June 7, 2008 Saturday morning show

This is Jeff Wareham, ScotiaMcLeod wealth advisor, with Beyond Funds Market weekly for June 7, 2008.

The first week of June 2008 seemed to be a miniature version of 2008 to date…credit concerns, rumours of instability at a major US broker, recession fears, unemployment, and spiraling oil prices…not to mention the divergence of performance between Canada and the US. New records fell this week, and any discussion of the week that was must clearly start with oil. By Wednesday, it appeared the dizzying spiral in oil prices might be abating…then, supply fears and political tensions led to a 13 percent spike over 2 days, and fast money flowed to crude, from US equity. The Dow and S&P plunged 3 percent on Friday as the traders moved away from stocks, on the back of an unexpectedly large rise in US unemployment.

The TSX actually had another strong week numerically, led by commodity and energy stocks. Friday saw the market spend much of the day in the heady territory above 15000, before fading 14969 at the close. This was a truly stellar performance beside the drooping Dow, which saw all 30 stocks fall, and S&P, which felt losses in every subsector.

Looking at global market performance, only commodity players are above water for the year, with Brazil, Mexico and Canada leading the way.

Is the strength in commodities here to stay?

In his monthly comments, ScotiaMcLeod:s Stephen Uzielli – Portfolio Manager, Equity Advisory Group notes:

“Last month former Chairman of the Federal Reserve Alan Greenspan said that the U.S. is still more likely than not to have a recession although he allowed that the there was less likelihood of a severe recession. Importantly he also said that it was premature to determine whether we had seen the worst of the financial crisis, saying this will ultimately be determined by the magnitude of the decline in housing prices. Those thoughts were echoed by U.S. Treasury Secretary Henry Paulson when he said it could take months until we see the end of the problems in financial markets.
These comments highlight our own concerns about the fragile nature of capital markets these days. Although we acknowledge that we may have seen the lows for the broad stock indices, the recent rally from the lows in March has been a case of too much, too soon; thus we remain cautious and expect significant volatility in the coming months. Even if the depths of the credit crisis are behind us, the most negative impacts on the consumer and domestic demand are yet to be seen. Longer term, we remain constructive and would be taking advantage of market dips to accumulate positions, particularly among defensive holdings and multinationals that can take advantage of growth in non-North American demand and the decline in the U.S. dollar.

Analysts have been steadily increasing their commodity price assumptions with the move in the price of crude oil above US$125 per barrel, and yet some estimates suggest that the share prices for Energy stocks are discounting only $80 per barrel. The most recent run-up in crude appears to be driven largely by speculation and the increased influence of financial players, as opposed to direct participants in the energy market. As a result, Energy stocks are vulnerable to a correction, at least in the short term.

Since last fall we have consistently made the argument that consensus estimates for corporate earnings growth were too high, and subject to downward revision. Our concerns were, and continue to stem from the implications on the broader industrial sectors of a U.S. economic slowdown driven by the slump in housing. Scotia Capital Portfolio Strategist Vincent Delisle wrote recently that: “In contrast to the S&P 500, which is still plagued by negative earnings revisions, the Canadian benchmark should continue to find solid support in these volatile markets in light of favourable profit wind. In the last three months, profit estimates have increased approximately 25% for Canadian Energy and Materials. U.S. resource companies have seen a more modest upswing in earnings revisions throughout the same period. In the U.S., eight of ten sectors are in negative earnings revisions versus five in Canada.

The spring equity rebound stumbled in the latter part of May, and mounting challenges to U.S. consumer spending, higher inflation, and record oil prices should translate into volatile markets in coming months.

Consumers have been resilient so far but they are now running out of alternatives. We expect Q2 and Q3 to offer weak macro headlines. Rising inflation expectations should exert upward pressure on long term yields, thus hurting bond performance and limiting multiple expansion”.

He adds that “May was a very strong month for the Canadian stock market, led higher by resource stocks responding to increasingly higher commodity prices. The top performing sectors during the period were Energy, Information Technology, and Materials.”

Uzielli goes on to state that “This cycle is reminiscent of the technology bubble at the beginning of this decade when the market’s direction, and amplitude, was driven by a very few number of stocks. Back then one stock, Nortel, represented close to 35%of the major Canadian index and portfolio managers were faced with the challenge of measuring their performance against a highly skewed market index. Recent conversations with several institutional money managers confirmed the existence of the same conundrum in the current market environment with the Energy sector representing almost 32% of the S&PTSX Index. And although it is a sub-index and not one single stock as in the Nortel days, it is one commodity, crude oil, which is driving almost a third of the “market”. Conservative portfolio management theory suggests that it is not prudent to allow any one position to be greater than 10% of a portfolio, and yet today we have a single commodity dictating valuations for the largest sub-sector of the market.

This is not to say we are negative on the Energy sector as it still represents 25% of the Canadian Core Portfolio and we do have a constructive outlook toward the group longer term. However, we remain underweight relative to the benchmark in keeping with our ongoing defensive bias, and our expectation that Canadian Financials, Telecommunication Services, Consumer Staples, and Industrials will outperform as the current cycle evolves.”

Uzielli’s comments came out before Friday’s market weakness, and they highlight one of the weaknesses in ETF investing, which I will highlight later in the show…just a reminder that you are listening to Beyond Funds Market Weekly, I am your host ScotiaMcLeod Wealth Advisor Jeff Wareham…stay tuned after the break, as I dig further into this issue, and I discuss the opportunity of leaving a planned gift to charity, and a couple of effective ways to do it.

Before the break, I was discussing the recent performance of the Canadian market and now I want to delve into the strength it has shown in the commodities boom, and the danger that a correction in commodities might present to an investor with heavy exposure to the Canadian market.

Before I begin this discussion, I must say that I am pleased with the creation of my new blog, at www.am980.ca, or www.beyondfunds.ca, where you may access past content from my show, and find further information on alternatives for investors outgrowing their mutual funds. I believe this will be a useful resource for investors with growing investment needs.

One of the most common quotes I frequently hear about commodities these days is “it’s different this time.” I cringe when I hear a commodities analyst or hedge fund manager on TV, espousing the view that “it’s different this time.” I harken back to the heady days of the tech bubble, when experts and mavens fought for the opportunity to tell us that valuations had nothing to do with such silly old concepts as earnings and profits…now it is about eyeballs and clicks…hogwash. Earnings, growth, and profits, are what business is all about. This key point is where the tech bubble and the commodities boom diverge…companies with no marketing plan or actual business model sold for millions or billions of dollars in the Tech Wreck, while the cornerstone companies of the commodities boom are posting often seemingly obscene profits. In that sense, it is different this time. Further, the growth of demand for commodities, from India and China, has created scarcity. As an economics graduate, I understand scarcity is another critical component for a long term boom in commodity prices. Scarcity in the energy field is exacerbated by the geopolitical realities of the world’s major oil suppliers…and the instability of oil production and refining capacity do make some of the price action in oil and gasoline seem sensible. Peak oil theorists will argue that production is declining just as demand exceeds supply, and that has led to the massive upswing in oil prices…again the story is credible, but is it the reason for the massive upswing we have seen in the price of oil?

I buy the bullish story on oil and other commodities…I am just not convinced “it is different this time.” Global oil demand is rising. China and India are consuming much more oil, gold, copper, and even food and water, as they emerge, from agrarian states into major, developing economies, and this trend will continue.

This bull case has led to the emergence of new ETFs, or exchange traded funds, and I think this is another, less frequently discussed, contributing factor. Why would this matter? Many global investors want to diversify by holding commodities as an alternative to investing in businesses. For example, you might choose to own gold, if you think that the US dollar is likely to fall, as historically the greenback and gold have moved in a countercyclical manner. Holding gold was once the reserve of central banks, and the wealthy, due to the cost of storage and security…but not now. You may buy certificates or ETFs backed up by real gold ownership…and there is a definite correlation to the increase in gold over the last few years, and the emergence of gold ETFs.

More and more ETFs come to market all the time. Commodity ones are hot, and these are having a real effect on the cost of the underlying commodities. When investors buy the fund, the fund buys the underlying commodities.

Hedge funds and traders also move quickly in and out of markets, and many follow the momentum, ride it, and sell before the momentum swings the other way.

Oil, gold, and many other commodities are being caught up in this perfect storm of demand.

The problem is, as with any bubble, even one based on sound underlying principles…that any unwinding of demand is like a precipice…once you have reached the top, look out below if you stumble. Yesterday’s market action had some very troubling, or at least telling, characteristics. Oil spiked over eight percent in one day, yet the price of the world’s largest oil producer fell. Does that make sense? Not really. Movement like this is frequently characteristic of bubbles.

If the so called fast money flows out of oil or other commodities, look out below.

Problem is, many Canadians have no idea what a big bet we generally have on the price of commodities. As I discussed in segment one, our index is now a commodities index, just as it was a tech index in the days of the tech bubble. The fall of one big tech player shaved about 50 percet off of our index in a couple of years. Many index or Canadian Equity mutual funds paid the price…and I fear that we are headed there again.

Don’t get me wrong. Our resource industries are booming, and are likely to survive a drop of commodities to more reasonable levels…but company valuations will swing with a downturn in price and earnings.

Funny thing is, I have given ETFs some of the blame for the commodities boom…but I also think they are part of the solution. Many global markets are not s levered to the price of commodities, and ETFs are a low cost way to invest in global markets, without the risk of owning an individual security, or the cost of a global mutual fund. ScotiaMcLeod, and most other major firms, can provide a list of ETFs chosen to provide this diversification, and it is a real alternative to discuss with your advisor.

It is time for our second break…stay tuned to Beyond Funds Market Weekly…after the break, I will talk further about making a planned gift to charity as a part of your estate plan.

Last week, I shared the idea of leaving a legacy to a charity of your choice…this week, I found some further information, including an article from The Toronto Star, written last September, by Talbot Boggs…I thought I would share a couple of excerpts with you…Boggs notes “Each year, millions of Canadians donate money to their favourite charities and receive a tax credit for their philanthropic efforts.

By giving through their life insurance policies, however, they can
significantly increase the size of their donation and they can choose how they receive the tax benefit, either as a tax credit today or as a credit for their estate in the future. "Life insurance is one of several strategies that Canadians can use to maximize their charitable donations…

Statistics Canada figures show that Canadian individuals, corporations and foundations donated a total of about $11 billion to the more than 80,000 registered charitable organizations in 2005.

To receive a tax benefit, the money donated must be considered a gift by
the Canada Revenue Agency. Gifts include cash, gifts in kinds like stocks and real estate, or a right to a future payment, such as proceeds from a life insurance policy.

A donation may be a gift the charity can use now or a deferred gift that only is available in the future, usually through a life insurance policy after the donor's death. To be eligible for a tax benefit, donations must be made to authorized charitable organizations, public and private foundations that fund good works, registered amateur athletic associations, governments and government agencies in Canada, and some foreign charities and universities.
Life insurance is a cost-effective means that allows you to make a much larger contribution to your charity of choice than would otherwise be possible.”

Further in the article, Boggs notes “Life insurance is just one of several other charitable donation strategies. You also may donate securities, property, annuities, RRSPs and, of course, cash. A charitable donation will only qualify for a tax credit for up to 75 per cent of the net income of the donor during his or her lifetime or up to 100 per cent at the time of the donor's death. If the donation exceeds the limit, there is a carry forward provision for five years during the lifetime of the donor or a one-year carry back provision at the time of the donor's death for the estate.

Despite the tax advantages, most Canadians donate to charities for other "All studies show that the tax benefit is the last reason why people give to charities," says Marvi Ricker, vice-president and managing director of philanthropic services with BMO Financial Group.

"They donate because they want to give back to society, they are interested in the cause, or because they are very well off financially and want to do something to help other people," Ricker says. Most donations go to religious organizations, followed by social services agencies such as the United Way, educational institutions and health-care groups, Ricker says.”

Bogg’s article raises some good points, and I agree that most people who choose to use insurance to leave a legacy may not do it for tax reasons, but consider this…why would you leave your money to Federal and Provincial taxes, when you may benefit a cause that has meant something to you instead.

Insurance has typically been used to protect against the risk of future financial loss. However, more and more, innovative insurance solutions are being used to safeguard the value of investors’ assets in a tax efficient manner. The gift of life insurance can be effective in providing a practical and affordable way to make sizeable charitable gifts to your favourite charities or private foundation. Not only will life insurance help increase the size of your gift, in most cases it will provide significant tax benefits.

There are Four Ways to Leave a Legacy through Life Insurance

1. Transfer ownership of a paid-up policy to a charity. This is equivalent to an outright gift of cash in the amount of the policy’s cash surrender value. The charity can surrender the policy immediately or retain it until the insured individual dies and collect the death benefit then.

2. Transfer ownership of an existing policy in which the premiums are still being paid. A policy is gifted to a charity and the person receives charitable receipts for each subsequent premium. Tax savings are received during life from donating the policy itself and subsequent premiums. The charity will receive the death benefit but no further receipt will be issued.

3. Create a new policy and name the charity as owner and beneficiary. This is an effective way to donate to a charity you are currently supporting. You receive a tax
receipt for annual premiums but not for the death benefit.

4. Designate the charity as the beneficiary of a new or existing policy so that the charity will receive the life insurance proceeds at death.

This will not generate any tax credit during your lifetime however the amount of the death benefit will be paid out as if it was a bequest made in your Will. In the year of death, your estate will receive a charitable receipt for the face amount of death benefit that the charity receives.

For individuals who are committed to making a meaningful legacy, planning a charitable gift is part of a comprehensive philanthropic plan. The plan should be driven by your values to create the most lasting contribution in the future. Insurance solutions for charitable gifting include annuities, life insurance, and wealth replacement plans. Your advisor will help you to develop a charitable plan utilizing insurance solutions that are integrated into your financial plan and reflect your investment and legacy objectives, while minimizing taxes on your estate and for your beneficiaries.

I am a big believer in using life insurance as a way to minimize or eliminate estate taxes, while giving a significant benefit to charity. Over the next few months, I will host members of various local charitable groups, and give them the opportunity to tell their story, and share how planned gifts have helped their cause.

That brings us to the end of another segment of Beyond Funds Market Weekly…I am your host, ScotiaMcLeod Wealth Advisor Jeff Wareham. If you have a question or comment on any content from my show, call me at (519) 660-3260, or email me, at jeff_wareham@scotiacapital.com. Show content, and additional market ideas and commentary may be found on my blog, at www.beyondfunds.ca, or on the AM 980 web site. Thanks for tuning in!