Opportunity Knocks – Part 1

Part 1: Forecast calls for clearing skies


As some of you may have noticed, our outlook in the 2011 year-end commentaries shifted from caution to forward looking optimism. So far this year, indicators have been promising with the markets (especially south of the border) providing consistent returns and the US economy surprising with a string of positive numbers. In our opinion, this rally is the beginning of a longer-term resurgence of the US markets; a market that has underperformed for over a decade. Although we cannot predict the future and the past is simply a potential indicator of future outcomes, we are starting to see signs that the next decade may prove favourable for equity investors.

Following Bernanke’s solemn March 26th comments to a group of investors in Virginia, speculation re-emerged about the potential for QE3. However, individuals are overlooking the the fact that we are already under the influence of another quantitative easing program. The three year Long-Term Refinancing Operation was announced by the European Central Bank at the end of 2011. LTRO directly addressed the funding problem and liquidity crisis in the European banking system; which nullified the risk of a near-term systemic banking crisis. For those who have been wondering where the stabilization in the markets came from at the beginning of the year, much of it can be attributed to this stimulus plan. The following chart illustrates how confidence increased amongst banks following the LTRO announcement. Interest rate swaps decreased dramatically in January and have continued to fall.

Interest Rate Swaps. Source: Bloomberg

Another derivative of LTRO was that it shifted investors’ focus. It allowed investors to take their eyes off of Europe and direct attention toward the quietly improving situation in the United States. This has been one of the strong drivers of the steady returns so far in 2012. With the US economy thawing and the immediate risk of a European collapse low, investors are willing to pay for future growth. Incidentally, future growth is something the market has been grossly discounting over the last decade. The market has a long ways to go before it even accounts for any growth.


When considering recent returns in the market one needs to put into context how poor long term returns have been, specifically over the last 15 years. It has been said that short-only strategies are a losing equation due to the fact that equity markets inevitably trend upwards alongside human evolution. Throughout time, equities have typically proven to deliver a premium over a government secured bond to compensate for the additional risk of ownership. However, as pointed out in a recent piece by Goldman Sachs, over the last decade annualized excess returns in equities compared to government bonds have been the most negative as in any period over the last 100 years (including the great depression).


What is most evident in the above chart, is the extended periods of strong excess returns following a prolonged under-performance of equities.

A major depressant to US productivity has been the lingering effects of the US housing market crash. The weight of this problem has factored heavily into the unemployment condition. Slowly but surely, however, US housing is rising from the ashes. The following chart shows the extreme contraction of US Housing Starts beginning in 2006 and the bottoming process that began two and a half years ago.


We’ve finally seen some job creation in the United States. The stabilization of jobs will feed directly into the housing rebound. High vacancy rates, due to foreclosures, won’t necessarily be an impediment towards new housing starts. Foreclosed homes are clustered in specific regions and not highly desirable substitutes for new home buyers. You have likely heard talk about the “shadow inventory” of home foreclosures which will hangover the housing market for years to come. What is commonly not mentioned however is the level of pent-up demand to purchase a new home. The demand stems from an ever increasing population (including immigration), young families, young professionals and renters now in a position to own who have all been on the sidelines for up to six years amidst a declining market. Combine with this demand a record low supply of new houses and you have a dynamic for absorbing the “shadow inventory” faster than most people expect. Furthermore, a little known fact is that approximately 300,000 homes are taken out of the supply inventory every year due to natural disasters and the like. The chart below illustrates the current abnormal supply/demand imbalance:

Source: Commerce Dept., New York Times

To compliment the supply/demand situation, affordability is at an all-time high with record low mortgage rates, cheap pricing and household incomes that are on the rebound. How are we approaching this opportunity? In addition to the general housing exposure we get to through an improving US economy, the Vertex Fund and the Vertex Growth Fund have a position in US mortgage insurers. As well, our two Value Funds have substantial exposure to forestry companies.

In part two, we will discuss the bullish signs for forestry, P&C insurance, high-yield, M&A and the US dollar.

until next time. . .
@The Vertex Team

For information on this update or the funds we offer, please contact a regional VP of sales:

Noel Dattrino
(Western Canada)

Michael Lindblad
(GTA & Eastern Ontario)

James Wilson
(GTA & Western Ontario, Maritime Canada)