The big event this year was the arrival of our first grandchild - Zoe Elizabeth Madeline Maddox-Wise. The most beautiful and intelligent child ever born, of course!
Carmen and I had a quick visit to Kamloops to help out during their first month, and Kelly-Anne, David and Zoe will be passing this way in just a couple of weeks, on their way to Ottawa on a house-hunting expedition. David's transfer has been confirmed, and they'll be moving there this summer. Carmen and I have just returned from a visit to Costa Rica. It's already the start of rainy season there, so the weather wasn't as nice as we had hoped. However, it was still good to get away and enjoy a far-different environment.	Zoe Maddox-Wise
We're also looking forward to our trip to Germany in September for Oktoberfest and Oberammergau.

Where We Are

The stock market returns shown in Table 1 are as of the end of April; 3 weeks later all stock markets are down on the year. Three weeks ago the looney was close to parity to the US dollar; now it is down 4.1%.

Three weeks ago bond yields were on the rise as central bankers and investors felt comfortable that we were emerging from the global recession. Rates are now falling again as the problems in Europe have shown that we are far from over our difficulties.

Table 1
2010 YTD Returns to 30 April

MSCI: Morgan Stanley - Capital International
EAFE: Europe, Australia & Far East
Globe: Globe & Mail

Most clients have balanced portfolios. I use the Globe Canadian Neutral Balanced Peer Index as my primary performance benchmark. As of the end of April, this index was up 2.2% on the year.

Within sectors, Precious Metals is continuing its run from last year, up 10.9% on the year even though gold itself is only up 4.8%. More broad-based Natural Resources funds are up on average 7.2%. Real Estate is next, up 4.1% to the end of April. Financial Services, up 2.2% on the year, Technology, up 1.5%, and Health Care, up only 0.2%, trail the field.

Where We're Heading

Chart 1

Chart 2 also shows the Bank of Canada forecast of economic growth for the next 2 years. The Bank is projecting only weak growth, as the government stimulus (ie deficit financing) that has been propping up the economy is removed.

Chart 2

Charts 3 and 4 show the trends for 2 leading indicators for employment. When things are looking up, employers first ask their existing workforce to work longer hours and overtime. Chart 3 shows that weekly overtime hours are up in the manufacturing sector.

Chart 3

Chart 4

While sales of existing homes are increasing (possibly as a result of investment in distressed properties as rental units), home resales don't generate much in the way of economic activity.

New housing is the important economic driver, and new home construction can't start without a building permit. Chart 5 shows that building permits have stabilized, but at a 50-year low level. The red line in Chart 5 shows a confidence index developed by the National Association of Home Builders. Builders are gradually regaining confidence, but are still indicating that their industry is very slow.

Chart 5

Chart 6

Interest Rates
Interest rates had been creeping up in the early part of the year. It was widely expected that the Bank of Canada would begin to tighten fiscal policy by raising short term interest rates in June. The Big Banks, anticipating this, have already increased mortgage rates.

The European credit crisis has changed the outlook. Europe is the largest single economic bloc in the world, and Europe is in crisis, overwhelmed by the government debts in the PIIGS (Portugal, Italy, Ireland, Greece and Spain). At this time, it is uncertain whether we are looking at the end of the Euro, and perhaps even the end of the European Union.

So far, the proposed "solution" to this overhang of sovereign debt is more debt, promised by European governments that either can't come up with the money (the PIIGS themselves and Britain), European governments that are reluctant to come up with the money (Germany and Netherlands), and the International Monetary Fund (which has no money; it has to get the promised funds from member countries, including Canada and the US. Last week, in a vote that was not widely reported, the US Senate voted 94-0 to withhold IMF funding from any country that was unlikely to be able to repay it).

I think it fair to say that there is absolutely no one in the world who knows how all of this will resolve itself. The bureaucrats and politicians appear to be trying to simply punt the problem ahead for a couple of years to buy some time.

The US has debt problems of its own. However, the US also has the luxury of having the world's reserve currency. Whenever times are uncertain, there is a rush back to the greenback. Chart 7 shows that interest rates in the US remain within a channel of declining rates that has been in place for 30 years. There is no indication that there will be a breakout to higher rates any time soon. The Euro crisis has caused US rates to fall substantially in just the last week. The 10-year Treasury, the most widely-traded bond in the world, is back to just 3.25%.

Chart 7

Chart 8

President Obama needs to get these mortgages rolled over without triggering a massive new wave of foreclosures. The US Federal Reserve will make sure that that happens, even if they have to buy every bond issued by the Treasury Department.

Crises will occur in the future whenever investors fear that this Grand Bargain will be broken: they will continue to roll over old unpayable government debt for new unpayable government debt only as long as they are assured that those interest payments will continue.

That's what happened to Greece. Bondholders began to fear that Greece would no longer be able to pay interest on the existing debt, so began to demand higher interest on the new debt. But higher interest payments simply made the problem worse for Greece, and increased the probability of default.

The EU and IMF had to step in and reassure everyone that the Grand Bargain will continue, for Greece and all the PIIGS.

Of course, this all means that paper currency is not really backed by anything. Some people, with justification, are asking whether at some time this whole cycle of ever-increasing debt paid for with ever-increasing amounts of paper will end. Is there something out there that has genuine value in and of itself?

Gold bugs know the answer: Gold. Gold bug math is pretty simple. World GDP is $60.69 x 10¹². Total world gold supply is 5.08 x 10⁹ oz. Therefore, if we were on the gold standard, gold would be worth $12,000 per ounce!

I'm not a gold bug. I think that other tangibles, including other metals, timber and farmland have intrinsic value. So have consumables such as energy and agricultural products.

What about intellectual property? Humans have brains, and are able to invent and innovate and improve their environment. Does intelligence have intrinsic value?

Tangibles have become a mainstream asset class, as some investors look to them as a diversifier away from stocks and bonds. Every action has consequences, and now financial futures dominate physical trading in most of the commodities.

To take just one example, the futures market in oil is now 12x the size of the physical oil market. This being the case, investor sentiment has become more important to commodity pricing than supply-demand fundamentals.

Therefore, should investor sentiment decide that the Grand Bargain is a case of the Emperor wearing no clothes, the prices of all commodities will shoot up to unheard-of levels.

This simple equation explains over 90% of the CAD/USD exchange rate fluctuation over the past decade.

As I write today, oil is trading at $69.01. According to the formula, the exchange rate ought to be $0.9051. The actual exchange rate today is $0.9317. The difference of 2.6¢ is within the standard error of estimate, and is due to factors such as Canada's perceived superior financial performance, the possibility that the Bank of Canada may raise interest rates, and the currency market's belief that oil prices are likely to rebound.

The trouble in Europe has caused the Euro to fall relative to the US dollar (and to the looney until last week, when falling oil prices caused the looney to fall faster than the Euro's tumble). Many pundits are predicting parity between the greenback and the Euro before too long.

Chart 9

A lower Euro means that Chinese goods entering Europe will be more expensive, while German exports will be cheaper. Depending upon the extent of the Euro's slide, this could clobber China's economy.

My conclusion: The looney will continue to be a petro-currency. European troubles will cause the Euro to continue to be weak.

Stock Market
Stock markets around the world had a huge recovery over the past year. For example, at the end of April the TSX was up 61% from its low in March, 2009. After such a rally, we shouldn't be surprised if the market stops for a while to take its breath.

Despite the big rebound, the TSX is still trading at levels below its long term trendline. See Chart 10.

Chart 10

Since future portfolio performance is highly dependent upon the purchase price - the lower the better - , we should be looking at Europe's problems as a future buying opportunity. Already some of Europe's best-financed banks are trading with dividend yields in the high single digits, and price/earnings ratios in the low single digits.

I've talked about conditions in previous letters. Conditions remain favourable for further market advances. Interest rates are low, and prospects are good that they will remain low. Corporate earnings are improving. Companies are raising dividends. The market is still trading below its long-term trendline.

My conclusion: Conditions remain favourable for further stock market gains.

Black Swans
All swans are white. Is the fact that you haven't seen a black swan proof that black swans don't exist? The answer is "no". In fact, black swans do exist. In financial markets, a "black swan" is an event that is so unusual that risk reduction strategies haven't taken the possibility into account.

We know that all that has happened in the past 2 years is that a banking debt crisis, caused by poor mortgage lending practices, has been transformed into a sovereign debt crisis. The basic problem of too much debt sloshing around the world hasn't gone away. This isn't a black swan.

However, the basic structure of global economics has become more unstable because of the debt problem. It could all come tumbling down if a true black swan made an appearance.

The black swan might make its appearance in the guise of war. It might come as a terrorist nuclear attack. It might be disease. It might be drought. It might be a solar flare that disrupts communications. If the big volcano on Iceland were to blow its top, the resulting disruption might tip Europe over the edge into depression.

Donald Rumsfeld expressed the idea of black swans very well, though he was ridiculed at the time: there are known knowns: these are the things that we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns -- the ones we don't know we don't know.

How do we protect our financial wealth as best we can from the known knowns, the known unknowns, and the unknown unknowns? Diversify; diversify; diversify!

Jacob Fugger the Rich (1459-1525) figured it out 500 years ago: Divide your fortune into four equal parts: stocks, real estate, bonds and gold. Be prepared to lose on one of them most of the time. During inflation you will lose on bonds and win on gold and real estate; during deflation you lose on real estate and win on bonds, while your stocks will see you through both periods.

It is interesting that "hiding your cash under the mattress" is not part of Jacob's strategy. Willingness to accept a loss is.

How do we follow Jacob Fugger's advice today?

• GICs, mortgage investment corporations and corporate bonds fit within the "bonds" category.
• Precious metals funds, natural resource funds, and energy royalty trusts will round out the "gold" category.
• For "real estate", we have on offer investments in Saskatchewan farmland, distressed Arizona housing, and subdivision development in Calgary and Colorado.
• We are emphasizing income over capital gains within the "stocks" classification, and put more emphasis on dividend funds in both Canada and overseas. As mentioned earlier, the crisis in Europe may represent a buying opportunity in the near future, should the situation become truly bleak.