Beware of Vertigo

Are stocks due for a fall or could they be headed for even higher ground?

Nothing seems to be able to derail the mighty stock market's current climb to new heights. We may well be experiencing the longest Bull Run in 80 years, as investors cheer tame inflation numbers, and continue to talk of big mergers that will propel the market forward. Are stocks due for a fall or could they be headed for even higher ground?

Indeed, with seemingly endless deals that are boundless in size, the stock market has entered a proverbial “melt-up” that will likely continue until John and Jane Q. Public are seduced by the lure of easy money. With billions of dollars being thrown around by private equity firms, hedge funds and foreign-government funds, we are naturally seeing a great deal of action in our equity markets?

In the first three months of 2007, the number of private equity deals involving Canadian buyers or sellers hit record territory. 13 bids were valued at well over $1 billion each - more than double the number just three short years ago. The mergers and acquisitions frenzy is led by deep-pocketed private equity funds. For the past seven quarters, about 400 to 500 deals took place per quarter in Canada. High profile deals included a $2.3 billion team bid by Goldman Sachs private equity and CanWest for Alliance Atlantis and a $1.2 billion joint effort by Ontario Teachers Pension Plan and the Richardson Family for Agricore.

A note of caution

However, many wise investors, including David Dreman and Warren Buffett have sounded a warning about the current environment of cash-flush private-equity funds, high corporate profits, and bond prices that fail to adequately reflect financial risk. They are warning investors not to lose their perspective on the markets and of the potential risks involved. And, as they say, when Warren Buffett speaks, it is a good idea to listen.

Another impact on financial markets around the world has been the falling US dollar. Many analysts think that the US dollar's slow but steady grind lower is set to continue. Slowing growth and the prospect of lower interest rates is likely to rekindle concerns about the United States' ability to finance its gaping current account deficit, which requires $2 billion a day to support it.

The US dollar factor

Stubbornly high readings on inflation are another reason that the US dollar could remain low. The implicit price deflator, one gauge of inflationary pressures in US GDP, jumped at a 4.0 per cent rate in the first quarter, the biggest move since early 1991. The dollar has now fallen to its lowest level ever against a basket of major currencies tracked by the Fed since 1973.

One of the questions we are constantly posing is: "Are equities really rallying, or is the measuring stick, a.k.a. the US dollar, weakening?" Since the beginning of 2002, the S&P is up 29 per cent, while the US dollar is off 30 per cent. So the obvious question is, which one has an effect on which?

Structurally, the slippage in the greenback is necessary for the continued re-inflation of asset classes. We can only guess at the tipping point for foreign holders of dollar-denominated assets, but we do know that it is bound to happen.

So what should you be doing?

We have been quietly watching media coverage of the Dow's 13,000 and humbly offer that intelligent investing isn't as simple as "We're going higher, so climb on board!" This advice is dangerous outside the context of time, and paints an incomplete picture of today's market environment.

Investor mood, while not yet euphoric, is clearly getting somewhat giddy. We have lived through a few bubbles and understand that markets can remain irrational longer than many can stay solvent. Still, when we start to hear pundits leapfrogging market milestones with reckless abandon, antennae should start to vibrate.

Some market basics

After watching the markets for nearly 20 years, we believe a few things are absolute:
• markets go up over time (in fact, they go up most of the time), but when they go down they go very fast
• when things look the best, investors should be most worried
• when they look the worst, investors should be most bullish
• the central banks always get what they want
• every extreme up-cycle leads to overdosing on leverage and speculation

One of the world's greatest investors, Jeremy Grantham, recently penned a piece titled “It's Everywhere, In Everything: The First Truly Global Bubble.” Just back from a six-week jaunt around the globe, he was struck by how pervasive speculative excesses truly are. If you are tempted to dismiss his comments, you should realize that his was one of the most articulate voices back in the 1999, warning of the disaster to soon befall the NASDAQ.

Financial markets remain a maze of contradictions and uncertainty. Nobody knows how long this will last or how we've come so far, so fast. But if we have learned anything over the years, it's to stay modest or the market will do it for you. For that reason that we encourage you to maintain your discipline in a portfolio structure created with your risk tolerance in mind.

Our process of investing with risk management foremost, using managers who have demonstrated their ability to manage in tough market environments, and who re-balance to ensure that we do not fall into market crowding traps, is a key ingredient to meeting your financial objectives.

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