From the Desk of Noël Philippot:

Special Market Commentary

Equity markets have been under intense pressure over the past year, as the fallout from the US housing crisis has spread globally. For most of the period, however, the Canadian market was largely spared, holding up much better than equity markets south of the border and around the world. Yes, the big six bank stocks were down, but the magnitude of the losses relative to their US and global peers were much less acute. Meanwhile, the unique nature of the Canadian stock market and specifically its heavy reliance on energy and materials stocks acted as an offset to financial stock weakness, helping the benchmark TSX index reach all-time highs as recently as June of this year. More recently, however, the TSX has been in a steep slide, with energy and resource stocks getting particularly hard hit, which has overwhelmed the recent rally in financial stocks.

Against this backdrop, a number of financial shocks have occurred. What began as a meltdown in the sub-prime mortgage market has spread to all variety of financial instruments, eventually taking down venerable institutions such as Bear Stearns and more recently forcing the US government to effectively take over Fannie Mae, Freddie Mac, and provide a sizable loan to American International Group (AIG).

This weekend, several U.S. financial firms were in the news with events related to the ongoing problems in global credit and real estate markets. Lehman Brothers filed for bankruptcy and the Bank of America acquired Merrill Lynch.

What are the Implications for the Canadian Market?

Over the past several years, there has been a huge shift in the investor base of a number of Canadian energy and material stocks. Many of these stocks were once primarily owned by Canadian institutional and individual investors, but this ownership base shifted to where many of these stocks are now primarily owned by US investors and by hedge funds. Many of these stocks are inter-listed (i.e. they trade on both the US and Canadian exchanges) and by looking at trading volumes both in Canada and south of the border, we can see just how acute the US influence has become. For example, consider that Potash Corp. has typically traded between two and three times as much volume south of the border as it has in Canada, but in the first six trading days of September, it traded more than 90 million shares in the US vs. about 13 million here in Canada. The Canadian market does not have the capacity to absorb such a tremendous amount of selling volume and thus shares of many of these companies have fallen far further than fundamentals might suggest was warranted.

At the peak, the TSX was comprised of almost 50% energy and materials stocks compared to less than 20% for the US market. Thus, a correction in commodity prices and commodity stocks has had a disproportionate impact on the performance of the TSX relative to the US or most other global indices. Since June, most commodity stocks are down between 30 and 50%, which to some degree reflects the sharp pullbacks in the underlying commodities, but also flows directly from the massive amount of selling from US hedge funds.

Outlook

August 2007 marked the unofficial start of what has become a deeper and more prolonged credit crunch than most forecasters imagined. There’s no question that the credit crisis remains a serious challenge to the global economy. The steps we are seeing taken by the U.S. Federal Reserve and others are necessary and will eventually restore the financial system and economy to good health. However, the resolution of any crisis is not without its twists and turns. Only 3 months ago, global inflation had become central bankers’ biggest concern as oil and food prices soared to record highs. Now, with inflation expected to fall sharply by year-end, policymakers have rightly turned their attention to the weakening growth outlook for the economy.

While the market remains fixed on the increased likelihood of recession, we remain focused on the deeply discounted valuations that currently exist in capital markets. Returns from global equity markets are near the worst ever through periods where the Fed has been cutting short-term interest rates, and while the problems are significant, they are not insurmountable.

The financial crisis has pushed global equity markets toward (or even through) the bottom of their fair-value bands – a level that is inconsistent with our expectation for a return to moderate growth and contained inflation.

What Should Investors do?

• Think Long-Term: The sell-off is potentially setting-up a very attractive buying opportunity. However, if one is worried about short-term fluctuations in their holdings, it should be noted that the extreme volatility may continue for some time to come. The Canadian market has just come off four successive calendar years of well above average gains. At the June peak, the TSX was some 165% above the March 2003 lows. It is still 120% above those levels. While the period of intense price declines may not have much further to run it would probably be overly optimistic to imagine that after a short sharp correction, the Canadian market would revert immediately back into a sustained bull advance. However, Investors with a long-term focus should recognize that this period of adjustment will present an opportunity to acquire great businesses at attractive valuations.

• Emphasize Diversification: The turmoil since last summer has been particularly wearing on the Canadian investors’ psyche because the two sectors hit hardest in the sell off - financials and commodity/energy stocks – add up to some 75% of the value of the Canadian market. While long-term investment returns tend to increase with the level of risk taken, it is also true that investors are unlikely to be rewarded for taking risks they could have reasonably avoided or diversified away. The market action of the past several months serves to underline this fact of investment life. Prudent, conservative investors do not have to accept the high degree of sector concentration risk inherent in the make-up of the Canadian stock market. They can and should mitigate those risks by diversifying their portfolios to include businesses and sectors not well represented in our domestic market.

• Avoid Chasing the Market:  Many of the recent extremes in the market have been driven by short term focused hedge-funds and hedge-fund-like investors which have the ability to cause highly dramatic and quick swings in whichever markets or sectors they may have a momentary interest. We believe that an investment strategy that tries to time these types of fluctuations will do little more than chase the market, with disappointing results. Rather, we would focus on a discipline that identifies high quality companies with market-leading positions and strong management teams capable of adapting to changing environments, preferably in a broad range of industries and geographic locations. Such a portfolio would usually not be able to avoid a market decline altogether, but it might be more resistant to decline and it would often recover earlier and more vigorously than the overall market.

• Look for opportunities that fit the situation: Emphasize stocks and sectors that tend to do well in an economic slowdown. Unfortunately for Canadian investors, these stocks and sectors tend to be in short supply in Canada, as the traditional defensive areas of the market – Consumer Staples, Health Care, Utilities – are generally under-represented. This just re-emphasizes the point made above: investors may need to look south of the border or abroad to gain more exposure to traditional defensive sectors.

This is certainly a very challenging time for all of us, and may be for some time yet.  With RBC Dominion Securities we are following a disciplined investment plan that is designed to handle both up and down markets with your ultimate goals in mind.  We remain committed to providing you with direction to steer the way through this storm.  Investors that are able to remain focused on their investment plan, and manage their emotions will be rewarded when the markets return to growth.  History has shown that throughout other economic crisis such as the Dot-Com meltdown or 9/11, that perseverance pays-off.  We encourage you to continue holding your quality investments, and recognize that the underlying reason to own these investments still exists although values may have dropped on the current news in the economy.

I truly appreciate working with you and your continued confidence in myself and RBC Dominion Securities.  I welcome you to call or e-mail me or my Associate Elisa Lok with any questions or concerns that you may have.

Sincerely

Noël Philippot

Investment Advisor

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