Commentaries

Jan. 3, 2003
Where the markets are going

The world's major stock markets have just returned their third straight negative calendar year. I have mentioned the rarity of such an event and discussed some of the performance statistics in previous commentaries. To recap, this market decline is the longest, and every bit as severe as, the stock market performance from 1939-42; that is, it is the worst decline in sixty years. And yet, somehow it doesn't feel like I thought it would.

Remember that in the early forties the world was engulfed in the greatest conflict the world has ever known – and it wasn't going well for our side. Markets in North America had to deal with some terrifying realities. It would not be overstatement to say our system of government, our economy, our way of life was at risk. Stock markets had to deal with the reality that millions of workers the world over were no longer, and may never again be, engaged in productive pursuits. Many had either taken up arms or were a part of the wartime economy where their purpose was to bring further destruction to the world's economy; as much as possible, to the enemy's economy. The death of millions takes a massive toll on the potential for an economy. There was a very real possibility that at least Europe would be lost to North America as a trading partner and that without a much more involved war effort, that North America was critically imperiled. Against this backdrop, it is not surprising that the outlook for company shares was not bright. I see nothing of remotely this magnitude in the worried world of today.

If some oracle had told me over two and a half years ago what the economy of today would look like I could not have imagined the stock market performance that we have witnessed. Compared to their levels at the peak of the stock market, economies are larger, the average company more profitable, the average household better paid, and interest rates are at historic lows. Productivity continues to grow at impressive levels as we become ever more efficient, continuing a near-unbroken centuries-old march by free capitalist economies. Armed with this prediction on the economy, my forecast for the world's stock markets three years ago would have been well off the mark. What we have witnessed in terms of economic performance has diverged massively from what we have seen in the performance of stock markets. Why the divergence? What has changed? How shall we make sense of it?

Stock markets and economies are tethered, but it is a long leash and it is rather stretchy. The long rubbery leash allows for the markets and the economy to move in opposite directions for a time, but not to do so indefinitely. The farther they diverge the greater the tension on their tether and the more inevitable the moment when they must snap back in line. As the economy continues to move forward, albeit at a less fevered pace than it set in the late nineties, it stretches its link to the stock market. At some point, a reckoning must come. I see very little evidence that it is the stock market that is heading in the right direction and that the economy is about to turn violently down. There is a good deal of evidence to suggest that the market declines are overdone, that markets are undervalued, and that they are due for a recovery that will ease the stretch between the economy and the markets.

I don't believe anything has changed in the fundamentals of investing. Markets will still rise over time, at about the same rate that they have historically (not at the higher rate experienced in the late nineties), and continue to reflect the ability of our society to generate increasing amounts of wealth. I believe the only thing that has changed in the equation for investors is the degree of volatility we will experience. Technology, modern communication, and high participation in the stock markets have combined to make for a much more volatile, erratic, even frightening experience. But this will not change the ultimate destiny of markets – they will rise over time.

Financial planning is by its very nature not a short-term pursuit. Neither financial plans, nor their assumptions, need change drastically for the vast majority of people as a result of a few years of decline. At the height of the markets I was questioned by clients regarding what they believed to be a too conservative assumption for growth. Nine percent was too low given a market advancing in the high teens or twenties they claimed. Just two years later, the questions are whether nine percent can be obtained given the terrible markets. My plans and assumptions are not based on the excesses of a tech bubble, or the excesses of a bear market. A too brief glimpse at the markets at their peak leads people to draw the wrong conclusion that their plans are well ahead of schedule due to higher short term average returns. A too brief glimpse at a despairing bear market also leads many to the mistaken conclusion that markets will never again rise. They assume that the average performance of the last three or four years will be the average for the next three, four or even forty years. I continue to assume that growth oriented portfolios will average nine percent, minus three percent for inflation: a six percent real rate of return.

I have been asked many times over the past year whether the recent poor market performance will necessitate a change to our financial plans, or whether our plans are still on track. It is a difficult question to answer with certainty since it requires an assumption about the future. However, in most cases, I don't believe our long-term plans have been impacted adversely since they assumed from the outset that markets would fluctuate and are based on a long run average rate of return that is the result of both good and bad short-term results. I have seen instances of plans running off track, however, this tends not to be as a result of market performance but rather investor behaviour. In general, investors all over the world are engaging in a behaviour that will harm their financial prospects. It is a "bear market necessity".

We've all heard the advice "buy low, sell high". Superficially, it is not a difficult concept to grasp. The reality is that it is poorly implemented and quite difficult to do consistently. It is quite common for me now to encounter people who are not saving and investing at the level they did a few years ago; understandably you may well say. Markets are looking treacherous, and they are hesitant to "throw good money after bad." Their reduced contribution to the equity markets – and this deviation from their financial plan - is not because their capacity to save has changed, but because their capacity for enduring market volatility has. It is because they no longer believe in the long-term potential of equity markets to generate their plan's assumed return. It is not, however, an example of "buying low". The reason this simple maxim is poorly implemented (and the main reason I encounter that financial plans derail) is that at times when markets are low, their short-term performance is, of course, quite poor. Frightening markets (the only kind that allow buying low!) and investors' experience in the preceding months has shaken their belief in their long-term plans and causes what is usually a temporary departure from the behaviour the plan demands. As markets recover – "look a little safer" they will say – they will again begin adhering to their plan and begin buying, but at higher prices. Our assumed rates of return for financial plans (which are lower for investors who are no longer adding funds to the markets for this very reason) include the benefit of buying at market lows such as this, include the benefit of Dollar Cost Averaging through these declines. Dollar Cost Averaging is simply the process of buying systematically through market lows in order to reduce the average cost of holding a security. This strategy helps investors avoid the dangers of market timing and their natural tendency to avoid purchasing at frightful lows and their propensity to increase their investing at the more euphoric market highs.

Continuing the disciplined buying called for in a long-term plan of asset accumulation takes courage. It also requires a sizable amount of either faith or knowledge in the market's ability to rise. Downturns of a short duration are often called corrections. A correction is a process of adjustment in pricing securities. It is the market's way of correcting itself and attempting to more accurately price securities based on new information. Bear markets differ from corrections in just one regard. Their longer duration is the result of a change in sentiment – an assault on the collective faith of the market participants. Without the abandonment of this faith, the selling necessary to create sharply falling share prices over such a duration could not take place. For many investors, it is the loss of this faith that harms their financial plans the most. For investors knowledgable enough of the market conditions and companies in a bear market, there is no issue of faith. Knowledgable investors will again profit in this bear market by taking advantage of the shaken faith of others – for every worried seller of a share there is an investor buying. One of them will be right, and history is on the side of the faithful.

Alan Cameron

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