A Little Less than Perfect

We are becoming somewhat concerned that some investors are starting to believe that the “perfect world” scenario of steady growth, low inflation and falling interest rates is here to stay. However, investors appear to be unaware of the risks associated with the current high levels of many of the world indices. As confusion surrounds the movement of interest rates and inflation, these markets are becoming a little less than perfect.

If we look at the history of the stock markets, we notice that, over the long term, Canada has actually underperformed and provided much more volatility than many other world markets. This is largely the result of the heavy concentration of the Canadian index in resources (and financial services). Yet, even in the historical context, we see that many of today’s portfolios that hold Canadian equities are showing the best return, as well as the most attraction for investors. Does this mean that there is a new paradigm shift in the Canadian markets and that Canada will continue this stellar performance?

Our studies show that the long term has been much more favourable for the non-Canadian indices and interestingly, the volatility of these indices has been measurably lower than Canada.

Yet, since late 2002, there has been a distinct shift to higher commodity-producing countries such as Canada. Interestingly, this change coincided with the beginning of the discontent with the Iraqi regime (Nov 2002, with war starting on Mar 20, 2003).

The chart above shows that shorter periods provided divergent returns over the last 10 years. The channel that we have highlighted represents how the Canadian markets have decoupled from the other indices. We consider this divergence to be unsustainable with the risk in Canada much higher than most suspect.

The effect of commodities
Much of the increase in Canada has been fueled by commodities, which is one of the leading reasons for an increase in the Canadian dollar against other currencies. The Canadian dollar now trades close to its 1976 – 1977 levels. (It hit an all-time low of 61.79 cents on Jan. 21, 2002.)

But it’s not just oil. Canada exports huge amounts of nickel, copper, aluminum and zinc. All these commodities are at or near record highs. Since they account for 35 per cent of Canada’s exports, the loonie is seen around the world as a commodity-based currency, and has been bid up accordingly.

But currency is a significant consideration. Over short periods, currency has enhanced volatility, and added to both gain and loss in many portfolios. However, in the longer-term, the effect on portfolios has not been as substantial as many would believe.

Conclusions
Based on some of the risks in the current environment, emphasis has been placed on commodity prices. Countries that are large producers of commodities have seen their stock market prices and currencies increase over the past few years. However, as many studies are showing, this may not be the norm. Experts believe that a reversion to the mean would signify that Canada needs to come back in line from both a stock market index and a currency viewpoint at some point in the future. However, we are concerned that investors may be doing the opposite, that their portfolios are too heavily weighted toward Canadian-based stocks.

That being said, although we have no idea when this reversion to a more normal market environment will happen, we believe it will take place. Our philosophy is to understand the risks in the markets, and construct a portfolio structure that is not located in one specific area. It should involve a more diversified approach by geographic regions, balanced between value and growth investment management styles, and employ competent managers who keep risk foremost in their approach to investment management.

We feel that this process is most suitable to meet most investors’ long-term financial objectives. In these times when certain markets can do no wrong, it may seem that you are not doing as well as you could, but this can be misleading. Those “hot” markets may be carrying a risk level that is too high and a correction to normality may be hard to tolerate. Price appreciation without considering the risk required to achieve that price is not the appropriate process to fulfill an investment objective. One analogy is driving a Formula One car. You may get home faster, but not necessarily more safely. Because the car is faster, it can be less controllable, and more susceptible to an accident that might prevent you from making it home at all.

As always, if you would like to review the risk levels of your current portfolio, please contact your closest CARP Certified Advisor for an appointment.