PICTON MAHONEY ASSET MANAGEMENT
CANADIAN EQUITY INVESTMENT OUTLOOK
O CTOBER 2010
Equity markets typically go through a number of phases during an
economic cycle. After an initial recovery rally, it is very common for
stocks to correct as economic growth decelerates and investors start to
fear the dreaded “double-dip” recession. Luckily, “double-dips” rarely
occur and stocks almost always resume their rally as the signs of a “soft
landing” become more evident. However, this economic cycle is very
different than any in the postwar era and there are well-founded fears
that a “double-dip” recession is more likely than in previous economic
recoveries. The capital market’s behavior in the third quarter reflected
these concerns. Stock markets hit an air pocket in the middle of the
quarter as economic data decelerated and fears of sovereign debt crises
continued to linger. However, equities began to find their footing on
the first signs of stabilization in key economic variables and then
rallied…hard! The 8.9% September rally for the S&P 500 Index proved
to be the strongest one for that month since 1939. The MSCI World
Index recovered to finish up 13.9% in the quarter (10.4% in Canadian
dollar terms) while the S&P/TSX Composite Index ended up 10.3%.
The Index groups with the best performance in Canada were the
Materials, Utilities and Consumer Staples sectors.
The chances of a “double dip” are higher this cycle due to the almost
unparalleled challenges that the world economy is facing, especially in
the more developed regions of the globe. Many countries are grappling
with the headwinds of significant private sector debt de-leveraging,
massive government deficit spending and central banks seemingly running
out of bullets when it comes to further ways to stimulate their economies.
The economic recovery to date has been much more anemic than usual
which has raised more legitimate fears of an impending recession.
As the recovery began to lose steam earlier this year, we started to mon-
itor a number of key short-term variables that we thought would be
important to resolving the ensuing “soft landing” versus “double dip”
debate. Many of these variables, including the US and Chinese
Purchasing Managers Indices as well as US employment data, have
begun to signal that the recent softness in the economy is stabilizing.
To be clear, we don’t expect the global economy to suddenly surge.
However, we also don’t believe that strong growth is necessary for
equities to rally considerably from current levels. What is necessary is
to have at least some positive growth that can sustain itself for a
reasonable time into the future. An economy showing at least some
sustainable growth allows deflationary fears to subside without
provoking inflationary fears. It allows risk seeking behavior to increase
and investors to refocus on stock picking as opposed to macro
economic analysis and the worries of higher stock correlations that
occur in more intensely macro-driven environments. Investors can
generate solid returns in a tepid economic recovery if the recovery
sustains itself and if valuations are attractive. We believe both of these
conditions exist today.
One simple reason for the economy to continue grinding higher
instead of slipping into recession is the current lack of consumption
excesses that have typically begun to emerge at this point in prior
stronger recoveries. For instance, it will be difficult for the US housing
sector to fall substantially from current levels when US housing starts
are still below bottoms from prior recessions and are not even keeping
up with the level of household formations. Similarly, US auto sales
haven’t been at levels this low since the early 1990’s causing the average
age of cars on the road to increase significantly. Consumers have
reduced their spending in order to begin rebuilding their savings. With
this much savings rate adjustment having already occurred, it becomes
increasingly difficult for consumer spending to remain such a large
drag on the economy. Of course should the economy still manage to
stumble the US Federal Reserve is prepared to embark on another
round of quantitative easing. Just the Fed’s announcement that it was
contemplating such a move has led to some of its benefit already being
felt in the US through recent declines in longer term bond yields and
the US dollar.
There is also a very large source of pent-up economic growth potential
emanating from unsustainably low levels of corporate capital spending.
The ratio of US corporate cash flow to non-residential fixed invest-
ment is at the highest levels it has been since at least the late 1940’s. US
corporations are producing almost as much as they did near the economic
peak, but with much lower labour costs. Machinery is aging and the
workforce may be getting overworked. It is possible that the recent
improvement in the tone of the stock market will improve corporate
confidence and kick-start capital spending programs. Increasing corporate
capital spending should lead to greater job gains and increasing
consumer incomes which should help reinforce the sustainability of the
economic recovery.
Unlike in past recoveries, the global economy has benefitted much
more from strong growth in the emerging economies. All eyes have
been recently focused on China which is a key driver of emerging economy
 PICTON MAHONEY ASSET MANAGEMENT
CANADIAN EQUITY INVESTMENT OUTLOOK
strength. Thus far, the Chinese government has done a solid job of
sustaining strong growth with its timely and effective use of counter-
cyclical policies. Avoiding social unrest has been a powerful motivator
for the Chinese to get their economic policy right. This provides some
confidence to us that China will generate reasonable levels of growth
for the foreseeable future. Increases in the last two Chinese Purchasing
Manager Index readings have also improved the prospects of a “soft
landing” for the global economy.
As a “slow but steady” economic growth environment emerges,
investors should start to focus more on the outstanding relative valua-
tion that equities provide today, especially compared to “safe haven”
alternatives like US government bonds. Chart 1 shows that the spread
between the operating cash flow yield of the S&P500 Index (Ex Financial
stocks) and the 10 year US treasury yield has diverged considerably
making stocks extremely attractive relative to bonds. The reason for
the attractive relative valuation of equities may stem from the adverse
economic events of 2008 and early 2009 which roiled all risk assets.
Investors seem to have become hypersensitive to the potential for
adverse events to occur in the economy and in stock markets. It certainly
doesn’t help that the 10 year compound annual growth rate of the S&P
500 index has recently experienced the second worst bear market since
1880! In spite of recent improvements in a few stock market related
sentiment surveys that we follow, we still believe a substantial “wall of
worry” exists that can help sustain further gains in equities. It is worth
noting that US equity markets are up this year despite outflows of $28
billion in US domestic equity mutual funds. Meanwhile, inflows into
bond mutual funds are starting to resemble those that flowed into equity
funds at the peak of the stock market bubble in 2000. The total return
prospects from stocks don’t have to be very high to beat the returns on
offer from low risk assets which should help to reverse some of these
money flows at some point.
Chart 1: The cash flow “yield” for equities has closely
tracked the 10 yr yield.
Stocks have rallied considerably from their lows earlier this year and
may be due for a pull-back. Perhaps up-coming US elections, the next
FOMC meeting or even the possible expiration of the massive George
Bush era tax cuts triggers such a pull-back. We continue to recommend
buying equities on weakness to position for further gains over the next
few quarters. However, we do not intend to get too greedy if the rally
unfolds as we expect. It remains our opinion that stock markets will
likely be stuck in longer term trading range as the world works through
the ill effects of large fiscal imbalances, growing public sector debt
(especially in more developed countries) and unbalanced global trade
flows. We have welcomed the government’s fiscal support throughout
the economic crisis that occurred, but wonder when the necessary
unwinding of this support will occur and what effects it will have on
economic growth. European sovereign debt issues this year have been
a reminder of the potential risk of crises in public sector finances
around the world. At best, high government debt loads are a long-
term headwind to economic growth as debt service payments replace
more productive uses of capital. At worst, these debt loads can derail
global financial markets and cause significant damage to the economy.
Markets also have to grapple with much bigger government involve-
ment in the economy. Many governments have been busy “closing the
barn door after the horses have escaped” by implementing greater and
greater levels of regulatory control on various industries, especially
finance. While sometimes necessary, greater regulatory interference
generally leads to sub-optimum capital allocation and an economy that
functions below its long run potential. Finally, we are unclear about the
potentially negative long-term consequences of central banks embarking
on a policy of literally printing money. The massive monetary stimulus
in place today has been necessary to stabilize the economy and help
stave off deflation. However, it seems reasonable to assume that an
easy, seamless exit from these monetary policies will become more and
more difficult to pull off given their growing size and impact on markets
and the economy. As an example, there are already growing trade
tensions as currency devaluations linked to monetary policy keep
occurring. The last thing the world economy needs is a significant trade
war to break out.
These difficult issues have already been clearly recognized by the market
and dominate headlines on a regular basis. Unfortunately, very little
concrete action has been taken to actually start remedying them. We
expect there will be various painful bouts in the economy and in markets
once the tough medicine starts to get administered. We still believe
that the actions required to truly change our debt driven recovery culture
will mean a period of below trend economic growth, earnings growth
and wealth accumulation.
 PICTON MAHONEY ASSET MANAGEMENT
CANADIAN EQUITY INVESTMENT OUTLOOK

The past three years have not been kind to many types of disciplined
stock selection strategies. One reason for this has been investors’
intense focus on macro economic factors and the potential for adverse
events occurring within the global economic system. According to
recent research done by Bernstein Research “when a lone factor (such
as risk today) has dominated stock returns, the market trades with high
correlation. Correlation drives mispricings of stocks and as it persists,
the opportunity set of the market grows. The return of differentiation
among stocks will occur when investors regain conviction and act to
profit from this.” The recent signs of economic stability may be setting
the stage for stock selection to begin playing a bigger part in portfolio
returns going forward.