The Sky Is Falling - Nicola Wealth

The Sky Is Falling


By John Nicola, CFP, CLU, CHFC

BLOG 2014-10 Sky Falling (header)

Henny Penny, better known as Chicken Little, has been synonymous with “end of the world” disasters as a result of the sky falling. According to legend, numerous variations on this story have been passed on from one generation to the next for 25 centuries.

As the cartoons below suggest, it is a constant factor in our perceptions of equity markets.

BLOG 2014-10 Sky Falling - Cartoon

It has been more than five years since the S&P 500 (the Standard & Poors U.S. stock index) reached a 13-year low of 676 in March of 2009. Since that time it has risen by almost 150% to September 2014 and there are many reasons to believe that it is due for a major correction or outright bear market (as we will outline below).

Does this mean that investors should sell their equity positions and wait on the sidelines for this inevitable financial calamity to pass?

We will make the case that this is not the time to sell and that market timing is both a statistically unreliable wealth building tool and an unfortunate way to increase transaction costs and taxes for investors.

But first let’s examine why there are good reasons to worry.

The Sky Is Falling

As noted above, the S&P 500 has risen almost 150% since March of 2009. The S&P/TSX Composite Index (Toronto Stock Exchange; representing Canadian stocks) and the MSCI World (Morgan Stanley Capital International); a measure of global stocks) have more than doubled in the same time frame.

Valuations for most indices are relatively high and the Case Shiller PE Index (below) is now at more than 25 – or 51.8% over the mean long term PE ratio of 16.6. Stocks are not cheap. (The Case Shiller Index measures the “PE,” or the ratio of stock prices to company earnings.)

BLOG 2014-10 Sky Falling - Shiller PE

The Euro area is very close to going back into recession. Inflation has dropped to 0.3% and could slide into deflation. Unemployment in the entire Eurozone is still over 11% (more than 4% higher than Canada and the U.S.).

BLOG 2014-10 Sky Falling - Euro Unemployment

Growth rates are dropping in China. As recently as 2008, China’s GDP/person (Gross Domestic Product per person) was growing at 6% per year more than the U.S. That has now shrunk to 2%. In 2009 it was estimated it would take emerging markets outside of China 35-40 years to catch up to U.S. GDP/person. At current growth rates it would now require 125 years.

BLOG 2014-10 Sky Falling - Emerging Market Incomes

This overall slowdown in global growth rates has had a significant impact on commodity prices, which hurts countries such as Canada and Australia. Since the peak in 2011, overall commodity prices are down 25%. They have dropped almost 11% since June of 2014.

The current glut of oil around the world has dropped prices to levels not seen for several years. This is likely to reduce what are already low levels of global inflation and cause significant cash flow problems for major oil producers such as Russia and Venezuela that rely on oil and gas prices to run their economies and fund their budgets.

Several well-known and successful investors have recently made comments about markets and future returns.

  • Bill Gross (recently departed from Pimco, the world’s largest manager of fixed income securities) was quoted as saying that subpar returns are to be expected for both stocks and bonds over the next decade or so. He suggests a net return of perhaps 4% per year for a balanced portfolio.
  • These sentiments were echoed last year by Jeremy Grantham who runs the well-respected investment management firm of GMO.
  • Finally, Carl Icahn, a successful billionaire investor / corporate raider has invested in hedges to protect the value of his own equity portfolio.

Surely all of this bad news is reason for just stepping out of the market and sitting on cash until these markets complete their correction or bear market.

That depends on a number of questions.

  • Is the glass half full or half empty? What are the positive factors that might impact the markets?
  • Does market timing work? How accurate do you have to be?
  • Does market timing even matter if you have the right asset allocation?
  • Is a bear market in stocks a potential disaster or an opportunity to add to a portfolio of quality companies at reduced prices?
  • If you are building wealth (by far the majority of our clients experience an increasing net worth over their lifetimes), then why wouldn’t you want to see asset prices drop from time to time to allow you to acquire them with less capital?
  • Even for our clients who are retired and, thus, no longer saving, we regularly rebalance their portfolios by selling assets when they have risen in value (relative to the rest of the portfolio) and purchasing assets when they have fallen in value (buy low, sell high).  Therefore, temporarily falling prices of high quality assets is a buying opportunity for savers and retirees alike.

Happy Days Are Here Again

BLOG 2014-10 Sky Falling - Mr Happy

U.S. oil and gas production has exploded in the last few years because of shale. This has had a major impact on the U.S. economy, including lowering their trade deficit and increasing employment, both because of the oil and gas and because many companies have chosen to “re-shore” their manufacturing plants back to the U.S.

(Of course increased oil and gas production in the U.S. is negative for Canada unless we can export surplus energy offshore.)

BLOG 2014-10 Sky Falling - US Crude Oil

Increased U.S. oil production has impacted global prices. As mentioned above, that could easily lower overall inflation rates and keep interest rates lower for a longer period than many people expect.

Both the U.S. and Canada have reduced their unemployment rates to the lowest levels in six years. At the same time, Canada will have eliminated its federal deficit by March of 2015 and the current U.S. fiscal deficit is now less than 40% of what it was in 2009.

BLOG 2014-10 Sky Falling - US Budget Deficit

Since this bull market started in March of 2009 there have been three major corrections for both the S&P 500 and the TSX. On average, markets dropped 14% and the correction took an average of 75 days from peak to trough. What are the chances one would be able to have picked all six of these corrections accurately and still benefited from the overall rise in equities?

Where Do We Stand?

So given the fact that the TSX has already dropped almost 10% in the last six weeks, are we happy or looking for the sky to fall?

In a couple of weeks’ time (October 29, 2014) we will be holding a seminar entitled “Real Assets, Real Returns,” where we will look at how alternative investment classes such as real estate, private equity, farmland, and infrastructure play an important role in building wealth and diversifying any portfolio.

We have already done what we feel is appropriate for our clients in the following ways:

  • Limited exposure to publicly traded equity markets to less than 35% for most client portfolios.
  • Used covered call and put options in certain NWM pooled funds to reduce the volatility of those equities and increase the cash flow that they yield on a tax efficient basis.
  • To provide some idea of how a covered writing approach can help reduce volatility and smooth out equity returns, look at the chart below which compares the NWM Strategic Income Fund (SIF) to the iShares S&P/TSX Capped Composite ETF from December 2007 until September 2014. The reason for choosing this period is that it represents a major bear market (December 2007 until March 2009) and a major bull market (March 2009 until September 2014). The chart shows each year’s return, the cumulative compounded return, and relative volatility. SIF has outperformed the TSX in this period of time with a net return of 7.28% vs. 4.20% for the index and has accomplished this with 30% less volatility (especially noticeable in 2008 and 2011).

BLOG 2014-10 Sky Falling - SIF TSX

  • Our focus when we acquire stocks is on value and dividend growth. When the prices of these companies drop we want to be in the position to acquire more of their shares.

In Summary

It may well be that markets continue to falter. With public markets it is a natural and reoccurring event since they are almost always more volatile than less liquid alternative asset classes such as private equity and hard asset real estate.

Since 2000 there have nine major corrections for the TSX of more than 10%. On average, the market has dropped 22% from peak to trough and it has lasted 163 days – or almost 6 months.

Earlier we asked the question: are we happy or waiting for the sky to fall? We believe reduced prices of important asset classes are great opportunities to add to our portfolios.

While the rest of the world meets a bear market with a “Chicken Little Attitude” and sees the sky falling, we take a more considered approach and are more than happy to use this period of time to rebalance client portfolios on a cost effective basis.

If you have any questions or concerns regarding this article or your portfolio, please do not hesitate to contact a member of your NWM Advisory Team.

 

Important Information:
 
1. Fund returns are quoted net of fund level fees and expenses.
2.
Past performance is not indicative of future returns.
3.
This document is not intended to provide legal, accounting, tax or specific investment advice. Please speak to your advisor regarding your unique situation, especially if you have near-term expenditures. Information contained in this document was obtained from sources believed to be reliable; however Nicola Wealth Management does not assume any responsibility for losses, whether direct, special or consequential, that arise out of the use of this information.