In This Issue

HOW DID WE DO?

 

By Gordon Pape

There are two ways to deal with past predictions. One is to simply ignore them and hope that everyone has long since forgotten some of the silly things you said. The other is to come clean – ‘fess up to the mistakes and take credit for the calls that were right. I have always opted for the latter so now is the time to look back at 2013 and see how we did.

In the issue of Jan. 14, 2013, I offered my fearless forecasts for the year ahead. Here’s what I said, and how things turned out.

The TSX. I began with the Toronto Stock Exchange, which had posted a total return of only 6.2% in 2012. In my comments, I noted that the energy sector, one of the key drivers of our economy, was in a state of uncertainty due to the shortage of pipeline capacity. That would result in discounted prices for our oil which in turn would have a negative effect on the profits of the energy companies and their share prices. Offsetting that to some extent would be gains in the financial sector, I suggested. Overall, I called for a gain of between 5% and 8% for the S&P/TSX Composite Index with a year-end close of between 13,055 and 13,428.

In this case, I wasn’t too far off the mark. The TSX did slightly better than I expected, but it was a tough grind and only a spurt in the last month propelled it to a gain of 9.6% for the year, finishing at 13,621.55.

The S&P 500. I wrote that, once again, New York would outperform Toronto. I suggested several reasons for this including the broad diversification of the U.S. market, strength in the information technology sector, and the exposure of U.S. multi-nationals to overseas markets, particularly China. The S&P 500 ended 2012 at 1,426.19 and I predicted a gain of between 9% and 12% in 2013, taking it to between 1,550 and 1,600 by year-end.

In this case I was directionally right but quantitatively way off the mark. All the New York indexes had powerhouse years, with the S&P 500 finishing at 1,848.36, up 29.6%. The Dow gained 26.5% and ended at 16,576.66 while the Nasdaq Composite was up an amazing 38.3% to close at 4,176.59. Nasdaq’s big gain was fuelled by the astounding performance of the IT sector with the Internet sub-index especially strong, advancing 65.5%.

EAFE Index. Many Canadian investors have been reluctant to invest in overseas markets in recent years. I believe there are several reasons for this including the (until recently) strong loonie, the series of crises in the Eurozone, and the slowdown in China’s growth rate. But despite all the problems, these markets have been performing well for the most part.

The MSCI EAFE Index tracks the performance of mid and large-cap stocks in developed markets in Europe, Australia, Asia, and the Far East. North and South American countries are excluded. EAFE turned in a strong performance in 2012, gaining 17.3%. I wrote that I didn’t think it would do as well in 2013 but that investors could still expect a nice return in the 8% to 10% range.

Again, I was directionally right but quantitatively wrong. The EAFE Index had a blockbuster year in 2013, gaining 23.8%. The astounding performance of the Japanese market, which was ahead 56.7% over the year, was a huge contributor to this result but all the major European markets also recorded double-digit gains.

Bonds. I predicted that commercial bond yields would start to rise, driving down prices, even though the central banks stood pat on their key rates. That would have a negative effect on fixed-income returns, which had been strong since the crash of 2008-09. As a result, I called for a return of between 3.2% and 3.5% in the DEX Universe Bond Index with the DEX All-Corporate Bond Index performing somewhat better with an advance of between 3.8% and 4.2%.

The actual result was much worse than I expected. When the first rumours surfaced in May that the Federal Reserve Board would start cutting back on its quantitative easing program, interest rates shot up and bond prices tumbled. The trend continued for the rest of the year, albeit at a slower pace. In the end, the Universe Bond Index actually lost ground, slipping 1.19%. As I forecast, the All-Corporate Bond Index did better, but the gain was a fractional 0.84%.

The best place for your fixed-income dollars in 2013 was Maple Bonds, which are denominated in U.S. currency. The fall in the value of the loonie propelled them to a big gain of 17.4% during the year. High-yield bonds also did well, with the DEX High Yield Bond Index up 5.41%.

GICs. I called for a modest improvement in GIC rates by the end of the year, although I warned they still wouldn’t look very attractive. I suggested that five-year rates at the Big Five banks could move up to around 2.5% while smaller foreign banks and credit unions might offer as much as 3.5% to 3.75%.

I was too optimistic on this one (or the banks were too stingy, depending on how you look at it). The best posted rate on a five-year GIC from a major bank at the end of the year was 2.3%, offered by TD Canada Trust. Among the smaller institutions, the top posted rate was 3.1% from Outlook Financial. However, it may be possible to squeeze out an extra quarter-point or so if you’re a good client and a skilled negotiator.

Gold. This is my big mea culpa for 2013. I wrote that I thought gold would end the year higher than its 2012 finish at US$1,675.80, although I said that it was anyone’s guess how much the increase would be. I expressed concern that if the Federal Reserve Board pulled the plug on quantitative easing sooner rather than later it would remove one of the main incentives for gold to rise. In the end, I called for an increase of between 5% and 10% in the price of bullion.

Rarely have I been so far off the mark on a call. Gold fell off a cliff in 2013, ending the year at just over US$1,200. That was a loss of over 28%. The gold mining stocks fared even worse, losing 48.4% over the year.

There’s no excuse for this one. It was a bad call, pure and simple. Fortunately, most of the others were directionally correct.

So that’s the 2013 story. Next week I’ll offer my predictions for the year ahead.

Gordon Pape’s new book, RRSPs: The Ultimate Wealth Builder, is now available at 28% off the suggested retail price. Go to: http://astore.amazon.ca/buildicaquizm-20

THE TOP STORY OF 2013

 

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There are several candidates for the biggest financial story of 2013. The BlackBerry collapse. The improbable resurgence of the Tokyo stock market. The dramatic fall in the price of bullion and its impact on the shares of gold mining companies, which collectively lost more than half their value. The rebound on Wall Street.

You could make a case for any of these but to my mind the most important story of the year was one that never happened – at least, not at the time.

It goes back to the third week in May. The U.S. markets had been on a steady climb since the start of the year, with the S&P 500 closing in on 1,670. Then word started spreading on Wall Street that the Federal Reserve Board was about to start winding down its quantitative easing (QE) program, which was pumping US$85 billion a month into the economy. Investors were rattled and the markets started to drift lower.

A few weeks later, Fed Chairman Ben Bernanke confirmed the speculation, saying that the “tapering” process would start later in the year and that QE would likely end entirely in 2014. Investors immediately hit the sell button, with the Dow and the S&P 500 recording their worst one-day losses since 2011. By the time the sell-off was done, the S&P had lost almost 6% from its May high.

But that was only part of story. The expectation that QE would end clobbered the bond market. One of the main objectives of the program is to hold interest rates down; as rumours spread that tapering could start as early as summer, yields on U.S. Treasuries shot up and Canadian government bonds followed suit. At the beginning of the year, the benchmark 10-year U.S. Treasury bond was yielding 1.76%; in late December it broke through the 3% level.

Rising yields mean lower bond prices so investors saw the value of their fixed-income securities tumble as the long bond bull market finally came to an end. But it wasn’t just bond investors that were hurt. A wide range of interest-sensitive securities was battered, including REITs, preferred shares, and utility stocks.

Investors were shell-shocked. These supposedly “safe” places for their money had provided strong returns since the market crash of 2008-09. Now they were being hammered for reasons many people couldn’t understand.

What they failed to realize was the close relationship between their investments and interest rates. The market is always balancing risk and return. When yields on Treasury bonds start to rise, smart investors demand a better return from higher risk securities to compensate. So while a 4.5% yield on a REIT might be acceptable with 10-year Treasuries paying 1.76%, it’s nowhere near enough when they’re offering 3%.

Absent a distribution increase, the only way yields on REITs can move higher is if the price drops, and that’s exactly what happened. The S&P/TSX Capped REIT Index lost 10.6% over the year, while utility stocks were down 8.9% and preferred shares 7.2%.

Finally, six months after the spring sell-off, tapering has finally been confirmed and will start this month. Ironically, the markets greeted the news by moving higher.

But this rising tide isn’t lifting all ships. Interest-sensitive securities will struggle in 2014 as upward pressure on rates continues. This means defensive investors will have to change their whole approach or risk experiencing more damage to their portfolio.

The spring speculation that tapering was about to begin turned out to be wrong. But it set in motion a train of events that had a huge impact on the stock and bond markets, which is why I rate it the top financial story of the year.

TWO INTERNATIONAL STOCKS FOR 2014

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In the last two issues of December, I picked several U.S. and Canadian stocks that I felt would do well in 2014. All were previous IWB recommendations.

To close out this series, let’s look overseas. Here are two international stocks that I like for the coming year. These trade as ADRs in New York.

Baidu Inc. (NDQ: BIDU). This is the Chinese equivalent of Google which obviously makes it a very large company with great growth potential. The stock was originally recommended by contributing editor Glenn Rogers in February 2011 at $128.80 (figures in U.S. dollars). It has been extremely volatile, falling to as low as $82.98 last April. But it has been on a tear since mid-summer, closing on Friday at $175.28. That’s just short of its 52-week high of $181.25, reached on Dec. 11.

Glenn Rogers last updated the stock as a Buy on Oct. 21 at $165.91, citing the company’s strong financial performance and growth potential. Shortly thereafter, the company issued some mixed third-quarter financial results. Total revenue was up 42.3% to almost $1.5 billion. However, most of that was absorbed in higher expenses; profit was ahead only 1.2% to $545.4 million.

Two major factors contributed to the higher costs. Selling, general and administrative expenses were $226.2 million, representing an increase of 115.4% from the corresponding period in 2012, primarily due to promotional expenses for mobile products. Research and development expenses were $178.2 million, a 77.5% increase from the corresponding period in 2012, due mainly to an increase in the number of research and development personnel. Both these represent an investment in future growth so investors were not overly concerned by the small size of the profit increase.

Baidu’s market cap is increasing rapidly and now stands at almost $63 billion. The stock is not cheap with a trailing 12-month p/e ratio of 36.1 and a forward p/e of 28.7. And there is no dividend so this is strictly a security for growth-oriented investors who are willing to live with volatility. But China has almost 600 million Internet users and most of them use Baidu. A few years from now, the current price will look cheap.

Diageo plc (NYSE: DEO). It’s hard to lose money on booze and this is the world’s largest liquor company. Based in London, it controls many of the best-known brands including Johnnie Walker, Crown Royal, J&B, Bushmills, Captain Morgan, Tanqueray, Guinness, and a host of others.

This is another pick from Glenn Rogers, who recommended it in September 2007 at $85.42 (figures in U.S. dollars). It fell all the way to the $40 level during the 2008-09 crash but has been on a steady rise since, finishing on Friday at $130.82. Glenn’s current target is $150.

The company only releases financials twice a year with the announcement of the first half results for fiscal 2014 due on Jan. 30. The dividend is tied directly to the bottom line; the payout in 2013 was $2.92 per share, up from $2.76 in 2012. It’s expected we will see another increase in the dividend this year.

The company has a market cap of almost $90 billion. The trailing 12-month p/e ratio is 21.8 while the forward p/e (based on expected 2014 results) is 17.5.

This is one of the rare growth stocks that also offers a reasonable dividend, with a current yield of 2.2%, based on the 2013 payout. It is therefore well suited for all types of portfolios. – G.P.

STOCKS: HOW MUCH GAS LEFT IN THE TANK?

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Contributing editor Tom Slee joins us for this first issue of 2014 with a look at the stock market and where it’s likely to go in the next 12 months. Tom managed millions of dollars in pension money during his career and is an expert in taxation. Here is his report.

Tom Slee writes:

According to the Chinese Zodiac, 2014 is the year of the Horse, a sign of speedy success. I hope that proves to be true for all of us. We are certainly off to a good start. Investors have their tails up. Economists feel that global growth is going to be surprisingly strong and come in close to 4%. Markets are already sensing this and a lot of the Wall Street gurus are gung ho. They see a second leg up in stocks following a staggering 29.6% surge in the S&P 500 last year. Canadian forecasters look for a rebound in most commodities and are almost equally upbeat.

It’s all very encouraging, suggesting a slam dunk as far as equities are concerned. Without raining on the parade, however, I think that there are a couple of things to consider. First, market forecasting is the weakest link in fundamental analysis. Many analysts regard it as a futile exercise because there are so many unknowns and investor sentiment can turn on a dime. An unexpected flare up in the Middle East, a surprise announcement by the Fed, or a European crisis and all the optimism would evaporate.

There is also a possibility that most of the good news is already built into the market. We have seen some extraordinary momentum during the last few months. Money managers are on a buying spree but it’s hard to see why. Earnings and economic growth are respectable but there has been no startling improvement. And that raises the question of whether all the easy money has been made. Are stocks relatively expensive and what are the chances of the S&P 500 having another bumper year? Is there any gas left in the tank?

I think the answer is yes to both questions. This is likely to be another good year for North American stocks and the surge in 2013 could provide the initial lift. We have impetus. Moreover, history is on our side. Since 1945 there have been 21 times when the S&P 500 gained more than 20% and in the following years the index recorded an average increase of 10% versus the normal average price gain of 8.7% since World War Two. A word of warning though: those subsequent years were bumpy rides. Each one was buffeted by corrections of 6% or more and some years stocks were volatile, suffering several setbacks before ending up in the plus column. That sort of experience is to be expected after a huge move and we may see at least one sharp correction in 2014.

So much for history; we are on firmer ground calculating the price of stocks and their likely values going forward. I feel that market forecasts should always be based on corporate earnings projections. Studies show that profit fluctuations have accounted for about two-thirds of year-to-year variations in Canadian stock market performance. So here goes.

Fourth-quarter numbers have not been posted yet but it looks as though S&P 500 earnings in 2013 will come in at about $110. With the index at 1,848 as of year-end, that means the American market is trading at a 16.8 price/earnings multiple. Last year’s Canadian earnings are expected to be approximately $815 and with the S&P/TSX Composite at 13,622 Toronto has a 16.7 multiple compared to 14.8 at the end of 2012. Stocks are no longer a bargain but they are not overpriced. As a matter of fact, if you build in the projected 2014 earnings growth our markets are relatively good value.

Looking ahead, I think we should see Canadian corporate earnings growth of close to 12% this year as the global recovery picks up steam and drives commodity prices higher. That would give us index profit in the $915 range and, assuming a 16 multiple, an S&P/TSX Composite close to 14,700 by the end of December. I am looking for a solid performance, slightly better than the 8% in 2013. As mentioned though, it may be a rocky ride.

American markets should do even better because they have two things going for them. Given the stronger economic forecasts, we could see good top-line (sales) growth and a 13% or so jump in corporate earnings to approximately $125. At the same time, it’s becoming obvious that American investors are now willing to pay more for stocks as concerns about a second financial collapse recede. Some U.S. equity strategists are projecting a price-earnings ratio of 18 on the S&P 500 over the next year or so. I think that is possible, especially if interest rate increases remain gradual. Therefore my 2014 forecast for the S&P 500 is about 2,050.

Turning to the sectors that are likely to do well, it`s going to be a much more positive environment for resources as international demand picks up. Copper in particular could do surprisingly well. Concerns about slowing Chinese demand are overblown and U.S. consumption should improve. That strength will support copper prices and Teck Resources, which is covered by my colleague Glenn Rogers, is one of the companies that is poised to benefit.

I also think that Canadian financial stocks are going to have a good year with the banks, despite their gloomy warnings, generating solid earnings growth and increased dividends. TD Bank remains my number one choice. Our life insurance companies are finally getting their act together and starting to look attractive. Elsewhere, the consumer sector is a mixed bag with Canadian household debt still hitting record highs. A lot of people are maxed out. However, certain retailers, such as Loblaw, with its Shoppers acquisition and REIT spin-off, could surprise us on the upside.

The U.S. market

As far as U.S. stocks are concerned, I think that Fed Chairman Ben Bernanke’s announcement on Dec. 18 that he is winding down the huge bond-buying program is a watershed. In effect, the Fed put a stamp of approval on the recovery. No wonder the Dow immediately jumped 300 points. Now investors have the best of both worlds. The central bank has unveiled a specific withdrawal program but at the same time emphasized that it will keep interest rates close to their record lows well past the point at which unemployment drops below 6.5%. That is generally taken to be 2015 or even 2016. Above all, the Chairman’s decision removes a major uncertainty.

With GDP growth now expected to exceed 3%, compared to about 2.3% here in Canada, many of the American market sectors are showing strength. According to the Equipment Leasing Foundation, investment in equipment and software is likely to grow at a rate of 3% or more. In November, U.S. industrial production jumped a surprising 1.1% as mining output strengthened and manufacturing was up 0.4%. The numbers are encouraging. Industrial capacity utilization is currently running at 79%, its highest level since June 2006. You can see why Mr. Bernanke felt that it was time to take his foot off the pedal.

One sector that I particularly like is Diversified Financial Services. That is really a group of three major banks – JPMorgan Chase, Citigroup, and Bank of America. Finalization of the new Volcker Rule has removed a great deal of uncertainty that has clouded these banks. They are also going to participate fully in the domestic recovery. Another big plus is that these banks hold excess capital that will become free after the stress tests in March. I expect this to be returned to shareholders in the form of dividends or share repurchase programs.

Another sector with plenty of promise is construction and engineering. Global markets for many of these companies remain uncertain but an increasing number of energy projects are underway in North America. Shale gas drilling is sparking a lot of activity. New air emission regulations are spurring more infrastructure work and homeland security requirements require extensive engineering. Keep in mind as well that this is a highly fragmented industry. Major players have numerous acquisition opportunities.

So, to sum up, 2014 should be a good year for the markets, although a choppy one and certainly not up to the level of 2013.

TOM SLEE’S 2014 STOCK PICKS

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Here are my two Canadian stock picks for 2014. Given our economic forecasts they are well positioned going into 2014.

Manulife Financial (TSX, NYSE: MFC). Manulife is a leading global provider of financial products with principal operations in Asia, Canada, and the United States. It conducts business in 21 countries and is Canada’s number one life insurer with a market cap of $32.8 billion. Revenues exceeded $30 billion last year and resulted in $1.7 billion of income for the common shareholders.

During the last few years, however, the company has struggled to repair substantial damage created by the financial collapse in 2008. There have been some unpleasant surprises and the stock has been out of favour.

I think that is going to change. First of all, Manulife’s largest losses resulted from extensive stock market exposure and that danger has been substantially reduced. Not only are stocks now moving higher, management has hedged more than 80% of its equity positions. At the same time, rising interest rates will improve earnings for the entire life insurance group and MFC’s recent third-quarter earnings were particularly strong. Profit of $0.54 a share was well above the $0.25 consensus forecast. I was especially encouraged by the top-line growth as wealth management sales jumped 34% year-over-year.

Trading at C$20.88, US$19.62, Manulife is expected to earn about $1.30 a share in 2013 and as much as $1.70 next year. We could see a dividend increase in 2014 and I have a revised target of $24 on the stock. The shares have risen 69% since we first recommended them at C$12.34 in February 2012 and should move higher.

Canadian Tire (TSX: CTC.A, OTC: CDNAF). This is my second Canadian pick mainly because this company is on a roll. The shares are trading at C$99.82, US$93.80, up 62% since we added them to our Buy List at $61.58 in June 2011. They still have a lot of upside potential.

Founded in 1922, Tire is one of the largest retailers in Canada and operates 490 stores. Revenues totaled $11.4 billion last year and profit came in at $499 million. Since then, the company has been barreling along in a year when many Canadian retailers, such as Target and Sears, struggled.

On Nov. 7 Tire announced third-quarter earnings of $1.85 a share, up 15% from 2012, and a 25% increase in the dividend to $1.75. Analysts expect to see a profit of $7.15 a share in 2013 and an improvement to the $7.75 range next year.

Perhaps most important as far as investors are concerned is the fact that since the company spun off its property into a REIT many analysts are valuing its stock on a net asset value basis. This, plus the good earnings, should continue to lift the shares. I have a $115 target.

My U.S. stock picks for 2014 are leaders in two key sectors.

Chicago Bridge & Iron (NYSE: CBI). This is a global engineering procurement and construction giant with 50,000 employees worldwide. CBI booked $5.5 billion of revenues in 2012 and with 50% of its operations in North America is well positioned to benefit from the energy boom. We should see earnings of $5.65 a share or more in 2014 (figures in U.S. dollars).

I am impressed by the company’s $25 billion backlog, which is becoming predominately U.S. based and therefore lower risk. With manageable debt levels, CBI is also well placed to make acquisitions in order to supplement organic growth.

We added Chicago Bridge to our Buy List last May at a price of $53.28. Currently the shares trade at $81.23, up 52% and through our revised $77 target. The stock has had a good run but we should see further growth to the $95 range this year.

JPMorgan Chase (NYSE: JPM). This is a multinational banking corporation with assets of more than $2.5 trillion. Market capital exceeds $215 billion. Revenues should exceed $100 billion this year and we can expect earnings of about $4.50 a share with a sizeable increase to approximately $6 in 2014.

In recent months, JPM has been receiving bad press and forced to incur substantial legal fees as well as penalties. This has masked the bank’s revenue growth and improving margins. The stock has suffered. Nevertheless JPM is now priced at $58.66, up 23% since we added it to the Buy List not quite a year ago at $47.85. I expect to see further growth in 2014 now that regulatory problems have been resolved, along with a dividend hike. Wall Street is looking for the stock to trade at $65 or more.

– end Tom Slee


YOUR QUESTIONS

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Claiming the pension credit

Q – I have a simple question, but have not been able to find a clear answer on my own. I am 55 years old and have a fair amount of RRSP holdings. I have been thinking of converting a small portion of these holdings to a RRIF to benefit from the $2,000 annual pension credit, if I can claim the withdrawals as pension income. Is there a minimum age that applies to claiming this credit? Thank you. – Evan F.

A – Unfortunately, you’re too young. You cannot claim the pension credit on RRIF withdrawals before age 65. – G.P.

NEWSLETTER COMING SOON

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Contributing editor Gavin Graham and well-known financial journalist Al Emid will soon be launching a new newsletter dealing with the exciting area of frontier markets. They are co-authors of the new book Investing in Frontier Markets published by Wiley and have a weekly show on satellite radio devoted to the subject.

IWB members will receive a free preview copy of the newsletter later this month. More details to follow.

That wraps up the first issue of 2014. We’ll be back on Jan. 13.

Best regards,

Gordon Pape

In This Issue

HOW DID WE DO?

 

By Gordon Pape

There are two ways to deal with past predictions. One is to simply ignore them and hope that everyone has long since forgotten some of the silly things you said. The other is to come clean – ‘fess up to the mistakes and take credit for the calls that were right. I have always opted for the latter so now is the time to look back at 2013 and see how we did.

In the issue of Jan. 14, 2013, I offered my fearless forecasts for the year ahead. Here’s what I said, and how things turned out.

The TSX. I began with the Toronto Stock Exchange, which had posted a total return of only 6.2% in 2012. In my comments, I noted that the energy sector, one of the key drivers of our economy, was in a state of uncertainty due to the shortage of pipeline capacity. That would result in discounted prices for our oil which in turn would have a negative effect on the profits of the energy companies and their share prices. Offsetting that to some extent would be gains in the financial sector, I suggested. Overall, I called for a gain of between 5% and 8% for the S&P/TSX Composite Index with a year-end close of between 13,055 and 13,428.

In this case, I wasn’t too far off the mark. The TSX did slightly better than I expected, but it was a tough grind and only a spurt in the last month propelled it to a gain of 9.6% for the year, finishing at 13,621.55.

The S&P 500. I wrote that, once again, New York would outperform Toronto. I suggested several reasons for this including the broad diversification of the U.S. market, strength in the information technology sector, and the exposure of U.S. multi-nationals to overseas markets, particularly China. The S&P 500 ended 2012 at 1,426.19 and I predicted a gain of between 9% and 12% in 2013, taking it to between 1,550 and 1,600 by year-end.

In this case I was directionally right but quantitatively way off the mark. All the New York indexes had powerhouse years, with the S&P 500 finishing at 1,848.36, up 29.6%. The Dow gained 26.5% and ended at 16,576.66 while the Nasdaq Composite was up an amazing 38.3% to close at 4,176.59. Nasdaq’s big gain was fuelled by the astounding performance of the IT sector with the Internet sub-index especially strong, advancing 65.5%.

EAFE Index. Many Canadian investors have been reluctant to invest in overseas markets in recent years. I believe there are several reasons for this including the (until recently) strong loonie, the series of crises in the Eurozone, and the slowdown in China’s growth rate. But despite all the problems, these markets have been performing well for the most part.

The MSCI EAFE Index tracks the performance of mid and large-cap stocks in developed markets in Europe, Australia, Asia, and the Far East. North and South American countries are excluded. EAFE turned in a strong performance in 2012, gaining 17.3%. I wrote that I didn’t think it would do as well in 2013 but that investors could still expect a nice return in the 8% to 10% range.

Again, I was directionally right but quantitatively wrong. The EAFE Index had a blockbuster year in 2013, gaining 23.8%. The astounding performance of the Japanese market, which was ahead 56.7% over the year, was a huge contributor to this result but all the major European markets also recorded double-digit gains.

Bonds. I predicted that commercial bond yields would start to rise, driving down prices, even though the central banks stood pat on their key rates. That would have a negative effect on fixed-income returns, which had been strong since the crash of 2008-09. As a result, I called for a return of between 3.2% and 3.5% in the DEX Universe Bond Index with the DEX All-Corporate Bond Index performing somewhat better with an advance of between 3.8% and 4.2%.

The actual result was much worse than I expected. When the first rumours surfaced in May that the Federal Reserve Board would start cutting back on its quantitative easing program, interest rates shot up and bond prices tumbled. The trend continued for the rest of the year, albeit at a slower pace. In the end, the Universe Bond Index actually lost ground, slipping 1.19%. As I forecast, the All-Corporate Bond Index did better, but the gain was a fractional 0.84%.

The best place for your fixed-income dollars in 2013 was Maple Bonds, which are denominated in U.S. currency. The fall in the value of the loonie propelled them to a big gain of 17.4% during the year. High-yield bonds also did well, with the DEX High Yield Bond Index up 5.41%.

GICs. I called for a modest improvement in GIC rates by the end of the year, although I warned they still wouldn’t look very attractive. I suggested that five-year rates at the Big Five banks could move up to around 2.5% while smaller foreign banks and credit unions might offer as much as 3.5% to 3.75%.

I was too optimistic on this one (or the banks were too stingy, depending on how you look at it). The best posted rate on a five-year GIC from a major bank at the end of the year was 2.3%, offered by TD Canada Trust. Among the smaller institutions, the top posted rate was 3.1% from Outlook Financial. However, it may be possible to squeeze out an extra quarter-point or so if you’re a good client and a skilled negotiator.

Gold. This is my big mea culpa for 2013. I wrote that I thought gold would end the year higher than its 2012 finish at US$1,675.80, although I said that it was anyone’s guess how much the increase would be. I expressed concern that if the Federal Reserve Board pulled the plug on quantitative easing sooner rather than later it would remove one of the main incentives for gold to rise. In the end, I called for an increase of between 5% and 10% in the price of bullion.

Rarely have I been so far off the mark on a call. Gold fell off a cliff in 2013, ending the year at just over US$1,200. That was a loss of over 28%. The gold mining stocks fared even worse, losing 48.4% over the year.

There’s no excuse for this one. It was a bad call, pure and simple. Fortunately, most of the others were directionally correct.

So that’s the 2013 story. Next week I’ll offer my predictions for the year ahead.

Gordon Pape’s new book, RRSPs: The Ultimate Wealth Builder, is now available at 28% off the suggested retail price. Go to: http://astore.amazon.ca/buildicaquizm-20

THE TOP STORY OF 2013

 

There are several candidates for the biggest financial story of 2013. The BlackBerry collapse. The improbable resurgence of the Tokyo stock market. The dramatic fall in the price of bullion and its impact on the shares of gold mining companies, which collectively lost more than half their value. The rebound on Wall Street.

You could make a case for any of these but to my mind the most important story of the year was one that never happened – at least, not at the time.

It goes back to the third week in May. The U.S. markets had been on a steady climb since the start of the year, with the S&P 500 closing in on 1,670. Then word started spreading on Wall Street that the Federal Reserve Board was about to start winding down its quantitative easing (QE) program, which was pumping US$85 billion a month into the economy. Investors were rattled and the markets started to drift lower.

A few weeks later, Fed Chairman Ben Bernanke confirmed the speculation, saying that the “tapering” process would start later in the year and that QE would likely end entirely in 2014. Investors immediately hit the sell button, with the Dow and the S&P 500 recording their worst one-day losses since 2011. By the time the sell-off was done, the S&P had lost almost 6% from its May high.

But that was only part of story. The expectation that QE would end clobbered the bond market. One of the main objectives of the program is to hold interest rates down; as rumours spread that tapering could start as early as summer, yields on U.S. Treasuries shot up and Canadian government bonds followed suit. At the beginning of the year, the benchmark 10-year U.S. Treasury bond was yielding 1.76%; in late December it broke through the 3% level.

Rising yields mean lower bond prices so investors saw the value of their fixed-income securities tumble as the long bond bull market finally came to an end. But it wasn’t just bond investors that were hurt. A wide range of interest-sensitive securities was battered, including REITs, preferred shares, and utility stocks.

Investors were shell-shocked. These supposedly “safe” places for their money had provided strong returns since the market crash of 2008-09. Now they were being hammered for reasons many people couldn’t understand.

What they failed to realize was the close relationship between their investments and interest rates. The market is always balancing risk and return. When yields on Treasury bonds start to rise, smart investors demand a better return from higher risk securities to compensate. So while a 4.5% yield on a REIT might be acceptable with 10-year Treasuries paying 1.76%, it’s nowhere near enough when they’re offering 3%.

Absent a distribution increase, the only way yields on REITs can move higher is if the price drops, and that’s exactly what happened. The S&P/TSX Capped REIT Index lost 10.6% over the year, while utility stocks were down 8.9% and preferred shares 7.2%.

Finally, six months after the spring sell-off, tapering has finally been confirmed and will start this month. Ironically, the markets greeted the news by moving higher.

But this rising tide isn’t lifting all ships. Interest-sensitive securities will struggle in 2014 as upward pressure on rates continues. This means defensive investors will have to change their whole approach or risk experiencing more damage to their portfolio.

The spring speculation that tapering was about to begin turned out to be wrong. But it set in motion a train of events that had a huge impact on the stock and bond markets, which is why I rate it the top financial story of the year.

TWO INTERNATIONAL STOCKS FOR 2014

In the last two issues of December, I picked several U.S. and Canadian stocks that I felt would do well in 2014. All were previous IWB recommendations.

To close out this series, let’s look overseas. Here are two international stocks that I like for the coming year. These trade as ADRs in New York.

Baidu Inc. (NDQ: BIDU). This is the Chinese equivalent of Google which obviously makes it a very large company with great growth potential. The stock was originally recommended by contributing editor Glenn Rogers in February 2011 at $128.80 (figures in U.S. dollars). It has been extremely volatile, falling to as low as $82.98 last April. But it has been on a tear since mid-summer, closing on Friday at $175.28. That’s just short of its 52-week high of $181.25, reached on Dec. 11.

Glenn Rogers last updated the stock as a Buy on Oct. 21 at $165.91, citing the company’s strong financial performance and growth potential. Shortly thereafter, the company issued some mixed third-quarter financial results. Total revenue was up 42.3% to almost $1.5 billion. However, most of that was absorbed in higher expenses; profit was ahead only 1.2% to $545.4 million.

Two major factors contributed to the higher costs. Selling, general and administrative expenses were $226.2 million, representing an increase of 115.4% from the corresponding period in 2012, primarily due to promotional expenses for mobile products. Research and development expenses were $178.2 million, a 77.5% increase from the corresponding period in 2012, due mainly to an increase in the number of research and development personnel. Both these represent an investment in future growth so investors were not overly concerned by the small size of the profit increase.

Baidu’s market cap is increasing rapidly and now stands at almost $63 billion. The stock is not cheap with a trailing 12-month p/e ratio of 36.1 and a forward p/e of 28.7. And there is no dividend so this is strictly a security for growth-oriented investors who are willing to live with volatility. But China has almost 600 million Internet users and most of them use Baidu. A few years from now, the current price will look cheap.

Diageo plc (NYSE: DEO). It’s hard to lose money on booze and this is the world’s largest liquor company. Based in London, it controls many of the best-known brands including Johnnie Walker, Crown Royal, J&B, Bushmills, Captain Morgan, Tanqueray, Guinness, and a host of others.

This is another pick from Glenn Rogers, who recommended it in September 2007 at $85.42 (figures in U.S. dollars). It fell all the way to the $40 level during the 2008-09 crash but has been on a steady rise since, finishing on Friday at $130.82. Glenn’s current target is $150.

The company only releases financials twice a year with the announcement of the first half results for fiscal 2014 due on Jan. 30. The dividend is tied directly to the bottom line; the payout in 2013 was $2.92 per share, up from $2.76 in 2012. It’s expected we will see another increase in the dividend this year.

The company has a market cap of almost $90 billion. The trailing 12-month p/e ratio is 21.8 while the forward p/e (based on expected 2014 results) is 17.5.

This is one of the rare growth stocks that also offers a reasonable dividend, with a current yield of 2.2%, based on the 2013 payout. It is therefore well suited for all types of portfolios. – G.P.

STOCKS: HOW MUCH GAS LEFT IN THE TANK?

Contributing editor Tom Slee joins us for this first issue of 2014 with a look at the stock market and where it’s likely to go in the next 12 months. Tom managed millions of dollars in pension money during his career and is an expert in taxation. Here is his report.

Tom Slee writes:

According to the Chinese Zodiac, 2014 is the year of the Horse, a sign of speedy success. I hope that proves to be true for all of us. We are certainly off to a good start. Investors have their tails up. Economists feel that global growth is going to be surprisingly strong and come in close to 4%. Markets are already sensing this and a lot of the Wall Street gurus are gung ho. They see a second leg up in stocks following a staggering 29.6% surge in the S&P 500 last year. Canadian forecasters look for a rebound in most commodities and are almost equally upbeat.

It’s all very encouraging, suggesting a slam dunk as far as equities are concerned. Without raining on the parade, however, I think that there are a couple of things to consider. First, market forecasting is the weakest link in fundamental analysis. Many analysts regard it as a futile exercise because there are so many unknowns and investor sentiment can turn on a dime. An unexpected flare up in the Middle East, a surprise announcement by the Fed, or a European crisis and all the optimism would evaporate.

There is also a possibility that most of the good news is already built into the market. We have seen some extraordinary momentum during the last few months. Money managers are on a buying spree but it’s hard to see why. Earnings and economic growth are respectable but there has been no startling improvement. And that raises the question of whether all the easy money has been made. Are stocks relatively expensive and what are the chances of the S&P 500 having another bumper year? Is there any gas left in the tank?

I think the answer is yes to both questions. This is likely to be another good year for North American stocks and the surge in 2013 could provide the initial lift. We have impetus. Moreover, history is on our side. Since 1945 there have been 21 times when the S&P 500 gained more than 20% and in the following years the index recorded an average increase of 10% versus the normal average price gain of 8.7% since World War Two. A word of warning though: those subsequent years were bumpy rides. Each one was buffeted by corrections of 6% or more and some years stocks were volatile, suffering several setbacks before ending up in the plus column. That sort of experience is to be expected after a huge move and we may see at least one sharp correction in 2014.

So much for history; we are on firmer ground calculating the price of stocks and their likely values going forward. I feel that market forecasts should always be based on corporate earnings projections. Studies show that profit fluctuations have accounted for about two-thirds of year-to-year variations in Canadian stock market performance. So here goes.

Fourth-quarter numbers have not been posted yet but it looks as though S&P 500 earnings in 2013 will come in at about $110. With the index at 1,848 as of year-end, that means the American market is trading at a 16.8 price/earnings multiple. Last year’s Canadian earnings are expected to be approximately $815 and with the S&P/TSX Composite at 13,622 Toronto has a 16.7 multiple compared to 14.8 at the end of 2012. Stocks are no longer a bargain but they are not overpriced. As a matter of fact, if you build in the projected 2014 earnings growth our markets are relatively good value.

Looking ahead, I think we should see Canadian corporate earnings growth of close to 12% this year as the global recovery picks up steam and drives commodity prices higher. That would give us index profit in the $915 range and, assuming a 16 multiple, an S&P/TSX Composite close to 14,700 by the end of December. I am looking for a solid performance, slightly better than the 8% in 2013. As mentioned though, it may be a rocky ride.

American markets should do even better because they have two things going for them. Given the stronger economic forecasts, we could see good top-line (sales) growth and a 13% or so jump in corporate earnings to approximately $125. At the same time, it’s becoming obvious that American investors are now willing to pay more for stocks as concerns about a second financial collapse recede. Some U.S. equity strategists are projecting a price-earnings ratio of 18 on the S&P 500 over the next year or so. I think that is possible, especially if interest rate increases remain gradual. Therefore my 2014 forecast for the S&P 500 is about 2,050.

Turning to the sectors that are likely to do well, it`s going to be a much more positive environment for resources as international demand picks up. Copper in particular could do surprisingly well. Concerns about slowing Chinese demand are overblown and U.S. consumption should improve. That strength will support copper prices and Teck Resources, which is covered by my colleague Glenn Rogers, is one of the companies that is poised to benefit.

I also think that Canadian financial stocks are going to have a good year with the banks, despite their gloomy warnings, generating solid earnings growth and increased dividends. TD Bank remains my number one choice. Our life insurance companies are finally getting their act together and starting to look attractive. Elsewhere, the consumer sector is a mixed bag with Canadian household debt still hitting record highs. A lot of people are maxed out. However, certain retailers, such as Loblaw, with its Shoppers acquisition and REIT spin-off, could surprise us on the upside.

The U.S. market

As far as U.S. stocks are concerned, I think that Fed Chairman Ben Bernanke’s announcement on Dec. 18 that he is winding down the huge bond-buying program is a watershed. In effect, the Fed put a stamp of approval on the recovery. No wonder the Dow immediately jumped 300 points. Now investors have the best of both worlds. The central bank has unveiled a specific withdrawal program but at the same time emphasized that it will keep interest rates close to their record lows well past the point at which unemployment drops below 6.5%. That is generally taken to be 2015 or even 2016. Above all, the Chairman’s decision removes a major uncertainty.

With GDP growth now expected to exceed 3%, compared to about 2.3% here in Canada, many of the American market sectors are showing strength. According to the Equipment Leasing Foundation, investment in equipment and software is likely to grow at a rate of 3% or more. In November, U.S. industrial production jumped a surprising 1.1% as mining output strengthened and manufacturing was up 0.4%. The numbers are encouraging. Industrial capacity utilization is currently running at 79%, its highest level since June 2006. You can see why Mr. Bernanke felt that it was time to take his foot off the pedal.

One sector that I particularly like is Diversified Financial Services. That is really a group of three major banks – JPMorgan Chase, Citigroup, and Bank of America. Finalization of the new Volcker Rule has removed a great deal of uncertainty that has clouded these banks. They are also going to participate fully in the domestic recovery. Another big plus is that these banks hold excess capital that will become free after the stress tests in March. I expect this to be returned to shareholders in the form of dividends or share repurchase programs.

Another sector with plenty of promise is construction and engineering. Global markets for many of these companies remain uncertain but an increasing number of energy projects are underway in North America. Shale gas drilling is sparking a lot of activity. New air emission regulations are spurring more infrastructure work and homeland security requirements require extensive engineering. Keep in mind as well that this is a highly fragmented industry. Major players have numerous acquisition opportunities.

So, to sum up, 2014 should be a good year for the markets, although a choppy one and certainly not up to the level of 2013.

TOM SLEE’S 2014 STOCK PICKS

Here are my two Canadian stock picks for 2014. Given our economic forecasts they are well positioned going into 2014.

Manulife Financial (TSX, NYSE: MFC). Manulife is a leading global provider of financial products with principal operations in Asia, Canada, and the United States. It conducts business in 21 countries and is Canada’s number one life insurer with a market cap of $32.8 billion. Revenues exceeded $30 billion last year and resulted in $1.7 billion of income for the common shareholders.

During the last few years, however, the company has struggled to repair substantial damage created by the financial collapse in 2008. There have been some unpleasant surprises and the stock has been out of favour.

I think that is going to change. First of all, Manulife’s largest losses resulted from extensive stock market exposure and that danger has been substantially reduced. Not only are stocks now moving higher, management has hedged more than 80% of its equity positions. At the same time, rising interest rates will improve earnings for the entire life insurance group and MFC’s recent third-quarter earnings were particularly strong. Profit of $0.54 a share was well above the $0.25 consensus forecast. I was especially encouraged by the top-line growth as wealth management sales jumped 34% year-over-year.

Trading at C$20.88, US$19.62, Manulife is expected to earn about $1.30 a share in 2013 and as much as $1.70 next year. We could see a dividend increase in 2014 and I have a revised target of $24 on the stock. The shares have risen 69% since we first recommended them at C$12.34 in February 2012 and should move higher.

Canadian Tire (TSX: CTC.A, OTC: CDNAF). This is my second Canadian pick mainly because this company is on a roll. The shares are trading at C$99.82, US$93.80, up 62% since we added them to our Buy List at $61.58 in June 2011. They still have a lot of upside potential.

Founded in 1922, Tire is one of the largest retailers in Canada and operates 490 stores. Revenues totaled $11.4 billion last year and profit came in at $499 million. Since then, the company has been barreling along in a year when many Canadian retailers, such as Target and Sears, struggled.

On Nov. 7 Tire announced third-quarter earnings of $1.85 a share, up 15% from 2012, and a 25% increase in the dividend to $1.75. Analysts expect to see a profit of $7.15 a share in 2013 and an improvement to the $7.75 range next year.

Perhaps most important as far as investors are concerned is the fact that since the company spun off its property into a REIT many analysts are valuing its stock on a net asset value basis. This, plus the good earnings, should continue to lift the shares. I have a $115 target.

My U.S. stock picks for 2014 are leaders in two key sectors.

Chicago Bridge & Iron (NYSE: CBI). This is a global engineering procurement and construction giant with 50,000 employees worldwide. CBI booked $5.5 billion of revenues in 2012 and with 50% of its operations in North America is well positioned to benefit from the energy boom. We should see earnings of $5.65 a share or more in 2014 (figures in U.S. dollars).

I am impressed by the company’s $25 billion backlog, which is becoming predominately U.S. based and therefore lower risk. With manageable debt levels, CBI is also well placed to make acquisitions in order to supplement organic growth.

We added Chicago Bridge to our Buy List last May at a price of $53.28. Currently the shares trade at $81.23, up 52% and through our revised $77 target. The stock has had a good run but we should see further growth to the $95 range this year.

JPMorgan Chase (NYSE: JPM). This is a multinational banking corporation with assets of more than $2.5 trillion. Market capital exceeds $215 billion. Revenues should exceed $100 billion this year and we can expect earnings of about $4.50 a share with a sizeable increase to approximately $6 in 2014.

In recent months, JPM has been receiving bad press and forced to incur substantial legal fees as well as penalties. This has masked the bank’s revenue growth and improving margins. The stock has suffered. Nevertheless JPM is now priced at $58.66, up 23% since we added it to the Buy List not quite a year ago at $47.85. I expect to see further growth in 2014 now that regulatory problems have been resolved, along with a dividend hike. Wall Street is looking for the stock to trade at $65 or more.

– end Tom Slee


YOUR QUESTIONS

Claiming the pension credit

Q – I have a simple question, but have not been able to find a clear answer on my own. I am 55 years old and have a fair amount of RRSP holdings. I have been thinking of converting a small portion of these holdings to a RRIF to benefit from the $2,000 annual pension credit, if I can claim the withdrawals as pension income. Is there a minimum age that applies to claiming this credit? Thank you. – Evan F.

A – Unfortunately, you’re too young. You cannot claim the pension credit on RRIF withdrawals before age 65. – G.P.

NEWSLETTER COMING SOON

Contributing editor Gavin Graham and well-known financial journalist Al Emid will soon be launching a new newsletter dealing with the exciting area of frontier markets. They are co-authors of the new book Investing in Frontier Markets published by Wiley and have a weekly show on satellite radio devoted to the subject.

IWB members will receive a free preview copy of the newsletter later this month. More details to follow.

That wraps up the first issue of 2014. We’ll be back on Jan. 13.

Best regards,

Gordon Pape