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One of the better analogies I’ve heard is to ‘picture yourself walking into a room of 20 people where you know that one has a life-threatening disease that will get passed on to you if you shake their hand. So what do you do? You don’t shake anyone’s hand!’ This is basically what has been happening in the banking system.

Forget about good news versus bad news or economic data versus earnings. What investors hate more than anything is uncertainty; and this credit crisis is creating more uncertainty about the current situation and future outlook than anyone has seen in decades, if ever. Hedge funds in many cases are unaware of what their holdings are because they don’t know the status of the financial institutions holding the underlying paper and whether it’s just another piece of ‘toxic debt.’ And rather than waiting to see how things turn out, investors have been desperately trying to get liquid and sell whatever they can sell, which has included stocks, commodities, currencies, corporate bonds; basically everything except US Treasury bonds which have become the ‘de facto’ safe investment in the current environment. Many banks are unsure which competitor will declare insolvency next so companies and other banks are staying liquid and not transacting at all. That situation, if it persisted, would obviously bring the entire economy to a grinding halt as payrolls could not be met, purchases could not be made and the trust basis that constitutes most financial transactions disappears.

Lowered interest rates and stimulus programs were nowhere near enough to get through a crisis like that; credit had to be loosened up and transactions needed to start occurring. The only way to do that was to remove the risk that financial institutions would continue to fail and that commerce could take place again. In other words, someone needed to say that there was a cure for that ‘life threatening disease’ out there. That was why the Federal Reserve in the US really needed to throw a lifeline to financial markets by aggressively coming to the rescue of the financial system. As fears increased and talk began to centre around the problems of the US in the 1930’s, US Federal Reserve Chairman Ben Bernanke, a student of those times, was quick to act such that the mistakes of that period would not be made again. The policy responses in the 1930’s transformed a stock market downturn into a full blown depression by advocating spending reductions and tighter monetary policy (i.e. “save your money, hide it under the mattress and don’t spend”). History has shown that to be the completely wrong response and policymakers, to their credit weren’t about to make the same mistake twice.

This is clearly the largest financial crisis of our generation. That said, it is also important to acknowledge that the policy response has been astounding. In aggregate, it adds up to more stimulus than the U.S. economy has ever seen in such a short period of time. As foreign as this may sound to free market advocates, this measure has been the most successful we have found in the study of past banking crises. More importantly, perhaps, it is the type of bailout that has the best track record reviving stock markets! In addition to leading a ‘coordinated global interest rate cut,’ the Fed also spearheaded a US$700 billion rescue package from the US government, including a direct capital infusion of US$250 billion into US banks to start to get lending activities going again and to increase the comfort level that bank assets are not ‘toxic.’ Other central banks and governments followed suit with Denmark, Germany and Ireland insuring all US bank deposits, the UK government also injected capital and guaranteed interbank debt. Given that one of the biggest issues driving down shares prices over the past six weeks in particular has been the worry about the safety of the banking system, the policy responses suggest there are now reasons to be hopeful when it comes to equities in general.

The policy response in the US, as shown in the chart below, has been a substantial cut in short-term interest rates, basically removing all of the tightening in policy enacted over the past four years, with rates most likely headed back down to the 50-year lows reached back in 2002. Money supply, which is shown in the top right chart, has exploded by almost 20% in the past month as the US Fed has attempted to re-liquify the US financial system by providing funds directly to institutions.

The U.S. dollar is the solitary significant asset that has increased in value in the past three turbulent, crisis-driven months, generating 15% return. It seems paradoxical that the currency underlying the credit problems that created the entire downturn would be viewed as the safe investment, but the US greenback had already fallen significantly while interest rates in the US were being reduced, and it seemed more likely that other currencies and interest rates were going to follow on the downside so investors shifted to where lightning had already struck, thinking that it probably wouldn’t strike there again! The rise and fall of the Euro has tracked the reversal in the US dollar. In January, 2007, the Euro was worth $1.30. In January, 2008, it reached $1.50. By mid-July, it hit $1.60. As of today it had fallen back to under $1.30. The move in the Canadian dollar has been even larger. It hit its peak of $1.14 last November and has fallen to about 80 cents since, a decline of 30 per cent. Investors have entrusted an enormous amount of money to the U.S. dollar, preferring “the full faith and credit of the U.S. government” to any other investment.

This seems remarkable since U.S. Treasury bonds pay very modest rates of interest – given the otherwise appalling risk that the global credit crisis embodies. Investors in these bonds are content to earn close to a zero real return, or a negative return, in exchange for preservation of capital. The flight of capital back to the U.S. dollar is, at first glance, curious. Two weeks ago, U.S. government debt climbed above $10-trillion for the first time – an obligation that represents $32,895 for every man, woman and child in the country (or twice Canada's per capita debt). And this $10-trillion doesn't include the escalating debt Washington has assumed in the credit crunch crisis. Fannie Mae and Freddie Mac, the government-sponsored mortgage companies that went broke, alone hold $5-trillion in debt. What appears to be happening is that investors are clearly worried about a global recession, and recessions are deflationary. In deflationary environments, cash is the one asset that increases in value – since the price of other assets must fall against it. When it comes to cash, the US is still viewed as the safest haven, even if they are about to ‘open the spigots’ in terms of increasing the money supply and debasing the currency. However, we expect that long-term forecasts of higher U.S. inflation, rather than deflation, may prove correct.

As Warren Buffett observed the other day, the U.S. dollar makes a terrible long-term investment. A very patient investor who held a dollar bill for the past 100 years would now have an investment worth 5 cents. But this is also true for other printed currencies. The credit crunch crises nevertheless show that there's still something special about the greenback in times of trouble. It is surely instructive that Mr. Buffett held on to U.S. dollars in his personal portfolio – at any rate, until he sold U.S. dollars last week to buy U.S. equities.

We still expect the US dollar to resume its downtrend once the worst part of this financial crisis passes. The longer-term problems facing the US economy have not been fixed, including the fact that they are now the largest debtor nation in the world and are still running annual trade deficits of over US$600 billion which must be funded by global purchases of US dollars. We also expect commodity prices to rebound, and with them the Canadian dollar. The chart below shows that the movement in the overall commodity group (as measured by the CRB index) has been one of the largest determinants of the move in the Canadian dollar. Both began recoveries in 2002 and have peaked in the past year.

Our view on commodity prices for some time has been that there was a speculative bubble building in commodity prices driven by increased levels of new financial players and emerging commodity funds. But, like the technology market and the bubble in technology stocks, there was also a strong, secular underlying story that would drive values higher over the longer-term. In technology, it was due to the productivity enhancements and cost reductions brought about by increased use of new technology, shifts from higher capital-to-labour ratios and declining costs of communications. For commodities, the strong longer-term story was premised on increasing demand from the fastest growing regions of the world combined with a chronic under-investment in new supplies and increasing costs of production. We believed that, in both cases, once the period of financial speculation passed we expected that the long-term growth stories would resume their upward moves. This happened with technology stocks as the Nasdaq index ‘bubbled up’ to over 5000 in the year 2000 but then crashed all the way back to under 1000 before resuming the upward trend over the last six years. For commodities, the decline of over 40% in prices in the past four months and the massive unwinding of speculative positions has taken prices below fair value and, in some cases, down to global cost break-even production levels, a point at which we expect to see some shutdowns in production, cancelled projects and even tighter supplies down the road. The chart below lines up the oil market with the Nasdaq market move following the cracking of the technology bubble.

We cannot ascertain yet how much of the speculative activity in the oil market has been unwound, but the chart above would suggest that oil could easily trade down to US$60/barrel in the short-term. However, the supply-demand dynamics suggest the range over the next few years should be US$70-100/barrel, and could be higher if supply disruptions occur. In terms of the actual market dynamics in oil, the situation is not nearly as dire as the action of the commodity would have us believe. Inventories in oil products overall remain relatively tight. Moreover, while demand growth in the US and Europe is negative, overall global demand has not fallen the way it did during the oil crisis in the 1970’s, with the demand for oil in 2008 still showing year-over-year growth of 1.3 million bpd. Demand growth in China is still running at a 5% annual growth rate. This may yet slow down but is, thus far, holding in much better than expected. The other side of the equation, supply growth, also supports the idea of higher prices down the road. Non-Opec supply was expected to grow by 1.7 million bpd this year, thereby offsetting much of the growth in global demand. It now looks more likely that non-Opec supply growth in 2008 will come in about the same level as in 2007, showing basically no growth. Higher finding costs and sharper production declines have lead to this shortfall.

What about the stock market? The past ten years may end up being referred to as ‘the lost decade’ as stock prices have shown basically no return over that period as investors have now endured two brutal bear markets, each very different in nature, over that time period. Global stock prices have fallen by over 40% in the past year, with the market decline in the past three months being as bad as any in history, including technology meltdown, the 1987 crash, the brutal 1973-74 bear market and even the 1929 crash. The most important question now is whether we are still early in this downturn or whether we’ve seen the worst and can start buying for the longer-term. The market is expecting a recession and is in the process of getting one as the chart below shows. Every time the OECD leading indicator has fallen to these levels (dotted red line) the global economy has ended up in a recession (gray shaded areas on the chart). But this is not news to stock investors! Stocks tend to fall about 1/3 in value during a recession and endure a bear market of about 12-18 months. Given that the stock market, by all broader measures, peaked in October of 2007 and the US economy probably entered a recession in the first quarter of this year, markets have already reflected all the bad news by these historical measures. Clearly the risk in the stock market now is that this credit crisis causes the recession to grow into something more serious than a normal downturn. Whether this actually occurs will depend on whether economies outside of the US and Europe get caught up in the spending downturn that emerged from the US credit crisis.

One of the more important sources of information and indicators of future growth we have been focusing on lately has been the quarterly commentaries on earnings guidance coming from the CEO’s of the very large multinational firms. In general these companies have still been showing relatively good third quarter earnings on continued global growth but have either been taking guidance lower for the next quarter or at least ‘widening the range’ of expectations to include the potential for lower earnings depending on how the global economy unfolds. But listening to the commentary from the CEO’s of major international companies such as Caterpillar, Dupont, IBM, Apple, Intel, Google, CN Rail and McDonald’s paints a far less bearish economic view going forward than the stock market currently seems to be pricing in. Although they see a slowdown in the cards, pointing out that the US in particular is in recession now and Europe is weakening, growth outside those regions remains strong and the longer-term growth stories for the emerging economies remains in place. Most importantly, those economies were not financially levered to the degree that the US economy was and individuals have substantial savings such that they can continue to implement their growth. As an example, Russian holdings of foreign reserves have grown from $12.3 billion to $530.6 billion over the past 10 years as the economy has expanded and the trade surplus swelled.

A key factor that will determine the direction of global economic growth will be the direction of China’s economy over the shorter-term and how strongly it is impacted by the recession in the US and Europe. The impact to date has not been dramatic but that could be changing. China's economic growth slowed in the third quarter, which marked the fifth consecutive quarterly slowdown, as concerns about the global financial crisis hurt demand in the world's fourth-largest economy. China's economy grew 9.0% in the third quarter from a year earlier, slower than the second quarter's 10.1% gain. The slowdown in growth came despite record-high trade surpluses in August and September and steady domestic investment. It is likely to prompt Beijing to stick to its pro-growth policy, and with inflation easing, encourage it to officially shift to a looser monetary policy and step up fiscal spending, economists say.

The consumer price index in September rose 4.6% from a year earlier, easing for the fifth month in a row. In October, Beijing slashed lending rates for the second time in as many months, cut deposit rates for the first time this year, and again released more banks' reserves into the banking system. The government has said it is adopting a "flexible and cautious" economic policy to deal with changes in the domestic and external situation. It said the international financial market remains turbulent and that growth in the world economy has slowed noticeably. These factors are exerting negative effects on China's domestic economy. But retail sales still rose 23.2% in September from a year earlier. Although investors have become very negative about overseas growth, we don’t expect Chinese economic growth to drop below the 5.7-9.0% range next year, slower than the past few years but still a strong number and well above what was seen in the last downturn eight years ago.

Our strategy in the stock market has turned decidedly more bullish in the past month as we feel that stock prices have fallen to levels that already reflect a global economic downturn. Moreover, sentiment and volatility indicators suggest that investors have levels of fear not seen in years and consistent with past market downturns. Also, individual stock valuations are also reaching levels well below normal ranges, even assuming that earnings forecasts are still way too optimistic. As the chart below shows, stocks are acting like the recession has already occurred. In the left panel we have super-imposed the current Dow Jones Industrial Average (blue line) on the price movement of the Dow during the 1987 crash. It has mirrored the downside. The cathartic sell-off we saw two weeks ago could still mark the low in the current downturn but, even if it has, the road back up won’t be straight up. Volatility will continue to be significant and we will probably re-rest the lows or something close to them. But we do believe we are in the process of forming a ‘buyable longer-term low’ in front of the traditionally strongest seasonal period of the year for the stock market, the November-January period. The way we look at it is that, if you view stocks trading at 100 right now, we fully expect them to be trading at 140 to 150 in two to three years; but they may still drop lower in the short-term. So if you have a longer-term investment horizon, it is now time to take equity exposure higher and we have been doing that in all of our asset allocation and balanced fund.

The right panel on the chart above shows the price-earnings (P-E) ratio for the Canadian market (S&P/TSX Composite Index). Valuations are now at the lowest level in 20 years based on earnings. We would add that earnings estimates going forward are still too optimistic and that earnings growth will, in almost all likelihood, be negative over the next year. But, even assuming lower earnings estimates, the speculative premium has now been taken out of stock prices. The other aspect of the current stock market environment that we like is that fear and negative sentiment has reached levels associated with market lows in the past. In the chart below, we show the movement of the Canadian stock market (upper chart) against the volatility index (VIX – lower chart) over the past seven years. It can be clearly seen that the spikes upward in the VIX have been associates with low points in stock prices.

The most recent upward spike in the VIX is unprecedented. It moved over 80 two weeks ago, matching the high during the 1987 crash which was the highest measure on record (recreating the index for the 1930’s apparently would show a level of over 100 but is the only other time that volatility has reached such extremes). Investors who follow the market on a daily basis are probably not surprised to hear about this volatility measure as the daily price action is stocks is unlike any of us has even seen. But the indicators are all consistent with period of lows in stock prices.

One final view of why we have shifted into equities to the degree we have in the past few weeks is illustrated in the chart below where we show the ratio of global stock to bond prices (top panel). The relative valuation of stock to (government) bonds has returned back to levels which are again consistent with period of stock market lows or, at the very least, times when your asset mix should be shifting away from bonds and into stocks. The bottom panel shows the deviation of global stock prices from their 12-month highs and is a very graphic demonstration of how brutal this downturn in stock prices has been. But in terms of damage done to stock prices already, the current downturn matches those of the worst prior downturns. Low and fallen prices aren’t enough to create a stock market bottom but the combination of attractive valuations, negative sentiment and reduced expectations all combine to put the pieces in place to form a market low. We continue to believe that the recent sharp sell-off has been more of a reaction to the financial crisis rather than an accurate future indicator of economic activity. Although a financial crisis can ultimately lead to an economic crisis, and therefore justify the fall in stock prices, we continue to expect that the global economic growth numbers will not be nearly as dire as the stock market decline is indicating. Liquidation of stocks and commodities has been aggressive due to the unwinding of the financial leverage of many participants as opposed to sales based on fundamental valuations. This, in our view, is what creates buying opportunities and we are acting accordingly in Canadian Balanced Growth Fund.

Our asset mix strategy has not clearly moved to an overweight position in equities with a subsequent reduction in cash and fixed income, although credit spread in the fixed income market are also looking very attractive as well. Within the stock market our purchases have been focused on the cyclical sectors of the market that have fallen the most in the downturn, including moving to overweight positions in Energy, Basic Materials, Industrials and Technology. One key sector where we remain underweight is the Financial sector. We continue to believe that bank and insurance companies will need to delever their balance sheets (i.e shrink assets) and raise additional capital in order to support growth going forward. Loan growth will be minimal and earnings growth will get diluted in the banking sector suggesting that expectations still have to be ratcheted downward. The Banking sector has held up relatively well thus far in the downturn but we don’t think it will lead the market in any recovery going forward, thus our continued underweight position.

Financial leverage and the stock market downturn has also claimed victims among the CEO’s of major companies as well as major corporate raiders. Chesapeake Energy Chairman was forced to sell a substantial portion of his stake in the company for $18.06 per share due to a margin call; the stock traded as high as $70 as recently as June. Billionaire investor Kirk Kerkorian has begun selling his stake in Ford Motor Co., raising new concerns about the health of the auto maker as well as Mr. Kerkorian's own casino and hotel holdings. In a regulatory filing, Mr. Kerkorian's investment company, Tracinda Corp., said it sold 7.3 million Ford shares on the open market Monday, at an average price of $2.43, well below the average of about $7 a share he paid for most of his holding. The move cut his Ford stake to 6.09% from 6.43%. In its filing, Tracinda said it intends to reduce its holding further and may sell all 133 million remaining shares. At the current share price, Mr. Kerkorian is looking at losing roughly $640 million of his original $980 million investment. In its filing with the Securities and Exchange Commission, Tracinda said it plans to shift its investments to casinos, hotels, oil and gas. Mr. Kerkorian used a $600 million credit line to help finance the Ford stake, and because of the decline in Ford shares he recently had to pledge 50 million more shares of MGM Mirage, which he controls, as collateral. According to SEC filings, he has put up a total of 100 million of his 149 million MGM Mirage shares to back the credit facility. MGM Mirage stock has fallen more than 85% since hitting above $100 per share last October, dinged by the weak economy and visa restrictions imposed by China that hinder visits to the company's Macau operations. The value of Mr. Kerkorian's almost 54% stake in MGM Mirage has sunk by almost $13 billion, to just over $2 billion

In terms of adding insult to injury, you don’t have to look any further than Yahoo Chairman Jerry Yang who had to disclose in his recent third quarter earnings report that his company paid financial advisors $37 million in the past quarter advising Yahoo on takeover defenses to fend off a hostile bid from Microsoft. This was as earnings for the quarter fell from $151.3 million in last year’s third quarter to $54.3 million in the current quarter. The company also lowered annual sales guidance from $7.60 billion to $7.27 billion and also announced they were being forced to lay off 10% of their work force, or 1,500 employees. In terms of the ‘input value’ for the $37 million, the advisors helped Jerry fight off a $33 cash bid for the company from Microsoft; Yahoo shares were trading at $12.07 at the close yesterday!

Mark Twain was ahead of the curve: “October. This is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August and February.”

John Zechner