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Market malaise
Where do we go from here?

Stock markets have traditionally been leading indicators. That is, the current direction of the stock market has usually been a sign of things to come for the economy in the subsequent six to eight months. Today, we're getting mixed signals and many investors aren't sure what to make of them.

Economic dichotomy

The North American economies are displaying impressive strength. First quarter U.S. economic growth was revised upward to an annualized figure of more than 6 per cent. The Canadian economy added more than 60,000 jobs in June alone, bringing the year-to-date total to about 300,000 new jobs added. Also, the housing market remains strong in both nations. Looks pretty good.

Recall that stock prices represent the consensus of the future expectations of all market participants. If stock prices are going up, it's because market participants anticipate good times ahead. However, these days the stock market only seems to fall in value on days ending with the letter 'y'. Under normal conditions, strong economic growth in the midst of falling stock prices would indicate one of two possibilities.

Either the economic figures are wrong and we're about to witness a sharp reversal of fortune; or the stock market is wrong. Since these aren't normal conditions, I'd guess the correct explanation lies behind door number three; which says that the fraud and misleading accounting plaguing corporate America is unduly punishing global stock prices.

Another argument would state that stock prices remain relatively expensive so further price weakness is warranted.

Bulls vs. Bears

I recently spoke with a couple of fund managers to get their views on this market.

Don Ferris, Asset Mix Strategist with Mawer Investment Management, is bullish. He says the figures don't lie - and he expects relatively strong growth for the second quarter of this year. If you don't believe the numbers he suggests taking a cue from the Bank of Canada's chief, David Dodge. He's been slowly raising interest rates because he is seeing strong economic growth. Ferris has kept a steady mix of 60 per cent stocks and 40 per cent bonds/cash but has been further diversifying lately - i.e. Canadian stock exposure has been reduced in favour of foreign stocks.

Irwin Michael, owner and lead manager of ABC Funds, is also bullish. While he admits that accounting fiascos have introduced even more uncertainty and frustration to his task of finding undervalued companies, he expects the positive economic momentum to continue without any serious interruption. He is using current volatility to selectively pounce on individual stock opportunities as they present themselves.

For a more company-specific view, Vito Maida, respected fund manager and president of Patient Capital Inc., says quality and value is a combination that continues to prove elusive in this environment. His research reveals that many companies continue to carry significant levels of debt; many intangible assets continue to be overvalued; and cash flow growth is unimpressive.

Mr. Maida is not alone in his view. Fund managers Gerry Coleman (CI's Harbour funds) and Larry Sarbit (AIC American Focussed) continue to stockpile cash as they struggle to find attractively valued stocks. Further, more than three hundred investment funds were sitting on at least 20 per cent in cash as of the end of June.

Recommendation

It would be fair to say that I'm cautiously optimistic. High stock valuations and broken investor confidence are two big negatives against a quickly rebounding stock market. On a brighter note, at some point stocks will stop falling because they'll be too attractively valued for investors to resist buying. Also, if the economy continues its strong growth, it's only a matter of time before stock prices are propped up.

Regarding investment portfolios, I continue to favour value stock pickers for the core. For investors who would like to maintain some defensive positioning, a small position in a precious metals fund or a larger than usual weighting in cash should provide a cushion in the face of further weakness. Resist the urge to make rash, emotionally driven decisions since they rarely yield much benefit.

In short, expect this environment to worsen before it improves - but it will eventually improve.

Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at dha@danhallett.com
 
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