Yield Curve, Beta and Growth

Posted by Ryan Irvine - Keystone Financial

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Market Buzz –  Strong Q1 Growth as Simple as “ABC”

In what proved to be one of the worst months in the past 14 months, the S&P/TSX composite index closed out the month on Friday down 77.68 points to 11,671. Despite what turned out to be a negative close this Friday, the S&P TSX Composite Index stemmed, if only momentarily, the 6.5 per cent sharp drop we had witnessed since May 12.

Toronto’s main index ended the week up 1.3 per cent following a string of volatile sessions. North American indexes are down sharply from the 2010 highs at beginning of the month. The financial media will tell you the market’s May swoon is mainly due to worries about Europe’s debt crisis. But a large part of the drop was overdue based on the entirely overly optimistic outlook broader market gains had baked into valuations.

Again, the market had recovered 60 per cent from its March lows in a one year span and a pause was necessary. As May draws to a close, the Toronto market’s main index is 5 per cent from its 2010 highs (posted April 26), while the Dow Jones industrials average has fallen almost 10 per cent – it should not be shocking.

This past week saw Asia Bio-Chem Group Corp. (ABC:TSX-V) report a solid set of Q1 2010 numbers. The company, a solid gainer from our Canadian Small-Cap Coverage Universe (www.keystocks.com ), is a China-based manufacturer of cornstarch and related by-products including: corn germ, gluten, and fiber for the Chinese domestic market.

Revenues for the quarter ended March 31, 2010, jumped 109.8 per cent to $39.9 million from $19.03 million in the same period of the prior year. Net income for the quarter was $2.1 million, or $0.028 per share, compared to net loss of $0.8 million for the corresponding period of 2009, an increase of $2.9 million.

Looking ahead to next week, thirty-two of 40 forecasters polled by Reuters expect the Bank of Canada to raise rates by 25 basis points (on June 1, 2010) to 0.50 percent. Canada’s 12 primary securities dealers were unanimous in that view. Eight of the 40 saw rates staying on hold next week.

Yields on overnight index swaps, which trade based on expectations for the key central bank rate, suggested investors see a 77 per cent chance the policy rate will rise to around 0.50 percent on June 1.

An expectation that the bank will hike rates on June 1 is already helping boost the Canadian dollar, which climbed to a one-week high early Friday. The currency could strengthen further if the predictions materialize. Good for purchasing power, but bad for Canadian exporters, a group we are largely cautious on.

Looniversity –  What’s in a Beta?

How much volatility can you expect from a given stock? That’s well worth knowing if you want to avoid being shocked into panic selling after buying it – which, particularly in the volatile small-cap segment, is a good thing. Some stocks trend upward with all the consistency of a firefly. Others are much steadier. Beta is what academics call the calculation used to quantify that volatility.

The beta figure compares the stock’s volatility to that of the S&P 500 index using the returns over the past five years. If a stock has a beta of 1, for instance, it means that over the past 60 months, its price has gained 10 per cent every time the S&P 500 has moved up 10 per cent. It has also declined 10 per cent on average when the S&P declines the same amount. In other words, the price tends to move in synch with the S&P and it is considered a relatively steady stock.

The more risky a stock is, the more its beta moves upward. A figure of 2.5 means a gain or loss of 25 per cent every time the S&P gains or losses just 10 per cent. Likewise, a beta of 0.7 means the stock moves just 7 per cent when the index moves in either direction. A low-beta stock will protect you in a general downturn; a high Beta means the potential for outsize rewards in an upturn.

Of course, that’s how it’s supposed to work in theory. In practice, unfortunately, past behaviour offers no guarantees about the future. If a company’s prospects change for better or worse, then its beta is likely to change too. So, use the figure as a guide to a stock’s tendencies, not as your own personal “Kreskin.”

Put it to Us?

Q. Can you explain the concept of a “yield curve”?

– Eric Anderson; Vancouver, BC

A. Outside of “stopping short to watch Beyonce walk by,” the “yield curve” can best be described through two examples.

1. A measure of the income generated by a bond. It is calculated as the amount of interest paid on a bond divided by the price.

2. The rate of return on an investment, usually expressed as an annual percentage rate.

The yield curve is a graphic line chart that shows interest rates at a specific point for all securities having equal risk, but different maturity dates. For bonds, it typically compares the two or five year treasury with the 30 year.

Securities with longer maturities usually have a higher yield. If short-term securities offer a higher yield, then the curve is said to be inverted. We do not suggest picturing Beyonce that way!

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