October 2007

The Stock Markets: Where do we stand?

Stock investments weathered a stormy summer this year. Is it over yet?

Late July, when everyone was playing footsies in the sand, stock markets took a dive the likes of which we have not seen in a while. The S&P/TSX, which came close to hitting 14,700 points, fell nearly 2,000 points in just a few weeks. This means that, based on this index, a $10,000 portfolio quickly lost $1,300. Ouch! Some investors panicked, which, as is always the case, was the worst thing to do.

The calm before or after the storm?

What happened this summer is called a market correction, that is, a drop of more than 10% in the stock indices. Some corrections are severe and last a long time. When the tech bubble burst in 2001, the stock market showed a negative performance for two years! By comparison, the recent correction seems to be much less threatening. As this is being written, the Canadian stock index has risen above 14,000 points. And, looking at its progression since the beginning of the year, we can see that, in 2007, the performance of the above-mentioned portfolio was, nevertheless, 8%.

Problem is, this scenario is likely to change again.

The causes are still there

If the markets tumbled, it's because major investors reacted to the US "credit crunch". The sub-prime loan approach, which was, in fact, denounced by Alan Greenspan, past Chairman of the US Central Bank, (see Briefly for an excerpt from his recent book), weakened large financial institutions and the overall US economy. People began to fear a recession.

When the Federal Reserve cut back rates, investors breathed a sigh of relief and markets sprang back. But we must not think we are out of the woods yet. Most of the underlying causes are still there, lurking in the background. US banks are still being affected by the "credit crunch", consumer confidence is at its lowest and people are worried about the upcoming corporate financial results. Mind you, the markets may still rebound strongly, but they are also likely to remain somewhat stable, or be jeopardized by a US recession.

What to do?

Which of these scenarios will prove to be true? It is difficult to say at this point, but managing your investments is precisely that, taking a variety of scenarios into consideration and not gambling on only one. To this end, here are three important issues we can discuss the next time we get together.

  • Horizon, goals and risk tolerance
    Any investment portfolio is subject to market volatility, causing it to grow or shrink in value. This could be a problem if you need your money back in the short term, but if you invest over the long term, for your retirement, for example, it’s easier to deal with volatility since the markets have a longer time line to get back on track, as shown in the diagram below. As such, it’s imperative that you properly define your goals, your investment horizon and your risk tolerance.

    Actualite Graph
    (Click on the image to enlarge)
  • Diversification
    The recent correction had less of an impact on investors with a balanced portfolio because the crisis led to a run on high-quality bonds. A portfolio in which assets are properly distributed among asset classes and different securities is more resistant to a volatile market.

  • Portfolio rebalancing
    Since not all investments move at the same rate (especially during a volatile period), all portfolios end up by straying from their ideal asset mix, the mix that reflects the investor’s profile. So, make sure you get back on track periodically.

As you can see, this past summer’s correction is nothing to lose sleep over, but that doesn’t mean you should let your investment strategy take care of itself. It’s important to take stock
when needed, to talk about it and to adjust it if appropriate.