MARKET UPDATE
Quarter-ended December 31, 2009
ECONOMIC COMMENTARY
What a dramatic difference a year can make! At the end of 2008, traumatized investors sat stunned at the
rapid pace at which the market decline had hit them and things only got worse in the early part of 2009. It
appeared that equity markets around the globe (with the more cyclical/volatile regions and sectors being
hit the hardest) were in an out-of control downward spiral. And then March 9th… as quickly as markets
had dropped off they seemingly hit the bottom and began a rapid ascent that continued (almost unabated)
for the next nine months. This rebound continued into the fourth quarter as equity markets drifted higher
in the final quarter of 2009 resulting in one of the strongest equity market rebounds in many years.
The Canadian equity index was up over 35% in 2009 which was well ahead of global MSCI World index
which was up 26.5% (in local currencies) and 12.9% in Canadian dollars. The broad US equity index
(S&P500) generated the exact same return over the 12-month period at 26.5% (in US$) but the weakening
of the US dollar by 16% in the second and third quarters reduced the annual return in 2009 to a moderate
9.1% (in C$). Emerging markets were extremely strong throughout the year posting four positive quarters
for a 12-month return of 63% (in local currencies) following the decline of 46% in 2008. Canadian Fixed
Income markets (as measured by the DEX universe index) turned slightly negative in the fourth quarter
and earned a return of 5.4% for the year. The DEX universe index earned a positive return in each and
every calendar year over the past decade which has led to an annualized return of 6.7% over that ten-year
period. As a result, bonds have been the strongest performing asset class from the point of view of a
Canadian investor over that period.
The table below summarizes the annualized returns for a number of the key capital markets:
Index Returns (in
Cdn$)
Canadian Equity
Canadian Small Cap
US Equity
US Small Cap
International Equity
Global Equity
Emerging Markets
Bonds
Cash
Index
S&P/TSX Composite
S&P/TSX Small Cap
S&P 500
Russell 2000 – Small Cap
MSCI EAFE
MSCI World
MSCI Emerging
DEX Universe Bond
91 day T-Bill
4th
Quarter
2009
3.86%
12.94%
4.09%
1.96%
0.34%
2.26%
6.59%
(0.17%)
0.07%
Source: eVestment Alliance, PC Bond Analytics, MSCI Barra, Standard & Poor’s
1 year
5 years
35.06%
62.38%
9.12%
9.74%
14.30%
12.85%
54.49%
5.42%
0.62%
7.65%
1.97%
(2.24%)
(2.15%)
1.26%
(0.15%)
12.81%
5.20%
2.99%
10 years
5.60%
5.45%
(4.04%)
0.28%
(1.59%)
(2.90%)
6.66%
6.67%
3.28%
MARKET COMMENTARY
Having briefly summarized the state of affairs in equity markets in the preceding paragraphs, we now
delve deeper into the drivers of performance in the past quarter, the past year and even the past decade. A
large part of the rebound that occurred in 2009 was driven by investors that realized that we were not in
the midst of another depression and that not all companies were on the verge of bankruptcy (though this
appeared to be the mindset in 2008 when everything seemed to fall in tandem). However, not only did
investors reverse their view on the probability of the recovery, they once again displayed a reduction in
risk aversion – they began to ‘pile in’ to some of the stocks that had fallen most dramatically. Also
contributing to the recovery was the increased optimism that the policy measures taken by federal banks
around the globe had returned a measure of stability to the global financial system.
After a movement to a very risk averse stance in 2008, the risk trade was certainly back in full effect in
2009 as evidenced by some of the top performing asset classes, geographic regions, commodities, market
capitalizations and sectors. That is, in each of these categories, the components that would have
historically been deemed the most volatile were those that experienced the largest gains. For instance,
equities were well ahead of bonds in 2009 and within the equity markets, emerging markets were well
ahead of developed markets. Within developed markets, small cap stocks outperformed large cap stocks
by a wide margin and the more cyclical sectors of the economy (Materials, Energy, Consumer
Discretionary) beat the defensive sectors handily. Within the Fixed Income sector, corporate bonds
dramatically outpaced ‘safe’ federal government bonds and with lower quality, higher yielding bonds
generating the strongest returns from the market bottom. It is fair to say that stocks deemed as lower
quality performed very well for the year as this type of stock not only led the early stages of the rally but
appeared to pick up momentum throughout the year (slowing down only late in the fourth quarter).
However, despite the strong returns in 2009 detailed in the previous paragraphs, equity markets remain
well below their peaks from various points in 2008. That is, the rebound that took place in 2009 was not
nearly enough to offset the dramatic declines that occurred in the previous year. An investor fully
invested for the two full year period in the Canadian equity index would have seen their $1 decline to
$0.90 (requiring 11% to reach December 31, 2007 levels). Even though markets have rebounded 55%
from the trough on March 9th, the index is still well below the peak that preceded the 50% decline that
began in June 2008. To return to this June 2008 peak would require an additional 28% return from the
year-end index level. On the global equity front, an unhedged Canadian investor would have had $0.82 at
the end of the two-year period meaning a further 22% return would be needed to return to the level at
December 31, 2007.
While stock market volatility is not uncommon during periods of economic uncertainty, we have
experienced these sharp moves in a very condensed period of time. The swings have been rapid and have
been bolstered even further by the tremendous momentum that can carry the market (in either direction).
This has been clearly seen over the past two years where the herd mentality has pushed prices first to
unreasonable levels at the peak until the bubble bursts but then drives prices to equally irrational levels on
the way down. The last market correction in the early 2000s was more drawn out as was the market
recovery.
We have seen two major bear markets and two major bull markets in the past decade – up and down
moves of greater than 50% over short periods of time. The drivers behind the bubbles were entirely
different, but the behavioural psychology of the underlying investors that led to the extreme moves were
similar. The result has been a decade in which most major equity markets generated negative annualized
returns. In the US, this marks the first decade ever that the S&P500 earned a negative return for the full
period. Prices fell in the 1930s, but dividends boosted the index slightly into positive territory. Global
markets also generated a negative return for the 10-year period. For the most part, the regions that were
able to generate positive equity returns since 1999 were those that are more natural resource-dependent
due to the rising demand from emerging markets. Clearly, Canada is one of these regions with nearly 50%
of our market index represented by resource stocks (Energy and Materials).
The equity markets have resumed their upward trend but the question remains - will it continue? While
the past two years have been extreme and momentum has played a large role in carrying the market to
both highs and lows, a more normalized environment could be around the corner. However, while the
pullback of 2008 may have been justified the extent to which it occurred was probably not. Similarly, in
2009, markets valuations were extremely cheap and a large component of the rebound was simply an
increase off of all-time lows. In order for the positive markets to continue, data will need to improve in
terms of corporate earnings and profitability and not only as a result of drastic cost cutting measures.
Many would argue that equities have already priced in the current earnings estimates for 2010 and
therefore further expansion must be the result of additional real revenue growth and upwards earnings
estimate revisions. Investors may have been satisfied with the ‘hope-driven’ rally in 2009 but that type of
rally cannot last and investors will be seeking a ‘growth-driven’ rally if things are to persist in 2010. The
other pressing issue is of course the fear that the economy and the markets have simply been propped up
by the massive government stimuli and once these are withdrawn there will be another major pullback.
Volatility is therefore to be expected for some time to come.