Market Buzz

Market Buzz – U.S. Risk Free Credit Rating Receives Negative Outlook from S & P’s and March Inflation Surprises in Canada
Canada’s leading index closed the four day work week of April 21st at 13,975 points, up 266 points, or 1.9 per cent, since the start of the week.

The market opened the week in rough waters on Monday when debt ratings giant Standard & Poor’s announced that it had reduced its outlook on the U.S. government’s credit rating to negative. The credit rating of the United States has historically been considered the global community’s risk-free benchmark. Experts debate the actual ramifications that the outlook change may potentially have on the U.S. debt market and bond yields, but it is clear that the move by Standard & Poor’s was a simple ‘cause-effect’ response to the country’s increasingly deteriorating balance sheet and the lack of political will to improve it. Under the current plan, the government proposes to cut $4 trillion off the deficit over the next 12 years. That rather large number still seems somewhat of a pittance considering that the U.S. federal deficit is estimated to be in the range of $1.56 trillion for 2011 alone. Another 12 years of amassing debt can only further increase the risk perceived in holding U.S. government debt and further threaten its declining position as the world’s safe haven of fixed income. Higher risk only increases the interest rates that investors will demand, which puts further pressure on the federal deficit and struggling economy.

Fortunately for the world’s largest economy the weekly news was not all negative. Throughout the later portion of the week, U.S. companies reported first quarter earnings with a surprisingly large number of key large-cap names confirming beats of analyst estimates. Many have pointed to the solid quarter of corporate earnings as a clear sign that the U.S. economy is indeed in recovery. The positive news had the S&P500 up 34 points, or 2.6 per cent, since the start of the week.

In Canada, inflation numbers for March hit the market with overall-CPI rising 3.3 per cent, the largest year-over-year increase since September 2008. The Bank of Canada (BOC) uses its influence over short term rates to keep annual price inflation within a healthy band of 1 per cent to 3 per cent. The overall-CPI numbers were a surprise to most economists and have many forecasting that the BOC will start raising rates again sometime this summer. Although we agree that rates will have to start moving up soon, the strong performance in overall-CPI was feed primarily by energy and food inflation. These commodities are excluded from core-CPI, which is the measure BOC uses when determining monetary policy. Core-CPI was 1.7 per cent over the past year, which although within the target band, is a level that the BOC did not expect to see until the third quarter.

Looniversity – Why Wall Street “Sells” are So Rare

One of the main reasons there are so few sells is that it is not economical to follow a stock with a sell rating. Providing research coverage requires a large investment of time and money. In order to remain profitable and cover the cost of providing research, brokerage firms need to be able to make money on transactions made by customers trading the stock or get investment banking business. A stock that is going up has the potential to generate profit for researchers because investors may buy the stock many times and will need more information throughout the time they own the stock. The sad truth is, a sell rating results in just one trade and it can lead to a less favourable relationships between the firm and the public company, which could lead to less investment banking business (it is rare for a public company to raise money through a brokerage which has a sell rating on their stock).

Historically, it is a rare occurrence to find research initiated on a company with a sell or hold rating because the cost of initiating coverage is not justified by the potential revenue of that research coverage. Coverage is usually initiated and maintained on companies that have the potential to be long-term winners, thereby generating income for a longer period than it took the brokerage to initiate coverage. Of course, investors want to buy stocks that are expected to rise, sometimes several times, which generates fee income that (hopefully) more than offsets the brokerage’s cost of providing that research.

Put it to Us?

Q. What is the most important factor to consider when valuing a stock?

– Fran Wilkensen; Edmonton, Alberta

A. Without question, the current spot price of pork bellies. But seriously, there are a multitude of factors that can influence the price of a stock. Indeed, the multiple relationships that form between each factor conspire to complicate valuations even more. That aside, most experts would agree the most important factor is related to earnings.

We often think about stocks, or a stock, as something apart from business. But, when you invest in a stock, you invest in a business. In a very real sense, you become a business owner – and business is about products, profits, and customers.

As a business owner, you must pay attention to the fundamentals of running a business. What’s the inventory situation? How much capital is needed to run the business, and how much does that capital cost? The bottom line or corporate earnings are the bottom line. As such, they are the most important consideration.

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