Putting your October statement into perspective

Dear Valued Clients,

Most of you are aware that September and October were extremely difficult months for stock markets (for the U.S. market, October 2008 was the worst month in over 20 years) – this will be reflected in the statement you’ll be receiving shortly.

A common question as I talk with clients is: “What exactly led to the current issues?”

Here’s my summarized version of how we got here:

1. Between 2001 and 2003, low interest rates encouraged global investors to begin taking on increasing amounts of borrowing and risk (generally without fully understanding the risk to which they were in fact exposed). As a result, it is now clear that debt driven demand for commodities, real estate, and stocks pushed up some prices to an unsustainable level.
2. Beginning in the middle of last year, we saw the opposite happening. As U.S. real estate prices started falling, mortgage defaults increased, and the level of debt underpinning these investments became clear, these same investors began to shed risk and sell assets, without regard to quality and often at whatever price they could get.
3. In the process of this unwinding of risk, there were massive write offs and financial institutions such as Lehman Brothers and Bear Stearns collapsed under the weight of the debt they had accumulated
4. Beginning this fall, the level of mistrust spiraled upwards and fear paralyzed markets – as financial institutions started building absolute worst case scenarios into their thinking, access to credit for consumers and businesses shrunk, and the financial system came close to seizing up.

Stock prices today are severely depressed as a result of this sequence of events. Recently I heard the current challenge for investors compared to shopping at a Boxing Day sale – with everything off 30% to 50%, our challenge is to differentiate between two categories of products:

• low quality items that are still expensive even at current prices, and
• high quality items that have been marked down and represent terrific value.

Where we find ourselves today
While there are still substantial issues to work through, the good news is that we do appear to be seeing greater stability in the global financial system – a number of financial industry leaders have commented that they are much more confident today than they were a month ago. And it’s important to remember that most conventional measures of market valuation point to the fact that the broad market is significantly undervalued.

It’s worth noting as well that despite its painful drop, Canada has actually withstood this year’s market turmoil comparatively well. Barron’s Magazine recently compared year to date performance for the 15 largest markets. Up to Friday, October 24, the Canadian market was down 33%, just ahead of Switzerland for the smallest decline, followed by the UK and the US with 40% drops. Overall, Asian markets were down 44% and European markets off 46%.

Given the drop in commodity prices and Canada’s reliance on resource stocks, this performance is better than we would have expected – and is in large part testimony to how well Canada’s banks have held up compared to those in the United States and Europe. If we see commodity prices recoup some of their recent declines, the Canadian market is quite well positioned compared to most.

Answers to common concerns
I thought it might be useful to discuss some of the concerns you might be experiencing as you watch your portfolio react to the current market conditions – and share with you my thoughts on these questions.

1. “We’re going into a deep recession”
Given the growing consensus on this subject, it appears that the world economy is indeed entering a very rough patch. But it’s important to remember that we’ve been here before. Depending on how you measure a recession, we have gone through ten of them since the Second World War, and markets came out of each one to move to higher levels. Recall that some of those recessions such as the one in the early ‘80s have been just as severe as anything currently forecasted.

2. “Today’s problems seem overwhelming and insurmountable”
We are most certainly facing daunting challenges. But once again, we’ve been here before.
As just one example, in December of 1990, the markets were down 30% in six months and the stock of Citicorp was cut in half. Canada and the U.S. were in recessions, residential and commercial real estate prices were off 25%, the U.S. was in a full blown banking crisis due to the savings and loan fiasco, and Iraq had occupied Kuwait, with no clear indication of how the West would respond.

Without in any way diminishing the magnitude of today’s issues, it’s worth remembering that we felt just as overwhelmed at points in the past and emerged just fine.

3. “With all the bad economic news still to come, this is not the time to be in stocks”
While the past is no guarantee of the future, it is the best guide we have. It is important to understand that the markets already reflect all of the bad news we know about – and that on past experience, recession-induced bear markets such as this one will see stock prices begin to rise well before the economy does.

As an aside, this was one of the key points Warren Buffett made in a recent New York Times article, explaining why he has shifted his own personal portfolio into stocks. This article is available on the New York Times website at www.newyorktimes.com.

As for the market pundits who seem to dominate the media these days, we need to look at their track record. One example is work done by CXO Advisory Group in Massachusetts. They tracked “measurable forecasts” by 50 prominent market forecasters. Their collective batting average? 48% or about the same as flipping a coin.

4. “We could go into another depression”
It is essential to recognize that today’s central bankers and political leaders learned from the terrible mistakes on fiscal, monetary and trade policy that turned what many economists believe should have been a normal recession into the most prolonged period of economic difficulty of the 20th century.
That’s why most economists believe the chances of another depression are exceedingly remote. Again, let me know if you’d be interested in recent articles from Fortune and Report on Business Magazine, explaining why this is so.

5. “I want to stick to safe investments”
At times like these when we’re overwhelmed with pessimism and downbeat news, it is understandable that some would find “safe” investments appealing. Every decision we make entails a mix of gain and pain. These days, the difficulty is the timing of when the gain and pain may occur. Stay on the sidelines and the gain in terms of peace of mind is immediate, with the pain to be felt down the road. Participate in the markets, on the other hand, and the pain of volatility and uncertainty is immediate with the gain to be had down the road.

While it may be tempting to seek the safety of secure investments, for most investors, the return on these investments will not allow them to hit their long term retirement goals. Sometimes the old advice is the best advice. At times like these, there may be value in revisiting your long term objectives, going over your cash needs and reviewing the plan you have in place to achieve your goals.

The good news is that most are properly positioned to be able to handle this downturn and wait until the market goes back up. In some cases, I am meeting with clients to review their financial plan and look at whether changes are needed to weather this storm. In a few instances, we are taking a hard look at their discretionary spending as a result.

Let me know if you would like to meet to reevaluate your goals, your current cash needs, or just to talk about your account. In particular, once you’ve had a chance to review your statement, don’t hesitate to give me a call if you have any questions or would like to talk about where you stand – you can reach me at (416) 355-6364.

Finally, please remember that I am in this with you and am here if you need me.

This article is for information purposes only. All performance data represents past performance and is not indicative of future performance. It is recommended that individuals consult with their Wealth Advisor before acting on any information contained in this article. ScotiaMcLeod does not offer tax advice, but working with our team of experts we are able to provide a suite of financial services for clients. The opinions stated are not necessarily those of Scotia Capital Inc. or The Bank of Nova Scotia. ScotiaMcLeod is a division of Scotia Capital Inc., Member CIPF.