What is happening to the markets?

Zoomer | September 27th, 2008

Investors, investment industry professionals, and even regulators have been
quite anxious
about the current market situation. Clearly, these are tough times — and
no one can predict
exactly what lies ahead in the next few days, weeks, or months.

Given this uncertainty, we thought it would
be helpful to review some fundamental truths
about investing that have guided our approach to
designing your portfolio; they are at the heart of
the advice we give our clients.

As well, we want to share our outlook for the
upcoming period.

Our advice is based on six principles:

1. Well-chosen stocks outperform every other
asset class over the long run — by much

The U.S. stock market provides the best data over
a long period of time, with good information going
back to 1925. If we go back over that time (which
includes the great stock market crash and depression
of the 1930s), stocks of large American companies
outperformed the bonds of those same companies
by a margin of roughly 1.75 to 1.

That means the money made from stocks was
almost twice that from bonds over five years, and
with compounding, nearly three times that of bonds
over a 20-year time frame.

2. The price for superior performance is volatility

Along with superior performance comes volatility.
As a general rule, stock markets make money
roughly three out of four years. That means, of course, that they lose money
the fourth year; the
reason stocks are a good long-term investment is
they do well enough in the 75 per cent of the time
they make money to offset the 25 per cent of the
time they lose it.

Academics call the margin of outperformance for
stocks over cash the equity risk premium. In fact,
the academics state that if stocks were not risky,
they would not provide a superior return — stocks
have to provide higher returns over time to
compensate investors for the volatility. If they
weren’t volatile, their return would be the same as
that of GICs. We would be happy to discuss the
principle of risk premium in stocks and what it
means the next time we meet.

3. Volatility cannot be avoided in the short term

We would all love to own stocks when they rise and
be on the sidelines when they fall. Unfortunately,
that’s simply not possible. If you were to ask a group
of investment professionals to name someone who
did a consistently great job of picking stocks over a
long period of time, a number of obvious
candidates would emerge — John Templeton
globally, Warren Buffett in the United States, and
Bob Krembil in Canada, who managed Trimark
Funds until 2000.

Ask those same professionals to name someone
who has consistently predicted when to get into
and out of the stock market and you would draw
a blank. Many people have made one, two, or
even three good calls on when to get out of the
market. However, no one has demonstrated the
ability to be consistently right — and those who
have tried to time getting in and out of markets
have typically been wrong at least as often as
they’ve been right.

Investing always entails a combination of pain and
gain — the question is when they occur. When we
have weeks like the one this month, the pain of
investing is immediate, the gain is in the future.
If you avoid stocks, the gain in peace of mind is
immediate, but the pain in lost opportunity and
retirement lifestyle is to come.

In times like these, sitting on the sidelines can be
tempting and is certainly an option if you truly
can’t live with the volatility we’ve experienced of
late. Let us remember, however, that history
shows that when stocks recover from a significant
drop, they tend to do it very quickly — being out
of the market can mean missing a rise of 25 per
cent or more.

4. Volatility decreases the longer you invest

The good news about volatility and risk is that
the longer your time horizon, the less of an issue
they are. Over periods of five or ten years, the
variations in returns are reduced to a fairly
modest level.

For investors who need to cash in their savings in
the near term, the present markets pose a real
problem. Before recommending that our clients
purchase investments for their portfolio, our
team tries to ensure that the money will not be
needed in the short term so that they are not in
the position of being forced to sell.

Historically, for investors with a time horizon of
ten years or more, volatility decreases to the
point that it is almost a non-issue.

5. Investing based on fads and emotional
reactions can be devastating

In our years in the investment industry, we have
seen fads come and go and have observed how
they can devastate portfolios.

That is why we generally bring a conservative
stance to the portfolios we construct for clients,
avoiding “flavour of the day” investments that are
hot one day and plunge the next. Similarly,
emotional reactions can be deadly to a well-balanced
portfolio. There is a well-known saying
that most investors fluctuate between fear and
greed. Excessive optimism dominated until
recently; today fear and pessimism rule.

Making decisions based on fear and greed can
destroy value in a portfolio. We see our role in
part as being an emotional anchor for our
clients — preventing the emotional highs from
becoming too high, the lows from becoming too
low. Until recently, our struggle with some clients
was avoiding an overly optimistic viewpoint,
throwing caution to the winds. Today, for some
of those same clients the challenge is to prevent
an excessively pessimistic and negative outlook.

6. Based on history, the right managers will
prove their worth over time

Our firm spends a great deal of time conducting
due diligence on the money managers whom we
recommend to clients.

Before we include money managers in client
portfolios, we look for strong investment convictions
and discipline, deep teams of investment
professionals, consistent outperformance over an
extended period of time, and a track record of
containing losses in downturns. Once we have
selected a money manager, we spend a lot of
time monitoring the stocks being bought.

We believe a strong team of managers is in place
that will serve us well over time. Even as we
write this, those managers are looking for
bargains among the stocks that have been beaten
down by recent events.

Some clients have expressed concern that we
are standing pat in the face of turbulent markets.
It is important to understand that while we may
not be changing the managers we work with,
below the surface your portfolio is being
modified as they realign the stocks they hold to
capitalize on opportunities.

Outlook for the period ahead

It is almost certain that stock markets will continue
to see unusually high levels of volatility in the
period ahead, and without question it will take
some time for U.S. and Canadian markets and
economies to work through the excesses of the
recent past, whether from the U.S. housing
bubble or the run-up in commodity prices.

As we look past the current environment and
ahead to the mid-term, despite the ups and
downs (especially the downs), there are a
number of encouraging signs:

– Central banks around the world have made it
clear that they will intervene if that is what it
takes to keep markets functioning — as they did
this month.

– The ban announced in the U.S. on short selling
of financial institutions (a tactic used by some
predatory investors to put pressure on the
stock prices of those companies) is likely to
reduce the extreme volatility in that sector.

– To this point, it has been a financial rather
than an economic crisis. While economies in
Canada, the U.S. and elsewhere have slowed,
there is no sign of a steep recession on the
horizon. The fact that the U.S. and Canadian
central banks did not cut interest rates at their
recent meetings suggests that they are not
predicting a significant downturn.

Again, we would be happy to discuss this with
you when we talk next.

– A number of very positive forces are in place
for the mid-term. Among these are generally
low inflation, the continued positive impact of
technology and innovation on productivity, the
overwhelmingly beneficial effects of increasing
global trade, good economic and political news
from most of Eastern Europe and South
America, and the inexorable momentum
towards opening up markets in China, India
and other parts of the developing world.

Importantly, while declining oil prices have hurt
stocks in the oil patch, they are helping boost
consumer confidence and wallets.

Good managers are finding exceptional values
today. As a result of the run-up in financial
stocks, some managers with a superior track
record for picking stocks largely avoided the
U.S. financial sector because of overheated
valuations; in some instances, these managers
are taking advantage of depressed prices to
start buying these stocks.

In summary

The American sportswriter Damon Runyon once
wrote, “The race may not go to the swift nor the
battle to the strong, but that’s the way to bet.”

When it comes to our investment strategy over
the next while, it is, of course, possible that past
lessons may not be of value going forward, and
some managers who have proven their worth in
the past may fail us in future.

That said, when it comes to investing, building on
the lessons of history and putting managers with
strong track records to work for us is the best
way to tilt the odds in our favour.

We look forward to discussing recent events in
more detail the next time we talk. Should you
have any immediate questions, we would be
delighted to address them.

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

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