Tuesday, September 9, 2008

The Big Grind

Alex Roslin

Financial Post Magazine

Published: Tuesday, September 09, 2008

[read the story at the FP Mag site]

HERE'S A PREDICTION: Whether or not the world's financial markets and the global economy start to rebound this fall, someone out there will try to make a few bucks selling T-shirts emblazoned with the slogan "2008: I survived the Summer from Hell." No doubt, the shirts will be popular gag gifts on trading floors across the country. A chuckle, after all, is a good way to blow off stress. And investors have been feeling plenty of that in recent months, as turbulent markets have see-sawed or just plain sunk, and gains have disappeared in perilous downward grinds.

Indeed, in the earthy argot of aggressive traders, many market professionals have reached the "puke point" - the point at which feelings of panic and disgust keep you awake at night. And who can blame them? The conditions that exist today are a toxic mix of credit-market chaos, rising inflation fears and a meltdown in the U.S. housing sector that's knocked consumers for a loop. It's a triple whammy, and no one can figure out how to call it. Not even legendary investing guru Warren Buffett. After hitting an all-time high of $150,000 just before Christmas, shares in his holding company, Berkshire Hathaway Inc., were down 20% throughout the summer, even below the 15% year-to-date decline in the Standard & Poor's 500 Index.

In financial circles, this kind of beast is called a "trader's market," and the only clear way through is to, well, trade - buying on temporary dips or short-selling on brief rallies, keeping bets modest and, with a little luck, building up strings of incremental gains. But that's a specialist's game. For the rest of us - from fund managers to investment advisers trying to calm edgy clients to Main Street investors wondering if their retirement plans are evaporating alongside the bottom lines on their RRSP statements - everything is up for review. Should you move your investments? Buy hedges like gold? Seek safety in cash? Start shopping for bargains on equities markets? There are no easy answers. Even the pros are having a hard time getting it right. Just ask Stephen Vita, a trader and money manager in Bradford Woods, Penn., and author of the popular AlchemyofTrading.com blog.

Vita spent most of July letting his funds slosh around in cash while he searched for opportunities. Better that than take a risk on some ill-timed trade that would eat into the 15% gain he'd made in the first six months of the year. But eventually, Vita spotted prey. The week of July 14th - when the Federal Reserve Board and U.S. Treasury jumped in to prop up mortgage-finance titans Freddie Mac and Fannie Mae - had been one of the most ludicrously volatile in recent history. Bank shares were diving like seabirds, taking markets down with them. Then a raft of government measures were introduced to save collapsing banks, and the markets bounced back.

Vita, however, wasn't impressed. He was certain the bounce was a "Trojan Horse Sucker Rally," a devious little rebound that lasts just long enough to reel in the innocent and the impatient before sputtering. He'd seen several such rallies burn investors during the dot-com bust-up, and he knew what to do: At 9:38 a.m. on July 22nd - just as the S&P 500 gapped down after opening - he moved in to short-sell an exchange- traded fund that tracked the index. (Short-selling is a way to profit when a security declines by borrowing it and selling, and then buying it back later at a lower price.) This was it, Vita thought. The market was toast and he was about to clean up. But he thought wrong, and his trade went sour almost right away as the S&P 500 catapulted right back up. Vita's Trojan Horse never materialized. It was turning into something entirely different, and he was being hung out to dry. At 10:20 a.m., he glumly jettisoned his short position and ate the loss. As a final irony, precisely one minute later, the S&P 500 sold off again, giving Vita a kick on his way out the door. "What a sick beast this is," he would later grumble on his blog.

No doubt, he's not the only person making that lament.

AS INVESTORS AROUND the world struggle to develop strategies for weathering the current storm, it's important to remember one thing: To know where you are going, you have to know where you are coming from. In this case, most fingers point back to former U.S. Federal Reserve chairman Alan Greenspan and the monetary policy he and other central bankers pursued in the final years of his tenure. According to this analysis, the seeds of the current crisis were planted during the bear market that followed the tech meltdown in the early years of this decade. To fight deflationary forces in the broader economy, Greenspan lowered interest rates, as did central bankers around the world, to stimulate the economy. The tactic worked: The U.S. avoided recession - not only from the tech crash, but also from the slowdown that followed Sept. 11.

Within a relatively short time, however, the emergence of China and India as economic powerhouses gave new life to Western economies. Demand for commodities like metals, steel and energy to fuel new Asian factories translated into strong job creation and wage growth in Europe and North America. Meanwhile, the influx of inexpensive televisions, computers and other goods kept consumers happily filling local malls.

Boom times were returning. Yet inflation was surprisingly absent. And with no immediate need to raise interest rates - and with the twin crises of the tech collapse and the Sept. 11 attacks still fresh in his mind - Greenspan kept them near historic lows. The result was a surplus of liquidity in the economy looking for places to go. Its first stop: the housing market, where it ignited the U.S. real estate boom. Adding fuel to the emerging flames was the fact that banking had undergone successive bouts of deregulation in the United States, turning the once stodgy debt markets into a speculative free-for-all. In addition, it set the stage for the real estate bubble, the subsequent subprime mortgage meltdown and the ensuing credit crisis.

But the real estate bubble was only the first problem. When cracks began emerging in the housing market, excess liquidity went looking for a new home and found it in commodities. By 2006, prices were beginning to surge in metals like nickel and copper. Dramatic psychological thresholds were crossed in January of this year as oil broke US$100 a barrel for the first time. A few weeks later, gold followed, breaking through the US$1,000-an-ounce market. But however exciting these trends may have been at the time - at least for those invested in such assets - they were unsustainable. Coupled with the disaster in financial markets stemming from a meltdown in credit markets, the boom in commodities delivered a double whammy to world markets, sending them into deep downward spirals. By summer, they were awash in grim market data - increasing inflation, economic contractions and rising unemployment.

These days, a mere glance at market charts will show you how rough things have become. Most of the world's major equities indices are in clear down trends, largely a result of the sledgehammer the credit crunch has taken to economies around the world. Japan's Nikkei Stock Average was the first to start its downward spiral, beginning in the summer of 2007. Major U.S. indices and European bourses followed this past winter and spring. Only the TSX has been a holdout. Its results haven't been good, but over the past year, it has at least shown itself capable of recovering from perilous lows - just above 12,000 points in January - to post record highs above 15,000 in June. Even with corrections in June and July, its year-to-date decline of 5% in mid-August was less than half that of its peers. It's not pretty, but the TSX at least has a pulse.

But even if the Canadian market is somewhat better off than its global peers, it still presents more questions than answers. How long will it be before we start seeing signs of recovery? Will markets get worse before they get better? What should investors do now, and what should they expect in the months ahead?

No one can answer those questions with any precision. But most experts agree that if you're looking for signs of recovery, don't hold your breath. For starters, the U.S. economy - still reeling under a real estate meltdown that saw housing prices fall 16% over the past year while inflation is running at 5.6% - appears unlikely to offer near-term respite. And now that Canadian housing prices have started to fall, too, concern has spread north of the border about the broader economy.

That said, not everyone sees impenetrable gloom. Take Lex Kerkovius, a portfolio manager and senior research analyst at Calgary-based wealth manager McLean & Partners, for example. In a late July newsletter, he identified 10 indicators that world markets had bottomed. Among his top observations: The U.S. market downturn is now a year old and getting long in the tooth, based on historical averages of length and depth of losses; the commodity sell-off this past summer, which drove oil prices down 20%, to approximately $115 in mid-August, has weakened some of the barriers that have been restraining economic growth; job losses in the U.S. have been lower than in previous recessions; and market bottoms are typically characterized by extreme volatility.

Kerkovius stopped well short of calling for a turn in the markets, and his outlook isn't shared by everyone. (Meredith Whitney, the Oppenheimer & Co. analyst who rose to prominence last year for her calls on bank losses and writedowns, continues to predict wreckage among U.S. bank stocks, for example). But market strategists or financial advisers aren't recommending investors get out altogether and park all their money in cash. More often, their statements point to opportunities in finding value in beaten-up stocks that are rebounding, as well as prospects in sectors with decent fundamentals.

Commodities, for instance, remain a promising long-term investment, in spite of the sector sell-off this summer, which has left investors with flat year-to-date returns. Oil remains a top pick. In a recent Forbes commentary David Dreman, chairman of New Jersey-based Dreman Value Management, advised investors to buy shares in oil and gas explorers if they didn't already hold them. His reasoning? Some companies with strong reserves are trading at low multiples, an indicator that their shares are ripe for price growth when the markets settle. What's more, analysts have been tending to base their estimates on $100 oil - well below prices that oil hit during the sell-off - which Dreman says could cause some pleasant earnings surprises in the next quarter or two.

CIBC World Markets economist Peter Buchanan offered a similarly positive assessment in a mid-August market strategy report. His report noted that oil's summer price drop was still not as severe as the decline that followed Hurricane Katrina in 2005. Global demand, he continued, will likely remain strong, due in part to the rapid rise of car cultures in Asia and the Middle East. And finally, he dismissed the notion that speculation was the driver behind this year's rapid increase in oil prices. Instead, Buchanan pinned the spike on a broader trend - that demand is threatening to outstrip supply, with emerging markets picking up slack that may be resulting from the U.S. economic slump.

Bottom line? The summer pullback "should prove no more lasting a detour in oil's five-year bull run" than other recent corrections. Likewise, Buchanan was positive on gold, even though it was down considerably from its peak of $1,000 an ounce earlier this year. Other analysts, meanwhile, point to the fact that gold remains a traditional safe haven and a hedge against a dropping U.S. dollar, which has sunk to new lows against major currencies this year.

In addition to market fundamentals, some investors are watching for historical market cycles, one of the most famous being "The Best Six Months" cycle. Developed by legendary investor Yale Hirsch, founder of the Stock Trader's Almanac, this investing tactic is based on the observation that nearly all market growth in the U.S. occurs between Nov. 1st and April 30th in a given year. According the 2008 addition of the almanac, now edited by Hirsch's son, Jeffrey, a $10,000 investment in the Dow Jones Industrial Average in 1950, reinvested every year during the best six months, would now be worth $578,410. The same amount invested during the other months would have grown by a mere $340. According to Don Vialoux, a former RBC Investments analyst and author of the DVTech Talk investing newsletter, says similar favourable periods, along with "sweet spots" for other assets, occur on markets worldwide. On the TSX, the best months occur between the end of September and the end of April. Between 1998 and 2007, those months returned an average of 9.3%. Vialoux says the patterns work because of recurring fundamental events. Markets tend to stumble in early fall due to tax-loss selling, for example, then get buoyed by earnings reports, consumer confidence as Christmas approaches and year-end bonuses flowing into tax-sheltered investments. In Vialoux's analysis, fundamentals are "lining up very, very nicely" for a seasonal play in equities and financials in the fall.

In the end, however, the markets will reveal their secrets, their patterns and their surprises as they unfold. And no one can know how they'll turn out. If that were possible, making any money by trading securities would be impossible. Things will get better, but until they do, the wisest of investors - regardless of the theories or sectors they follow - will all have one strategy in common: risk management - knowing when to cut losses and never risking more than a limited amount of their asset base in a single trade. If there's one sure way to stay out of trouble in a turbulent market, that may be it.

TAGS: market timing, seasonality, Don Vialoux, gold, crude oil, Stock Trader's Almanac