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.

There is a Darwinian notion here for me. Outcomes are, to an extent, predetermined. Outliers appear continually and their impassioned exploits are rejected or rewarded based on things that are largely out of their control.  Demographics,  perhaps like natural selection, decide the timing for these mutations.  Gladwell concludes that the individual player has less to do with the outcome than we might give credit for… so I think I’ll wait for the unifying theory.

These notions can be considered when looking at our new generation of leaders.  The Jones Generation refers to that portion of the  population born between 1955 and 1964. They are the lost generation, sandwiched between Boomers and Gen Xs. President Obama and Prime Minister Harper are part of Gen Jones.  This generation had the shared experience of starting their careers in the recession of the early eighties. There  is a certain shared frustration as a result of  high expectations for success meeting 20% interest rates.  The view is that their older boomer brothers and sisters had an easier road.  Apparently, once they did manage to get a toehold on careers and families, the Joneses turned into perhaps  the greatest consumer generation of all time. It seems that as leaders the Joneses should remember some of the lessons of the early eighties. Tough times require a willingness to compete. Perhaps 10,000 hours working through a previous recession will serve as great training for this current group of leaders to succeed in the task at hand.

(Click on the chart to see a bigger version)

This chart represents my attempt at defining a normal or ”equilibrium” return to equity markets. The data starts in 1970.  Each value represents a 15 year compounded return for a portfolio comprised of one  third Canadian equity, one third US equity and one third international equity.  I think this is a reasonable period in that each data point considers at least two market cycles.The lowest 15 year period equals 8.5% and the highest, just shy of 20% compounded return. If this year ended at the values we are at today the 15 year return will be about 6%.

So how can this data help us?  Should we expect better return in 2009 and can we define what that amount might be? Unfortunately, with all due respect to market strategists and technical analysts, the investments markets are not so easily mined . The risk to equities is not altered by recent experience. We continue to have a random outcome in the short term. Cheaper doesn’t mean less risky. As my friend Brad Steiman from Dimensional Fund Advisors likes to say “stock prices have no memory.” While our expected return may be higher after a large correction  it comes with the cost of higher risk.

I think the most sensible approach is to build more efficient portfolios. If we focus getting the return provided by  the broad markets we end up with ample reward to our efforts. Our investment success should not be determined by “when” the return shows up but rather by how we participate when it does.

I will provide more detail on how we build better portfolios in future posts.