Corrections Breed Opportunity

08/28/2008 12:00 am EST

Focus: GLOBAL

Gordon Pape

Editor and Publisher, The Income Investor and the Internet Wealth Builder

Gordon Pape, editor of the Canada Report, gets ready to go bargain hunting.

In both June and July, I warned that the high-flying Toronto Stock Exchange (TSX) looked vulnerable to a correction, [even though] the TSX was the top-performing market in the world in the first half of 2008. I recommended building cash reserves to the 20% to 25% range and focusing on defensive, oversold stocks like Gildan Activewear (NYSE: GIL).

Gildan was one of the few stars in what has otherwise been a gloomy month in Toronto. The S&P/TSX (^GSPTSE) Composite Index has fallen more than 1,600 points (almost 11%) from its all-time high of 15,154.77 reached in June. And the carnage may not be over yet.

The sudden drop in commodities prices was the main reason for the reversal. The Canadian market rests on two pillars: financials and resources. The financial sector has taken a big hit as a result of fallout from the US subprime mess, although it has shown signs of a modest recovery recently. And now the pillar of the resource sector has been kicked out from under it.

The Canadian dollar (loonie) has also been sucked into the commodities downdraft, slipping back to US95.91c, and some currency experts predict it may go even lower. In a recent analysis before the loonie started its tumble, Dagmara Fijalkowski of RBC Capital Markets concluded that the downturn in the US dollar, which has lasted 6-1/2 years, may be about to end.

The average duration of these cycles is about seven years, she said, noting that the loonie is “vulnerable to weakness in energy prices and slowdown in global growth” and Canada's manufacturing sector has been hit by “the double whammy of a strong currency and the US slowdown”.

However, there are several factors that should limit the downside risk to Canada's currency and could possibly trigger an early rebound from an oversold position:

  • The largest budget surpluses among the G7 countries for the past ten years.
  • An interest rate advantage as the Fed cuts rates more aggressively than the Bank of Canada.
  • A housing market and financial sector that are in better shape than their US counterparts.
  • Unemployment is 6.1%, near 30-year lows.

The critical factor determining the market’s course over the next few months will be commodity prices. If they continue to soften, we should expect continuing weakness on the TSX. The “glass-is-half-full” view of that situation is that it will provide some great buying opportunities. Some stocks had been running way ahead of themselves, such as Potash Corporation of Saskatchewan (NYSE: POT). This correction will give investors a chance to take positions at much more reasonable prices.

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