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Second Quarter 2008

June 1, 2008 • Print This Article

Andras Group Quarterly News - Second Quarter 2008

This is the first of our new quarterly newsletters, which will provide more detail than our previous issues. We hope that our perspective on the markets helps you answer questions you may have and stimulates discussion. As always, if you have any questions, please give us a call.

"Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell."

- Sir John Templeton

The Markets

Canadian Markets

From a technical perspective we believe that equity markets are oversold, especially in the United States, and rallies are likely due to short covering and reallocations of capital seeking higher returns. However, we do not believe that rallies will be extended and maintained. It is more likely that markets will continue to be volatile. As long as food and energy prices remain high and financial institutions are restrained from providing liquidity, the consumers will be restrained and business expansion should be muted. What the market place is facing at this time is uncertainty. Once investors see that there is some sense of direction, liquidity should return to the market.

The weakness in financials and the rise in oil have occurred in step, which has caused turmoil in the system. Sentiment is as Bearish as it was in March and over the past ten years when sentiment has been this negative markets have rebounded. Insider buying has increased dramatically and technical charts may be signaling a low. Traditionally, the more negative people become, the closer the market is to a bottom. That is why it has been said that in a bear market stocks return to their rightful owners. Simply put, retail investors panic and sophisticated investors buy.

Equity and preferred share dividend yields and yields on longer maturity bonds have risen as money is pulled out of investments that have perceived risk and goes to the safety of cash and near cash. The Bank of Canada, following the Fed's lead could leave interest rates at very low levels for an extended period of time. However, inflation is beginning to creep into the system and is now above the Bank of Canada official guidelines. The question at this point is what direction the B.O.C. will take, higher growth through lower rates or raise rates to combat inflation.

As always, we maintain a long-term approach, with an appreciation that there could be short term opportunities. We continue to look for opportunities to buy well-capitalized, well-managed companies that will weather the storm in the long run. Many of these are trading at discounted prices, prices that only make sense in light of investor pessimism.

The completion of the BCE deal come December bodes well for the markets. The perception is that those involved with the deal feel that conditions will be better at that time and the write-downs faced by the financial backers will not be as drastic as they would appear based on the current market. Canadian banks and insurers, for the most part, avoided the sub-prime mess and have far superior balance sheet ratios than most U.S. and international lenders. Dividend yields are attractive and appear secure.

The Canadian markets have been distorted by the heavy weighting of energy companies on the TSX. Record energy prices have boosted the prospects of Canadian energy companies. Although share prices do not fully reflect current oil prices ($140.00 bbl) and natural gas prices ($13.50 mcf), they have been trending higher and have provided support for the broader index. The dominance of energy issues and individual equities such as Research In Motion and Potash have masked broad weakness in the general market, as seen by sharp corrections in the materials and energy sectors. Especially hard hit this year have been the common and preferred shares of the Canadian financial service companies. As of this writing the TSX is in negative territory for 2008.

US Markets

Asset and loan write-downs continue to impact the financial service sector in the United States. Poor lending practices in the US led to the housing bubble and subsequent sub-prime mortgage meltdown. The drop in real estate values could lead to higher housing foreclosure rates. This puts further pressure on housing values and boosts loan loss experience. Surveys have shown that half of U.S. home owners who purchased homes in 2006 owe more on their mortgages then their houses are currently worth.

In the wake of the financial crisis, there has been a much overdue tightening of lending standards by US bankers. The liquidity squeeze now extends beyond the mortgage market and impacts business lending and the issuing of credit card debt and consumer debt.

Tightened liquidity combined with high personal debt levels and high prices of energy and food and we see an economic environment that makes recovery a slow process. At the moment, inflation is contained to fuel and food. Consumers are forced to spend more of their incomes on necessities. This means that we should see a pull back on discretionary spending, further hampering the ability of companies to raise prices and dampening core inflation. The Fed is likely to hold interest rates at current levels. This is key to the strength of the American markets. If interest rates are increased the economic conditions will continue to tighten. If interest rates are lowered it will hurt the U.S. dollar and continue to cause turmoil in the market place. What we have seen recently with the retrenchment in the price of oil and other commodities is a perceived strengthening of the U.S. dollar. This boosts enthusiasm and may lead to a strengthening of U.S. retail market conditions. As the dollar strengthens, commodity prices should continue to drop which will help to stabilize the overall global economy. This is good for the long term stability of the global markets.

Much of the fear of recession, inflation, and continued below trend economic growth are already priced in to the markets. The American indices are now in Bear Market territory. Funds have been taken out of the equity markets and put into liquid assets earning very low returns. In fact the dividend yield on the S&P 500 is now above the risk-free Fed Funds rate. This has happened three times in the last 20 years (1992, 2002, and 2008). Each time was a period of pessimism and the last two times marked market turnarounds.


Most investors who seek long term appreciation and stable growth tend to be risk-averse. This is one of the big reasons that the equities with "perceived safety" have suffered with the market as a whole. Preferred shares have trended down with common shares because investors are demanding high risk premiums for entering the markets. With Treasury Bill yields low and "risk Free" assets offering very low returns investors are in a precarious position when looking for decent returns.

We believe that equities that pay reasonable dividends will, in the long term, have less share price volatility and will tend to insulate the accounts from negative share price shocks. In addition, dividend paying companies tend to be conservatively managed and have relatively low P/E multiples which should provide some share price protection in down markets. However, financial service equities, which are characterized by both high dividends and relatively low P/E ratios, were sharply lower due to concerns emanating from the troubled American financial sector. Underexposure in the hot areas of the market and defensive positioning has muted returns.

We tread lightly with commodity based stocks, very few of which pay a dividend. Share prices tend to be vulnerable to any pull back in the price of the underlying commodity. These stocks are volatile by their very nature. Potash Corporation of Saskatchewan should have much higher earnings due to high fertilizer prices. The high P/E and parabolic share price chart indicate that the stock is vulnerable to a substantial price correction even if the growth fundamentals appear sound. Although we believe that the demand for agricultural products will remain strong, we are cautious of investing in only one position in this area. We are participating in the agricultural boom through the Claymore Agriculture index which holds Potash and the iShares Canadian Materials.

Bond maturities should remain short term. The yield on one year T'bills is 2.95% vs. 3.40% for a 5 year Canada bonds. The small difference in yield does not justify extending the bond durations any longer than 5 years. There could be a trading opportunity if yields on longer maturities and corporate bonds continue to back up.

Dividend and income trust distribution yields are currently higher then bond yields. As long as balance sheets are sound and earnings prospects hold up, investors should be rewarded with the opportunity for capital appreciation when markets eventually recover.

When fear is rampant and the Bear is roaming, wise investors hold on, clip their coupons and wait for better days. Selling into a Bear Market guarantees that low equity values will be locked in. Investors that have sold in a panic will not reinvest until a comfort level is reestablished. Unfortunately, comfort levels are not usually reached until equity values are higher then they were when the investor sold.

We believe that economic and equity value recovery will be subdued and investors should brace for below trend returns while this volatility remains. If history is any example, however, we will face substantial opportunities when this credit situation works itself through the system.

Filed under: Quarterly Reports

The opinions, estimates and projections contained herein are those of the author as of the date hereof and are subject to change without notice and may not reflect those of Mackie Research Capital Corporation ("MRCC"). The information and opinions contained herein have been compiled and derived from sources believed to be reliable, but no representation or warranty, expressed or implied, is made as to their accuracy or completeness. Neither the author nor MRCC accepts liability whatsoever for any loss arising from any use of this report or its contents. Information may be available to MRCC which is not reflected herein. This report is not to be construed as an offer to sell or a solicitation for an offer to buy any securities. Member-Canadian Investor Protection Fund / member-fonds canadien de protection des ├ępargnants.

Mackie Research Capital Corporation (MRCC) makes no representations whatsoever about any other website which you may access through this one. When you access a non-MRCC website please understand that it is independent from MRCC and that MRCC has no control over the content on that website. The content, accuracy, opinions expressed, and other links provided by these resources are not investigated, verified, monitored, or endorsed by MRCC.


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