The Manager's Commentary - March 2011

In recent years, and especially in the aftermath of the sub-prime crisis, the impact of extreme events on investment returns has garnered a great deal of attention. What statisticians refer to as “tail risk” (so named for the low probability tips on a normal bell-shaped distribution) has become popularly known as a “black swan” event. Black swans are defined as occurrences which are universally surprising, which have a major impact, and which are swiftly rationalized in hindsight. Whether it’s the Asian debt crisis of 1997, the terrorist attack on 9-11, or the near financial meltdown of 2008, such jarring incidents tend to occur infrequently. With the uprising in the Middle East and the near simultaneous earthquake disaster in Japan, however, the world experienced two black swan events in the span of a month. As markets grappled with the immediate and long term impacts of these developments, equity indices turned down sharply. At the time, many strategists worried that the hobbling of the world’s third largest economy, the jump in geopolitical risk imparted by Arab revolution, and the spike in oil prices precipitated by both events could be enough to derail both the economic recovery and the building uptrend in stock prices. In reality, though, economies and stock markets tend to digest one-off shocks fairly well and the losses of early March we recouped by month-end. As the following graph shows, even the massive market plunge during the subprime crisis has been mostly erased, despite this decline being the largest since 1929.

A more important driver of long term returns is valuation and at 21 times earnings, the TSX seems quite rich at the moment. A quick peak beneath the hood, however, reveals a prime cause of this condition: the materials sector now fetches a multiple of 30 times, while accounting for a 22% index weight. The rest of the market trades at a more palatable multiple of 18 and the Pender Canadian Dividend Fund can be had for an even more reasonable 17 times earnings. As we’ve noted before, the premium valuation of some index groups has them resting on a precarious perch – this is a more likely source of market risk in the quarters ahead than a single world event.

Dixon Mitchell Investment Counsel
March 31, 2011