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Irrational Markets

The recent extreme volatility of financial markets deserves some analysis and comment. At all times market action represents a combination of fundamentals and emotion. Fundamentals include economic data that reveal economic growth or decline and information related to specific industries or companies. Strong economic numbers should signal improved prospects for corporations and their investors. Weak economic numbers signal the opposite. A corporation showing increasing earnings with the potential for further growth, and maybe a dividend increase, should also see their stock price appreciate. In the long term these fundamental trends determine whether markets and individual securities rise or fall. In the short term, however, emotion can rule markets and fundamentals can be ignored. We are in such a period today.

To better understand why we are where we are today in financial markets we need to look back at the period from 2002 to 2008. Equity markets in Canada and the U.S. rose steadily, often providing double digit returns. Money managers focused on capital gains with little regard for dividends or price earnings multiples. The market crash of 2008 was a traumatic experience for many managers. While after the crash there was more attention paid to dividends, the main impact on strategy was to convince many money managers that they should never allow themselves to be caught in a major market sell off again. The result is a money management community that will hit the sell button quickly and often at any hint that equity markets are heading down. The recent sell off of equity markets was caused by the Federal Reserve Chairman Bernanke announcing that the present stimulation program could be ending. It would be ending only if present positive trends in the U.S. continued and employment levels reached acceptable levels. In simple terms,the U.S. economy is now potentially improving fast enough to no longer need the stimulus program. This good economic news was ignored, the end of stimulus was emphasised, and the selling started and snowballed.

As proof of the foregoing comments investors should look back over the last several years. A year ago the market fell sharply because the European Union was going to collapse bringing down world financial markets. The European Union is still with us. At various times it has been the fear that China is going to fall into recession that affects the market. China however continued to grow at 7%+.

More recently in Canada it was the news that the U.S. telecom Verizon was in the market to buy a junior Canadian wireless provider in financial trouble. This sent Canadian telecom stocks down significantly. The assumption one must take to justify selling is that Verizon would aggressively spend hundreds of millions of dollars to become a major Canadian telephone provider – a very unlikely event. It is more likely Verizon will enter the Canadian market with caution and have only a marginal impact on Canadian Telecoms.So again, Canadian equity markets are reacting to something that has not yet happened and may in fact never happen.

Adding to market volatility has been the introduction of computer trading. The moment a buy or sell order is entered into the market, computer programs kick in, buying or selling 100 shares at prices just above or below the order placed. If an order is at the market the computers are able to shave a little off each order to the benefit of the bank or broker running the program. The Stock Exchange claims that liquidity is improved, but investors are paying for that liquidity. Also if there is a rush to buy or sell by investors the computers will magnify the trend and add to volatility. The retail investor viewing the mindless swings of equity markets has become doubtful about investing. The basic function of moving savings from investors to corporations, who will put the funds to profitable use, has been interrupted. New equity issues are few and far between and many small companies are starved for funds. Anecdotal evidence indicates that many small investors, wary of equities, are continuing to buy long-term bond funds. With the decades old bond rally ending the timing couldn’t be worse. Bond investors should focus on positions in short-term bonds or short-term bond funds. Also an option are actively traded bond funds that can hedge out the risks of rising interest rates.

Before developing an investment strategy in this environment, an investor should step back and view the world as it is, rather than have a clouded view of day to day equity markets. The U.S. economy continues to make steady progress with the financial sector now in good shape. The housing sector is expanding, with prices for existing houses rising and housing starts trending upwards. In Canada, slow economic growth continues and the housing market is stable; this should relieve some of the recent fears of an imminent collapse. All in all,corporate earnings have been good with more surprises on the upside than the downside, and there have been more dividend increases than cuts. Despite the wild gyrations of equity and fixed income markets, in the real world, and particularly in the corporate world, where investors are participating, things are ok. The simple advice is to ignore the daily ups and downs and focus on your portfolio’s cash flow. Is it holding its own? Can it be increased without increasing risk? In the long run reality governs all markets and quality investments will provide solid returns. As a firm, when and where appropriate we are utilizing many non-traditional asset classes, such as private real estate investment trusts, a short-term private mortgage fund, and a credit strategy fund (bond hedge) to reduce the market volatility of our client portfolios. These investments have more consistent values and tend to provide excellent cash flows in the 5-8% range.

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