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Jeff Saut: Canadian Loonie Tunes


History shows that good things tend to happen to cheap stocks.


Editor's Note: The following article was written by Raymond James Chief Investment Strategist Jeff Saut. It has been reproduced with permission for the benefit of the Minyanville community.

Having grown up in Michigan, I have long had a love affair with Canada. That relationship rose to new heights in the fourth quarter of 2001 when I began embracing the theme of "stuff." Recall that I have deemed "stuff" to be things like oil, natural gas, coal, timber, cement, fertilizer, grain, water, precious/base-metals, etc.

Said theme was driven by the reasoning that with 3 bln people from the emerging markets entering the 21st century, per capita incomes were going to steadily rise. And when incomes rise, people tend to consume more "stuff" (China already consumes 32% of the world's rice and 47% of the world's cement).

Unsurprisingly, history tells us there is an acceleration "hook" to this per capita process. For example, if one assumes per capita incomes in a developing country increase by 50% over a three-year period, the folks earning more than that country's per capita income do not rise by that same 50%, but by a much larger percentage (150%, 200%, etc.). This is an important point, for when it comes to the purchasing of goods and services, history also shows that there are thresholds, and when those thresholds are "hit," dramatic things happen. To wit, when per capita incomes are under $1,000, nobody owns a television, but when per capita incomes exceed $1,000, everybody owns a TV.

Clearly, investing in "stuff" over the past six years has been a profitable strategy, and following that investment "food chain" also led me to invest in countries rich in natural resources – a.k.a. "stuff." Enter Canada, on which I have been steadfastly bullish. Indeed, I have been heavily invested in Canada for the last six years. In fact, Canada's preeminent newspaper, the Globe & Mail, carried a story about my firm's unbridled bullishness and actually mocked my firm's prediction that the Canadian dollar (known in slang as "the Loonie") was going to rise from its then price of $0.65 U.S. to parity with the greenback ($1 U.S. = $1 C). Well, parity was the "call" five years ago, and last week the Loonie achieved parity with the U.S. dollar for the first time in 31 years.

The Loonie's rise, however, has caused some collateral damage in that its strength has hurt Canada's manufacturing industry. The result has, at the margin, created a bifurcated Canada such that the eastern provinces have experienced muted economic growth while the western provinces are seeing explosive growth driven by their vast deposits of natural resources. Nevertheless, as an investor I have been pretty happy with Canada's situation until last week's "Alberta Ambush."

For much of this year I have roiled against the government's increasing movement towards intervention and regulation. Little did I know I had to worry about the same thing in Canada's most business-friendly province, namely Alberta. As I understand it, last week the Alberta Provincial Government proposed changes to Alberta's tax code that raises the existing Royalty regime for the province's oil industry. The proposed changes would hike the government's Royalty rate from 25% to 33%, combined with a sliding scale "Oil Sands Severance Tax" (OSST). Taken together, these changes could lift the government's "take" from roughly 47% to 64%, leaving the remaining 36% for the developers/investors. Consequently, the folks providing the "risk capital" and developing the projects by default become minority participants in their own projects. This, ladies and gentlemen, is the sort of thing one expects to hear from Venezuela, not Canada!

I sat aghast as I read Alberta's proposed changes, questioning, "Are these folks trying to kill the goose that laid the golden egg?!" While I would be surprised if the tax changes are voted "in" as proposed, the psychological damage for investors has already occurred.

When taken in concert with last year's "Halloween Surprise" (changing the tax rate for Canada's royalty trust), and the Loonie's parity position with the U.S. dollar, the "Alberta Ambush" has caused me to rethink my investment position on Canada.

While I still believe the demand for "stuff" from all the "new entrants" joining the world's economy will drive the economies of natural resource-based countries, I am worried about recent developments and proposed developments in Canada.

Therefore, I am reducing my long-held index positions in the iShares MSCI Canadian Index Fund (EWC). However, I am not yet reducing investments in the shares of select Canadian companies. As for the Canadian dollar, while I continue to like the Loonie, I have never thought it would rise materially above parity with the U.S. dollar. So hereto, I am reducing my Canadian currency holdings.

Turning to the U.S. markets, I reiterate the comments my firm made to institutional accounts last week in that on a short-term basis the markets may have worked themselves into a lose/lose position. As stated, if the Fed does not cut interest rates, the equity markets should decline.

If it cuts them by 25 basis points (bp), the recent rally has probably already discounted it. And if it cuts by 50 bp, after an initial upside celebration, participants will likely contemplate why the Fed is so worried.

Fearfully, the Fed did cut by an outsized 50 bp, yet the best performers were not the financial, industrial, and cyclic sectors that one would have expected to show the best relative performance following the rate cut. Nope, it was oil, gold, and most of the commodity indices that surged while the U.S. Dollar Index tested its all-time low.

Furthermore, since the August 16 low, Lowry's Buying Power Index has been

"unusually sluggish, rising just 11 net points in more than a month of rally (including Tuesday's strong gain), and is still 64 points below its mid-July high. At the same time, Selling Pressure has dropped by 61 points since mid-August showing that the rally has resulted primarily from a withdrawal of sellers rather than dynamic buying."

Additionally, around September 22 in the northern hemisphere, when night and day are nearly the same length and the sun crosses the celestial equator moving southward, we mark the autumnal equinox, or the beginning of autumn. This year, the Autumnal Equinox was at 5:51 a.m. EDT on September 23, and as money manager Paul Montgomery notes:

"The legendary trader W.D. Gann reportedly claimed that capital and commodity markets tend to top on or around September 22nd more often than any other day of the year. There is no apparently economic logic behind this reported observation... but... in as much as September 22nd happens to be the usual date of the Autumnal Equinox... Initially, we never took such notions seriously... however ... we have experienced first hand the October Massacre of 1978; the October Massacre of 1987; the October 'Crashette' of 1989; the 1997 Asian collapse; the 1998 Long Term Capital sell-off, etc. And remember the Great Gold Boom of the 1970s. While bullion peaked on January 21, 1980, the gold and silver stocks made their all time bull market highs on September 22, 1980. This day also saw the major peak in many oil stocks, which were enjoying a parallel bull market at the time. Also prior to the Great Crash of 1929, the last stock market index to make its then all time peak, the Dow Jones Utility Index, did so on September 21, 1929."

While I am certainly not predicting any "crashes," I do think caution is warranted on a short-term basis since bottoms tend to be a function of both price and time. Hopefully we met the downside price requirement on August 16, but now we may have to exhibit some patience awaiting the time component. Moreover, the dollar-dive remains problematic, for while the DJIA was up 2.8% in dollar terms last week, if you change the "measuring stick" from U.S. dollars to New Zealand dollars (which rallied 4.1% last week versus the U.S. dollar), the DJIA lost 1.3% (2.8% - 4.1% = -1.3%). Further, some of the commodities look to me like they are experiencing short-term upside blow-offs (read: price peaks) with crude oil up 5.4% last week while coffee (+9.8%), corn (+8.9%), and a number of other commodities made that 5.4% rally look tame. And the "commodity cacophony" caused the Goldman Sachs Commodity Index to tag new all-time highs, which broke the PowerShares DB Agriculture Fund (DBA) and the Market Vectors Agribusiness (MOO) shares out to the upside in the charts.

The call for this week: Well, it is another week, and I am on the road again. This time it is to the Midwest to see institutional accounts and do some public seminars for my firm's retail advisors. And it is just as well I am away, for while I was pretty aggressive on the long-side at the mid-August lows, I am now more cautious.

I do, however, think a number of select stocks have made their "valuation lows," and I have been emphasizing those names, particularly in the large-cap, technology, and healthcare sectors, preferably names that posses a dividend yield.

For example, free cash flow yields on large pharmaceutical stocks exceed the yield on U.S. 10-year Treasury notes by the greatest margin since 1990, when my firm's database begins. Specifically, Pfizer's (PFE) cash flow yield is the richest in the group, and it could get even richer. For the 12 months ended June 30, Pfizer's free cash flow of $11.5 bln amounts to 7.5% of its enterprise value, compared with a 17-year average of 3.5%. However, that includes a $2.8 bln payment of a capital gains tax for the sale of its consumer health business. Excluding that payment, its free cash flow yield is 9.3%. Johnson & Johnson (JNJ) places second with a 6.7% yield, its richest in at least 17 years. History shows that good things tend to happen to cheap stocks. I continue to invest accordingly.

No positions in stocks mentioned.
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