More 2010 than 2008

Posted on: August 15, 2011 in: Economic Growth, Uncategorized, US Equities with 0 comments

iShares CDN Russell 2000 ( Ticker: XSU )

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Europe’s debt crisis continues to hammer global equity markets. Investors fear a repeat of 2008. While that is a possibility, current conditions make it more likely that we will see a repeat of 2010 instead, when markets wilted in the summer heat before starting a rapid six-month rally.

The fall in equities has been swift and sharp. From their April highs, equity indices like the S&P TSX 60, the S&P 500, the MSCI EAFE and the MSCI Emerging Markets fell between 17 and 21%, erasing all the gains for the year-to-date and putting them all solidly in correction territory. The VIX Index, a proxy for market panic, hit nearly 50, a level last seen during the May 2010 Flash Crash but far below the all-time October 2008 high of 90.

The market weakness is not surprising given all the punches they have taken all year. In January, expensive commodities led to inflation, higher interest rates in developing markets, riots in the Arab world, and lower economic growth. The Japanese disaster hurt supply chains. Greece nearly defaulted before it was saved. U.S. politicians bickered over debt. The latest punch was S&P’s downgrade of U.S. debt.

S&P’s action, largely symbolic, coincided with the latest round of selling pressure, but it did not cause it. In fact, investors seeking safety bought even more of the downgraded U.S. debt,  pushing prices on 10-year U.S. Treasuries to within a fraction of face value and yields to an all-time low of 2.13%. The U.S. dollar rallied as well to nearly parity with our Loonie.

What really triggered the equity sell-off was fear over the solvency of French and Italian banks holding large amounts of Greek, Irish and other poor quality sovereign debt. If a Lehman-sized bank like Société Générale and BNP Paribas were to fail, then we could well see 2008 lows.

In that sense, conditions now resemble 2008: U.S. credit crisis then; Euro-zone credit crisis now. However, the differences are greater. Banks are much better capitalized and less leveraged than in 2008. With the lessons of 2008 still fresh, finance and central bank officials have a better idea of how to respond to a credit crisis. In 2008, banks stopped lending to each other and hastened the fall of Lehman and Bear Stearns before that. Now, the cost of inter-bank borrowing has gone up slightly in the Euro-zone but credit is still flowing, and central banks are there to provide liquidity if it becomes necessary.

Economies are growing, albeit slower than expected. After a year of record profits, U.S. companies have reduced their debt loads and are sitting on over $1 trillion in cash reserves. U.S. employment continues to rise in fits. Any move by corporations to expand production will boost employment further.

Then there is the possibility of economic stimulus. The U.S. government’s hands are tied but other countries can step in. One possibility is China. It has let its currency appreciate nearly 7% since May 2010. That should see China’s trade surplus with other countries, especially the United States, shrink. It may also spur rich Chinese firms to buy overseas assets.

Finally, there are corporate valuations. The price to earnings ratio of the S&P 500 is at about 12, well below the long-term average of 16. Dividends on the Dow Jones Index are yielding about 2.6%, a full half a percentage point over the 10-year Treasury. Both are good indicators of a cheap market.

Of course, it may get even cheaper, simply on the selling momentum. But a resolution of the Euro debt situation would see markets stage a quick and sustained rebound, perhaps on par with the 20 to 30% rallies we enjoyed in the second half of last year. When they do, the best ETFs to be in will be the ones that overreact to market movements. Also, with the possibility of the U.S. dollar weakening on further stimulus, Canadian investors would do well to go for a currency hedged ETF. The iShares Russell 2000 Hedged to C$ (XSU-TO) ETF of U.S. small cap stocks meets both these requirements. Conservative investors could choose a large cap ETF.

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archerETF Metrix XSU
Category US Equity
Benchmark Russell 2000
Total Holdings 1978
52 Week High $18.78
Recent Price $17.41
52 Week Low $12.93
Avg Daily Volume 0.03 Million Shrs
Avg Daily Volume ($) $0.56 Million
Total Market Cap $67.10 Million
ETF Annual Fee 0.35%
ETF Trading Currency CAD
ETF FX Exposure USD Hedged to CAD
Annual Volatility 29.4%
Correlation to S&P 500 -0.9%
Return to Risk Ratio Not Available
Use of Leverage No
Use of Futures No
6 month Return -10.18%
1 Year Return 6.95%
2 Year Return 22.60%
3 Year Return -9.70%
Dividend Yield (TTM) 0.77%

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© 2011 archerETF Portfolio Management is a division of Bellwether Investment Management, a discretionary portfolio manager registered with the Ontario Securities Commission. This report is provided for information only and does not constitute investment advice. While we believe the information to be accurate and timely, we make no claim or warranty to that effect. Please seek professional advice before making any investment decision. We may hold positions in any or all securities discussed in this report.

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