It seems that the global financial system has come down with a fever after being exposed to many contagions that came out during the spring bloom.   In March we saw a wave take grip with the Japanese Tsunami causing terrible loss and damage.  Then, as the crocuses broke ground, inflation reared its ugly head in many of the emerging markets that have been the bright spot for global growth coming out of the Great Recession of 2008.  Civil unrest lead to the toppling of tyrannical regimes throughout Northern Africa and the Middle East and global growth slowed (lead by the US).  And, if this was not enough, the sovereign debt crisis that swept through Europe last spring bloomed again with the impending default of Greek debt. 

What a spring it has been! Even with the summer weather we’ve had here in Ottawa, it has been hard to find a bright spot in the financial markets. 

Even with all of the things I have listed above, you may find it hard to believe but, we are continuing to maintain a positive outlook for equity markets in 2011.

Let me take a moment to share a number of reasons we believe the second half of 2011 will play out similar to what we saw in 2010.

At the peak in 2007, US GDP was at roughly $14.5 trillion and since the peak it has grown to around $15 trillion currently.  This is not a tremendous amount of growth but it is also in line with our expectations for the foreseeable future.  However this does represent, in absolute terms, growth.

Throughout the rest of the world, largely driven by the emerging economies that we feel will continue to drive global growth going forward, there was more pronounced increase.  The global economy peaked at $61 trillion prior to the recession and has since grown to $68 trillion (approximately). 

Looking at the US markets as a benchmark, the companies that comprise them have seen Earnings Per Share (EPS) grow by 21% since the previous market peak yet the S&P 500 is down roughly 20% over this same period.  Currently, 19% of US stocks are trading above their 10 week moving average which is a trend that has signalled a market bottom over the last 30 years of stock market data.  This would give some indication that stocks in the US, and similarly in the global markets, would be somewhat undervalued as a whole.

Another comparison between summer 2010 and 2011 is in market sentiment.  Last summer 30% of market participants surveyed were bullish, 40% bearish and the remaining 30% were neutral.  After solid performance in the second half of 2010 brought out more bulls, the spring volatility has returned sentiment to the exact same split as last summer.  In looking at market sentiment, this contrarian indicator provides insight into what the general masses feel and, for the contrarian investor, indicates a possible rally in equity markets.

Although there has been a great deal of talk surrounding a double dip to the recession and, subsequently, another significant market correction, we feel that the concrete numbers are indicating that this is not likely.  These three indicators have historically been very strong when assessing the potential performance of the markets:

1. The Yield Curve – This measures the interest rate differential of short term government bonds vs. long term government bonds.  On average, long term (10 year bonds) offer 1.45% more interest than short term bonds (3 month bonds), meaning that the yield curve slopes up to the right. This would indicate that longer term interest rates will have to be higher to curb off potential future growth.  Prior to a recession, the yield curve is typically downward slopping or inverted by -0.18%, indicating that longer term bonds offer less interest then shorter term bonds because the bond market is predicting that interest rates will have to go down to stimulate the economy.  Currently, the differential is 2.9%, which is far above the average and indicating quite the opposite of a recession.
2. Real Rates – As anyone who has short term savings accounts knows, current interest rates are not that high.  What you might be surprised to know is that the real rates of return generated on short term bonds is actually negative 1.3%.  This is calculated by subtracting rate of inflation from the 3 month government bond rates.  On average, real rates run at +1.3% and 6 months before a recession they are typically +2.5%.  The fact that current real rates are negative means that there is a significant disincentive to save money.  This comes at a key time when baby boomers across the Western world are retiring and in need of income that can keep pace with inflation.  This leaves few options for generating income and could lead many people to buy equities in order to generate yield.
3. Inventories – Even with the restocking of inventories (after they were dwindled down to razor thin levels throughout 2008 and early 2009) we are still currently around 14% below the trend.  This would indicate that, with inventories currently being under stocked, there is still room for growth in supply just to meet regular demand of goods.  By definition, if inventories are fully stocked the excess inventories would be at 0% and, by comparison, 6 months prior to a recession they are usually about 3% above trend. 

In conclusion, we feel that there is a very strong case to be made that the second half of 2011 will close out on a positive note.  The difficulty for us, as advisors and for investors in general, is weeding through the noise that we receive on a daily basis from various media sources.

Take this headline as an example, which I received as I considered the topic for this this blog (July 6^th 2011).  At the time I received it, the TSX was down 31.08 points or -0.23%.  Sometimes good news is bad news to the media.

Debt crisis hammers TSX
The Toronto stock market was lower Wednesday as commodity prices declined and the U.S. dollar strengthened in the wake of another wave of pessimism over the European government debt crisis.