There are however, periods of time when economic risk is higher; the global debt problems and Japan’s difficult natural disaster come to mind. In some time periods earnings are generally not growing. If markets are discounting higher risk then it stands to reason there should be some additional volatility and in this past quarter at least, uncertainty has resulted in lower stock prices.

Markets work properly when they can move both higher and lower. If common stock prices were simply pegged higher each quarter then they would not well reflect the variant conditions of the economy and society in general.

From 1970 to the end of 2010, total returns to stocks in Canada (S&P/TSX) and the US (S&P 500) have increased at a compounded rate greater than 10%. Inflation has been about 4% so real returns for the period are about 6% and investors have been well paid for accepting the risk of holding stocks. Not all decades are equal. The past 10 years have been less giving. In Canada the average returns since 2001 have been 6.6%. Inflation averaged 2.4% for a net of 4.2% in real inflation adjusted return. So the premium for holding risky assets has been below average.

How should this recent result impact our future expectations? Even in a below average return decade, patient investors did okay. They were rewarded with real returns and grew their money. While a definition of risk can be a future where “you don’t know the outcome,” long term averages should be attributed some predictive power. It seems to me that it makes more sense to consider a bigger sample (more years) than assume the recent experience will continue into the future.

There is plenty of risk in stock markets that is well rewarded and a source of good compensation for investors. There is also lots of risk assumed by the investment community that has no or perhaps negative compensation. Our investment focus is the elimination of risk that has no payoff.

Public stock market indexes have been a source of dramatic returns in excess of inflation for more than a hundred years. Investors can capture the returns to indexes at very low cost. However, there are problems with indexes. The S&P 500 for example is dominated by large growth companies. The calculation of the index has a bias toward large capitalization stocks. These features represent risk without compensation.

Another prominent example of non-compensated risk is assuming that stock markets provide risk free return by selecting only stocks that go up. Focus lists of investment houses are typical examples of this type of approach. The problem with these list approaches is they are not investable. You can’t be the first into the stock choices and the first out so the “return to the list” is not the investor experience. In my view, non-compensated risk like this should be minimized since they ultimately do not support the goals of investors.

Simple index returns can be improved upon. A better exposure to risk provides better compensation. We spend our time working at identifying risk worth taking and where possible, eliminating risk that doesn’t pay.

Patrick

September 9, 2011

The volatility and pressure in world stock markets is regrettable. Risk has manifested in providing little if any return for the past decade. It seems to me that this current downturn has been triggered by the perception of a lack of effective leadership on the part of governments around the globe.

Of the three main players in the economy – individuals, corporations and governments – the investment markets are concerned primarily with corporations. At this point, North American corporations as a group are much better off – as measured by balance sheet financial strength – than previous median levels. Companies have less debt and more cash than we expect them to have. This is a good thing that should be a source of investor confidence. On the other hand, many of the world governments are bankrupt: Iceland, Greece and Ireland come to mind.

Investment markets are concerned with predicting the future. In the bond markets, payback (yield) for investing in 10 Year Government of Canada Bonds is about two and a half percent. The same is true of 10 year U.S. treasuries.  Investors buying these yields are willing to take a return, after inflation, of less than zero for 10 years. That number looks worse after taxes. It is worth noting that in the case of Canada and the U.S., investors in government debt appear unconcerned about default.

Individuals in North America have more debt than usual and the unemployment rate remains relatively high. The recent recession has been a difficult and persistent one for consumers.

The agreement to extend US Government debt was essential in that all financial interests were served and every investor would have experienced losses if it had not been confirmed. The US Government is too big to fail. Essentially, all countries in the G10 are too big to fail.

Sellers in the stock market will see much slower growth in the future. In terms of national accounts, aggregate demand is a function of buying power. The pessimistic view is that individual consumers and governments are tapped out. Companies who might otherwise be expanding are reluctant to do so if, in the future, there are fewer customers willing to buy their products. The thinking is that with fewer customers there is no growth. This is an important assumption that may prove to be incorrect.

In my view, predictions of future corporate earnings are a poor guide to investment decisions. This poor predictive power holds true for those that use so-called top down (aggregate economy based) analysis or bottom up (individual company) focus. Professional analyst predictions are frequently wrong and show little persistence when they do get it right. I think the balance of investment return for appropriate risk assumed will re-establish. Stocks will outperform bonds in the future, just as they have in the past. Good companies will innovate to find new customers and are already doing so.

We will re-balance our allocations once things settle down and we can confirm how this recent decline has impacted the plans for your portfolio. We re-balance when we have the evidence to do so and avoid the trap of attempting to generate investment returns by predicting short term outcomes.

Thank you for being our client and please pass this along to any friends or colleagues who could use a little reassurance and understanding.

Best Regards,

Patrick

Over generations, the concept of saving has been instilled in most Canadians as a top priority.  Many of us were taught early on the value of a dollar and to save for a rainy day. Sadly, saving has become a mere afterthought to thousands of Canadians.  Looking at this graph, you can see just how bad the savings rate has declined, from a high of 20% in the early 1980s to less than 4% in 2010. With the savings rate declining and the population aging quickly, the situation doesn’t bode well for the adults of this generation and baby boomers.

Source: Statistics Canada. Sector Accounts, Persons and Unincorporated Businesses. CANSIM Table no. 380-000.

With the CPP and OAS providing retirees with a minimum level of income and employment pension plans shrinking, it is becoming more and more important for individuals to take control of their personal financial plans if they want to have a comfortable retirement.

The government provides many incentives to invest through the RRSP program. Contributions are tax deductible, thereby decreasing the tax bill and all taxes are deferred on savings and interest until retirement.  In reality, Canadians are not taking advantage of these incentives and are letting the benefits slip away.  Over the last 50 years Canadians have made more than $600 billion in RRSP contributions yet have unused RRSP contributions totalling an additional $500 billion. During the last decade, the percentage of individuals who have made contributions to the RRSP program has fallen from 41% to 34%.  During a time when people should be saving more, the opposite is actually occurring.

Consumption has been the main cause of the declining savings rate.  Just like our neighbours to the south, Canadians have become mass consumers.  People are putting an emphasis on current consumption rather than future savings.  In addition, volatility in the market and disappointing performances in the past has had a profound affect on the behaviour of Canadians. They would prefer to spend their money today rather than lose it in the market.  But, by making sacrifices in the present and taking a long term view to consumption, savers will, over time, have more money and have the ability to enjoy it longer.

Many Canadians have problems saving money.   They do not have a budget or a well thought out savings plan.  Without a plan, expenses and debt can spiral out of control and makes saving impossible.  The implications of this situation are far reaching and easily avoidable.  Not only do these people miss out on the magic of compounding, but also the tax incentives that occur yearly. Having a feasible plan in order and sticking to it takes discipline and time.  But, the future rewards are well worth it

Success in investing begins with individuals saving for the future.  As a group, savers build up cash flow headroom through discipline and sacrifices. Savers become great investors because they have time on their side and the cash to take advantage of opportunities.  They have the flexibility to ride out volatility in the market and set their sights on the long term without letting short term issues get in their way.  To most people, saving is a part of life and a way to watch their money grow over time.  But, to many Canadians, the lifestyle of consuming and spending now will only lead to a future of cutting back and making great sacrifices in their golden years.

The opinions expressed in these articles are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson GMP or its affiliates.

The investment world doesn’t simply replicate the physical world. As illustrated in the table below, for year ending 2009, 57 percent of the world’s population account for 84 percent of total GDP and 95 percent of stock capitalization.

Simple strategies based on one factor, such as allocating large percentages of your investment dollars to China or India may randomly work out, but such strategies probably represent more risk than intended.

Risk without return is never a good thing. For example, China recently surpassed Japan in GDP but the Chinese stock market is less than a quarter the size of Japan’s. The size difference is a measure of relative risk, and a determination of required return from a new investor’s point of view. In this example, new investors in the Chinese market require more return for Chinese investments than for investments in Japan.

Capital is generally free to move between stock markets so the dollar value or market capitalization of each market is a summary of all investor views about the prospects for that market. In a sense, the wisdom of the many, each making independent decisions can be summarized by the willingness to invest in one market versus another. In this way, relative market capitalization represents risk adjusted return for country allocation. Bigger markets are less risky than smaller markets. They also probably provide less return. Risk and return are always related.

“Perfect Country Allocation” may be achieved by replicating the market capitalization below for each country: 42 percent US, 9 percent UK and Japan and so on. In diversifying by relative market capitalization, an investor would capture the return to stocks wherever that return is realised. This investment portfolio would increase with expanding markets and decrease with relative decliners. A portfolio would therefore be perfectly diversified as to country selection. If the goal is to capture growth wherever it manifests, then this portfolio would achieve the result. Diversification works best when it eliminates the risk that provides no aggregate return, leaving only risk that provides compensation. This portfolio would capture the return to increases in earnings. It would not capture the positive or negative returns resulting from capital movements between markets.

So why isn’t everyone doing this? I think the answer lies with spending. Investors and their advisors allocate more money to markets where the money will be spent. This is reasonable but somewhat inefficient in that the domestic market doesn’t capture price changes in imports. Great economies like Switzerland, Hong Kong and Finland have relative GDP of 10 times their population weight. Canada and the US have less than 5 times or half the measure. In time, goods from very productive economies get relatively expensive. Investing in these economies or companies compensates you for the price increases. You don’t want to be the greatest investor in an economy that is shrinking in comparison to the rest of the world.

Implication for Investors

International diversification increases complexity (risk) and expense for individual investors. Yet from a North American point of view many markets are growing faster than our domestic markets. A broadly diversified approach which limits the error of investing in the wrong country at the wrong time should allow your portfolio to experience better results. Big bets on individual countries add risks that you simply don’t get paid for in the long run.

Patrick

The opinions expressed in these articles are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson GMP or its affiliates.

Unfortunately, from a purely statistical basis it takes about 30 years of data to make a confident assessment of skill for investment management.  The evidence of “beating the street” simply cannot be identified in one, three and five year tables.  For practitioners, this presents a big problem as 30 years is an investment lifetime. Also, the skillful manager is generally about to retire once you have confidently identified his or her ability. It would be much more convenient if we could confidently identify future out-performance. Unfortunately, there is always uncertainty. If we knew the outcome, returns on stocks would be equal to returns on bonds.

In my opinion, the time and effort to identify a hot hand is better spent on good portfolio construction. Good financial advisors have processes that generally guide clients towards strategies designed to minimize errors of judgement. They focus on cost control. They provide guidance around matching fixed income from your portfolio to income you require from the accounts in retirement. Good advice often encourages investors to patiently allow stock market return to be realised by the portfolio in a consistent repeatable approach. There is generally much less of a focus on market timing. They recognise that the recent past offers little in the way of predictive power.

In our practice we focus on repeatable investment success. Our portfolio approach has been refined through more than thirty years of combined, on the job, experience. If we are already working with you great – if not, let’s meet to see if we can be of service.

Patrick

As Children, we should all be taught to aspire to own a commercial bank (dealer). Dealers have a very interesting and sustainable business model. Essentially, they lend money they don’t have, which creates money in the hands of the borrower. This “miracle of capitalism” is created by the fractional reserve system of the Federal Reserve. The interest paid on these loans is earnings for the commercial bank. The leverage to assets is big; the Fed requires a 10 percent reserve so that a commercial bank can loan up to ten times its asset base.

In the US, commercial banks and investment banks were divided by the Glass-Steagall Act of 1933.  After the depression is was thought that risky investment banking activities needed to be separate from the Fed-backed activities of commercial banks. Glass-Steagall also introduced deposit insurance on deposits (FDIC), further protecting the interests of depositors. The act (not FDIC) was repealed in 1999 in an effort to allow US dealers to compete on a level field with Great Britain. Margaret Thatcher’s “big bang” deregulated the UK financial system in 1986. Canada followed in the late 1980s and dissolved the restrictions for commercial and investment bank mergers. Trust companies were also deregulated. Insurance companies maintained some of their independence though Canada’s big 6 retail banks are finding ways to capture market share in the insurance business as well.

Given the extremely low cost of capital and advantaged position banks share with respect to the Fed, it is difficult to compete with dealers as a group.

The promise of Big Bang and deregulation was reduced cost of capital for customers. In addition, reduction of regulatory involvement was seen as a method of increasing competition and innovation by combining access to debt and equity capabilities. Stanley Hartt, deputy Minister of Finance for Canada 1985-88 summarizes the view at that time as “the banks felt they had to grow to survive”.

These conclusions have been greatly challenged by the financial crises of 2008-09.  Leading up to the Fall of 2008, one stop financial supermarkets were able to securitize debt, selling it off to institutional investors to raise additional cash assets. This in turn allowed for more leverage to earnings and more risk assumed. The system was clearly out of equilibrium. In September 2008, perhaps precipitated by the collapse of Lehman Brothers, the system froze. Banks would no longer lend to one another for fear of undisclosed liabilities (non-visibility) reducing the real credit worthiness of the borrowing parties and increasing the likelihood of default.

Big isn’t better, and in some cases as we have recently experienced, it is much worse. Canadian banks have faired better than most. A major contributing factor is that they didn’t get their wish about eliminating foreign ownership restrictions.  Canadian banks are limited to 10% foreign ownership. It seems to me that as a group they should be grateful for the failure in their lobby effort to have that restriction eliminated. It saved their asset base and our banks and protected them from much more of the downside of the credit crises of 2008-09. Instead, in 2009 the Canadian economy and financial system has experienced strong relative growth compared to the international competition.

Commercial banks are too big to fail because of the unique arrangement they have with taxpayers. FDIC (CDIC in Canada) insures assets to 250k (100k). If they default, the government, backed by tax revenues, guarantees the liability. This call on tax dollars creates an incentive to accept more risk, in an effort to maximize shareholder profit, since Banks are credited with the positive return to risk but are insured for losses.

For banks it is very unlikely if not impossible to reorganize under bankruptcy protection. Unlike other corporations like airlines, for banks bankruptcy is equal to liquidation.

Clearly there is something wrong with this system. The old idea of building scale to eliminate the competition appears to be in conflict with the best interests of the economy as a whole.

We could try to use a 1930s solution and disentangle commercial banks and investment banks or perhaps more realistically, the consequences of bank failures could be minimized. To my thinking the latter approach is more likely. New regulation can be introduced to reduce potential claims on taxpayers.

A group has been formed to provide recommendations on just that line of thinking. The Squam Lake Working Group on Financial Regulation is a group comprised of 15 leading academics who want to bring the system back into equilibrium. The thinking is that if the incentives of scale are reduced and the costs to society of banks failures are minimized, then a better equilibrium will be established for the financial system and by extension, the economy as a whole. The group had developed several practical solutions to improve the systemic problems. It appears the US administration is listening.

While most of the worries and economic turmoil persists, there has been some measure of relief to the stock markets. We are at a point of growing divergence between wall street and main street. More evidence is expected of shrinking economies in North America and overseas yet these backward looking measures were not reflected in the recent buoyant return to stocks across the world.

The short term return to investment returns is random but momentum trends do make themselves known. For this positive return environment to continue investors will have to ignore the results from main street. They will have to ignore the fact that consumers are saving more and deferring large purchases. The market will have to rally in the face of lower earnings reports from companies and yes more bankruptcies and higher unemployment figures. There are no assurances, risk is pervasive even from these price levels. If this is the beginning of a turnaround in fortune for the stock markets then it would be consistent with the beginning of other bull markets, shrugging off the bad news and climbing higher in spite of the evidence.

Today’s  Opening Value

We posted new lows last week and the S&P 500 is priced at less than half of the value in November 2007.  The recent investment experience has been brutal. Last week was one of the worst in terms of stock market performance that we have seen in the past couple of years and just about everyone is looking for the misery to continue.

Last Thursday Bank of Montreal economist Douglas Porter, suggested the worst was over and we should begin to consider the prospects of a better economy by the end of 2009. His opinion wasn’t appreciated by those that offered comment. Practically no one agreed with his point of view. The average opinion was outright critical and many dismissed his thoughts as someone who is shilling for a bank, his opinion therefore bought and paid for. I don’t know Douglas Porter other than by his reputation as a good economist.  I do have some respect for his decision to release information to the hostile crowd. He was, I think,  aware of the probable feedback. So what is going on here? Is everyone so sure that they know the future will be a continuation of the recent past? Is Porter simply rolling the dice with other people’s money (risk) to generate profit for his bank? It seems to me that investors understand there is higher risk in the investment markets. Their recent experience is bad and they look for this to continue. The idea that economists or financial analysts can predict the bottom for investment markets is a source of irritation bordering on anger.

For the sake of clarity here are some basic financial principles in which we can rely:

• Higher return comes with higher risk. The risk premium or compensation for risk is higher when things are not going well.
• Investment decisions should be made on a forward-looking basis not by looking at the recent past as prologue.
• It is improbable to predict or time the turn in the investment markets.
• Short term returns from a trough, or market low,  is very high.
• Selling after a significant drop in prices means you will probably give up significant short term return when the market recovers.
• Some short term traders will correctly predict the turn in the market but only by chance.

It’s 3 o’clock, an hour before the close of the markets. I really don’t prescribe to technical analysis for stock trading, but like reading your horoscope, it makes you feel better to see a five star day.  We are currently equal to the old low from last November. Optimists (bulls) cling to the notion that this value represented a low level from which the markets would slowly and carefully resume an new upward trajectory. So to avoid a problem I am posting this before the close of market trading. Maybe the market (world) cares about the S&P 500 staying above 752 or maybe not. Intellectually I know it doesn’t make any difference. Emotionally I could use the boost.

Patrick, as an investment advisor, how do you balance the risks and need of an individual investor who is trying to make a return in a market dominated by big players/hedge funds/institutions who have a very different risk profile and appetite than a small investor has. Seems to me that the small guy is just along for the ride, be it good or bad, and has to try to anticipate the risk profile of those who dominate the markets because they are the players that will ultimately determine how well markets perform and react to events.

I think this is a great comment and reflects the attitudes of many small investors especially when reviewing the results of 2008. It seems to me that the central concern is… how can a small investor compete? The assumption here is that the bigger players have the advantage and seem to be the biggest influence in establishing prices. Lets look at some of the evidence.

We know that in the aggregate, the returns available to all investors is the return to the markets. That’s all there is. On average then, if costs are lower for those getting the market return, the average return to “passive investors” will be greater than the average return the “active investors” receive when costs are considered. This  simple important point was perhaps first introduced by Bill Sharpe in his 1991 article titled the Arithmetic of Active management.

There are several implications to consider:

Star Hedge Fund, portfolio managers and large institutional investors spend all of their time and effort trying to outperform their contemporaries. They spend money employing managers and analysts. They have marketing staff and advertising budgets. They trade to exploit opportunities so as to gain relative advantage. All of these initiatives cost money.  So if  manager A gets some advantage then, by definition, the other managers must do worse. The costs employed in these efforts  reduces the total return available to the group.  Though it may seem intuitive, it is worth noting that despite  the considerable “advantages” and effort employed, as a group they under-perform the return provided by the markets in which they invest . They must because of the costs of their operations.

Some active managers will do better, though any innovation is quickly adapted by the competition. It’s a big arms race and we all benefit in the outcome as prices of assets are refined. It helps our markets operate more efficiently. We need active managers to ensure that prices are fair. Their efforts act as a kind of subsidy to all investors, ensuring a reasonable relationship between risk and return. We need not jump to the conclusion the prices are always “correct” but there is significant pressure brought to bare so that investments move to equilibrium value, where risk and return are in balance.

It’s really tough to compete as an active manager. These people are smart, committed and well financed. The dream of opening a discount brokerage account and competing with these folks is probably going to turn into a nightmare. The occasional exception, like a lottery winner, doesn’t change the math. Unless you are born into this world wealthy, building your own hedge fund probably happens after you retire from you life’s work. Discount brokerage accounts have helped to reduce the costs for individuals to trade stocks.  But bringing a knife to a gunfight is not my idea of a relaxing retirement plan.  You have to look at the incentives. Discount brokerages do better when clients trade more.  Clients do worse when they trade more. It doesn’t matter if the cost of the transaction is zero. I will provide more on this in a future post.

Our mandate is to help small investors win by putting them at an advantage. We focus on capturing the return provided by the asset classes in which we invest. We focus on keeping costs down and minimizing taxes. We focus on providing service on financial issues outside of investment returns.  We play a winning game not a losing one.