In This Issue

DISSECTING DUGUAY

By Gordon Pape, Editor and Publisher

During these difficult times, when no one seems to have any kind of a handle on what will happen next, I find myself parsing closely the words and phases of people who presumably have access to more meaningful information than the rest of us.

So it was that I read and re-read the press reports of the testimony given to the Parliamentary Finance Committee last week by Pierre Duguay, deputy governor of the Bank of Canada, as well as the official text of his opening statement as published on the Bank’s website. In the end, I was left with the empty feeling that Mr. Duguay and his colleagues are just as confused as the rest of us. Even worse, some of his answers to questions from MPs seem to suggest that part of the problem is the fault of the media.

First, let’s take a quick look at the opening statement, which presumably was drafted with great care. Much of it is devoted to praise for the Canadian banking system and what a great model it is for the world (seems we’re hearing that a lot lately).

“Unlike their counterparts in other major economies, Canadian banks have not been materially affected by the financial crisis,” he said. Uh-huh. I guess the drop in profits at most banks, the plunge in the share prices, and the fact they are papering Bay Street with new issues of notes, preferred shares, and common stock doesn’t count. But at least the government hasn’t had to bail them out (yet) so that’s a big plus.

The deputy governor did admit there have been some problems in the Canadian financial system, saying it “has felt the effects of the global turmoil which has increased funding needs while at the same time raising the costs and the uncertainty of term funding”. In an effort to deal with this, the BoC has embarked on a series of “unprecedented” measures in an effort to “stabilize” the system. In other words, our banks are fine; we just have to do things we have never done before to keep them stable. If I were about to undergo surgery, those aren’t the kind of words I’d want to here from the doctor!

But one thing is clear. Thus far at least, our system has worked much better than that of other countries and no one is accusing the Bank of Canada of dithering. They have acted quickly and decisively. Score one for them.

Some of Duguay’s other comments left me less impressed, however. For example, Canadian Press quoted him as saying that “when people hear bad news, that affects confidence and the effect on confidence can certainly amplify the problem”.

What does that mean? That the media should stop reporting bad new? That Statistics Canada should cease telling us that the GDP is shrinking and unemployment is climbing? The news is bad. It is not, however, the cause of this recession, only a symptom.

Recessions/depressions are not a new phenomenon. They have been happening for centuries, long before the mass media was ever conceived of. The Tulipomania Depression of the 17th century brought financial havoc to England and the Netherlands. In the early 18th century, the South Sea Bubble decimated the fortunes of the British upper and middle classes. From 1873 to 1896, the whole world suffered through what is now known as “The Long Depression”, which started, as this one did, with a financial panic in the U.S. in 1873. At a time when communications were so slow, the media was not a significant factor in any of these cases. The common element in all of them was greed, pure and simple.

In another answer to a question, Canadian Press quotes Mr. Duguay as saying: “When consumers are nervous about employment prospects they stop spending and at that point it doesn’t matter much whether credit is available or not; they prefer not to go into debt.”

Of course, that’s simple prudence – the kind that might have kept us out of this mess had everyone been doing it. I’m sure he didn’t intend it this way, but the deputy governor almost seems to be suggesting that it is our duty to make use of credit and spend even if we think our jobs could disappear. If everyone did that, we’d end up in an even bigger mess.

Finally, I read the comments Mr. Duguay made about the controversial Bank of Canada contention that our economy will rebound quickly and grow at a robust rate of 3.8% in 2010. That forecast is now so hedged with ifs and buts to be virtually worthless, in my view.

“Stabilization of the global financial system remains a precondition for the global and Canadian economic recoveries,” he said. “Investor and public confidence has been badly shaken, but will recover with the timely implementation of ambitious plans in some major countries to address toxic assets and to recapitalize financial institutions. However, if these national and multilateral measures are not timely, bold, and well-executed, Canada’s economic recovery will be both attenuated and delayed.”

Bottom line: we aren’t going to get well before the rest of the world does. We’d all better start rooting hard for President Obama’s stimulus plan. That’s where our future lies, not in what Ottawa does. – G.P.

TOM SLEE: LIFECO EARNINGS HAMMERED

TOP

We welcome back contributing editor Tom Slee who this week offers his views on why the life insurance companies, which he knows well having worked in the industry for many years, have turned out to be less recession-proof than expected. Here is his report:

Tom Slee writes:

The economic tsunami has claimed another industry. Canadian lifecos, for years regarded as “recession proof”, hit a brick wall in the fourth quarter. Results were terrible, far worse than anticipated. All of the major players were battered as plunging markets stripped away their reserves and inflicted serious losses.

Flagship Manulife Financial was hardest hit. CEO Dominic D’Alessandro has admitted that his segregated fund and annuity contracts are now $26 billion under water. That is about as bad as it gets! No wonder the leading credit agencies downgraded Sun Life and Manulife.

For almost 10 years, ever since the industry was demutualized, the leading Canadian life insurance companies were a success story. They gobbled up smaller competitors, rationalized the industry, and successfully expanded abroad. Canadian morbidity and mortality rates improved, earnings grew, and the companies generated excess capital. So when the downturn loomed I looked to this sector as one of our shelters. In fact, as you know, I thought lifecos would weather the storm better than the banks. That has not been the case. Great West Life’s shares fell 58% from their high. Sun Life dropped 64% and Manulife plunged a staggering 70%, closing last week below $10. It’s a disaster area!

What went wrong? How could a tightly regulated industry, based on strength and security, a supposedly defensive sector, seriously underperform in a market downturn? The main reason, I think, is that since going public the lifecos have became more performance driven and gradually changed their product mix. Segregated funds, variable annuities, and wealth management offered better profit margins than conventional life insurance. So they became the name of the game. There was only one problem. This new business thrust was priced and dependant on above-average investment returns. So the lifecos were forced to manage their portfolios more aggressively. Long-term government bonds, the insurance industry’s stock in trade, were no longer going to do the trick and managers turned to the stock market and more esoteric securities.

Consequently, when disaster struck, the insurance companies were hit on several fronts. Sharply lower stock prices required large reserve increases to support the now exposed segregated funds and guaranteed annuities. At the same time, many fixed-income investments became impaired or devalued and had to be written down because of the mark-to-market rules. To make matters worse, interest rates have remained stubbornly low, as money poured into the bond market driving prices higher. This, in turn, squeezed the lifecos’ margins on new policies. Even established business was hurt by the low rates. Canadian insurers are well matched with blocks of long-term fixed assets offsetting life insurance liabilities but low interest rates create a reinvestment problem and trigger additional reserve requirements.

In short, the stock market collapse and downgrading of fixed-income securities, primarily due to the subprime fiasco, created a perfect storm and undermined the Canadian lifecos. All the tight regulations, competent management, and normal safeguards were swept away and there was very little that the companies could do. As I have mentioned before, this market crash was widespread as well as deep. There was no place to hide. Good investment managers, and Sun and Manulife are acknowledged to be some of the best in the business, suffered along with everybody else. The only salvation was to vacate the markets altogether and that was never an option. Life insurance is about investing premiums and using the resulting income to pay claims. That is how it works. Insurance companies would go broke if they liquidated their portfolios and sat on huge amounts of cash for a year or so.

Looking ahead, we have a bit of a conundrum. Normally in a recession companies report lower earnings and disappointed investors drive their stocks lower. The shares recover when results improve. In the case of lifecos, though, the market itself is determining their earnings, a market, incidentally, that their own slumping stocks are helping to depress. For example, Great West and Manulife reported strong profitable sales in the fourth quarter but that did very little for their bottom lines. Yet it has been estimated that any meaningful increase in stock prices, say to the December 2007 levels, would allow Manulife to release $5.3 billion in segregated fund reserves and cause earnings to spring back by more than $2 a share. Great West and Sun are in the same boat. That means any recommendation concerning Sun Life Financial, Industrial Alliance (TSX: IAG), and Manulife, all currently on our Buy list, is really a call on the market itself.

My feeling is that all of these excellent companies will not only survive but do well in 2010 and beyond. Manulife, for example, is already on the acquisition trail. Earnings are going to fluctuate but gradually improve as markets recover. Nevertheless, lifeco stocks are likely to lag. Seared by the financial sector collapse, investors will almost certainly shy away from insurers for a while, especially now that their earnings quality is suspect. We could also see lifecos issuing more stock to bolster capital and meet regulatory requirements and that will hurt the share prices.

Therefore, I am putting Manulife, Sun, and Industrial Alliance on Hold. They are so depressed that there is likely to be some rebound but I would not accumulate them for long-term growth at this stage. Specific updates on each company follow.

 

TOM SLEE’S UPDATES

Industrial Alliance (TSX: IAG, OTC: IDLLF)

Originally recommended on Feb. 25/08 (IWB #2808) at C$36, US$35.01. Closed Friday at C$14.26, US$16.35 (Jan. 27)

Industrial Alliance had a bad fourth quarter, which is putting it mildly. After reporting a profitable first nine months, the company suffered a loss of $1.37 a share in the final period. It was a shock! Analysts had been looking for a profit of about 65c a share. Stock market volatility, commercial paper write-downs, and impaired bonds all took their toll. For the year, IAG made 80c a share, compared to $3 in 2007. Management believes a 2009 profit of $2.50 a share is possible but that assumes an average TSX market of about 9,000 over the next 12 months.

There is more bad news. I was discouraged by slowing high-value individual life sales during the fourth quarter. This probably reflects the deepening recession and may become a problem for all the lifecos in 2009. Group pension sales, on the other hand, were strong but this division ran into some poor claims experience. On the plus side, IAG has strengthened its claims reserves and is now much better equipped to withstand a prolonged period of low interest rates.

Future earnings depend to a great extent on a stock market recovery releasing reserves which means that at best they are going to be volatile, although with the 2008 provisions there is protection on the downside. Management is confident that it can maintain the 98c dividend. Even so, I would defer new commitments.

Note that although the shares trade over the counter in the U.S., volume is very light and trading is infrequent. American readers should buy on the TSX if possible.

Action now: Industrial Alliance becomes a Hold.

Sun Life Financial (TSX, NYSE: SLF)

Originally recommended on Oct. 23/00 (IWB #2038) at C$29.85. Closed Friday at C$15.68, US$12.29.

There is a similar story at Sun Life Financial. The company reported a fourth-quarter operating loss of $1.25 a share, a far cry from the 10c profit that Bay Street had been anticipating. As a result, Sun had a loss of 12c a share in 2008, down from a profit of $3.98 a share the year before. It was a miserable performance. Amidst the poor numbers, however, there were a few bright spots.

For the record, Sun actually had earnings of 23c a share in the fourth quarter but that included a one-time $1.48 gain from the sale of a 37% stake in giant CI Financial Income Fund to Bank of Nova Scotia. The sale turned out to be a very smart move. Sun made a handsome profit, bolstered its capital position with the $2.3 billion cash proceeds, and retained a strategic relationship with CI. The fund has access to Sun’s distribution network and the insurer earns fees from any sales.

As expected, the fourth-quarter numbers were savaged by equity-related charges, asset impairments, and provisions for future credit defaults. Write-downs and realized losses amounted to $155 million and going forward the company remains highly vulnerable. One analyst estimates that a 10% drop in equity markets would cost Sun as much as $350 million. Hopefully, we are not going to see anything like that but obviously forecasted earnings remain a question mark.

On the other side of the coin, SLF has $2.5 billion of excess capital thanks to the CI sale and the reserves have been strengthened by more conservative actuarial assumptions. Management believes that the $1.44 dividend is safe. The balance sheet remains strong.

On Feb. 12, Moody’s downgraded Sun’s debt and preferred shares. It was a serious blow. The agency’s decision will not affect 2009 earnings but may hamper the stock’s recovery. It’s one more hill to climb.

Action now: Sun Life becomes a Hold. I think that the stock has been oversold but Sun is likely to lag in the eventual market recovery. Manulife, with its strong institutional following, is a better long-term bet amongst the lifecos.

Manulife Financial (TSX, NYSE: MFC)

Originally recommended on Aug. 21/00 (IWB #2031) at C$14.20 (split-adjusted). Closed Friday at C$9.65, US$7.49.

Manulife racked up a $1.24 a share loss in the fourth quarter, an even worse number than the previously announced warning of a 95c a share loss. Its segregated funds required more reserves than anticipated. As a result, earnings for 2008 were a meager 32c a share, a sharp reduction from the $2.83 a share earned the year before. This is a devastating setback and there are far too many uncertainties to hazard a guess at what we can expect in 2009 and even 2010. Management will be able to release substantial amounts of reserves if the market jumps but then have to rebuild them if there is a correction.

There is, however, one big difference between MFC and the other major insurers. Instead of hunkering down, the management team is moving aggressively to take full advantage of the present chaos. The company has just issued $275 million of preferred shares and is poised to bid about US$1 billion for part of American International Group’s Asian life insurance business. That may be only the start. MFC has filed a prospectus with regulators, allowing it to raise up to $10 billion for further acquisitions.

I view the present earnings setback as a glitch and expect Manulife to power ahead once markets stabilize. My concern is that investors have been disillusioned about the lifecos and while MFC should rebound from its present level, it will be some time before the stock commands a multiple of 20 or more again.

Action now: Manulife becomes a Hold but the shares are almost certainly oversold. Aggressive investors seeking short-term capital gains and able to assume some risk should consider taking a position at this stage.

Toronto Dominion Bank (TSX, NYSE: TD)

Originally recommended on Feb. 12/07 (IWB #2706) at C$69.85, US$59.59. Closed Friday at C$35.36, US$27.60.

The banks, by comparison, are weathering the storm much better. TD Bank, my first choice in the sector, reported cash earnings of $810 million, or 96c a share for the first quarter of fiscal 2009. Admittedly, that was nothing to write home about. TD made $1.42 a share in the same quarter a year ago. However, the results were in line with expectations and TD’s capital numbers were good. The Tier 1 ratio improved to 10.1% from 9.8% during the quarter.

That having been said, TD, along with the other banks, is facing some serious difficulties. Margins are under pressure and Personal and Commercial unrealized loan losses jumped $1.2 billion to $2.6 billion in the quarter. Wealth Management earnings fell sharply. Given the serious economic slowdown, these trends are likely to continue in the coming quarters.

Nevertheless, the results were encouraging. Moody’s confirmed its Aaa rating, and the dividend appears to be safe. On balance, I think that at these depressed levels and with a 6.9% yield, TD Bank is looking attractive.

Action now: TD Bank becomes a Buy with a target of $44. I have set a $32 revisit level.

Rogers Communications (TSX: RCI.B, NYSE: RCI)

Originally recommended on April 23/07 (IWB #2716) at C$42.10, US$37.41. Closed Friday at C$26.20, US$20.41.

On a different front, Rogers Communications had a good fourth quarter despite the recession. Operating earnings were $902 million, up from $884 million the year before. That was equal to $1.57 a share versus 99c in 2007. Free cash flow totaled $1.3 billion and management celebrated by increasing the dividend 16% to $1.16 a year.

Looking ahead, Rogers is well equipped to ride out the recession. Free cash flow is expected to exceed $1.5 billion this year and the company has no major refinancing requirements until 2011. Revenue growth, though, is bound to slow from the solid 12% in 2008 to perhaps about 5% this year and earnings of about $2 a share are expected in 2009.

Rogers remains the industry leader with operating momentum. Keep in mind too that to some extent the credit market collapse and slowing consumption work to the company’s advantage. New entrants into the business are likely to defer commitments and tone down costly marketing campaigns.

The stock, of course, has been badly hurt and is likely to remain volatile. Nevertheless, I would gradually accumulate Rogers at these levels.

Action now: Buy Rogers with a reduced target of $42. I will revisit the stock if it dips to $24.

THE CASE FOR GOLD

The price of bullion briefly broke through US$1,000 a couple of weeks ago before pulling back. With stock markets still spiraling down and the world economy “in shambles” to use Warren Buffett’s words, many people see gold as the ultimate safe haven in these tough times. But is it? Guest contributor

John Lawrence Reynolds takes a long, hard look at gold and whether you should add some to your portfolio. John is an award-winning author whose latest book Bubbles, Bankers & Bailouts is now available through our Best Books store at http://astore.amazon.ca/buildicaquizm-20

John Lawrence Reynolds writes:

For years, a subculture has developed around the concept of gold as a means of surviving an oft-predicted financial collapse. Dubbed Gold Bugs by those who sneered at the purported wisdom of investing in the shiny metal, True Believers are now pointing at the detritus of the current situation, gleefully saying: “We told you so!” Is now the time to take them seriously? Or, assuming their claims remain valid, is it too late to board this particular bandwagon?

The origin of their persistent promotion of gold since about 2002 was the enormous U.S. debt accrued during the years of Bush the Second, a level that sounds almost nostalgic considering the most recent estimate of that country’s bail-out costs. The result, they argued with persuasion, can only be inflation for which gold is the ultimate refuge. Many believed; most did not. Canadian gold bugs have been led by the eloquent John Embry, who has spent his career tracking and managing gold investments, first as manager of the RBC Precious Metals Fund and now on behalf of Sprott Investments.

Embry is passionate and convincing. During a heated televised debate in 2006 Embry was chided by his “Equities Forever!” opponent for focusing on the mounting U.S. debt rather than the rising Dow Jones and TSX indices. Why spend money on lifeless gold, the equities promoter sneered, when you can reap profits from equities? “Profits,” Embry responded, “are ephemeral. Debt is forever.”

Eloquent Embry may be, but perfectly prescient he’s not. For the last five years he and other advocates have predicted gold was on the verge of breaking the US$1,000 per ounce price on its way to $2,000 and beyond. The metal touched the first figure for a day or so in March 2008 before slipping back to the $800-$900 range, an event that Embry et al attribute to secretive backroom dealings by national banks to limit its true value and protect their national currencies. In late February of this year it popped through the $1,000 ceiling once more, but temporarily.

Are the gold bugs correct about an international price manipulation cartel worthy of a Robert Ludlum novel? So far, no evidence of a gold-based Illumanati has surfaced. Fundamentals and logic, however, suggest that gold represents a preferred haven against the ravages of imminent inflation and other economic disasters. Gold now boasts new and widening credibility, and should occupy a sector of every portfolio.

Consider the historic and mystical role of gold, surviving as a measure of wealth for more than two millennia and outlasting, you may have noticed, frankincense and myrrh. Here’s the core of the gold bugs’ premise: Compared with gold, every other means of universal exchange is based on promise and trust, and numerous cultures rank gold as a symbol of status higher than home ownership. But let’s also note that gold pays no interest or dividends, and its price fluctuates as widely and unpredictably as any commodity. So what qualifies it as a must-have investment sector?

The value of all commodities, of course, is dictated by supply and demand, and in this respect gold qualifies as A Sure Thing for future price appreciation. Here’s why:

Dwindling supply: Gold is not only scarce, it is becoming more difficult to locate, extract, and refine year by year. Many mines are located in countries rampant with corruption and face ongoing threats of nationalization. In addition, refining gold often involves immersing the ore in cyanide, creating horrendous environmental problems. It’s not unusual for even the best-managed mines to deal with extraction costs of $500 or more per ounce of gold, one reason why production has fallen since 2001 despite a quadrupling of its price over the same period.

Massive economic uncertainty: Anyone who predicts when the absolute bottom of the current equity market will be reached and the launch of global economic recovery will begin is a charlatan. Such uncertainty on a global scale historically has driven investors to gold.

Past central bank sales: The central banks of 107 countries hold an estimated 29,784 metric tonnes of gold, or just under 20% of the world’s above-ground supply. These countries claim to honour a 1999 agreement not to sell collectively more than 400 tonnes of their gold reserves in any calendar year. According to various sources, they have wildly exceeded this figure in order to suppress the price of gold vis-a-vis their currencies, yet their efforts have not prevented it from increasing in value faster than inflation.

Future central bank purchases: Some central banks have become active buyers of gold, recognizing the need and opportunity to build up reserves. In North American and Western European countries, gold typically represents between 50% and 75% of the nations’ foreign exchange reserves. By contrast, the metal accounts for only 2.1% of Japan’s forex reserves, 3.1% of India’s, and a mere 0.9% of China’s. Each of these nations reportedly is seeking to expand its reserves without disrupting other monetary positions. Remember, they will be purchasing from a dwindling supply.

Rising consumer demand in Asia: Citizens of Asia value gold as economic comfort in turbulent times, as they have for generations. Gold represents security against the actions of corrupt governments and the uncertainty of paper currencies. Given the rise of the middle class in India, China, and elsewhere gold, in spite of the current credit crisis, remains poised for enormous growth, an event made more convenient and thus more likely thanks to easy access to pricing and availability via the Internet. True, the impact of the current crisis on China has been enormous. When the recovery occurs, however, the hunger for financial security from gold will be even more intense.

Investment demand: The more gold is seen as a judicious investment in the current financial environment, the more it will attract uninformed investors, commonly referred to as The Greater Fools. In a sadly consistent manner, the higher gold rises in price, the more people will want to acquire it, following the rule that bullish tendencies become self-fulfilling prophesies. Alas, this will spell disaster for the uninitiated, but it presents substantial profit opportunities for the blissfully aware who enter the market with a fixed exit strategy.

Monetary inflation: Over nearly three decades, the nominal GDP of the U.S. has grown 5.3 times, yet the country’s money supply increased 10.4 times – and that’s before the current bailout program. Internationally, the world’s money supply grew 6.6 times during the same period yet the gold supply in 2009 is just 1.5 times the 1980 amount. This imbalance will serve as a driving force for gold pricing over the next few years.

Here’s another measure: In 1980, gold hit a high of $850 per ounce, or about $2,400 in today’s currency, based on the Consumer Price Index. True, 1980 was an exceptional year, the peak of the most recent inflationary period. But these are exceptional times as well, making $2,000+ per ounce gold appear not only reasonable but highly probable within the next 12-18 months.

Negative real interest rates: Bond markets are being strangled by current interest rates to the point where buy-and-hold investors are losing money after inflation is accounted for. As long as this continues, one of the major knocks against gold – that it pays no dividend or interest – no longer applies.

Bear market in stocks: Between March 2000 and November 2008, the S&P 500 lost 50.7%. Over the same period, gold increased by 161%. How much lower will stocks fall? How much higher will gold soar? In November 2005, MotleyFool.com began tracking the price of one share of Google versus one ounce of gold, each valued around $700 at the time. On Feb. 20 of this year, the Google share had fallen to $344.80 while gold topped $975.

Should you assume gold bugs were mistaken in their long-term predictions of an imminent bull market for gold and are likely to maintain the error of their ways? Or do you believe that, as John Embry headlined in a March 2007 edition of Investor’s Digest: “The time for gold ‘to go ballistic’ approaches”?

I’m a believer, with caveats. My sense is to choose gold as a stability factor in a portfolio over the next two years or so. I’m holding about 10% of my RRSP in large-cap gold stocks as opposed to actual gold bullion, but that’s my conservative nature. Should you choose to hitch your investment wagon to gold, here are your alternatives:

1. Large-cap stocks. Choose from among familiar names: Barrick, Goldcorp, Kinross (an IWB recommendation), and El Dorado. Upside: Less volatility than juniors and good capitalization. Downside: Much future growth is already built into the share price.

2. Junior stocks. This is where the major growth potential lies, assuming gold crowds $1,500 and investment capital shows up to get moribund mines back in operation. I favour companies with most of their activities in North America: Wesdome, Rubicon Minerals, Orvana, Aurizon. Upside: Enormous growth potential. Downside: Wild price fluctuations.

3. Gold and Precious Metals Funds. Take a Gravol before you track the performance of these funds, which deliver a new definition for volatility. Three to check out:

iUnits ETF, up a scintillating 0.4% (all valuations as of March 6) over six months, down 11.7% over 12 months, with an average five-year return of 11.1% (respective group averages for the same periods: -24.9%, -37.3% and +3.2%).

RBC Global Precious Metals Fund, skewed to large-cap producers. Performance: down 17.7% over six months, down 28% over 12 months, with an average yield of +7.7% over five years.

Sprott Gold & Precious Metals Fund has a larger junior element with predictably wilder fluctuations: down 31% over six months, down 44.5% over 12 months, and an average loss of 5.3% over five years. Even with those dismal figures, its 10-year performance is +10.7%.

Upside: You’re in the game. Downside: It’s a wild ride, so far.

4. SPDR Gold Shares (NYSE: GLD) buys you into their bullion reserve management at a fee of 0.4% per annum of the daily net asset value. You can trade your shares like ordinary stock based on that day’s gold price. Upside: As easy to trade as ETFs, but this is gold, not shares in gold producers. Downside: You’re focused on the price, not producer performance.

5. Gold certificates. Available from Scotiabank among other sources, these are easily purchased and exchanged, entitling you to the declared value of bullion. Upside: Convenient. Downside: It’s still paper, not gold, and a few gold bugs question the existence of gold in the coffers of smaller certificate issuers.

6. Gold wafers and bars. Marketed by ScotiaMocatta (the precious metals division of Scotiabank), Questrade, and others. Upside: The Real Thing. Downside: You’ll need a place to keep it, preferably a safe deposit box, and expect scrutiny from the money-laundering police if you purchase more than $10,000 worth.

7. Gold coins. More attractive and interesting than bars and wafers, but if your primary interest is investing for future gain, avoid exotic coins that carry a premium for their collectability. Stick with .9999 purity Maple Leaf coins in denominations from 1/20th of an ounce to a full ounce. There is no GST on these coins, but some provinces apply PST. Upside: They’re impressive to handle and show off. Downside: Not the most effective way to buy into gold, and there remains the storage problem.

– end John Lawrence Reynolds

 

YOUR QUESTIONS

General Electric

Q – Has anyone worked out the dollar per share worth of GE if we totally discount its financial arm GE Capital? – Michael L.

A – No one in our organization has done that. We recommended selling GE at US$36.61 in March 2008. Although we have been watching the stock, we are not prepared to take a new position in it at this time and so we have not done the type of analysis you refer to. – G.P.

MEMBERS’ CORNER

Comments on Reynolds book

Member comment: I was curious about the discussion of sovereign ratings in the excerpt from the John Lawrence Reynolds book published in IWB #2909. He indicates that all countries except Canada would see their ratings fall to non-investment grade by 2040. It seemed strange that Mr. Reynolds quoted a report by Standard & Poor’s but the reference was to a report of the Singapore Management University. Why not quote Standard & Poor’s directly? So I used your link to read the Singapore Management University report and didn’t find it any clearer.

I also don’t have the precise words from the S&P report, but having Googled and read other comments about it, I believe S&P wasn’t predicting what will happen with sovereign ratings. I think the S&P report discusses the serious underfunding of national pension plans, and anticipates that, IF the current situation continues, THEN sovereign ratings of nations other than Canada will fall dramatically. The course could change if action is taken. I think we in Canada shouldn’t be quite as optimistic as Mr. Reynolds would have us believe. It’s always best to quote the original source. – Cheryl K.

Response from John Lawrence Reynolds: One of the goals of my book was to inject some degree of optimism or encouragement wherever I could locate a credible source and the S&P report was one of the rare nuggets found. While my source was a conference at Singapore Management University, an institution with which I am familiar, similar data can be located elsewhere. If the writer will access the IMF Finance & Development magazine, Volume 43, Number 3, available at http://www.imf.org/external/pubs/ft/fandd/2006/09/groome.htm she’ll find the original reference including this chart:

Mounting pressures
Aging and related government liabilities could result in downgrades of sovereign ratings.

(hypothetical long-term sovereign ratings, base-case scenario)

 
2005
2020
2030
2040
Australia
AAA
AA
BBB
Non-IG
Canada
AAA
AAA
AAA
AA
France
AAA
A
Non-IG
Non-IG
Germany
AAA
AAA
A
Non-IG
Italy
AA
A
Non-IG
Non-IG
Japan
AA
Non-IG
Non-IG
Non-IG
Korea
A
A
Non-IG
Non-IG
Spain
AAA
AAA
BBB
Non-IG
Sweden
AAA
AAA
A
Non-IG
United Kingdom
AAA
AAA
A
Non-IG
United States
AAA
BBB
Non-IG
Non-IG
Source: Standard & Poor’s 2006.
Note: Non-IG = Non-Investment Grade.

Buy now?

Member comment: Would you please clarify if the recommendations by John Lawrence Reynolds are formal endorsement of IWB, specifically, “There are two good reasons for entering the market now”. Should we be buying? – John R.

Response: No, a book excerpt should not been seen as a formal IWB endorsement to take specific action. The comments are those of Mr. Reynolds and were written a few months ago (there is no such thing as an “instant book”). We do, however, endorse the book as providing valuable insights into the current situation. – G.P.

 

That’s all for this week. Please note that the IWB will take a holiday next week. We’ll see you again on March 23.

Best regards,

Gordon Pape
gordon.pape@buildingwealth.ca
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In This Issue

DISSECTING DUGUAY

By Gordon Pape, Editor and Publisher

During these difficult times, when no one seems to have any kind of a handle on what will happen next, I find myself parsing closely the words and phases of people who presumably have access to more meaningful information than the rest of us.

So it was that I read and re-read the press reports of the testimony given to the Parliamentary Finance Committee last week by Pierre Duguay, deputy governor of the Bank of Canada, as well as the official text of his opening statement as published on the Bank’s website. In the end, I was left with the empty feeling that Mr. Duguay and his colleagues are just as confused as the rest of us. Even worse, some of his answers to questions from MPs seem to suggest that part of the problem is the fault of the media.

First, let’s take a quick look at the opening statement, which presumably was drafted with great care. Much of it is devoted to praise for the Canadian banking system and what a great model it is for the world (seems we’re hearing that a lot lately).

“Unlike their counterparts in other major economies, Canadian banks have not been materially affected by the financial crisis,” he said. Uh-huh. I guess the drop in profits at most banks, the plunge in the share prices, and the fact they are papering Bay Street with new issues of notes, preferred shares, and common stock doesn’t count. But at least the government hasn’t had to bail them out (yet) so that’s a big plus.

The deputy governor did admit there have been some problems in the Canadian financial system, saying it “has felt the effects of the global turmoil which has increased funding needs while at the same time raising the costs and the uncertainty of term funding”. In an effort to deal with this, the BoC has embarked on a series of “unprecedented” measures in an effort to “stabilize” the system. In other words, our banks are fine; we just have to do things we have never done before to keep them stable. If I were about to undergo surgery, those aren’t the kind of words I’d want to here from the doctor!

But one thing is clear. Thus far at least, our system has worked much better than that of other countries and no one is accusing the Bank of Canada of dithering. They have acted quickly and decisively. Score one for them.

Some of Duguay’s other comments left me less impressed, however. For example, Canadian Press quoted him as saying that “when people hear bad news, that affects confidence and the effect on confidence can certainly amplify the problem”.

What does that mean? That the media should stop reporting bad new? That Statistics Canada should cease telling us that the GDP is shrinking and unemployment is climbing? The news is bad. It is not, however, the cause of this recession, only a symptom.

Recessions/depressions are not a new phenomenon. They have been happening for centuries, long before the mass media was ever conceived of. The Tulipomania Depression of the 17th century brought financial havoc to England and the Netherlands. In the early 18th century, the South Sea Bubble decimated the fortunes of the British upper and middle classes. From 1873 to 1896, the whole world suffered through what is now known as “The Long Depression”, which started, as this one did, with a financial panic in the U.S. in 1873. At a time when communications were so slow, the media was not a significant factor in any of these cases. The common element in all of them was greed, pure and simple.

In another answer to a question, Canadian Press quotes Mr. Duguay as saying: “When consumers are nervous about employment prospects they stop spending and at that point it doesn’t matter much whether credit is available or not; they prefer not to go into debt.”

Of course, that’s simple prudence – the kind that might have kept us out of this mess had everyone been doing it. I’m sure he didn’t intend it this way, but the deputy governor almost seems to be suggesting that it is our duty to make use of credit and spend even if we think our jobs could disappear. If everyone did that, we’d end up in an even bigger mess.

Finally, I read the comments Mr. Duguay made about the controversial Bank of Canada contention that our economy will rebound quickly and grow at a robust rate of 3.8% in 2010. That forecast is now so hedged with ifs and buts to be virtually worthless, in my view.

“Stabilization of the global financial system remains a precondition for the global and Canadian economic recoveries,” he said. “Investor and public confidence has been badly shaken, but will recover with the timely implementation of ambitious plans in some major countries to address toxic assets and to recapitalize financial institutions. However, if these national and multilateral measures are not timely, bold, and well-executed, Canada’s economic recovery will be both attenuated and delayed.”

Bottom line: we aren’t going to get well before the rest of the world does. We’d all better start rooting hard for President Obama’s stimulus plan. That’s where our future lies, not in what Ottawa does. – G.P.

TOM SLEE: LIFECO EARNINGS HAMMERED

We welcome back contributing editor Tom Slee who this week offers his views on why the life insurance companies, which he knows well having worked in the industry for many years, have turned out to be less recession-proof than expected. Here is his report:

Tom Slee writes:

The economic tsunami has claimed another industry. Canadian lifecos, for years regarded as “recession proof”, hit a brick wall in the fourth quarter. Results were terrible, far worse than anticipated. All of the major players were battered as plunging markets stripped away their reserves and inflicted serious losses.

Flagship Manulife Financial was hardest hit. CEO Dominic D’Alessandro has admitted that his segregated fund and annuity contracts are now $26 billion under water. That is about as bad as it gets! No wonder the leading credit agencies downgraded Sun Life and Manulife.

For almost 10 years, ever since the industry was demutualized, the leading Canadian life insurance companies were a success story. They gobbled up smaller competitors, rationalized the industry, and successfully expanded abroad. Canadian morbidity and mortality rates improved, earnings grew, and the companies generated excess capital. So when the downturn loomed I looked to this sector as one of our shelters. In fact, as you know, I thought lifecos would weather the storm better than the banks. That has not been the case. Great West Life’s shares fell 58% from their high. Sun Life dropped 64% and Manulife plunged a staggering 70%, closing last week below $10. It’s a disaster area!

What went wrong? How could a tightly regulated industry, based on strength and security, a supposedly defensive sector, seriously underperform in a market downturn? The main reason, I think, is that since going public the lifecos have became more performance driven and gradually changed their product mix. Segregated funds, variable annuities, and wealth management offered better profit margins than conventional life insurance. So they became the name of the game. There was only one problem. This new business thrust was priced and dependant on above-average investment returns. So the lifecos were forced to manage their portfolios more aggressively. Long-term government bonds, the insurance industry’s stock in trade, were no longer going to do the trick and managers turned to the stock market and more esoteric securities.

Consequently, when disaster struck, the insurance companies were hit on several fronts. Sharply lower stock prices required large reserve increases to support the now exposed segregated funds and guaranteed annuities. At the same time, many fixed-income investments became impaired or devalued and had to be written down because of the mark-to-market rules. To make matters worse, interest rates have remained stubbornly low, as money poured into the bond market driving prices higher. This, in turn, squeezed the lifecos’ margins on new policies. Even established business was hurt by the low rates. Canadian insurers are well matched with blocks of long-term fixed assets offsetting life insurance liabilities but low interest rates create a reinvestment problem and trigger additional reserve requirements.

In short, the stock market collapse and downgrading of fixed-income securities, primarily due to the subprime fiasco, created a perfect storm and undermined the Canadian lifecos. All the tight regulations, competent management, and normal safeguards were swept away and there was very little that the companies could do. As I have mentioned before, this market crash was widespread as well as deep. There was no place to hide. Good investment managers, and Sun and Manulife are acknowledged to be some of the best in the business, suffered along with everybody else. The only salvation was to vacate the markets altogether and that was never an option. Life insurance is about investing premiums and using the resulting income to pay claims. That is how it works. Insurance companies would go broke if they liquidated their portfolios and sat on huge amounts of cash for a year or so.

Looking ahead, we have a bit of a conundrum. Normally in a recession companies report lower earnings and disappointed investors drive their stocks lower. The shares recover when results improve. In the case of lifecos, though, the market itself is determining their earnings, a market, incidentally, that their own slumping stocks are helping to depress. For example, Great West and Manulife reported strong profitable sales in the fourth quarter but that did very little for their bottom lines. Yet it has been estimated that any meaningful increase in stock prices, say to the December 2007 levels, would allow Manulife to release $5.3 billion in segregated fund reserves and cause earnings to spring back by more than $2 a share. Great West and Sun are in the same boat. That means any recommendation concerning Sun Life Financial, Industrial Alliance (TSX: IAG), and Manulife, all currently on our Buy list, is really a call on the market itself.

My feeling is that all of these excellent companies will not only survive but do well in 2010 and beyond. Manulife, for example, is already on the acquisition trail. Earnings are going to fluctuate but gradually improve as markets recover. Nevertheless, lifeco stocks are likely to lag. Seared by the financial sector collapse, investors will almost certainly shy away from insurers for a while, especially now that their earnings quality is suspect. We could also see lifecos issuing more stock to bolster capital and meet regulatory requirements and that will hurt the share prices.

Therefore, I am putting Manulife, Sun, and Industrial Alliance on Hold. They are so depressed that there is likely to be some rebound but I would not accumulate them for long-term growth at this stage. Specific updates on each company follow.

 

TOM SLEE’S UPDATES

Industrial Alliance (TSX: IAG, OTC: IDLLF)

Originally recommended on Feb. 25/08 (IWB #2808) at C$36, US$35.01. Closed Friday at C$14.26, US$16.35 (Jan. 27)

Industrial Alliance had a bad fourth quarter, which is putting it mildly. After reporting a profitable first nine months, the company suffered a loss of $1.37 a share in the final period. It was a shock! Analysts had been looking for a profit of about 65c a share. Stock market volatility, commercial paper write-downs, and impaired bonds all took their toll. For the year, IAG made 80c a share, compared to $3 in 2007. Management believes a 2009 profit of $2.50 a share is possible but that assumes an average TSX market of about 9,000 over the next 12 months.

There is more bad news. I was discouraged by slowing high-value individual life sales during the fourth quarter. This probably reflects the deepening recession and may become a problem for all the lifecos in 2009. Group pension sales, on the other hand, were strong but this division ran into some poor claims experience. On the plus side, IAG has strengthened its claims reserves and is now much better equipped to withstand a prolonged period of low interest rates.

Future earnings depend to a great extent on a stock market recovery releasing reserves which means that at best they are going to be volatile, although with the 2008 provisions there is protection on the downside. Management is confident that it can maintain the 98c dividend. Even so, I would defer new commitments.

Note that although the shares trade over the counter in the U.S., volume is very light and trading is infrequent. American readers should buy on the TSX if possible.

Action now: Industrial Alliance becomes a Hold.

Sun Life Financial (TSX, NYSE: SLF)

Originally recommended on Oct. 23/00 (IWB #2038) at C$29.85. Closed Friday at C$15.68, US$12.29.

There is a similar story at Sun Life Financial. The company reported a fourth-quarter operating loss of $1.25 a share, a far cry from the 10c profit that Bay Street had been anticipating. As a result, Sun had a loss of 12c a share in 2008, down from a profit of $3.98 a share the year before. It was a miserable performance. Amidst the poor numbers, however, there were a few bright spots.

For the record, Sun actually had earnings of 23c a share in the fourth quarter but that included a one-time $1.48 gain from the sale of a 37% stake in giant CI Financial Income Fund to Bank of Nova Scotia. The sale turned out to be a very smart move. Sun made a handsome profit, bolstered its capital position with the $2.3 billion cash proceeds, and retained a strategic relationship with CI. The fund has access to Sun’s distribution network and the insurer earns fees from any sales.

As expected, the fourth-quarter numbers were savaged by equity-related charges, asset impairments, and provisions for future credit defaults. Write-downs and realized losses amounted to $155 million and going forward the company remains highly vulnerable. One analyst estimates that a 10% drop in equity markets would cost Sun as much as $350 million. Hopefully, we are not going to see anything like that but obviously forecasted earnings remain a question mark.

On the other side of the coin, SLF has $2.5 billion of excess capital thanks to the CI sale and the reserves have been strengthened by more conservative actuarial assumptions. Management believes that the $1.44 dividend is safe. The balance sheet remains strong.

On Feb. 12, Moody’s downgraded Sun’s debt and preferred shares. It was a serious blow. The agency’s decision will not affect 2009 earnings but may hamper the stock’s recovery. It’s one more hill to climb.

Action now: Sun Life becomes a Hold. I think that the stock has been oversold but Sun is likely to lag in the eventual market recovery. Manulife, with its strong institutional following, is a better long-term bet amongst the lifecos.

Manulife Financial (TSX, NYSE: MFC)

Originally recommended on Aug. 21/00 (IWB #2031) at C$14.20 (split-adjusted). Closed Friday at C$9.65, US$7.49.

Manulife racked up a $1.24 a share loss in the fourth quarter, an even worse number than the previously announced warning of a 95c a share loss. Its segregated funds required more reserves than anticipated. As a result, earnings for 2008 were a meager 32c a share, a sharp reduction from the $2.83 a share earned the year before. This is a devastating setback and there are far too many uncertainties to hazard a guess at what we can expect in 2009 and even 2010. Management will be able to release substantial amounts of reserves if the market jumps but then have to rebuild them if there is a correction.

There is, however, one big difference between MFC and the other major insurers. Instead of hunkering down, the management team is moving aggressively to take full advantage of the present chaos. The company has just issued $275 million of preferred shares and is poised to bid about US$1 billion for part of American International Group’s Asian life insurance business. That may be only the start. MFC has filed a prospectus with regulators, allowing it to raise up to $10 billion for further acquisitions.

I view the present earnings setback as a glitch and expect Manulife to power ahead once markets stabilize. My concern is that investors have been disillusioned about the lifecos and while MFC should rebound from its present level, it will be some time before the stock commands a multiple of 20 or more again.

Action now: Manulife becomes a Hold but the shares are almost certainly oversold. Aggressive investors seeking short-term capital gains and able to assume some risk should consider taking a position at this stage.

Toronto Dominion Bank (TSX, NYSE: TD)

Originally recommended on Feb. 12/07 (IWB #2706) at C$69.85, US$59.59. Closed Friday at C$35.36, US$27.60.

The banks, by comparison, are weathering the storm much better. TD Bank, my first choice in the sector, reported cash earnings of $810 million, or 96c a share for the first quarter of fiscal 2009. Admittedly, that was nothing to write home about. TD made $1.42 a share in the same quarter a year ago. However, the results were in line with expectations and TD’s capital numbers were good. The Tier 1 ratio improved to 10.1% from 9.8% during the quarter.

That having been said, TD, along with the other banks, is facing some serious difficulties. Margins are under pressure and Personal and Commercial unrealized loan losses jumped $1.2 billion to $2.6 billion in the quarter. Wealth Management earnings fell sharply. Given the serious economic slowdown, these trends are likely to continue in the coming quarters.

Nevertheless, the results were encouraging. Moody’s confirmed its Aaa rating, and the dividend appears to be safe. On balance, I think that at these depressed levels and with a 6.9% yield, TD Bank is looking attractive.

Action now: TD Bank becomes a Buy with a target of $44. I have set a $32 revisit level.

Rogers Communications (TSX: RCI.B, NYSE: RCI)

Originally recommended on April 23/07 (IWB #2716) at C$42.10, US$37.41. Closed Friday at C$26.20, US$20.41.

On a different front, Rogers Communications had a good fourth quarter despite the recession. Operating earnings were $902 million, up from $884 million the year before. That was equal to $1.57 a share versus 99c in 2007. Free cash flow totaled $1.3 billion and management celebrated by increasing the dividend 16% to $1.16 a year.

Looking ahead, Rogers is well equipped to ride out the recession. Free cash flow is expected to exceed $1.5 billion this year and the company has no major refinancing requirements until 2011. Revenue growth, though, is bound to slow from the solid 12% in 2008 to perhaps about 5% this year and earnings of about $2 a share are expected in 2009.

Rogers remains the industry leader with operating momentum. Keep in mind too that to some extent the credit market collapse and slowing consumption work to the company’s advantage. New entrants into the business are likely to defer commitments and tone down costly marketing campaigns.

The stock, of course, has been badly hurt and is likely to remain volatile. Nevertheless, I would gradually accumulate Rogers at these levels.

Action now: Buy Rogers with a reduced target of $42. I will revisit the stock if it dips to $24.

THE CASE FOR GOLD

The price of bullion briefly broke through US$1,000 a couple of weeks ago before pulling back. With stock markets still spiraling down and the world economy “in shambles” to use Warren Buffett’s words, many people see gold as the ultimate safe haven in these tough times. But is it? Guest contributor

John Lawrence Reynolds takes a long, hard look at gold and whether you should add some to your portfolio. John is an award-winning author whose latest book Bubbles, Bankers & Bailouts is now available through our Best Books store at http://astore.amazon.ca/buildicaquizm-20

John Lawrence Reynolds writes:

For years, a subculture has developed around the concept of gold as a means of surviving an oft-predicted financial collapse. Dubbed Gold Bugs by those who sneered at the purported wisdom of investing in the shiny metal, True Believers are now pointing at the detritus of the current situation, gleefully saying: “We told you so!” Is now the time to take them seriously? Or, assuming their claims remain valid, is it too late to board this particular bandwagon?

The origin of their persistent promotion of gold since about 2002 was the enormous U.S. debt accrued during the years of Bush the Second, a level that sounds almost nostalgic considering the most recent estimate of that country’s bail-out costs. The result, they argued with persuasion, can only be inflation for which gold is the ultimate refuge. Many believed; most did not. Canadian gold bugs have been led by the eloquent John Embry, who has spent his career tracking and managing gold investments, first as manager of the RBC Precious Metals Fund and now on behalf of Sprott Investments.

Embry is passionate and convincing. During a heated televised debate in 2006 Embry was chided by his “Equities Forever!” opponent for focusing on the mounting U.S. debt rather than the rising Dow Jones and TSX indices. Why spend money on lifeless gold, the equities promoter sneered, when you can reap profits from equities? “Profits,” Embry responded, “are ephemeral. Debt is forever.”

Eloquent Embry may be, but perfectly prescient he’s not. For the last five years he and other advocates have predicted gold was on the verge of breaking the US$1,000 per ounce price on its way to $2,000 and beyond. The metal touched the first figure for a day or so in March 2008 before slipping back to the $800-$900 range, an event that Embry et al attribute to secretive backroom dealings by national banks to limit its true value and protect their national currencies. In late February of this year it popped through the $1,000 ceiling once more, but temporarily.

Are the gold bugs correct about an international price manipulation cartel worthy of a Robert Ludlum novel? So far, no evidence of a gold-based Illumanati has surfaced. Fundamentals and logic, however, suggest that gold represents a preferred haven against the ravages of imminent inflation and other economic disasters. Gold now boasts new and widening credibility, and should occupy a sector of every portfolio.

Consider the historic and mystical role of gold, surviving as a measure of wealth for more than two millennia and outlasting, you may have noticed, frankincense and myrrh. Here’s the core of the gold bugs’ premise: Compared with gold, every other means of universal exchange is based on promise and trust, and numerous cultures rank gold as a symbol of status higher than home ownership. But let’s also note that gold pays no interest or dividends, and its price fluctuates as widely and unpredictably as any commodity. So what qualifies it as a must-have investment sector?

The value of all commodities, of course, is dictated by supply and demand, and in this respect gold qualifies as A Sure Thing for future price appreciation. Here’s why:

Dwindling supply: Gold is not only scarce, it is becoming more difficult to locate, extract, and refine year by year. Many mines are located in countries rampant with corruption and face ongoing threats of nationalization. In addition, refining gold often involves immersing the ore in cyanide, creating horrendous environmental problems. It’s not unusual for even the best-managed mines to deal with extraction costs of $500 or more per ounce of gold, one reason why production has fallen since 2001 despite a quadrupling of its price over the same period.

Massive economic uncertainty: Anyone who predicts when the absolute bottom of the current equity market will be reached and the launch of global economic recovery will begin is a charlatan. Such uncertainty on a global scale historically has driven investors to gold.

Past central bank sales: The central banks of 107 countries hold an estimated 29,784 metric tonnes of gold, or just under 20% of the world’s above-ground supply. These countries claim to honour a 1999 agreement not to sell collectively more than 400 tonnes of their gold reserves in any calendar year. According to various sources, they have wildly exceeded this figure in order to suppress the price of gold vis-a-vis their currencies, yet their efforts have not prevented it from increasing in value faster than inflation.

Future central bank purchases: Some central banks have become active buyers of gold, recognizing the need and opportunity to build up reserves. In North American and Western European countries, gold typically represents between 50% and 75% of the nations’ foreign exchange reserves. By contrast, the metal accounts for only 2.1% of Japan’s forex reserves, 3.1% of India’s, and a mere 0.9% of China’s. Each of these nations reportedly is seeking to expand its reserves without disrupting other monetary positions. Remember, they will be purchasing from a dwindling supply.

Rising consumer demand in Asia: Citizens of Asia value gold as economic comfort in turbulent times, as they have for generations. Gold represents security against the actions of corrupt governments and the uncertainty of paper currencies. Given the rise of the middle class in India, China, and elsewhere gold, in spite of the current credit crisis, remains poised for enormous growth, an event made more convenient and thus more likely thanks to easy access to pricing and availability via the Internet. True, the impact of the current crisis on China has been enormous. When the recovery occurs, however, the hunger for financial security from gold will be even more intense.

Investment demand: The more gold is seen as a judicious investment in the current financial environment, the more it will attract uninformed investors, commonly referred to as The Greater Fools. In a sadly consistent manner, the higher gold rises in price, the more people will want to acquire it, following the rule that bullish tendencies become self-fulfilling prophesies. Alas, this will spell disaster for the uninitiated, but it presents substantial profit opportunities for the blissfully aware who enter the market with a fixed exit strategy.

Monetary inflation: Over nearly three decades, the nominal GDP of the U.S. has grown 5.3 times, yet the country’s money supply increased 10.4 times – and that’s before the current bailout program. Internationally, the world’s money supply grew 6.6 times during the same period yet the gold supply in 2009 is just 1.5 times the 1980 amount. This imbalance will serve as a driving force for gold pricing over the next few years.

Here’s another measure: In 1980, gold hit a high of $850 per ounce, or about $2,400 in today’s currency, based on the Consumer Price Index. True, 1980 was an exceptional year, the peak of the most recent inflationary period. But these are exceptional times as well, making $2,000+ per ounce gold appear not only reasonable but highly probable within the next 12-18 months.

Negative real interest rates: Bond markets are being strangled by current interest rates to the point where buy-and-hold investors are losing money after inflation is accounted for. As long as this continues, one of the major knocks against gold – that it pays no dividend or interest – no longer applies.

Bear market in stocks: Between March 2000 and November 2008, the S&P 500 lost 50.7%. Over the same period, gold increased by 161%. How much lower will stocks fall? How much higher will gold soar? In November 2005, MotleyFool.com began tracking the price of one share of Google versus one ounce of gold, each valued around $700 at the time. On Feb. 20 of this year, the Google share had fallen to $344.80 while gold topped $975.

Should you assume gold bugs were mistaken in their long-term predictions of an imminent bull market for gold and are likely to maintain the error of their ways? Or do you believe that, as John Embry headlined in a March 2007 edition of Investor’s Digest: “The time for gold ‘to go ballistic’ approaches”?

I’m a believer, with caveats. My sense is to choose gold as a stability factor in a portfolio over the next two years or so. I’m holding about 10% of my RRSP in large-cap gold stocks as opposed to actual gold bullion, but that’s my conservative nature. Should you choose to hitch your investment wagon to gold, here are your alternatives:

1. Large-cap stocks. Choose from among familiar names: Barrick, Goldcorp, Kinross (an IWB recommendation), and El Dorado. Upside: Less volatility than juniors and good capitalization. Downside: Much future growth is already built into the share price.

2. Junior stocks. This is where the major growth potential lies, assuming gold crowds $1,500 and investment capital shows up to get moribund mines back in operation. I favour companies with most of their activities in North America: Wesdome, Rubicon Minerals, Orvana, Aurizon. Upside: Enormous growth potential. Downside: Wild price fluctuations.

3. Gold and Precious Metals Funds. Take a Gravol before you track the performance of these funds, which deliver a new definition for volatility. Three to check out:

iUnits ETF, up a scintillating 0.4% (all valuations as of March 6) over six months, down 11.7% over 12 months, with an average five-year return of 11.1% (respective group averages for the same periods: -24.9%, -37.3% and +3.2%).

RBC Global Precious Metals Fund, skewed to large-cap producers. Performance: down 17.7% over six months, down 28% over 12 months, with an average yield of +7.7% over five years.

Sprott Gold & Precious Metals Fund has a larger junior element with predictably wilder fluctuations: down 31% over six months, down 44.5% over 12 months, and an average loss of 5.3% over five years. Even with those dismal figures, its 10-year performance is +10.7%.

Upside: You’re in the game. Downside: It’s a wild ride, so far.

4. SPDR Gold Shares (NYSE: GLD) buys you into their bullion reserve management at a fee of 0.4% per annum of the daily net asset value. You can trade your shares like ordinary stock based on that day’s gold price. Upside: As easy to trade as ETFs, but this is gold, not shares in gold producers. Downside: You’re focused on the price, not producer performance.

5. Gold certificates. Available from Scotiabank among other sources, these are easily purchased and exchanged, entitling you to the declared value of bullion. Upside: Convenient. Downside: It’s still paper, not gold, and a few gold bugs question the existence of gold in the coffers of smaller certificate issuers.

6. Gold wafers and bars. Marketed by ScotiaMocatta (the precious metals division of Scotiabank), Questrade, and others. Upside: The Real Thing. Downside: You’ll need a place to keep it, preferably a safe deposit box, and expect scrutiny from the money-laundering police if you purchase more than $10,000 worth.

7. Gold coins. More attractive and interesting than bars and wafers, but if your primary interest is investing for future gain, avoid exotic coins that carry a premium for their collectability. Stick with .9999 purity Maple Leaf coins in denominations from 1/20th of an ounce to a full ounce. There is no GST on these coins, but some provinces apply PST. Upside: They’re impressive to handle and show off. Downside: Not the most effective way to buy into gold, and there remains the storage problem.

– end John Lawrence Reynolds

 

YOUR QUESTIONS

General Electric

Q – Has anyone worked out the dollar per share worth of GE if we totally discount its financial arm GE Capital? – Michael L.

A – No one in our organization has done that. We recommended selling GE at US$36.61 in March 2008. Although we have been watching the stock, we are not prepared to take a new position in it at this time and so we have not done the type of analysis you refer to. – G.P.

MEMBERS’ CORNER

Comments on Reynolds book

Member comment: I was curious about the discussion of sovereign ratings in the excerpt from the John Lawrence Reynolds book published in IWB #2909. He indicates that all countries except Canada would see their ratings fall to non-investment grade by 2040. It seemed strange that Mr. Reynolds quoted a report by Standard & Poor’s but the reference was to a report of the Singapore Management University. Why not quote Standard & Poor’s directly? So I used your link to read the Singapore Management University report and didn’t find it any clearer.

I also don’t have the precise words from the S&P report, but having Googled and read other comments about it, I believe S&P wasn’t predicting what will happen with sovereign ratings. I think the S&P report discusses the serious underfunding of national pension plans, and anticipates that, IF the current situation continues, THEN sovereign ratings of nations other than Canada will fall dramatically. The course could change if action is taken. I think we in Canada shouldn’t be quite as optimistic as Mr. Reynolds would have us believe. It’s always best to quote the original source. – Cheryl K.

Response from John Lawrence Reynolds: One of the goals of my book was to inject some degree of optimism or encouragement wherever I could locate a credible source and the S&P report was one of the rare nuggets found. While my source was a conference at Singapore Management University, an institution with which I am familiar, similar data can be located elsewhere. If the writer will access the IMF Finance & Development magazine, Volume 43, Number 3, available at http://www.imf.org/external/pubs/ft/fandd/2006/09/groome.htm she’ll find the original reference including this chart:

Mounting pressures
Aging and related government liabilities could result in downgrades of sovereign ratings.

(hypothetical long-term sovereign ratings, base-case scenario)

 
2005
2020
2030
2040
Australia
AAA
AA
BBB
Non-IG
Canada
AAA
AAA
AAA
AA
France
AAA
A
Non-IG
Non-IG
Germany
AAA
AAA
A
Non-IG
Italy
AA
A
Non-IG
Non-IG
Japan
AA
Non-IG
Non-IG
Non-IG
Korea
A
A
Non-IG
Non-IG
Spain
AAA
AAA
BBB
Non-IG
Sweden
AAA
AAA
A
Non-IG
United Kingdom
AAA
AAA
A
Non-IG
United States
AAA
BBB
Non-IG
Non-IG
Source: Standard & Poor’s 2006.
Note: Non-IG = Non-Investment Grade.

Buy now?

Member comment: Would you please clarify if the recommendations by John Lawrence Reynolds are formal endorsement of IWB, specifically, “There are two good reasons for entering the market now”. Should we be buying? – John R.

Response: No, a book excerpt should not been seen as a formal IWB endorsement to take specific action. The comments are those of Mr. Reynolds and were written a few months ago (there is no such thing as an “instant book”). We do, however, endorse the book as providing valuable insights into the current situation. – G.P.

 

That’s all for this week. Please note that the IWB will take a holiday next week. We’ll see you again on March 23.

Best regards,

Gordon Pape
gordon.pape@buildingwealth.ca
Circulation matters: customer.service@buildingwealth.ca

All material in the Internet Wealth Builder is copyright Gordon Pape Enterprises Ltd. and may not be reproduced in whole or in part in any form without written consent. None of the content in this newsletter is intended to be, nor should be interpreted as, an invitation to buy or sell securities. All recommendations are based on information that is believed to be reliable. However, results are not guaranteed and the publishers, contributors, and distributors of the Internet Wealth Builder assume no liability whatsoever for any material losses that may occur. Readers are advised to consult a professional financial advisor before making any investment decisions. The staff of and contributors to the Internet Wealth Builder may hold positions in securities mentioned in this newsletter, either personally or through managed accounts. No compensation for recommending particular securities, services, or financial advisors is solicited or accepted.