After the stock market meltdown in October 1987, I watched a colleague scream, “Armageddon, Armageddon, Armageddon!” “Hunh?” I replied.
He said, “This game is over and I’m a gettin’ out of here.” Then he walked out the door and left the business. Unfortunately, he missed the 16 per cent gain in the S&P 500 in 1988 and the 31 per cent gain in 1989, and it highlights the quintessential example of why it’s hard to time the market.
Now it’s 2009 and the question is, should we be screaming armageddon and running to the root cellar with our arms full of canned goods, or should we be staying in the game and looking for long-term bargains? Generally, I am paid to be an optimist, so I am hoping that 2009 will be more like 1989 with its huge rebound, rather than like 1929 with the Great Depression that followed. Here are few reasons to be cautiously optimistic along with some ideas to consider.
Government Sponsored Initiatives
In today’s economic climate, central banks and governments are taking an active role in managing money supply, interest rates, and fiscal spending programs. The American government, in concert with the U.S. Treasury and Federal Reserve, has provided guarantees and direct funding to help stabilize the banking system. They have also worked closely with the central banks and finance ministries of the G7 countries, helping to co-ordinate a global bailout. The credit markets are again awash with cash. Interest rates have not been this low since the end of the last bear market in 2002. The exception is the home mortgage market, which is still price-sticky but may come down very soon.
This was not the case in 1929 or immediately after. In Canada, for example, the Bank of Canada only came into existence in 1935, six years after the crash. The Employment and Social Insurance Act of 1935 had a limited payment structure and its creation also came six years after the crash. The U.S. banking system suffered massive sell-offs and bankruptcies as investors removed deposits and either put them “under the mattress” or converted to gold. The Canadian banking system avoided this fate; however, their lending policies became extremely restrictive causing further delays to the end of the depression. To make matters worse, as global activity plummeted, many nations erected tariffs and trade barriers to protect domestic industries, which reduced global trade. Throw in a series of droughts and wheat crop failures, and you can see why it took so long for the Canadian economy to recover from the 1929 crash.
Derivative Investment Products
This area represents the greatest difference for small investors between 1929 and 2009. Over the last 80 years, the financial markets have grown in size and complexity. Risk management became one of the overriding tenets in modern portfolio theory. Strategies and products that were once the domain of hedge- and pension-fund managers are now open to the individual investor. Options and futures, equity-linked notes, and exchange-traded funds are tools you can use to reduce risk and increase return in your investment portfolio. Volatility is one measure of risk. Volatility comes with opportunity. For example, contact your advisor and look into the strategy of buying 100 shares of XYZ Corporation (or your favourite bank stock) and then selling a call option with a six-month expiry term. Potential returns are quite profitable. Equity-linked notes provide investors with a principal guarantee along with the ability to participate in a variety of stock, commodity, and currency exposures. Horizon Beta Pro offers exchange-traded funds with leveraged exposure to rising or falling markets. Call your advisor for information.
Alternate Investment Asset Classes
While many investors may still be fearful of looking at their stock portfolio, cash tends to migrate towards the greatest-return asset class with the least amount of perceived risk. The meltdown in the stock market actually started in the corporate debt market. Earnings disintegrated and stock prices collapsed due to massive write-downs of junk bonds held by corporations as assets. This led to a flight-to-quality syndrome, whereby investors sell corporate bonds and buy government-issued ones. This has created an opportunity because many good-quality bonds have fallen in price leading to higher than normal yields both in the short and long end of the interest-rate curve. For example, at the time of writing, the difference between a 90-day Government of Canada treasury bill and a 90-day Bankers Acceptance issued by one of Canada’s major banks was around 2 per cent. Up until last year, the difference was about 0.25 per cent. The same can be said for bank GIC rates and bond yields issued by the same bank offering the GIC. Personally, I would rather have the higher yield and buy the bond when allocating funds towards fixed income. Warning: not all bonds are created equal. The terms of your protection are stated in the trust indenture and not all bonds give you the same protection, so talk to your advisor before you invest. I also believe that once confidence is restored in the debt markets, cash will, once again, migrate to the stock market to get the best return with a measured degree of risk.
Dollar Cost Averaging
For those investors in the building phase of their investment wealth cycle, now is a very important time to examine your holdings and decide which ones you should add positions to. Monthly purchasing programs with financial institutions and mutual-fund companies are the best example of dollar cost averaging. For those investors with cash on the sidelines, reallocate cash into high dividend-paying stocks. Another strategy is to subscribe to dividend-reinvestment programs offered by many companies. Instead of receiving a cash dividend, you receive additional shares of the company. Over time, an initial investment of 100 shares paying a five-per-cent dividend could grow to 200 shares in less than 16 years, and this assumes no increase in dividends. There are two added benefits: shares from the dividend-reinvestment program are purchased commission free and at a discount to the prevailing market price.
Lastly, over a long cycle, stock markets are driven by the general level of economic activity, prevailing interest rates, and corporate profits. In the short run, they can be affected by manias that drive stock prices to euphoric levels or punish them and cause them to plummet in waves of capitulation selling. Volatility continues to increase and global markets are now more closely linked than ever before. A financial misstep in Germany or South Korea last night can have a negative impact on your Canadian investment portfolio today. Therefore, step number one: stop checking your stock portfolio seven times a day. It could be down three per cent in the morning and up four per cent in the afternoon. If you have a diversified portfolio and are investing for the long term, evaluate and monitor it weekly, monthly, or even quarterly. Let your advisor have the sleepless nights. If anything important comes up, they are paid to alert you to opportunities or warn you of dangers. I only have to look at the last bear market and kick myself for not buying blue-chip stocks that went on sale 50 per cent or more below their previous peak.