September already! Why does summer fly by so quickly? The trees are starting to turn, and that reminds us that we have to be like the squirrels, and store up supplies for the coming cold weather. Carmen and I stayed home for much of the summer. It ended up being a "home reno" time as we did some things, like refinishing the bedroom floors, that we had planned for years but never got around to. Like all renos, it quickly grew into a much larger project than we had planned! We were able to get away at the end of August and visited friends in Central America where we have property, before having a wonderful weekend in LA with our daughter. She's a TV executive, and her programs won several "People's Choice" awards. Her new shows are "Secret Circle" and "Ringer". Hope you enjoy them! I have just returned from a wonderful few days hiking in the Lake O'Hara region with my sister from Ottawa. The mountains are spectacular and larches were in full colour. It was a great success despite bouts of "interesting" weather that included thunder, lightning and sleet.

on the set of "Friends" Playa Manzanillo, Costa Rica

Where We Are

I reported in my May newsletter that US GDP growth in the 1st quarter was only +0.1%. Any slowdown at all will push US data into an official recession. Political gridlock within the Euro-zone in Europe is making that region (which is comparable to the US in economic terms) an accident waiting to happen.

Bond, stock and currency markets have reacted to this news in their usual way. Bond yields have gone down, making bond prices go up (prices move in a direction opposite to yields). Stock markets have retreated by about 10% from their April highs. The Canadian dollar has fallen relative to the US greenback and the Euro, and resource prices, oil in particular, have dropped in anticipation of lower demand.

Rising bond prices plus the currency boost has given global fixed income a particularly robust return on the year. Table 1 indicates how the various market indexes performed up to the end of August.

Table 1
2011 YTD Returns to 31 August

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

Among sectors, Gold has been the huge winner. Gold went from USD$1405.50 at the beginning of the year to $1813.50 by the end of August. That's a rise of 29%! Precious Metals funds didn't follow, as they are down -3.9% on the year. (Last year, the funds outpaced the metal.)

More general Natural Resources funds are even worse; they are down -9.0% on the year (to the end of August) in response to potential reduced demand in a soft economy.

Technology remains relatively strong, still up +1.9% on the year. Health Care remains up +1.0%, and Real Estate is down -1.1%. After a strong start, Financial Services has fallen in response to the European banking problems. It is down -10.1% on the year.

Worries about weakness in the developed world have affected the Emerging Markets, which are down -12.0% on the year. Surprisingly, Europe is doing better than that, down only -6.5% year-to-date.

Where We're Heading

The economic events that fill the media airwaves have at their base the issue of excessive government debt in the developed world (US, Europe and Japan).

Solutions now being proposed are basically kicking the can down the road. You can't solve a debt problem with more debt. Someone, sometime, is going to have to take a loss. The bankers are busily making sure it's not them! The politicians are busily making sure it's not now!

I'll try to give a layman's explanation of some of the economic principles behind all the talk in the next few sections. I hope that I haven't lapsed into econo-babble.

Gross Domestic Product - Part 1
The definition of a recession is a decline in Gross Domestic Product (GDP) over 2 consecutive quarters. But what is GDP, and how is it measured?

The equation is quite straightforward:

GDP = C + G + (E-I)

C = spending by individuals and corporations
G = government spending
E = exports
I = imports

Since essentially all spending by consumers, companies or governments passes through the banking system, central banks are able to monitor the components of GDP fairly readily. (Cash transactions, such as black market or drug deals, are not recorded, which is why these are always treated as estimates).

As investors, we want C (private sector spending) to grow. This is what allows companies to grow their revenues and profits, and allows their stock price to increase.

Government spending is an important component of GDP. It represents almost 40% of Canada's GDP. When governments increase spending because of "stimulus", GDP will rise even if the spending has been financed by debt. Conversely, when governments cut back, GDP will fall.

Just to complicate things, C and G are interconnected.

Governments have no money. Their only sources of revenue are taxes and fees that they extract from people and businesses. Referring to the formula above, G (tax revenue, which the government then spends) results in a decrease in C (private spending), since money sent to Ottawa is no longer available for consumption.

In fact, numerous studies have shown that increased taxes decrease private sector activity by more than the taxes raised. The converse is also true: decreased taxes increase private sector activity by more than the decrease in taxes. In many cases the taxes raised from this increased activity more than offset the tax decrease!

There is also a feedback loop. Much of the money that governments spend (G) goes to individuals and corporations. Those recipients spend the revenue, thus contributing to C.

Let's apply this formula to the efforts that governments need to make to get their debt problems under control.

If governments cut back on deficit spending, C (private sector spending) may go down because of the feedback loop. This is recessionary, since both G and C are declining. GDP will remain positive only if the spending cuts are gradual, or if net exports (E-I) increase to compensate for the drop in C and G.

Canada has a strong enough economy to be able to reduce deficit spending, but for countries like Greece, reducing both G and C will cause a deflationary spiral.

If a government were to decrease taxes G might go down, but C will increase. The Canadian government's plan to reduce corporate taxes fits within this approach. It might not help overall GDP much, but the private sector (C) may well prosper in a lower-tax environment.

What will happen if a government chooses to address its budget deficit by raising taxes? President Obama is trying this approach. He wants to increase G (higher taxes for the rich) by lowering C (after-tax spending by the rich). It does not take a genius to figure out that the result is likely to be a decrease in GDP!

Gross Domestic Product - Part 2
There is also a 2nd definition of GDP:

GDP = Money Supply * Velocity

Money Supply = basically the cash that's in your pocket or in your chequing account at the bank
Velocity = number of times that the same dollar is spent in a year

However, the velocity of money for a bank is very high. Retail banks can lend $8 for every $1 that you deposit into your savings account or into a GIC. This ability is a result of something called the fractional reserve system, which applies only to banks. In the boom some investment banks were levered up to 30x their assets.

This deceptively simple formula is the key to understanding what is happening during our current economic malaise. The money supply has increased because central banks flooded the economy with newly-printed dollars, but velocity has plummeted.

There are several reasons for the decrease in velocity:

• The banks are no longer levered to the same degree as before 2008;
• The banks are not as willing to extend loans to businesses or individuals;
• Businesses are able to obtain financing through the corporate bond market, and are less reliant on bank loans;
• Individuals are saving more, plus getting out of debt has become more of a priority;
• Baby boomers are past their peak spending years.

Currency
I've written over and over that the Canadian looney is a petro-currency that rises and falls in line with the WTI oil price. The regression equation is:

USD/CAD = $0.56 +.005* Oil Price

As I write this letter, oil is trading at $81.80/bbl. The equation suggests that the exchange rate should be $0.969. The actual close today was $0.9727. 'Nuff said!

Interest Rates
The US Federal Reserve Bank has confirmed that it plans to keep interest rates at or close to zero into 2013. Given the close alignment between Canada and the US, that means that Canadian interest rates will remain at rock-bottom levels for the next year and a half too.

Last week, the US Fed went further and introduced something called "Operation Twist". The Fed announced that it would begin selling short-term US Treasury Bonds that it has in its portfolio, and use the proceeds to purchase long-dated US Treasury Bonds, up to 30 years in term.

The idea is to lower long-term interest rates, which are already quite low by historical standards (see Chart 1), and stimulate demand.

Chart 1

The supposedly-independent Fed has agreed to become a buyer in the long-dated market, thus increasing demand (and prices), and making the issue of long-dated bonds both easier and cheaper for the Treasury Department. It might be good for the government, but it is a disaster for pension funds and life insurance companies, both of which have to fund long-term liabilities through the bond market.

In any event, investors who want to be buyers of bonds or GICs can expect extremely low interest rates for the foreseeable future, all across the maturity spectrum. The only way to get more yield is to take on more risk, either through the corporate bond market, or through dividend-paying stocks. This is not good if you are a risk-averse pensioner trying to live off RRIF investment returns.

Conversely, I'd say that now could be an excellent time to take on debt for a worthwhile purpose, such as an RRSP top-up loan or home improvement, since we know that interest rates are going to remain low for a long time.

Canadian interest rates will remain at rock-bottom levels for the next year-and-a-half

In a world of diminished economic activity, we may see a softening in the prices of commodities, particularly the metals and forestry products that are most sensitive to economic activity.

Note the "if" in the previous paragraph! There is an alternative possibility out there. It is possible that governments continue unending stimulus, to the point where investors finally realize that paper money is just paper, backed by nothing.

In this environment, gold and silver will be recognized as the store of value that they have been throughout history.

Ned Goodman, who I consider to be Canada's greatest investor, recently made the observation that 1 oz of gold can buy the same basket of goods and services today as it did in 1973, when Richard Nixon removed the convertibility of the US dollar into gold. (Ned also speculated that 1 oz of gold could buy that same basket of goods and services at the time of Jesus Christ!)

In 1973, US$65.14 could buy you 1 oz of gold; now $65.14 will purchase 0.036 oz. The greenback lost 96% of its purchasing power in only 38 years! To be fair, the US government's Consumer Price Index says that the dollar has "only" lost 80% of its purchasing power since 1973. The lesson: some gold belongs in your portfolio!

The broadest measure of commodity prices is the Commodities Research Bureau (CRB) Index. As shown in Chart 2, the Canadian stock market tends to out-perform the US market when commodity prices are strong, and under-perform when commodities are weak.

We are currently in a period of generally weak commodity prices, so our foreign investments are more likely to out-perform domestic stocks.

Chart 2

Stock Market
While macro events, such as the on-going saga with Greek government debt, can temporarily derail the stock market, ultimately the stock market is a market for the pricing of individual stocks, and it is the profitability of each company that determines the value that the market places on its shares.

Individual companies may prosper, even during a period of slow economic growth!

Canadian and US companies continue to do very well. See Chart 3. Profits have recovered completely from the 2008-2009 recession.

Chart 3

My forecast was substantially more conservative than that of many financial analysts, who were predicting profits of $115 for the US stock market by the end of this year. They are madly retreating from that hopelessly-optimistic position, and in so doing are contributing to the current market pullback. Seriously, I don't know why anyone listens to these guys, but they continue to have influence despite being wrong almost all the time.

Many companies have taken advantage of low interest rates and a strong market for corporate bond issues to build up their cash positions. Corporate cash is now the highest that it has ever been. According to Morningstar.ca: "The cash position of companies in the Russell 3000 Index is US$1.5 trillion. This is huge and up 60% in three years."

Action Plan

• Governments may have to become serious about handling their debt and deficit issues. If they do, global economic activity will slow;
• Money-printing by central banks is not inflationary as long as "velocity of money" remains low;
• Commodity prices will be weak in a slow economy;
• The Canadian stock market outperforms the US market during times of rising commodity prices, and underperforms when commodity prices are weak;
• The Canadian looney is a petro-currency, and its value is dependent upon the oil price;
• Gold has retained its purchasing power over time, while paper currencies have lost value;
• Interest rates will remain at rock-bottom levels for the next year and a half;
• Corporate profits remain solid and are on track for another 25% gain over the next 2 years;
• Corporate cash positions are strong so companies will be able to weather economic turbulence.

Diversify! Diversify! Diversify!

I continue to believe that pension-type balanced funds should form the core of most people's retirement portfolios.

They have served the test of time. As I have described in previous letters, a balanced portfolio should be able to support a 6% withdrawal rate without running out of money.

Action Plan - Fixed Income
The best 5-year GIC rate that I can give you right now is 2.55% compounded annually. This rate has the CDIC guarantee. If you need more than that, we have to go non-guaranteed offerings. Let's look at a few.

The recent retreat to safety has caused the interest rate spread between non-investment-grade corporate bonds and government bonds to widen significantly. Mutual funds that invest within this space are now sporting internal yields (income from the investments held by the fund) approaching 9%. One of my favourites in this space has paid 5 cents per share per month to investors since inception; this works out to a cash yield of 8.6%.

We also have several exempt market offerings that are interesting. These investments are not listed on any stock exchange, so liquidity (the ability to sell) is limited. On the plus side, they are not marked to market, so the value on your statement remains constant, much like the stated value of a GIC.

I continue to like Azcan the Calgary-based company that invests in distressed Phoenix-area real estate. An investment in an Azcan unit has a cash yield of 4%, paid semi-annually. The yield is covered by the rents paid by tenants in the houses that the company owns, and there is potential for a capital gain whenever the Phoenix real estate market turns around.

I like mortgage investment corporations. A MIC provides first mortgages to builders and developers of residential property. We have 2 on offer, and I have invested in both. One works mainly in Ontario; the other is more active in Western Canada. They pay interest to investors in the 7-8% range.

The Wine Investment Fund Canada may be the most intriguing exempt market offering of all! WIF invests in a portfolio of fine Bordeaux wines that are stored in a bonded and insured warehouse in London. The portfolio will be sold after 5 years. There is a substantial market among the wealthy for fine wines, so as a vintage gets consumed the scarcity factor causes the remaining product to rise in price.

It's a big business, and there is even a published index of wine prices (www.liv-ex.com). This allows WIF to value its portfolio monthly.

Fine wines have outperformed both the Canadian and US stock markets handily over the past decade (see Chart 4), with lower volatility as well. The average 5-year return (in CAD) has been 14.3% compounded annually, and the worst 5-year performance was +8.9%. The index has its ups and downs, and like stocks, the best time to buy is during a downturn. We're in one of those times of weakness right now.

Chart 4

Action Plan - Equities

The best time to invest is at the point of maximum pessimism.
Sir John Templeton

Be fearful when others are greedy; be greedy when others are fearful.
Warren Buffett

Chart 5 shows the trend that has been in place for the Toronto stock market for the past 80 years. As September comes to a close, we are 17.8% below the trendline.

Assuming eventual "reversion to the mean", this indicates that we should have above-average investment returns over the next while: if we return to trend in 2 years, it works out to a 17.8% annualized return! Of course there might be a hiccup or two along the way; markets never move in a straight line.

Chart 5

I mentioned in earlier sections that the US stock market outperforms the Canadian market when commodity prices are weak. In addition, the looney is a petro-currency, so the exchange rate also might be adverse if oil prices are weak.

Putting the two together indicates that we should be placing more emphasis on US and global investments. The last decade, in which the Canadian dollar was very strong, may have caused your currency diversification to be out of balance. It may need adjustment to our new environment.

In a slow economy, I think we also want to emphasize dividend funds. This is consistent with my practice for many years, so no change there.

Action Plan - Insured Investments
If you are still trying to accumulate retirement savings, how does a guaranteed minimum 5% return sound to you? If you are already retired and worried about whether your nest egg will last, would a guaranteed lifetime withdrawal rate of 5% of initial capital give you peace of mind?

These are the principal features of Guaranteed Retirement Income Portfolios (GRIPs) that are offered by several life insurance companies. The returns are ultimately guaranteed by Assuris, the life insurance equivalent of CDIC.

Not only are you assured of a 5% minimum return and/or a 5% minimum withdrawal benefit, but if the markets turn around and are better than expected, the GRIPs offer resets that will adjust your benefit to the new and higher market value.

The GRIP is a structure. You can hold a wide variety of equity or fixed income investments within the structure. Because of the reset feature, it pays to maximize equity exposure within the GRIP.