We indicated in our last two monthly market letters that the stock market was as ‘oversold’ on a technical basis as it had been in over 60 years and that any type of good news would probably create at least another trading rally. Well we have certainly seen that since the market hit its last low back on March 9th as stock prices have rallied by over 24% in Canada, over 27% in the US and over 40% on the Emerging Markets. In the US, the financial stocks have been at the forefront with a rise of over 70% on the XLF (the US Financials Index). Surprisingly strong earnings from CitiBank, Wells Fargo, Goldman Sachs and Bank of America helped to fuel the gains as the stocks had been decimated over the past year and investor expectations were obviously extremely low. In Canada, the cyclical/resource sectors have lead the way with a 35% gain for the Energy sector and a 75% gain for the Metal Mining sector as well as a 52% gain for the Financials, lead by the major banks and Manulife. What we continue to like about the current rally is that it has had more positive technical characteristics than any of the prior rally attempts. The gains have been more broadly based with smaller stocks starting to participate in the rally as well. Insider buying has also spiked higher in the past few months as the ratio of insider buying to selling has spiked over one times. The prior four occasions when this occurred were around market bottoms in 2003, 2003, 1998 and 1994.

Each new low on the overall market in the past three months had been accompanied by fewer and fewer individual stocks also hitting new lows, a clear benchmark of a market that is in the process of finding a bottom. While there should be no doubt that there is more bad news in front of us in terms of restructuring, bailouts, poor earnings and dismal forecasts, we continue to believe that the stock market had already anticipated most of this dismal news when it fell by over 40% in 2008. What investors may not be fully aware of was how drastic the economic downturn was last fall when the financial crisis hit a crescendo. We have all experienced recessions in the past with their consequent 25-30% drops in stock prices but what was happening last fall, in retrospect, was clearly something much more serious than that. When companies and individuals have no faith in the financial system they don’t just slow down their spending, they bring it to a grinding halt. The economic data from last fall was reflecting that possibility which is one reason why the stock market dropped so much more than in a typical downturn. The timing of the rescue program and the massive, co-ordinated global stimulus program has reduced that extraordinary economic risk to a large degree and has just put the economy into the somewhat normal ‘downturn’ position that many of us had expected we were heading towards anyways. I refer to this in the header as the ‘Economic Outlook Move Back Down to DefCon 4’ (from the highest crisis level of DefCon 5) as just a play on the old defense conditions alerts of the US military and is really just meant to paint the picture that, even though we are in a recession, we are not heading towards a financial system meltdown. That realization alone has probably been enough to move stock prices up a level to normal ‘recessionary levels’ and has been largely responsible for the gains of the past month.

The fact that this current rally has been lead by the financial stocks is one clear requirement for recovery since we have not before seen a sustained recovery that didn’t include the financials. What has also fuelled prices higher in the past six weeks has been the substantial amount of cash ‘on the sidelines’ that has been moving back into stocks on every small pullback in prices. With so many investors wanting to buy into this market on short-term weakness, the stock market has done what it typically does in such a situation and has not given these investors that opportunity. In fact, the fear of ‘missing a rally’ after the substantial losses realized over the past year has lead to some aggressive buying in the past week in particular. While we have been and continue to be very bullish over the medium term, we are a bit concerned that the stock market has run too fast, too quickly and that there will be some more downturns as we work towards a recovery. But we shouldn’t kid ourselves. Clearly the economy is not ‘out of the woods’ yet in terms of earnings and growth. However we do continue to hear in the media about the ‘mustard seeds’ or ‘green shoots’ indicators of nascent growth that are starting to show up in some of the data points that is giving investors some hope that we may have seen the worst for now. In the US, which was the first economy to sink into the recession as the financial and economic crisis was created in the US banking system, the fundamental economic backdrop may be in the process of stabilizing, or at least not deteriorating at as great a rate suggesting as well a better reason for stocks to have found a bottom. The chart below is one such ‘mustard seed’ and shows how consumers in the US have become more confident in the past month; only 40% of consumers polled said that economy was worsening in April versus 70% the prior month. On the other side of the coin, 20% of consumers polled said they thought the economy was improving versus 7% feeling that way a month earlier.

In the maelstorm of bad economic news and the instability of the financial system of the past year, investors can easily forget about how the economy and markets generally ‘overshoot’ in any particular direction and how there are natural stabilizers that bring these indicators back to their longer-term averages. The chart below shows how such common indicators as home sales, spending, sentiment and durable goods orders in the US have begun to stabilize and some even improve over the past month or so, it is probably more important to understand why this is starting to occur and why it should continue.

Housing starts in the US had fallen from peak annual levels of over two million units less than two years ago to as low as 500,000 annual units recently. But it should be understood and remembered that ‘new household formation’ in the US is around 1.2 million annually, meaning that unless all these new families are moving in with ‘mom and dad’, the inventories of new homes will start to be reduced and then home building will have to start to pick up again. The same logic can be applied to the other ‘lame duck’, the auto industry. US production had been running around 15 million vehicles annually before the recession but have now dropped to an annual production rate below 9 million. The normal replacement demand for the industry is around 12-13 million vehicles so, once again, unless everyone is suddenly going to drive their existing vehicle for many more years than they typically have (and some will), then inventories will start to get worked down and production will begin to rise again. In fact, inventory levels for many basic manufactured goods has started to fall recently suggesting that the excesses are starting to get worked through and that a time to re-start the building and manufacturing processes is closer at hand. Its this type of data that has started to filter into the thinking of some more ‘risk oriented’ investors and is one of the reasons why we have seen such a strong rise in the stock market over the past six weeks.

Outside of the US, the biggest source of global economic strength and bullishness for stock investors has been the recovery of the Chinese economy. After being one of the ‘engines’ of global economic growth in the expansion from 2002-2007 and the largest ‘real’ contributor to the strength in global commodity markets, the Chinese economy had retreated sharply following the 2008 Summer Olympics and the growing global recession. Growth had slowed from an annual rate of over 15% in late 2007 to under 8% in the final quarter of 2008 with worries that it would deteriorate further since much of the growth is ‘export-based’ and most of those economies that the Chinese export into (i.e. US, Japan, Europe) were in severe downturns. But reduced interest rates and a US$586 billion stimulus program has done the trick and lead to an explosion in money supply, a huge expansion in bank loans (30% year-over-year growth) and a strong rebound in the Purchasing Managers Index. Commodity markets have witnessed massive buying from China as well with copper imports reaching a record high of 375,000 million tonnes in March and iron ore imports reaching a monthly record of 52.1 million tonnes. China has also been stockpiling crude oil into inventories while prices are low as well as agricultural products and finished steel. There are some worries that this buying will subside once inventories and rebuilt and if real consumer demand doesn’t materialize, but the indications are that this economy is back on the track to recovery.

Chinese Prime Minister Wen Jiabao said Beijing's stimulus measures are helping consumer spending and growth, and while he warned of some "prolonged difficulties" as the financial crisis spreads, foreign auto makers and other manufacturers already are seeing an unexpected rebound in sales in China. The resilience of Chinese spending contrasts with sharp cutbacks by American and European consumers, and may help China recover faster from the financial crisis. Economic growth slowed to 6.1% in the first quarter, as retail sales rose 15.9% for the period. While that was slower than the 17.7% rise in spending in the fourth quarter of last year, economists say the growth in consumption is encouraging given rising unemployment in the country and the contrast with shrinking consumption in other major economies. Mr. Wen has stressed that "confidence is more important than gold or money," and consumer spending levels suggest Beijing's efforts to boost morale are working. Since stimulus funds began flowing this year, the measures have had a particularly "significant impact" on auto sales as the auto boom in rural China is a "genuine" long-term trend supported by improved roads and the rapid pace of urbanization. The global financial crisis also is highlighting the differences between Chinese and global buyers. Three-quarters of China's consumers plan to maintain or increase their spending next year, according to a study by the Boston Consulting Group -- nearly double that of the U.S. and European Union. Consumers appear to be less nervous about their personal finances, with only 23% expecting the economy to worsen in 2009, compared with 32% in the U.S., 49% in Europe and 57% in Japan. Chinese consumers are spending, in part, because they have greater confidence in the government, rooted in three decades of rising economic growth.

The stabilization in the US economy and a recovery in China remain key ingredients necessary to fuel further stock gains. But a prime reason for the stock market’s recent strength and why it has suffered so few pull-backs in this current run is because of the record levels of cash and liquidity that is ‘out of the market’ right now and itchy to jump back in at almost every opportunity for fear of missing the next bull market. Combining record high cash levels with exceptionally high ‘short’ positions in stocks is always a recipe to send prices higher, at least in the short-term. Ultimately the stock market needs to see an improvement in both the economy and corporate earnings to sustain the advance, but the simple fact is that if cash levels are high then you have way more potential buyers of stocks than sellers.

One of the best performing stock groups in the recent run has been the Technology Sector. This seemed to make sense since the businesses had not deteriorated nearly as much as after the tech market meltdown in 2001 and the stocks were already trading at record low valuation levels (some like Sierra Wireless were trading below their net cash values – that is, the stocks were indicating that the existing business were worth ‘less than nothing’ and would only erode the existing cash balances). Meanwhile, most tech companies generate net cash, have strong balance sheets and, most importantly, do business on a global basis selling into some of the fastest growing markets in the world. To help matters further, some of the major players have recently reported earnings which surprised to the upside and some even spoke about ‘improving market conditions’ as inventory levels got worked down and demand stabilized. IBM and Apple have continued to grow while Research in Motion ‘blew away’ the expectations in their recent quarterly report showing better than expected revenue, earnings and gross margins and providing guidance that was also ahead of ‘street’ expectations. Investors have been rewarded with a gain of over 70% in the stock over the past six weeks. In the past week, Intel Corp. said the personal-computer market "bottomed out" in the first quarter, suggesting that conditions may be starting to improve for the hard-hit area of technology sector. The chip maker reported a 55% drop in profit for the period, but still exceeded the downbeat projections it issued in mid-January. Intel executives said the company benefited from cost-cutting measures as well as improved demand, with orders strengthening through the quarter -- particularly for chips used in consumer notebook PCs. "The quarter was better than we expected," said Intel's CFO.

Gold and gold stocks continue to be one of the more confusing calls to make on the markets. Certainly the massive printing of money on a global basis in order to get the economy back on track again ultimately has to be good for gold as it reduces the value of all paper currencies as ‘competitive devaluation’ starts to take hold with interest rates being pushed close to zero. All the extra Dollars, Euros being produced just dilutes the value of the currencies as a group and tend to make hard assets like gold look better in comparison. Moreover, all of this stimulus is expected to lead to higher inflation levels down the road, even though in the short-term there is so much excess capacity in the global economy that inflation is not on anybody’s radar screen. That situation would change though if the economy started to recover. All of these potential outcomes seemed to have been incorporated into the movement of gold prices which did touch over $1,000 per ounce last July for the first time and then again in February of 2009. Also, as shown in the left-side panel on the chart below, this has helped gold stocks handily beat the performance of every other stock group on the Canadian stock market over the past year. Gold stocks became the ‘safe haven’ from the meltdown occurring in global financial markets.

But with the stock market rallying sharply over the past six weeks, the need for a ‘safe haven’ has been reduced and gold stocks have significantly lagged by heading down while the overall stock market advanced over 25%. More worrisome has been the fact that gold has not been able to build on the gains from last year despite the plethora of bad economic news, the unprecedented rate of new money growth and the record low level of global interest rates. Investor demand has slowed down, traditional buyers from India in particular have scoffed at buying jewellery at these higher levels (even during the ‘wedding season’) and the price of gold is now teetering just above its 200-day moving average of just over US$860 per ounce. A break below that level would most likely send the technical traders into a selling frenzy that could see prices check back all the way to the next level of support at around US$750 per ounce, an outcome even more likely if the stock market rally continues.

So why hold gold stocks at all given that potential scenario? Well, gold could just as easily bounce off support at this 200-day level and it wouldn’t take much to push it back up through the earlier highs. This still seems somewhat justified in terms of the massive printing of money, the dilution of paper currencies and the ultimate risk of higher inflation as the economy starts to stabilize. But the other important reason to own the stocks is that they have substantially lagged the move in gold prices thus far and are actually cheaper than they have been in over 30 years on the basis of typical measures used to value gold stocks (i.e. the ‘price to cash flow’ and ‘price to net asset value’). The right-side panel on the chart above graphs the ratio of the TSX Gold and Silver Index to the price of gold bullion since 1980. What can be clearly seen is that the Gold and Silver Index is trading near its lowest ratio to the price of gold in that entire period and is certainly well below the historical averages. This suggests less downside risk for gold stocks even if gold bullion prices end up falling further yet potentially more upside if gold prices reverse their recent downtrend. Corporate activity may be the spark that starts moving the sector higher again. Many of the gold companies successfully raised new equity during the run-up in prices over the past eight months and are in very good financial shape. Also, given the rising costs and growing scarcity of new mining projects, the cheaper alternative to generate growth is clearly through buying other companies as opposed to sticking drill bits in the ground. As the credit market conditions continue to become more relaxed and some normalcy returns, we expect to see a pick-up in corporate activity in the gold sector (as we do in most resource sectors including the base metals, agriculture, coal and energy stocks). Our favourite names are the mid-sized producers that have strong growth potential in undeveloped properties and have not hedged (or ‘pre-sold’) their forward production. At the top of our list would be Agnico-Eagle Mines, Yamana Gold and Redback Mines.

Stocks have had a significant bounce off the March lows and, although we still believe that we are looking at sharply higher stock prices over the next few years, there is also the risk that stocks will pull back in the short-term as first quarter earnings and guidance are released and more details come forward on the financial rescue program for the banks. We have therefore reduced our stock exposure to some degree but still remain with slight ‘overweight’ positions in stocks versus bonds or cash. The chart below (which we have shown before and can be accessed at http://dshort.com/charts/bear-markets.html?four-bears) compares the path of the three largest bear markets of the past century versus the current downturn. Although the initial drops were all similar we continue to argue that the economic deterioration underlying those moves is not nearly as dire this time around and that this market won’t follow those same paths.

But until the economic outlook becomes a bit more comforting to the investing public in general and the banking crisis is more fully resolved, we expect the market to continue to be very volatile. We expect more pullbacks as well as rallies like we have seen over the past month with the stock market overall exhibiting a ‘two steps forward, one step back’ type of pattern. After a 25% gain in six weeks (including substantially larger gains in many of the sectors and stocks where we had overweight positions) we might be closer to the ‘one step back’ portion of the pattern. But with an eye to the medium term economic outlook and the continued attractive longer-term valuations of stocks versus bonds or cash, we don’t want to get too bearish in the short term and have therefore only taken some profits and basically moved back closer to a neutral/slight underweight position on stocks overall. We will pay close attention to the economic releases over the next few months to see if the economic stabilization we have seen starts to turn into a slow recovery and if the guidance from individual companies follows suit. Although the economy is still struggling, the positive impact of the stimulus programs, the exceptionally low level of interest rates, the substantial amount of money still ‘on the sidelines’ and the potential for more corporate activity such as we have seen in the pharmaceutical sector there should continue to be a strong underlying trend to the stock market. “Sell in May and go away” may be the old adage and it certainly was the right strategy in 2008, but we would be wary of ‘going away’ too long as we still expect superior stock returns over the next three to five years.

John Zechner