August, 2008
The Second Opinion: Portfolio Threats
It is a fact that when people fear losing their jobs they start holding off on making purchases, especially large ones. It follows that when many people spend less money it will inevitably be bad for the economy and the stock market, and therefore, perhaps also your investment portfolio. Consider that in July the Canadian economy lost 55,200 jobs—the highest single month job loss in 17 years (anyone remember the ‘91 recession?).
It is also a fact that if people see the value of their homes decline they will feel less wealthy and start to spend less. This too can have a negative effect on corporate profits and can also have a negative effect on the economy, the stock market, and your portfolio.
It is interesting to note that the last time we saw such large job losses it was also preceded by a major housing decline (similar to the one currently taking place in the US), and followed by a major recession.
This economic environment can turn out to be a disaster for your portfolio. The emotions that come with the fear of possibly losing your job, your home, or your home equity, is enough for many average workers to stop spending, hurting the economy, the stock market, and potentially your portfolio. That is why in this edition of The Second Opinion we will focus on Warren’s tip #20: Understand How Emotion and Logic Move the Market. You will also find some interesting insight into the US housing crisis and how it could impact your portfolio, from Second Opinion’s Vice President, Ken Hawkins.
Tip #20: Understand how emotion and logic move the market
by Warren MacKenzie
Why this is important: If you think the market moves on logic, you may try to use logic to predict the market’s direction over the short term. The truth is, the market moves on emotion. If you think it moves on logic and fundamentals, you are likely going to lose money.
It is easy to think that the market moves based on logic, facts, or events that occur in the world. We see the changes in the markets, we know the facts about certain events, and then we mentally create a cause-and-effect relationship. However, it is group thinking or the herd mentality, not facts, that cause major shifts in the market. Believing that the market moves mainly on facts can cause you to multiply your investment losses. Consider what superstar investor Warren Buffett has said: “When the price of a stock can be influenced by a ‘herd’ on Wall Street with prices set at the margin by the most emotional person, or the greediest person, or the most depressed person, it is hard to argue that the market always prices rationally. In fact, market prices are frequently nonsensical.”
When the herd believes the market is going up, we decide to invest. When the market starts to go down, many of us fear the worst and decide to sell. This emotional response often outweighs the logic of sticking with the investment strategy.
Financial results are based on facts. What influences the market, however, are not those facts, but how the facts are interpreted. Even more important is how the actual financial results compare with the results that the investment community expected.
Markets change direction at the top of a bull market because most people who want to invest already have jumped on the bandwagon and are in the market. With no new supply of investors, the market falls from lack of available buyers to pickup the shares of those people who need to sell for any of a number of reasons.
At the bottom of a bear market, the market starts to turn around because most of those people fearful of losing more money have already sold their shares. With no ready supply of cheap shares, the market starts to rise because, with the sellers already out of the market, the buyers have to buy shares from those who are less willing to sell.
As Robert Prechter, who writes The Elliott Wave Theorist newsletter points out, there is utilitarian economics, and there is herd-mentality economics. We can use televisions as an example. In utilitarian economics, as the price of TVs goes higher, the demand for TVs will fall; as their price drops significantly, then the demand for them will increase. When the price is very high, people will delay making a purchase and, when the price is very low, consumers may buy a TV for every room in the house. This is a reasonable and logical way to manage one’s money.
On the other hand, when buying stocks on the stock market, people use a very different logic. When buying stocks, the demand increases as the price goes higher and the demand drops as the price falls. This is exactly the opposite of what logic would dictate. The higher the price for individual stocks, the more stock investors want to buy, and as the price drops, investors have less and less desire to buy. In fact they usually want to sell what they already own.
It is as if people were thinking: “The herd is running in this direction so this must be the right way to go.” Personally, they don’t know which way to go or why the herd is running in that direction but assume that someone else does know. They don’t want to be left out, so they follow the herd because it seems safer.
At the end of a cycle, at the critical point where the main trend of the market changes, either to a bull market or a bear market, most investors will assume, wrongly, that the market will continue on its previous course. The average investor and the majority of experts will be equally wrong and their advice will compound the problems for those following their advice.
Unfortunately, investment managers also find it safest to run with the herd. If a manager loses money in a year when most other managers also lose money, he is unlikely to be fired. However, if, fearing a market crash, he moves out of the market, but the crash does not occur and, as a result, he underperforms while most managers had a very good year, he is likely to be fired. So in cases like this, the manager often decides to stick with the herd even though his common sense and instincts tell him to stand aside.
Bottom line: Investors would be better off not listening to experts who predict which way the market will go. If you are going to listen to the experts, however, take the contrarian approach: try to determine what the consensus is and then bet that the opposite will happen.
What you can do now: Stop trying to use logic to predict where the market will go. Instead, focus on saving money and sticking to your investment strategy whether the market is rising or falling.
The US Housing Crisis: Can it Affect Me?
by Ken Hawkins
It has been about a year since we saw the first major signs that the US housing bubble was about to burst. The sub-prime mortgage market was starting to meltdown causing a cascading effect on the housing and credit markets alike.
Since then the average house price is down over 16% from a year ago and in some places in the US the prices are off by over 20%. There are a record number of foreclosures putting downward pressure on house prices. Over 10 million Americans owe more on their homes than what their homes are currently worth. Some banks and mortgage companies have been shut down while others have taken major write downs. It is estimated that there will be over $1 trillion written off because of bad mortgage loans.
The damage has not been isolated to the US market. The problem has been exported across the world. This was evidenced in Canada by the asset backed commercial paper (ABCP) fiasco and the large write-offs at our banks. Major stock markets around the world are down over 20% year to date. We are in the midst of a bear market, and the economy is dramatically slowing down. What started out as a “housing” problem in the US is now impacting the economy and the stock markets world wide.
What does this mean for Canadian investors? There are two different issues to focus on. One deals with the relatively narrow issue of the impact of the US housing market for Canadian investors and the other with the broader issue of a slowing economy and the bear market cycle we are currently in.
The weak housing market will certainly negatively impact Canadian companies that export construction materials to the US. In Canada, the biggest industry to be impacted is the softwood lumber industry. Plants are being shut down, especially in B.C., due to the weak demand in housing. The weak US house prices have caused many boomers and retirees to look to the US, particularly in the south, for a second home. Albertans who might have traditionally bought a retirement property in B.C. are now looking to Arizona. Home sales in the Okanogan, as an example, are down sharply from a year ago.
The broader issues of weak economic growth, job losses, higher inflation and dropping corporate earnings are typical of bear markets and, in that respect, this time does not look significantly different than past bear markets. The weakening economy is finally having an impact on commodity prices, especially oil, causing them to soften. Crude prices recently dropped below $116 a barrel, down over $30 from the recent record high less than a month ago. Up until now, strong commodity prices have insulated the Canadian stock market from much of the damage. However, recently a strong US dollar and a US market that is showing some strength has in the short term resulted in strong relative performance for US stocks compared to Canadian stocks.
In this period of uncertainty, we do not know when the bear market will end and the stocks will resume their long term upward trend. However, the recent performance of capital markets has demonstrated the value of a broadly diversified portfolio. Those with broadly diversified portfolios, although they have also suffered, have avoided the worst effects.
