Golden Capital Securities

Investment Outlook

February 2001

Are we headed for a recession?  Or just puttering along in low gear?

On January 31st, the US Federal Bank lowered interest rates by fifty basis points (half of one percent) for the second time in less than a month.  This decrease was obviously in hopes of adverting an American recession, or, at the very least, shortening any economic slowdown that would occur.  Alan Greenspan, the chairman of the US Federal Bank mentioned about a week ago that the US economy was growing at "very close to zero percent".  Being this close to the precipice is not a good situation for any economy in which to be.  Mr. Greenspan chose his words incredibly carefully and came just short of mentioning the word recession.  Since the financial markets analyze each of his words for possible meaning and undertone, the care with which he must take in talking to the public is mind-boggling .  Overall, he does not feel that we are in a recession, yet, but really I do not envy his speech writer.  

Realistically, the US Fed had done a masterful job at guiding the markets to agree that 50 bps was the one and only option for the economy.  If the Fed had decided to decrease rates by less than fifty basis points, say 25 bps or *gasp* leave the rates unchanged, the market would have been very disappointed and a sharp and sudden sell-off would likely have occurred.  Even though a decrease of less than 50 would have indicated that the economy was doing better than most people had thought, the equity markets have built themselves around an overnight lending rate of 5.5% and any divergence form that rate would force a reassessment of their valuations.  Conversely, a rate decrease of more than 50 basis points would be devastating for both the equity markets and the economy.  If the Federal Bank felt it necessary to decrease rates by greater than what the market was expecting, that would indicate that the economy was in a very had situation to warrant that level of change in interest rates, the stock market would have been spooked and likely sold off by even more than the small / no change scenario.  Either way, Alan Greenspan and the Federal Open Market Committee (FOMC) had guided the markets in such a way that any other choice except the 50 basis point move would have sent the equity markets for a serious slide.

Are we really headed for a recession, or just a slow-down?  Unfortunately, the data at this point, as usual, is not definitive.  Growth rates have certainly slowed, confidence levels are lower, but demand in some areas is still growing.  For example, demand for durable goods like computers and airplanes increased in December by 2.2% year over year and single family home sales are at their strongest level since November 1998, a good thing.  While the index of leading economic indicators in the US fell in December and labour costs had their largest annual increase since 1991, that's bad.  Overall, there are signs that the economy is definitely slowing, but there is little to indicate that, at this point, we are headed for a recession.  Our belief is that over the next four to six months the US economy, and the Canadian economy right behind it, will likely experience a slowdown, with some industries experiencing significantly more hardship than others. Some individual industries will even experience recession-type conditions, but we feel that overall the North American economies will be flat to slightly expansionary.

If you believe in the contrarian methodology to investing there have been a couple of recent reports that would give those with alternative views some good indications.  Just recently, the US Conference Board's monthly report on Consumer Confidence was released this week and the index reached its lowest point since 1993, the last economic low point.  The Confidence Index is a survey of consumers' assessment of current business and labor market conditions - when this reaches a low, could this be a contrarian sign?  

As with market peaks, when the Coffee Barrista at the local Starbucks is giving economic recommendations that "the worst is yet to come", it is likely already here.  When the days get the darkest, the Spring cannot be that far away.

Alternatively, many companies across several industries have announced layoffs in order to cut costs and  increase profits.  Recent layoffs have included DaimlerChrysler saying "Bye for now" to 26,000, Xerox cuts 6000, WorldCom laying off up to 11,500 (15% of its total workforce), Boeing 8,000, and on and on.  CNN reported that for the six days leading up to the end of the month 67,800 employees had been, or will soon be, laid-off by major companies.  This number doesn't even include the ongoing layoffs by many Internet companies as they vainly attempt to cut costs.  I will allow that lay-offs this numerous will be a negative to the economy, but I would hypothesize that these layoffs should have happened months ago.

Although many people view large corporations as cold, faceless machines of capitalism, most of the "C" level executives realize that their employees do have families and that good workers are hard to find.  Companies with large pools of labour in tight labour markets would likely retain as many of their employees as possible, for as long as possible, in hopes that they will come back to work once demand for their products returns.  In a world of perfect knowledge, layoffs would have started at the peak of the demand, but how can a company lay people off when it has a record number of orders and profits?  It can't!  So to retain the employees for as long as possible and allow for the shortest amount of time before demand increases sufficiently to hire the workers back, many companies would start lay-offs just as the economy is troughing.  Another contrarian indicator.

So, given our assumption that the North American economies are not going to go into deep recession and will likely just loll along for the next several months, where should investors put their money?

Europe is one choice, especially with the recent increases in allowable foreign content in RRSPs.  Traditionally, the EU's economies have lagged North American cycles by about 4 to 12 months.  There have been significant efficiencies achieved between the countries, with even more to come in the future as the Euro is accepted and used as the currency of the region.  Assuming that the downturn in the US economy started in October / December (although you would have a hard time trying to prove that) that gives European Union investments another two to ten months of economic growth and hopefully enough time for North American economists to figure out what is happening domestically.

For those people who want to keep their investments in North America some of the sectors that we are watching are Semiconductors, Canadian Financial Services, Industrial and Service efficiency providers and other early expansion sectors.  Semiconductor stocks have, over the last several years, generally led the equity markets up and down. From the chart below, you can see how drastically the sector has been beaten up; from a high of 1362 in March of 2000 to a low of 516 right at the end of November.  Within the last couple of weeks the index has had a nice increase, could this be a leading indicator for the market's turn around?

Source: Bigcharts.com

We also like Financial Services, especially in Canada, as there has been some recent consolidation and there is likely to be more.  With the re-election of the Federal Liberal Government look for merger talks between the chartered banks to resume; it didn't work the first time, it could work now.  Canadian Banks have been on a steady decline down the world rankings and in efforts to compete on the world scene they must grow larger (to the chagrin of many Canadians).  Recent acquisitions in the US by the Royal Bank and TD Waterhouse's joint venture with Charles Schwab for a UK-based brokerage firm are perfect examples of the banks trying desperately to catch up to their American counterparts.  Looking into the future, there will likely be one day that the rules on foreign ownership of Canadian chartered banks is lifted, opening the door for even larger mergers, but public pressure will likely keep that years away.

Industry and Service efficiency is a very broad and sweeping term, but refers to companies that will increase the productivity of employees, capital or the fixed assets in an enterprise.  With the recent round of layoffs and cost cuttings, companies will be looking for other ways to become more productive with their investments in people and machines.  If there is no more fat to cut from the system, then increased profitability can only come from using what they have more efficiently. Whether through software to increase end to end integration or outsourced manufacturing so that the company can focus on what they do best, increased productivity through technology and specialization will be in strong demand.  Examples of these sectors would be systems integration software, Contract Electronic Manufacturers (CEM), and supply chain and service chain management software.

Retail is often the first area of the consumer economy to come back from a recession when people start feeling better about their economic situation.  Companies in the retail space tend to notice an increase in demand before industrial and manufacturing companies as excess inventories must first be cleared before new products are ordered.  The S&P Retail index (chart below) has been on a strong upwards trend since its bottom in October, just ahead of the Holiday season.  When sales information from the Holiday 2000 season begins to hit the markets (February, March and April), we feel that there might be a down-turn and at that time the sector might begin to look more attractive.    

Source: Bigcharts.com

Finally, the charts below update our recommendations for our longer term Core Holdings for both Canadian and US accounts.  Relatively speaking we did fairly well, outperforming the TSE 300 by 9% and the S&P 500 by just over 5% in January.   We realized some profits in the US account as two stocks reached our one-year targets in just the first month of the year.  We have also added Lucent (LU-NYSE) to the US portfolio starting February 1st.  Some Canadian picks are approaching our targets as well.  Look for changes and additions to the portfolios as we progress through the year.

Canadian Core Holdings

US Core Holdings

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Until next month.