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Adapting to the "new normal"

Thursday November, 2011


When I started in the financial services 16 years ago with Investors Group, we were taught from the beginning that stocks will always outperform bonds and other forms of fixed income over the long term (which most people agreed is a period of five years or more). During my first five years in the business, that was definitely true. But then the problems began.

The problems started in the autumn of 2000 after the high-tech bubble burst and we experienced a correction of some magnitude. That one took most investors between two and three years to recover from. A few more years of decent gains were then offset by the U.S.-led credit crisis in 2008, which was followed by a nice recovery in 2009, allowing investors who stayed invested to regain most, if not all of their money.

To sum up, not many investors made a lot of money except those with good percentages in natural resources or precious metals (fuelled mostly by Asian growth), which are two of the more volatile sectors. Because of that, most people didn’t have more than the recommended 10% to 15% cushion to protect again a meltdown that never occurred. For that reason, the term “The Lost Decade” was coined, and it’s not without merit.

The obstacles ahead

We are in the middle of two big problems. The U.S. problem is “big,” because it’s the world’s largest economy. Americans overspent and are trying to balance their finances, which may take a few years. The housing market collapsed, especially in certain states and areas (California, Michigan, Florida, Nevada and Arizona were some of the hardest hit). This situation has stabilized but is still years away from being normal. The other big negative is high unemployment, which stresses government benefit programs and finances and stops people from consuming more or buying one of those cheap homes.

The second big problem is the sovereign debt disaster in Europe. Getting 17 countries to agree on major changes isn’t easy. The U.S. is a single country, so nearly all of its problems are internal ones, with the roadblocks being the political process. Europe, on the other hand, has a number of countries that need some major restructuring. But years of government largesse (funded by borrowed money) have insulated populations of most peripheral southern European nations from economic realities. Now, no one wants to do the same government-guaranteed job for less money or have their government-guaranteed benefits packages or pensions reduced. Yet those are precisely the kinds of drastic actions that are needed for countries like Greece, Spain, Portugal, and now Italy, to get back to some sort of fiscal balance. I believe Europe will take the necessary steps to climb out of this, but it won’t be pretty or quick.

What’s the good news?

The good news is that China, India, and other emerging markets have mostly burgeoning economies with good growth rates and much younger populations that are far away from retirement age. There is some inflation risk as a result, but so far, China and India have proven to be fairly adept at managing monetary and debt risks through various growth stages.

The big question is whether this good news will be enough to offset the doom and gloom from the U.S. and Europe. So far, it’s been a saw-off, with stock markets reacting to the unfolding eurozone crisis with daily gyrations of hundreds of points in many cases, as one crisis begets a “solution” only to be supplanted by another crisis.

Volatility has increased

My educated guess is that we may see a “range-bound” market for a few years. Volatility will continue to be higher than average. From June 2003 to June 2007(1,007 trading days), only six days saw the S&P 500 Composite Index experience moves of +/- 2%. That period was a period of extremely low volatility. But from June 2007 to June 2011 (1,009 trading days), the S&P 500 saw 166 days where the index moved +/- 2%, which was a massive difference.

When I started in this business, you could diversify a client’s portfolio geographically, which helped “smooth the ride.” As world economies have become more closely tied, this strategy hasn’t been effective at reducing the volatility of portfolios. Major world stock indexes seem to be more and more closely correlated, and I don’t see that changing. All that means is that one tool has been removed from our toolbox, and we must use other methods to reduce volatility and increase returns.

What to do?

For every market condition, there are strategies we can employ to take advantage of the prevailing conditions at that time. What once worked may not be effective today or in the foreseeable future. I will explore some of those strategies in my next column, including a fresh look at diversification, the benefits of disciplined and regular investment, and the “marathon” mindset.

 

 

 

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