What’s Going on?

Since mid-August, investors have experienced a marked increase in equity market volatility, compared to the experience of the prior five years. Also, the markets for Residential Mortgage-Backed Securities (RMBS) and the Collateralized Debt Obligations (CDOs) comprised of them, began to seize up.

As I write this, the Canadian stock market as measured by the S&P/TSX Composite Index is experiencing its tenth correction of more than five per cent since the October 2002 bear market low. The U.S. stock market as measured by the Standard & Poor's 500 Index is in the midst of its eighth (Charts 1 & 2).

Equity Markets are being buffeted by a credit crunch and repricing of risk that has been under

way since mid-2007, the locus of which is in the market for CDOs, specifically those comprised

of RMBS. Investors fear that the U.S. real estate market is crashing, and that rising sub-prime

mortgage defaults, and the resulting defaults in MBS. And CDOs will have knock-on effects on

the broader U.S. economy, perhaps precipitating an economic recession.

An old saw has it that the market hates uncertainty. There is always some uncertainty in

markets. No one can ever know the future with any precision. Right now, we believe the main

reason the market is having such difficulty with the credit crisis is that it is so hard to get a

handle on how big the problem is. For example, 6 months after the crisis got underway, we still

do not have clarity about who is holding the securities or how much, which specific securities

they are holding, and the risk of default of each security.

We have been advising since 2001 that we believe the monetary backdrop in North America,

and in many developed countries around the world, has changed from one characterized by

disinflationary/deflationary forces, to one characterized by increasing inflationary pressure.

In response to the stock market meltdown that started in 2000, the Fed embarked on the most aggressive easing of monetary policy in its history. At the same time, the Bank of Japan was holding the overnight interest rate at zero, and had instituted "quantitative easing," whereby the BOJ flooded the banking system with reserves well in excess of demand. In addition, the European Central Bank took its administered rate down to 2 per cent and kept it there for an extended period of time.

As this process got underway, the U.S. dollar began to weaken against the global basket of currencies, and commodities markets broke out of their 22-year downtrend. The great bond and equity bull markets of the 1980s and 1990s were characterized by a transition from market capitalization and profitability domination by the resource sector in the wake of the inflationary 1970s, to the more recent domination by the financial sector. We believe that the secular trend is in the process of turning back toward the real economy and real assets, away from the financial economy and financial assets.

If Markets Are Up, Why Do I Feel Down?

Mark Russell, one of our Canadian equity specialists, engaged in a very useful exercise

recently: he examined year to-date results for the S&P/TSX Index to see which stocks were the major point contributors to the rise in the index. He found that of the 550 point the index had risen in 2007 to November 20, the bulk of the rise-531 points is explained by only 3 stocks. As important as the

contributors to the rise in the index year to date, are those stocks that have fallen the most over

the same period, of which the big five Canadian banks and National bank are 6 of the 8 biggest

laggers, stripping 245 points off the value of the index.

So, if an investor was holding individual equities, but did not hold any of the biggest gainers,

then they lagged the index. Further, given the concentration of market capitalization represented

by the big 5 banks, it is likely that the typical equity investor has badly lagged the index.

The market is very selective at this juncture, so security selection will continue to be important in

the future. However, it is possible that we will see an improvement in the market breadth in

coming months. Since 1990, breadth has not stayed at this low level for more than a few months time.

We believe the crisis is not intractable and that markets will get through this, and globally the

economic impact while significant will neither be debilitating nor a precursor to global recession.

We believe the uncertainty is causing many to forecast very dire consequences for the U.S

economy. We believe if there is a risk of an economic surprise, it is that the economic growth in

the U.S. could be considerably more robust than the consensus of economists suggest.

We further believe that this renewed fear has created another buying opportunity, as it has

restored the potential for double-digit returns over the next 12 months.