Market Update – what's an investor to do?

As markets continue to slide south, there is a general feeling that there are few places to hide. Here's some information that may help you further cope with today's volatile markets.

Everything is going down

Well, not everything is going down. Most major U.S. bond indexes have posted mildly positive returns so far this year while global bond indexes have posted more robust returns in dollar terms. Over the last 52 weeks, the Lehman Aggregate - a broad index of U.S. bonds - has returned +7.17% while the Lehman U.S. corporate bond index has returned +3.69%. Canadian government bonds (aided by a weak dollar) have returned +9.61%.

Nonetheless, it is completely understandable that many investors are concerned there are few safe places in the current environment. Equity markets around the world have declined in lockstep and diversification has not helped much as international markets have performed slightly worse in aggregate than the domestic markets. Emerging markets (except raw material exporters like Brazil) have fared even worse. Cash has also not been a great investment as higher rates of inflation have resulted in a negative interest rate in real terms.

What's the point of diversification then?

There are several aspects of portfolio diversification worth remembering:

• Relative performance matters in both up and down markets. It is common among investment professionals to rue the asymmetric behavior of how investors react to markets. When markets go up, people think in relative terms. They want their portfolios to go up as much or more than the benchmarks. However, when markets go down, many investors focus on absolute return. Investors focus on the absolute level of the loss versus a relative return versus the appropriate benchmark. This focus on the absolute loss often results in investors selling at the bottom as there is a legitimate fear that the loss may never be recouped. Investors should consider whether this is wise. We are all prisoners of what financial markets give us over time. Investors, therefore, should remember that relative returns matter just as much when markets fall. Investment professionals and the consultants who serve as gatekeepers in our industry measure performance through a full market cycle of both up and down markets. They also look for out-performance in both up and down markets. Why? In a down market, a diversified portfolio which declines less is going to have an easier time recouping losses when markets inevitably rise again.
• Diversification does work. Asset class diversification has been working over the last year and investors with a suitable weighting in bonds have fared better than those who had forsaken bonds. While bond returns have been broadly flat this year across a range of instruments, the 52-week numbers show positive returns in the 5-12% range depending upon the sector. Compare this with equities where every major index has had negative returns both year-to-date and over the last 52 weeks. Many of the declines are in the double digits. Note: this does not mean that your portfolio has not declined in the last 12 months. It probably has. However, if you had some bond exposure, you likely performed better than a portfolio that just held equities.
• Product diversification matters. There is no single product which can accomplish all of an investor's needs in either up or down markets. Increasingly, product diversification will matter as much or more than diversification among asset classes. To deal with risks such as longevity, inflation and mortality, clients will need a wide range of financial products, each of which may mitigate a specific risk. For instance, an annuity with a living benefit rider has the potential to address longevity risk. It has the added benefit of protection in down markets. Until the contract owner takes income, the account can never have a value below the original amount placed into the account because of the annual step up feature.

Is there value in the stock market?

There is always value and opportunity in the stock market. It is always interesting to watch the activity of strategic buyers when markets decline. Since price declines provide opportunity, strategic buyers have made bold moves in a number of industries to grow larger and solidify their competitive position. For instance, the tie-up between Wrigley and Mars creates a global confectionary giant with strong growth prospects in emerging markets. Wrigley stock is up $24 from its February lows. Mars, a long-term player in the confectionary market, saw value where others did not.

InBev's bid for Budweiser also could result in a global brewing giant operating in major markets around the world. Finally, Bunge, Ltd., a company with roots in Holland and Argentina is looking to buy Corn Product International. In this case, both companies' stock prices are up strongly over the last five years because of increases in demand for food and grain prices. Still a potential tie-up appears to make sense to compete with other agribusiness giants.

The problem with broad benchmarks such as the S&P 500 or Dow Jones Industrials is that they often mask areas where relative performance is good. These "headline" indexes are also used by the media to generate sensational headlines or to scare viewers of financial news shows. The following information from the online version of The Wall Street Journal shows some industries in the stock market that have performed well this year:

• Brewers: +15.69%
• Railroads: +26.64%
• Oil equipment and services: +21.21%
• Biotechnology: +4.74%

To be sure, many industries associated with the financial and consumer goods sectors have deep double digit declines this year and I am in no way suggesting that this is an easy market. However, the alert investor knows that the current economic conditions are forcing industries and companies to change and adapt. The natural process of adapting to the new economic reality and price declines provides investors opportunity to profit in the future.

What should I be worried about?

We have continually emphasized that the mortgage/housing crisis is not over and will not be over for some time — perhaps one to two years. This is largely because home prices have not declined sufficiently to balance out supply and demand. The speculative bubble in housing will take some time to play out as have all past bubbles including technology stocks in the late 1990s and railroad stocks in the late 1800s. The current unwind has negative ramifications for financial stocks and certain consumer stocks, particularly the auto industry.

The emotional ups and downs of the market are deeply troubling

We feel your pain, and the financial press exacerbates these emotional swings on a daily basis. You need to remember that the market never seems to be in equilibrium and, therefore, it is more important than ever that you maintain your equilibrium. When pessimism is rampant, that is usually a sign that opportunity is waiting around the corner. I remember back during the commercial real estate crisis in the early 1990s, I was sitting next to a credit officer from the then Bank of Boston. He was the definition of pessimism. He declared that no new office tower would ever be built in Boston again and that no one would ever refurbish an existing office tower to meet modern communications standards as the payback would take years. I remember musing to myself that this sounded like a buying opportunity. Some six or seven years later, Boston's per-square-foot leasing rates were setting new records, new office towers were rising and people were making money again in commercial real estate.

What else can you tell us to calm our nerves?

Market declines are a fact of investing life. They are part of the risk that you take in order to enjoy good returns over time. There have been 10 bear markets since 1950 and there are likely to be 10 more over the next 50 years. We know that since 1950, markets have finished higher in 42 of the last 57 years or 74% of the time. Those are pretty good odds. As you sip your morning cup of coffee and read or watch the latest scary headlines, please remember to keep those odds in mind.