WEALTH Matters — FALL 2011


Disappointing. That about sums up the third quarter of 2011, the worst quarter stock markets have seen since 2008. The graph shows stock market performance since the start of 2011. The S&P/TSX (blue line) lost 12.6% in the quarter, and the S&P500 (red line) lost 13.4%.



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If there is one thing that investors do not like, it is uncertainty, as it breeds fear, which leads to higher levels of volatility as the fearful sell off and the bargain hunters buy. Over the 63 trading days on the TSX/S&P this past quarter, 11 of those days saw movement of more than 2% either way. In other words, 1 out of every 6 trading days had volatility greater than 2%, and this does not account for the volatility seen throughout the day. It is no wonder that many investors have seen their confidence wane. With many of the headwinds that have dogged markets throughout 2011 still to be resolved, it is likely that markets will continue to remain volatile for the foreseeable future, certainly until a credible solution to the eurozone debt issue is found.

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Many professional portfolio managers believe that when there is this much fear in the market, it is a signal that we’re near the bottom of the market cycle. Fundamentals are strong and should provide support for the market at these levels:

· Corporate profits are strong

· Corporate balance sheets have very high cash reserve levels

· Share price-earnings multiples are as low as they’ve been since 1980

· Government bond prices have been bid up so high that future yields are less than inflation, even before taxes.

· The dividend yields on many stocks are now higher than the yield on the same company’s bonds.

Many portfolio analysts believe these fundamentals set the stage for strong share price recovery once the uncertainty about European debt crisis subsides.

By mid-June, Canada’s S&P/TSX Composite index had already experienced a technical correction – a decline of 10% from its earlier peak - but had rebounded somewhat by the end of the 2nd quarter to be flat at the half-year mark. The 3rd quarter declines bring the TSX’s total decline to 18.5% from its 2011 peak of May 5, and the S&P500 is off just over 17% of its May 29 peak. A 20% drop from a peak is usually considered a ‘bear’ market, and this would be the 7th bear market in the past 20 years.

The strongest market gains are usually made shortly after the largest declines. If it has been some time since you re-balanced your portfolio, this may be a good time to do so, to add to your equity allocations at low prices if they have been pushed below their target percentage of assets. This may be easier said than done – the same fear that creates the buying opportunity makes many investors reluctant to take advantage of it. That’s why a re-balancing strategy based on set periods or percentage ‘off target’ can help take the emotion out of the decision.

There were some unusual forces at work in the world economy, which contributed to these market declines. After being relatively quick to react to the 2008 financial crisis, this time around policy makers have not handled the crisis of confidence very well. The quarter began with acknowledgement that economic growth and job creation in Europe and the US would likely be slower than had been expected. This turned the focus to government debt levels, swollen by deficit spending after the 2008 credit crisis. In the US, the Democrats and Republicans played a dangerous game of chicken with approving an increase to the country's ‘debt ceiling’ early in the quarter, fighting to the last minute before finally agreeing to a watered-down compromise, and receiving a credit downgrade as a reward. Financial markets sold off sharply in the two weeks leading up to that deadline, with investors dumping stocks and buying investments traditionally regarded as safe havens, driving up the price of bonds and gold in the process. Similarly in Europe, there has been a seemingly never-ending string of proposals to help heavily indebted nations - especially Greece - meet their debt obligations. Austerity and support programs have been hashed out again and again, but no strong definitive commitment has been made, and markets fear a default is inevitable. The key uncertainty is just how large a loss Greek bondholders would suffer if a default, and how to prevent the shock of such writedowns from destabilizing European banks and weaker economies. The quarter ended without a credible plan, and the uncertainty weighed on markets.

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