December 19, 2013

Catching fire at the movies and in stock markets

You’ve no doubt heard of the movie The Hunger Games: Catching Fire. It was released to theatres in November.

Apparently, its title is in keeping with a dominant theme. U.S. stock markets also set an incendiary pace in the latest month.

All three major indices crashed through significant benchmarks. The Dow Jones Industrials (DJI) index blew past 16,000 and the S&P 500 climbed above 1,800 while both were on their way to new all-time highs.

NASDAQ exceeded 4,000 and is now only 15% below the pinnacle it reached in February 2000.

The NASDAQ index has risen nearly 200% versus its most recent trough level of 1,378 in February 2009. A 200% increase means the index value has risen by a factor of three.

Compared with that same date in early ‘09, which was a low point for all the major indices, the S&P 500 is +146%, the DJI +128% and Toronto’s stock exchange, the TSX, +65%.

While the U.S. indices are soaring with the eagles, the TSX is lumbering with the hippos.

After recording a post-recession improvement, the TSX has been more-or-less flat for the past three years. It appears destined to languish until there is a significant pick-up in world trade and global commodity prices.

There is one company on the home-town exchange that has been garnering attention. Air Canada has taken flight. Its share value has risen 300% year-over-year, although at $8.00 it’s still below the $20.00 once commanded at the beginning of 2007.

The airline is one among a number of companies that have benefitted from moving employees off a “defined benefit” pension plan and onto a “defined contribution” track.

In the latter, the company is no longer responsible for guaranteeing a certain rate of return. Instead, it’s up to workers themselves to manage their own investments for retirement earnings.

A positive factor for airlines everywhere has been a several-years lull in the price of oil which has kept the cost of jet fuel under wraps. Combined with purchases of lighter and more efficient next-generation passenger aircraft, revenues versus expenditures have come back into better alignment.

Also in the transportation sector, railroad companies around North America are experiencing a profit bonanza. A main contributor has been a strong level of returns from moving a vastly greater quantity of oil in tanker cars.

“Unit” trains comprised of 100 cars or so — long-utilized for the transportation of a single commodity such as wheat or coal — are now being employed to move oil. Huge storage and loading terminals are a boon to efficiency.

Long snaking trains of combustible hydrocarbons are coming under increasing scrutiny.

Investigation into the causes of the Lac-Mégantic freight train derailment, subsequent explosions and tragic loss of life will almost certainly bring legislative changes to improve safety and tighten regulations.

There’s likely to be a requirement for more “buffer” cars. They serve a role similar to firebreaks in forested areas. Their purpose is to limit the chain reaction of a catastrophic event.

Since buffer cars either run empty or are filled with a static material such as gravel, they generate limited or zero revenue.

Also, all oil isn’t the same. There are different grades with varying levels of risk. The train involved in the Lac Mégantic disaster was carrying shale oil from the Bakken field in North Dakota. It’s lighter and therefore potentially more flammable.

We’re becoming side-tracked. There’s more to say about the stock markets. NASDAQ is +35%, or higher by more than a third, versus November 2012’s closing, while the S&P 500 is +29% and the DJI, +25%.

Internationally, the U.S. stock indices aren’t the only ones experiencing a “bang-up” time. The German DAX 30 is ahead to a similar degree, +27% year-over-year, while Tokyo’s Nikkei 225 is +66%.

Will the current strong level of demand for equities continue?

Many in the financial-planning community think the answer is “Yes,” finding justification in a couple of key trends.

As interest rates begin to move higher again, or even when there is a hint that such is imminent, there’s likely to be a greater shift out of bonds and into equities.

This effect was already witnessed earlier this year when the Federal Reserve started discussing its plans to “taper” $85 billion in monthly bond purchases.

In such circumstances, investors bail on bonds because a rise in interest rates — simply as a mathematical exercise — cause a fall in value, which is to say a decrease in the selling price.

Also, as more and more baby boomers retire, they’ll be looking for returns higher than what will be received from bank certificates and government notes. That means more “gambling” on equities.

The future for buying company shares as an investment strategy looks buoyant, but keep in mind that if stock prices begin to outstrip profits, weakening their underlying value, there is also potential for nerve-wracking volatility.

For more articles by Alex Carrick on the Canadian and U.S. economies, please see his market insights. Mr. Carrick also has an economics blog.

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