Now, it is official: the correction in all but a few stock markets for the last 8 months has just been reclassified as a “Bear Market”, a condition where prices fall more than 20% from their peak. Credit market turmoil continues unabated, with the banks worldwide basically having stopped lending all together. Even the red hot Canadian market, with more than 60% comprised of resource related stocks, has fallen 10% from its peak since the beginning of June.
The following table summarizes the price performance of the main indices for the second quarter and the first half of 2008.
|Second Quarter||First Half|
|In local currency||In Canadian Dollars||In local currency||In Canadian Dollars|
|S&P/TSX (Cdn)||+ 8.37%||+ 8.37%||+ 4.58%||+ 4.58%|
|S&P 500 (US)||– 3.23%||– 3.59%||– 12.83%||– 10.81%|
|Nasdaq (US)||+ 0.61%||+ 0.24%||– 13.55%||– 11.54%|
|Europe (EUR)||– 5.06%||– 5.61%||– 19.92%||– 11.52%|
|Nikkei (Japan)||+ 7.63%||+ 0.65%||– 11.93%||– 5.22%|
Gold has stayed roughly at the same level since our last quarterly letter at around US$ 900.00 an ounce, as has the Loonie and the Euro.
With markets in the doldrums and oil prices at horrendously high levels, there is no better time for us to address some of the news you have undoubtedly read in newspapers and hopefully help you keep some long term perspective regarding the US election, markets and more specifically, your portfolios.
On the US Presidential Election and its impact on stock markets:
Most investors believe that if a Democratic President takes over the White House, it will be bad for financial markets. It most likely has something to do with the stereotype that Democrats are tax-and-spend socialists whereas Republicans are responsible managers and friendly to businesses. However, history has shown otherwise. Since 1928, White House changes from Republican to Democrat averaged a 5.8% return for the S&P 500 in the election year and a 20.7% in the inauguration year. In cases where the change was from Democrat to Republican (which is not the case this time around), the return has averaged 13.2% in the election year and a negative 6.6% in the inauguration year. Under both scenarios, stocks tend to do OK in the election year.
What should be noticed is this: when Republicans win, returns are better than average in the election year but reverse course in the inauguration year; when the Democrats win, it is the opposite, i.e. returns are “so-so” in the election year but outstanding in the inauguration year.
One explanation for this phenomenon is the fact that neither Republicans nor Democrats keep their campaign promises very often. Consequently, business people fearing the tax-and-spend socialists refrain from further investment commitments (thereby producing tepid returns in the election year) only to find out that the economic environment under Democratic leadership was not as bad as they thought (stocks then do better in the inauguration year). Conversely, those believing Republicans are good for business (stocks therefore do well in the election year) then realize the environment was not as good as they hoped under their leadership (hence disappointing returns for stocks in the inauguration year).
Overall, history shows that a White House leadership change has no long term impact on stock markets returns.
On the banking system, bankers’ compensation and hedge funds:
Ever since the subprime mess and the ensuing write-offs unfolded, governments and central bankers around the world have been talking about regulations and reforms in the banking industry. However, we believe that the root of the problem lies in the compensation structure of the investment banking industry. Let us explain:
We know for a fact that results and compensation are inherently linked, i.e. compensation “A” will produce result “A” and compensation “B” will produce result “B”. Salesmen on commission tend to work harder than those on fixed salary because of the potential for unlimited upside that the commission structure offers.
If you take a closer look at the compensation structure in the banks, you’ll quickly realize that not only are the repercussions light for underperformance, rewards are outrageous for outperformance (sometimes in the hundreds of millions of dollars). Therefore, these bankers turn themselves into cowboys and swing for the fences. Why shouldn’t they? They don’t have much to lose. In fact, they have been treating shareholders’ capital as hedge funds, with similar compensation structures, i.e. no downside and lots of upside in total compensation. The big difference is that hedge funds must disclose to their stakeholders what they are charging through prospectuses, whereas investment bankers have no such requirements. As long as the boards of directors, who are supposed to represent the shareholders and uphold governance, knowingly or not, implement a compensation system that rewards high risk activities with little or no repercussions, there is no form of regulation that can ever change the greed element in a person’s character. It’s human nature!
On market volatility and you:
June was a brutal month for most investors. Whether you are online looking at the numbers now or waiting for them in the mail, your reaction will likely be the same: shouldn’t I be doing something about it?
The answer is: probably not.
A golf analogy here might help you understand our thinking (our apologies for the non golfers): As golfers all know too well, there is no such thing as a perfect round and hitting bad shots is part of the game. Phil Mickelson did it in the US Open, Jean Van de Velde did it in the British Open and countless other pros do it every week. However, after you find yourself in a tough lie behind a tree, the correct decision is to stay disciplined, take your medicine, get back in the fairway and scramble for par. In the end, the one bad drive won’t matter much by the end of your round.
It is not very dissimilar in investing. Volatility is part of the game. You cannot avoid it if you want to keep up with the markets. Trying to react to short term stock market volatility is like trying to hit a golf shot you cannot execute. It will likely do more harm than good. Just as in golf, if you can manage to resist the temptation and stay disciplined, a well chosen strategy properly aligned with your goals and objectives will likely yield its best results over the long run and the one day, one month even one year’s “bad shot” won’t matter much in the overall scheme of things.
On market corrections, bear markets and recovery:
There are questions abounding these days about the state of the economy, the stock market and when it will recover, if it recovers at all. Some even compare our recent decline as the beginning of a Japanese style bear market (1990s) that could last a decade. We, on the other hand, are much more confident that things are not as bad as they look. Firstly, Japan was plagued with the decade long bear market because the Japanese government refused to let the banking sector restructure and write off the bad loans. Consequently, the country went through a decade long liquidity crisis that crippled the economy. Conversely, the US banking industry is already restructuring, bringing in new capital from diversified sources. In our view, it is actually a “disguised bankruptcy” in financial terms: there is a massive change of guard in management, a whole new slate of shareholders and huge write-offs of asset values. Doesn’t it look like a bankruptcy after all? Air Canada went through the same thing and its planes have not stopped flying…
The important point to remember here is that in a free capitalist system, the banking system is simply a conduit for money to flow from the savers to the borrowers. In a financial crisis, when banks write down bad assets, they basically acknowledge the losses and impute them to the shareholders. Banks’ capital will then decrease, share prices drop and shareholders lose money. If the banks require more capital to operate efficiently, they either will merge or will raise money by issuing new shares. In the meantime, the conduit continues to operate, probably more cautiously than before the crisis and with time, the system will repair itself. This is what happened at every crisis we have experienced after the depression of 1929.
Corrections (or bear markets) are an integral part of the long term progression of equity markets because after all, it reflects the growing rate of the economy, albeit punctuated by some slowdowns or recessions.
Unless you can tell when to get in and when to get out, it is probably a good idea to stick with a proven strategy over the long term and ignore the “noises” along the way. Unfortunately, it does require a hefty dose of discipline and objectivity, if you have been reading our letters over the last 2 years on behavior finance, you will realize how tough it is to stay the course when we, human beings, are under the influence of so many psychological flaws. That is the main reason for our fundamentally driven quantitative approach. It allows us not to get sea sick by keeping our eyes on the horizon during stormy weathers…
Have a good summer.
The Claret Team