Various leading indicators suggest a constructive backdrop for equities ahead. Improving economic fundamentals and positive leading indicators like the LEI and ISM Services Index signal further equity market gains. The author recommends an overweight position in equities over bonds, with a focus on cyclical sectors that have outperformed recently. On the fixed income side, the author advocates a "bear flattener" strategy of favoring corporate bonds over Treasuries and long-term bonds over short-term bonds.

1. Kevin Cheng, CFA
Kevincheng21@hotmail.com
647.996.8896
Market Outlook – April 2010
Over the past two
decades, a flatter
yield curve has
implied positive
market returns,
with average
returns of 12.5%
The Macro View:
Improving Economic Fundamentals Suggest Cyclical Positioning
Over the past few quarters, market dynamics have been characterized by low interest
rates, surging government spending and increased intervention in the financial system.
However, these dynamics are starting to change as the global economy begins to recover
from a deep recession and financial crisis. Global central banks are beginning to tighten
policy (or have become more hawkish), quantitative easing is drawing to a close, and
government stimulus is running dry.
Some of the notable government stimulus packages implemented during the financial crisis
include: TALF ($900BN), TARP ($700BN), Fannie Mae/Freddie Mac ($400BN), AIG ($53BN),
Bear Stearns ($29BN), etc. Governments have gone to such extraordinary lengths to
support economic growth and save the financial system that the primary concern for
markets right now remains whether that growth can be sustained without these simulative
measures and within a higher interest rate environment.
Firstly, the prospects of higher short term rates (in both Canada and the U.S.) are not likely
to have any immediate impact to economic growth, as monetary policy normally operates
with a lagged effect. As highlighted in Exhibit 1, a flatter yield curve has typically suggested
more tepid equity market gains. This correlation has been well established over the past
two decades, and is particularly noticeable during periods where the yield curve is
flattening (but has not yet inverted). Over that time, the S&P 500 averaged annual gains of
12.5%, which suggests additional upside for equity markets from this juncture.
Exhibit 1: Flatter Curve Suggests More Tepid Equity Market Gains
-3
-2
-1
0
1
2
3
4
Jan-90 Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10
-60%
-40%
-20%
0%
20%
40%
60%
UST 10-year minus 2-year (adv 12-mths, L) S&P 500 (y/y % chg, R)
Source: Bloomberg;
Furthermore, despite some pockets of still soft U.S. economic data, (most notably
unemployment), a number of economic indicators have started to improve recently. A key
example has been the Conference Board’s Leading Economic Indicators (LEI) Index, which
has improved significantly over the past year. As Exhibit 2 illustrates, the LEI Index has
been tightly positively correlated (approximately 60%) with North American equity market
returns over the past few economic cycles and I expect this cycle to be no different.
Moreover, by advancing the LEI index modestly, the index can be used as an important
market timing indicator for evaluating future returns. For example, when the LEI Index has
been positive on a y/y basis, North American equity markets have averaged returns of
11.5%.

2. Various leading
indicators suggest
a constructive
backdrop for
equities ahead
Exhibit 2-LEI Outlook: Constructive For North American Equities
-75%
-50%
-25%
0%
25%
50%
75%
Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10
-12
-9
-6
-3
0
3
6
9
12
Average (SPX and TSX y/y % chg) Leading Economic Indicators (y/y % chg, adv 6-mths)
Source: Bloomberg
Another important market indicator for future equity returns is the ISM Services Index.
Given that both Canada and U.S. are heavily weighted towards the service sector, the ISM
Index provides a good indication of the health and performance of this key component of
the North American economy. As Exhibit 3 demonstrates, the ISM Services Index has
proven to be an excellent indicator for predicting turns in the market.
Exhibit 3-ISM Services Signals Further Equity Market Gains
-75%
-50%
-25%
0%
25%
50%
75%
Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10
30
35
40
45
50
55
60
65
70
Average (SPX and TSX y/y % chg) ISM Services (advanced 6-mths)
Source: Bloomberg
Asset Allocation
Equities over Bonds
Despite the impressive year over year gains achieved so far on the S&P 500 and the TSX,
key leading indicators continue to suggest that the current stock market rally is not over
just yet. Given that the AGF’s Canadian Balanced Fund is currently benchmarked against
the total return index of the S&P TSX (60%) and the DEX Universe Bond Total Return Index
(40%), I would suggest a slightly more aggressive tilt to the current asset allocation mix
with a 35-30% weighting in bonds and 65% to 70% weighting in equities.
From my perspective, the North American economies look to be in the early innings of a
slow yet sustainable long-term recovery, similar to the situation in the mid-1990s. During
that time frame, annual equity returns averaged approximately 16%, further justifying an
overweight in equities. Taking into consideration that the Canadian Balanced fund has a
low-to-medium risk profile, the following Exhibit shows my recommended asset allocation
weights.

3. Stay the investment
course: Cyclicals
have worked well
over the past few
quarters and are
likely to outperform
in the near-term”
Exhibit 4-Asset Allocation Recommendations
Top 10 Sector Allocation
Recomm.
Asset Class Weight (%) Weight (%) Difference
Governments 31.4 27.8 -3.6
Materials 18.4 19.9 1.5
Energy 15.4 16.4 1.0
Financials 9.5 11.0 1.5
Telecom Services 5.0 5.5 0.5
Consumer Staples 4.5 3.5 -1.0
Provincials 3.6 2.5 -1.1
Utilities 1.7 1.7 0.0
Industrials 1.1 1.4 0.3
Info. Technology 1.1 2.0 0.9
Total 91.7 91.7 0.0
Regional Mix
Weight
Weight Recomm. Difference
Canada 74.0% 78.0% 4.0%
United States 12.7% 14.2% 1.5%
Latin America 0.6% 0.6% 0.0%
Pacific Rim 0.3% 0.8% 0.5%
Cash 12.4% 6.4% -6.0%
Source: AGF Website
Equity Outlook
Equities: Cyclicals over Defensives
Following one of the deepest recessions since the Great Depression, the thematic trade of
long cyclicals (relative to defensives) has performed very well over the past few quarters.
As shown in Exhibit 5, six of the top 10 sectors on a year over year basis are cyclically
sensitive. Going forward, I expect these sectors to continue to outperform their defensive
counterparts, as global economic prospects continue to improve.
Exhibit 5-Cyclicals Outperform Defensives
12-mth % chg
Sector Type S&P TSX S&P 500 Average
Financials Cyclical 60.4% 80.4% 70.4%
Industrials Cyclical 46.7% 68.6% 57.6%
Technology Cyclical 40.6% 56.4% 48.5%
Consumer Discretionary Cyclical 28.1% 67.1% 47.6%
Materials Cyclical 24.2% 53.0% 38.6%
Health Care Defensive 38.2% 31.7% 34.9%
Energy Cyclical 32.9% 26.7% 29.8%
Utilities Defensive 32.2% 15.6% 23.9%
Consumer Staples Defensive 13.3% 31.7% 22.5%
Telecom Services Defensive 15.2% 5.8% 10.5%
Index 38.0% 46.6% 42.3%
This thematic trade has worked well on both the S&P TSX and the S&P 500. As
demonstrated in Exhibit 6, the sector performance of S&P 500 Industrials relative to
Consumer Staples has typically outperformed during upswings in the S&P 500 and
underperformed during downswings. Meanwhile, the TSX Energy sector has also
outperformed TSX Utilities throughout the various TSX cycles.
On balance, the current phase of the equity market rally offers a higher risk and lower
reward profile relative to the market profile 6 months ago. However, investors can still
expect to see high single-digit to low double digit returns over the next few years as the
economy continues to recover. At this stage of the cycle, benchmark outperformance will
likely result from asset allocation and sector selection as opposed to security selection.

4. Historic lows in the
Fed Funds rate,
combined with
underlying demand
for 10-year
Treasuries suggest
a Bear Flattener
strategy
Exhibit 6- Thematic Trade Works In Both North American Markets
40
60
80
100
120
140
160
180
Dec-97 Dec-99 Dec-01 Dec-03 Dec-05 Dec-07 Dec-09
80
100
120
140
160
180
200
220
240
260
280
Industrials / Cons. Staples (R) S&P 500 (1995=100, L)
50
75
100
125
150
175
200
225
Dec-97 Dec-99 Dec-01 Dec-03 Dec-05 Dec-07
50
75
100
125
150
175
200
225
Energy / Utilities (R) S&P TSX (1997 = 100, L)
Source: Bloomberg
Fixed Income Outlook
Bear Flatteners; Corporates over Treasuries
Given the current rate environment, short-term interest rates are likely to increase at a
faster rate than long-term interest rates and fixed income investors should employ a bear
flattener strategy to outperform relative benchmarks. There are two primary drivers behind
the bear flattener strategy a) record low fed funds target rate and b) strong underlying
demand for long term US$-denominated debt.
Firstly, the Fed funds target rate is already at an all-time low with no where to go but up.
Since 1971, the Fed Funds rate has averaged 622bps average, and barring another
financial crisis, interest rates are likely to rise from their current 25bps level towards their
long term-average over the next few years. That should continue to lift rates significantly
at the short-end of the curve, suggesting that the portfolio should be underweight short-
term bonds in the near term.
Exhibit 7: Interest Rates Set To Rise From Historic Lows
0
5
10
15
20
25
Jan-71 Jan-76 Jan-81 Jan-86 Jan-91 Jan-96 Jan-01 Jan-06
Fed Funds Target Rate Long-term Average
Source: Bloomberg
The second driver in the bear flattener strategy is that foreign demand for US$
denominated debt still remains very strong as demonstrated by last week’s U.S. Treasury
10-year auction. Results in that auction came in at an all time high of 3.72x bid-to-cover,
as shown in Exhibit 8. Moreover, indirects were also strong at 43.1% (outpacing Primary
Dealers for the first time since September), which suggests that China may have resumed
its purchases of U.S. Treasuries. In addition, the ongoing problems within Europe, (most
notably Portugal, Ireland, Greece, Spain or the PIGS economies), remain a lingering
headwind to European debt markets, thus leaving fixed income investors with few
alternatives outside of U.S. Treasuries. Net-net, investors should remain overweight long-
term bonds relative to short-term bonds, to outperform the benchmark in the near term.

5. Equities over
Bonds, Cyclicals
over Defensives,
Corporates over
Treasuries
Exhibit 8: Foreigners Still Willing To Fund U.S. Debt
1.0
1.5
2.0
2.5
3.0
3.5
4.0
Nov-93 Nov-95 Nov-97 Nov-99 Nov-01 Nov-03 Nov-05 Nov-07 Nov-09
UST 10-year auction: bid-to-cover
Record High
Source: Bloomberg
Meanwhile, a healthy corporate sector, strong balance sheets, declining default rates and
attractive yields continue to merit an overweight allocation for Corporate bonds within the
fixed income portfolio. As shown in Exhibit 7, corporate yield spreads continue to come off
their highs (a 630 bps spread), reached during the height of the bear market in Q4 2008,
and has further room for improvement. On balance, improving economic fundamentals are
likely to help corporate spreads to narrow towards their longer term average of 215bps.
Exhibit 9: Corporate Backdrop Supportive Of Narrower Spreads
0
1
2
3
4
5
6
7
Jan-71 Jan-76 Jan-81 Jan-86 Jan-91 Jan-96 Jan-01 Jan-06
Corporate Spreads (BAA - 10yr UST, %) Long-term Average
Source: Bloomberg
Investment Summary
Investors should be properly positioned for a modest economic recovery, which means that
despite a rising rate environment stocks should still do well. Within equity markets,
investment managers should favor stocks over bonds with a focus on cyclical sectors (ie.
Industrials, Info technology, Consumer Discretionary), higher beta names (ie. small cap
over large caps) and currencies with a cyclical-tilt (ie. Long CAD, AUD versus USD). On the
fixed income side, investors should favour spread product (ie. Corporates, High-Yield), while
remaining overweight long term bonds relative to short term bonds, in light of higher
interest rates on the horizon. Overall, central banks are likely to err on the side of caution
when it comes to raising interest rates, as growth risks continue to outweigh inflation risks,
at this point in the cycle.