Although the stock
market remains extremely volatile, common share prices have
been quietly trending upward over the past 12 months.
Surprisingly, market indices have continued to climb a
formidable wall of worry including weakening North American
economic activity, fluctuating currencies and commodity
prices, festering Iraq/Iran/Mid-East turmoil, etc. and have
ascended to new cycle highs. At the same time equity markets
have welcomed numerous share buybacks, mergers, acquisitions
and leveraged buyouts. Overall, these events lead to the
inevitable question: how does one explain this dichotomy?
In our view the
explanation to this elongated economic cycle, rising stock
prices and growing number of corporate takeovers relates
primarily to one factor: interest rates. The present low
cost of capital at 4% to 6% largely explains, in our
opinion, the stock market’s enduring vitality and the
penchant for investors, corporations, private equity and
hedge funds to aggressively finance equity purchases,
privatizations and corporate takeovers. In actuality,
interest rates are a vital ingredient to a healthy economy
and a vigorous stock market; they remain an important cost
of doing business.
In simple terms,
interest rates, today, are relatively low and there is
excessive liquidity in the economic system. This financial
environment largely explains the ongoing market resilience
and the constant flow of corporate takeovers such as Inco,
Falconbridge, Sleemans, etc. Furthermore, the resulting
reduced supply of Canadian investment-grade securities has
also provided a natural buffer to any price weakness. It is
a simple question of demand and supply: increasing demand
for Canadian common stocks combined with a decreasing supply
of available equities. In fact, with the freshly proposed
Xstrata takeover of LionOre Mining of over $4.6 billion
Canadian and a rumoured buyout of BCE, these two financial
developments could further heighten the surging demand for
Canadian equities as these funds are recycled.
Interestingly, with the first quarter 2007 U.S. GNP growth
rate running at a non-threatening +2.5% this should ease the
considerable concern of an economic recession and, at the
same time, U.S. Federal Reserve tightening.
Overall, it is our
view that as long as corporate earnings remain respectable,
interest rates continue stable at the 4%-6% level and there
are no unforeseen major negatives relating to currency,
politics or an international economic event, we expect to
retain our positive investment outlook to at least the end
of 2007.
Irwin A. Michael, CFA
