2006 Investment Outlook

Margaret M. Samuel, CFA, Chief Investment Officer and Portfolio Manager, Quadrexx Asset Management Inc., and Director, The Empire Club of Canada; W. David Wilson, Chair, Ontario Securities Commission; Thomas S. Caldwell, CM, Chairman, Caldwell Securities Ltd.; Reverend Bruce Smith, King-Bay Chaplain, King-Bay Chaplaincy; Jay Smith, First Vice-President and Investment Advisor, CIBC Wood Gundy; Robert L. Brooks, Senior Executive Vice-President and Group Treasurer, The Bank of Nova Scotia, and Past President, The Empire Club of Canada; Richard W. Nesbitt, CEO, TSX Group; Jim C. Kelly, Managing Director, Canadian Liquid Product Sales, RBC Capital Markets; William F. White, President, IBK Capital Corp., and Director, The Empire Club of Canada; Eugene McBurney, Chairman, GMP Capital Corp.; Morley W. Salmon, Chairman, Limited Market Dealers Association of Canada; Christina A. Cavanagh, Executive Director, Toronto CFA Society; Nick Barisheff, Founder and President, Bullion Marketing Services Inc.; Joseph J. Oliver, President and CEO, Investment Dealers Association of Canada; Bruce Shaw, Managing Director, Institutional Equities, TD Newcrest; and David Fleck, EMD Capital Markets and Head of Equity Products, BMO Nesbitt Burns Inc.

Introduction by William Whittaker

We gather today to learn if the bulls or bears will be rampaging through our markets in 2006. A popular urban legend says we should look to the Super Bowl for the answer as a seemingly startling correlation appears to exist between who wins the Super Bowl and how the market will perform in the upcoming year. According to the "Super Bowl Indicator," a triumphant team from the old American Football League (now the American Football Conference) foreshadows a down market but a winner from the old NFL (now the National Football Conference) means dust off your red cape as the bulls are coming.

Believe it or not, the Super Bowl Indicator has been on the money 30 out of 38 times which by my math represents a success rate of more than 80 per cent.

An alternative theory linking the Super Bowl to stock market performance in reverse fashion postulates that Wall Street’s results can be used to predict the outcome of the game. According to this theory, if the Dow rises from the end of November until Super Bowl day, the team whose full name appears later in the alphabet will win. So don’t bet on the Indianapolis Colts this year.

Thankfully, we don’t have to rely on the Super Bowl results to predict this year’s market as our three speakers today will do that for us, hopefully with more accuracy!

I will introduce each speaker separately. He will speak for 10 minutes or so on his particular topic.

Our first speaker is Tony Fell, Chair of RBC Capital Markets. After joining Dominion Securities in 1959, Mr. Fell was appointed to various senior executive positions, including President in 1973, President and Chief Executive Officer in 1980 and Chairman and Chief Executive Officer of RBC Dominion Securities in 1992 following its 1988 acquisition by the Royal Bank of Canada. Mr. Fell has served on numerous community and industry organizations including the Toronto Stock Exchange as Governor and the Investment Dealers Association of Canada as Chairman. He is currently a director of BCE Inc., Loblaw Companies Limited, CAE Inc. and Chairman of the Munich Re Group. He is also past Chair of the Board of Trustees of the University Health Network and was awarded the Order of Canada in 2001.

Mr. Fell.

Anthony Fell

Good afternoon ladies and gentlemen. It’s a pleasure to be here to share some views on the investment outlook.

As time is short I am going to focus on two market segments: the outlook for commodity prices in general and secondly gold prices.

At the outset I should say that my focus is on the longer term, five years to a decade or more. A long view is essential in commodities because an analysis of the past century or more clearly illustrates commodity prices, both up and down, move in cycles averaging perhaps 15 to 20 years.

There is now a debate as to whether the upswing in commodity prices which started four or five years ago is a cyclical upturn now cresting with prices destined to decline, or just the first phase of a long-term secular uptrend.

A 15-year bull market in commodities, which saw the CRB Commodity Index more than triple, terminated abruptly in 1980.

This was followed by a vicious 20-year bear market from 1980 to about the year 2001, during which the CRB Index declined by half and far more than that in real terms.

This brutal bear market terminated in or around the year 2001 and in the most recent four years the CRB Index has risen by about 85 per cent–just slightly surpassing its previous all-time high in 1980.

It is my view that a new secular bull market in commodities commenced in 2001 and we are now four years into a rising commodity market which will last another decade and probably longer.

Having said that, no market goes in a straight line.

After very strong gains over the past four years, we may well see some consolidation in commodity prices or a modest pull back in 2006 before entering the second stage of the long-term secular uptrend which I believe will carry prices to much higher levels.

My positive view is based on several fundamentals.

First, for the past 25 years we have had massive under-investment in all commodity areas including energy, and the broad cross section of metals–primarily due to low prices. Exploration programs were drastically reduced while many mines, smelters and refineries were shut down for both economic and environmental reasons.

So for more than two decades we have had reduced exploration, capacity closures and rising demand. Is it any wonder that major shortages, especially in energy and metals, are now looming?

The second factor is the lead-time required to bring on new capacity.

Developing natural resources isn’t like the manufacturing business where you build a new plant, which will come on stream in a year or two.

First, you’ve got to discover a mine or an oil and gas field, then you have to get it permitted, develop it, build smelters or refineries and perhaps port facilities or long pipelines through remote areas. All of this can take up to 10 years.

Demands from aboriginal groups and environmental interests can add years to projects or stop them altogether.

Alaska’s North Slope oil was discovered in 1968 and took nine years to get to market.

Oil was discovered in the North Sea in 1969 and finally got to market in 1977.

The Voisey Bay nickel mine in Labrador was discovered in 1993 and just came on stream last year.

Many experts believe uranium holds the answer to some of our energy concerns but the earliest a new nuclear plant could be on stream in the United States is at least 10 years out.

Third, for most natural resource companies, reserve replacement has become increasingly difficult. How many new mines or oil fields are there?

Most certainly, all have not been discovered but if you talk to the major mining companies large-scale new deposits are incredibly rare. For example, there hasn’t been a new lead mine brought on stream anywhere in the world for more than 25 years and a number have been closed.

Is it any wonder the price of lead has more than doubled in the past few years? For much the same reason the price of nickel and copper has tripled and uranium has quadrupled.

With each year that goes by, oil and gas companies around the world are having increasing difficulty replacing reserves as production rates rise and oil fields deplete.

Ultimately reserve replacement in many commodities, especially oil and gold, will become an insurmountable problem.

Fourth, the cost of major new natural resource projects is escalating dramatically as companies must access more remote regions. Massive cost overruns on natural resource projects around the globe are the order of the day.

Fifth, not withstanding looming energy shortages, efforts and commitment to conservation, especially in North America, are pathetically weak–almost non-existent.

Sixth, growth in Asia. Compared to previous commodity cycles over the past 100 years this is the big new kid on the block.

I’m not going to comment on this because the impact of growth in Asia on commodity markets has been massively covered by numerous experts.

Suffice to say, the underlying uptrend of commodity consumption in Asia is clear, it’s strong, it’s long-term and it’s not going to go away.

Finally, commodities are gradually emerging as a viable and acceptable alternative asset class for major institutional investors, especially pension funds around the world, a number of which have already started to invest in commodities.

I believe institutional investors will increasingly look on commodities as a separate asset class, just like they do real estate or private equity.

It is estimated that global pension fund assets now amount to approximately $15 trillion so a 3-per-cent exposure to commodities would amount to $450 billion.

When you cut through it all, the case for rising commodity prices over the coming decade is quite simple and in my view crystal clear:

Supplies on a global basis are finite and dwindling;
Reserve replacement in virtually all commodities has become a major issue;
Lead times and development costs are rising dramatically;
Consumption is rising; and
There will be increasing institutional investment.

We have here the ingredients for a continuation of the secular bull market in commodity prices over the coming decade.

Gold Prices

Notwithstanding volatility, I believe the price of gold and gold shares are going higher, probably much higher, over the coming several years.

Sometimes the best investment opportunities are so simple–so obvious–that the markets miss them completely. That’s where oil was six years ago at $12 a barrel.

In the 1970s the price of gold went up 2,000 per cent. Most investors didn’t see it coming.

I am positive on gold for the following reasons.

First: There has not been a major new gold discovery in the past four or five years and we will probably see peak global gold production in 2008. In the meantime I anticipate accelerating demand.

Second: Gold is one-part commodity and three-parts currency. It was J.P. Morgan who said in 1913, "Gold is money and nothing more."

Bear in mind when we talk about a strong dollar or a strong euro or yen we are really talking about the best of a bad lot. Central bankers notwithstanding, gold is the ultimate standard against which all fiat paper currencies are measured.

In the currency world, the U.S. dollar and the euro are becoming increasingly suspect. In the U.S. an ongoing trade deficit of three-quarters of a trillion dollars is off the charts and fiscal responsibility in America is a distant memory. In Europe, the new constitution was rejected and the ECB’s one-size-fits-all monetary policy is proving highly devisive between countries.

In this environment gold bullion is gaining renewed credibility as a global currency and reserve asset. Over the past year, gold is up 21 per cent in dollar terms and 36 per cent against the euro and the yen. Over the past five years we have seen a major breakout of gold prices against virtually all currencies.

Third: How long will Asian central banks finance the U.S. trade deficit?

At last report nine Asian central banks held almost $3 trillion of foreign exchange reserves, almost all U.S. dollars. That’s up about $400 billion over the past year.

Will Asian central banks increase their U.S. dollar holdings to four trillion or five trillion? I think not. My view is that Asian central banks are becoming uncomfortable and will be looking to diversify their reserve assets and gold will be on the shopping list.

Fourth: Central bank selling of gold used to be a concern to the market but no longer.

Central bank sales are diminishing and some central banks have stated their intention to increase their gold reserves. Central banks currently hold only a billion ounces valued at approximately $500 billion which is now just a rounding error in the overall scheme of things.

Fifth: Notwithstanding recent market action there is widespread investor skepticism of gold and gold shares, which is very positive.

A sixth reason I am positive on the outlook for gold is I believe over the past decade there has been a substantial increase in systemic risk in the global financial system which has benefited greatly from an extended period of incredibly low interest rates, easy credit and massive increases in global liquidity.

Emerging market and high-yield debt credit spreads are near all-time low levels and bank loan losses are minimal. Investors are reaching for yield and not being paid for risk.

Global imbalances in international trade and foreign exchange reserves are now so massive and have been going on for so long that they are accepted as normal–which they aren’t.

Financial markets are now in a euphoric state with an overriding view that central bankers are in firm control and that we will never again have a really serious recession or a global financial crisis such as a run on the U.S. dollar.

Well, I don’t believe it. Long periods of extremely low interest rates, high credit creation and massive liquidity often have an unhappy ending and the record shows that gold bullion represents an effective hedge and a solid store of value in times of economic and financial distress.

Finally, it is estimated total historical cumulative gold production amounts to five billion ounces. With annual gold production now running at only 76 million ounces, the total gold stock is increasing at the rate of only 1 1/2 per cent per year.

At the same time, governments around the world are increasing the money supply and creating credit at a rate of two or three times that and ultimately this simple fact will manifest itself in much higher gold prices.

Quality investment opportunities with real potential for major gains over several years don’t come along very often and my advice is to be overweight in both gold bullion and gold shares.

Fortuitously, it is now much easier for investors to buy gold bullion. You no longer have to open a commodity or futures account. All you have to do is to buy the StreetTracks gold ETF listed on the New York Stock Exchange by stock symbol GLD.

Each share represents 1/10 of an ounce of gold safely tucked away in the vaults of the Hong Kong Shanghai Bank.

This investment vehicle has only been on the market for about a year but already the trust holds 8.5 million ounces valued at $4.5 billion which, as a matter of interest, is more than 10 per cent of global annual gold production.

In closing, I wish the Empire Club of Canada every continued success. The club has provided a valuable forum for discussion of the major topics of the day for more than 100 years.

I also wish everyone here today a great New Year and every success in your future investment programs and strategies.

Introduction by William Whittaker

Our next speaker is David Rosenberg, Merrill Lynch’s Chief Economist for North America, who is responsible for formulating and communicating North American economic, interest-rate and earnings outlooks to Merrill Lynch clients.

Mr. Rosenberg joined Merrill Lynch in May 2000 as the Canadian Chief Economist and Strategist. He began his investment career in 1983 at the Bank of Canada as an economist. Prior to joining Merrill Lynch, Mr. Rosenberg was a senior economist at Nesbitt Burns and at the Bank of Nova Scotia.

Mr. Rosenberg.

David Rosenberg

Thank you. It’s an honour to be here at the Empire Club today to deliver the macro and market message as we see it at Merrill Lynch, and it’s a pleasure to be back home.

It’s been exactly three years since I left Toronto for New York and I find that when I come back, the two questions I get asked the most is what my biggest regret has been, and what my greatest achievement has been. Well, the greatest regret, without a shadow of a doubt, was moving onto the U.S. payroll with the Canadian dollar at 62 cents. I often get accused of having stuck to my deflation theme far too long, but so would you if you had made a similar move. As for the greatest achievement, I’d have to say, its having replaced Steven Roach as the most pessimistic economist on Wall Street.

Maybe pessimistic is too strong a word–I prefer cautious or better yet contrarian. And I think in the forecasting business, to be successful you have to have a bit of a contrarian streak because if you never wager against the consensus, you’re going to have trouble beating the market, and in this business, you only have to be right 55 per cent or 60 per cent of the time to be successful.

So getting to the fearless forecast, I think the consensus on the U.S. economy for 2006, which is 3.4-per-cent real GDP growth, is highly optimistic. Basically, the consensus is telling you that for the first time ever, a 200-basis-point tightening by the Fed, coupled with a 130-basis-point flattening of the yield curve, is not going to put a single dent in the economy the following year. I’m not really into predicting unprecedented events, and we have several models of the U.S. economy that all point in the direction of around 2 1/2-per-cent growth–hardly a disaster, and I actually think recession risks are quite low for this year, no higher than 20 per cent. But those risks rise for 2007 the more the Fed feels compelled to do in the next few months, given the lags that are involved. This is really a classic "soft landing" scenario, not that much different from the growth rates we had endured in 2003, 1995 and 1986–all years, by the way, that saw the Fed ultimately forced to cut rates. Be that as it may, if we are right, then the growth bulls, inflation mongers and bond bears are probably the ones that are going to be the most disappointed.

In terms of areas of the economy that we think are going to outperform this year, I would point to capex, exports and commercial construction as relative bright spots. Large-cap export-oriented industrials tend to have large foreign sales exposure, and since we’re bearish on the U.S. dollar, this is going to translate into good earnings news for the capital goods group. The laggards will be consumer spending, especially on cyclically sensitive items, and housing, where the helium is already starting to come out of the balloon. In fact, the U.S. housing boom, both directly and indirectly, has permeated the economic landscape to such an extent that even a flattening in home prices, and the negative effect that would have over mortgage equity withdrawal and household cash flow, would alone drain more than a full percentage point out of consumer spending growth. So as far as I’m concerned, the single biggest risk to the outlook is what happens to home prices, and while the mania wasn’t national in scope, it engulfed about 60 per cent of the U.S. by our estimates. I’m not predicting a collapse, but even a slowing in home prices is going to have its repercussions on the U.S. consumer.

Now from a "big picture" top-down perspective, when the economy slows to 2 1/2 per cent when potential GDP growth is closer to say 3 1/4 per cent to 3 1/2 per cent, you build up extra slack in the economy. So as we saw in 1995, the unemployment rate drifts a bit higher to 5.3 per cent from 5 per cent, inflation and inflation expectations recede, and in the coming year I expect to see both total and core consumer inflation plunging and converging near 1 1/2 per cent, and as part of that forecast we have built in a $55/barrel oil price assumption.

So that inflation landscape, along with real growth of 2 1/2 per cent, means we stand a very good chance of re-testing 4 per cent on the U.S. 10-year note, and as I said earlier, there has never been a soft landing that did not involve a couple of Fed easings. And while it’s not evident to the naked eye today, I think the economy will be soft enough to give Mr. Bernanke the leeway to embark on an easing cycle in the second half of the year and re-steepen what is an unsustainably flat yield curve today. All you have to know is that soft landings are fertile soil for Treasuries, and that’s true whether or not yields are at 6 per cent, 5 per cent or 4 per cent. So we remain steadfast bond bulls.

Now I don’t call the stock market any more. We have Rich Bernstein who is our chief strategist making that call in the U.S. and David Wolf here in Toronto making the call in Canada. Rich is forecasting 1,260 on the S&P 500 in the next 12 months so another flattish year. We like dividend growth and yield plays, defensive areas like staples, health care, utilities and telecom services, large cap over small cap and a continued focus on quality. Mr. Wolf sees 11,700 on the TSX, so another year of relative out-performance and roughly a 6-per-cent total return, and again underpinned by our overexposure to resource stocks, especially the metals.

Now I want to make this point and make it emphatically. I obviously do not have the rosiest of scenarios for the U.S. consumer. The combination of the lagged impact of the Fed rate hikes, the end of the housing boom and the steps that the regulators from the Office of the Comptroller of the Currency to the FDIC to the Office of Savings and Thrift are taking to curb the credit cycle are going to seriously test the "resilience" of the U.S. consumer. But don’t mistake that with the other 80 per cent of the global economy, which I expect will continue to perform reasonably well. I just got back from Asia and there is a real buzz there. There is still no sign of anything but a boom in China and any country that can magically find $285 billion of missing GDP as it did last week is obviously a formidable force. That was like discovering that the entire Swiss economy was hiding in Guangdong province!

Japan’s recovery is the real deal. This is the first time in 15 years that we have a pickup in domestic demand that’s not hinging exclusively on government building of bridges and paving of river beds that nobody needs. The most impressive aspect of Japan’s recent move to positive growth, beyond the fact that golf membership fees and land prices are going back up, is that bank lending is growing again. What was a defunct credit creation system for more than a decade has turned around visibly and that is vital for the sustainability of Japan’s revival. And let’s keep in mind that Japan, with an 11-per-cent share of global GDP, is still the second-biggest economy in the world and a big importer of commodities.

If Japan was the surprise of 2005, Germany, the world’s third-largest economy, is probably going to be the surprise of 2006 and we’re seeing early signs of that already. In fact, it’s not widely known that the VAT tax in Germany is going to go up three percentage points in 2007, which means we’re going to likely have a pre-VAT spending spree there in the second half of the year. This is all relevant to Canada because while our economy is sensitive to the U.S. with 80 per cent of our exports heading south of the border, the Canadian equity market is much more sensitive to the global economy, as we saw during the Asian crisis of the late ’90s.

When we do the country-by-country bean count, it looks like global GDP growth in real terms will only slow fractionally this year to 3 per cent from 3.3 per cent, and that is a demand pace good enough to provide lingering support for the commodity markets in general. Now you take what is going to be a sustained positive income shock to Canada from the commodity bull market, more tax cuts coming, and a Bank of Canada that is now playing catch-up to the Fed, and it’s very difficult to be anything but positive on the Canadian dollar outlook; and it’s no longer glib to say that we’ll hit par in the next few years.

Whether or not I’ll be able to switch back to the Canadian payroll between now and then is a different story. Thanks for your time, today. Happy New Year and happy trading.

Introduction by William Whittaker

Our final speaker is Miklos Nagy, President, Founder and CEO of Quadrexx Asset Management Inc. Mr. Nagy is also Chairman, Co-founder and CEO of Canadian Hedge Watch Inc., a Toronto-based publishing and educational firm focusing on the Canadian hedge fund industry.

Mr. Nagy is a leading authority on alternative investments and hedge funds in Canada. He is a co-author of Canada’s first hedge fund book "Hedge Funds for Canadians," one of the best selling financial books in 2004 and of the course material for the new Chartered Alternative Investment Planner designation.

Mr. Nagy is a founding board member of the Canadian Institute of Financial Planners, a member of the CFA Institute, the Toronto CFA Society and a founding member of the CFA Society of Budapest, Hungary.

Mr. Nagy.

Miklos Nagy

Mr. President, distinguished guests and members of the Empire Club of Canada, it’s an honour for me to speak to you today and I’d like to begin by sharing a joke with you.

Three of the world’s most successful and renowned money managers are travelling on the same private jet en route to an international monetary conference. Tragically, the jet develops engine trouble, loses altitude, and goes down over the Bermuda Triangle. There are no survivors.

In an instant, the three world-class money managers are standing before God’s throne. There, at the gates of heaven, are Peter Lynch, the market-beater who made Fidelity Magellan a household name; Sir John Templeton, the legendary founder of the Templeton funds; and George Soros, the most daring and successful hedge fund manager of them all.

God addresses them and says, "I’m going to ask each of you just one question. How you answer will determine where you spend eternity."

Turning first to Peter Lynch he asks, "Peter, what do you believe in?"

Awestruck, Peter Lynch stammers, "Well… I’d have to say that I believe growth stocks should be a big part of every investor’s portfolio."

"That’s good, my son," says God. "Come and sit here at my right hand."

Now God turns to Sir John and repeats, "What do you believe?"

Templeton reflects a moment and then answers, "If truth be told, I believe above all in diversifying into international and emerging markets."

"Wonderful, my son," God beams. "Come sit at my left hand."

"And you, George," booms the voice of God, "what do you believe?"

And without a second’s hesitation, Soros replies, "I believe that you are sitting in my chair!"

Joking aside, today I’d like to speak to you about hedge funds, their status over the past year and their prospects in Canada in this New Year, 2006. Now the term "hedge fund" has become rather a dirty word lately, particularly in Canada. In fact you might say that hedge funds have recently appealed only to reporters and politicians because they’ve been newsworthy, easy to blame and fascinating.

As of the end of 2005 the total assets under management in hedge funds worldwide is estimated to have been around US$1.2 trillion and, given that most hedge funds use some leverage, the total investment by hedge funds could actually be as much as twice that. This compares to about US$16 trillion invested in mutual funds. A mere 15 years ago in 1990, the total assets in hedge funds were about US$67 billion. What has caused this astonishing 21-per-cent-plus annualized rate of growth in hedge funds?

The answer is simple: their equally astonishing performance as measured by both return and risk. Between 1988 and the end of 2005 hedge funds on average delivered about 25-per-cent higher returns per year than the S&P500 with 40-per-cent less risk. Looking at the more recent and rocky past five years, as at the end of November 2005, hedge funds overall had averaged an 8-per-cent rate of return with 5-per-cent risk, (as measured by annualized standard deviation) while the S&P500 had an almost flat rate of return of 0.6 per cent coupled with about 15-per-cent volatility in the same period. Even though some research suggests that hedge fund returns may be somewhat overstated due to "non-reporting" bias, it is generally accepted that the risk-return profile of hedge funds is significantly better than that of the S&P500 and even more so when compared to long-only equity mutual funds (which also have survivorship bias).

The various global hedge fund indices that are tracked by a number of respectable organizations generally show significantly higher returns and–more importantly–lower risk, for hedge funds overall compared to any major equity index regardless of the time frame and/or geographical location. The degree of difference in favour of hedge fund risk and return and the amount and robustness of the data leave no doubt that this is not an aberration and that the stats can no longer be ignored.

What is it about hedge funds that produces these results? As far as the higher returns go it is simply their relative freedom from the constraints to which mutual funds are subject. The basic idea introduced about 60 years ago by Winslow Jones gives hedge funds three significant advantages: first the ability to invest a portion or even all the portfolio in short positions, second the use of leverage and third more concentrated positions.

Most important of these is the ability to invest in shorts as it provides a cushion and allows hedge funds to lessen the blows that equity markets inevitably suffer from time to time.

Some hedge funds have made spectacular returns and a few have suffered spectacular losses so, as with any investment, allocations to hedge funds need to be diversified. Don’t put too much in any one hedge fund.

In the press it’s been open season on hedge funds recently with alarming headlines announcing big losses, but those funds are very much in the minority. In fact, there are just two causes for higher than normal losses: bad management and fraud, and we know very well that hedge funds are not the only vehicles for fraud in the investment world. Human inventiveness is unlimited and while we should try to make fraud harder to commit we will never be able to eliminate it.

On the other hand, losses stemming from bad calls will occur sometimes because it is impossible to make spectacular gains without the corollary of occasional higher than normal losses. I strongly believe that if regulators increase hedge fund supervision too much in their effort to significantly reduce the extravagant losses that occur only infrequently, they will also suppress the healthy gains in this sector and eliminate most or all of the advantages offered by hedge funds