Year End Review – The 2007 Mood Swings

The year 2007 is destined to be a memorable one for investors. Volatility was a recurring part of the picture, triggered by fears over huge waves of US mortgage defaults, Chinese market bubbles, increases in oil prices leading to inflation and concerns around interest rates, and also by the strong Canadian dollar appreciation effect on global investments. To illustrate this volatility: the Dow Jones Industrial Average hit a record high 34 times, but is now significantly down from those peaks. Canada has experienced similar swings.

In the first half of the year, concern centred around the Chinese market’s bubble-like condition, and its effect on commodities around the world. In the second half of 2007, a credit panic led to interest rate cuts in the US, Canada and the UK. Inflation fears drove oil, gold and other commodities to record levels. Now inflation has given way to a new fear: a possible recession.

Our banking system lost its innocence
US, European, and Canadian banks, insurance companies and other institutional investors from around the world tallied up tens of billions of dollars in losses from bad bets on complicated US mortgage securities packaged by the brokerage industry with acronyms such as ABCPs, CDOs in SIVs — now familiar from negative headlines. Globally well-respected financial institutions drank the AAA Kool-Aid; financial debacles, which are almost as old as finance itself, were then magnified by the ebbs and flows of human emotion.

China’s success
China has been the major focus for this volatility, around March and then later in August we saw dramatic swings as China’s financial industry struggled to process an inflow of money from as many as 100,000 new trading accounts a day. This surge in demand broke local trading records and made the Shanghai and Shenzhen stock exchanges among the world’s busiest. Most of these speculators were new to market swings, and had never seen the dark side of investment volatility.

Investors shouldn’t be deluded into thinking that those emerging market rallies will last. Look up the rise and fall of U.S. technology stocks in the 1990s for example. While China and India are larger markets than before, nearly one billion workers in Asia earn less than $2 a day. They can afford a coke, but until they can afford a car and computer, global rebalancing will proceed slowly.

All these concerns on the part of Canadian investors were reflected in the Canadian dollar, which reached never-before-seen highs, followed by a rapid drop. This unprecedented degree of volatility in the currency greatly affected foreign holdings for Canadian investors.

Where should your portfolio be in 2008?
In the last quarter, we’ve seen a dramatic change over the whole year. The Canadian dollar has depreciated significantly against the US dollar, large caps and dividend-oriented companies have again become more interesting, and a shift in investment styles is evident. Suddenly global- oriented companies offer more attractive value than Canadian and emerging markets.

Since 2002, the greatest impact on globally focused portfolios has been the stealth-like negative effect of an increasing Canadian dollar. Although many global managers did a good job in managing investments, and neutrality of currency provided great returns, the once-in-thirty years rise in the Canadian dollar diminished their success. If you have been in an investment with a strong global bias, you may not have been too happy with your returns over the past three years, but now is NOT the time to change.

The recent dramatic slide in the Canadian dollar from $1.10 tells you much about where currency traders think the economy is going. The trigger for the latest drop has been the plunge in Canada’s current account surplus, which fell to its lowest level since the third quarter of 2003. Our loss in manufacturing is now beginning to hurt more than the revenue we receive from oil exports. Consequently, analysts are expecting relatively weak macroeconomic data from Canada, and a further reduction in the Canadian dollar. Currency markets are hard to forecast, and there is a case to be made that the dollar is near a bottom.

Another definite trend has been a flight to quality. There has been a shift from small caps to large cap dividend-oriented companies, and to more certain bond interest income. This generally happens after a year like 2007. Investors are looking for reasonable valuations in high quality investments.

Manage your portfolio to your goals
This year has served as a reminder that making decisions in an uncertain world can be difficult. Economic forecasts are not consistently accurate enough to serve as a basis for investment decisions. They also say nothing about the degree to which risks are already reflected in financial asset prices.

Investors should consider looking past 2008, and focusing on the long term with a portfolio that is consistent with their continuing investment objectives. But they should be able to live with it in shorter-term market dislocations such as a cyclical bear market.

Understanding and managing risks are the most important aspects of the investing process. Take too much risk and you might jeopardize your financial future with huge losses. Take too little and you jeopardize your financial future with returns that are barely enough to cover your expenses.

An anecdote to illustrate this point comes from the book The Intelligent Investor by Benjamin Graham (considered the godfather of modern investing):

“I once interviewed a group of retirees in Boca Raton, one of Florida’s wealthiest retirement communities. I asked these people mostly in their seventies – if they had beaten the market over their investing lifetimes. Some said yes, some said no; most weren’t sure. Then one man said – ‘Who cares? All I know is that my investments earned enough for me to end up in Boca Raton’”.

Could there be a more perfect answer? After all, the whole point of investing is not to earn more money than average, but to earn enough money to meet your own needs. What matters isn’t crossing the finishing line before anybody else but making sure you cross it.


If you would like to take this opportunity to review your portfolio, please contact your closest CARP Certified Advisor.

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