Trader’s Narrative

Today the Bank of Canada decided to maintain their historically low interest rates at 0.25% but they did sound cautiously optimistic:

Recent indicators point to the start of a global recovery from a deep, synchronous recession. Global economic and financial developments have been somewhat more favourable than expected at the time of the July Monetary Policy Report (MPR), although significant fragilities remain.

A recovery in economic activity is also under way in Canada. This resumption of growth is supported by monetary and fiscal stimulus, increased household wealth, improving financial conditions, higher commodity prices, and stronger business and consumer confidence. However, heightened volatility and persistent strength in the Canadian dollar are working to slow growth and subdue inflation pressures. The current strength in the dollar is expected, over time, to more than fully offset the favourable developments since July.

Source: Bank of Canada

Unlike Australia, who has already started ended their easing cycle, they believe that inflation is not a danger and won’t be for the foreseeable future. Not only is it being kept in check by the frail economic recovery, the annoyingly strong Canadian dollar promises to keep a lid on it, if it does creep up.

Add to that the intoxicating cocktail of a commodity based economy, a strong real estate market (see below), strong fiscal discipline, and a famed (and quite boring) political stability that rivals Switzerland and you have the makings of a love affair:

One of the main reasons for our resilience has been the health of our real estate markets. I must confess that I was surprised to see the subdued reaction of the Canadian real estate market to the crash of its US counter part. After all, the two economies are intertwined like no other two countries in the world. However, for all our inter-dependence, there are significant differences. Canadian bankers never quite got the hang of laughing in the face of infinite risk or perhaps our regulators have yet to be so completely and embarrassingly captured as they are in the US.

Whatever the root cause, the Canadian real estate market has bounced back after a very late and shallow decline. As well, while our mortgages do default, the rate is extremely low and has barely experienced an uptick worthy of note:

Source: Globe & Mail

Canadian REITs gave long term investors quite a scare late last year as they were dumped along with everything else. However, while their price may have declined, their value continued to be very attractive. When I featured RioCan (REI.un) in November 2008 it was trading at $13 Cdn and yielding 10% - since then it has risen to $18 Cdn - and that’s not even considering all those juicy monthly distributions.

Meanwhile, Canadian equities have risen 27.3% in 2009 and slightly over 50% since their spring lows. But here’s the curious thing. While most major stock markets around the world have recovered from their shallow retracement in late September and gone on to newer highs for the year, the Canadian S&P/TSX index has not. That non-confirmation is slightly unnerving, especially when you consider just how much the Canadian equity markets have going for them.

The above is a short clip from the full video, available free here.

For more information, check out the implied deflation in the TIPS spread and the message of Dr. Copper.

Below is an article written by Mark Galasiewski, editor of Elliott Wave International’s Asian Financial Forecast. Although it uses Australian data to illustrate its point, the same can be shown with US central bank rates and short term T-Bill rates:

The following is excerpted from Elliott Wave International’s Global Market Perspective. The full 120-page publication, which features forecasts for every major world market, is available free until April 30. Visit Elliott Wave International to download it free.

Conventional wisdom says that central banks can influence or even direct financial markets and the macroeconomy. The very existence of Elliott waves challenges such assumptions. For if markets responded to every central bank directive, how could Elliott waves exist? Parallel trend channels, Fibonacci price relationships, the similarity of form between waves of different sizes and time periods—none of that would be possible. Central bank decisions would have to coincide perfectly with turning points in Elliott waves, and we know that just doesn’t happen. But even without using waves, we can expose the conventional wisdom for the fallacy that it is.

Take, for example, this assertion in a recent article in a U.K. economic weekly: “Part of the aim of central banks in driving down interest rates is to encourage a greater risk appetite among investors.” Two key assumptions underlie that statement: a) central banks determine interest rates; and b) lower interest rates can increase society’s appetite for risk.

To see how the first assumption is false, let’s take a look at the daily chart of Australian interest rate data. It duplicates a study that Elliott Wave International has often done with U.S. interest rate data. It shows how movements in the cash target rate set by Australia’s central bank, the Reserve Bank of Australia (RBA), appear to follow those in 3-month Australian Treasury Bills. After decisive moves up in T-bills from 2006 to early 2008, for example, the RBA faithfully raised its target. T-bills have since led the RBA during the financial crisis of the past year. In fact, the record indicates that the RBA almost always follows T-bills over time.

The proper conclusion to draw is not that the RBA has orchestrated the decline in rates since the early 1980s—but that it’s been riding it. During good times, central bankers look like geniuses; during bad times, they get tarred and feathered. Closer to the truth is that their interest-rate decisions are not proactive, but reactive, and that they continually follow in the footsteps of the market for lack of any other useful guide.

Now let’s look at the second assumption: that lower interest rates increase society’s appetite for risk. A simple glance at the weekly chart shows this assumption to be false. After the 1987 crash, the ASX All Ordinaries actually rallied for two years on rising rates and then sold off through 1990 on falling rates. Stocks then rose in 1991 on continued falling rates and sold off in 1992 on even lower rates. Continue following the chart to the right and you will see that there is no consistent correlation between the direction of interest rates and that of the stock market.

The myth of central bank potency is so pervasive that conventional analysts can’t even imagine a better explanation for price trends: that the market is the dog wagging its central bank tail, not the other way around.

For more information, download Elliott Wave International’s FREE issue of Global Market Perspective, available until April 30. The 120-page publication covers every major world market, global interest rates, international currencies, metals, energy and more.

Mark Galasiewski is the editor of Elliott Wave International’s Asian Financial Forecast and member of EWI’s Global Market Perspective team covering Asian stock indexes.

According to Jim Stack of Investech Research, there are a few conditions which must be met before a new bull market can be born. They are a mix of monetary, technical and sentiment measures. I’ve looked at four of them already:

• Consumer Sentiment
• Formal Recession
• 20%+ Decline
• Coppock Guide

Here is the fifth: monetary policy. Of course, almost every single central bank around the world has reduced interest rates. Here is a quick summary of a few key ones:

US Fed
The intended Fed funds rate stands at 1% but the problem is that the Federal Reserve took its sweet time in lowering interest rates. Rates topped out in June 2006 at 5.25% and were taken down by the Fed subsequently. But as the bond market repeatedly was warning, the Fed was behind the curve by a very wide margin.

The US is also undertaking a gargantuan multi-trillion dollar fiscal stimulus package with a much more comprehensive one waiting in the wings until January 20th 2009 when Obama takes over.

Canada
Almost one full year ago, the Canadian central bank began its easing cycle and I wrote that since central banks move in packs, this was the beginning of a world-wide trend.

The Canadian central bank has since lowered interest rates continuously. The overnight rate has almost halved from 4.5% to 2.5%. The next meeting in early December is seen by almost all as another opportunity to cut further.

China
The Chinese central bank announced a massive 108 basis point cut in their key interest rate today (to 5.58%). While this is their fourth time cutting rates since September, this recent move shows just how worried the Chinese government is. Usually interest rates are stepped up or down by just a 27 basis points but this move is four times larger in magnitude.

China has also announced a $590 billion fiscal stimulus package as well as lowering the reserve requirements for several banks to pump more money into their economy. Right now, putting money into a bank account is a losing proposition since the latest data has inflation at 4% and banks pay 2.5%. Basically, China is pushing its people to consume, rather than save.

England
The Bank of England is no stranger to large rate cuts. At the beginning of November, it cut 150 basis points off its key lending rate (from 4.5% to 3%). That followed a 50 basis point cut in early October 2008. Most are expecting another cut next week when the monetary policy committee meets. Some are even calling for a further 0.50% cut.

England is also pushing forward a VAT reduction (to 15.0%, from 17.5%), and a $30 billion stimulus package.

European Central Bank
The ECB has been the most sluggish in responding to the current decline in economic activity. They are under pressure in their next meeting of December 4th to take drastic action and lower by 50 basis points. But considering the extremely hawkish tone of the ECB that is very unlikely.

The ECB has already cut 100 basis points since October to bring their rate to 3.25%. But as the Eurozone faces its first recession in 15 years, it may not be enough.

Australia
The Reserve Bank of Australia topped up its rate in March 2008 at 7.25% and ever since has been lowering it. On October, it also cut 100 basis points and more recently, by 75 basis points to bring the target cash rate to 5.25%. This is the steepest cut in rates since the 1991 recession in Australia. And it may just help them to dodge most if not all of the fallout.

The Australian government is also implementing a stimulus package of $6.7 billion - helping first time home buyers and pensioners.

Japan
In its most recent decision, the Bank of Japan held interest rates steady at 0.3% (not a typo). They are reluctant to return to the zero interest rate policy they adopted between 2001 to 2006 because it was not that helpful. But the Japanese central bank is pursuing alternative ways of pumping money into their economy. For example by accepting a wider assortment of assets as collateral.

Warm up the helicopters!
At this point, all central banks are focused on the present battle against the very real danger of a deflationary spiral. Of course, if they overdo it, as they almost always do, then they have to quickly mop up the extra money sloshing around the world financial markets without causing another dramatic downturn.

Don’t you just love central planning comrade?

In Why The Price Dividend Ratio Is Better Than PE Ratio I argued that the lesser ratio based on dividends offers more insight. Here’s a follow up with an interactive long term chart.

It contains a massive amount of information so it can take a while to load… be patient, it is worth it. Not only does it show the historic ratio, it is interactive so you can zoom in on a shorter time frame by using the slider at the bottom:

The data is from 1871 to June 2008. To bring it up to date, the most recent data for the S&P 500 Index (SPX) gives a P/D ratio of just under 32. A year ago it was at 54. The last time we saw a price dividend ratio of 32 was in 1991. To put the current 3.13% dividend yield into perspective, in June 1932 stocks were yielding on average 14% and in July 1982, stocks yielded 6%.

Right now the Dow Jones price dividend ratio is 25.7 which is very close to the long term average. But the ratio can over shoot on the downside. By the way, I’m still looking for similar historical data for the Dow Jones, so if you have a lead, let me know.

And keep in mind that both the numerator and denominator are constantly changing, so this is a fluid number. Although we’ve seen prices fall dramatically these past few weeks, dividends can also fall. So the good news is that this ratio has fallen a lot but the bad news is that it can continue to fall as dividends are cut or reduced.

On the plus side, an important variable that can act as an emergency break on this ratio is the interest rate. If the Fed takes rates down to 1% or less, which some believe is a matter of when not if, then dividends will be much more attractive, relative to the alternatives in the bond market.

Already if you look around you’ll find quite a few high yielding household names like Pfizer (PFE) which is now yielding 7.7%. Looking back almost 30 years (I got tired of looking back more) Pfizer has never skipped or lowered a dividend payment but has consistently raised it.

Unless Bernanke takes interest rates down to zero, what we could be facing is a return of this ratio to the “normal” range it has occupied for most of its history. That is somewhere between 12 and 35. Under this scenario, the stock market would flop around for decades as it waited for dividend growth to catch up to it. We’ve seen this sort of market before. From 1966 to 1983 the Dow Jones was a snooze fest. Except for a few harrowing dips, it went sideways and grinded down even the most optimistic bull.

To avoid such a stark reality, I say the Fed should re-inflate like it was 1999 - Disclosure: I’m massively long seaweed CDOs.