Golden Capital Securities

Investment Outlook

December 2000

- This month's report is a Nortel Free Zone -

Election uncertainty? What election uncertainty?!?!  It appears that the only uncertainty that actually occurred in the Federal election was whether the Liberals would achieve a majority or a substantial majority.  Reflecting this lack of uncertainty, the last couple of days leading up to the election saw the Canadian dollar reverse some of its previous loses, rebounding around 2% from its low. However, is this a trend that is likely to continue?  Or, will the currency, like the government, remain in status quo?

Canadian Dollar per US Dollar

Source: Bridge

There are basically two aspects of the economy that the government can affect: Fiscal Policy and Monetary Policy.  Fiscal Policy is the spending that government undertakes, sometimes liberally (no pun intended), on items such as healthcare, education and military.  Monetary policy is how the government plans to pay for this spending: issue debt, raise taxes, cut government waste or print more money.  

The Liberal government will not likely move away significantly from their current platform they presented in the mini-budget announced just days before the election call.  We are likely to see some increased spending, some tax relief and pay down a little of our staggering debt; it was not a significant change, but it did offer a little for everyone.  Personal and Corporate taxes in Canada are still relatively high when compared to other G7 countries, but really not that much higher than the total level of taxes in the US when you include all levels and forms.  The Canadian economy is expected to perform strongly over the next year and likely with it our balance of payments (as an export driven economy, if we export more Canadian goods, foreign purchasers must buy Canadian dollars with which to pay).  Conversely, a low Canadian dollar makes Canadian goods cheaper on the international market.  Therefore, do not expect the Government to step-in and support the dollar if it gets too low.

So, where is the dollar going over the next 12 to 36 months?

Purchasing Power Parity (PPP) is the economic principle that supposes that if the same basket of goods could be bought in two different countries, the exchange rate should move to make the two baskets cost the same amount.  This principle is often used, on a theoretical basis, to determine whether a currency is either under or overvalued.  Historically, the Canadian dollar has generally been undervalued compared to its theoretical PPP versus the US dollar, meaning that the basket of goods is actually cheaper in Canada than in the US.  

Currently, the OECD, Organisation for Economic Co-operation and Development, estimates that the Canadian dollar is undervalued by 22% (November 24th,2000) which would value the Canadian dollar at just under $0.80.   All things being equal (a famous economic term meaning that in the real world this doesn't work) individuals should buy Canadian items, buying up the Canadian dollar and selling the US dollar, thus bringing everything back into balance.  However, obviously not everything works as it theoretically should and that is why we see a movement away from PPP. 

Fundamentally, although we likely will not see the true PPP of $0.80, we are expecting  the dollar to return to its recent trading band of $0.66 to $0.68.  We have a strong economy in regions like Ontario and Alberta, at least until we determine whether the US has achieved their economic soft landing, a relatively pro-business government and Quebec sovereignty has been put on the back burner.  The discount of 15% from PPP that 68 cents implies is more palatable to each of the government, industry and the public.  

However, the technical traders in our firm are expecting a brief pop in price, which we may currently be seeing, and then a downward trend that may test our previous lows of 64 cents, with a probable test ultimately of 62 cents.  Either way, the 68 cent barrier ($1.47 US dollar per Canadian) is a formidable upside barrier.

Have we hit the bottom in the stock markets?

The direction of the market over the next few months will likely be sideways and volatile for several reasons.  First, the general sentiment of the market is still negative, many investors have been badly beaten up and the financial press is trying desperately to find reasons for the decrease: Presidential turmoil, market overvaluation and a slowing economy.  Some of these reasons are more valid for the market's turmoil than others, but overall sentiment is negative.  The fact is, people fear losing their money, but they also fear being left behind in a market rally.

Second, some excellent companies have been forced down excessively by margin calls.  Companies that are otherwise excellent long term investments, have been sold down as investors sell the stock to cover margin calls on good and bad stocks alike.  If you look at the quality of management, earnings and business plan in a stock, the likelihood of making a good investment is greatly increased.

When we speak of "the markets", these days it implicitly refers to the large contingent of technology stocks which have captured the public's attention.  In reality, there are many other sectors of the market which have fared reasonably well over the past 6 months.  Healthcare and pharmaceutical stocks are excellent examples of this brief focus of attention.

Third, as the economy slows and the market drops, investors have been moving their investments from stocks into bonds to take advantage of the high relative interest rates and relative security of investment quality bonds.  This movement to quality has also further depressed the market.  However, this might be an excellent opportunity for investors since interest rates are at relative highs.  Plus, as the economy continues to slow, we might expect that the US Federal Bank will begin to decrease interest rates.  If this decrease occurs, investors could expect capital gains on top of their interest.

Finally, there has been little market leadership by industry.  Over the past three years, various sectors within the technology stocks have taken turns leading the market upwards (hardware, chips, software, internet and, most recently, optical networking).  However, recently there has been little leadership as investors flee to defensive stocks, then jump out again if the market looks to be trending upwards.  There just has not been an industry recently that has inspired investors.

Therefore, we are expecting that the market will trend sideways over a couple of volatile months as there is little high profile market leadership. If interest rates begin to drop in the Spring, as we expect,  both bond investors and those currently on the sidelines will begin to move back into equities, beginning a new trend.  

The volatility of the market as measured by the CBOE Volatility Index (VIX) (the orange line below), appears to have a most interesting relationship with respect to the NASDAQ market.  Over the past five years there seems to have been an inverse correlation between volatility and the NASDAQ Composite (the black line).  If you look to the peaks of the volatility over this time period, they often occur when the market has been in a downturn.  Conversely, when volatility has decreased, the market has trended upwards.  If we look at the far right hand side of the chart, the last several weeks has seen volatility increase to relative highs and the markets decrease to 52 week lows. Could this indicate that the market is about to turn?

Here at Golden Capital, one of the technical indicators that we monitor is a proprietary combination of information which shows 'divergence in momentum'.  This indicator measures the velocity of the buying and selling in a stock or index and measures the strength and conviction of trends, both up and down.  It is the magnitude of these trends relative to previous ones that could indicate whether a stock is set for a buying opportunity as strength increases, or perhaps at a relative peak and that it is time to sell.  Currently, most of both the stocks and indices that we follow have negative momentum to them, but consolation should be found in that the velocity of the momentum appears to be decreasing.  Hopefully, most of the sellers have all sold, and only the buyers are left, waiting for a reason to begin buying again.

However, as mentioned above, we are hard pressed to find many indicators that would precipitate a near term change in direction.  Even at their current depressed level, technology stocks can still be viewed as overvalued when evaluated using more traditional valuation techniques.  The US economy is slowing, but the US Federal Bank has not yet indicated at what point they would consider decreasing interest rates to encourage economic growth.  And the projections for Holiday retail sales growth, though generally still positive, will likely not come close to last year's 7% growth rate.  

The market will likely spend some time finding its future direction, but when you are only looking for the floor, you can't see the sky. 

Hindsight Being 20/20

Finally, yet another indicator that the market may be near the bottom.  You may recall that back during the Spring high tech employees were demanding stock options rather than cash as the majority of their compensation package; willing to take lower salaries in hopes of becoming instant multi-millionaires when their company went public.  There were stories of people leaving Harvard and Wharton Business schools, just months before completing their MBAs, to take jobs at dot-coms just because of the stock options.  Even some landlords in Silicon Valley were only willing to rent office space for stock and were no longer accepting cash.  In retrospect, if I had thought about it for more than two seconds, that should have been an obvious red flag that the market had reached a top.  

In a dramatic reversal, just like the stock market, companies like Amazon.com and Priceline.com have begun to pay substantial cash payments to executives and even staff in hopes of retaining them.  Employees are no longer accepting the large option grants as compensation (what's the point when they already have several thousand options that are significantly out of the money) and are instead demanding cash.  Now this begs the question, if the company has limited cash reserves, has yet to make a profit and cannot go back in to an unreceptive stock market to issue more equity, how are they going to continue to pay out cash?  

The freeing up of much needed cash was one of the initial attractions to the dot-com companies for issuing stock and options.  Rather than paying cash, which does affects net income on the financial statements as a direct cash expense, they were able to issue an almost expenseless compensation benefit that only recently even had to be mentioned on the financial statements.  If this trend of money-losing companies paying out desperately needed cash to employees continues, some of the cash strapped companies may decline even faster towards bankruptcy as they are forced to actually pay their employees, rather than shifting business risk onto them with stock and options.  It will be interesting to see if this trend continues and these cash-poor, high tech companies are able to retain their high priced talent.

Until next month.