Another input factor we like to look at is investor sentiment.  The chart below shows the Conference Board’s Survey of Investor Expectations of stock prices over the following 12 months.  This figure has collapsed in 2011 from an expectation of 10% growth in the survey done in the spring to a 30% decline in prices when the most recent survey was done in September.  For those ‘contrarians’ who like to invest when others are most worried, now looks like the perfect time to be adding stock market exposure.  The last time that the sentiment was this bearish was in early 2009, which coincided with the lows in stocks seen in March of that year.  While this indicator on its own is not enough to move us in or out of the market, when combined with other indicators we have found it a very useful tool for market timing.  In this case the substantial bearish sentiment is coinciding with a time of record low interest rates, low stock valuations, positive earnings growth and economic data which is not indicating any imminent risk of a recession.

Investors' Outlook for Stocks Back to Market Lows

In terms of the sectors that we have been focused on, the technology group continues to stand out as having exceptionally low valuations, strong growth potential and exposure to the fastest growing areas of the world, the emerging economies.  Moreover, the business model for technology has also improved dramatically since the collapse of the bubble in 2001 as the larger companies tend to have very high gross margins and thus high levels of profitability.  They also generate net cash from operations and the individual companies tend to have high cash balances and low levels of debt.  Intel, Microsoft, Qualcomm, Apple, IBM, Oracle, Google and even HP all stand out as having those attributes and yet most trade at single-digit multiples of earnings.  Apple and Qualcomm have slightly higher multiples due to their superior growth rates while HP trades at under 5 times current earnings due to management changes in the past quarter.  The chart below shows the net cash generation of the sector as a percentage of their market value (referred to as the ‘free cash flow yield’).  This number has had a nearly uninterrupted move higher ever since the end of the technology bubble and currently sits at a yield of greater than 8%.  Theoretically this means that if the companies used all of their excess cash to buy back their own stocks, then the entire sector could be bought out in under 12 years!

Technology Looking Great on Cash Generation

Another sector where we have overweight positions in is the Basic Materials group, particularly the copper, coal, iron ore and fertilizer stocks.  Copper, in particular, is looking very attractive right now as supply growth continues to be constrained and demand remains strong despite global growth fears.  There has been a sudden surge in cancelled copper warrants on the London Metals Exchange (LME). Cancelled warrants as a percentage of total LME inventory reached a 2011 year high of 12.72% last week.  The rising number of cancelled copper warrants has increased speculation that the China State Reserve Bureau (SRB) is buying certain commodities to support its smelters.  A rise in cancelled warrants signals rising physical demand, suggesting more demand for the underlying physical commodity. Cancelled warrants are a valuable indicator of consumption trends, which in turn can provide cues to possible future price action.  The recent rise in warrants suggests that physical demand is picking up again and that this is happening at a time when there have been supply disruptions from strikes and production outages.  The collapse in copper prices from $4 to $3 last month seemed to be a technical breakdown in the price driven by fears about a return to recession.  If the market comes back soon then the copper stocks, which fell by as much as 40% in the past two months, could be looking like incredible buys.  Among the larger stocks we continue to like Freeport McMoran and Teck Resources while, in the mid-sized producers, we have added to positions in Quadra FNX, Lundin Mining, Hudbay Minerals and Ivanhoe Mines.  In the Hedge Fund we have added COPX, the Global X Copper Miners ETF.

For most of the past three years our Investment Strategy has been positioned for a recovering global economy, low short-term interest rates, increased corporate profits and a bias towards the cyclical/resource companies that benefit most from the continued expansion of developing economies.  Our view on Asset Mix still favours stocks over bonds by a wide margin due to valuation differentials.  Our goal is to have any portfolio positioned so that it would achieve maximum returns subject to the risks being taken.  We continue to have an overweight position in stocks (about 125% of the benchmark stock weight) with a bias towards Basic Materials, Energy, Technology and Industrial sectors as well as an underweight position in bonds, expecting that bond yields have to move higher at some point, thus pushing prices lower.  Stocks are lower because investors are, in our opinion, ignoring many of the positive factors that will push stocks higher over the next number of years including the secular growth story going on in the emerging economies, which now make up a significant 30% of the global economy.  While China garners most headlines, a similar story is taking place in many other emerging economies which are embracing capitalism and expanding industrial production at the greatest rate we have seen since the end of the Second World War.  Governments and consumers in those economies are also net savers, meaning that they have the ability to supply capital to support their continued growth.  Also, the US consumer is now in much better shape than they were during the financial crisis.  Three years of debt de-levering is starting to work and personal balance sheets are starting to come down to more normal levels.  Meanwhile, the business sector is in better financial shape than it has ever been.  US companies are sitting on a combined total of over US$2 trillion in net cash that is slowly being deployed back into the most attractive economic opportunities, including expansion, acquisitions, capital spending, stock buybacks, dividend increases and even increasing payrolls.  The problems of some financially-impaired European economies on their own will not be enough to bring down the global economy.

To put in perspective how well bonds have performed and how poorly stocks have done, the 30-year returns on Treasury bonds is above that of stocks over the 30 year period ended September 30th, 2011.  That is the first time that’s happened since before the Civil War!  Stocks had risen more than bonds over every 30-year period from 1861 until now.  To say that history is on your side now by being a buyer of stocks and a seller of bonds is an understatement to say the least.  We’ve had two stocks removed from our portfolio by takeovers in the past month and both were done at premiums of more than 100% over the prior 20 days average price in the stock.  Stocks are looking more under-valued on a long-term basis than they have in decades.  Unless the global economy is about to head into a sharp, extended downturn, then it’s definitely a great time to be adding stocks to your portfolio.  Our view on the economy is clearly more upbeat and we continue to hold substantial overweight positions in economically-sensitive stocks.

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