I

the NVESTMENT COMPASS

Quarterly Market Commentary
Spring 2009

Suite 213 5455 152nd St. ● South Surrey BC Canada ● Tel (604) 576 - 8908 ● invest@pacificapartners.com

Debunking the Hype – Summary:

misled by headlines  Headlines aren‟t a good measure of fu-
ture market performance as has been
In this issue
R ecord unemployment, unprece-
dented stimulus packages, and
“bleak” economic reports top the head-

demonstrated over many decades.
High yield bonds could be preparing for
Debunking the Hype lines of even the most respected news- a significant rally, but it still looks early.
- misled by headlines papers across the globe. It‟s no sur- I
 nter-market relationships (between
prise that many investors feel impend-
Stocks, Bonds, Currencies, and Com-
pg 1
ing “doom and gloom” when it comes to
their investments. modities) can provide insight into how
markets are poised for future moves.
Is it Time to Buy Junk? Fortunately, we can find comfort in
- a look at high yield- knowing that newspaper headlines are
often a poor indicator of where invest-
bonds
ments are headed and are in fact better
pg 4 indicators of where investments have
Recent unemployment headlines, as sampled
below, demonstrate the dreary outlook that
been. This may seem counterintuitive,
highly regarded mainstream publishers are pre-
Uncovering the future but the fact is that investors often incor-
senting.
- Inter-market insights rectly infer that the past or even current
economic environment will dictate mar-
ket returns over the coming periods. “Job Fair Offers a Glimmer
pg 5 of Hope Amid the Gloom”
History has shown that this is the case. – April 1, 2009 The Toronto Globe & Mail
In fact, once either economic dread or
“Euro Jobless Rate
Media market euphoria hits the main stream
Surges to 8.5 pct”
media, the end is usually close at hand.
watch: To understand why, it is important to - April 1, 2009 Forbes
recognize that the stock and credit mar-
kets are forward looking entities. In
“ADP Sees Another
simple terms, they provide positive re- Steep Drop in Jobs”
turns if the future economic outlook be- – April 1, 2009 Wall Street Journal
comes brighter than the current eco-
nomic outlook.

Pacifica Partners has ap- From the perspective of the investor, what
In that regard, when the economy is should be kept in mind is that phrases like “amid
peared on BNN and the Fi- already viewed by the masses nega- the gloom”, “jobless rate surges”, “steep drop”
nancial Post. Interviews & tively, the only real investment concern are only intended to entice readership. How-
published commentaries are is “can the economy get any worse?” ever, the reader often infers that the increasing
available online at: number of jobless individuals implies a doomed
stock market. Yet, this is not the case.

(continued on page 2)
pg 2

(continued from page 1)

500 index gained 23%, 115%, and 178% in the respective one,
five, and ten year periods immediately following the publication.
To demonstrate, we look to Time magazine‟s February 8th 1982 Again, once concerns over the banking crisis hit mainstream
cover entitled, “Unemployment, The Biggest Worry” (top of page- media the market recovery had already begun.
3). Over the one year period prior to the issue hitting print, the
S&P 500 had already lost 12%. However, one year after the is- Inflationary concerns are no different than any other mainstream
sue was published, the S&P 500 index gained 27%, 5 years later economic fear. And, with record stimulus packages put forth by
it gained 144%, and 10 years later it gained 259%. Even in an- governments and central banks, inflationary pressures may in-
nualized terms the gains deed arise. However, many investors have already flocked into
gold based investments in order to hedge their risk to a potential
were impressive, with gains of 27%, 19.5%, and 13% per year inflationary environment. In response to this move, gold climbed
for each of the periods respectively to over $1000 USD / ounce in February of 2009. Fortunately,
we felt that the Gold story was over-bought and chose not to
Unemployment may be a recurring economic theme in every
take our clients down that road. Subsequently, gold prices cor-
generation; however the current financial crisis is of course
rected sharply.
unique. It turns out that this may not be true either. The financial
crisis of 2008/2009 that has origins in sub-prime mortgage lend-
ing and the securitization of these mortgages, is on some levels In essence, the market has already accommodated for the pos-
not that different from the Savings and Loan Crisis of the „80s sibility of inflation by adjusting its valuations accordingly. In the
and early „90s. In both cases, weak regulatory supervision re- mean time, the headlines of mainstream publications read as
sulted in banks (and savings and loan associations) becoming follows:
increasingly involved in speculative real estate and commercial
“Some see Inflation as Key Threat”
loans.
- London Free Press March 29, 2009

Without conducting an in depth comparison of either crisis, it is

sufficient to say that the headlines weren‟t that different than “Inflation Fears Grow After Fed
those currently being depicted: Prints $1.2 Trillion”
– CBS News March 20, 2009

“US Inflation Threat Worries Chinese Too”

”Georgia Bank Failure is 21st of 2009” – Dallas Morning News March 24, 2009
– March 30, 2009 BankInfoSecurity.com

Time magazine once again allows us to put these inflationary

”Wall Street Slides on Worries concerns into a historical context with their October 22, 1979
Over Bank Failure Risks” issue entitled “The Squeeze of ‟79 – Tighter Money, Higher
– March 20, 2009 News.com.au Prices, Wall Street Woes” (bottom of page 3).

“Community Banks Caught in Again, the US stock market returns immediately following the
Sins of Bigger Banks” publication date were impressive. In fact the annualized returns
– March 30, 2009 Seattle Times over the period were more than 12% per year.

The lesson of all of this is that investment decisions built from

extreme emotional responses to such things as irrational fear or
As indicated in the first headline, it is true that 21 US banks have market euphoria do not serve investors well. A good gauge of
failed up to the end of March of this year. It is also a fact, how- consensus opinion comes from the headlines making the main-
ever, that an additional 25 US banks failed in 2008. As concern- stream publications. It is a reminder that the doom and gloom
ing as these facts are, 1984 witnessed more bank failures during present in the media today is likely already reflected in the
the early stages of the Savings and Loan crisis. 106 banks failed valuation of the market. Market sentiment usually sours or im-
in 1984 despite the fact that 99 US bank had already failed in proves faster than that of the main-stream. This is what often
1983. creates opportunities for profiting from excessive fear.

How did the markets and the media respond? Using the Decem- The headlines on the right side of page 3 are a sample of what
ber 3rd 1984 cover of Time magazine entitled, “America‟s Banks we see in newsstands today – fortunately, they too are
– Awash in Troubles” as a marker (middle of page 3), the S&P bleak.
pg 3

Today’s
Headlines
pg 4

Is it Time to Buy Junk? depressed high-yield bond prices rebound with improving eco-
nomic outlook. In addition, since debt holders possess
- a look at high yield bonds “senior” claims to a firm‟s assets over that of its equity holders,
the high-yield bond space can at times pose a better risk-

A s market uncertainty now begins to show signs of subsid-

ing and investors begin to shift out of bonds and cash and
enter back into the relatively risky equity markets, shifts within
reward profile than equities.

In order to demonstrate the potential upside that high-yield

bonds possess, the chart to the left (bottom) compares the
bond holdings themselves are also taking place. In fact, in-
returns in the high-yield bond space (HYB) to the S&P 500
vestors are now shifting from treasuries (government bonds)
index.
which represent the lowest risk bonds, to the relatively risky
side of the bond market, corporate bonds. As the economy Default rates are a key risk factor in determining the safety
continues to further strengthen, investors will also return to level and the timing of when to invest in high yield bonds. The
buying high yield corporate bonds, also known as “junk” downside of investing into a high-yield bond mutual fund or
bonds. ETF can be quantified from the percentage of high-yield bond
holdings within that portfolio that default on their debt obliga-
Although the term “junk” can be unsettling for any investor,
tions. Generally, a “good” fund will have a default rate of ap-
high yield bonds are simply bonds that aren‟t considered
proximately 1-2% or less, which is usually a fraction of the per-
„investment grade‟ because they don‟t have BBB- or higher
ratings (as per S&P bond ratings). However, high-yield bonds centage of total defaults in the high-yield market.
possess higher yields in order to compensate investors for
their higher default risk. The title „junk‟ itself is also bit of a
misnomer, which dates back to the early 1980s when Mi-
chael Milken, a pioneer in the high-yield bond market was
ironically convicted of securities fraud. Today, however, the
US high-yield bond market is almost $1 trillion in size and
its Canadian counterpart is over $50 billion, with institutions
such as pension plans and mutual fund investors as major
participants.

Since investor demand for high yield bonds is closely tied to

global risk appetite, the yield spread (difference) between
treasuries and high-yield bonds, called the high yield “credit
spread”, is thus a key indicator of economic health. Note
that at the height of the bull market, high yield bonds paid in
roughly 8%, compared to 4% from US Treasuries (a 4%
credit spread), but today that spread is closer to 18%, a
sure sign of market fear.
Historically, high yield bond investing has been safest when
Much like equities, high-yield bonds have historically achieved default rates are declining from their highs. As the chart
outstanding returns in recovery phases of economic cycles, as above shows default rates can be tracked but we are not yet
at the levels seen in previous recessions. At this point, pa-
tience and careful observation is warranted as the worst is
likely yet to come.

How should I invest?

High yield bonds are difficult to buy as they trade in large
lots ($25k to $1million). In addition, the task of finding the
best opportunities is best left to an experienced high yield
bond manager, preferably one with a measurable long-term
track record. Furthermore, a high-yield bond fund is best
suited as part of an actively managed portfolio. At some
point in the future, the portfolio manager should be able to
gauge when to take a position within a high-
yield bond fund, and also when that position
should be scaled back or even eliminated.
pg 5

The US dollar has a strong effect on commodity prices. For

Uncovering the Future - example, a strong US dollar impacts capital flow into com-
Inter-market insights modity stocks and the currencies of commodity producing
countries. Likewise, the converse is true.

I n surging economic environments the most common ex-

planation for a robust economy almost always includes
some form of overconfidence in which runaway price trends
This relationship is encapsulated in the chart below entitled
“$US influence on Commodities & Emerging Markets” – show-
ing how copper (perhaps the most economically sensitive of
are explained away by a newly discovered universal “truth”. the base metals) acts relative to the $US and in turn, how the
emerging market economies‟ stock markets move quite tightly
For example, the reason given for the commodity boom in with copper.
recent years was that China and India were moving into the
industrial age. In turn their vast populations would continue The Euro € and the Yen ¥
to consume commodities at a rapid pace. However, we
took a different view in that we examined the commodities How does the Yen and Euro relationship come into play? The
boom by looking at it from another perspective. In particu- relationship between the Japanese Yen and the Euro is an
lar, we examined inter-market relationships, or relationships important barometer of international risk appetite. For years,
of seemingly unre- investors have been taking advantage of near 0% interest
lated asset classes. rates in Japan to borrow capital. Borrowed Yen is converted
Of specific impor- to Euros in order for investors to take advantage of opportuni-
tance was the rela- ties in Europe. In turn, during this conversion process, the Yen
tionships of gold to is sold (it depreciates) and the Euro is bought (it appreciates).
the US dollar, and
This Yen “carry trade” (money borrowed cheaply in Japan and
the Japanese Yen
invested elsewhere in the world) provided the market with ex-
versus the Euro.
cess liquidity during the boom that helped launch stock and
real estate markets skyward. When the run-up eventually col-
lapsed, these borrowers began to pay their debts back to
Gold and the US Dollar Japanese banks. In order to do this, they had to buy back
Japanese Yen and sell their Euro denominated holdings.
Gold and the US dollar both tend to move in opposite direc- Hence the recent strength in the Yen has coincided with
tions from one another. This relationship hit extremes in weaker stock markets. The stronger the Yen became, the
1985 and 2001 in which the US dollar began two separate more investors had to sell international assets to stem their
multi-year declines with gold moving in the opposite direc- losses.
tion. As a result, investors – recognizing this change over
time – began shifting their investment focus into gold and (continued on page 6)
the mining sector.

It is, however, important to note that even

prominent relationships like the gold-US-
dollar trend will sometimes deviate from
the norm. Take the recent occurrence of
both rising gold prices and a rising US
dollar which occurred after markets bot-
tomed in late December. With investors
afraid of the potential of rising inflation
amidst the uncertainty in the US econ-
omy, they bought gold. But while some
investors were rushing into gold, other
investors who invested abroad were buy-
ing US Treasuries (US dollars) – an in-
vestment considered by many to be the
safest investment in the world.
pg 6

(continued from page 5) Pacifica Partners featured by Segal School of Business

Prior to the recent market rebound,
we noted that the Japanese Yen
was weakening indicating a com-
ing rebound in markets. Notice,
that this led the stock market‟s ad-
vance by several weeks.

Why are these two

seemingly unrelated
relationships important?
Movement of the Yen/Euro cross
will help us confirm if markets are
ready to break out and continue a
strong, sustained rally. This is one
of the first places analysts will look
in order to determine the level of
risk investors are willing to as-
sume.

Thus, in order for us to discern

future market direction, we do not
look at economic forecasts with too
much enthusiasm (as an aside –
the closest the official score keep-
ers of the US economy have ever
come to calling a recession was six
months after the fact). In fact, the
S&P500 actually topped out early
in 2007 – at least a year before the
recession was deemed to even
exist. In general, inter-market rela-
tionships are real time forecasters
for the direction of the markets and
provide a better look into the fu-
ture.

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1, 2009, and does not necessarily reflect subsequent Partners Inc. is not liable for any errors or omissions in Contact us:
market events and conditions. the information or for any loss or damage suffered.

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