Financial Post: Wealthy Boomer

Robert Smith, CFA, CFP

At the height of the 2008 financial crisis, I handed over this blog to Markham-based financial advisor Robert Smith. He produced an insightful “guest blog” titled Grandpa at the Casino. You can access it here.

Now Smith, who is a chartered financial analyst and a certified financial planner, is back.

Smith believes — and I concur — that indebted governments will inevitably take the least painful route out of their problems  and continue to resort to the printing presses to repay their debts. So sooner or later, inflation will be a problem, at which point those parked in debt securities issued by those governments will experience a loss of purchasing power.

Smith sees far more security in equities: in the stocks of solid dividend-paying companies that provide real products and necessary services that consumers will need no matter what happens to the global economy. He mentions four examples: McDonald’s, Pepsi, WellPoint and Procter & Gamble, businesses he says that are ‘not going to go away,’ are able to pass on price increases to their suppliers and customers and can be bought at a price reasonable for the profit they earn.

“I recommend that clients think more about what companies they actually own and why these companies are worth something, and less about what the market says their holdings are worth on a day they do not need to sell,” he writes.

The full text of the letter follows:

In the fall of 2008, I wrote to clients to try to help them make sense of troubling times.  After watching the market’s recent reaction to the US debt ceiling showdown, the S&P downgrade, and the trouble in Europe, I feel it is another good time to write to clients.  I apologize for the length of this piece, but I want to explain exactly what I feel is happening, what this means for your investments, and – most importantly – what we should do moving forward.

Anyone watching the news in the past few weeks must be wondering how the sun keeps managing to rise amidst all of the doom and gloom.  Throughout my now 20 year career, I have watched times like this come and go.  We have survived them all and I have every confidence that this will be no different.  Clearly, there are serious problems, but I believe that much of what I’ve read lately is missing the real issues.

The Issues

Whether we are watching rioting in Greece, the US debt-ceiling showdown, or even the City of Toronto simply trying to reduce the number of libraries they offer, the issues in each case are exactly the same:

Governments every where have promised far more to themselves and their constituents, than can ever possibly be delivered under the status quo.

However it occurs, the unwinding of these promises will take years and years, be very emotional, very theatrical, and ultimately very painful.

The pain will not be shared equally so a lot of debate/fighting will occur over who should endure the most pain.

I certainly have my own personal social and political opinions on these matters but will do my best to omit them here.  My personal beliefs simply do not matter as it relates to investing your money.

Similarly, your own political leanings (i.e. how you believe things ought to be, or wish they were) are politically important and valid.  They should not, however, play a role in determining the best actions to take with your life savings.  With the politically biased and polarized media we receive today, I feel it is important to keep this in mind… if we are to make smart choices.

The official debt and the true debt

There are two government debt numbers that are important.  Firstly, there is the official debt figure which can be objectively totaled.  This is the $14.3 trillion dollar amount officially cited in the US or the $564 billion figure for the much smaller economy of Canada.  Secondly, there is the true debt that is the official amount, plus the costs of the vast future promises made by government such as social security, health care, government pensions, etc.

The exact size of this true debt figure is impossible to precisely measure, but it is foolish to think the true number isn’t many times the official number.  I have read reports that reasonably show why this true debt figure is greater than $200 trillion (over 13X the official number!) in the US alone.

Whatever the final figure truly is, or whatever you can accept it to be, the number is staggering and sobering, and most-importantly, far beyond what can be delivered under the status quo.

Additionally, it would be naïve and foolish to think that the Canadian people and our government will somehow be spared from reconciling our own over promises with emotional, theatrical, and painful choices. Make no mistake about it… just as the governments of Europe and the USA, the promises made by Canadian governments cannot possibly be met under the status quo.  Canadians are simply on a higher deck of this same boat.

How debt is repaid

Any individual that has ever been in debt knows there is only one way out.  That is to forego spending on more pleasurable items and direct that money back to the lender.  If you couldn’t repay, you went bankrupt.  Pretty simple.

Traditionally, corporations had similar options available to them, but 2.5 years ago many corporations borrowed way too much, and as opposed to the actual companies becoming bankrupt and their lenders paying the price of default, the companies were deemed  to be ‘too-big-to-fail’ and the debts were transferred to the government.

While all governments may repay their debts just like individuals, many (but not all) governments have another convenient and unique option.  They can simply print money to repay their debts.  Call it ‘Quantitative Easing’, or any other fancy title (more are coming), but printing money is a debt-repayment option available to governments such as the United States and Canada.

It should seem obvious, but it is still important to note that the printing of money is not without cost.  Printing more and more money will ultimately result in inflation.  In the case of inflating the currency, the debts can be more easily repaid with cheaper, devalued dollars.  With inflation, the borrower wins on their debt, and the lender loses on the debt, and the people get poorer because everything costs more.

A Choice for Government

So a money-printing government has a choice:  They can cut spending and dramatically reduce future entitlements (and deal with the problems this approach will bring), or they can print more and more money (and deal with the problems this approach will bring).

Despite all the recent theatrics and political posturing about “heroic” agreements and compromise, I don’t see any political will or even a remote desire among the voting public to even acknowledge the true debt… let alone attempt to pay it off.

Until the pain of high inflation is experienced by the voting public, I believe that printing money – albeit with a fancier name, and always in response to the moment’s latest ‘crisis’ – will be the only way to get, or stay, elected.  I believe that the pain of high inflation will ultimately change the political will, but until that pain is experienced, I think the option to print-money is the likely outcome.

Inflation

The 1970’s saw a period with high inflation and we should think about what happened then throughout that period.

Many recent retirees will remember buying their first home in the early 70’s for $10,000 or $20,000.  It did not take too many years of higher inflation to make $10,000 go from being what a house was worth to what, say, a new car was worth (now it is a used car).  If you had this amount of money in a house, your wealth kept pace with inflation.  If you had this amount of cash sitting in a bank account earning little or no interest, however, you suddenly were poorer in that your money wouldn’t buy as much.

I don’t see it much these days, but early in my career; I would prepare tax returns for elderly people who had retired in the very-early 70’s.  It was not uncommon to see tax slips for the pensions they were receiving.  Slips showing pensions of $100 or $200 per month were more common than not.  At the time they retired, this was a reasonable amount for a pension based on typical wages at that time.  When they retired, $200 per month bought a lot of what a household needs, but the era’s inflation quickly caused this to become a rather insignificant sum… one that would barely pay the heating bill.  Suddenly, inflation caused these people to become significantly poorer.

The government will tell you that inflation is under control because if you need to buy a flat-screen TV, you will find that this has dropped sharply in price.  At the same time, however, a trip to the grocery store will show you that food has increased by about 10-12% in the past year alone!  The cost to fill up your car has also risen significantly as does heating or cooling your home.  I expect this is the beginning of a long trend.

In times of inflation, the value of money in the future – whether it is money sitting in a bank account or a promised monthly pension – drops significantly in terms of what that money may buy.  Real things on the other hand, whether it is a house, or a business that can raise its prices, or commodities such as food, energy, or materials tend to rise in value and keep pace with inflation.

In simplest terms, I think your financial future is most assured, and your ability to meet your future expenses is most secure, when you own more real things and fewer promises.

Your investments — what you really own

Watching the daily ups and downs in reported investment values, the movements soon seem very abstract and it is easy to forget what you truly own in your investment accounts.  I pay little attention to the daily ups and downs, but rather pay very close attention to which companies are inside the funds you own.  When I look inside the investments held by almost all clients, I see businesses that give me comfort because I believe they are well equipped to deal with the real issues, and survive through the scary periods in which we find ourselves.

A business gives me comfort when I know it is not going away, the business is able to pass on price increases to their suppliers and customers, and we own it at a price that is reasonable for the profit it earns.  If a business does not exhibit these qualities, I want no part of it for your life savings.

McDonald’s

For example, the funds in our client portfolios own companies such as McDonald’s.  As we all know, McDonald’s sells cheap food all over the world and owns one of the largest collections of prime real estate in the world.  No matter what riots occur in Greece, whether the S&P calls the US a deadbeat, or whether Toronto mayor Rob Ford is able to close a library without being lynched, it is easy to conclude with 100% certainty that people will continue to need to eat.  If food prices or wages rise via inflation, McDonald’s has the power and clout to force these inflationary costs on to their suppliers or raise their prices to their customers.  I would not apply this logic to a single high-end restaurant, but it is difficult to imagine that McDonald’s won’t safely deliver decent results year after year.

Pepsi

Another example of a company owned in most of your funds is Pepsi.  Pepsi sells cola, of course, but you may not be aware that they also sell hundreds of other products as well such as tea, sports drinks, juices, as well as comfort foods like chips and other snacks.  Again, this company is not going anywhere because people in all parts of the world need to eat and drink.  Finally, Pepsi has the ability to pass on price increases to their suppliers and customers.

Wellpoint

A third business owned in almost all client portfolios is WellPoint.  This is one of the largest providers of health-care insurance in the US insuring about 1 in 9 US citizens.  WellPoint’s enormous size and efficiency give it tremendous pricing power.  This helps ensure its profit can safely continue in the face of rising prices.  Furthermore, the population is aging rapidly and, with that, so is the demand for health care.

Procter & Gamble

A fourth and final business I will highlight is Procter and Gamble.  We all use their products every day as do billions of people around the world.  Will parents EVER stop buying diapers for their babies?  Will we EVER stop washing our clothes or dishes with soap?  How about wearing make-up and applying deodorant? Just as it is safe to conclude that the need for these products will continue, it is safe to conclude that the profits for these companies will safely continue.

There are easily 100 different businesses found in almost all client portfolios which I could discuss in this fashion.  I could go on about how people will not check the news before deciding to pay another month of their cable TV bill, or how people will not look to see if Greece riots have stopped before continuing to insure their homes, or how people will not factor the latest S&P debt ratings when determining whether they need to turn on the heat.  I think the point is made.

You would see we own businesses that sell products people will continue to need in every area of the globe… we are diversified among several different industries and often own multiple businesses within these various industries.  All of these businesses can react and adjust as the times dictate… and the managers of the funds can also sell any business where the price gets too high and change it for a similarly strong business at a more reasonable price.

Businesses like these – and not government promises, or over promises – is what I believe truly gives you the greatest safety.

What should you do?

The only goal of the news is to scare you enough that you keep watching.  As such, I would try to avoid watching the news.  If you must watch, keep in mind that their job is to sensationalize and frighten.

History shows that continuing to buy investments during scary periods ultimately proves to be wise, but it takes a strong stomach.  People who continued to buy investments throughout the last 3 years have enjoyed far better results than those who did not.  I expect this time will be no different.

Similarly, history also shows that panic selling when the market is scary and then returning after “things feel right” does not work.  You inevitably end up selling low and buying high.  Not once in my 20 year career have I seen someone successfully win to this.  I expect this time will be no different.

Thankfully, people do not get a daily statement showing the changed value of their home from the day before.  Whether it is your house or your investments, the price matters only on the day you sell – not the day before or the day after.  I recommend that clients think more about what companies they actually own and why these companies are worth something, and less about what the market says their holdings are worth on a day they do not need to sell.

Most importantly, though, I recommend that you focus on the fact that (despite the news’ best attempts to convince you otherwise) people will continue to need to buy necessities and business will continue to find a way to profitably sell these necessities to them.  In other words, business is NOT going away.

As an exercise, you may wish to try to think of what you will no longer buy as a result of what you see on the news.  Will you stop buying groceries?  Will you stop insuring your car?  Will you forego medicine when you, or your family, are sick?

If you can’t think of many ways by which your shopping will change, it stands to reason that the businesses that supply these things will be fine.  We can extend this to say that shares of these businesses may be the best investments to own if you want to be fine.  I think that is a good sign that these scary times – like those scary times prior – shall pass.

The world’s problems are not new or recent (although the news would suggest otherwise) but rather have evolved over several decades.  Similarly, the solutions will take a long time to play out. Government has promised more than can be delivered and everyone will want someone else to bear the cost for this.

Again, I apologize for the length of this letter but feel these are important issues to understand.  I look at your portfolio as money that must provide you and your family with critical things such as food, shelter, and health care.  It is money that has to be able to buy these critical things down the road.  I have every confidence that we are invested properly to best endure what faces us.

If you need to talk

As many of you know, I am currently on holidays and actually writing this piece from my cottage.  Ironically, my holidays this year are giving me more time than usual to read and try to make sense of what is happening in the world.  I have access to my office computer, as well as the internet.  I am staying on top of things and – if I feel they are warranted – you can be assured that I will recommend changes.

I must insist that taking a brief break from my holidays to talk on the phone is absolutely no problem… please don’t hesitate to ask if needed.

Your trust and confidence are greatly appreciated.

Sincerely,

Robert A. Smith, CFA, CFP

Related

• The perils of selling low

– 62 –

The chart above is almost self-explanatory but is certainly worth perusing if you’re among the legions of investors tempted to salvage what’s left of their portfolios by selling at current depressed levels.

With global markets down 20% or so and thus near official “correction” (if not “bear market”) territory, panicky investors clearly are selling in a desperate attempt to prevent still greater losses.

Only time will tell if that’s the correct response but locking in losses 20% below the spring high may doom any attempt to get back to the previous high water mark.

The chart, courtesy of Fidelity Investments Canada, shows $300,000 invested in a balanced portfolio at the peak of the S&P/TSX on June 18, 2008. Fidelity shows two scenarios, one in which a hypothetical investor switches to an all-bond portfolio at the market low on March 9, 2009,  and the other where the investor weathers the storm and remains in a balanced portfolio of stocks and bonds.

It shows that while the bond investor hasn’t experienced as much volatility as a balanced investor with exposure to the stock market, two years later the balanced investor is ahead.

There’s a right time and a wrong time to exit markets

Of course, Fidelity recognizes that this particular example is an extreme one and that most investors are somewhere between. Here’s how Fidelity Canada spokesman Chris Pepper puts it:

Our message is that it is important to exit the market for the right reasons, when the fundamentals, risk tolerance, goals and time horizon tell us it is the right thing to do, and not because of our emotions at a point in time.

All that said, it’s worth reminding readers that mutual fund companies like Fidelity, which are pretty much stuck with being “long-only” in their equity funds, are strongly motivated to reinforce the “stay invested” philosophy of investing. Thousands of financial advisors that sell their funds would agree, and presumably many more happy clients that made Fidelity the world’s largest mutual fund company.

Market timers could draw quite different conclusions from this chart

Most fund companies and many financial advisors also preach that it’s impossible to consistently time the market.

However, bears and market timers could take the same chart and make some quite different arguments. With the benefit of hindsight, a market timer examining this chart could also make the case for “he who panics early panics best.” Note that the first few months after the June 2008 high depicts a sharp drop, then a little blip upwards: anyone who sold that rally would have been spared the subsequent painful ultimate peak-to-trough drop of about 50% suffered by almost every major stock market that year.

Even taking an initial 10% haircut, one could have taken what remained and put it in a combination of reverse leveraged ETFs (or better yet iPath ETNs if they had been available then) and/or gold bull ETFs and made out like a bandit — relative to the Fidelity course of riding the balanced portfolio down to the bottom and then back up again.

Not that I’m advocating such a strategy right now. I make the point only to remind readers that charts of this nature may look dramatic, but there are many variables to consider. Every stock panic is different and there’s no assurance this one will be as severe and protracted as the 2008-2009 one was.

Even now, pundits are speculating about a possible bottom, while the optimists are once again putting their faith in the governments that got us in this mess in the first place. Quantitative Easing 3 anyone?

Are we witnessing the failure of the “Great Reflation” experiment?

Then again, the current panic could turn out to be even worse than 2008, particularly if you believe the financial crisis that triggered it has never really gone away. Most pundits believe that had governments not stepped in to avert it three years ago, the world was poised for a repeat of the Great Depression of the 1930s. What’s worrisome now is that the U.S. federal reserve and other central banks appear to have used up much of their ammo.

Anthony Boeckh

In his book, The Great Reflation, Anthony Boeckh outlined his thesis that this experiment by most Western nations to “reflate” the global economy was unprecedented. Veteran stock market analyst Richard Russell has repeatedly said governments will inevitably choose to run the printing presses and debase their currencies, rather than accept deflation. “Inflate or die,” is the motto Russell believes politicians live by.

Unfortunately, recent market action suggests the experiment is not going well.
As Columbia University professor Joseph Stiglitz argued in Wednesday’s Financial Times, most stimulus packages were “too weak, too short and not well designed.” The gamble may have been lost, he suggests. [See The Great Recession: We lost the economic gamble.]

How individuals cope with this will depend just how truly balanced and diversified their portfolios really are. My column from last Friday still applies. [See Better hedge than time market]. Hold quality dividend-paying stocks by all means and be prepared to add to them as more blood pours in the streets. But gold funds, cash and bonds and inverse ETFs (and inverse leveraged ETNs like iPath’s) that profit from further market declines may help investors sleep at night on the road to whatever bottom is before us.
– 62 –

Vancouver Sun

Odlum Brown's Murray Leith

Odlum Brown Ltd. director of research Murray Leith says he’s confident that economic fundamentals will “ultimately make the indiscriminate selling look silly.” In a mass email to retail investors Tuesday, Leith lists six reasons to be optimistic about the U.S. economy.

The subject line was the slightly confusing “2008 Game Plan even though 2008 is not going to happen.” Leith started his advisory by referring to Mad Money host Jim Cramer’s recent statement that he’s waiting to buy stocks like Johnson & Johnson because  “he wants a greater margin of safety in case there is a panic on the scale of 2008, even though he expects the economy to hold up.”

Leith says that while it was significant, the stock market rout of the past few weeks “will not derail the U.S. economic recovery. We believe the drop in interest rates and gasoline prices will have a greater impact on Main Street than the action in the stock market.”

Like the good value-oriented contrarian he is, Leith says he personally bought UPS and PWF on Friday, RBA, ECA, NXY, and JPM so far this week and plans to buy more this week. “Don’t forget that the object of the investment exercise is to buy low and sell high.  Good companies will continue to prosper in the muddle-through economic recovery that we believe will stay on track.”

Investors more confident in U.S. than European banks

Below, in his own words, are Leith’s six reasons for optimism about the U.S.:

1.) U.S. home affordability is at a record level, due to the significant drop in home prices and interest rates.  The U.S. housing industry has already collapsed. Many homes have been foreclosed and debts have been written off. Housing could still get worse, but from its already depressed state, the marginal damage to the overall economy would be minimal.  More likely, in our opinion, the significant drop in mortgage rates recently will lead to a bounce off bottom.

2.) The price of oil and other commodities have dropped significantly, which will put discretionary spending money in consumers’ pockets.

3.) Money is flowing from the European banking system to the American banking system, because institutions have more faith in America and its banks. They are also buying U.S. Government debt and driving yields lower, which also suggests that talk of a U.S. debt crisis is misplaced.

4.) The U.S. manufacturing sector is in the early stages of revival, driven by improved competitiveness. The improvement in competitiveness is being driven by the weakness in the U.S. dollar, inflation in emerging markets, the high price of transporting goods overseas, and American ingenuity and innovation.

5.)  Jobs are being created, albeit at a slower pace than hoped. But such is to be expected following a financial crisis. In our opinion, the jobs market will continue to recover.

6.) U.S. consumers are paying down debt and saving more, setting the stage for a brighter future.

- 62 –

I don’t know about you but I found the past weekend particularly restful because markets were closed. Alas, with the resumption of the work week comes the resumption of last week’s negative market action.

The extra few days has allowed a few more market observers to analyze events and guide investors. Here are five public commentaries from some prominent Canadian market observers:

Gordon Pape’s Internet Wealth Builder: another recession? 

Internet Wealth Builder

Gordon Pape

In an August 8th piece titled Decision Time!, Gordon Pape suggests that after last week’s market correction, “we could be headed for another recession,” which could be even worse than the last one.

If you didn’t figure out what kind of investor you are during the crash of 2008-09, you’d better make up your mind in a hurry. The next few months are likely to be rough.

Pape compares last week’s “tumble” to the record-breaking Dow plunge of 778 points on Sept. 29, 2008 after the U.S. House of Representatives rejected a $700 billion bail-out package for the banks shortly after Lehman Brothers filed for bankruptcy protection:

After that, it was all downhill for five months. The difference is that this time there was no single event to trigger the massive sell-off. Rather, it seemed to be a culmination of months of bad news.

Governments around the world were able to stave off a depression in 2008-2009 by throwing trillions of dollars into stimulus packages. “It worked, at least temporarily,” Pape writes, “But now governments are out of ammunition, with some on the verge of declaring bankruptcy themselves. There’s no money left to throw at the problem. Neither is there any room left on the interest rate side.”

The U.S. federal funds rate has effectively been at zero for some years and Pape questions how effective another round of quantitative easing (QE3) would be.

The other option is printing more currency: something Alan Greenspan said on the radio this morning when he told reporters the U.S. could always pay its bills that way. As Pape notes, that would drive up inflation. Little wonder gold continues to spike higher!

Pape says he has been advising reducing exposure to stocks and building up cash and fixed income since June, suggesting one safe harbour is the iShares DEX Short Term Bond Index Fund (TSX: XSB).

If protecting what you have is the number one concern, you should consider keeping most or all of your assets in fixed income and cash until there is clear evidence the world economy is in a genuine recovery mode.

But those with some risk tolerance should be prepared to do some bottom fishing. Pape notes Canadian bank stocks presented standout bargains in the winter of 2009, with BMO yielding over 11% at one point.  “There is a real possibility that we may see a replay of 2008-09. If so, you’ll be able to buy high-quality stocks at 50 or 60 cents on the dollar. But bide your time. It took several months for that market crash to run its course.”

Pape suggests any rally can be used to sell lower-quality stocks and once the sell-off ends after a few months, more aggressive investors can start picking up bargain stocks. “As a general rule (and there will be exceptions) wait until the indexes have rebounded by 15%-20% before you move and confine yourself to dividend-paying blue chips. You can easily double your money in a year, as 2009 proved.”

Patrick McKeough’s Inner Circle: replay of 2008 “not inevitable”

TSInetwork.ca

Pat McKeough

Toronto-based Pat McKeough, who publishes The Successful Investor and Wall Street Forecaster newsletters, concedes that investors who witnessed last Thursday’s 500 point plunge in the Dow …

… can’t help but wonder if we face a replay of the 2007-2009 market plunge. However, though today’s situation could turn out badly, that’s not inevitable. It’s much different from a few years ago.

The 2007-2009 drop was about the collapse of the housing boom while “today’s problem grows out of government attempts at ‘fixing’ the economy in recent years. These fixes, which were mostly unsuccessful, bloated government spending and created huge debts. “

But despite today’s slow economic growth, businesses are piling up record-breaking hoards of cash. “This situation helps hold down interest rates. It’s also a reason why the American dollar is so cheap.”

McKeough continues to advise sticking with his three-pronged investment model, and holding a diversified portfolio of high-quality stocks spread among the five main sectors of the economy.

Meisel  issues Mea Culpa

Phases & Cycles

Ron Meisels

Montreal-based Ron Meisels, of Phases & Cycles Inc., has issued a bulletin entitled “Mea Culpa,” in which he acknowledges that after successfully calling the markets’ direction from the low of March 2009 to the high recent high in May 2011 ….

… we have failed to call the market’s direction correctly more recently .. It now seems obvious that either the indicators all failed or that we have totally misread them. It does not matter; the fact is that we were wrong.

While market sentiment is as “oversold as it was at all major lows in the last two years, the damage done in the last 8 to 10 days is overwhelming,” Meisels says. The 200-day moving averages on all market indices have turned down and are “unlikely to turn back up in the near future. Important support levels have been broken.”

He expects a rally shortly but warns “it is better to be out for now and if necessary enter again, than to wait around for a miracle.”

Mastracci: Don’t get trampled heading for the exits

KCM Wealth

Adrian Mastracci

Vancouver-based portfolio manager Adrian Mastracci, of KCM Wealth Management, notes in an email advisory to clients that “trying to exit Dodge in a big hurry can be like a congested parking lot. Investors often get trampled rushing to the exits to unload at any price.”

The US debt downgrade is a wake-up call that a weak global economy won’t make volatility go away. The financial situation is quite tenuous but frantically trying to find the exits is the wrong, knee-jerk decision. Investors who don’t have an asset mix they can live with (such as 50% stocks to 50% bonds) should find an advisor who can help them.

 

Andrew Teasdale: This is not a normal time

moneymanagedproperly.com

Andrew Teasdale

Finally (this added after initial version of this blog went up), the following analysis from Andrew Teasdale [www.moneymanagedproperly.com] was sent to me after Friday’s blog on assessing the risks investors are taking on. Teasdale has been bearish since well before the 2008 market crash [as was evident in a video interview I did with him that year] and says he went to cash in May of this year.

He began by addressing the efficient market points made by Larry Swedroe in the previous blog. Swedroe is basically an “indexer” and believer in efficient markets. So is Mark Hebner’s Index Fund Advisors and IFA’s 5-point bulletin issued today is worth reading too. Click here.

Teasdale is clearly skeptical about the markets being “efficient” in light of the near depression of 2008 and the extraordinary measures governments have taken since then to stave it off — what Anthony Boeckh has termed The Great Reflation.

I’ve edited down Teasdale’s analysis in places but will simply run this in Andrew’s own words, published here with his permission:

While all the news that appears to have led to the current market gyrations were in fact in the public domain prior to downturn, it is wrong to assume these risks were all fully priced into the market: for one we have had a number of rounds of quantitative easing on a global level which have supported asset prices at a time when underlying economic growth has been anaemic and government debt expanding.

The developments that have taken place with respect to sovereign debt issues are developments that would have been obvious from the build up of debt and structural economic imbalances in the global economy by 2007 at the latest.

Yet, surely if the information that was in the public domain was fully priced into the market in 2007, why has it taken massive government stimulus, ultra low interest rates and central bank support of asset prices just to get markets back to levels that were lower still than those prevailing at the 2007 highs?

Markets, governments, rating agencies and central banks ignored risks that should have been embedded in prices, but were not, for a long time.  How can we be so sure that market prices are fully reflecting risks and returns at all points in time?

The fact is, we are out of equilibrium and the size and timing, in terms of probabilities, of the current market movements are such that they cannot be considered normal.   When things were normal (when markets and economies moved to small extremes and back and ultimately always stabilised on an upward return trajectory) there was little to shake the complacency.

With respect to equities; valuations have been on a downward trajectory since 2000 when so called rational investors  bid up components of global markets to ridiculous highs.  The clarity that hindsight confers is really of benefit  to the irrational investor who ignores important valuation fundamentals and gets caught up with the crowd since rational investors who have access to and use all available information that is in the market place will not be so enlightened after the fact.

Many portfolios not positioned for this correction

This is clearly not normal (that is it is not a normal risk associated with a well balanced economic and market universe) and while I agree that investors should have had portfolios positioned to cope with the risks, and hence would not be selling in the current moment, the fact of the matter is that many investors are not so positioned and many others are driven by short term factors.

Likewise, the more markets fall, the better the value and the lower risk all things being equal, but we cannot use an historical benchmark to determine just how valuable or significant those returns are going to be.

Market risks and returns will not get back to normal until global economic imbalances are wrung out of the system; until then we will have to live with an uncomfortable extreme.  In truth, because of the extreme imbalances, we do not know when things will go back to normal: will the imbalances get wrung out in one go (like the Berlin Wall and the fall of communism in the early 1990s) or will these imbalances be exposed to a long slow death.

In this sense, long term returns from equities may be well below historical averages because economies will be unable to generate the earnings growth needed to support historical average returns, which is again, something which is not normal.

People need to accept that this is not normal, for to assume that everything is normal ignores a reality which must be incorporated into decisions and planning.  That would be what a rationale investor would do.  Just like wartime, we need to learn to accept and to cope and to realise that what life was like in peace time will not return until the war has ended.

PS – as I write the market (S&P) is touching the September 2010 lows which I believe are critical as they represented the point at which the market recovered from its previous jitters; these were jitters I might add, from which the market was seemingly rescued by central bank intervention.

 And me?

For what it’s worth, my own stance is no different than it was in Friday’s column here. It amounts to the old saw that if you can’t take the heat, stay out of the kitchen. Those who can take it should find some refuge in traditional asset allocation, perhaps buttressed by some portfolio hedging strategies mentioned in the column. Those who kicked themselves for missing the chance to snap up stock bargains like the ones in March 2009 may have another opportunity.

I’d be building a larger emergency nest egg and cutting debt. Those with jobs should do what they can to keep them.

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Tridelta.ca

Ted Rechtshaffen

Today’s blog headline comes from financial planner Ted Rechtshaffen, president of Toronto-based Tridelta Financial. I’d contacted him for the article in today’s paper headlined “Better to hedge than time market.”

Our chat came too late in the day for that piece but he made some excellent points. “I think the issue is always looking at what is the risk you’re really holding,” he told me. Investors need to understand what they own and assess what really may be at risk. Back in 2008, while investors may not have realized how bad it could get, someone with a portfolio 40% in bonds, 25% in utility and consumer staples stocks and 10% in precious metals might still have been down 10 or 15% but withstood a terrible time, he says.

Nor does Rechtshaffen expect us to be descending into the pits of hell again. In 2008 and now again in 2011 it’s still about fear and greed. It’s also about capital preservation, which was the thrust of an email advisory Tridelta sent to clients in mid June. It began by pointing out that the market goes up seven in ten years and that $100 invested in the Toronto market in 1950 would now be worth more than $33,000.

That said, clients were told that “downside risk has meaningfully increased over the short term” what with the U.S. debt crisis, Chinese inflation, Greece and everything else. In discretionary portfolios, a few “higher beta” stocks were sold but for the most part, portfolios remain largely invested in bonds, preferred shares and more conservative stocks.

Keith Richards: Time to get bullish

I also got some late input from Keith Richards, portfolio manager with Worldsource Securities Inc. in Barrie, Ont. Here’s what he said via email after I asked him to comment on an earlier communique that it was “time to get bullish.” :

moneyshow.com

Keith Richards

Yes. Very much so. AAII sentiment indicator just went below 35% bulls (historically, this is a very, very strong buy signal). In other words—this is really, really close to the “moment of final capitulation” we talk about. My guess is that, even though S&P broke my previously stated support of 1250-ish level, it will bottom out in the next few days and this will be a screaming buying opportunity. You know my favorite saying is Templeton’s “To buy when others are despondently selling and to sell what others are greedily buying requires the greatest fortitude, even while offering the greatest reward.” He was a technical analyst without even knowing it!!!

I held cash in a big way from April (37% in my equity model)—then started buying this week—I am down to 18% cash and may spend even more of it in the next few days. Honestly—this is the moment I’ve been waiting for. This is the time to buy and not panic. It’s how the rich get richer – and the poor (panic-orientated emotional investors) keep getting poorer.

The fools bought at the top of the range. Disciplined investors remain patient and buy in the panic.

P.S. VIX is spiking which can indicate too much movement too fast. RSI (which is a momentum indicator) just today [Thursday] went mega-oversold at a level of 23 (anything below 30 is oversold) and the AAII sentiment indicator I mentioned in last email hit 27% bulls—meaning that most investors are in pure panic mode. This is just beautiful.

Larry Swedroe: Markets are back to normal

Larry Swedroe

I also heard from indexing guru Larry Swedroe, whose latest market commentary can be found here at CBS Moneywatch.com. See Don’t panic: stock market crises are normal.

In an email to journalists, after listing most of the well-known market worries, none of it good news, Swedroe added this:

It’s important to remember that all of it is known already and thus the information should be embedded in prices.  The problem is that we often see selling begetting more selling, even without more bad news, or news that was worse than already expected … We faced a similar situation in March 2009,and the market proceeded to provide a return of about 100% over the next two years.

Swedroe then ticked off some more positive developments: the falling US$ benefits the US economy by making imports more competitive and imports less so; oil prices have fallen; interest rates have fallen across the board; corporate earnings are strong; Japan has bounced back and T-bill rates are so low (sometimes negative) that investors feel pressure to take on risk, making stocks more attractive than bonds.

In short, crises are normal and bear markets are when you earn the greatest returns. But since this crisis is financially driven, markets could seize up as with the Lehman crisis so “investors should at least consider increasing their amount of liquid assets.” Thus, the three-month emergency reserve mentioned in Thursday’s blog might be raised to six months.

Swedroe closed on a note similar to how we began this blog: that during crises correlations of risky assets tends to rise to one. Investors need to review (with their advisors) their investment plan to determine if they are taking on more risk than they have the ability or need to take. The bull market of the last two years was an opportunity to lower equity exposure.

An ordinary investor: Markets don’t care when your Findependence Day is

P.S. After this appeared, I got an email from an ordinary investor who wished to remain anonymous. Here’s what he wrote:

I think people really don’t understand the risk involved investing in equities. Holding for the long-term increases the risk that you will suffer through a crash. Also, the reason the equity risk premium exists is that it sometimes does not materialize. The period from 1966-1982 had markets return 0% excluding dividends. Sometimes the market does not care when your personal Findependence Day is.

I’m just a lowly independent investor trying not to “blow up” while I try to get to my own Findependence Day. The reality is all of us may have to work longer and spend less. Larry Swedroe calls this your “Plan B”, as uncertainty risk, different from investment risk, is incomputable.

A calm mind helps investors: try meditation

mindfulinvestor.com

Finally, since we’re addressing dealing with human emotions (i.e. fear and panic) this is a good moment to remind investors of a book I reviewed in 2010 called The Mindful Investor. Click here for a video interview I conducted with co-author Maria Gonzalez which describes how her co-author, financial advisor Graham Byron, found meditation useful during the months of the 2008-2009 meltdown.

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More than 40% of Canadians are financially unprepared for a “rainy day” and unsure they will be able to meet their obligations in an emergency, a Leger Marketing survey finds.

The survey of 1504 adults commissioned by BMO in July found a quarter of respondents (26%) had less than three months worth of emergency savings. That’s the minimum most financial advisors recommend households have on hand, and many counsel six months or more.

Debt servicing costs compete with emergency savings

Only 30% have enough of an emergency cushion to last a year or more. BMO blames debt and everyday expenses for these low savings levels.47% of respondents cited credit card or mortgage debt and 41% everyday expenses.

BMO senior vice president Lynne Kilpatrick recommends that debtors consolidate their debt loads by using a line of credit with a lower interest rate, or transferring to a low-rate credit card.

Of those that are saving, 46% hold their savings in investments like GICs, mutual funds or ETFs. 34% use Tax Free Savings Accounts to hold these investments and 15% use high-interest savings accounts for their rainy day fund.

See also my related column about BMO’s five tips on how to avoid hitting your own personal debt ceiling which ran Wednesday here.

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Financial Post

Vanguard Canada's Atul Tiwari

Moody’s Investor’s Service predicts the imminent entry of Vanguard into Canada will force leading domestic fund companies to reduce fees: a “win win” for retail investors but “a negative for Canadian asset managers’ profitability.”

Moody’s describes the Canadian mutual fund industry as “one of the highest fee mutual fund markets in the world.”

With US$1.7 trillion in assets worldwide, “Vanguard’s low-cost model is certain to exert price pressure on Canada’s dominant mutual fund players,” says a mid-June report entitled Vanguard in Canada is Negative for Incumbent Asset Managers. It notes the domestic fund market is dominated by ten players, including the asset management arms of all five big banks. The other five are IGM Financial Inc., Fidelity Investments Canada, Dynamic Funds, AGF Investments Inc. and Franklin Templeton.

Canada’s equity fund MERs more than twice that of US

Citing Morningstar, the report finds median asset-weighted Managment Expense Ratios [MERs or ERs] for equity funds sold by Canadian asset managers are 2.31%, compared to 1.9% in the UK and 0.94% in the U.S.

Canadian fixed-income funds have a median expense ratio of 1.31%, versus 1.14% for the UK and 0.75% for the U.S. Even Canadian money market funds are almost twice as costly: 0.8% versus 0.41% for the UK and 0.47% for the US.

If anything, Vanguard’s position as a low-cost manager is the polar opposite of Canadian mutual fund companies. Moody’s says Vanguard’s average MER is a stingy 0.21%, “a competitive advantage we expect Vanguard to exploit.”

Moody’s says foreign mutual fund companies like Vanguard have not been active in Canada because regulations prohibit investors from buying mutual funds domiciled outside Canada. “These barriers to entry have limited distribution competition, allowing domestic fund companies to maintain high fees.”

However, institutional investors and retail investors are permitted to buy ETFs domiciled outside Canada. Vanguard has yet to say if its focus here will be index mutual funds, ETFs or both.

New Pooled pensions a second way Vanguard can shake up the industry

Financial Post

Ottawa's PRPP champion, Ted Menzies

As I noted in a piece on the weekend — Pooled Pensions: Keep it Simple –  Vanguard’s imminent arrival also bodes well for the federal government’s new Pooled Registered Pension Plans (PRPPs).

That’s Ottawa’s new pension solution aimed at providing market-sensitive pensions to millions of workers in small and medium-sized Canadian businesses.

The article notes Canada’s pension industry has a strong preference for active investment management, which tends to have higher costs than the passive approach Vanguard is largely known for (both in index mutual funds and ETFs).

Vanguard says it has not been approached to bid on PRPP business, but it would do well to initiate the possibility, given its extensive history with U.S. based 401(k) plans.

Spokesperson Rebecca Katz said this in an email responding to my query about its interest in PRPPs:

We have a long history of working with defined-contribution plans and were early proponents of automatic savings plans, auto contribution step-up programs, and well-diversified, low-cost default options (Target Date funds) — all programs that significantly increase the chances that employees will reach their retirement savings goals.

In short, Vanguard is poised to shake up both Canada’s mutual fund industry and possibly its pension industry. While defenders of Canada’s asset managers argue other foreign entities failed to make an impact when they entered Canada — Scudder being the dominant one — Moody’s says “we expect it to be more successful than its predecessors in gaining domestic market share.”

That’s a plus for ordinary people who hope to retire one day. As I noted at the end of Saturday’s piece,  Ottawa needs to remind the financial industry it exists to serve future retirees, not the other way round.

In this context, Vanguard’s imminent arrival is the best thing to happen to investors in many years — unless of course they’re over concentrated in Canadian banks and mutual fund stocks.

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Russell Canada

Keith Pangretitsch

Global unrest and seemingly chronic market volatility is starting to take its toll on retirement expectations for Canadian investors, according to the latest quarterly results of the Russell Financial Health Index.

Second-quarter results of the index — an online calculator that gauges Canadians’ overall financial health — fell to 44.18, down almost four points from 48 the three previous quarters. That’s the lowest the index has been since it was created late in 2008, when financial markets worldwide were cratering.

Broad diversification best protection against macro shocks

When it comes to their future retirement, Canadians are especially concerned about having a reliable source of income and having enough income to cover essentials. Russell Investments Canada director of national sales Keith Pangretitsch says that while “we continue to see strengthening fundamentals in our economy” Canadians continue to feel uneasy about everything from inflation to various governments on the brink of bankruptcy.

He suggests avoiding getting too distracted by short-term market moves and the news, and “focus on the fact that a  broad diversification along with the appropriate asset allocation for their situation is the best defence against these macro-shocks.”

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As the world watches the government of the planet’s largest economy grapple with its ever-rising debt ceiling, there may be a money management lesson for individual citizens.

That, at any rate, is what the Bank of Montreal seems to think. With a week to go until Washington comes up against the August 2nd deadline for raising the US$14.3 trillion debt ceiling, BMO has issued five tips for how individuals can avoid hitting their own personal debt ceilings.

Who knows, maybe Uncle Sam could also benefit from some of them, such as Number 1: “Don’t Overspend” or Number 2: “Curb Credit Card Debt.”

Numbers 3 and 4 are more in the realm of personal finance: “Invest to Save” (especially in a Tax Free Savings Account or TFSA) and “Become Mortgage Free Faster.”

Just like America, one in three Canadians are living at or beyond their means, with 27% living paycheque to paycheque — a 10%  increase over last year. Of course, the US does have recourse to something most individuals do not: a printing press.

American citizens are in just as precarious a situation. See this article about ten facts concerning the average US family’s financial condition.

Tip Number 5 could apply to individuals in either country or to Washington: “Have a Plan B.”

Both indebted citizens and Uncle Sam may need a Plan B

Investors around the world are holding their breath to discover what Plan B may be for America. Hopefully it’s not B as in Banana Republic, as some have suggested. Speaking of bananas, check out this spoof new Federal Reserve Note.

Less than 24 hours after I first wrote this, a Reuters news story used Plan B in its headline: Obama seeks “Plan B” as debt plans stall.

However, our own Terry Corcoran thinks the U.S. will dodge the bullet this time around. See his post here.

Newsletter rater Mark Hulbert notes here that gold and the Swiss franc are viewed as safe havens during this tense countdown but suggests big American multinational stocks with dividends could also be a beneficiary.

The Vanguard Group has an interesting Q&A for investors here but generally suggests they “wait and see” before doing something they may soon regret. As personal finance columnist Jane Bryant Quinn tweeted on Wednesday, cash and gold may be short-term havens but if the crisis passes investors may soon regret selling out core stock and bond positions.

Or maybe Captain America will come to the rescue, as editorial cartoons have suggested recently: most show the superhero attempting to deal heroically with the growing mountain of debt, such as this and the one featured above (posted with permission of Aislin of the Montreal Gazette).

(And yes, I did view the 3D film this weekend and enjoyed it.)

P.S.
A column based on this blog ran in the paper on Wed. Aug 3 under the headline Avoid your personal debt ceiling.

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Fotolia

Three oft-cited risks to retirement are outliving your money, inflation and rising health care costs. But baby boomers approaching the holy grail of Retirement may not have considered the cognitive loss that accompanies aging.

A BMO Retirement Institute report issued Tuesday notes that with rising life expectancies, more baby boomers will have to deal with the decline of their cognitive abilities — including that of making complex financial decisions.

Contrary to popular belief, investment skill doesn’t improve with age once you pass your prime. As Alzheimer’s Disease and other forms of dementia afflict us, our ability to make sound financial decisions is impaired.

The problem is exacerbated by the fact that during the early onset of these conditions, the person afflicted may not be even aware of it, according to University of Toronto professor of medicine Dr. Michael Baker.

The need for a Continuing Power of Attorney (CPOA)

That’s why we need to act while we’re still of sound mind and prepare a legal document called the Continuing Power of Attorney or CPOA. This gives another person — sometimes a spouse, sometimes a child or other family member — legal authority to make decisions about your finances and delegate your financial affairs in the event you’re no longer able to manage your money or business.

The report by BMO Retirement Institute Tina Di Vito is entitled Financial Decision Making: Who will manage your money when you can’t? The report features two guest contributors: Dr. Baker and Elena Hoffstein, providing respectively medical and legal perspectives on this problem.

It’s no exaggeration to describe this as a severe looming problem. The number of Canadians with Alzheimer’s is projected to more than double from 500,000 today to 1.235 million by 2038. And here’s a scary stat — the likelihood of developing dementia doubles every five years once you reach age 60. Note that the first wave of boomers born in 1946 have been turning 65 throughout 2011.

Here’s what BMO advisory counsel member Elena Hoffstein (Partner, Fasken Martineau DuMoulin) says in the BMO release:

It’s very important for Canadians to appreciate that they should plan for mental incapacity while they are still mentally capable. Without a CPOA in place, often the only recourse is to have a court-appointed guardian manage your affairs.

Column version ran Wednesday

P.S. The column version of this blog ran in Wednesday’s paper under the headline Prepare Now, While Still of Sound Mind.

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