‘Better’ Doesn’t Mean ‘Good’

On Monday, the Bank of Canada released the results of two quarterly surveys it uses to gauge the mood of business and lending decision-makers, the Business Outlook Survey (BOS) and the Senior Loan Officer Survey (SLOS).

Both measures of sentiment showed improvement from the respective January surveys, but we’re talking about rebounds off historic lows. As is the case with much of the economic data we’re seeing these days, the story is all about the second derivative–the nature of the change–rather than the absolute numbers.

Regarding the Business Outlook Survey, senior managers in Canada are still pessimistic, but the view isn’t as grim as it was in January. The BOS, a summary of interviews conducted with top people at 100 firms selected to reflect the composition of Canada’s GDP, revealed that managers still anticipate weak sales and will put off major capital expansion and new hiring for the foreseeable future.

In resource-rich Western Canada, late to the malaise, efforts to reduce spending are gaining intensity, and hiring intentions are now weaker than in the country at large.

Firms across Canada still report tighter terms and conditions for obtaining credit–the costs are higher, and they have to answer more questions before loans will be made.

Those perceptions are reinforced by the data revealed in the Senior Loan Officer Survey, which collects information about the business lending practices of major Canadian financial institutions.

It’s important to note that the statistical value of both surveys is limited by the fact that each comprises a small sample size. As well, the BOS was conducted February 23 to March 20, well before what’s become a significant rally off equity index lows had time to invade the consciousness of respondents. The SLOS data was gathered March 17 through March 24.

SPRTCM Index

Source: Bloomberg

The incremental progress we see in the BOS and the SLOS seems at odds with the 25 percent rallies we’ve seen in the S&P/Toronto Stock Exchange Income Trust Index, the S&P/TSX Composite as well as the S&P 500. But it’s important to note that the market is often disconnected from on-the-ground economic conditions. Financial markets are forward-looking mechanisms, and the fact that deterioration has slowed–not even reversing, in the case of many indicators–is good enough to let slip at least some of the animal spirits.

After all, it’s gotta slow down before it turns around.

The most significant single factor in the global economic meltdown is the rapid and violent demolition of the US financial system brought about by Lehman Brothers’ Sept. 15, 2008 bankruptcy filing. It’s widely accepted among economists, policymakers and investors that until we see signs of health in US banking, the global situation is dodgy. And we know, because more than 70 percent of its trade is conducted with its neighbor to the south, that Canada is more concerned than most with what becomes of Citigroup (NYSE: C), Bank of America (NYSE: BAC), Wells Fargo (NYSE: WFC) and Goldman Sachs (NYSE: GS), for example.

The latter two firms issued rosy announcements in recent days, Wells Fargo trouncing Street expectations with USD3 billion in first quarter earnings, Goldman manufacturing a USD3.39 per share profit and raising USD5 billion to start paying back the US government. (Set aside for present purposes questions about the impact on both sets of books of the Financial Accounting Standards Board’s cave-in to Congressional pressure on mark-to-market rules, and ignore the fact that Goldman basically disappeared December 2008 as far as it was concerned.)

Let’s take a look at a broader indication of the state of the US financial system, the HSBC Financial Clog Index. It measures the aggregate level of stress in the system based on four factors: interbank stress, measured by the TED Spread and the LIBOR-OIS Spread; financial institution default risk, measured by US financial credit-default swap spreads; mortgage agency credit spreads, measured by credit spreads for Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE); and equity volatility, measured by the Chicago Board Options Exchange Volatility Index, or VIX.

GP Clog Index

Source: Bloomberg

The ridiculous spike you see on the chart above is the Lehman Effect, the near-implosion brought about by the systemic stress exerted when it went under in mid-September last year. Note we’re still at well-above-normal levels–but conditions are improving. Again, we’re concerned with the nature of the change, and the nature of this change is “less stress.” Hopefully, soon, increased lending activity will translate into more aggressive capital expenditure decisions and more hiring, and then we won’t be concerned with government efforts to stimulate aggregate demand anymore because people will have jobs to fund goods purchases and mortgage payments.

A top-of-mind question for most investors on a mid-spring Tuesday is whether we’re entering a new bull run or merely suffering a bear tease. For value-focused, income-oriented investors, the question remains one of distribution sustainability. In Canadian Edge, operational performance has always been the primary concern, and, though we’ve experienced our fair share of price deterioration with many Portfolio recommendations, in the main the companies we recommend have withstood the many stress tests this financial crisis/recession hath wrought.

That’s not to say, however, that in times such as these discipline isn’t important. During bull runs it’s easy to buy and hold. Amid the kind of uncertainty we’re still mired in, though, we have to be more active about booking profits on winners and cutting loose losers. We made such moves back in the summer of 2008, recommending that CE readers take some money off the energy table. But we also found a couple solid trusts with demonstrated business success trading at cheap valuations during the late-2008 maelstrom.

It’s good to understand the many pieces of information that impact equity prices and the value of your portfolio. It’s also possible to get overwhelmed by data. The most important discipline, however, is emotional: Don’t get too high on the upside (i.e., don’t get addicted to your winners; take profits) and don’t double down on losers (i.e., don’t get addicted to your losers; doubling down is good money after bad).

A little equanimity goes a long way.

Roger Conrad
KCI Investing

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