Commentaries

In my discussions with clients over the past few months there have been several recurring themes. Since the issues are clearly of common interest, I would like to discuss them here and provide some opinions.

Obviously, this is an uncomfortable market in which to be investing. The exciting returns of the late nineties bull market are fading from memory. The problem of fading memories has forever plagued investors. History can be a guide, not just in investing but in economics, politics, personal relationships and most other endeavours. However, in investment markets the lessons of history tend to be quickly discarded. We are inundated with the news of the day and can be mostly forgiven our absorption in our present day challenges. However, the investment markets tend to be the least forgiving judge we will encounter.

I would like to discuss the current bear market, provide some statistics and history, and make some general comments on investment strategies for clients. Then I will move to the topic of the financial scandals that have rocked the markets this year. From there I will turn to the terrorist attacks of 2001 and the looming threat of conflict in the Middle East. For the vast majority of my clients, this is a once-in-a-lifetime bear market. The current decline's duration now at least rivals the bear markets of 1973-74 and 1939-42. The percentage decline from peak to trough either meets or exceeds both these bear markets (depending upon the index used for comparison). Few of my clients have vivid memories of investing before the 1930s!

The current bear market is unique in many ways. Despite the low markets of today, we are in an economy still growing at a pace long deemed acceptable, with unemployment rates so low that just a decade ago there would have been concern of them being too low, interest rates and inflation in low single digits, and by analogous accounts, a good earnings year for most everyone. Surely some of this large decline we have experienced is the result of a too extreme reaction to the excessive peaks of the bull market. The economic fundamentals of this bear market are nowhere near as dire as they were in past market declines, and lead me to conclude that the decline is the flip side of the same coin that pushed the tech markets to such lofty heights. Just as that peak was difficult to justify or sustain, so too is this bottom.

At this moment, the former star NASDAQ has declined by more than 78% from its intraday peak of 5132.52 in March, 2000. The S&P500, a broader measure of the U.S. market, has declined from its intraday peak by 49%. The TSE has fallen roughly the same 49%. Most markets outside North America have fared as poorly or worse. This takes most North American market indices to levels first seen roughly six years ago. Few individual funds owned by clients have fallen to near the level of the indices. Portfolios as a whole, being typically far better diversified and constructed than any individual market or mutual fund, have not fallen to this extent either. The sole consolation of this fact (I assure you that I am aware it is meagre consolation) is that this leaves portfolios in a better position as markets recover. I seek to have portfolios outperform during bad markets more than in good markets. By preserving as much of portfolios as possible during market declines, there is more money at work when markets recover.

The strategy of constructing client portfolios depends on individual client objectives. For those who are drawing on portfolios or are likely to do so in the next few years, we seek to have a mix of assets that would have some more conservative holdings (i.e. less likely to have significantly declined recently) along with some meant to be held for the long term (i.e. held through the bull and bear market cycle). The idea is to draw from the conservative, wealth preserving funds at their times of relative strength - selling them when they are doing better than other holdings - and to draw from the more aggressive funds at their peaks, such as we saw two years ago. If you now feel that your objectives have changed, wish to discuss your portfolio's structure or how this strategy effects you, we should talk.

The financial scandals that have hit the markets this year, most notably Enron and Worldcom, are big, but not new. If history is a guide, they will soon enough be forgotten. Few people I've spoken with lately seem to remember the many scandals and financial crises that seem to dot the landscape of both bull and bear markets, for these scandals too have faded away. Generally speaking, we will always have criminals and the immoral among us. They are not by any means limited to the financial (or political!) field. The perception that this is more prevalent today is not supported by the facts. While the Enron disaster is a particularly large one, there have been others of greater economic significance - although probably none with worse timing. Every market decline brings about a larger number of these stories because they can temporarily remain hidden during strong markets. Bre X was significant to Canadian markets and the gold industry. But it was not of the scope of some more widespread and potentially harmful financial crises of the past. Several derivatives scandals have come and gone, mostly during the bull markets of the nineties. They had an effect at the time but were quickly forgotten and lost in the continuing bull run. Orange County, Sumitomo Trust, Barings Bank, Daiwa Bank, Long Term Credit Bank (LTCB) and Metallgesellschaft were all multi-billion dollar financial boondoggles to name but a few. Each had its impact, but Enron has been more significant only in that it came at a time when other market fears were also prevalent. LTCB required a multi-billion dollar bailout by the Federal Reserve Bank due to fears it could lead to a domino effect of financial collapses. This was in the summer of 1998. In the span of just over two months, the LTCB crisis, aided by Russia's debt default, knocked over 20% from the value of the S&P. However, the powerful bull market put those losses back on the board in just two months. That same crisis today would be greeted by fear, not bargain hunters. The fundamentals would not be different, just the emotional reaction. Market emotions are not permanent however, and this fear too shall pass.

A far more significant crisis of confidence for the markets, at least in terms of its ethical implications, was presented by the junk bond scandals of the late eighties (perhaps more easily remembered by the several movies they spawned). Junk bonds were partly blamed for the market crash in October 1987. But, the year 1987 actually generated a positive market return even with the crash. The Savings and Loan crisis, starting in 1989, was financially more threatening by several orders of magnitude than any current financial concern. Congress created Resolution Trust Corporation to deal with the mess created by over 700 failed savings and loans, with assets totalling more than $600 billion. At one point in its six-year life of unravelling the mess, RTC had more than 8600 employees. The recession of 1990-91 was due in no small part to this crisis. The stock markets declined 9% for the year 1990. It was the most significant banking crisis since the thirties. The stock market's response was remarkably measured compared to our current bear market's response to less threatening, but, given that the Middle East was also a concern in 1990, remarkably similar concerns.

This brings us to the constant market irritant of the Middle East. In my last commentary I stated my opinion that the threats to markets and the world's leading liberal democracies are very much less today than they were during the Cold War. Whether this is true or not does little to assuage the immediate concerns of today's CNN-watchers I'm sure. The accuracy of the old adage that wars help the economy is shaky at best. By far the best thing for economies and markets would be constant peace, security and free trade. Since that ideal is not imminent, there is some comfort in the fact that we are at least trending in the right direction.

The current conflict with Iraq is now weighing heavily on the markets. More than anything, uncertainty hurts stock markets. Markets are made up of buyers and sellers. When there are more people wanting to buy than sell, share prices tend to rise until enough sellers are enticed to sell that the numbers balance. When there are more wanting to sell than buy, shares fall in price until tempted buyers equal sellers. This must always be so. For every buyer of a share there is a seller. What uncertainty does is limit the number of buyers. Faced with the uncertainty of a looming Middle Eastern conflict some buyers are inclined to delay their purchase - they "wait and see". This is all that is necessary for lower markets. If the fear also brings about more sellers, then so much more the imbalance. Once the issue is less uncertain, buyers tend to return, regardless of how the issue is resolved.

The conflict with Iraq is not without precedent, and to be frank, I am somewhat surprised by the market reaction to this uncertainty. In fact, there is an almost perfect parallel and a high degree of certainty simply because we have been through this before. The Persian Gulf War could not provide a more useful historical guide. During that conflict there was more reason for uncertainty than exists today (there was no experience in fighting Iraq at that time - there is now). This time I cannot imagine why the uncertainty still looms large, but it does.

The Persian Gulf War began with Iraq's invasion of Kuwait on August 2, 1990. The oil price at the end of July that year was approximately $17.50 per barrel. By the end of August it had increased 50%, and by October it was over $34. On August 5th, G.H.W. Bush famously said, "this aggression will not stand." A deadline was set at January 15, 1991 for Iraq's withdrawal from Kuwait. The uncertainty time frame was thus set. The U.S. stock market declined from the date of the invasion. By mid-October it had fallen 17%. As the coalition against Iraq built in strength, some of the uncertainty waned. Still, the lingering fears of the "fierce Republican Guard" and the potential harm from the "mother of all battles", or "an uprising in the Arab Street" remained. On January 15th, the S&P closed at 313, down from the invasion date by 12%, and at levels first seen in July of 1987, three and a half years earlier. Fighting began early in the morning of January 17th. Markets were at 327 by the end of that day. The course of the next six weeks leading to a cease-fire agreement on February 28th will be remembered by most. The graphic images of a decisive battle remain. The U.S. stock market closed at 370.5 on March 1st, having increased by 18% from the onset of the battle, and 4% higher than the day before the invasion of Kuwait.

The uncertainty leading up to the battle had brought the market down. But, even before the battle began the market had started the process of predicting the outcome. The gains that started in October were the beginning of that prediction but the real gains came as buyers returned with the certainty that evolved along with the military campaign. Oil prices were down to $16 per barrel in February of 1991, the risk premium gone.

This summer has seen the fears of a new conflict and the uncertainty it brings pound already weakened markets. The markets are at levels not seen iyears, and while the clamour over Iraq intensified this summer, the market responded with the worst third quarter return in fifteen years. Oil prices started 2002 at roughly $20 per barrel and have now increased 50% - a familiar response. Is the market response justified? Is it rational? Is disaster lurking in the Middle East for the West? Many of the answers depend on one's political philosophy. Clearly, Canadian and U.S. public opinion differ on many of the issues involved. I will betray some of my political leanings in offering my predictions, however, I am confident that my political view is shared by the major participants in the investment markets (i.e. I may be rather right wing, but so are pension fund managers, currency traders, and most everyone in my industry).

Venetius, a Roman writing in the fifth century advised "let him who desires peace, prepare for war." Saddam Hussein's days are numbered as leader of Iraq. I believe you can count the months on one hand. As the U.S. prepares for war, the more convincingly the better, they make Hussein's overthrow by forces within Iraq more and more likely. I would put the likelihood just below 50% at this point. If this does not happen, and the U.S. goes to war, it will be a remarkably short battle. In the last 11 years, the U.S. military has made tremendous advances (there were no satellite-guided munitions in the Gulf War, the U.S. was hindered by weather and visibility, and by their coalition partners - not so this time). The Iraqi military, weakened as it was by the Gulf War, has fallen into further disrepair during 11 sanctioned years. Currently, the U.S. military represents 40% of the world's military spending, and an astounding 80% of military research and development. All that spending will help make this a short fight, followed by years of "nation-building." I do not believe that Iraqi people will in large numbers be willing to die to save a vicious tyrant. I do believe in the humanity and morality of any attempt to liberate them and allow them to live with the freedoms we take for granted. As was the case in Afghanistan, the U.S. will more likely be seen as a liberating army than an invading one. Less than four months after going in to Afghanistan, the new president, Hamid Karzai, sat beside his new (female) Minister of Women's Affairs at the U.S. Capitol. I would hope for such a swift result in Iraq.

The U.S. will not lose this war. Nor is there a reasonable fear the Arab nations will rise to Iraq's defence. It hasn't happened before in over fifty years of wars and confrontations. I don't believe it will happen now to defend a leader who has invaded two of his neighbours already and who strikes fear in the others. After more than fifty years of trying in vain to overcome Israeli military superiority, I cannot imagine that Arab nations will now presume to triumph over the U.S., Britain, and Israel combined.

Oil prices, now high due to fears of supply interruptions will fall below $20 a barrel. The fears are exaggerated. No nation on earth is more dependent upon the free flow of oil than the Arab oil-producing states of the Middle East. While I often hear the charge that the U.S. is "only concerned about cheap oil", I believe the argument is disingenuous. If the U.S. simply wanted oil, and had the desire to seize it, there is no nation who could stop them. They have not invaded Alberta yet. But short of naked aggression, if they simply wanted cheaper oil, they could have ended the Iraqi sanctions years ago. The additional supply, coupled with calming statements, would see the oil price plummet. I do not believe they are "in it for the oil" at all. This war may cost hundreds of billions before it is done. That would buy a lot of oil if they simply ended the sanctions and tough talk. If I were to suspect anyone's motives, it might be the oil-producing states (Iran, Saudi Arabia, Russia, etc.) that now benefit from 50% higher oil prices without having to reduce their supply. The biggest winners in the Iraqi standoff and continued tensions are the other Middle Eastern states. They have a vested interest in the status quo of perpetual tension without resolution.

Lower oil prices will help the economies of the world (not just the U.S.). The easing of hostilities and the lifting of uncertainties will help the stock markets. If, as a result of the liberation of Iraq, the rest of the world's dictatorships begin to fall or reform, so much the better. If it just this one dictator that is lost to the world, it is a step in the right direction. As Edmund Burke once said: "All that is necessary for the triumph of evil is that good men do nothing." Liberating the people of Iraq would be something.

Alan Cameron

Commentaries

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