Feature5 - Perspective
[What follows is not financial advice. Do not follow it.]
The S&P/TSX Composite Indices experienced intraday lows last August, when the subprime mortgage market in the U.S. began to implode. The question in most investors’ minds is whether we’re repeating the worst of 1929, a limited but virulent salt-sea bubble burst, or mere jitters and turbulence.
Should we sell? Should we buy? Will the market continue to decline? To help answer such inquiries, we must begin with a more basic question: What has caused the market volatility?
Cause And Effect
One usually cannot pin the genesis of a stock market’s trend on one issue. This case, however, provides an exception. Some may point to a crumbling U.S. economy, others to the souring of subprime loans. However, the seeds of these problems were sown with the U.S. housing bubble that was fuelled by access to cheap credit. Since that housing bubble has burst, its effects have rippled across the U.S. economy and financial markets.
Weak retail sales numbers illustrate the fact that consumers are pulling back on their once-exuberant spending habits. Exacerbating the reduction in spending is the tightening purse strings of U.S banks. These financial institutions have been rocked by rising residential mortgage defaults and the resulting deterioration in the derivative investments backed by these loans. U.S. banks have written off more than US$100 billion as subprime loans have dropped in value. Lending costs for corporations are rising as credit conditions tighten, leading to fears that earnings are going to slow or even contract. And this, of course, has led to the final link in this chain reaction: falling stock prices.
Just The Beginning Or Is The End In Sight?
The U.S. federal government is developing a multi-billion dollar fiscal stimulus package and the central bank cut its key lending rate by 75 basis points in an effort to provide a lift to the economy. How effective these efforts will be in averting a recession in the world’s largest economy is a difficult question to answer. One reason is that the very cause of the problem lies in cheap credit. Some might say that you cannot solve a problem by worsening its cause. Another reason is that "recession" has a technical meaning (negative growth in two consecutive quarters), which is remote from real world issues. A third is that wars are a vast stimulation to the North American economy and the U.S. finds itself increasingly on a permanent war-footing.
Consider some perspective. For investors who take a long view (which we advocate), the answer to whether the markets will quickly stabilize matters little. Economic whirlpools will continue to present themselves over time. But nevertheless, many investors are wondering what action, if any, to
take in the present environment.
To Sell Or Not To Sell?
Investors who have the time to watch the markets on a daily basis, following their every twist and turn, may find trading opportunities in the near term. Stocks will experience inevitable rallies and pullbacks over the next several months. For most individuals, however, trying to pick a bottom during a correction period is an exercise in futility. Some may guess correctly. Most will not. It is important to note that sharp stock market declines are fortunately rare, but when they do occur, the key indices are usually higher six to twelve months later. Whatever we individually decide, today’s stock market valuations are unlikely to portend a protracted stock market decline. Many stocks are trading at reasonable valuations, a fact that makes a prolonged bear market considerably less likely. This evidence suggests that wholesale selling of equity portfolios would be an unwise move. A review of speculative investments and risk levels inherent in lower quality stocks may be prudent, but indiscriminate selling would likely result in lost opportunities.
Where Might There Be Bargains?
Bank stocks face near-term headwinds. They have been among the hardest hit among stocks thus far. The reasons lie in write-downs of asset-backed securities, a slowdown in merger and acquisition activity, fewer initial public offerings and rising loan losses.
Banks south of the border have much larger exposure to toxic subprime loans, making the outlook for U.S. banks much cloudier than that of their Canadian counterparts. With U.S. banks expected to record additional asset write-downs in the coming months, significant advances in bank stocks, on either side of the
border, are unlikely. Longer term, however, it appears some bank stocks may be trading at very reasonable valuations. This is an area to watch.
Resource stocks have pulled in two directions. Stocks of commodity based companies have been a key source of weakness in the Canadian equity market thus far in 2008. Energy shares are down 10.2% since the beginning of the year, while base metals stocks have fallen 14.8%. The bears are claiming that a U.S. economic slowdown will lead to reduced demand for Canada’s commodities. The bull case argues that economic growth in developing countries such as India and China has little to do with the U.S., and these countries have a need for base metals and energy that will not abate any time soon. Investors may choose to wait on the sidelines as the bears are currently winning this tug-of-war. When the tables turn, however, there could be a vibrant rebound in these stocks as many are trading at attractive valuation levels and are generating strong cash flows.
Unexplained sell-offs are a puzzle. Share price weakness among bank and resource stocks is somewhat understandable given current economic and financial conditions. In other areas, however, share weakness appears unjustified. It is not readily apparent what impact a slowing U.S. economy should have on the fortunes of Canadian cable and telecom companies, yet many of these stocks are down 15% in 2008 to date. With healthy dividends, investors can afford to hold on to shares of some of these companies that have solid market positions and strong free cash flow generation.
Something similar could be said about Canada’s life insurance companies. Yes, many do have operations in the U.S., but sales of life insurance policies are not generally considered cyclically sensitive. Moreover, valuations for some of these companies are at multi-year lows. Investors have also been shedding units of Canadian real estate investment trusts, with little regard for the sector’s strong underlying fundamentals. Vacancy rates are low and the cost of borrowing has remained in check. Those fearing a real estate bust like the one seen in the early 1990s should take note that real estate companies’ debt levels are much more reasonable today than they were then. Dividend yields are north of 7% on many high quality REITs and such cash flows are enticing in these volatile markets.
Some U.S. consumer discretionary names will be ripe for the picking. The stock market is always forward looking. Just as it does not wait for the confirmation of a recession before it begins to sell-off, it also does not wait for the end of a recession to start rallying. Investors would be wise to start scouring the U.S. stock market for good quality, low-debt consumer discretionary companies that have strong market positions. Myopic market participants have been selling shares of some U.S. consumer discretionary companies to levels that do not appear to reflect their long-term value. A company with strong brand recognition and reasonable debt levels should be able to weather the economic turmoil. While it may still be early to pick up some of these beaten down names, investors may want to create a watch list of stocks to pick up once the sell-off abates.
Conclusion
Unlike past bear markets, such as the one that began after the tech bubble burst in 2000, valuation levels on Canadian and U.S. stocks are at much more reasonable levels today. This suggests that a stock market bottom may not be too far off. Investors should also be encouraged by the rate cuts set forth by the U.S. and Canadian central banks. These efforts could provide support to equity markets.
One cannot, however, ignore the potential effect of continued negative economic and financial news. If jobless claims continue to rise and more subprime loans are written down, equity markets will likely remain volatile. Amidst such noise, stocks of solid, cash flow generating companies may continue to be sold off. Astute investors will keep an eye out for such bargains to emerge, leaving them better off in the long run.
[The above is not financial advice. Do not follow it.]
