December 26, 1999

North American stock markets in general have had a banner year. This is particularly so when measuring the popular indexes. The TSE 300 index at 8367, yearly high 8383, is up 29% on the year and trades at 39.8 times earnings to yield 1.32%. The Dow Jones Industrial Index at 11406, yearly high 11443, is up 24.2% and trades at 24.7 times earnings to yield 1.31%. The S&P 500 index at 1458, yearly high 1461, is up 18.6% on the year and trades at 33.1 p/e to yield 1.14% on cash dividends. The NASDAQ trading at its high of 3969 is up a whopping 81% as year-end approaches. However, stock markets have been selective, as these 4 indexes show, both in appreciation and in trading value. For example, one can compare the 33 multiple of the S&P 500 to the 25 times multiple of the T.Rowe Price New Horizon Small-Cap Fund. In actual fact, the market has been quite selective, favoring technology stocks and breadth has been poor to date. The S&P 500 index at current levels implies, from a mathematical point of view, that investors expect an average earnings growth rate of 15% a year over the next 10 years. This is a tall order considering that growth in earnings amounted to 6.2%/year over the last 50 years and profit growth is expected to be 5-7% over the next couple of years.

Interestingly, the Dow Jones and S&P indexes, while increasing in value, nevertheless trade at just about the same p/es as this time last year, implying that significant growth in earnings occurred combined with changes in the company component in the indexes. Yield is lower, suggesting that dividend pay-outs did not keep up with earnings. The TSE is now trading at a much loftier multiple and could signify less potential for further gain.

The bond market has not followed suit. US long-term bonds currently trading at a 6.49% yield are down 12.2% (including re-invested interest) over the year ago figure of 5.09% yield. Long Canadas trade at a 6.27% yield compared with 5.25% a year ago. US 2-year bonds trade at 6.26% vs. 4.66% last year. Canada 2-year bonds trade at 5.93% vs. 4.76% a year ago.

Commodity prices, as measured by the CRB futures index, stands at 205 up 7% from 191 a year ago. Gold at $287 is almost unchanged from the US$286 level of a year ago after having traded as low as $252 during the year compared with a 1998 low of $275.not much higher than its low of $275 in late August. Oil in recent weeks has been trading at about US$26 compared with $12 at this time last year.

The US economy has performed very strongly. US Gross Domestic Product rose at a 5.7% annual rate in the third quarter compared with a 1.9% rate in the 2ndQ and 3.7% in the 1stQ. So far in the 4th quarter, consumer spending rose 0.5% in November after a 0.7% rise in October. November spending was 7.6% higher than the same month last year, the biggest year-over-year gain in more than a decade. On the personal income side, wages, salaries, rent collections, interest and dividends grew 0.4% in November after surging 1.3% in October. All this means that US Gross Domestic Product will most likely grow at an annual rate of another 5.5% in the 4th quarter.

At first glance, inflation does not appear significant when looking at the more traditional components. Producer Price Index rose a moderate 0.2% in November compared with a 0.1% decline in October. So far this year wholesale prices have risen at an annual rate of 2.9% compared with no change for all of 1998. Consumer prices in November rose only 0.1%. However, retail sales in November were up a surprisingly high 0.9%. During the month of November, average hourly wages rose 0.1% and the unemployment rate held at a 29-year low of 4.1%. The economy added 234,000 jobs in November, less than the 263,000 in October, but nevertheless an impressive 2.4 million jobs in the 11 months this year. US housing starts in November fell 2.3% to a seasonally adjusted 1.60 million. Higher mortgage interest rates have capped the housing sector since building hit a 12-year peak of 1.82 million starts in January.

On the negative side, The US trade deficit fueled by strong consumer demand reached a record $25.9 billion in October, a 7.4% increase from $24.1 billion in September. This means that in the first 10 months the US trade deficit has reached $262 billion, far ahead of the record deficit of $164 billion for all of 1998. Another worrisome factor is what could turn out to be an unusually steep rise in the money supply in January 2000 caused by cash demands related to Y2K concerns. The so-called M3 supply in November grew by about 18% on an annual basis compared with 5.7% for the first 6 months of the year.

The gains in wealth from rising stock markets is enormous and over the last 2 years are equivalent to about 45% of disposable income. There is discussion taking place in some circles that the Federal Reserve should be looking at not only the traditional measures of inflation such as employment, wages, consumer and producer price indexes but also changes in real and financial assets. One recent study indicates that such a Broad Price Index is currently running at a rate higher than the Fed Funds rate, i.e. 6% and rising vs. 5.5%. If this is the case, it implies that the Fed.s monetary policy is presently too accommodative.

The policy-setting Federal Open Market Committee raised the overnight bank lending rate a quarter-point three times since June, to 5.5% and the feeling is it will increase the rate by at least another quarter-point at the next FOMC meetings Feb 1-2, 2000.

The US dollar on December 23 traded at101.33 yen near the 4 year low of 101.25 reached on November 26. The dollar is down 18% since early July. International investors are buying Japanese stocks; the Nikkei 225 has risen 35% this year. With continued interest early in the new year, this buying could knock the dollar down to the 100-yen level at which time the Bank of Japan may intervene. So far the US$ has been strong against the euro, up close to 15%, but with the European economy looking stronger global investing into European stocks may very well weaken the dollar. Both of these factors may produce additional US trade deficits.

Gold: The announcement in early December that the Dutch Central Bank will sell 300 tonnes of gold over the next 5 years knocked gold prices down to $US276/ounce. However, this selling will be in conjunction with the recent Washington Agreement of European Central Banks limiting annual gold sales at 400 tonnes a year for the next 5 years. Gold supply is expected to decline 5 to 10% from the 1998 level of 4,123 tonnes to an estimated 3,800 tonnes in 2000. This means that supply and demand should continue to balance out evenly. A rise in price to US$325 level in 2000 can be expected.

The fact that the Federal Reserve will most likely not consider a hike in interest rates before Feb 1, 2000 means that we may see a continuation in a strong North American stock market over the next month or two. However, there is no question that the Fed will allow the economy to continue to grow at a 5.5-5.7% rate. A 10 to 15% drop in equity prices combined with a 50 basis point rate hike should be enough to cool demand. As the stock market was selective on its way up, it will be equally selective on its way down. Although technological advances in IT, transmission, internet, etc. are most exciting, many stocks in such domains are trading at unrealistically high levels and are way ahead of themselves. At the same time many stocks of well managed companies are lagging behind. A great deal of equity transactions is paper shuffles as evidenced by rapid run-ups of stocks following an IPO. Day trading continues to be an abuse that cannot have many lifelines left. Bonds trading at a 6.5% yield also look attractive if inflation is kept in check. Current yields of 6.41% for US 10-year treasury notes yield 472 basis points more than the 1.69% yield on most current 10-year Japanese bonds and 118 basis points more than the 5.23 % yield on 10-year German bonds.

The current edition of LATEST PICKS will look at some overlooked growth stocks, some out of favor, some high yielding common shares and even look at an example of a company whose stock may be trading ahead of itself.