Perspectives – October 18th, 2012

October 18, 2012

Where we stand in 2012 – Insights from a Wall Street legend

As October comes to a close, we’re now three quarters and a few weeks through a very eventful 2012.

I’d like to summarize what’s happened this year and share my thoughts on how I’m recommending portfolio’s be positioned for the period ahead. To help do that, I’ve tapped into insights from Barton Biggs, a legendary observer of the investment scene who passed away earlier this year after 40 years in the investment industry. Before we get into his views, here’s a summary of 2012 to date.

This year has been a tale of three quarters, with returns to the end of September of a positive 5% in Canada. Note that this is the third consecutive year of substantial underperformance by Canadian stocks – 2012 has seen gains of 16% in the U.S. and 13% globally.

The first quarter saw the strongest start for the U.S. stock market since 1998, driven by a reduction of fears about Europe, as well as stronger economic data in the U.S. The second quarter gave many of those gains back, due to escalating concerns about the European currency union and slowing global growth, accompanied by discouraging data on employment. We also saw a slowdown in China and India, putting downward pressure on the prices of oil and other commodities and stocks in general.

Over this last quarter markets bounced back, as the U.S. Federal Reserve Board and the European Central Bank (ECB) put measures in place to stabilize economies and to boost growth prospects. In particular, European confidence was boosted by the ECB’s announcement that it would support Greece, Spain and other countries whose economies are struggling.

Here’s a summary of global market performance in 2012 to date, all in local currency.

2012 Canada U.S. Europe Emerging Markets Global Returns
Q1 +5% +13% +8% +11% +12%
Q2 (6%) (3%) (4%) (5%) (4%)
Q3 +7% +6% +7% +6% +6%
2012 to Date +5% +16% +11% +11% +13%

Source: MSCI returns including dividends, all returns in local currency

Guidance from a Wall Street legend

Of course looking back is always easy – looking forward is more challenging. To help me do that, one of the sources I’ve always looked to has been legendary Wall Street veteran Barton Biggs. Given that my philosophy is aligned fairly closely with Biggs, I thought it worthwhile to share his views with you.

Barton Biggs entered the investment industry in 1961 and in 1973 joined Morgan Stanley, where he served as chief global strategist from 1985 until his retirement in 2003. He was named 10 times to the All-America research team and was voted Wall Street’s top global strategist each year from 1996 to 2000. Among his claims to fame:

· He predicted the bull market that began in 1982 and warned investors about Japanese stocks prior to their collapse in 1989.

· In an interview in July of 1999, he identified a bubble in the US market and advised investors to sell tech stocks,

· He correctly called the bottom in US stocks in March 2009

Biggs wrote extensively on how investors can prosper in volatile markets. Three of his themes are especially relevant today:

· Why owning stocks is essential for most investors

· The challenges of investing rationally in an irrational world

· The psychological makeup of successful investors

Why owning stocks is essential

One insight from Biggs relates to why almost all investors need to own equities at some point in their investing lives:

The history of the world is one of progress and as a congenital optimist, I believe in equities.   Fundamentally, in the long run you want to be an owner, not a lender”

Biggs also discussed the trap of making short-term safety your only investment consideration and sacrificing higher returns for lower volatility:

Warren Buffett put it best when he said he would always pick an investment strategy that over five years would give him a 12% compounded annual return, but that was volatile over one that promised a stable 8% return annually.”

Rational investing in an irrational world

Biggs also wrote widely on the challenges of being caught up in the emotions of the market and also the tendency to root our investment outlook in what happened in the immediate past, rather in than what’s happening today and what will happen tomorrow.

This is no different than military officers who attempt to prepare for the next war by applying the lessons from the last one, without recognizing that the context is entirely different. Biggs’ comment helps explain peculiarities such as massive inflows into government bonds during a period of all-time low rates, leading to the virtual certainty of capital losses when interest rates rise (which has been happening over the last few  years):

As investors, we always have to be aware of our innate and very human tendency to be fighting the last war. We forget that Mr. Market is an ingenious sadist and that he delights in torturing us in different ways …. Mr. Market is a manic depressive with huge mood swings and you should bet against him, not with him, particularly when he is raving.”

Biggs went on to refer to a comment by Warren Buffett about investing – that it is like being in business with a partner who has a bi-polar disorder:

When your partner (with a bi-polar personality) is deeply distressed, depressed and in a dark mood and offers to sell his share of the business at a huge discount, you should buy it. When he is ebullient and optimistic and wants to buy your share from you at an exorbitant premium, you should oblige him. As usual, Buffett makes it sound easier than it is because measuring the level of intensity of the mood swings of your bi-polar partner is far from an exact science.”

The psychological makeup of successful investors

As a result of the strong emotions at play, many money managers find it hard to stick to their strategies. Here’s what Biggs had to say about the importance of immunizing yourself from the psychological effects of the swings of the market:

“The investment process is only half the battle. The other weighty component is struggling with yourself and immunizing yourself from the psychological effects of the swings of the market, career risk, the pressure of benchmarks, competition and the loneliness of the long distance runner.”

And Biggs offered one final piece of advice about knowing yourself and your foibles which will particularly resonate for those of you who remember the tech boom in the late 1990s – while this advice is oriented to investment professionals, it applies to individual investors as well:

“At the extreme moments of fear and greed, the power of the daily price momentum and the mood and passions of “the crowd” are tremendously important psychological influences on you. It takes a strong, self-confident, emotionally mature person to stand firm against disdain, mockery and repudiation when the market itself seems to be absolutely confirming that you are both mad and wrong.”

What this means for your portfolio

In my email at the end of last quarter, I outlined some guiding principles in my approach to building client portfolios, five of which I repeat here. Should you be interested in doing so, I’d be pleased to discuss these guidelines at our next meeting.

1.Taking the right level of risk

My starting point with clients is to identify the rate of return they need in order to achieve their retirement goals and then to construct a portfolio based on that return objective. My goal is to take the right level of risk for each client – enough that we can be fairly confident that over time you’ll achieve your objectives, without taking more risk than is necessary.

In fact, it’s my view that one of the biggest mistakes is to focus on how much risk investors want to take (which in markets we’ve seen of late is as little as possible) rather than the more important and fundamental question of how much risk investors need to take in order to hit their long-term goals. Taking excessive risk increases the psychological stresses that Biggs describes, but taking insufficient risk, while comfortable in the short term, is a sure route to a long- run failure to achieve your objectives.

2. A buffer for retired clients

All that being said, for retired clients, I believe in maintaining secure, liquid funds to cover three years of expenses. Having that buffer means that we reduce the risk of having to sell equity holdings at depressed levels; this also reduces the stress and anxiety that Biggs referred to.

3. Adhering to your plan

Regardless of what happens to markets in the short term, barring a significant change in your circumstances, I recommend sticking to the investment allocations we’ve agreed to.

Barton Biggs pointed out that this is easier said than done. Some of you may recall my advice in early 2009, as we faced what appeared to be an end-of-the-world scenario and some stocks hit lows they hadn’t seen in 20 years. At that time, I urged clients to continue to maintain a core level of equity exposure.  My mantra was, “the recovery is inevitable.”

Of course market reversals from current levels are always possible; however, taking a long-term view, at current levels there is a strong case for stocks over bonds and I continue to believe that clients will prosper from taking Barton Biggs’ advice to be an owner rather than a lender.

4. Diversifying portfolios

When building equity portfolios, I’ve always advocated strong diversification outside Canada. This helped my clients through most of the 1990s, then hurt them in the decade after 2000, then helped them again in the past couple of years.

Going forward, I have no idea whether the Canadian market will do better or worse than global markets, but I do know that we represent less than 5% of investing opportunities around the world. In addition, because of our resource focus Canada’s market will tend to be more volatile over time than the U.S. or Europe.  Fundamental analysis suggests greater potential in US and other global markets.

5. Focus on diversified yield for fixed income

With interest rates at historic lows, achieving greater yield without significant risk requires using fixed income funds that offer a tactical mix of government, corporate, emerging market bonds along with REIT’s and conservative dividend funds.  These products can reduce the risk of owning only one type of fixed income investment (i.e. corporate bonds).  Diversifcation in fixed income is as important as diversification in equities.

We do have to be increasingly selective regarding dividend paying equity funds, however, as some equities that pay steady dividends now look expensive by historical standards and appear to have stretched valuations – this is because investor appetite for yield had bid up prices of those dividend paying stocks.

Should you have questions about anything in this note or about any other issue, please feel free to give me or one of the members of my team a call.

Return on Life

The investment industry focuses on “return on investment” or ROI.  As a financial life planner, achieving a reasonable ROI is an important component of what I do – but it is not the most important thing.  The most important activity I do is to ensure money issues do not get in the way of my clients achieving the best return on life their money can support.

What can money not buy?

Awash in Cash

The world is awash in cash:

US Commercial Bank Deposits + 9 Trillion – up from 2.5 Trillion in 2000*

Canadian Commercial cash reserves – $525 Billion – 1/3 of Canadian economy

British Commercial cash reserves = $1.2 Trillion

US Household Cash to GDP = 8% – up from 2% in 2007 – highest  level since 1945

*Source – US Federal Reserve Board

Money is a lot like water – it takes the path of least resistance.  At some point these cash holders (not to mention bond holders) will recognize that the potential for growth of the shares of quality companies far exceeds the guaranteed “below inflation” rate of return on cash and bonds – and they will start buying equities.  This will drive stock prices up dramatically.

Financial Toolkit

This is an online resource with multiple modules on all aspects of finances.  Highly recommended as something you make the time to go through.


Flights are booked, VISA is in process, packing list is started, travel shots done, international travel pack for my phone scheduled and Andrew, along with Nancy, ready to take care of things while I am in Nepal.  Whatever happened to just taking off?

I’ve spoken to Sasha and we are meeting in Katmandu on Nov 2nd. We’ll plan the trek when we get there – which is kind of impromptu!

Richard Yasinski CFP