The Chinese calendar proclaims this as the Year of the Rat. Based on the behavior of economies and financial markets over the past few months, investors would be forgiven for thinking that a plague has descended upon the financial system. But on occasion it is useful to step back from the day-to-day shenanigans of markets and take a bird’s-eye view of events.

When it comes to evaluating how well people “read” the macro picture of financial markets, it is important always to distinguish between skill and luck. And it is really only with the passing of time, or evolvement of a number of market cycles, that one can separate the wheat from the chaff.

Donald Coxe, Global Portfolio Strategist of BMO Financial Group, is one of a select group of analysts that have been remarkably right on the “big picture” outlook for many years. My market views essentially concur with Donald’s investment recommendations as published in the January edition of Basic Points, entitled “The Year of the Rats”. I have therefore deemed it opportune to share his words of wisdom with you in the paragraphs below.

1.

The financial crisis is not centered in stock markets. Its primary locus is in financial derivatives, and in their impact on the stock prices of leading banks. Until the downward drift of bank stocks and the upward drift of derivative debt yields are reversed, the stock market will continue to slide. Keep overall equity exposure to minimums, and emphasize quality.
2.

Bond investors face two risks: inflation and credit. Nominal Treasury bond yields are far too low, and quality corporates are too rare – with 71% of corporate debt junk-rated. Buy inflation-hedged sovereign bonds – preferably in major foreign currencies. Simplicity is good: avoid complex products that are subject to drastic rating writedowns.
3.

Commodity stocks are at risk to the extent that the financial frauds and foolishness are able to abort the global economic recovery. A US recession would be good news only for gold stocks. It would be bad news for base metal and steel stocks, and negative news for oil stocks. Agricultural stocks should not be hurt, except that major bear raids will likely spew blood broadly across stock markets.
4.

Any panic-driven selloffs in commodity stocks are unlikely to take them off the top-performers lists for more than a few weeks. They are not just fair-weather friends. Not only are most of the majors very cheap on a forward-earnings basis, but mining and oil companies that ordinarily search for resources in remote regions will take advantage of selloffs to acquire reserves in politically safe regions at bargain cost. Coming out the other side of this slowdown, these stocks will experience big increases in their absolute and relative PEs. Someday a big Sovereign Wealth Fund is going to decide that bailing out banks isn’t as profitable as owning matchless reserves of minerals.
5.

Food price inflation should strengthen through the year. It could be offset by broad price declines across the US economy as it struggles with recession, but it is becoming embedded in the global economy and will be a challenge for many years. It will produce a full-blown crisis when a major crop failure occurs.
6.

The Canadian dollar trades right around parity. It might not climb sharply higher if a US recession is confirmed, because of the impact on the industrial sector and tourism. It remains a fundamentally strong currency, and the greenback remains a fundamentally weak currency. Canadian borrowers should borrow in greenbacks.
7.

Gold’s move has been dramatic, but retail investors in North America and Europe have not yet shown signs of true gold fever. That means there is still substantial upside. Soaring silver and platinum prices confirm that this gold move is no mere spastic twitch. The expression “as good as gold” in reference to Treasuries and other US debt instruments should be restricted to use as a warm-up joke at investment policy meetings.
8.

Defence stocks have solidly outperformed the S&P for most of the Bush presidency. Iraq and Afghanistan have run down a wide range of Pentagon inventories and a new generation of fighter jets cannot be postponed much longer. No matter who wins the presidency, these companies should continue to prosper.
9.

Sovereign Wealth Funds have been buying US banks. Wall Street cites these purchases as evidence of great value in bank stocks. For nations that are overweight Treasuries in their holdings and underweight influence in American politics, swapping Treasuries for bank equities and convertibles makes sense. That does not necessarily mean that the stocks are great value for investors who cannot get other – unspecified – returns on their investments.
10.

Use panic days to strengthen your equity portfolio, buying the agricultural, gold and oil stocks you will want to own after the bear retreats to his cave – and selling stocks that are too dependent on US consumers. Retain your quality base-metal stocks: they may well be taken out by other mining companies, or a Sovereign Wealth Fund.
11.

The US small-cap bear market may be overshooting because investors haven’t analyzed the likely improved competitive positions of companies whose principal competitors were bought by Private Equity or are Canadian or European companies hurt by the weakening dollar.
12.

Be like all wise cottage owners: Protect your possessions from Rats.

Source: Victor Adair

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