ECONOMY

Canada - On a year-over-year basis, core Canadian inflation was at a two-year low of 1.5% in December.  Total inflation was down to 2.4%.  Much of this drop in inflation was due to the GST reduction of 1% and price discounting offered by retailers.  For all of 2008, the increase in the cost of living will likely be the smallest since 1999.

It is not going to remain as such.  Price discounting by retailers and the 1% GST cut have a permanent impact on the price level, but a temporary effect on inflation.  The impact of these measures is over within one year.  The Bank of Canada has already indicated that although they expect the inflation rate to drop this year to 1.5%, they expect inflation to go back over 2% in 2009.  It is unlikely that the Bank of Canada will aggressively reduce interest rates.

Canadian retail sales were up 0.7% month-over-month in November, which was better than had been expected.  Excluding autos, retail sales were up 1.7% month-over-month.  This was the third gain in four months.  Real retail sales were up only 0.2% in November, mainly due to price effects.  The biggest gain was in gasoline prices at 4%.

There were significant gains in general merchandise, furniture and clothing.  Food and beverages were up only 0.9%.  Canadian retailers did a good job of keeping Canadians shopping at home, rather than going to the US, by lowering prices.  Automotive sales were up 0.6% on the month, but that was mostly due to gasoline sales.  New car sales fell 3.5% and used car sales fell 0.4%.  Building and outdoor home supplies dropped 2.4%, indicating that the home renovation business is very soft.

Canadian building permits increased by 0.4% month-over-month in December, after a 9.9% month-over-month drop in November.  Non-residential permits fell by 2%, while residential increased by 1.8%.  There was a 10.8% month-over-month increase in multiple family permits.  Single-family permits fell by 3.2%.  This suggests that housing activity will likely fall slightly in 2008.

Initial jobless claims in Canada jumped to 375,000 for the week ending January 26, increasing by 69,000 over the previous week.  The four-week moving average now stands at 326,000 which is an increase of over 10,000 from the previous week, and the highest since September 2005.

Canadian GDP increased 0.1% month-over-month in November.  This was in line with expectations.  The goods producing sector had mixed results, utilities and construction had increased production.  Natural resources, mining and oil, and manufacturing all had reductions.  Services sector gains were broad-based.  These numbers are well below Canada's potential rate of growth, which for the fourth quarter will likely come out at 1.5%.

U.S. - Existing home sales in the US fell 2.2% month-over-month in December to an annualized sales rate of 4.89 million units, down 22% from last year.  Single-family sales slipped 2.0%.  Condos sales fell 3.3%.  The single-family sales rate is now at the lowest level since January 1998.  Sales of new homes were down 4.7% in December to an annual rate of 604,000 units.  There is some price capitulation occurring in the housing market.  Months’ supply of total existing homes fell back to 9.6 while single-family months’ supply fell to 9.2 from 9.8.  Both measures are still very high.  Mortgage rates, however, are low and trending lower.  Mortgage applications for new home purchases have held up fairly well, and this is one plus for the future.

One area where the US is making real headway is in agricultural exports.  They are selling equipment and services.  Over the past 12 months, farm, fishing and forestry occupations have increased employment by 7.5%.  Agriculture has made a big comeback in the US, with the biggest growth on the export side.  It has offset some of the loss in jobs in home building.

The US economy lost 17,000 nonfarm payroll jobs in January, which followed a strong upward revision in December.  Nonfarm payrolls during the last month of the year jumped 82,000, up from a previously reported 18,000 increase.  Average hourly earnings were up 0.2% in January, or 3.7% over the last year.  The unemployment rate slipped slightly to 4.9% from 5.0%.  There were fewer people looking for jobs.  Construction and manufacturing continued to lose jobs.  Education, health services, leisure and hospitality had job gains.

US durable good orders rose by 5.2% month-over-month in December, and ex-transportation were up 2.6%.  This was better than the market had expected.  Core capital goods production rose by 4.4% month-over-month.  There was a 7.6% month-over-month jump in machinery orders, and an 11.3% month-over-month increase in transportation equipment orders.  Inventories increased by 1.1% month-over-month, the biggest increase since September 2006.  There is still a slowdown in the US manufacturing sector, as well as in overall economic activity in the US.  The weaker dollar is showing some positive impact on US exports.

US personal income was up 0.5% month-over-month in December, and personal spending was up 0.2%.  Personal consumption expenditures in real terms were flat on a monthly basis, with consumption of both durable and non-durable goods in December being soft.  Real disposable income, however, was up 0.2%, the first increase in three months.  Price pressures remain quite tame at the present time.

Newsprint consumption continues to decline.  US data indicates that dailies’ consumption in December was down 19.3% year-over-year, and total consumption for the year was down 15.4%.  This is one of the worst quarterly drops in history.  Consumption by commercial printers was up slightly, resulting in not quite as bad a total number.  US demand fell 13.1% year-over-year in December, and 11% year-to-date.  Canadian demand was up 2.8% year-over-year in December, but down 4.2% for 2007.  North American demand fell by over 1 million tonnes during the year.

Domestic mills absorbed 942,000 tonnes of the drop, while imports were down by 60,000 tonnes, or 42.3%.  Exports, however, climbed 7.3% in 2007, but December exports were the lowest since February 2007, at just 171,000 tonnes.  Shipments to Asia were considerably lower (excluding Japan), with a decline of 44,000 tonnes, or 61.2%, year-over-year.

At the consumer level, inventories were just 34 days supply, the lowest since 2002.  AbitibiBowater has taken steps to reduce production.  As a result, price increases went through $25 for the November-December period, and $20 for January.  In some cases, price increases were delayed due to various contracts; however most of the industry has accepted increases.

MARKET

There has been considerable damage to the technical factors in this market.  It will be very difficult for the market to start a new uptrend.  The Volatility Index is in the upper 20s, signalling increased market panic.  Sentiment is very negative.  There is no breadth.  The percentage of stocks trading above their 200-day moving average recently hit 13%, the lowest level since at least 1994.  Investors have been virtually chased out of all sectors.  On January 30, the S&P 500 was 140 points, or 10%, below its 200-day moving average.  There are a considerable number of resistance points, both in Toronto and the New York markets, which are going to be difficult to surpass over the next short period of time.

Merrill Lynch, Bear Stearns, Goldman Sachs and Wachovia Corp. have improved their balance sheets before debt markets worsened.  These firms offered at least $14.4 billion of bonds in the past week.  Banks are concerned that borrowing costs are going to climb with the fallout from bond insurers downgrades.  In addition, there was a trading loss of $7.2 billion by Société Général which has disturbed major institutional trading.

The market for commercial mortgage-backed securities hit zero in January for the first time in 20 years.  Conditions have worsened, pushing yield premiums to record levels, and forcing issuers to hold onto loans in their inventories, and limiting their ability to make new loans.

About half of the S&P 500’s, 92 Financial Services companies have now reported fourth-quarter earnings.  So far, these earnings are down 140% from the fourth quarter of last year.  Earnings from the Financial sector are now down about 30% from its peak in mid-2007.  A number of the banks now look cheap by historical measures.  Many US bank prices are now close to book value.

They are now starting to look much more interesting.  Normally, bank stock prices turn upward several months before earnings hit bottom.  There are still expectations though of further write-downs.  However, it now looks that by third quarter of this year, most of the bad news will be out of the way and bank stocks should be in a reasonable buying range.  It is premature to start accumulating US banks just yet. 

The market rally has experienced has all the characteristics of a bull trap.  It likely can go slightly higher to about 1,425 on the S&P 500.  There is still not enough major institutional accumulation to indicate that this market can go much above that level.  Although there is definite improvement in the advance/decline, and the net new highs in the transports have recovered significantly, there is still no indication that a new bull market is appearing.

A move above 1,425 with some volume would likely bring in considerable buying.  The market’s major concern is still the fate of the mortgage insurance brokers, asset-based securities, and sub-prime mortgages.  These have to be further into the cycle before the market starts a new major uptrend.

There has never been a recession that did not see the S&P 500 decline 20% from a peak to trough.  A full reversal of this bull market would mean just below 1,100 on the S&P 500.  That would mean a multiple of about 13.5% on estimated earnings for 2008.  It would make the market quite cheap, but bear markets always make the market very cheap.

Bear markets normally end when the recession is about 60% complete.  Based on economist forecasts, this would mean bottom on the US markets some time around the end of May or early June.  The Canadian market likely will not see the same extremes; however the timing could be about the same.

The market remains very vulnerable to any severe bad news.  The drop in the ISM service sector index sent the averages down 2.5% or more.  The markets, however, did not make new lows.  Support at 1,310 has to hold.  A test of this level and a bounce could lead to a very strong rally.