For several years we have been analyzing the abuse of credit in the US (and Europe), whether that was in the form of “no money down” mortgages, subprime loans, collateral debt obligation, structured investment vehicles, etc. This phenomenal credit excess will continue to hamper global economic growth and is very, very different than the “usual” economic recessions that most investors have experienced.

David Rosenberg, the ex-chief economist at Merrill Lynch (US), is an exceptionally astute economist. His latest letter provides an excellent summary of the evolution of the credit crisis, as well as his expectation of its impact on our future economic growth.

The McGann Wealth Management team continues to take a very cautious approach to the equity markets. Our belief is that lower stock markets lie ahead and we wait in anticipation of buying great companies at discounted prices. In the meantime, we continue to favour high dividend paying stocks, preferred shares and corporate bonds.

To view David Rosenberg’s article click here: David Rosenberg Economic Outlook

Best regards,

Mike

The great news is that excellent buying opportunities are on the way. Its days like today, that speed up the process, with Canadian and US stock markets down 3%. Since the high of the market on April 23, 2010 the S&P 500 has declined 14.5%. Our Canadian market has declined 8%, so we have faired somewhat better, although several of our financial stocks (ie. banks) have declined substantially more (i.e. Bank of Montreal, peaked at $65.41 and closed today at $57.35, for a decline of just over 12% since the April peak).

Its a great time to have fixed-income, such as bonds and high quality preferred shares. I anticipate continued choppy markets over the next two quarters , as we await further buying opportunities. My expectation is that we are approximately one third of the way through this market decline. For those of you who have not purchased any gold bullion, now would be another excellent time to buy. Many portfolio managers expect some kind of sovereign debt default in 2011, placing even more downward pressure on the already punished Euro. Gold has now clearly moved into the number 2 spot, as the world’s second reserve currency. With the severe decline in the Euro, more and more sovereign and institutional monies are moving away from Euro and into gold bulliion.

Best regards (and happy Canada Day to all !)

Mike

RE: State of New Jersey: “The firm (Moody’s) on Dec. 17 cut the debt rating to Ba1, one level below investment grade, from Baa3, and said it may lower it further, citing concerns over how the town will close a $12 million budget gap and make up for a $50 million, or 1.7 percent, decrease in its tax base over the past two years.”

“The scenario happening in New Jersey may be a harbinger” as communities struggle with declining revenue, said Chris Hoene, director of the Center for Research and Innovation at the Washington-based cities league. “The phenomenon of cities in fiscal distress is certainly something that will be on the rise for the next few years.”

Many of these ongoing fiscal scenarios are not being fully “felt” by the markets because of the massive global efforts with “stimulus” – READ -Borrowed money (and or printed money).

The net result, as we are starting to see, is higher interest rates globally. Last week, 2 year Greek bonds hit a high yield of 24 % !! Don’t think that Canada is affected? Our 5 year fixed mortgage has increased from 3.9% to 6.25% in the span of two months.

Higher debt levels; rising interest rates; a withdrawal of stimulus; Ongoing high US unemployment; Rising tax rates (in the US effective January 1, 2011); It all points to significant headwinds for an overvalued stock market ! At the very least, its a time to have great caution.

Contrast that with the Aggressive Advisor, who wants you to throw caution at the wind, and be fully invested in equities .

A new client of mine was given this advice in 2007 and 2008 , and was convinced to borrow $400,000 over two years to maximize growth. Currently, this investor has a portfolio of
$ 296,665. The bottom line: his Aggressive Advisor has cost him $103,334 in capital PLUS interest payments of $24,585 over the same period.
SUMMARY: Being aggressive over the last 3 years has put a significant dent in this investor’s retirement plan.. AND that’s after a 70% rebound off last year’s stock market lows. I am restructuring this portfolio immediately, to reflect a very uncertain market.

Being cautious over the last few years has really paid off.

Sincerely,

Mike McGann

Please find below an article that outlines the US interest rate scenario. The letter is an excerpt from this week’s newsletter from John Mauldin.

Best regards,

Mike McGann

Where Are Rates Headed And Why?By: Barry Habib, Chairman, Mortgage Success Source

So the Fed stopped buying Mortgage Backed Securities, and people are wondering if this will affect mortgage rates . There’s been plenty of whistling past the graveyard, guesswork and denial, where so-called experts have been trying to tell us that there will be minimal – if any – change to rates.
That pipe dream is just nonsense.
Let’s look at what we can expect for mortgage rates and the overall Bond market in the months ahead. During the past fifteen months, the Fed purchased $1.25 Trillion in MBS, which represented 80% of the mortgage market. Prior to this program, mortgage rates were above 6%. Now that the Fed program has ended, it’s reasonable to assume that mortgage rates will rise back towards those levels.
Just How Much Money is $1.25 Trillion?
In today’s financial headlines – the word Trillion is often casually thrown around. So much so, that it’s easy to lose perspective on how much money this really represents. Picture a stack of $100 bills. It might surprise you to know that it only takes a stack four inches high to be worth $100,000. So $1,000,000 would be a stack of $100 bills 40 inches tall. How about a Billion? Well, you would have to stack $100 bills up to the top of the Empire State Building…twice…in order to reach a Billion. So to picture $1.25 Trillion represented by a stack of $100 bills – that stack would be 850 miles high. If you could turn that stack on its side and were able to drive alongside it, it would take you longer than 14 hours to reach the end. If you laid those $100 bills down side by side, they would travel around the world 50 times. We’re talking about a lot of money here.
The Fed’s purchasing influence has been significant. And now in the absence of this safety net, Bond prices and mortgage rates will experience greater volatility and a gradual worsening. Adding to this is the fact that the Fed will, albeit gradually, begin to sell some of their mortgage holdings, as they reverse their quantitative easing measures. It doesn’t take a rocket scientist to see that this will pressure Bond prices…but read on, because there are additional factors at play, which will influence Bond prices lower and mortgage rates higher.
What Moves Mortgage Rates?
Mortgage Rates are not pegged to the 10-year Treasury Note, as some have reported in the media. Those in the know do understand that mortgage rates are based on the pricing of Mortgage Backed Securities (MBS)…and these Mortgage Bonds are influenced by many different factors.
They respond quite well to technical signals as well as Stock market volatility, as money can be drawn from or parked into Mortgage Bonds. Certainly, the news and inflation implications also play a heavy role in influencing Mortgage Backed Securities.
And just like the aforementioned influential factors, Treasuries can also play a role in the price direction of Mortgage Bonds. Last year, the 10-year Treasury Note was at approximately 2.2% and has since moved towards 4%. During this time, mortgage rates have been virtually unchanged. But now, Treasuries are offering yields that are close to the current Mortgage Backed Security rates, which are offered to investors.
Let’s take a moment to understand the difference between the mortgage rate a borrower pays and the coupon yield on a Mortgage Backed Security that an investor receives. If a borrower pays 5.25% on their loan, only 4.5% of that is passed on as a coupon yield to the investor. This is because the mortgage loan servicer (that’s who you make your payment to) takes a piece of the action. Additionally – the aggregators of these loans, like Fannie Mae and Freddie Mac take a piece as well. And let’s not forget the folks on Wall Street, who need to get paid for underwriting, securitizing and selling this paper.
We know that Treasuries are backed by the full faith and credit of the US Government and are free from state income tax. And the 10-Year Treasury Note, while clearly not pegged to Mortgage Backed Securities, does offer investors a competitive alternative with a similar maturity period to Mortgage Backed Securities. But because of greater safety and tax advantages, the 10-Year Note will always trade at a lower yield than Mortgage Backed Securities, and therefore put a floor beneath how low Mortgage Backed Security coupon yields and corresponding home loan rates for borrowers can go.

The US is spending at an unprecedented rate – and its spending money it doesn’t have. This means that more and more Treasuries will continuously need to be auctioned off. And in order to entice buyers to keep absorbing this supply, yields will very likely need to continue higher, just as they have for over the past year.
Additionally – sovereign debt has come into question. Downgrades in the sovereign debt of both Greece and Portugal are a warning to the US that the same can happen here, which would drive the cost of borrowing much higher. Our government currently spends $1.49 for each $1.00 it brings in. Our debt is now 57% of GDP…and rising. Does anyone really believe that Treasury yields are headed lower? As Treasury yields move higher from their current levels, mortgage backed security coupon yields will also need to move higher in order for investors to want to purchase them.

The Ever-Important Carry Trade

While the Fed’s end of the MBS purchase program and eventual selling of MBS – along with an almost certain move higher in Treasury yields – all tell us that mortgage rates are headed higher, there is another important element that could have an even greater influence in moving yields higher and prices lower throughout the Bond market. It’s called an unwinding of the “carry trade.” The low interest rate environment in the US has provided fertile ground for the carry trade, where large investors can borrow at very low rates, and leverage into higher yields, resulting in huge returns.
Let’s take an example: An investor wishes to purchase $1M in Mortgage Bonds yielding 4.5%. This would provide $45,000 as an annual return. In order to make the purchase, the investor puts up only 10% of $1M, or $100,000 in cash – and borrows the other $900,000 at the Fed Funds Rate + 2%, for example – which would be a borrowing cost of 2.25% or $20,250. This investor receives a $45,000 return, but subtracts a $20,250 cost to borrow $900,000 – leaving them with a net return of $24,750. Remember, the investor needed only to invest 10% of the $1M purchase – or $100,000 in cash. This gives the investor a whopping 24.75% return on their investment in a boring little old Mortgage Bond. And of course, this “carry trade” can be used in other securities as well.
While the investor understands that there are always market risks at play – the juicy 24.75% yield cushion gives them much added comfort to stay in the trade. But the biggest risk for the investor is if their borrowing costs – which are based on the Fed Funds Rate – were to rise.
When the Fed starts to hike rates, it will signal the beginning of a tightening cycle. A few Fed hikes can cause the yield cushion to quickly evaporate…and the decline in Bond values from overall higher yields could turn the trade from highly profitable to highly costly in a very short period of time. So why do these carry trade investors have such a care free attitude and confident air? It’s because Ben Bernanke and the Fed have assured them that there is nothing to fear. How did the Fed do that?
Via “Fed Speak,” these carry trade investors hear that “conditions warrant exceptionally low rates for an extended period of time.” Translation: your biggest fear – that a hike in the Fed Funds Rate, which increases your borrowing costs and wipes out your gains – won’t happen anytime soon. It’s this “extended period” verbiage that is keeping the carry trade in place. When the Fed removes the “extended period” language, this will signal that hikes will begin in the near future, and that risk will prompt investors to begin to “unwind” their carry trade holdings. This will include the selling of Mortgage Backed Securities, which will assuredly push yields higher still.
When will the Fed remove the “extended period” language? It may happen sooner than you think. Kansas City Fed President Thomas Hoenig has officially dissented to the “extended period” language at the last two Fed meetings. And recently, St. Louis Fed President James Bullard, while yet to officially dissent, has stated that he feels “extended period” is inappropriate language and should be replaced by “data dependent.” And there have been grumblings from other Fed members, who are growing more concerned that leaving rates too low for too long can spawn asset bubbles or inflation down the road.

What It All Comes Down To
When all the factors are considered – the chances of higher interest rates are a virtual lock. And anyone in the market to borrow should consider acting sooner rather than later. With such low rates still in our hands…and all these various factors pointing at the inevitable fact of rates moving higher…you have to wonder what people sitting on the sidelines are waiting for?
It brings to mind the closing scene of the movie “Dumb and Dumber,” where two good-hearted but incredibly stupid heroes Lloyd and Harry are hitch-hiking, when along pulls up a bus full of beautiful Hawaiian Tropic models in bikinis. The models tell Lloyd and Harry that they are looking for two “oil boys” to lube them up before each of their photo shoots on the tour. Lloyd and Harry explain that there is a town down the road, where they should be able to find two lucky guys to help them out. As the bus pulls away, Lloyd and Harry look at each other and declare that one day their opportunity will come – they just have to keep their eyes open.
Here’s hoping you have your eyes wide open to take advantage of this fleeting opportunity…before it’s gone.

Stock market momentum is an amazing thing….it defies logic and refuses to address some very blatent short-term (and long-term) problems. Much like Nortel at $110; investors couldn’t get in fast enough, even though earnings started to dissappoint, and the sales channels were backing up. Similarly in today’s markets, US GDP numbers are looking rosy, jobless claims have stopped rising, and the housing market looks like it may still have a pulse…….as such, stocks continue to rally. Meanwhile, an unbiased observer would note the following:

1. Higher GDP numbers (around the world, but particularly the US) are simply a result of a concerted effort of world governments throwing a virtual endless amount of “stimulus” (read: borrowed or printed money) at the economy. What happens as this stimulus gets pulled back ?
2. The US housing market is still in terrible shape. “Based on the data from one of the nation’s biggest mortgage servicers, nearly 7.5 million loans are in some stage of delinquency or foreclosure, while an additional one million properties are already bank-owned”. “What’s more, with nearly one-quarter of US mortgages now “underwater”, almost 11 million borrowers are now trapped in loans backed by assets, the value of which is dropping like a stone”. (Wealth Daily, March 22, 2010)
3. ” Kansas City, MO, school district votes to close 29 schools (out of 61 total) to address $50 Million budget shortfall” *(Associated Press-March 11, 2010)
4. “New Jersey Governor Chris Christie on Thursday declared a “fiscal emergency,” allowing him to reserve or freeze state spending as part of his plan to tackle one of the largest 2011 deficits among the US states. “The deficit in the current budget is $2.2 billion, while the gap in the following budget has spiked to $11 billion from a forecast of $8 billion in November. Next year’s deficit is the largest-per-capita budget shortfall of ANY US state.” (Reuters Feb 11, 2010)
5. “The mire facing California, for example, makes Greece’s woes look somewhat manageable. California, staring at a $20 billion budget gap during the next 17 months, accounts for about 13percent of the U.S. economy. Greece accounts for just 3 percent of the economy of countries that use the euro…. Things are so bad in Nevada, meanwhile, that the state could lay off every worker paid from its general fund and it would still be $300 million in the red, according to state Assembly Speaker Barbara Buckley.” (Associated Press, Feb 14, 2010)
6. “For those who hold to the consensus view and its rose-coloured glasses, it looks like we are on the cusp of a renewed job creation cycle in the United States……..Dig deeper still into those jobs numbers, however, and you will start to see that there are some signs of rot beneath the surface in the U.S. labour market – signs that should give one pause as to the sustainability of this nascent economic recovery…..Looking past the headlines, what I find myself pondering is that if the best the U.S. labour market can do is print modestly negative headline payroll reports at this stage of the cycle, what are the numbers going to look like when the government stops doling out all the cheques that are supporting demand?”(David Rosenberg, Globe & Mail , March 10, 2010)

Our largest trading partner and neighbour is in a very precarious financial situation. It will take years and perhaps decades to right these deep rooted debt problems (not just in the US, but also the likes of Greece, Portugal, Spain, Italy and the UK). With sovereign debt risk rising, bond yields are rising as well, which will raise interest rates globally on bonds……AND other debt, like mortgages, making the problems even worse.
 

To me, this market is full of BULL ! When the stock market finally discounts the “reality” of what is actually happening, stock prices will be significantly lower. I don’t like this any more than you do, however, it will bring another round of glorious buying opportunites for those of us that have the patience.

Best regards,

Mike
P.S. I recommend you read his article:

The Rubber Hits the Road

Its an excellent update and review. You can get the pdf here:
 

Are you ready for another lost decade?
 

Best regards,

Mike

Most of the “technical indicators” point to lower markets: the S&P 500 has cleanly broken its upward sloping trendline, since March 2009. Price oscillators, such as the MACD, have broken down, indicating that stocks are headed lower.

The Global debt problem is getting worse, with countries such as Greece, Portugal, Spain, Italy and the UK with very high sovereign debt. As a result, interest rates are on the rise. 10 year interest rates have risen by almost 4% in the last few weeks on Greek bonds. This has put very serious downward pressure on the Euro and thus, upward pressure on the US $.

A rising US$ is putting downward pressure on commodity prices with copper down 18%, aluminum down 14%, lead down 14% and oil down over 7.5% in the last week. Commodity inventories are very high and mostly likely will add to the pressure for lower prices in the coming weeks.

Higher interest rates are inevitable in the US and then in Canada. It won’t be from the usual inflationary pressures, but rather from the increase debt risk.

Stocks have had a good run from the March 2009 lows. Its time to protect profit and await the great opportunities that are coming.

Regards

Mike

“Forget all the calculations off the “artificial” March lows. Forget the 25 per-cent market slide in the first 10 weeks of the year to that awful trough. Here is the reality: The S&P 500, from point to point, rallied 23 per cent in 2009 even though earnings per share for the year as a whole cam in at a whopping $21 less than first estimated.
Now that is remarkable. It almost wants to make you believe in the tooth fairy. ”

The operating earnings estimate for the S&P 500 coming into 2009 was $77. For the actual earnings to come in at $56, is a 27% decline in earnings ! Now you tell me…….if you were invested in a good company stock, say Royal Bank, and they released earnings down 27% from the estimate, do you really think a rally of 23% in the stock would occur, or be justified ?

The S&P 500 is highly overvalued. The masses can feel good that the US has avoided a more severe recession, than might otherwise have happened, without a Fed throwing trillions of dollars at the economy. US economic reality will set in , sometime in 2010. Rest assured, the serious problems of very high unemployment, growing mortgage defaults and foreclosures, high and growing government deficits, will have to be addressed (when it comes to calculating any “real” recovery). The great news is that those investors that have taken measures to protect their portfolios, will have another great selection of investment opportunities (no diffferent than last year at this time, when you could have bought Oil, Gold, the S&P 500, TSX, China …….etc.)

For the next series of “blogs”, I will be discussing exactly where to invest , once this overdue correction is upon us.

Best regards,

Mike McGann
Director, Wealth Advisor