october, 2009
The second Opinion: What do I do now?
Introduction
The past year or two have been an interesting time in the markets. Over this period, we have seen one of the largest global downturns and subsequent stock market recoveries in history. For many investors, these events were not as ‘interesting’ as they were ‘terrifying’. Watching their portfolio free fall scared many investors into selling at the bottom, thereby missing the recovery. The drop was so frightening for some that they are now contemplating never buying stocks again. These investors are asking themselves, “What do I do now?”
Second Opinion, of course, has an answer to this question. In short – do what every investor should be doing regardless of market conditions. That is, ensure your asset mix is in line with your target rate of return as shown in your financial plan. Don’t know what your asset mix is? Find out. Don’t have a financial plan showing your target rate of return? Get one.
To elaborate, Second Opinion Vice President Ken Hawkins has put together two good articles to help uncertain investors. The first one, entitled ‘On the Other Side of the Valley’, provides market commentary, while the second ‘What do I do Now?’ is designed to help investors who sold their equities at the bottom and now have large cash balances that they are unsure what to do with.
For investors contemplating never investing in stocks again, we present Warren MacKenzie’s tip, ‘Don’t Obsess Over Avoiding Stock Market Risk’. This tip will explain to you why avoiding the stock market altogether will likely be detrimental to your long term financial health.
We close by presenting a new addition to our newsletter — a calendar of upcoming events called ‘Mark the Date’. Don’t forget to mark your calendar!
Carlo Palazzo, CFP, CIM
On the Other Side of the Valley
Introduction
Looking at a variety of stock charts over the last couple of weeks, the patterns all look very similar. In the last 12 months, major indexes in Canada, the U.S. and globally all have a ‘V’ shape with current prices close to what they were one year ago. Over that time frame, we suffered the worst financial crisis and loss of confidence since the depression. The stock markets worldwide also experienced one of the strongest rallies on record. Many investors are just as shocked with the rapid rise in the last six months as they were with the precipitous drop from the summer of 2008 to early March 2009.
Although the S&P/TSX Composite is currently up almost 47% from March lows, it still has to advance by over 36% to reach its previous highs in June of 2008. In understanding what the markets are going to do from here, it is important to understand how we got here in the first place.
Back from the Brink
From its peak to its trough, the S&P 500 Index was down more than 55%, and the S&P/TSX Composite Index in Canada was off over 50%. Both these drops were the largest declines in the market since the Great Depression, and as stocks were falling, there was a palpable fear among investors about the potential for a worldwide financial catastrophe. There was a major concern that the U.S. banking system would collapse and the Government would have to nationalize it to save it. Also credit was drying up and investors were concerned it would cause a global recession and potentially a depression. However, by the March 2009 lows, these two fears were discounted into the stocks prices.
Governments around the world reacted to an imploding financial system by providing major fiscal stimulus, dramatically increasing money within the system, and propping up banks and other major financial institutions. This action helped to avert the crisis and restore confidence in the economy, the financial system and the capital markets.
Markets Take Off
From the March lows, markets worldwide rallied with a ferociousness only matched by their declines. At the recent peak, the S&P 500 was up 60% and S&P/TSX Composite up 55% from their lows. Like the large drops, we had to go back to the Great Depression to find just as large of a rebound. In retrospect, there were many reasons for this strong performance including:
- A rebound after a sharp sell-off is a natural phenomenon, as prices revert back to a trend line. The larger the decline the stronger the rebound. As an analogy, a ball dropped from ten feet will bounce higher than one dropped from five feet.
- Much of the rebound is a reflection of the fact that markets often overshoot on both the downside and the upside.
- Valuations were very attractive on a dividend yield, price/sales and price-to-book basis.
- Market participants believed the global economy has turned the corner, with the substantial backing from central banks and governments supporting an improvement in sentiment and activity. Economic data has changed from ’bad’ to ’less bad‘ to ’stable‘ to ’good’.
- Second quarter earnings results turned out better than expected, mainly due to extensive cost cutting by businesses.
- The Federal Reserve has continued to pump money into the system and kept interest rates low.
Are Markets Ready for a Correction or Not?
As there are at most times in the market, there is a divergence of opinion among investors. The rapid rise in the market has many people concerned. As the market is overbought, a significant pullback would be expected. How much of a pull back and the decline is still open to debate. There are good arguments for both sides of the debate.
The Bullish Case – Still a Good Time to Buy
- The U.S. headline inflation rate was negative in July for the fifth consecutive month, falling to a 59½-year low. This will allow the Federal Reserve Board to keep interest rates low.
- There is still a tremendous amount of cash on the sidelines earning very little. This is all potential buying power that can drive stocks higher.
- Longer-term valuation measures of the market, such as price/book value and stock market capitalization as a percentage of GDP, although higher, are quite reasonable.
- Financial markets have stabilized and economic indicators have improved allowing investors to be more optimistic about earnings expectations.
- The yield curve is also very steep and positive in its slope.
The Bearish Case – Caution is Required
- The pace of economic growth in the U.S. is expected to be choppy and slow. There is a consensus view that the economic growth will be substandard. Many believe that it will not be a ’V-shaped’ recovery but a ‘square root shaped’ recovery. After some initial growth, it is expected that growth will level off.
- Significant further upside to equity markets likely requires improvement in the real economy.
- U.S. consumers are cutting back, and are not expected to provide much stimulus to the economy. The number of unemployed is still rising.
- Through August, the federal deficit hit $1.38 trillion, or three times last year’s all-time record deficit of $454.8 billion.
- The U.S. Government’s official debt is now at an all-time high of $11.8 trillion, or over $100,000 for each and every household in America.
- Markets are fairly valued, no longer cheap to attract buyers.
- Stocks now appear to require some solid earnings gains to keep up the momentum. This is unlikely given the slow economic recovery.
Conclusion
Although some of the signals are mixed, and experts differ in their opinions, we are still early into a bull market cycle and the longer term upside should be good from these levels. Although a correction may or may not be imminent, investors should continue to invest in equities up to a level that is appropriate for their long-term objectives.
What do I do now
Not All Investors are Happy
With the markets sharply off their lows, one would think that all investors are happy. However, for those who have been on the sidelines, with too much cash, missing one of the largest rallies on record has resulted in anxiety, worries and feelings of regret. This is compounded by the fact that their cash is earning next to nothing. They want to buy stocks, but are afraid of buying them only to see them drop. Having come so far, so fast, it is prudent to expect that a correction is inevitable. Should this stop cash-rich investors? Is it too late to get back into the market?
The Rally is Not as Impressive as it Appears
When market commentators discuss the rebound in the market, they measure it from the absolute bottom – a single point in time. At the bottom, the TSX Composite Index was 7,479 and the gain from 7,479 to the new high of 11,500 provides a return of 53.7%, which is pretty impressive.
However, when the TSX first bottomed in November 2008 to the time that it reached a new low in March 2009, it mostly traded between 8,000 and 9,000. It was only below 8,000 for a few days. Rather than use the absolute bottom, if we take the average of the trading range of 8,000 to 9,000, then the market would be up 35% – which is still impressive, but considerably lower than when measured from the absolute bottom. The market is still well below the high of just over 15,000. To reach the old highs, stocks would have to rally another 36%.
Still More Left in the Market
In the Canadian stock market, the high in a previous bull market has always been exceeded in a new bull market, a fact that is obvious when looking at any long term chart. There is no doubt that we are in a new bull market. Therefore, the question is not if the market will reach new highs but when.
Using the iShares S&P/TSX 60 (XIU), we forecasted the upside returns – over different time periods – should this ETF return to its old high. The XIU closed at $16.40 on October 2nd, and its old high was $22.48. It currently pays an annual dividend of $0.69, providing a current dividend yield of 4.2%. Assuming this dividend stays constant, we calculated the annual returns on XIU if it reached its old high, and then being conservative, we calculated returns if it were to make up only 50% of the difference between its current price and its old high. A recovery of 50% of the difference would yield a price of $19.44. The investment returns are shown in the chart below.
If it took two years to reach $19.44 or $22.48, then the annualized returns would be 12.7% and 20.6% respectively. Even if it took five years, the annualized returns would be 6.9% and 9.6% respectively. In the current environment, bond yields are very low with one to three-year government bonds yielding 1.24%, three to five -year bonds 2.25%, and five to 10-year bonds at 2.99%. Even with the most modest return expectations, the equities look very attractive at current prices when compared to bonds.
| Annualized Returns on the iShares S&P/TSX 60 | ||
| # Years | To 50% of the Difference ($19.44) |
To the Previous High ($22.48) |
| 1 | 22.70% | 41.30% |
| 2 | 12.70% | 20.60% |
| 3 | 9.50% | 14.40% |
| 4 | 7.90% | 11.40% |
| 5 | 6.90% | 9.60% |
Strategies for Investing Excess Cash
The following sections outline strategies for investing excess cash in your account.
Wait for Correction
There will be a correction in the markets, but we don’t know when it will happen, from what level will it correct, and how far it will drop. As an investor you can wait until a correction takes place and then buy after it drops. However, will it be at a lower price than it is currently? Also, if it does correct, will you recognize it as a good buying opportunity and buy at a good price?
Buy Now but Remain Underweight
As an example, if your long-term asset mix calls for 70% equities, than buy equities so that your asset mix would be 60%. If the market continues to rise, then at least you would have a solid investment in equities. If the markets go down, then you can buy additional equities to either bring it up to target weight or even over-weight equities.
Dollar Cost Averaging
On a regular basis, either each week or every month, use the excess cash to buy additional equities. This is a form of time ‘diversification’. If the markets go down or are choppy, you could be averaging out your costs.
Conclusion
We are still early in the bull market and although many people are calling for a correction, and there could be weakness in the short term, there is good upside over the next few years – but only for those people who invest. The question becomes weighing the short term downside risk against the longer term upside potential, and having a strategy to get invested. The extreme volatility over the last 12 months has demonstrated the importance of having a strategy to effectively deal with the emotional and psychological issues most investors are faced with. It is never too late to have a rational investment strategy that you stick with.
Don't Obsess Over Avoiding Stock Market Risk
Why this is important: The stock market represents an important asset class that most investors should hold. Investors who try to eliminate risk by avoiding stocks entirely may be exposing themselves to other risks that, in the long run, can be just as serious.
It really doesn’t matter how the money disappeared, or where it went, if you don’t have enough to maintain your lifestyle in retirement. The impact of a lower standard of living is the same whether your capital was eroded by inflation or deflation, or lost in a stock market crash. A wise and cautious investor therefore takes precautions against all risks.
The major risks you face include those related to inflation, deflation, currency, reinvestment, interest rates, income tax, default, bad managers, liquidity, and fraud. But the biggest risk is running out of money.
Some people invest only in bonds and bank-issued guaranteed investment certificates (GICs) because they hope to avoid all risk. However, they may lose if interest rates go higher, or if inflation rises, and they will pay more in income tax. They are also exposed to reinvestment risk. This is the risk that when the guaranteed investments mature, the capital may have to be reinvested at a lower rate. Retirees who became comfortable with a lifestyle based on earning 10% on GICs have had to make significant lifestyle adjustments when their matured funds had to be reinvested at 5%.
People buying real estate face the risk of deflation. Real estate generally falls in value when interest rates go higher. Furthermore, real estate markets can go up or down, and it is not a liquid investment.
Canadians, who in 2003 used their dollars to invest in US Treasury bills in the belief that they were a very safe investment, came to understand the real meaning of currency risk as the US dollar fell against its Canadian counterpart. Some very safe T-bill accounts lost almost 20% due to the increase in the value of the Canadian dollar versus the US greenback.
Sometimes people invest in a managed portfolio of stocks to avoid non-systematic risk only to incur ’manager risk.’ That’s when the person managing your mutual fund makes a wrong call, resulting in your portfolio falling in value.
A properly designed investment portfolio should be diversified to include many different asset classes. You want a number of asset classes to increase the probability that one or two of the asset classes will be rising in value to offset the loss in value of the asset classes that are in a down cycle. When losses are offset by gains, it tends to reduce the overall risk of the portfolio.
Of course, if all of your capital is invested in the right asset class, at just the right time, you are going to be a big winner. If all your money happens to be in long-term bonds at a time when interest rates fall, your portfolio will increase in value sharply. However, don’t plan on being this lucky. For most investors the safe and sensible approach is to diversify and not make large bets where success depends on any specific economic outcome.
Bottom line: There is safety in numbers – in this case meaning numbers of different asset classes. The best risk-reduction strategy is to be diversified by using multiple asset classes in your investment portfolio.
What you can do now: Check to see that you have at least three or four of the following asset classes in your investment portfolio: cash, short-term bonds, long-term bonds, common stocks (held as individual stocks, mutual funds, or ETFs), hedge funds, managed futures, and income trusts.
Mark the Date
Second Opinion will be appearing at the following events in the coming weeks. Please contact Heather Pritchard at 416.640.0550 ext. 223 or hpritchard@secondopinions.ca if you'd like more information.
| Event | Date and Location |
| Presentation Workshop: 10 Ways to Improve Your Portfolio Conducted by Jorge Ramos |
October 21st @ 2:15 pm The WorldMoney Show Toronto Metro Toronto Convention Centre 255 Front Street West Toronto, Ontario |
| Presentation Workshop: Going It Alone: Tips and Traps for the Do-It-Yourself Investor Conducted by Warren MacKenzie |
October 21st @ 5:00 pm The WorldMoney Show Toronto Metro Toronto Convention Centre 255 Front Street West Toronto, Ontario |
| Seminar: Retirement: Adventure ... or Misadventure? Conducted by Mark Gagnon and Warren MacKenzie |
October 29th @ 9:00 am Second Opinion Corporate Offices 4141 Yonge Street Toronto, Ontario |
