Wednesday, 7 March 2012

January is behind us, and now that most people have had the opportunity to absorb their investment results from their 2011 statements, this seems like a good time to pause and try and place things into a historical perspective.

Dating back to the tech bubble of 2000 through the credit crisis of 2008, investors have been dealing with a frustrating market environment.  In the U.S., for example, the S&P Index has only just returned within the last week to its previous high, set in early 2000, while the MSCI World Stock index is still well down over the past decade. While the Canadian TSX 10 year index has certainly fared better, at a compounded rate of under 7%, it still lags historical averages.

2011 offered little relief from long-term stress. In fact, for a good part of the year if you believed the media, 2011 resembled 2008 with the world teetering on the edge of another credit abyss. In 2011 worry over potential problems became more important than economic reality.  Strong corporate earnings, increasing employment numbers in North America, and continued economic recovery throughout most of the world could not overcome a lack of faith in politicians and governments and the fear of nations defaulting on their debt. 

Throughout the second half of 2011 the debate over U.S. debt levels and the European debt crisis resulted in stock market volatility that was significant, frequent, and affected all markets as investors moved to the dubious safety of bonds despite credit downgrades and the threat of default. All world equity markets had negative returns for the year. Canada was down 11.1%, the MSCI Europe, Asia and Far East index was down 14.8%, and emerging markets dropped 14.8%. The U.S. S&P Index led all G7 nations, with a non return of 0%.

What made the situation even worse were the severe and comprehensive swings in the market. Historically, for example, the S&P 500 index sees a 2% change in daily values once a quarter. In the summer of 2011 such a swing happened, on average, twice a week.

Even worse, instead of stock markets being a mechanism for separating good stocks from bad, everything moved in lock-step in 2011, with no place to hide. Again, in the history of the S&P 500 there have only been 11 days when more than 98% of the stocks that make up the index all moved in the same direction, and 6 of those days occurred in 2011. 

With long-term investment results being moderate at best, and with recent investment results being negative, people are naturally expressing concern. Some are fleeing investment markets for the perceived safety of cash, interest bearing investments, government bonds or real estate. Unfortunately, there is risk associated with every type of investment. At current 1-year GIC rates of 2.5%, for example, it would take almost 29 years for money to double. In fact, with the current rate of inflation running at approximately 3%, the purchasing power of a GIC investment will actually decline significantly over time. For its part, real estate can offer long-term growth, but as U.S. residents have discovered to their cost, housing prices can fall significantly. Although Canada has not, yet, had a significant pull back in real estate prices, it did happen in the early 1980’s and 1990’s, and recent headlines have warned of potential headwinds for the Canadian residential real estate market, with prices currently at all time highs.

Equity investments have historically offered those who have stayed consistently invested higher long-term returns, with the price for those returns being shorter-term volatility.  The emphasis, however, should be on the words “consistently” and “long-term”.  There have been extended periods where stocks have traded within a range for an extended period.  Although these ‘sideways’ markets have lasted, on average, 13 years, the good news is that we are currently in the 12th year of this current cycle. At some point, values will move forward to new highs.

One of the reasons that people tend to fear market volatility, I believe, is that they tend to have a limited sense of their own long-term investment horizon. A 50-year-old couple, for example, will tend to say “ We want to retire at 62, so we only have a 12 year investment period. We can’t afford to wait out this period of volatility.” Their need for investment returns does not, however, stop at retirement. Indeed, statistically speaking, there is currently a better than 50% chance that one of this couple will be alive and needing an income, at age 90. This means that this couple still have a 40-year investment horizon. Yes, there will be a need to provide an income at age 62. However, if their funds are to last a lifetime, they still need to generate the kind of returns that only long-term equity investments have historically provided. They therefore need to maintain a disciplined, diversified portfolio of investments and not be swayed by emotion when the periodic storms of despair sweep the investment landscape. 

As Kim Shannon with Sionna Investments notes: “Long term equity market returns apply only if a portfolio remains invested throughout the volatility.” As the following chart indicates, individual investors have historically had the unfortunate tendency to pull out of a market at the low point, only to get back in at the high point, once ‘greed overcomes fear’. The result is below average returns, constant dissatisfaction, and a failure to reach even market average returns over time.

(The line graph shows the value of the S&P 500 index, and the bar graph shows the flow in and out of U.S. equities. Clearly, investors were selling just at the time they should have been buying)

So where does that leave us going forward into 2012? Having taken part in over a dozen meetings with bank economists and investment fund managers and Chief Investment Officers over the past month, I have noticed a remarkably positive attitude emerging – even among those who have been on the more negative side over the past couple of years. Eric Bushell (C.I. Investments), for example, feels that the announcement by the European Central Bank in November 2011 that it would provide 700 billion Euros in unlimited bank financing, with further lending to come by the end of February 2012 has gone a long way towards resolving the credit situation in Europe. Martin Hubbes (CEO, AGF Financial) agrees. He feels that European leaders are taking the right steps, and that the world is closer to global economic health than it was a year ago.. Both Hubbes and Fred Sturm (MacKenzie Financial) point to encouraging signs that the U.S. economy is getting stronger. Corporate profits are high, employment numbers are surprisingly robust over the past few months, and there are clear indications over the past 4 months that the important U.S. housing market has stabilized, and is even projected to grow (for the first time in 4 years) in 2012.  .
Although there are still global issues to be resolved, Kim Shannon and Gerry Coleman (Harbour Funds) feel that there are several reasons to be optimistic. With markets having already priced in a negative outlook in 2011, equity valuations are now attractively priced.  In some cases, valuations are as low as they were in early 2009. Eric Bushell and many others are particularly positive on U.S. stock valuations. Although the U.S. market has under-performed for over a decade, there seems to be a widespread attitude among fund managers that the stage is set for a comeback in U.S. equities.

There is also a consensus that, with GICs and government bond rates of return at near historic lows, equity dividend yields are appealing. Why invest your money in a GIC with a bank at 1.5%, when that same bank’s stock pays a dividend that approaches 4%? Plus, when the price of that bank’s stock fell (temporarily) as a result of headline news in Europe, the dividend yield on that stock actually rose.  (I,e, an $0.80 distribution on a $20 stock stays the same if that stock price falls to $15. The yield therefore rises from 4% to 5.33%) The holder of that stock is therefore being paid a premium well above interest rates to wait for a market recovery. 

There is no question that there are still global problems that need to be overcome. National debt levels are still too high, and both the U.S. and Europe need to move faster to control their debt issues.  There will continue to be policy mistakes on the global scene, and we have not seen the end of periodic volatility in world markets. Nevertheless, in the words of GLC Asset Management:
Barring a natural disaster, geopolitical crisis or a dramatic 
political misstep, we feel the odds are for a positive surprise,
which  would boost global stock markets should ‘better than 
feared’ news come out of Europe…We are optimistically 
leaning forward on our toes rather than on our heels as far
as our outlook for stock markets in 2012…(and)…we expect
bond markets to lag in 2012.

Over the last few years, since the start of the credit crisis, bonds and bond funds have been the refuge of choice from a world of equity volatility. However with 10 Year Government of Canada matching an all time historical low rate of 1.95% in November, 2011, the days of government bonds as a safe haven may well be numbered.

Since the exceptionally high interest rates of the early 1980’s, when mortgages were renewing at 18% to 20%, there has been a long steady decline in interest rates. That has resulted in a 30-year bull market for bonds and bond funds, since every percentage point decline in rates has resulted in capital appreciation of existing bonds.  Now that a historical low has been reached, we may well be approaching a historical shift in long-term trends. 

Although the U.S. Federal Reserve has indicated that it intends to keep interest rates at current levels through 2014, there is little doubt that eventually interest rates will have to rise. The implications for such a rise are indeed bleak for investors who have become used to steady returns from bond funds. Not only will they be saddled with historic low rates of return on government bonds, but for every 1% rise in future interest rates the capital value of their existing portfolio of bonds will decrease by between 6% and 8%. The prospect for corporate and high yield bonds is not nearly as bleak, given the current significant rate spread between these investments and government bonds, but these options have always had a degree of volatility that the true equity refugee has traditionally been unwilling to tolerate. Gerry Coleman perhaps stated it best. In speaking of those who have relied on bonds and bond funds to provide a reliable rate of return he noted: “Enjoy the party, but dance close to the door.” 

So there we have it. According to those who are paid to know, equities have under-performed over the past decade but offer good value, hope for the future, and should ultimately return to their long term averages. Bonds have been a safe refuge over the past decades but the outlook for bonds in a rising interest rate environment is problematic. The best advice for investors going forward is much the same as it has been in the past. Keep a diversified portfolio that is in keeping with both your risk tolerance and investment horizon. Ignore the short term media storms and blaring headlines, and try as much as possible to keep your emotions in check. Keep in mind that challenges have always created opportunities, and that those who done best over time are those who stayed disciplined.