To restate the obvious, this summer has been another time of extreme volatility in the markets. The intense and relentless media coverage has been unsettling to say the least. Headline news, political gridlock, and brinkmanship in the US contributed heavily to investor fear and angst.

What has become increasingly clear as we’ve moved into September is the growing dichotomy between the developed countries and the developing countries. High debt in the developed countries of Japan, US and Europe will strain their balance sheets and provide an impediment to stronger economic growth over the next 18 months and longer. In contrast, the developing countries of China, India, South East Asia and Latin America have growing populations and growing economies. To put this into perspective, here’s an interesting statistic. Emerging market consumer spending as a percentage of global spending was 17% in the 1990′s. By 2008, it had grown to 25%!

As we move forward, we anticipate economic growth from emerging markets of about 6% – 8%. North America is anticipated to grow between 0% and 2%, which will be insufficient to resolve the high unemployment rate any time soon. As a reminder, however, unemployment rates are a lagging economic indicator and stock market momentum can turn upwards before we see unemployment rates turn down.

In the current environment, momentum is still negative and North American consumer sentiment is very cautious. Businesses too have grown increasingly cautious as many sit on above average levels of cash. The chart below (click it for a larger version) shows the performance of stocks (as measured by the US S&P500) relative to long-term bonds dating back to 2002. You can see the extreme “oversold” equity position that occurred in 2008/2009 and now again in 2011. The chart shows that stocks are more attractive opportunities for growth than long-term bonds.

Canada is not immune to the current economic and market outlook although we are well positioned with our resource-weighted stock market, our fiscal prudence and political stability. Large cap companies that pay reliable dividends will be one of the ways to get ahead. We are advocating higher than usual cash positions (5%-10%), some exposure to gold, and a barbell positioning in our client accounts. By this, we mean having exposure to the defensive stocks, such as financials, telcos, utilities, and REITs, and some exposure to commodities, including the dividend-paying energy stocks, and to a lesser extent, materials that have lower dividend yields. We are reducing exposure to small cap companies in this more uncertain environment.

One final message. Every year since 1993 when I began working in financial services, there has been some type of global or local “turmoil” that has rocked the stock markets. The declines have varied depending on each crisis and the level of anxiety. This is one of those times. What I do know is this. The world did not grind to a halt during other crises and it won’t this time either. None of us know the best time to sell or when to get into the market. If the average age of retirement is 62 years, most of us need to plan on about 25 to 30 years of retirement living where we will need to rely on our retirement savings for income. Keeping too much of our money in cash at 1% or fixed income at 2%-3% will not get us to where we need to be. Despite the ups and downs, the best way to stay ahead of inflation and taxes is in the equity market. That being said, we will have to learn to live with periods of volatility moving forward.

Times are unsettled. Please feel free to contact us to review your portfolio.

Dear Valued Clients,

Most of you are aware that September and October were extremely difficult months for stock markets (for the U.S. market, October 2008 was the worst month in over 20 years) – this will be reflected in the statement you’ll be receiving shortly.

A common question as I talk with clients is: “What exactly led to the current issues?”

Here’s my summarized version of how we got here:

1. Between 2001 and 2003, low interest rates encouraged global investors to begin taking on increasing amounts of borrowing and risk (generally without fully understanding the risk to which they were in fact exposed). As a result, it is now clear that debt driven demand for commodities, real estate, and stocks pushed up some prices to an unsustainable level.
2. Beginning in the middle of last year, we saw the opposite happening. As U.S. real estate prices started falling, mortgage defaults increased, and the level of debt underpinning these investments became clear, these same investors began to shed risk and sell assets, without regard to quality and often at whatever price they could get.
3. In the process of this unwinding of risk, there were massive write offs and financial institutions such as Lehman Brothers and Bear Stearns collapsed under the weight of the debt they had accumulated
4. Beginning this fall, the level of mistrust spiraled upwards and fear paralyzed markets – as financial institutions started building absolute worst case scenarios into their thinking, access to credit for consumers and businesses shrunk, and the financial system came close to seizing up.

Stock prices today are severely depressed as a result of this sequence of events. Recently I heard the current challenge for investors compared to shopping at a Boxing Day sale – with everything off 30% to 50%, our challenge is to differentiate between two categories of products:

• low quality items that are still expensive even at current prices, and
• high quality items that have been marked down and represent terrific value.

Where we find ourselves today
While there are still substantial issues to work through, the good news is that we do appear to be seeing greater stability in the global financial system – a number of financial industry leaders have commented that they are much more confident today than they were a month ago. And it’s important to remember that most conventional measures of market valuation point to the fact that the broad market is significantly undervalued.

It’s worth noting as well that despite its painful drop, Canada has actually withstood this year’s market turmoil comparatively well. Barron’s Magazine recently compared year to date performance for the 15 largest markets. Up to Friday, October 24, the Canadian market was down 33%, just ahead of Switzerland for the smallest decline, followed by the UK and the US with 40% drops. Overall, Asian markets were down 44% and European markets off 46%.

Given the drop in commodity prices and Canada’s reliance on resource stocks, this performance is better than we would have expected – and is in large part testimony to how well Canada’s banks have held up compared to those in the United States and Europe. If we see commodity prices recoup some of their recent declines, the Canadian market is quite well positioned compared to most.

Answers to common concerns
I thought it might be useful to discuss some of the concerns you might be experiencing as you watch your portfolio react to the current market conditions – and share with you my thoughts on these questions.

1. “We’re going into a deep recession”
Given the growing consensus on this subject, it appears that the world economy is indeed entering a very rough patch. But it’s important to remember that we’ve been here before. Depending on how you measure a recession, we have gone through ten of them since the Second World War, and markets came out of each one to move to higher levels. Recall that some of those recessions such as the one in the early ‘80s have been just as severe as anything currently forecasted.

2. “Today’s problems seem overwhelming and insurmountable”
We are most certainly facing daunting challenges. But once again, we’ve been here before.
As just one example, in December of 1990, the markets were down 30% in six months and the stock of Citicorp was cut in half. Canada and the U.S. were in recessions, residential and commercial real estate prices were off 25%, the U.S. was in a full blown banking crisis due to the savings and loan fiasco, and Iraq had occupied Kuwait, with no clear indication of how the West would respond.

Without in any way diminishing the magnitude of today’s issues, it’s worth remembering that we felt just as overwhelmed at points in the past and emerged just fine.

3. “With all the bad economic news still to come, this is not the time to be in stocks”
While the past is no guarantee of the future, it is the best guide we have. It is important to understand that the markets already reflect all of the bad news we know about – and that on past experience, recession-induced bear markets such as this one will see stock prices begin to rise well before the economy does.

As an aside, this was one of the key points Warren Buffett made in a recent New York Times article, explaining why he has shifted his own personal portfolio into stocks. This article is available on the New York Times website at www.newyorktimes.com.

As for the market pundits who seem to dominate the media these days, we need to look at their track record. One example is work done by CXO Advisory Group in Massachusetts. They tracked “measurable forecasts” by 50 prominent market forecasters. Their collective batting average? 48% or about the same as flipping a coin.

4. “We could go into another depression”
It is essential to recognize that today’s central bankers and political leaders learned from the terrible mistakes on fiscal, monetary and trade policy that turned what many economists believe should have been a normal recession into the most prolonged period of economic difficulty of the 20th century.
That’s why most economists believe the chances of another depression are exceedingly remote. Again, let me know if you’d be interested in recent articles from Fortune and Report on Business Magazine, explaining why this is so.

5. “I want to stick to safe investments”
At times like these when we’re overwhelmed with pessimism and downbeat news, it is understandable that some would find “safe” investments appealing. Every decision we make entails a mix of gain and pain. These days, the difficulty is the timing of when the gain and pain may occur. Stay on the sidelines and the gain in terms of peace of mind is immediate, with the pain to be felt down the road. Participate in the markets, on the other hand, and the pain of volatility and uncertainty is immediate with the gain to be had down the road.

While it may be tempting to seek the safety of secure investments, for most investors, the return on these investments will not allow them to hit their long term retirement goals. Sometimes the old advice is the best advice. At times like these, there may be value in revisiting your long term objectives, going over your cash needs and reviewing the plan you have in place to achieve your goals.

The good news is that most are properly positioned to be able to handle this downturn and wait until the market goes back up. In some cases, I am meeting with clients to review their financial plan and look at whether changes are needed to weather this storm. In a few instances, we are taking a hard look at their discretionary spending as a result.

Let me know if you would like to meet to reevaluate your goals, your current cash needs, or just to talk about your account. In particular, once you’ve had a chance to review your statement, don’t hesitate to give me a call if you have any questions or would like to talk about where you stand – you can reach me at (416) 355-6364.

Finally, please remember that I am in this with you and am here if you need me.

This article is for information purposes only. All performance data represents past performance and is not indicative of future performance. It is recommended that individuals consult with their Wealth Advisor before acting on any information contained in this article. ScotiaMcLeod does not offer tax advice, but working with our team of experts we are able to provide a suite of financial services for clients. The opinions stated are not necessarily those of Scotia Capital Inc. or The Bank of Nova Scotia. ScotiaMcLeod is a division of Scotia Capital Inc., Member CIPF.

This report illustrates that the positive returns from Canada are not all that they seem and that strength has not been broadly based across all stocks and sectors. It also emphasizes the need for investors to understand the composition of their equity portfolios, how they compare to the composition of the TSX Index, and more importantly how their portfolios are structured to meet their long term investment goals.

Read the full report: The TSX Index – Positive, But Misleading

In volatile markets and when investment portfolio returns are lower, it’s not uncommon for investors to question the wisdom of past investment choices. Some investors might be tempted to pull out of long-term strategies or to invest too conservatively by shifting their portfolio towards guaranteed products such as GIC’s. While there is a place for lower risk investments in a well-diversified portfolio, there is a danger of being too conservatively invested and missing the growth potential of the markets. Reduced real spending power during ones’ retirement years and the possibility of re-investment risk in a declining interest rate environment are two concerns. If you would like more information, email me for a copy of “Overly Conservative Portfolios do not Guarantee Investment Success” by Russell Investments.

The credit turmoil in the U.S. financials and the Bear Stearns situation specifically prompted questions about Canadian investors’ protection in the case of investment dealer bankruptcy. ScotiaMcLeod is a member of the IDA (Investment Dealers Association of Canada) and a member of the Canadian Investor Protection Fund (CIPF) that provides investor protection for investment dealer bankruptcy. Each unregistered and registered account held by an investor is protected up to a limit of C$1 million for any combination of cash and securities. The limit applies to any shortfall and CIFP does not cover losses from market fluctuations or losses from the bankruptcy of an issuer. Please go to cipf.ca for more information.

Corporate earnings reporting season is underway for companies listed on the S&P500 and thus far, results have been much stronger than anticipated. These numbers are closely watched as they give an indication of the health of the economy. Not at all surprising, US financials and consumer discretionary companies reported the most declines in year over year earnings per share. These results mean that either there will be a longer than expected wait for corporate America to feel the negative impact of the housing slump and related mortgage debacle, or more likely, that management has collectively done a good job of “managing expectations” for profit growth, in effect under-promising and out-delivering! We maintain our position that analyst consensus estimates are too optimistic for 2008 and 2009 and are therefore subject to downward revisions.

As positive as we are in the longer-term outlook that sees a recovery from the current brief economic downturn, we still advocate holding 10% – 15% cash positions in equity portfolios to protect against the risk of another market correction and we favor invest-ment in the defensive sectors of the market such as consumer staples.

The fact remains that growth in North America is slowing, the U.S. Housing Market is in bad shape and is expected to decline further, the U.S. consumer is spending less, and jobs are disappearing in the U.S. Add to that higher food and gas prices and you don’t get a pretty picture for the North American economy.

Winter 2008 Update

Volatility in global financial markets has increased substantially over the past six months, beginning with the equity market downturn at the beginning of the summer of 2007. Equity markets did briefly recover much of their losses, but have since moved lower, and the path appears to remain rocky.

Key Points to Remember
• It is a market of stocks, not a stock market. Although the benchmark indices have posted negative returns over the past twelve months, with sharply negative returns in the last three, sector and individual share price performance has been very mixed.

-In the S&P/TSX Composite Index, Utilities and Materials have posted positive returns over the past three months even as the index posted a -7.1% return.
-68 of the 257 members of the index are in positive territory over this period – 28 of which have provided returns in excess of 10%.

• After a sluggish performance in the first half of 2007, bonds have provided solid returns as equity markets moved lower. Over the past 12 months, the DEX Universe Bond Index has returned 4.9%, after marking a 4.4% gain over the last three months.

Where are things headed?
Our Portfolio Advisory Group continues to hold a constructive view of markets going forward:

• Although the pace is expected to slow, Scotia Economics is forecasting growth will remain in positive territory – in 2008 the Canadian economy is expected to grow 2.2%, while the U.S. is expected to grow by 1.8%, Japan by 1.4%, Western Europe by 2.0%. Softening growth in the industrialized world will temper performance in developing nations, but nonetheless, Scotia Economic believes China’s economic expansion will remain robust, especially as they move towards the 2008 Beijing Olympics in August, while India, Russia, and a number of other emerging nations will continue to outperform.

• Scotia Economics is forecasting a 0.5% reduction in the Bank of Canada’s overnight target rate to 3.75% by mid 2008, to address tight credit conditions, slowing growth, and the strong Canadian dollar. In the U.S., the Federal Reserve is expected to lower its funds rate a further 1.0% to 3.25% to address risks of a housing recession and associated financial contagion.

• With lower benchmark rates, Scotia Economics is also forecasting short-term bond yields to continue to decline from current levels over the next six months. Longer term bond yields however are forecast to bottom in the first quarter of this year near current levels, and then to rise over the balance of the year. Benchmark 2-year Canada yields are expected to fall towards 3.0%, but 5-year yields are expected to rise back above 3.70% and 10-year yields are forecast to rise back above 4.00% by the third quarter.

• Scotia Capital Portfolio Strategist Vincent Delisle has highlighted that the S&P 500 and the S&P/TSX Composite are in correction territory, with both indices more than 10% below their peaks. He believes those peaks are unlikely to be revisited in the coming months, and hence has recommended lowering equity exposure in favour of cash/money markets. However, he continues to call for positive equity market performance for 2008, based on a recovery in the second half of the year. His forecast level for the S&P/TSX Composite for the end of 2008 is 14,500, and 1575 for the S&P 500.

• After rising 16.8% in 2007, the Canadian dollar is expected to continue to gain versus the U.S. dollar, based on merchandise trade and fiscal surpluses, stronger relative underlying economic fundamentals. The Canadian dollar is also expected to appreciate versus the Pound Sterling; however, it is expected to lose ground versus the Euro, the Japanese Yen, the Australian Dollar, and the Chinese Yuan.

What do you do now?
• In times like these, we remind investors as we did last summer and again last fall that we have been here before. Investors should not panic – stick with your long-term plan, and maintain a diversified portfolio that meets your risk tolerance.

• Quality Financials look good for the long term but expect that bank stocks will remain volatile in the short term. Coming out of this pullback, other defensive sectors like Telecommunications, Pipelines/Utilities, Consumer Staples, and Gold will outperform.

• We also recommend greater emphasis on dividends and U.S. multinationals. Dividends provide downside support and become an increasingly significant part of total return calculations when the market is trending lower.

• Given our outlook for longer term yields to rise, we continue to recommend active fixed income investors focus on 2-4 year maturities of high quality corporate issues.

• Although the near term outlook is for the Canadian dollar to appreciate versus the U.S. dollar, the U.S. equity market is home to numerous multinationals and offers Canadian investors many attractive investment alternatives.

This publication is intended only to convey information. It is not to be construed as an investment guide or as an offer or solicitation of an offer to buy or sell any of the securities mentioned in it. The author is an employee of ScotiaMcLeod, a division of Scotia Capital Inc. (“SCI”), but the data selection, analysis and views expressed herein are solely those of the author and not those of SCI. The author has taken all usual and reasonable precautions to determine that the information contained in this publication has been obtained from sources believed to be reliable and that the procedures used to summarize and analyze such information are based on approved practices and principles in the investment industry. However, the market forces underlying investment value are subject to sudden and dramatic changes and data availability varies from one moment to the next. Consequently, neither the author nor SCI can make any warranty as to the accuracy or completeness of information, analysis or views contained in this publication or their usefulness or suitability in any particular circumstance. You should not undertake any investment or portfolio assessment or other transaction on the basis of this publication, but should first consult your investment advisor, who can assess all relevant particulars of any proposed investment or transaction. SCI and the author accept no liability of whatsoever kind for any damages or losses incurred by you as a result of f reliance upon or use of this publication in contravention of this notice. TM Trademark used under authorization and control of The Bank of Nova Scotia. ScotiaMcLeod is a division of Scotia Capital Inc., Member CIPF.

The US economy is slowing down. A soft US economy is forecast with growth projected to be less than 1%. It’s unclear if the country will slip into recession, however the Feds are expected to lower the overnight bank rate by 100 bps to stimulate economic growth.

Canada is in a more enviable position with our economic growth expected to be above 2% due to our resource base. However, with about 80% of our exports to the U.S., it’s difficult to see how we won’t be affected by the U.S. slowdown.

Global demand for our commodities will help our economy this year. Did you know that in 1987, our total trade with China was $8.7 Billion and in 2006, it had grown to $42.1 Billion? (StatsCan). According to Dennis Gartman,, writing on January 15th, “gold has become the world’s third reservable currency. It is the anchor or quiet harbour to which frightened…and not so frightened…capital seems to return.” And, the general consensus seems to be that the C$ will remain close to par, while the U.S.$ will remain weak.

2007 was a challenging year for investors as the Canadian stock market leaders were concentrated in a narrow list of companies. The top five TSX gainers contributed 89% of the total 2007 gains; RIM, Potash and Alcan alone accounted for about 72% of the return.

We began 2007 on a positive market tone and ended the year on a negative note, plus we experienced heightened volatility in the markets. Some analysts believe the opposite will happen this year – we’ll begin 2008 with negative market sentiment plus volatility and end on a more positive note. Certainly the continued volatility in the stock markets will test our patience!

The 4th year of a U.S. Presidential election and the positive effect of expected interest rate cuts by the Feds are what is behind the more optimistic outlook. As we have absolutely no control over the markets, we’ll just have to wait and see. Single digit stock market returns are expected however.

Hedge Funds have become increasingly popular investments over the past decade and have recently garnered a great deal of attention in the financial press. Here’s an article prepared by our Portfolio Advisory Group that provides information you should know.

Over the last decade, hedge Funds have become an increasingly popular investment vehicle and an integral part of financial markets. Their diversified investment strategies and low correlation to traditional asset classes allowed them to be marketed as an “alternative” asset class for retail and institutional investors. The hedge fund industry has become big business in terms of assets under management and its influence on financial markets. It is estimated that industry assets under management “were” approaching U$1.7 trillion globally.

Read the full article here: Hedge Funds – Things You Should Know (pdf-43kb)

As the U.S. mortgage crisis continues to send waves around world financial markets, major world equity indices are off 8-10%. Our Portfolio Strategist, Vincent DeLisle, wrote earlier this week that he believes we may have gone through 80% of the potential decline. Time will tell.

It is not uncommon for markets to pull back. Equity markets regularly have corrections of less than 5%, corrections of 5 to 10% typically occur once or twice a year, and bear markets, defined as more than 20% corrections, occur every 4 years or so. This current, intermediate type of correction may take one to three months to resolve itself.

We know that market volatility is unsettling to investors. To help give you perspective on the current situation, we have attached below a report prepared earlier this week by our Portfolio Advisory Team.

As always, if you have any questions or concerns, please call.

Bev

Volatile Markets – Stick to your long term strategy (pdf-37kb)