ROB'S COMMENTARY

THE LOST DECADE (continued)

The World Market Index is still much lower today than ten years ago. In September of 2000, the TSX (Toronto market) stood at 11,150. On June 30, 2010, almost a full decade later, the TSX closed at 11,263 representing only a negligible average annualized increase. The TSX fell 4% in June and is down 4% year-to-date in 2010. The S&P 500 in the USA was at 1,524 in March of 2000. More than a full decade later, it stood at 1,040, or, almost one-third lower than ten years ago. The accompanying chart provides the annualized average returns for the past ten years. Only the TSX (of the major world indexes noted) had a small, positive return.

Many, many world class companies which have higher earnings per share than ten years ago, higher dividend yields, and lower price/earnings multiples (all positive trends) are trading at lower levels today than ten years ago. These include Coca Cola, Microsoft, UPS, Merck, Intel and AT&T. Take just one example: Coca Cola closed at US$59.06 on June 29, 2000. As I write, Coke trades at $US52.50 - yet Coke’s earnings, sales and dividends are much higher in 2010 than 2000.

In early July, 2010, the TSX is still 23% below its all-time high set in 2008. The S&P 500 (USA) index is 38% below its all-time high set in late 2007.

The valuation of the market is much more attractive today than ten years ago, as measured by dividend yields, price/earnings multiples and corporate earnings.

Interest rates have reached multi-generational lows over this past decade. This has also made it difficult for investors. It would have been much easier had GIC and Bond rates been in the 8% range, as it was in the mid-90s. This was not the case. We believe that higher rates are slowly coming our way. Looking back, investors have faced a near “Perfect Storm” of historically low interest rates and a ten-year underperformance of the equity markets. This has led many to call the first decade of the 21st century, “The Lost Decade.”

As illustrated in graphical form (below), since 1930, on a calendar decade-by-decade basis, the equity markets (represented by the S&P 500) in the first decade of this century performed the worst of any decade, even that of the Great Depression (1930 to 1939). Over the past 80 years there have been two negative decades: the 1930s were down an average of -0.08% per year; the 2000-2009 decade declined an average of -0.95% per annum. Yet over this entire 80 year period, the S&P 500 averaged a positive return of 9.80% per annum from 1930 to 2009. We feel that we are due for a few positive years!

Of the 9.80% average annual return, 44% was from dividend income. The remainder was from capital appreciation. Dividend income matters!

During all 100 years of the 20th century, North American stocks returned just over 9.0%. But there were several periods when the broader indexes (price gains only) were flat. These periods (each averaging about 15 years) produced total annualized returns to investors of 5.5%, entirely consisting of dividends. We are big proponents of dividend income from stocks.

The return for each decade is for 10 years ended December 31; for example, the return for the 1930s is for the 10 year period from December 31, 1929 through December 31, 1939. The index is unmanaged, and its results assume reinvested distributions but do not reflect the effect of sales charges, commissions or expenses. Source: Capital International Asset Management (Canada), Inc.

The TSX market may not have the same exact ratios but the trends would be similar over the longer term.

THE LOST DECADE

From January 1, 2000 to December 31, 2009, the first decade of this century, the U.S. stock market (S&P 500) averaged a return of –5.82% per annum (in Cdn. $). The MSCI EAFE (Europe, Australia and Far East) averaged –4.22% per year; the MSCI World Index was -5.06%. The Canadian market showed a positive return, but this was only a 3.39% average annual return over the past decade.

It is hard to believe that world indices for the most part are lower today than ten years ago. Yet the underlying earnings of these indices (the companies representing the market) are higher today than ten years ago. Coca Cola, Procter and Gamble and Microsoft, to take a few examples, are trading at lower prices today than ten years ago, yet their earnings are higher today as are their dividends.

What is the clue to this puzzle? It all comes down to valuation in the end analysis. If you recall ten years ago, at the dawn of a new century, we were at or near the peak of the technology bubble and many securities traded at extreme valuations. The pendulum of fear versus greed had firmly swung to greed (excessive optimism or jubilation was the primary emotion driving markets).

Moving forward to more recent history, from July 2008 to March 2009 the TSX index in Canada dropped a staggering 55%, as did most markets in the world (some had even greater declines). This represented the greatest drop since the Great Depression. The pendulum of fear versus greed had clearly swung to the extreme of fear (anxiety and heightened nervousness by investors). From March 2009, the low point of the recent bear market, to the end of December the TSX rallied by 55%, and it is still almost one-quarter below its 2008 peak.

Given this extreme volatility in the past, what about the future? Our view throughout 2009 and looking forward is one of pragmatic optimism. Cash levels remain at historically high levels, and with interest rates ranging from zero to 3.7% on fixed income (bonds and GICs of both short and long maturities), institutions and pension funds need an alternative to these low paying rates. Secondly, over the past 40 years, investors have always had the opportunity to invest in GICs or bonds at interest rates that provided returns of 4% to 6% to 8%, to even 10% or 12% at times (going back to the late 1970s and 1980s). Today, this alternative simply does not exist. For example, bond markets for the first time in many years are simply not providing investors with many attractive options that combine high quality with decent rates.

What About The Economy?

It is important to realize that investors cannot always find a direct link between the economic and market conditions. Consider that from 1999 to 2007, the “real world” economy that we live and shop in was doing very well for the most part. Unemployment was low (down to 5% or so), the housing industry was booming, the shopping malls were busy, and it was difficult often to get a building contractor, plumber, carpenter or electrician. Jump forward to 2009: housing starts have evaporated, unemployment has doubled (to about 10%), shopping malls are less congested and it is less difficult to find tradespersons.

On the other hand, the equity markets are lower worldwide than ten years ago. Yet earnings and dividends are higher, meaning stock valuations are even more appealing today. This, coupled with generational low interest rates (the opportunity cost of GICs and bonds is less appealing), and abundant cash on the sidelines, provides us with the basis of our cautiously optimistic stance.

Quality always remains paramount to us. In addition, the tried and true investing principles of diversification, individual stock valuations, and common sense remain critical. I would personally like to say “Thank you” to all of our wonderful clients for staying the course through a most difficult period.