In times of confident bull markets (i.e. not the present) investors gravitate towards smaller, more volatile stocks, looking for "pure plays" that have significant operating leverage to improving fundamental drivers (e.g. the price of oil, interest rates, emerging market growth, etc.). Investors, like young men in a liquor store, seek to maximize the bang for their buck, and in doing so, they willingly take on more and more risk. In boom times, investors are quick to finance small companies that are billed as 'the next (insert successful company name)' or are being run by 'the former management team at so-and-so company' or 'provide significant exposure to a given commodity'. In essence, small capitalization companies (technically defined as having market caps between $250 million and $1 billion, while micro caps are smaller than $250 million) have greater leverage than large caps to a common set of business drivers. And when the market in general is rallying and money is easy to come by, this strategy works quite well and small caps tend to significantly outperform their larger cap brethren. But when the music stops, you better make sure you have a place to sit.
A long time ago (the mid 90s) in a galaxy far far away (Western Europe) it was determined that the major economies of Europe needed to become more integrated in an effort to remain competitive with an increasingly ascendant United States. There was a need to increase the mobility of labour within European countries - while an Oregonian may be willing to relocate to South Carolina in pursuit of economic opportunity, it is far less likely for a Belgian to relocate to Italy or an Austrian to move to France (cultural and linguistic reasons tend to dominate) - and reduce the restrictions on the trade of goods and services. It seemed to make sense that in the pursuit of unity it would be necessary to harmonize interest rates and create a single currency. With that in mind, the Euro was born on January 1, 1999 and became the national currency of most of the major economies in Western Europe (with the notable exceptions of the UK and Switzerland)... finally you could tour the Louvre, the Colosseum, and the Heineken Brewery (strongly recommended!) without having to pay exorbitant fees to currency dealers every few days... ah travel bliss, thy name is Euro. With much fanfare the Euro made its debut and over the next two years... it was a total disaster! Like an overhyped IPO the new currency was at its peak (1.1800) the day it was unveiled and then went on to lose close to thirty percent of its value versus the dollar over the next two years. Europeans were up in arms with this decline in their wealth and Americans went shopping. But a funny thing happened on the way to the great currency graveyard in the sky (residents include the Zimbabwe Dollar, Turkish Lira, Argentina Peso), it sprang back to life.
July was not a good month for Canadian stocks. Let's get the numbers out of the way right now and then try to get our bearings: the TSX was down 6.04%, the materials sub-index was down 12.18%, the energy sub-index was down 13.00%, the TSX Venture was down 15.62% and the CRB Commodity Index had its WORST MONTH IN 28 YEARS! OK, now instead of rehashing last week's blog, "And the first one now will later be last, for the times they are a-changin' - Bob Dylan", where we talked about the disconnect that was occurring between commodities and commodity stocks and the recent outflow from commodity strategies into financials and other out-of-favor sectors, lets look at another piece of the puzzle, volatility. Volatility measurements attempt to quantify in percentage terms the movements in a stock price or index over a given period of time, usually a year. The higher the percentage, the more volatile the stock (or if you prefer, more risky), and vice versa. That said, volatility is something that investors have never really been able to get fully comfortable with. Let's take a look...
Keeping one's perspective in life-and-death situations is usually easier said than done. When it comes to nearly-life-and-death, like rapidly falling stock markets, perspective is no less important. The current nose-dive in the Canadian stock market - down 7.7% this month - comes against a backdrop of a global bear market where major indices are down somewhere between 10% and 25% on a year-to-date basis (versus only a 3.4% decline YTD in Canada, the best performance of OECD countries). Not that knowing somebody else is losing money makes the sting of a declining stock portfolio any easier to handle, but it does help keep us realistic in our expectations. As Alan Greenspan once said, ''It is just not credible that the United States can remain an oasis of prosperity unaffected by a world that is experiencing greatly increased stress,'' and neither can the Canadian stock market. Let's take a step back and look at the underlying drivers in this current market downturn...
A quick search on Fannie Mae and Freddie Mac on Google News yields more than 40,000 stories on the Internet from the past week. Suffice it to say, they've been in the news. With their stock prices plummeting, home foreclosures accelerating and Bernanke/Paulson/Bush doing a seemingly endless string of glorified public service announcements trying to soothe the fears of homeowners, clearly something significant is taking place. So what's happening behind the doors at those cutesy-named corporations? And how does this impact global markets? As we see it, the salient points are as follows:
Against the unpleasant backdrop of high food and energy prices and slowing global growth we've talked recently about the commodity trade (Commodities are the new T-bills - June 20th) and the money pouring into commodity funds as investors face a diminishing number of opportunities in the traditional asset classes (equities, bonds, real estate...). The out-performance in commodities in recent years has been joined at the hip to the surging economic growth in emerging economies, namely Brazil, Russia, India and China (the BRICs). Taking a step back however, it would be more appropriate to write this acronym as briC given the overwhelming influence of China's voracious demand and its mind-blowing infrastructure build-out - $9.3 Trillion over the next ten years... accounting for roughly 43% of the expected build in ALL emerging economies over the next decade (Russia, Brazil and India are but an RBI to China's Grand slam). Taking yet another step back, the Chinese economy has been growing at roughly 9.3% annually for the past fifteen years (meaning it has roughly quadrupled since 1993), but it hasn't grown at that rate every year... there have been a few speed bumps along the way. For instance, in the late 90s economic growth in China slowed to roughly 7% (see chart below), while inflation coasted along at about zero from 1997 to 2002. Today though, the situation is a little different and the authorities in Beijing are dealing with a new set of economic circumstances
Front Street Resource Peformance Fund - Manager Commentary
The resource markets have seen a dramatic correction in July and into early August. Oil has dropped $30 per barrel in the last month while gold has fallen over $100 per ounce in the last 10 sessions alone. Liquidity issues in the credit markets have spilled over into equities with small caps being sold rather aggressively. Many less liquid names have seen their share prices drop more than 10% on repeated days. The market is treating the resources sector as though the world is heading into a global recession, which we do not believe to be the case.
Front Street Energy Venture Fund - Monthly Commentary
Resource players took it on the chin during the month of July. The investor rotation (out of Energy/Materials into Financials/Technology) that began in June, accelerated during the month of July on further evidence of slowing industrial production.
Front Street Resource Hedge Fund Ltd. - Monthly Commentary
Resource players took it on the chin during July. The investor rotation (out of Energy/Materials into Financials/Technology) that began in June, accelerated in July, as the energy prices hit a boiling point for the economy worldwide, and began to slide. The slide in energy carried all commodities lower. The MSCI Worldwide index is now showing the group in an official Bear Market, as it has dropped in excess of 20% from its highs of May. The Front Street Resource Hedge Fund dropped 12.16% during the month.
Front Street Energy & Power Performance Fund - Monthly Commentary
Resource players took it on the chin during the month of July. The investor rotation (out of Energy/Materials into Financials/Technology) that began in June, accelerated during the month of July on further evidence of slowing industrial production.
Front Street Canadian Hedge - Monthly Commentary
The month of July was poor for the overall TSX Index, which was down 6.04%, but it was a nasty month for the materials and energy sub-indices, which were down 12.18% and 13.00% respectively. To put this performance into perspective, it has been close to three years since energy stocks have had such a weak month and it has been six years since materials have recorded such a decline.
Front Street Canadian Hedge - Monthly Commentary
After putting in two solid months of gains in April and May, global equity markets came apart in June as crude oil and a host of other commodities surged to new highs while financial institutions were once again under attack. The S&P 500 had its worst month since September 2002, declining 8.60%, while the NASDAQ fell an even greater 9.10%. The resource-insulated TSX managed to lose only 1.68% on the month, with double-digit gains in gold and fertilizers stocks offsetting sharp losses in virtually all other sectors.