Quarterly portfolio Summary Sample ETF Portfolio June 30, 2013 Target Current Investment Mix: % $ % Fixed Income: 64.95% $16,238.15 65.00% Growth: 35.00% $8,749.74 35.00% Cash/Cash Equivalents:* 0.05% $12.11 0.00% Totals: 100.00% $25,000.00 100.00% Estimated Annual Income: $625.01 Est. Annual Investment Costs: 0.22% $56.12 Bond Maturities: $ Cash/Cash Equivalents: $12 2018* $1,441 2014* $1,441 2019 $0 2015* $1,441 2020 $5,000 2016* $1,441 2021 $5,000 2017* $1,441 *Estimated maturity in ETFs Preferred Shares: $1,587.45 % of Portfolio: 6.35% Stock Market Sector Weightings: $8,749.74 Invested for growth & allocated to Energy (includes pipelines) 16.380% (Horizon S&P/TSX 60 Equal Weight Index) Financial Services: 11.120% (Horizon S&P/TSX 60 Equal Weight Index) Mining & Metals: 11.345% (Horizon S&P/TSX 60 Equal Weight Index) Gold & Precious Metals: 0.000% Industrial Products: 18.000% (Horizon S&P/TSX & BMO Industrials ETFs) Communications: 3.477% (Horizon S&P/TSX 60 Equal Weight Index) Utilities: 19.407% (BMO Utilities & Horizon S&P/TSX ETFs) Consumer Staples: 5.922% (Horizon S&P/TSX 60 Equal Weight Index) Transportation: 3.504% (BMO Industials Index) Consumer Discretionary: 0.000% Health Care: 2.350% (Horizon S&P/TSX 60 Equal Weight Index) Real Estate: 0.000% Forestry: 0.000% Technology: 1.380% (Horizon S&P/TSX 60 Equal Weight Index) Inverse ETFs/Short Positions: 0.000% Effective Market Exposure: 92.885%
Sample Exchange Traded Fund Portfolio 30-Jun-2013 Credit Average Book Current Market Est. Annual Investment's Description Rating Cost: Value: Price: Value: Yield:* Income: $12 Cash Balance $1.00 $12.11 $1.00 $12.11 0.00% $0.00 Interest/Dividends Received Bonds and GICs: 725 First Asset DEX 1-5 Year Laddered (BXF) $9.94 $7,206.50 $9.94 $7,206.50 n/a n/a Government Strip Bond Index $5,000 Transcanada Pipelines Ltd A $76.54 $3,826.80 $76.54 $3,826.80 3.66% $153.14 Discount Bond, Matures: 20-Nov-2020 $5,000 Bell Canada A $72.35 $3,617.40 $72.35 $3,617.40 4.14% $167.96 Discount Bond, Matures: 01-Jun-2021 (low) Cash, Bond and GIC Totals: $14,662.81 $14,662.81 2.19% $321.10 Preferred Shares: 95 ishares S&P/TSX Canadian CPD $16.71 $1,587.45 $16.71 $1,587.45 4.40% $69.85 Preferred Share Index Fixed Income Investment Totals: $16,250.26 $16,250.26 2.41% $390.95
Credit Average Book Current Market Est. Annual shares Investment's Description Rating Cost: Value: Price: Value: Yield:* Income: Growth Investments: Broad Market Index: 540 Horizon S&P/TSX 60 HEW $10.65 $5,751.00 $10.65 $5,751.00 2.32% $133.42 Equal Weight Index Industrial Products Sector: 87 BMO S&P/TSX ZIN $17.27 $1,502.49 $17.27 $1,502.49 1.51% $22.69 Equal Weight Industrials Index Utilities Sector: 105 BMO S&P/TSX ZUT $14.25 $1,496.25 $14.25 $1,496.25 5.21% $77.95 Equal Weight Utilities Index Growth Investment Totals: $8,749.74 $8,749.74 2.68% $234.07 ETF Portfolio Totals: $25,000.00 $25,000.00 2.50% $625.01 Est. Annual Income does not include the accrued interest earned on the discount bonds. Bond pricing = The 'Bid' price as at the close of the last trading day in the period. Data provided by Bondview. Stock market data = closing trade on the last trading day in the period. Data provided by QuoteMedia. * Distribution Yield = the 12-month trailing $ distributions divided by the portfolio's Average Cost - representing the portfolio's yield, not the market yield. The ETF distributions may include a Return of Capital and it may not be accurate to compare individual ETF distribution yields.
Review: ETF Portfolio As the ETF portfolio was started on June 28, 2013, there is no history to review. Thought and Concerns: During the fall, winter and spring, investors seemed to breath a collective sigh of relief at putting the worst of the financial crisis behind them. Stock markets rose to new highs and bond yields hit new lows what could be better! For a while it seemed that we had no worries that is until it suddenly became apparent to investors that better economic news might cause central banks to slow their liquidity injections - a brand new worry for investors. A few of our observations. The worse things get the higher stock markets go! It is such an odd environment for investors. It used to be that as the economy gained strength, corporate profits increased and stock markets rose. But it now seems corporate profits and stock markets are no longer connected to economic growth. As the following chart demonstrates, it would appear the stock markets bottomed in 2009 at approximately the same time as economic growth peaked. As economic growth began to decline, stock markets became more bullish.
Much of the stock market strength is attributed to increasing corporate profits. Which also seems odd corporate profits increasing as economic growth decreases! As the chart from the St. Louis Federal Reserve Bank demonstrates corporate, after-tax, profits are at record highs. Much of the corporate profit growth can be attributed to declining income tax liabilities and labour cost reductions as companies try to maximize their productivity levels. The New York Times recently published a couple of charts, which depicts just how much corporate income tax payments have declined, further enhancing corporate profits. U.S. corporate taxation is sitting as historical lows. In the United States it appears employment levels are at generational lows, which seems to correlate well to a slowing economic growth scenario, but not record high profits and stock market values. Historically, when employment is low corporate revenues and profits suffer. Below is another St. Louis Reserve Bank chart that crystalizes the employment picture in the U.S. over the past 70 years. As you can see employment levels are back where they were in the 1980s.
Note: Notice how employment makes a sharp rise after each recession, but despite all of the extraordinary efforts of governments and central banks employment has not moved high this time around. The divergence between economic growth and stock market performance is even more pronounced in Europe where most countries are either in recession or approaching recession, as the following charts from The Economist and the European Central Bank shows.
European economic growth
Source: European Central Bank Data European unemployment levels, at 12.1% or 19.22 million people, has been rising for over 7 years and has reached a record high. This is happening at the same time as the European economies move into recession and their stock markets reach new highs. As the following recent chart demonstrates, European unemployment continues to rise and will probably get worse as economic growth slows. European unemployment rate (as a % of labour force)
Source: European Central Bank Data The weak economic growth in North America and Europe, while not very supportive for high stock market valuations, should help support the ongoing central bank liquidity operations which suppress interest rates and provide abundant financial resources for financial systems and governments. But havenʼt interest rates started a new trend higher? Yes, interest rates have jumped over the past 6 weeks. In Canada and the United States, bond prices have dropped. For example, the yields for 10-year bonds have increased by about 84 basis points or 0.84% - from 1.63% to 2.47%. Thatʼs a big jump! The recent increase in interest rates has hurt the market prices for bonds, preferred shares and interest sensitive stocks. Why are interest rates rising? Well, we donʼt think the increase in rates is due to any of the following traditional influences Rising inflation Improving economic growth Increasing demand for loans
Rising credit risk In fact, the inflation rate continues to decline. As the following chart, from The Economist, shows U.S. inflation continues to decline, with the Core CPI rate hitting new lows. Note: Central Banks are very concerned about the continuing decline in inflation rates. They fully expected consumer inflation expectations and actual inflation rates to rise as they injected more and more liquidity into the financial systems. They are worried that if inflation turns into deflation then consumption will slow making it harder to stimulate economic growth. For example, if prices began to fall and we thought that prices would continue to decline, then we would probably delay purchases. We might delay buying that new car, TV, computer, house, etc. We might say - Iʼll wait 6 months to buy when prices are lower. Our decision to delay purchases would have a negative impact on economic growth. (Some writers believe the price of oil holds the key to this tug-o-war between inflation and deflation. If oil prices were to fall, the decline could push the CPI numbers into negative territory.) As we discussed above, economic growth is still weak so we doubt this could be a factor in the recent interest rate rise. Given the current employment trends and the record amount of cash held by companies, there is no evidence the demand for loans has increased sufficiently to warrant a jump in interest rates. An increase in credit risk levels does not seem a very plausible explanation for interest rates increasing. (Although this might be a concern in the Junk/High- Yield bond area where rising interest rates could heighten default risk.) The rise in interest rates appears to have very broad affecting all government and corporate equally.
Most investment commentators agree interest rates have increased because investors fear central banks will begin to reverse the easy money policies of the past few years. If so, then the recent rise in interest rates may simply reflect a market adjustment as traders close out trades (selling bonds) they held in anticipation of unlimited easy money keeping interest rates depress indefinitely. If the recent increase in interest rates is simply a market adjustment, then we can expect rates to become more volatile within a trading range as traders continue to guess at changes in central bank policies. How high could interest rates go? Almost everyone believes interest rates have gone too low artificially suppressed by central bank actions. But no one really knows for sure. Each perspective and forecast for interest rates is shaped by our historic memory. Interest rates have been declining for over 30 years in Canada and, for over 30 years, the investment industry has been warning us about the imminent rise in interest rates. Note: Japan is a good example of where interest rates have not bottomed and moved higher, but rather they continue to stay at historically low levels. According to Bloomberg, the Japanese 10-year bond yield is currently at 0.88% and, as the chart below shows, the bondʼs yield has traded in a range under 2.0% for the past 15 years. Source: European Central Bank Data
We believe the economic and demographic trends in the developed economies continue to support low interest rates. But interest rates will still fluctuate within a range our best guess between 2.00% and 3.50% for the 10-year bond. Year Yield on June 1st 2007 4.62% 2008 3.71% 2009 3.45% 2010 3.09% 2011 3.08% 2012 1.79% 2013 2.50% Note: Below is a chart with the 10-year bond yields going back to 2007 Source: Bank of Canada We do not think rising interest rates are something investors should fear? Not really, rising interest rates would have a positive side affect for savers and pension plans. We believe a balanced and well-designed investment plan would actually benefit from rising interest rates. Even if interest rates were to go back to where they were prior to the financial crisis (5-year GICs @ 4.00% and 10-year bond @ 4.62%), savers and retirees would both benefit. How about corporate profits? As mentioned above, corporate profits are at historical highs along with profit margins, as companies have successfully reduced their operating costs, financing costs and income tax liabilities - a result of lower corporate income tax rates and increased booking of profits offshore. We believe the long-term decline in corporate taxation may become an area for investors to watch. If governments continue to run deficits and the economies remain weak it may become an attractive option for governments to increase corporate taxation (by either increasing tax rates or closing offshore tax loop holes, or both). Any increase in corporate tax payments will decrease the earnings available to support stock market prices. Another aspect of earnings to watch will be the sustainability of earnings growth. So far in the second quarter, the number of companies issuing negative profit guidance has reached a level not seen since the 1990s Tech bubble, as the chart below demonstrates.
Note: As the beginning of the second-quarter earnings season approaches, the negative guidance sentiment is weighing on analyst estimates. So far, S&P 500 companies have issued 97 negative earnings pre-announcements and only 15 positive ones, for a negative to positive ratio of 6.5. The guidance has contributed to the downward slide in second quarter estimates, with EPS currently estimated to grow 3.0%, down from the 8.4% estimate at the beginning of the year. In summary Most of the developed economies are struggling to generate positive growth; individuals continue to struggle to find full employment; central banks continue to inject liquidity into the financial system (depressing interest rates and distorting capital flows) and stock markets continue to reach for new highs. Although corporate profits are at record highs, investors need to watch for their sustainability at these levels. Taxation and current offshore income tax policies may be about to change. Now, more than ever, investors need to ensure they have a well-defined plan for the management of their expenses, debt, savings and investments. Portfolio changes
No investment changes are necessary at this time.