How Bad Is It? – The Sequel


By John Nicola, CFP, CLU, CHFC

 
“In the middle of difficulty lies opportunity.” 
– Albert Einstein

Six weeks ago, we sent out a newsletter in the midst of the banking crisis and market meltdown to provide some facts and explanations for our clients. Notwithstanding multi-trillion dollar government bailouts and investments in financial institutions, we did not expect that the worst was over — and we have not been disappointed.

Since then, almost all asset classes (equities, commodities, debt and real estate) have continued to fall significantly. This continued erosion of capital and wealth may raise some or all of the following questions for many of you.

When will this end?

We do not know, but we are likely in the worst recession since 1974 and we should expect it to last through most if not all of next year. Investors also need to remember that markets are leading indicators and they will start to recover well before the real economy does.

Should I sell now and go into cash? In other words, should I get out of this storm and buy back these assets when markets have calmed down and stopped falling?

No, for reasons we’ll outline below.

To what degree has this affected my retirement plans? Does it mean I’ll need to work another 5 or 10 years?

If you have a portfolio based on cash flow rather than capital gains, then the impact of this market on its earned income is far less than on its price. As of the end of October most of our clients’ portfolios were down in price between 6-7% (vs. over -20% for balanced portfolios in traditional asset classes and -40% or more for individuals who have been primarily invested in equities). Cash flows (dividends, interest and rents) have changed very little over the last year or so. While some companies are going to reduce dividends during a recession, the reduction is usually small when compared to the amount their share prices may already have fallen. (More on the relationship between price and cash flow [yield] below.)

As our advisors, why did you not see this coming and put us into cash a year ago?

This is always a fair question to ask. Our answer is that we build portfolios based on principles of cash flow, diversification and balance. We are not market timers; we believe that most of the time, trying to time the market simply does not work and one’s mistakes would heavily outweigh the few “predicted” outcomes. When markets implode, as has been the recent case with equities, corporate bonds and REITs, it is imperative to rebalance and acquire these assets now when they are selling at the cheapest prices, so long as those assets represent quality and value. And that is exactly what we are doing now.

Is there anything worth investing in now?

This is the most interesting question, with the short answer being ‘yes.’ We will outline below some specific suggestions for turning this crisis into a potentially outstanding long-term investment opportunity. First, though, a quick update on how the last 6 weeks have gone.

As mentioned earlier, we wrote a newsletter at the beginning of October called “How Bad Is It?” (click here to view)

Since then, there has been a litany of more bad news. However, there have also been a few bright spots on the horizon. We’ll try and make the case that there are some great opportunities out there, but as with growing mushrooms they are hidden in the dark and covered in— well you know the rest.

What’s getting worse?

  • The TSX is down an additional 20% in the last 6 weeks through to November 21, 2008 (down -44% for the year). In addition, other markets and asset classes continue to have their worst calendar year since 1929, as seen by the following charts from Barron’s.

  • Unemployment is rising in the U.S. (but not yet in Canada). Goldman Sachs now expects it to climb to more than 10%. On November 21, 2008, they were quoted as saying: 

“We have marked down our forecasts for U.S. real GDP in response to continuing signs of falling domestic and foreign demand, labor market deterioration, renewed tightening in financial conditions, and an apparent impasse in fiscal policy pending the transfer of power to the Obama administration in late January. As a result, we expect the unemployment rate to reach 9% by the fourth quarter of 2009, profits to fall 25% for 2009 as a whole following an estimated 10% drop this year, and the Federal Open Market Committee (FOMC) to use nontraditional policy tools more aggressively, as detailed below…

“We now estimate that real GDP is falling at a 5% annual rate in the current quarter, and we expect this to be followed by declines of 3% and 1% in the next two quarters. This deepens and extends the expected recession, bringing the drop in GDP close to the decline seen in 1982 (2.3% in our forecast versus 2.7% then). Previously we had estimated changes of -3.5%, -2%, and zero, respectively. In the second half of 2009, we expect growth to average 1%, only slightly less than before.”

  • The Tories now expect a deficit for fiscal 2009 — Canada’s first deficit since 1997. (Some perspective is required here: virtually all other G7 countries have been running deficits in the range of 2% to 6% of GDP for many years. Even if Canada does have a deficit, it is expected to be far less than 1% of GDP. We also have dramatically cut our debt-to-GDP ratio in the last 10 years from about 100% to 60% [including provincial debt].)
  • The average house price in Canada fell almost 10% in October when compared to 12 months earlier.
  • The price of oil has fallen an additional 40% since mid-October and is now at $50; about 1/3rd of what it was in July of 2008.
  • Consumer prices dropped by 1% in October in both the U.S. and Canada. This is the largest one-month drop since 1959 in Canada and 1947 in the U.S. Deflation is a possibility at some point next year.
  • Chrysler, GM and Ford are looking for multi-billion dollar bailouts before they run out of cash in a few months time.
  • Many of Canada’s largest and most respected companies are down considerably (in some cases more than the market when measured from their peaks). Here are some examples:

 
This is a good place to see if the glass is half full.

But first allow me to ask what may appear to be a dumb question: if you were in the market for a new home (primary residence or recreational), would you want to buy in a rising or falling marketplace?

Obviously we want to buy when prices have fallen. Most of us like to “get a deal” or “buy when things are on sale.”

So it is with investments. For most of you, there are two financial assumptions that you share in common

  1. Your overall wealth will rise over time, and
  2. Your need for cash flow from your portfolio will increase over time (if only to deal with the impact of inflation).

If both of these are true for most of you, then you will be a net buyer of investments for the rest of your lives.

That should mean that you want and need the price of good quality assets to drop from time to time in order to acquire them without having to constantly pay more. It would be safe to say that a lot of assets have dropped in price and, as a result, their yields have increased dramatically. It has been decades since the Royal Bank paid a 5.5% dividend yield and Sun Life has never distributed 6.7% as a dividend since it demutualized in 1999.

What other good news can we glean from the carnage in the markets?

Real Estate Trusts as an asset class are selling well below their Net Asset Value, as seen from the chart below. In some cases legitimate risks exist, but for many we feel there is compelling value and yields have not been this good for more than a decade. In some cases yields are at an all-time high.

** Cap rates are calculated using forward looking estimates for information purposes only. Future results may vary. Investors should consider other factors when making an investment decision. **

  • The overall stock market has dropped dramatically as a percentage to GDP (as seen from the chart below from Barron’s, November 21, 2008).
     

     
  • For the first time in more than 50 years the dividend yield on the TSX is higher than the yield on 10-year bonds.
     

     
  • Corporate Bonds have been severely punished. Both high quality and junk bonds. The chart below makes a strong case for value in a well diversified quality corporate bond pool.
     

Below is just one example of a High Yield Bond fund that, in our opinion, represents good value going forward.


Source: www.globeinvestorgold.com

So what does one do in this kind of environment?

These are the steps we feel our clients should be taking:

  1. Rebalance portfolios to acquire income-producing equities.
  2. Add discounted Corporate Bond pools into registered accounts.
  3. If the cash flow generated by existing portfolios is not being used, then use it to acquire both of the above asset classes.

We are not trying to time markets. We look for relative value and there are some very good stories out there. As I stated above, I believe this recession will last a long time and will be deep. Equity markets can definitely get worse in a period such as this.

The important question, however, is: how will these assets look in 5 years?

I am perfectly willing to acquire debt and equity that is selling at prices 40-60% below market peaks and collect a cash flow from them while I wait for a recovery. It has always seemed to me that the money you make on your investments is more dependent on how well you buy vs. when you sell.

It is a tough, challenging marketplace with great volatility and opportunity; perhaps the following quotes express it best.

“A wise man will make more opportunities than he finds.”
– Francis Bacon

“Opportunity… often it comes in the form of misfortune, or temporary defeat.”
– Napoleon Hill

 
John Nicola, CFP, CLU, CHFC
CEO & Chairman