which would argue for stock gains of over 25% over the next two years.

Another positive indicator in our Five Indicator model is Stock/Sector Valuations (currently at +1).  Although prices and valuations have recovered significantly from the absurdly low levels of early 2009 (which is why the indicator is at +1 instead of +2), stocks are still relatively under-valued compared to historical levels by many measures.  In terms of Price-Earnings ratios, global stocks are trading around 14.2 times consensus trend earnings versus a historical level of close to 16 times.  Another good indicator of stock valuations is the difference between the earnings yield on stocks and the yield on the 10-year government bond, shown in the chart below.  The earnings yield is simply the total earnings of the S&P500 companies divided by the level of the index (i.e. what the stocks would yield if they paid out all of their earnings).  For the mathematically-inclined, it is the inverse of the Price-Earnings ratio.  Looking at this indicator over the past 20 years show that it has vacillated around the zero line, being negative during the period around the year 2000 (when stocks were clearly over-valued at the peak of the Technology Bubble).  Since then, the indicator has had a positive value as interest rates moved to record-low levels.   As we enter 2011, stocks have an earnings yield which is more than 4% above the prevailing 10-year bond yield, and earnings are still growing. In our view, this is a healthy level of excess return to be paid for taking the inherently higher risk and volatility of investing in stocks.

The only ‘fly in the ointment’ that we see right now is the Sentiment/Technical indicator, which we currently have rated at -2.   Although we consider this one the least important of our five indicators, it does give us a sense of where other investors are in terms of their outlooks and can be a good, but not necessarily timely, indicator of when stocks are starting to exhibit a higher degree of risk.  Also, since sentiment and technical conditions tend to change more quickly and dramatically than economic growth, profits or stock prices, we tend to use this indicator more for shorter-term adjustments to the asset mix. This is somewhat the case now as we remain bullish on stocks over the next two to three year period but are getting more concerned in the shorter- term that the market may be setting up for a correction at some point early in 2011.  As shown below, the ratio of Bulls/Bears among the advisory services has given some pretty good short-term calls over the past year.  This indicator reached levels of over 2 times twice in 2010, just before the corrections the market experienced in late January and then again early May.  It also gave a great ‘Buy Signal;’ in August last year when the ratio actually moved into negative territory (i.e. more Bears than Bulls on the stock market).  The ratio has been trending higher ever since the August lows and is now very close to the level seen prior to both corrections last year.  Not enough, in our view, to move out of stocks again.  But certainly this is enough of a change to move the Sentiment Indicator to a -2 reading.

Although gold prices have had a great move over the past eight years, there is still some very bullish buying activity out of Asia, and particularly China.  Scotia Mocatta notes that all Chinese gold production is sold domestically (and they’ve been the world’s largest producer for a number of years) and that they have also imported ~260 tonnes annually in recent years.  However, recent buying from China suggests much higher import demand this year.  At the recent pace of around 5 tonnes per week, Scotia Mocatta would do China’s entire normal volume themselves!  Clearly the gold buying from China is broadening out and continuing to grow.  The investment trend away from fiat (paper) currencies should continue; and all roads in that scenario lead to higher gold!  Also, the operator of South Korea’s exchange has stated that gold demand in that nation is set to increase as Koreans buy more bars and boost investments as currencies weaken.  Korean investments in offshore gold futures almost doubled from 2008 to about 300,000 contracts this year, while Korea Exchange is set to start a spot market for bullion in 2012.  We think that there is a good chance that gold prices could move above US$1500 per ounce in 2011 and perhaps as high as US$2000 per ounce under the right conditions.  Gold stocks have clearly not kept pace with the gains in bullion prices and we think that this gap will close in 2011, suggesting that gold stocks should do well this year even if gold prices don’t show further large gains.  Gold stocks, in our view, are trading as if gold was still in the US$1100-1200 range.  Barrick Gold and Kinross Gold remain our favourites among the larger names while Yamana and Osisko still look interesting in the mid-sized group.

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