Want To Know The Secret To Your Children’s Upward Mobility?

Your parents' property wealth can determine your lot in life

For some time now, we’ve seen rising inequality in North America. And as a result, social mobility has been declining, particularly respective to many of our peer nations.

Pew Research Center,  a nonpartisan organization that informs the public about the issues, attitudes and trends shaping the world, has new data on the differences in how rich and poor families raise their children and it indicates that we’re becoming a two-tier society — one in which who you become depends heavily on who your parents are.

Pew’s survey found that rich parents tend to coddle their kids, creating busy after-school schedules full of soccer games and violin lessons. Working-class kids, however, are left much more to their own devices, given fewer resources and less stroking. According to Pew, that makes them more independent and closer to their parents. Yet it doesn’t help working-class youths climb the socioeconomic ladder. Once they hit their working years, they struggle just as their parents did.

Inequality and a lack of social mobility isn’t a new phenomenon. It’s always been the norm. In the wonderful 2014 book The Son Also Rises, University of California academic Gregory Clark shows that birth (or more precisely, the family one is born into) has accounted for about 50% of people’s success in life across nearly every country and time period. On top of that, Clark found that it takes 10 generations or more for inherited upward mobility to wear off. Even in the New World, we’re more like the inhabitants of Downton Abbey than we would like to admit.

Why is this? Much of it has to do with education, including better schooling for rich children but also those after-school resources cited by Pew. But there’s a larger factor driving this, too: real estate. Rich kids are more likely to inherit property wealth from their parents, increasingly the fastest way up the economic ladder. Academics like Thomas Piketty have written at length about real estate’s importance in building socioeconomic oligopolies. More recently, former British financial regulator Adair Turner has made a strong case for real estate as the single biggest driving factor in our two-tier economy.

“There is something about a modern economy that is extremely real estate intensive,” Turner, author of Between Debt and the Devil, asserted in a recent interview. “Living in a ‘nice’ location is a high-income want, as is good education and health care.”

These desires are what economists call “elastic” wants. They are constantly in demand, and in lieu of proper price control, their cost can and will spiral almost infinitely (unlike, say, the price of a pair of pants, shoes, or even a car, which is somewhat bounded).

Just as rising education costs make it harder for the poor to climb the socioeconomic ladder, so too do higher real estate prices. Banks aren’t willing to extend credit to those who can’t put down 30% cash on a new home, but rising rents are making it tougher for people to save. That’s making it harder, if not impossible, for working-class (and even some middle-class) families to buy a home. As an increasing share of global wealth is held in housing, those who lack real estate, fall and are left behind.  This last detail is particularly evident in British Columbia’s Lower Mainland Region.

What’s the solution? Some believe that the price inflation of elastic economic goods like health care, housing and education need to be constrained by smarter policies involving both the public and the private sector. In the case of real estate, some are calling for changes to immigration policy and what constitutes residency. But that would do nothing to fix the problem. Instead, it would create a more divisive property market, since private companies would have no impetus to create any kind of affordable housing, focusing primarily on the most profitable segment(s).

Others believe that the quickest fix would be tax reform that focuses on rewarding people for residency and penalizing foreign investors and luxury home buyers.  They argue that when only the rich can afford property, and property makes up an increasing amount of global wealth, and a larger percentage of that wealth is kept in the family, then you really do have the makings of a new Gilded Era.  On the surface, this seems to have some appeal.  Closer inspection, however, shows that this can lead to retaliatory action from other countries, does little to address supply issues, and is counter to market related policies.  To date, no one has been able to properly explain to me how higher taxes will leave me with more money for housing.  In fact, I believe that more taxes will decrease affordability and create asset-price inflation that fuels the cycle of inequality I have outlined above.

I have a simple solution.  If social mobility is related to financial wealth, and financial wealth is commensurate with property wealth, why not simply invest in real estate?  Start small if you have to, but start now.    You may not begin with your dream home, but you will get a home, a great investment, and a legacy for your children.

Let's get started.  Together.

The Closest You'll Get To A Sure Thing

Since I first moved to Toronto in 1986 and got my first job as a stock broker, I’ve seen a lot of the ugly underbelly of the Bay Street/Wall Street money machine beast.  I’ve also seen a lot of success and wealth created over the years. I’ve fought long and hard and have learned a lot of very important lessons both from keeping my eyes open and observing others and also from my own hard knocks and failures and losses.

Yes, I've had losses and I’ve made a ton of trading and investing mistakes just like everybody who has ever traded or invested has.

I bring all this up because this Easter, at a family function, I got a great question from a niece, a variation of the most common question I get from many new investors:  I am going to graduate this year and I've saved a few thousand dollars. How and in what should I invest it in?

Money and life is complex, and so is my answer.

If she was going to buy stocks with that money, I suggested she check out some of my current employer's top recommendations and buy a few shares of her favorite two or three from the model portfolio. Otherwise, she could also visit some of the larger financial institutions' websites for their picks.  Regardless of what stocks you buy and when you do it the first time, when you first start out investing and trading, you should be prepared for painful times and lessons which will cost you money and profits in your portfolio. You should consider upfront what you would do if you started putting that money to work and immediately saw it blow up.

I remember reading articles in Institutional Investor back in 2007 that quoted “professional” institutional brokers and salespeople explaining how they were selling “risk-free” securities that guaranteed 5% or more income. Within twelve months, those people's employers, the Morgan Stanleys, JPMs, and Goldmans of the world, needed trillions in new taxpayer support and bailouts because those “risk-free” assets weren’t.  In Canada, few people remember the ABCP fiasco (Do the words:  "Asset-Backed Commercial Paper" ring any bells?)

I also remember the time I was watching television and a speaker gave a presentation about his options trading formula and before he could get to the microphone, he screamed to the audience, “Forget everything else you heard today, if you follow my options trading plan, you’re guaranteed to make money and never lose.”

Don’t think anybody’s immune to huge losses and wipeouts. Even the Warren Buffett’s and other financiers/insiders of the moneyed world, who had hundreds of billions of dollars invested in the same TBTF (Too Big To Fail) banks that would have been wiped out and other assets that too would have been wiped out without all the “emergency measures” and welfare and bailouts and accounting changes that were made back in 2008 too, obviously can’t avoid mistakes too. Buffett’s big money has enabled him to spend the last few decades buying warrants, convertible debt and discounted equity directly from giant corporations in ways that retail investors can’t even fathom, much less get access to.

So think about all that even before buying a single share of any stock in any publicly-traded company. And before you pull any trigger and open up any stock account, I’d suggest asking yourself if that money might be better used in starting a new app company or website business that you have come up with and think could be a big winner. The experience of running a business and more to the point, the upside of betting on your own actions creating value rather than betting on other people at other companies ability to create value for you as a shareholder, is probably the best bet for your money at this age and stage of your life.

"You’re 18. You’ve got a whole career and a whole life ahead of you. Bet on yourself first. Stocks and other people can come later. And either way, understand that it will take a lot of time, perseverance and luck to make that few thousand dollars you’re looking to put to work in the stock market turn into something meaningful to your overall future income and investments."

How Shopping For A Financial Advisor Can Go Wrong

As part of my continuing education program, I recently attended a seminar that highlighted new research which shows why an advisor who may be good for some investors, may be far from ideal for others.

I’ll start with an example that was used by the speaker: 

Let's presume you have a health problem and you visit two or three internists. Chances are good you would receive a similar diagnosis and treatment from each doctor. 

But if, for argument’s sake, you take a financial problem, or your retirement goals, to two or three financial advisors the results would be surprising. New studies show that you're unlikely to get the same, or even similar, recommendations about what investment products to buy or what strategy to pursue. And that could make a big difference in your financial future. 

According to a recent report from Cogent Research LLC, a market-research firm in Cambridge, Mass. , retirement-savings recommendations vary greatly based on the type of firm for which a financial advisor works.

For instance, registered investment advisors or planners, who own their own firms lean toward using the products offered by mutual-fund companies, Cogent says. By contrast, advisers who are affiliated with independent broker-dealers often suggest insurance products like annuities of one flavor or another, the report says, while advisers who work for the big national brokerage firms tend to suggest both insurance products and a mix of other investments, but mostly stocks and bonds. 

Meanwhile, a report from GDC Research in Sherborn, Mass., and Practical Perspectives in North Andover, Mass., says advisors in different channels use not only different products but also different strategies to generate retirement income for their clients. 

Some use the same investment strategy for both building and tapping a nest egg. For instance, they will adjust the mix of stocks, bonds and other assets in a portfolio as the client approaches and enters retirement, but they won’t introduce a new asset class in retirement. Others will make bigger adjustments, putting some assets needed for short-term expenses in safe investments like money-market accounts while leaving assets for long-term expenses in riskier investments like stocks. And some like to buy annuities to generate a steady income to cover essential costs or a desired standard of living. 

The findings of the two studies illustrate the need for older investors to exercise caution when searching for a retirement-focused advisor, and to consider interviewing professionals from at least three different types of firms: a registered investment advisor or planner, an advisor affiliated with an independent broker-dealer, and perhaps an advisor with a national brokerage firm before selecting one. 

At a minimum, experts suggest asking potential advisors how they are compensated, because that can affect their approach. For instance, some advisors might not recommend annuity products as part of a retirement-income plan, even if it might be appropriate, because they aren't licensed to sell such products and thus don't earn a commission on them. Other advisors, meanwhile, might not recommend mutual funds because the compensation they receive for selling an annuity is greater. 

Experts also suggest asking potential advisors for samples or actual retirement-income plans for clients whose financial profiles and goals are similar to yours. That's because what works for one person might not work for someone with different resources, assets and lifestyle. For instance, retirees who have sufficient assets and resources to fund 30-plus years of retirement can use what's called a systematic withdrawal approach, taking a certain percentage of your money out of your nest egg annually to produce retirement income while investing the portfolio largely in dividend-paying stocks or mutual funds. But retirees with few resources might need a different strategy and products, such as immediate annuities. 

Experts also emphasize that retirement-income plans and retirement-savings plans are very different things. The latter tend to invest, diversify and wait, which is fine if you are 20 or 30 years from retiring. The former, ideally, will assemble a group of investments that produce both steady income and long-term growth. 

I would suggest that those either in or approaching retirement seek an advisor who has a strong commitment and focus on retirement-income planning and has access to a broad range of products and services to suit those needs.

The 5 Golden Rules of Investing Success

There are many more people watching share prices than investing in stocks. Most realize that investing is the way out of living from paycheck to paycheck, but do not know where to start. Stocks and shares seem to be the reserve of the rich; a risky business where the novice loses their shirt. But there must be away to get started without getting burned? Here are five rules to stock market investing success to get you started.

Rule 1. Get online and research not only the companies that you would like to invest in, but also the investment firms that you may want to partner with.

Many websites and investment firms provide investors with free stock market tools that a few years ago would not even be available to the professional fund manager;
     Real time share prices.
     Fundamental information.
     Portfolio tracking.
     News.
     Opinion.
     Many more free services!
These free services let you make highly informed financial decisions on what share to buy and when to sell them.
Researching your stock market investments might seem like work. That is because equity investing is work.
Sadly investing is not a short cut to wealth, you need to treat it like any other way of making money -with focus and determination. Hopefully you will find it a lot of fun and more like a pastime than a chore.
Just as you cannot do a crossword without a pen, you shouldn’t invest without the best stock market tools which are online these days.
Fortunately, fully-integrated investment firms such as Global Securities Corporation can help you with equities, fixed income, commodities and risk management products.

Rule 2. Limit the size of any individual investment.

Until you own at least 30 different companies’ shares, never buy more than $10,000 worth of any share.
Risking too much on any stock investment is a recipe for disaster, even for the sophisticated stock market investor. Keeping your individual share investments small keeps your capital pot safe and lowers the stress that can make investing unpleasant. Once you have 30 stocks you can grow the scale of each investment, but until that day stay diversified.

Rule 3. Diversify. Build a stock portfolio of at least 30 different investments.

Take no notice of the people that say put all your eggs in one basket. A portfolio gives you a certainty that bad luck won’t hurt you and that your choices on average will deliver the return your share picking deserves. This portfolio return over the years will outperform anything a bank will offer you on deposit and will compound.
A diversified portfolio will mean you will miss out on good luck, but investing isn’t about good luck. Bad luck and good luck cancel out over time but if you have too much of your money in too few shares then bad luck can knock you out of the game.
This is called ‘gambler's ruin’ and the way to avoid by having a portfolio.

Rule 4. Use research reports and your own common sense.

Unsurprisingly, the markets are fluid and there are many different ways to analyze investments. To be successful you need to be constantly on the lookout for new methods; old ones are always eaten away by the efficient market.

Rule 5. Invest in shares for the long-term.

Buy shares you think you will hold for three or more years. When the world’s most successful investor, Warren Buffett, claims sloth as his most profitable investing trait you should take note. Slow and steady wins the stock market investing race.
Value investing is a great skill to learn.
Put your investing money in an RRSP or TFSA and let the profits roll up tax free. While interest from the bank is taxed, using these tools can protect your stock market profits and dividends from tax; one more reason to let the long-term take hold.
Just remember, by the time you can afford a Ferrari from stock investing you will be too old to want one.
You think that’s bad? Perhaps you should wonder if you have any other way to get Ferrari rich at all, before you worry how long it will take.
If you can see stock market investing as a part time job from now until retirement you will do very well indeed from it; it is the short-term speculators that usually get burnt.

Investing is how the average investor can get rich slow. It is one of the few ways available to an average fellow, but because it takes hard work, discipline and time, not many people sign up for it.

If you really care about your finances and your long term prosperity it is always a good time to start investing. It is a long road, but a profitable one.

Are Stocks Still A Bargain?

With global stocks up approx­i­mately 25% from their Fall 2011 low and many market watchers from various financial media sources endorsing equities in recent weeks, it’s hardly sur­pris­ing that investors are won­der­ing if stocks are still a good bargain.

While some mea­sures of sen­ti­ment – notably abnor­mally low volatility levels – could be inter­preted as flash­ing yel­low cau­tion signs, val­u­a­tions and fun­da­men­tals still favor global stocks over the long term.

Cur­rently, equi­ties look rea­son­ably priced on an absolute basis. Devel­oped mar­ket equi­ties are trad­ing at around 14.5x trail­ing earn­ings, while large emerg­ing mar­kets are trad­ing at roughly 12x earnings. These val­u­a­tions are sig­nif­i­cantly above those touched dur­ing last year’s trough, but both emerg­ing and devel­oped mar­ket stocks are now trad­ing at a significant discount to their long term averages.

The rel­a­tive case for stocks, how­ever, is even more com­pelling as equi­ties look very cheap com­pared to bonds. While equity val­u­a­tions are mod­estly below their long-term aver­age, bond val­u­a­tions are sig­nif­i­cantly above theirs when mea­sured by vir­tu­ally any metric.

Nowhere is this more evi­dent than in the U.S. Treasury Market. Late last year, the yield on the 10-year Trea­sury note dipped below the level of core infla­tion for the first time since 1980. Rather than pay­ing investors the typ­i­cal long-term aver­age real yield of 2.5% to 3%, the US gov­ern­ment is now pay­ing a neg­a­tive real yield to bor­row. As a result, unless the US is slid­ing toward Japan­ese style defla­tion – and so far there is lit­tle evi­dence of this – US Trea­suries look extremely expen­sive and investors in 10-year notes are accept­ing a loss in pur­chas­ing power and no real income. In addi­tion, because coupons are so low, the dura­tion or inter­est rate risk of Trea­suries is at or near a his­toric high.

Some investors have weighed the volatil­ity of stocks against the low yield on bonds and opted for a third choice: Cash. A tac­ti­cal move into cash is cer­tainly rea­son­able for brief peri­ods of time. But if you’re wor­ried about long-term pur­chas­ing power, hav­ing a sig­nif­i­cant, long-term allo­ca­tion to an asset pay­ing zero return makes lit­tle sense. Stocks are a more rea­son­able option to consider.

To be sure, invest­ing in equi­ties has its risks. Some have argued that equity val­u­a­tions are flat­tered by his­tor­i­cally high mar­gins. But in the United States at least, a com­bi­na­tion of just enough gross domes­tic prod­uct growth, ane­mic wage growth and low rates should support margins over the near term.

Among other risks, while US defla­tion looks unlikely, it’s pos­si­ble and it’s a sce­nario that would clearly favor bonds. Under the oppo­site sce­nario – higher US inflation – equi­ties would surely suf­fer thanks to lower mul­ti­ples. How­ever, in an infla­tion sce­nario, equi­ties would likely hold up bet­ter than bonds or cash.

In short, equi­ties may not offer the stel­lar prospects of the 1980s or 1990s, but absent a bout of defla­tion, stocks are likely to out­per­form the alter­na­tives over the long term.

AA Is The New AAA.

AA Is The New AAA.

In other words, Standard & Poor’s U.S. Debt downgrade doesn’t change a thing.

America’s loss of its Standard & Poor’s AAA debt rating on Friday will continue to provoke strong reactions, from markets and pundits alike. But nothing has really changed.

Now is not the time to give in to emotions and make rash moves. It's the time to take a few deep breaths and dispassionately set a sensible course for the future.

Let's start with a little perspective. Yes, the fact that U.S. debt no longer carries a top triple-A rating is troubling. But it's not as if S&P told investors something they didn't know before (i.e; that the country's long-term finances are a mess).

As for the economic effect the downgrade might have, that's far from clear. Ultimately, though, bond investors' expectations will be the primary determinant of the yields on Treasury bonds, not the opinion of the ratings agencies.

And, so far, investors seem to be rushing into Treasuries not away from them. So I think people may be overreacting to the whole downgrade thing.

That said, whether the sell-off was an overreaction to the downgrade, the growing sense that the economy may be weaker than previously thought or something else, investors have clearly shown they're extremely nervous about stocks.

But this isn't exactly news either.

Although we lose sight of it from time to time, the fact is that the stock market is and always has been a very volatile place.

The flip side of that volatility, though, is that stocks have also generated some pretty impressive long-term returns. If you look at the 56 rolling 30-year periods from 1926 through 2010 (1926-1955, 1927-1956, etc. through 1981-2010) the lowest annualized return stocks have delivered over a 30-year span is 8.5%, and the average 30-year annualized return for all those periods is 11.3%. For bonds, the numbers are 1.5% and 5.1%, respectively.

This doesn't mean stocks will generate the same gains over the next 30 years. I wouldn't be surprised to see them come in considerably lower.

But I don't see any reason why, over the long term, one would expect stocks to underperform bonds or cash, especially considering the current low yields on bonds and cash equivalents. Remember, just yesterday the U.S. Federal Reserve vowed to keep interest rates at close to zero for the next two years.

So it seems to me that the challenge for someone investing his nest egg today is still pretty much what it was before all the debt-ceiling-downgrade political drama: to participate in stocks' long-term growth without getting hammered too badly when stocks suffer their inevitable periodic declines.

There are two ways you can try to do that. One is to attempt to outguess the market — that is, capitalize on stocks when they're doing well and then move out of them into bonds or cash or gold or whatever to avoid downturns.

The other is to invest in a reasonable mix of stocks and bonds and basically stick to it, allowing the bond portion of your portfolio to dampen stocks' swings. The first approach — moving in, out and around various parts of the market — is difficult-to-impossible to pull off consistently.

If you doubt that, just consider recent events. In the weeks leading up to August 2, investors' biggest fear was that Congress and the Obama administration might fail to raise the debt ceiling on time and thus spark a stock-market meltdown.

People were so convinced that this would threaten their portfolios that many considered moving their money into cash to protect against that possibility. When Congress and the White House reached a deal before the Tuesday deadline, the big market swoon everyone feared was averted.

However, two days later, while investors were still feeling good about dodging the debt-limit bullet, the Dow plummeted 510 points on concerns about the European debt crisis and the possibility of the U.S. sliding back into recession.

And then came Monday's wild 635-point Dow free fall in the wake of S&P's downgrades.
My point is that you can never really tell what might initiate a market decline — let alone know when it might occur.

The more sensible way to participate in stocks' long-term growth is to create a mix of stocks and bonds that gives you the benefit of the balance of probabilities at solid returns and offers at least some protection.

The longer away you are from retirement and the more your stomach can handle the value of your retirement savings taking the occasional decline, the more you can devote to stocks.

The closer you are to retirement and the more upset you get when your nest egg gets scrambled, the more you should tilt toward bonds and cash. If you're on the verge of retirement, that mix might be somewhere around half in stocks and half in bonds.

Taking the asset allocation approach and sticking with it (except for periodic rebalancing) won't immunize you against losses. But it can help you manage the downside risk of stocks without giving up all the upside.

And, more importantly, it gives you a rational way of dealing with the stock market's volatility and keeping downturns to a magnitude you can handle, rather than engaging in a never-ending guessing game.

By trying out different blends and seeing what sort of losses they incurred, you can get a better feel for what stocks-bonds allocation might be right for you.

Remember, though, if you go with too conservative a strategy to guard against market downturns, you limit your upside. So to get a sense of whether the asset allocation you choose will give you a large enough nest egg to support you in retirement, I suggest you use many of the excellent retirement income calculators available for free through many respected financial websites and investment companies.

I don't want to downplay the seriousness of the situation facing investors today. We could very well see lots more turmoil in the financial markets and further declines in stock prices.

But the fact is that there will always be something going on that investors will feel compelled to react to, whether it's the threat of a recession triggering a market meltdown or, in better times, rosy reports of economic growth and corporate profits suggesting the markets will soar.

But if you invest on the basis of hunches and speculation rather than setting a coherent long-term strategy and sticking to it, you'll put yourself at risk of selling after prices have already fallen and buying back in when prices are already inflated.

In the end, that will make it tougher for you to earn the returns you'll need to build a decent nest egg and harder for you to maintain your emotional equilibrium in tumultuous times like these.

2011 Outlook

“Prediction is very difficult, especially about the future.” -- Niels Bohr

While 2010 was a respectable year, and in a few instances an excellent one, for most financial markets, it came with the sobering realization that many of the global imbalances investors thought were behind us remain, albeit in a slightly altered form. Which leaves the question; will 2011 be the year when these imbalances re-erupt? I believe the answer is no, at least not during the next 12 months.

For 2011, I believe the overall global economic environment is likely to remain conducive for risky assets. I would expect developed markets to stage steady, yet uninspiring recovery. Growth should be subdued but positive, with inflation remaining low. While rates will rise over time, given low inflation and anemic demand for capital from everyone except sovereign borrowers, I believe bond markets will remain stable enough so as not to derail the equity market rally. In emerging markets, I would continue to expect outsized growth, although that growth is likely to slow as emerging market central banks wrestle with inflationary pressures.

For investors, this means considering an overweight to equities and continued exposure to commodities, particularly the more cyclically oriented ones. Within credit, investors should consider overweighting corporate credit versus sovereign credit.

While cyclical factors should support financial markets for another year, to be clear I don’t believe that the market’s bottom in 2009 marked the beginning of a new cyclical bull market. The debt problems that derailed the global economy in 2007 are largely still present; they have simply morphed from the private to the public balance sheet. Government unwillingness to address these issues, particularly in the U.S., leaves both equities and bond markets vulnerable in the long-term to wrenching fiscal austerity, unexpected inflation, or potentially both. Fortunately, that pending crisis looks like it can be postponed for at least another year.

Volatility

A little over three years ago, the Dow Industrials and the TSX hit an all time high and the list of established Wall Street firms still included Lehman Brothers, Bear Stearns, and Merrill Lynch. In the summer of 2008, most financial participants believed the worst of the subprime crisis had been experienced, world equity markets had recovered, and the US Federal Reserve (Fed) was grappling with the highest inflation in decades. A little over a year ago, financial leaders struggled to prevent what seemed like an inevitable slide toward the first global depression in 80 years.

Three years, three different market environments that experts were mistakenly confident would continue. Extrapolating from the past is a dangerous exercise during even the best and most stable of times. During periods of volatility, it is simple folly. Today, it is no illusion that the world has become more volatile. Consider the following: 10-year trailing U.S. inflation volatility is at a 50+ year high, over the past two years dollar volatility is the highest on record, and gold prices are the most volatile they have been since the mid-1980’s.

Nor is the recent volatility limited to financial markets. The volatility in asset prices has coincided with – orguably been caused by – a similar spike in political instability. The U.S. Congress has changed hands --- Republican to Democrat and back again – twice in a six-year period. This has not happened since the 1950s. At the same time, the U.S. Federal Reserve has tripled the size of its balance sheet over the past thirty months, and plans to continue this exercise through at least the middle of 2011. Outside the United States, the tenure of Japanese prime ministers is starting to resemble that of Italian ones, and an indecisive election in the United Kingdom has produced the first coalition government since the Second World War. Canada and Ireland have minority governments. Politically, economically, and financially we are living in an age of renewed volatility.

The one unqualified prediction that I will make for 2011 is that economic and political volatility will continue. There are three reasons to believe this.

First, many of the global imbalances which precipitated the previous crisis are still around, albeit in slightly altered forms. Instead of a pending subprime meltdown, we have the growing risk of sovereign debt, which will be further exacerbated by aging populations and unsustainable entitlement spending in much of the developed world.

Second, the aftermath of financial bubbles is characterized by slow, anemic recoveries in both economic growth and housing. Both of these will contribute to overall economic and political volatility.

Finally, the ongoing economic shift from developing to emerging markets will be a slow process, one that is likely to play out over decades. As it does, there are likely to be accompanying growing pains.

The good news for investors in the near term is that many of the longer-term imbalances still facing the global economy are unlikely to erupt over the next 12 months. So my baseline view for 2011 is a temporary lull followed by a lackluster but steady recovery in the developed markets with continued low inflation. In the emerging markets, we would expect continued strong economic growth. All things considered, not a bad environment for global equity markets.

Bonds are likely to hold up, at least through the first half of the year, but given valuations and supply issues they don’t appear to offer the best value.

It is important to note that the relatively sanguine outlook for next year does not imply that the global economy has put its troubles behind it. On the contrary, many of the structural imbalances that pushed us into the global crisis are still with us, albeit in an altered form. Ironically, many of the policies that are likely to promote a decent year for economies and markets, i.e. extension of the Bush tax cuts and maintaining transfer payments to individuals (employment benefits in the U.S.), will exacerbate the longer-term imbalances. At some point, the strain is likely to begin to show even on the largest and richest nations, but that is probably not an issue for 2011.

Demographics, Growth and Investments.

The Alternative To Growth Is Decline. Europe Is Proof.

A shrinking population and inflated expectations are a damaging mix.

Growth, whether it is economic growth or population growth, has almost become a swearword in the modern lexicon. It now needs to be qualified by the adjective "sustainable", or no one will subscribe to it.

Whenever a phrase is so self-evidently correct that no right-minded person would call for the opposite, it is usually a good indication that it is meaningless.

This is true for "sustainable growth", because no one would call for unsustainable growth. It is also true for "moving forward", as only some crustaceans prefer going backwards, and for "real action", because few voters would opt for "fake action" instead.

Apart from these semantic peculiarities, it is remarkable that the idea of limiting growth is striking a chord with voters in many Western countries, or at least with focus groups in those countries. Canadians seem quick to judge our American cousins with their seeming preoccupation with growth (at any cost). Will this hubris cost us down the road?

After one of the longest periods of growth in Canada's recent history, it seems that many Canadians have obviously forgotten that there is only one thing that's more unpleasant than dealing with the side-effects of growth. It's dealing with the side-effects of decline. In order to remind ourselves about this, we should look at Europe.

The financial crisis has hit Europe hard. It mercilessly exposed the weaknesses of Europe's social and economic model. Over the past decades, Europe had developed into a place in which governments took on an ever-increasing role, consuming more and more of the national economic output.

Taxes were no longer sufficient to satisfy politicians' appetite for more generous spending commitments, so deficits had to fill the gap between tax revenues and political ambitions.

At the same time, Europeans ceased to reproduce. In industrialised nations, the birthrate needs to be 2.1 children per woman in order to keep the native population stable. In many European countries, however, it has been far below this figure.
In the worst year so far, Italy recorded a fertility rate of 1.19. It has since recovered a bit, but with birthrates in the region between 1.3 and 1.4 in countries such as Germany, Italy or Spain, it is still far from the level at which these countries would remain stable.

A shrinking population would be a challenge in itself, but in Europe's case the problems are multiplied by rapidly improving life expectancy. Although arguably today's older generations are far healthier and generally more active than previous generations, it is nevertheless true that older populations mean relatively fewer taxpayers, more pensioners and more people in need of health care.

The mix of high-spending governments, increased life expectancy and lower fertility had for a long time produced a Europe that was a rather pleasant place to live.

However, it was not economically sustainable. After the shock of the financial crisis, Europeans are slowly waking up to the fact that they have created a continent that is on the verge of shrinking, with regard to its economic significance and its overall population.

As a whole, Europe will lose more than 60 million people over the next five decades. The remaining population will be much older than any other population in world history. In terms of demography, Europe is entering uncharted territory. What it will mean to live in country where there are as many people over the age of 80 as there are people under the age of 20 is hard to imagine, but many Europeans countries will soon find out.

The challenges of this demographic change are going to be enormous. Fewer taxpayers will have to shoulder an unprecedented increase in healthcare facilities. Qualified labour will be in short supply as working-age populations are already shrinking across Europe. This in turn will push up wages and prices; inflationary pressures are increasing.

Meanwhile, it will become more difficult to service the existing debt burdens.

The European example is a clear indication of what happens if a society enters into the no-growth zone. It sucks the energy out of the economy, and politicians are condemned to managing the decline with little room for manoeuvre.

When comparing Canada's growth chances to the European predicament of shrinking and decline, it should not be hard to decide which path is more tempting.

Growth is not everything, but without growth everything is more difficult.

Until investors realise this, they won’t be offered "truly forward-moving real action" on investment choices.

Year End Review

Looking Back - and Looking Forward

2009 was one of those years that reminded us what a roller coaster the stock market can be – and also of the dangers of conventional thinking.

After the collapse in global financial markets last fall and the resulting pummeling taken by stock markets around the world, the consensus in January was that the worst was behind us. That was a sharp reminder of the danger of conventional thinking – by early March, markets in Canada had declined by a further 15% and the U.S. was down by 25%.

At that point, the consensus shifted and there was growing sentiment that we might be entering a long period of economic stagnation; that’s when we heard respected economic forecasters talk about a one in five chance of another depression. It was precisely at this point that the coordinated stimulus spending by governments around the world finally had an impact and we began seeing signs of an economic recovery. From the market’s bottom on March 9 to the end of November, global markets were up by 50% to 65%.

Thus, 2009 was a sharp reminder that it’s impossible to predict short term market movements.

Instead we need to focus on two key questions:

1. First, what do the prospects for economic and profit growth look like in the mid term – 12 to 18 months and beyond?
2. Second, to what extent are these prospects for growth accurately reflected in today’s prices of stocks and bonds?

Mid-Term Prospects For Growth

In building portfolios, we have to start with some core assumptions about the environment we’ll be in going forward.

Noted British historian Paul Johnson has written that at every given point in time, you can always point to good news and bad news – the only difference is the balance between the two and what the media pays attention to.

In early 2000 (at the height of the tech bubble) and the beginning of 2008 (at the top of the real estate and finance bubble), all we read about was good news – almost no attention was paid to any offsetting concerns. By contrast, during market bottoms at the end of 2003 and early 2009, all we saw was the bad news – it’s as if there were no positives on the horizon.

Despite the recovery in the global economy and markets since the early part of this year, the general sentiment and confidence level among many people today is quite negative. Much of that is driven by concerns about the U.S. economy – still the engine of global growth.

And certainly there are lots of things to worry about in the U.S. – stubbornly high unemployment, a housing market that is still depressed (although no longer in decline) and Government deficits.

Without dismissing the short term challenges facing the US, it’s important not to lose sight of some important underlying positives.

In an August cover story on “The case for optimism” Business Week Magazine highlighted a number of reasons to be positive, among them the impact of technology and free markets in emerging economies.

Click here to read more about what Business Week had to say:
http://www.businessweek.com/magazine/toc/09_34/B4144optimism.htm?chan=magazine+channel_top+stories

And recently two respected columnists at the New York Times, Thomas Friedman and David Brooks, weighed in on both the positives in the U.S. and some of the challenges that America faces.

http://www.nytimes.com/2009/11/22/opinion/22friedman.html
http://www.nytimes.com/2009/11/17/opinion/17brooks.html

The bottom line is: In the mid term I believe the positives outweigh the negatives and that the dire predictions about America’s decline are overstated. It may not see the rapid growth we’ve seen in the past but it will see solid growth.

Today’s Valuation Levels

Being right on our midterm outlook for the economy only helps us if we buy stocks and bonds at attractive prices.

With regard to bonds, at current interest rates of about 3% it is hard to make a case for Government bonds as anything except a safe harbour against more market disruption.

The returns on corporate bonds are more interesting – especially toward the bottom of the investment grade category, which currently yield about 6%. Note that we do have to be very selective here, since companies with low investment grade ratings are susceptible to shocks and downgrades should the economy run into difficulty.
On the issue of valuation levels of stocks, there are lots of academics who have made a career of studying markets. Of these, I follow two in particular – Jeremy Siegel at the Wharton School at the University of Pennsylvania and Robert Shiller at Yale. Between them, they forecast both the technology and the U.S. real estate bubbles.

Robert Shiller believes stocks should be valued based on their average earnings over the past ten years, using what he calls the Cyclically Adujsted Price Earnings ratio (CAPE for short). Employing that measure, at the end of November Shiller calculates the U.S. market’s multiple is 19.5 x times average earnings for the past ten years, within the normal historical range (although at the high end of that range.)

Prior to 2008, you have to go back to 1992 to find the last time we saw this multiple consistently below twenty times average ten year earnings. Throughout the period from 1997 to 2001, this multiple was in the thirties and forties – when the multiple was in its forties, you were paying twice as much for a dollar of earnings as you are today.

Jeremy Siegel is the best known researcher on long term returns in the stock market and author of Stocks for the Long Run, often cited as one of the all-time ten most influential books on investing. Among his claims to fame is an article in the Wall Street Journal at the peak of the tech mania in early 2000, predicting that sector’s collapse.

In September, Siegel did two interviews on long term returns and current valuations, in which he talked about his research and his opinion that stocks offered good value at the time. You can see those interviews below:

Professor Jeremy Siegel on today’s market outlook:
http://www.clientinsights.ca/video/today-s-valuation-levels-and-market-outlook/type:investor

Professor Jeremy Siegel on long term stock returns:
http://www.clientinsights.ca/video/stocks-for-the-long-run-and-long-term-returns/type:investor

The bottom line from these two experts: While stocks are not as cheap as they were in March, by historical standards they do offer reasonable value.

While we can expect continued volatility in 2010, we do believe that returns on stocks in the period ahead will be in line with historical levels.

The Right Approach For Your Portfolio

While my team and I spend a great deal of time focusing on the big picture, the most important issue is how we adapt that view to each client’s individual portfolio.

For older clients, we have always been believers in maintaining conservative, balanced portfolios – that stance protected our retired clients from the worst of the decline in 2008 and early this year. Today, we are focusing on higher quality stocks, as we believe that these will provide the best risk return trade-off going forward.

In summary, we are cautiously optimistic about the American, Canadian and the global economy’s ability to work through some of the current issues they face – and believe that valuations on stocks will make quality stocks an attractive investment in the mid-term.

We look forward to continuing to work with you in 2010 to ensure you have the portfolio that is right for you – and thank you again for the opportunity to work with you over the past while.

As always, my team and I area always available to talk about any questions that you might have.

In the meantime, best wishes for a relaxing holiday season – I look forward to talking in 2010.

Quarterly Review - Cautiously Optimistic

As I write this new post, it’s two weeks from the end of the third quarter in what continues to be a most eventful year for stock markets and the economy.

It’s also one year since the weekend that shook the foundations of Wall Street and of the global financial system – when Lehman Brothers collapsed, Merrill Lynch vanished as an independent entity and AIG was taken over by the U.S. government.

In light of that, I thought it might be worthwhile to briefly summarize where we’ve been this year, where we are today and the prospects for the period ahead – and also to highlight some lessons from last year’s financial collapse.

Where we’ve been

Six months ago, in early March, it truly did feel like the world might be coming to an end – talk of a return to a Great Depression like economy dominated radio, television and newspaper. Understandably, fear was rampant – and stocks responded to these nightmarish scenarios by hitting the lowest levels in years, with financials especially hard hit.

Although no one knew it at the time, that turned out to be the bottom. Since then, we’ve seen the economy move back from the precipice – there is a growing consensus that we’ll return to economic growth in the second half of this year. The Economist magazine recently ran a cover story discussing the extent to which the economic recovery was led by Asia.

As a result, we’ve had a strong recovery in markets – from their bottom in the beginning of March, stock markets are up 50%, retracing a good portion of the losses since last fall.

The second quarter of this year, from March to June, was especially strong – since 1956 the Canadian market has only had three quarters that rose more than this one.

In the meantime, here are six lessons from the last twelve months:

1. We were reminded of just how volatile stocks can be.
2. And of the importance of true diversification.
3. Many investors discovered that they’re less comfortable with risk and volatility in their portfolio than they had believed.
4. Investors were also reminded of the need to focus on what they can control – understanding cash needs and thinking through how much risk they can live with to fund those needs.
5. In some cases, investors began rethinking retirement plans as a result.
6. Finally, we were reminded that in today’s world, we need to expect the unexpected.

Where we are today

A year ago, the market was characterized by rampant optimism. The Canadian market had hit a new high in June of 2008 and any concerns were set aside as minor annoyances.

By contrast, six months ago the market was overwhelmed by absolute pessimism – there was no sign of hope anywhere.

Today, the market is somewhere between those two extremes and many investors can be characterized as extremely nervous.

As a general rule, I think a certain level of healthy anxiety is positive – what gets investors in trouble is an excess of either optimism or pessimism. While today’s mood may be erring on the side of being a bit too pessimistic, I think being cautious in the current market makes sense … provided that prudent caution doesn’t cross the line into panicked inertia.

The good news is that there are still excellent opportunities for investors who are prepared for short term volatility. I spend a lot of time listening to the best market minds and to managers who have lived through multiple cycles. I am reassured that most say that they are still finding very good value – not to the extent that they did earlier this year, but still well ahead of what they would have seen a year ago.

The outlook going forward

In August, Business Week ran a cover story called “The case for optimism.”

The premise was simple: Beyond the issues facing the global economy, there are many underlying positives that give cause for optimism if we look out two and three years and beyond.

There are things happening under the surface that will drive economic growth … and with that economic growth will come growth in stock prices. Examples include the positive impact of technology, the recovering US housing market, the revitalization of economies and the incredible energy from the developing world’s educated youth and emerging middle class.

Click here to access all the Business Week stories on The Case for OPTIMISM :

http://www.businessweek.com/magazine/toc/09_34/B4144optimism.htm?chan=magazine+channel_top+stories

And here to view a three minute video with interviews with CEOs of Dow Corning, Eastman Kodak and Intuit.

http://feedroom.businessweek.com/?fr_story=34b1f5ab213d48a160a767c9c6c50d091f6cc7a3

Volatility

Let me close by talking about market volatility.

In 1907, U.S. financier J. Pierpoint Morgan almost singlehandedly averted a banking panic among U.S. investors by pledging large sums of his own money, and convinced other New York bankers to do the same, to shore up the banking system. At the time, the United States did not have a central bank to inject liquidity back into the market.

Later in life, someone asked him his best guess on the direction of markets. His answer: “They will go up and they will go down.”

One hundred years later, that’s still the best answer to someone looking for a short term market forecast. No one can predict market movements in the immediate period ahead – all we can do is understand clearly how much short term volatility we can live with, adjust our portfolios accordingly and stay focused on the horizon as we deal with the rough waters. No one likes volatility … but for most of us it’s the necessary price to arrive at our ultimate destination.

An Unconventional Approach for Unconventional Times

An Unconventional Approach for Unconventional Times

In other words, everything you know about asset allocation is wrong.

Strong words indeed.

The unprecedented seems to happen all too frequently in financial markets. Is there something wrong with the way financial advisors build their clients' portfolios?

Modern Portfolio Theory (MPT) has been the very bedrock of investment management and, more specifically, portfolio construction and asset allocation, for decades. To oversimplify, one might explain MPT in this way: It is literally a mathematical proof for the idea that you shouldn't put all of your investment eggs in one basket. According to MPT, a portfolio of non-correlated assets — distributed across the risk spectrum — can lower the overall risk of a portfolio.

Of course, MPT has been picked apart by legions of critics over the years. But suddenly, in the aftermath of the recent stock market debacle — in which nothing seemed to work at all — critics of MPT are gaining currency.

The very foundation of modern asset allocation just doesn't work, they say.

Enter “Post Modern” Portfolio Theory (PMPT).

The debate between believers in the two different approaches to portfolio construction centers around how they define risk, and how that risk influences returns. MPT models risk using standard deviation above and below expected returns (also called mean variance). PMPT models risk using only standard deviation below expected returns (semivariance). In other words, MPT assumes that there is such a thing as upside “risk,” whereas PMPT proponents believe that only downside risk matters to investors.

This difference seems to give PMPT modeling greater power to predict disasters. In fact, applying MPT's concept of standard deviation to the monthly returns of the S&P 500 indicates a monthly loss greater than 12.8 percent has nearly no chance of happening. But it has occurred 12 times since 1926.

PMPT, say supporters, allows for last year's upset because it measures asymmetrical return distributions.

It’s a Post Modern World.

When the world was presented with Mean Variance Analysis [the basis of MPT] for looking at risk/return, it was the first of its kind back in 1952. No one had seen nor done anything like that before.

However, problem with the mean variance approach and what is known as the Capital Asset Pricing Model was that it assumed that every investor has the same objective. And that's just not true.

What is risk? To many, it is essentially the fact that we don't know what's going to happen, good or bad.

In short, predicting the future is impossible — though both MPT and PMPT still try to do this with modeling.

A major difference is that MPT assumes all investors have the same investment objective: to maximize the expected return for a given level of risk as measured by deviations around the mean. And so, for example, many retirement calculators suggest that 40 year olds who claim to have moderate risk tolerance plunk 40 percent of their assets in fixed income — which assumes these individuals, whether janitor or executive, will have exactly the same goals.

Subscribers to PMPT say, conversely, that investors have different and often very specific goals. The focal point should not be the maximum return possible given a certain level of risk, but rather the rate of return that must be earned in order to accomplish these specific investment goals, such as retirement or paying for college tuition, with minimum risk.

The risk, then, is defined as the possibility that the investor will be unable to accomplish the goal. As a result, returns below the target rate of return (“downside risk”) incur risk; returns above the target do not. With client portfolios suffering some of the largest losses in a generation, wouldn't everyone want a better handle on downside risk?

Don’t get me wrong. I do not have the audacity (nor the post graduate degrees) to suggest that MPT is wrong. The trouble I have is in the input variables. We've been using long-term averages for inputs. Historic averages have no predictive power at all. We’re told that by the very same people who expound on the virtues of MPT.

Indeed the concept of average expected returns, a central assumption in MPT, has taken a huge whack in the wake of the worst bear market in years, a bear so savage that it wiped out 12 years of equity returns in 16 months. Until now, who would have imagined the following could be true: Between 1969 and 2009, investing in 20-year Treasury bonds yielded better returns than investing in the S&P 500, according to research provided by Standard and Poor.

So much for the idea that over the long term, greater risk means greater reward.

Just food for thought.

I SEE GLOBAL OPPORTUNITIES

Everyday, I see unique opportunities for growth--for my clients, and for Global Securities Corporation.

With stabilizing markets and resurgent capital flows, in countries around the world, amidst constantly shifting conditions, I see new potential and new challenges.

As long term growth and global finance continue to transform economies even in challenging circumstances, capital markets will play an increasingly vital role as people, capital and ideas come together in new ways.

At Global Securities Corporation, we help our clients to allocate capital and manage risk, and thus collectively do our part to help foster entrepreneurship, drive efficiency and encourage economic reform. Our clients' aspirations and the investments they make drive change. Investors fund strategic initiatives, build new businesses and strengthen existing ones. They look for new ways to improve investment performance and take advantage of the opportunities that arise every day.

Our clients' objectives are often multifaceted and difficult to execute. But we are firm in the belief that the solutions to their complex problems can create significant value for corporations, investors, families, and the societies they serve, both domestically and abroad.

Global Securities Corporation and Alexander Teh advise, finance and invest in client initiatives in both established and emerging economies. We utilize tools and vehicles that allow us to operate at the center of the global markets, offering our clients products and services that help them manage and take advantage of the unique opportunities they face.

Our people and the culture and principles that they represent are the foundation of our ability to create value for our clients. Teamwork, integrity and a daily commitment are the hallmarks of our vision.

Clients both new and long-standing, in markets both emerging and well-established, through prosperous and challenging conditions, have valued our deep understanding of the ever-changing global markets as a source of advice and outstanding execution.

Financial History In The Making

FINANCIAL HISTORY IN THE MAKING

So much has happened this month, it's hard to know where to begin. It’s been a month to end all months with one monumental crisis following another. At times, events were moving so quickly it was hard to keep up. Many analysts I know stayed up all night, several times, as developments and markets spiraled out of control in what’s being called a "financial tsunami".
What lies ahead is unknown because massive changes are still taking place as the worst financial crisis since the Great Depression unfolds.

We do know that this is clearly the end of an era and the beginning of a new one, and we’ll all be affected in one way or another.

LENDER OF LAST RESORT

For now, opinions are running rampant and although we can make some valid assumptions, no one actually knows how this will all end up. Here’s why…

As you all know, the bailouts this month were massive and truly mind boggling, but the big spending actually started before. First, there was the $150 billion in stimulus checks, booming money supply, super low interest rates and the Bear Stearns bust.

Then came the takeover of Fannie Mae and Freddie Mac, which made the government responsible for about half of the mortgages in the U.S. , totaling about $5 trillion. This amounted to the biggest bailout ever, costing $200 billion. But if just 10% of those loans have to be covered, it would mean another $500 billion and this alone equals the size of the entire annual defense budget...

Then things really intensified.

A HOUSE OF CARDS

Lehman Brothers went bankrupt, Merrill Lynch agreed to be bought and the foundation of the financial system took a serious blow. Wall Street started to panic and the Federal Reserve, along with the world’s largest central banks, poured unprecedented amounts of money into the banking system to provide ever more liquidity as stocks fell sharply and the banking situation grew more serious.

The government then took over AIG, to avoid the worst collapse in history of the U.S. ’s largest insurer. Money market funds, which have always been considered safe, came under pressure. Worried investors started pulling out of these to preserve their savings, resulting in the Fed also having to lend banks about $400 billion in guarantees to meet these withdrawal demands. The bottom line was that in just one week, the Fed spent over $1 trillion to keep things going.

Next, Washington Mutual failed, which was the biggest bank failure in U.S. history. While all this was happening, the bailout package was a top priority. Bernanke and Paulson were desperate to get it passed, and fast. The President pushed for it too as they all warned that the alternative would be far worse.

PANIC SET IN

But the House rejected it and this shocked the markets. The Dow plunged in its biggest one day loss ever, dropping $1.3 trillion, which was way more than the $700 billion requested in the bailout.

Seeing the market’s reaction, the package then passed quickly but stocks continued falling sharply anyway. The general feeling was that the $700 billion won’t be enough and the plan is insufficient. Some feel this could be like the initial low estimates for the Iraq war and the final bailout tally could be $2 to $5 trillion, or more.

REALITY HITS MAIN STREET

Meanwhile, folks on Main Street were generally against the package. They simply didn’t trust it or the politicians. Once they saw the stock market’s reaction to the no vote, however, many people changed their minds as it became more obvious that this wasn’t simply a plan to bailout the mistakes made by greedy Wall Street big shots.

People saw the writing on the wall and realized that this would affect everyone, resulting in a worsening economy, more job losses and no credit. And since U.S. retirement assets are already down $2 trillion in the past 15 months, dropping 401 and real estate values, bank failures and insecurity are also taking their toll.

The economy is the number one concern for most people and they’re irritated at the mud slinging direction the election has taken while the priority issues take a back seat. So it’ll be interesting to see how the election unfolds too.

DELICATE GLOBAL FINANCIAL SYSTEM

There’s no question these are dangerous times and the financial world is in uncharted waters. The global financial system is on very thin ice, teetering on collapse. Last week's coordinated interest rate drop by seven central banks clearly illustrates this because it was the first time ever that so many central banks lowered rates together and by half a percent. They’re literally pulling out all the stops to revive lending and the world economy. In Canada, there is another half-point drop in the Bank of Canada rate expected.

Will these efforts work? Will they be enough? Those are the most important unanswered questions of the day and only time will tell, but we should know much more in the critical month or so ahead. Why?

HYPER-INFLATION OR DEFLATION?

The Fed is spending money at an astronomical rate. It’s creating this money out of thin air by monetizing bad debts and whatever else it has to. Remember, this is on top of all the other ongoing government expenses and it’s extremely inflationary.

Normally, there is a lag of about a year or so between money creation and inflation but eventually, what’s recently happened will result in massive inflation, a much lower U.S. dollar and a soaring gold price. This is inevitable but not necessarily.

The bottom line is this, if the banks start to lend again, then the economy will be on the road to recovery and inflation. But we know the banks are scared and they’re being extremely cautious, for good reason. So if the banks decide not to lend and instead just sit on their cash, then the inflation process will freeze.

In other words, the risk of deflation has greatly increased. Inflation is not a given and much will depend on what the banks do, or don’t do in the period just ahead. The Fed is providing the ammunition but the banks have to use it. If they don’t, the outcome could be much different than what most analysts feel is a done deal.

WHAT TO DO

At this point, it’s best to be prepared for either outcome.

That means gold and commodities (despite their recent collapse) for inflation and cash for deflation, at least until we see how things unfold.

For now, important changes are taking place but that also means challenges and opportunities.

This may all end up differently than what we initially thought, but we’ll adapt and keep an open mind. Whatever lies ahead, the current challenge is getting safely from here to there relatively unscathed and we’ll do our best.

Global Uncertainty -- The Credit Crisis Legacy

The recent gyrations in world capital markets have left investors exhausted. True, oil prices have fallen from their most vertiginous highs, the dollar is a bit stronger, and the stock market has actually risen over the past month. But none of those things have happened in a smooth and steady fashion. The stock market’s “ascent,” in particular, has come straight out a carnival's rollercoaster blueprint. Since the beginning of July, there have been six days on which the Standard & Poor 500 has gone up or down by at least two per cent, and daily moves of more than one per cent—like the ones we saw at the start of last week—have come to seem practically routine. Precipitous falls in the market have frequently been followed immediately by sharp rallies, and vice versa. And, while some of these moves have been occasioned by real news, more often it’s been impossible to tell just what made investors so damn exuberant or so gloomy.

Not that long ago, stock-market volatility appeared to be a thing of the past; between the end of 2003 and the end of 2006 there were only two days with moves of two per cent. But, ever since the credit crisis began, big moves have become common. The conventional explanation for this is “uncertainty”: investors’ sense of what the future holds is in constant flux, so stock prices are, too. But, in the dearth of new news, you might expect uncertainty to result in tentative oscillations, rather than in the huge waves of buying and selling that we’ve been seeing. In this market, the same traders who on Tuesday seem convinced that the apocalypse is nigh are, on Wednesday, just as sure that we’ve weathered the storm. If investors are unsure about tomorrow, why are they acting so certain about today?

Much of what’s happening is a function of what economists call “herding.” In conditions of uncertainty, humans, like other animals, herd together for protection. In unstable markets, this leads to trend-following: buy when others buy, sell when they sell. Many studies have found that mutual-fund managers herd, for a couple of important reasons. First, herding offers money managers the reassurance that their performance, whether good or bad, won’t diverge too much from the norm. It also gives them a chance to piggyback on the knowledge of their competitors. That’s why, when a stock starts to rise, traders often assume that there must be a good reason, and therefore buy in order not to miss the party. This can create a feedback loop: as more people buy the stock, the more certain others become that there must be a good reason to do so (even if they don’t know what that is). And these feedback loops have been accentuated by the spread of quantitative-trading strategies that explicitly aim at riding the herd effect. These strategies can magnify trends instead of countering them. The result is that an individual stock can move up or down ten per cent on a day with no real news.

Uncertainty also stimulates big moves because traders react to it in an unusual way. Work done by Daniel Ellsberg in the early sixties suggests that, faced with ambiguity, most people try to minimize possible losses. But there’s considerable evidence that many traders, by contrast, deal with ambiguity by trying to maximize potential gains—thus the familiar dictum that volatility creates opportunities. In part, this is because it’s the job of traders to trade. But it’s also because market professionals appear to be chronically overconfident. A 2005 study of traders and investment bankers at two large banks, for instance, found that they significantly overestimated their knowledge of finance and the accuracy of their predictions. A 2002 survey of experienced foreign-exchange traders found, similarly, that they were far more sure of their market forecasts than performance justified. Overconfidence matters, because it can encourage excess trading. A study of individual investors by the economists Markus Glaser and Martin Weber, for instance, found that investors who thought more highly of their ability also traded more. What’s worse, the effect seems to be magnified in times of uncertainty. The business-school professors Itzhak Ben-David and John Doukas, in a study based on twenty years of trading by institutional investors, found that when there’s a profusion of “ambiguous information” about stocks investors trade more frequently, not less. And they do so even though, on average, they end up losing on their trades.

Oddly, then, the very things—uncertainty and lack of information—that might seem to make less trading and smaller bets advisable are pushing stock-market traders in the opposite direction. And this tendency is exacerbated by the fact that we are in a down market: the S. & P. 500 has fallen almost fourteen per cent this year. Mebane Faber, of Cambria Investment Management, recently did a study showing that, historically, volatility is significantly greater in down markets than in up ones. One likely reason is that traders, like gamblers, often find themselves “chasing losses”—if you’ve lost a lot, it’s tempting to make big bets, in an attempt to get your money back.

So far, all this volatility has had little lasting effect on the value of the stock market. But in the long run volatility is a very bad thing, because it makes ordinary investors less inclined to trust markets. As a corrective to the recklessness of recent years, this might seem desirable, but too much risk aversion makes capital more expensive for everyone from businesses to homeowners, and the economy less dynamic. Once we get a clearer idea about the future, today’s volatility should diminish. But for now we’re stuck in a Yeatsian market: the best lack all conviction, while the worst are full of passionate intensity. Let’s hope the center can hold.

Credit Crisis To Last Into 2009

A growing number of bank analysts are saying the Global Credit Crisis will extend well into 2009, if not beyond.

This means more pressure on financial stocks and bank balance sheets; banks have added $25 billion to loss reserves so far, but face mounting consumer credit losses in a second wave of the crisis that some bank executives have acknowledged will be worse than the first, which has cost hundreds of billions of dollars in write-downs and losses.

Wall Street’s originate-to-distribute model, designed to mitigate risk by spreading it around, actually exacerbated those risks. It encouraged banks to loosen lending standards because more loan volume meant higher profits; then it led to over-leverage, and finally to complacency. More and more paper dollars were created for trading on the assumption that housing prices would always go up.

The first wave of the crisis affected trading books, but the second will hit lending.

As long as housing values were rising, borrowers could refinance in perpetuity to avoid default. Losses mounted when the refinancing option disappeared. Banks relied too heavily on the securitization markets to boost lending to consumers, particularly in the form of mortgages.

In time, some lending will return, but the sky-high revenues of recent years will be hard to reclaim.

The banking sector’s pullback in lending will cause further painful losses. Many believe banks will have to reserve an additional $170 billion through the end of next year just to keep up with estimated loan losses. “New and unforeseen strains on consumer liquidity will push more consumers into precarious credit positions and cause consumer credit losses to be far worse than what is currently estimated, even by the most draconian of investors”.

Here in Canada, an accepted truism of the global banking crisis is that the big Canadian banks have done rather better than their global peers, avoiding the worst of the writedowns.

Commentators and analysts have spouted words of comfort about the Canadian banking sector for months, and even Federal Finance Minister Jim Flaherty noted in April after meeting the big bank chiefs in Toronto that Bay Street has avoided the worst pitfalls that have beset banks elsewhere.

But that idea is becoming increasingly difficult to uphold as a few of the Canadian banks ratcheted up their losses in second-quarter results announced this week.

Almost all the bank chiefs warned, too, about slowing capital markets and rising loan losses.

The notion that Canada's banks are relatively unscathed is starting to look like misplaced optimism.

Royal Bank of Canada, the country's biggest bank, confirmed Thursday that its writedowns on structured products now stand at $1.6-billion - a sum that would have been unthinkable last year when Canada's banking sector was on a long winning streak.

RBC chief Gord Nixon was "not happy" about his bank's writedowns, but you have to wonder what he thought of the charges at Canadian Imperial Bank of Commerce, which now total $6.7-billion after the bank acknowledged its investments in structured products produced another $2.5-billion in losses in the second quarter.

RBC and CIBC now share the ignominy of featuring among the global banking top 40 for largest writedowns and credit losses since the banking sector was thrown into crisis last year. (Writedowns refer to structured products being marked to market value, whereas credit losses reflect expected and actual loan defaults.)

RBC sits at number 40 and CIBC's latest charges mean it has leapfrogged up the league table [according to the latest data from Bloomberg], moving into 16th spot above Germany's West LB -- which has taken US$4.8-billion in writedowns and is the subject of a European Union bailout plan -- and Societe Generale, which has incurred US$6.3-billion in writedowns.

In proportion to the size of the bank's assets before the full impact of the crisis hit last year, CIBC's losses are as bad as those of UBS -- the Swiss bank that has suffered US$38.2-billion in writedowns -- and worse than the losses recorded by HSBC Holdings (US$19.5-billion) and JP Morgan Chase & Co. (US$9.7-billion). CIBC's losses as a proportion of total assets are almost as severe as those of Citigroup Inc. (US$43-billion) the poster child for the financial crisis.

Picking on RBC and CIBC alone highlights an important point -- not all Canadian banks are equal when it comes to the financial crisis. Toronto-Dominion Bank has supposedly incurred no writedowns. Bank of Montreal, National Bank of Canada, and Bank of Nova Scotia escaped major writedowns this quarter, but their combined writedowns on structured products stand at more than $1.8-billion since the crisis began.

Leaving writedowns aside, Canadian bank CEOs have painted a bleak picture this week for their outlook on the remainder of 2008.

Even Toronto-Dominion Bank chief Ed Clark -- one of the few CEOs in North America or Europe who can truly claim to have steered his bank through the financial crisis without taking a big hit -- is projecting no earnings growth in 2008 for his bank, amid rising loan losses, stifled investment banking activity, and the potential spillover from the U.S. economic slowdown into Canada.

Still, there are some positives for the Canadian banks.

Their writedowns are so far on paper only, and if the market for certain structured products turns around they will reverse some of their losses, as BMO did this week, announcing it made a gain of $42-million on investments that had previously been written down.

More importantly perhaps, Canada has so far not seen a house price slump like the U.S. and some parts of Europe.

Certainly some Canadian banks are exposed to the collapse of the U.S. housing market through their U.S. subsidiaries -- notably RBC bumped up the provision for loan losses at its bank in Florida and other southern states. But the biggest advantage the Canadian banks have over their peers around the world is the strength of the Canadian economy and their strong domestic retail operations. Let's hope this continues.

Higher Oil Prices Not Necessarily Shocking.

Much has changed in the decades since embargoes and war in the Middle East upset oil markets.

We've become much more energy efficient. Computers have made us more productive. And we've learned to temper our inflation expectations.

Consider that gleaming stainless steel refrigerator in your kitchen.

It isn't just the colour that has changed since you were a kid.

The average refrigerator is 70 per cent more energy efficient and nearly a third larger than in the early 1970s.

The transformation goes a long way to explaining why oil at more than $130 (U.S.) a barrel isn't likely to rattle the global economy as badly as the oil shocks of the 1970s and 1980s. The same holds true for cars, air conditioners and many other energy-sucking machines.

"Despite the surge in oil prices this decade, there are scant signs that the current oil shock is affecting the global economy in a manner similar to the 1970s," according to a report last week by Goldman Sachs economist Jim O'Neill.

It's true that the magnitude of the price spike is impressive. Oil is up nearly 50 per cent this year and 85 per cent in the past two years.

And adjusted for inflation, oil has never been this expensive.

But for pure shock value the recent runup pales compared to 1973 when oil shot up nearly fivefold (to $12 a barrel from $2.50), or 1979 when the price of oil more than tripled (to $40 a barrel from $12).

More importantly, the economy is better equipped to withstand energy price surges. It now takes about half as much energy to produce a dollar of gross domestic product than it did in the early 1970s.

Over the past three decades, global energy intensity - energy consumption as a percentage of GDP - has declined 1.5 to 2 per cent a year. And today's high energy prices are likely to make us even greener by spurring a new round of conservation and energy efficiency.

Already, there are tentative signs that consumers are reacting to higher pump prices. In recent weeks, U.S. sales of sport utility vehicles and pickup trucks have fallen sharply. Gas demand is also down a bit, but consumption has proven to be stubbornly inelastic in recent years. Longer term, higher vehicle fuel economy standards would significantly curb per capita consumption in Canada and the United States - the two biggest energy guzzlers among the world's largest industrialized economies.

A lot more needs to happen. Goldman Sachs points out that Japan has been leading the way in reducing its dependence on foreign oil. If the United States, Russia, China and India matched those gains, global energy consumption could be cut by 20 per cent. The latter three have not had the infrastructure of oil dependency and addition ingrained into their culture--yet.

Countries must resist the temptation to limit the price of gas. And countries such as China, which already caps gasoline prices, should relax those controls and let prices rise. This will encourage conservation and spur the search for alternatives.

Energy efficiency is only part of the reason we're better off than in the 1970s.

Our economies are more knowledge-based than industrial-based. The service sector has taken over from manufacturing as the primary economic driver.

As a result, the consumption of oil - and energy in general - is less of a burden on the economy.

In the United States, for example, oil consumption sucks up 5.75 per cent of GDP, compared with 7.5 per cent in 1980.

By that measure, it would take a price of $172 a barrel to feel like 1980.

Even then, it's unlikely that high prices will unleash the kind of virulent inflation that occurred in the past. The simple answer is that inflation expectations are much lower now. Neither consumers, businesses, nor investors expect to be paying substantially more for most of the stuff they buy in the months ahead.

"Inflation expectations are much better anchored now than they were in the 1970s and 1980s," according to Goldman Sachs.

Assuming the world's major central banks are successful in keeping inflation at bay, pricey oil could have a silver lining.

Conservation and efficiency will cut carbon-dioxide emissions and make the planet cleaner. The market is sending clear signals. We just need to heed them.

Governments must avoid the temptation to intervene, except to aid those least able to cope. Consumers must continue to make wise energy choices. And producers must reinvest more of their profits into the quest for unconventional and alternative energy sources.

That will keep this shock from becoming truly shocking.

Capital Flight or Foreign Investment -- or History?

There are mixed signals for the global economy.

As recently as ten years ago, emerging markets still held their hands out for development loans and foreign aid. Today, their fiscal prudence and wealth has put them in the position of bailing out the western banking system.

Why are investors taking so long to realize this critical distinction and its meaning?

Inflation is rising at a time of global slowdown. The US economy is weakening while commodities soar. There may be both inflation and slow growth in the US, and maybe also in Europe, but both the growth and inflation pictures may look very different in emerging markets. From low levels, inflation has risen with strong upsurges in domestic demand in emerging markets. However, growth will continue to be robust, if slightly down.

Resurgent inflation is a more global problem in my view than slowdown, which appears to be largely limited to the US, albeit with possible spillovers to Europe coming.

Gross national savings are over 30 per cent of GDP on average in emerging countries, and for a decade private and official savers in these countries have been investing overseas – in the US and Europe – under the impression that these were safer markets than at home.

Yet the dollar is far from the safest currency and not the store of value it was. US Treasuries are not zero risk – the implicit myth in the term “the risk-free rate”. Treasuries have currency, curve and volatility risks. Investors in triple A structured credit got a shock when they realised their investment was risky. Likewise emerging market savers are getting a shock about Treasuries and other US and European assets.

The money is returning home, and the move is structural, not cyclical.

The global imbalance of a negative US personal savings rate on the one hand being financed by high emerging savings on the other is starting to reverse. With this reversal, or rebalancing, is coming, I believe, a currency realignment and a series of investment booms across emerging economies as investment focus shifts. Rather than using “decoupling” in describing the impact of the credit crunch on emerging markets, we should use “negative correlation”.

Many central banks in emerging markets know the costs of inflation and the need to move fast in preventing it. The widespread implicit assumption that emerging market central banks will simply allow inflation to rise without taking action is broadly incorrect in my view. In some countries interest rates have started to rise and exchange rates also, though both these dynamics have further to go.

Whatever the choices of individual countries, the logic of global rebalancing remains: if the rest of the world is tiring of financing the US, then the US current account deficit has to shrink and US goods and services need to become cheaper in real terms vis-à-vis emerging goods and services. It is not credible that the world will revert to the same level of capital flows to the US after the credit crunch is over. The least painful way to do this is through gradual exchange rate appreciation of emerging currencies.

The policy asymmetry between the US and emerging markets is that the emerging markets, with undervalued currencies, have an additional degree of freedom. They have the choice to mess up (do nothing) or control inflation (let the currency rise, raise interest rates). I believe that emerging market central banks will largely pass this test and do the sensible thing, though this is not what the market appears to have priced in yet.

The US must hope for the best. Ben Bernanke, chairman of the Federal Reserve, has focused on lower rates to cope with a slowdown. If currency weakness is gradual over the next couple of years, this will cause gradual importation of inflation, balanced by the US domestic slowdown’s deflationary impact. If, however, currency adjustment is quick, the US has little policy scope to avoid stagflation.

The most important impact of the credit crunch on emerging markets may be through asset allocation, starting with an inflow into emerging local currency debt, and then real investments. The emerging market private and public sector investor has for years been investing overseas: into the US and Europe. This has been to reduce risk, to get out of the home market.

This used to be called capital flight, is now called foreign investment, and may shortly be history.