Rational Advisor

Hey, I am back from out East. It was a wonderful trip.

Got to sit down with the Dartmouth/Halifax branch met a bunch of new guys.

This was a trip for the Kevins – Kevin S from Bedford NS, and Kevin P from St Margaret’s Bay in NS, and Kevin D out of St John’s New Foundland.

Kevin P’s son is part of an amazing band called Faded Blue, and we were taken to a gig at a bar in Halifax called the Seahorse. What can I say, I was totally WOW’d. This is an amazingly talented band, and I just couldn’t believe that they were not discovered yet. I have become a huge fan of them. You can expect me to be at any concerts in the Toronto region. Thanks a lot Kevin P.

Here’s some links for them

www.fadedblue.ca

just watch the you tube link to see how great they were. http://www.youtube.com/watch?v=MICQGQM5ZxA

Then after that we went to do a presentation for Kevin S and his clients, and again I really enjoyed it. Kevin S is my fly fishing buddy (he taught me how to NOT catch fish!). It’s always good to see the investor’s faces, and answer their concerns. Most of the concerns are not about returns, but really volatility. They are afraid when they don’t know the downside of their investments. Many people get caught up in comparisomitis, that’s always thinking it’s better on the other side, or some other investment. However once the risks of these other investments are outlined, and they are shown what measures have been taken to reduce the risk, they realize that obtaining a return that meets their criteria is better than rolling the dice on the markets.

We also met with Mark L and his friend Elle who I was really impressed with. Elle’s a Harvard professor of engineering and we had a great discussion on the investment world, and the BS that’s in there. The problem with Investing and Engineering is that unlike Engineering the numbers do not have a static meaning. We place far too much reliance on a past number or performance, and try to think that its better because it had a better past number. This may be true for Engineering, but not for investing. Unlike Engineering the investment world is fluid. Sometimes it’s not in the numbers but more in the structure of management.

Elle’s done well, by reducing the risk in his investment choices. We do the same, by trying to counter the obvious risks. However in the markets, all risk cannot be mitigated, they can however be reduced.

From there we went on to luverly St. John’s NF. A gorgeous place. I once thought Kelowna was the place to be in Canada, well now, we have two great tourist sites, Kelowna in BC and St. John’s in NF. St. John’s is the oldest city in North America founded in 1497. http://en.wikipedia.org/wiki/St._John’s,_Newfoundland_and_Labrador

We had an amazing Seafood meal. I met Calvin and Kevin and hiked upto their offices (not recommended for the weak of heart). The next day we presented to Kevin’s clients, and it was great. Cal’s going to be a great planner, he has the right mentality – calm and thinking. There were a couple of challenges, where I had to explain that just because a return is high, does not make it a better investment. What has to be considered is the risk taken to achieve that return.

With that I now bring you back to the regularly scheduled program – the markets

Just as some intestinal fortitude was needed, Mr, Bernanke has a bowel collapse The US Federal Reserve cut a key interest rate by a half point on Tuesday - the first cut in over four years - and left the door open to further relief to prevent a painful housing slump and a credit crunch from driving the US into recession.

Was it the right move? Hard to say.

The market’s initial response is ‘Thank you, Ben. The markets loved it, propelling stocks up 335.97 points in the US - its biggest one-day point jump in nearly five years.

“Today’s action is intended to help forestall some adverse effects on the economy that might otherwise arise from disruptions in financial markets and to promote moderate growth over time,” the Fed said in a statement released after its closed-door meeting.

The rate decrease increases the chance that the US economy will be able to avoid a recession and consumers will keep spending.

I however believe that the situation for the Fed could become tricky. . This does nothing to solve the underlying problem. Interest rates were too low for too long, bad loans were made, those were repackaged into instruments that made the risk seem negligible, and now, no one wants to hold the bag. After months of being the inflation hawk, Benny has thrown all of that up at the first sign of trouble because the markets wanted him to bail them out of a problem that they created. The Fed’s response to this summer’s market volatility may eventually lead investors to worry more about how bad the current credit climate is, and how vulnerable the U.S. economy might be to it. The big rate cut had downsides, too. It raises the risk of inflation. And it does little to correct the biggest problem of the moment: the paralysis in certain debt markets owing to fear about the quality of loan collateral such as mortgage backed securities. I fail to see how dropping rates, makes the Asset Backed Securities more safer – those assets still have their risks and problems. Dispelling that fear requires improved disclosures about the real value of those securities – not necessary lower short-term rates.

Dundee Wealth sale

We’ve just experienced in Canada a change in equity ownership due to asset backed securities. Apparently Dundee was one of the wealth management arms that used a lot of Asset Backed securities to make it’s returns look better. Now that the proverbial crap has hit the fan, they will have a new equity partner – Bank of No Service. No matter what they call it – this was a bailout. The Bank of Nova Scotia has struck a $348 million deal to acquire 18% of Dundee Wealth Inc., with an option to increase its stake to 20%… and beyond that to take control of the financial advisory enterprise. The Bank will also pay $260 million to acquire Dundee Bank of Canada, an unprofitable business that some say Scotiabank never really wanted. The higher banking rates offered by Dundee were attractive, and gathered over $2 Billion, however it had difficulty in finding ways to invest the deposits at higher returns. And what’s more Canada’s banking regulators demanded that increasing amounts of capital be set aside to cover the growing depositor base. Dundee had invested more than $380 million in asset (crappy)-backed commercial paper. Dundee had to extend their line of credit with Scotia bank to $500 million. So chasing crappy paper just because it looked good, eventually meant you had to sell a part of your firm. I am skeptical of business leaders that try to put a rosy tone to “we got screwed, we made a boo-boo” statements. Be careful, be very careful… This could very well have been like the British Northern Rock banking fiasco! Where the bank ran out of money to lend and people pulled out their money like crazy, causing a bank run. So when investing in companies that provide higher than normal interest rates for savings chequing accounts, you have to wonder what risks are they taking! This includes foreign banks coming into Canada.

Meanwhile, thanks to Benny Baby dropping rates, the US dollar fell to a new all-time low against the Canadian dollar, and euro after the rate cut, because lower rates make a currency a less attractive investment. Crude oil futures also increased, and gold prices rallied to a multi-decade high.

These factors could add up to trouble for the consumer. Though the Fed tends to measure inflation after stripping out volatile food and energy prices, high commodity costs trickle down to average Americans and can dampen their spending power.

If they were concerned about inflation before, they should be more concerned now. This half-point rate slash maybe considered as “overkill.”

Gold

Thanks to the falling US$ gold has also had a remarkable run. Investors are afraid that their US$ will be worthless, and that’s why they are purchasing gold. What we are seeing is a bubble in gold thanks to Bubble Ben Bernanke. So, if you want to know when gold will finish increasing look to the US$.

As the US$ falls, the export trade numbers increase and the GDP of the US increases – more people buy cheaper US goods. As the GDP increases the economy gets stronger and investors come in. As investors start buying up US shares with foreign monies, they have to buy them with US$, which means it would need to go higher. US$ also goes higher because fo a regime change in 2008. US$ higher means Gold will then fall.

A lot of people quote China and India as large purchasers of gold, and they are, but no more than previous years – they didn’t all of a sudden decide lets put more money into gold! Gold after all give you no interest, and costs you for storage. What’s prompted the increase has also been the slowdown in central banks selling of gold.

Gold was at a high of $850 an ounce in January 1980, as high inflation linked to strong Oil prices, Soviet intervention in Afghanistan and the impact of the Iranian revolution prompted investors to buy the precious metals. Similar events are in the news today – Oil, Afghanistan, Iran! And remember Gold fell sharply after that period. Once Russia left Afghanistan, Oil prices came down, and Iran became boring news.

I am concerned that many Gold bugs are saying “It’s different this time” – just like it was when technology went up, and people said the same thing!

C$

The Canadian dollar has seen some steep ebbs and flows in its history. In 1864, the greenback traded at $2.78, an all-time low for the U.S. currency. In 2002, by contrast, the loonie traded as low as 62 cents.
From recent numbers on inflation it seems like Dodge has beaten inflation. From Statistics Canada, the inflation rate hit an 8 month low in August as consumers paid less at the pumps. CPI rose at a 1.7% annual rate, a sharp drop from 2.2% in July.

The drop in US rates also led to a fall in the US$ against the Cdn$, allowing it to hit parity. And don’t we know it, almost every paper had that as their main headline news. Most of the reason for the loonie’s rise is the US$ demise, but also remember our country is commodity based, oil, gas, wheat etc which all have also risen over the years. I heard a few reports that say once the Americans get their financial house in order the loonie will drop back. Right now, I think what we’re seeing is speculators pushing the loonie to par, rather than underlying economic forces. Parity is just a number! This entire obsession with parity is unfounded. The exchange rate for the dollar is not a good indicator of how strong the economy is. The important measures of economic strength are employment growth, GDP and inflation. No real significance for the average Canadian other than the reduced spending power of Canadian NHL players who are paid in US$. Could we just get a life now!

We are no way as rich as the Americans by every economic yardstick, from standard of living to personal income. For sure we can go into a US store and buy goods with the same power as an American, but the fact is their counterpart in the states still earns about 20% more than the Canadian does.

I think what we are seeing now in the US dollar is similar to what happened with Canada in the 1990s. We had way too much debt. And deficits were WAAYYY too large. We were basically forced into devaluation scenario to pull out of this nosedive. The US is attempting the very same thing now. Just as Canada got out of its debt problems, by dropping its currency and increasing its trade, so will the US.

It is hilarious how Canadian cheer this news. Canadians have such envy, Obsession-Compulsion and fixation of the Good old USA that reaching parity is watched with baited breath. For an export based economy such as Canada’s, this is very, very bad news.

Remember the Media’s prime directive is not to ‘educate and inform’. It is ‘to bring the audience to the advertiser’. Content is operational expense between the revenue generating advertisements. As such it is easier to bring stories like Britney, Beckham, Lindsay, Paris, and the exciting dollar parity!

The loonie versus the Euro has stayed the same the last couple of years:
Today its worth 0.70442 Sept 20, 2007
A year ago 0.70343 Sept 20, 2006
Two years ago 0.70664 Sept 20, 2005

See, it’s only against the US$ and only because they wanted to!

Is it unfair to lay this at Mr. Bush’s feet? Yes and no. Currencies are complicated beasts and their gyrations are not driven solely, or even primarily, by government policy. The five major countries whose currencies have appreciated the most in the past year — Norway, Brazil, Australia, Canada and New Zealand — are each prolific producers of natural resources. As commodity prices rise, so does the value of their exports, and their currencies. The U.S., as a huge importer of oil and other raw materials, pays the price. Those are macroeconomic forces.

Yet, when it comes to the U.S. dollar, the question of confidence still lingers. Would oil cost $80 (U.S. or Canadian) a barrel if not for the misadventure in Iraq? Would the US dollar have fallen so rapidly against the euro — 30 per cent in the past five years — if not for the Bush administration’s free-spirited approach to fiscal policy? U.S. federal spending rose nearly 7 per cent a year from 2000 to 2006, directed by a Republican president and a Republican Congress. It’s hard to know if Mr. Kerry would have managed things very differently — but harder still to imagine he could have done any worse.

Today, the United States is running a deficit of 1.3% of GDP — hardly a disaster, but still twice the size of the deficit of the euro area, according to forecasts published by The Economist. The trade deficit, at 5.7% of GDP, is a bigger overhang for its currency. Small wonder the traders and reserve banks of the world have been selling greenbacks.

What next?

The US Fed might pause after this cut, having gotten all of its cutting out of the way at once.

In the long run, it’s always foolish to bet against America, which did not become the world’s wealthiest nation by accident. It will rebound; it always does. The mortgage crisis, and the resulting economic slowdown, will shrink the trade deficit. And Mr. Bush is now a lame-duck president whose party might well lose in 2008. Anyone remember how the U.S. economy — and the currency — performed during the last four years of Clintonomics?

For Canada there is a good chance that we could see Canadian interest rates come down – Our dollar is too high, and inflation is low. The Canadian dollar may have overshot its fair value is trading at a level above what the country’s economic fundamentals justify. There is probably about 5 cents of headlines movement that is speculative.
Bank of Canada Governor David Dodge has said that speculative gains in the currency would cause “monetary policy to be more stimulative than it otherwise would have been” — in other words, lower interest rates.

History shows the outlook for stocks is promising after fed rate cuts. In the 11 times the US Fed has started to cut rates since 1945, the S&P 500 has gained 12% in the six months flowing, on average according to Standard & Poor’s.

But don’t get too excited. After four of the 11 initial rate cuts stocks fell, including in 1990, when the S&P 500 index fell 14% as the economy struggled with a bear marketing housing that led to the S&L crisis, and junk bond meltdown – a situation eerily similar to today’s housing problems in the US and credit crunch.

And don’t forget the last time the US Fed went on a rate cutting binge: In January 2001, nearly ten months into what turn into a devastating bear market, stock prices continued to fall for 21 more months.

And for those who think that when there is a recession in the US stocks prices go down. History is against you.

When you look at all the recessions over the past 150 years, as identified by the US National Bureau of Economic Research (NBER), the unofficial arbiter in the US of when recessions start and finish.

Over the last six decades, the stock market more often than not was higher when a recession came to an end than when ii began. Just the opposite is the case over the century before that.

During the 11 NBER identified recessions from 1945 onwards, the stock market rose 7 times and fell 4 times. The average stock market gain over the 11 was 3%. The average before 1945 was -13%. Why the difference, because recession shave been much shorter after 1945.

The average recession since 1945 has averaged 10 months, prior to 1945 the average was 12 years.

A bubble is forming in Emerging markets, and commodities, all because of a dropping US interest rate and thereby its currency. I find it hard to bet against the US, after all they control almost half of the world’s wealth. The US didn’t become the world’s wealthiest nation by accident. It will rebound, it always does. The mortgage crisis, and the resulting economic slowdown, will shrink the trade deficit. And Mr. Bush is now a lame-duck president whose party might well lose in 2008. Think of all of the world class companies that they have – Wal-mart, Proctor & Gamble, General Mills, etc.

As about Gold, there are just too many bulls, and that alone worries me. Nobody thinks it’s going down!!

What’s an investor to do? Investors can expect more big swings in the stock markets in the coming weeks as traders react to each and every nugget of economic news.

Try to remain rational. Predicting where to invest based on which countries and sectors are likely to perform best is a little like predicting the Soccer World Cup winners for the next five years. We can make educated guesses based on current lineups, future draft picks, coaching personnel and the financial stability of the team, but there are a host of possible events to turn a potential World Cup Cup contender into a playoff wannabe. Same goes for investing.

In 2004 and 2005, emerging markets such as India and Latin America, were excellent choices, producing group returns of 16.8 per cent and 31.2 per cent respectively. Much like China and precious metals are doing today

But in 2000 emerging markets were at the bottom of the heap, losing 28.2 per cent as a group. In 1999, they were up 57.2 per cent.

Whew! That is a roller coaster ride and some might say it is exactly what you would expect from a volatile investment.

Not so fast. Let’s take global income, i.e. global government bonds. While the gain/loss swings are not so large, the place where global income sits in returns is also all over the map. In 2002, one of the worst years for equity performance, global bonds, not surprisingly, offered the best returns at 18.1 per cent.

One year later, global income was in the basement with a loss of 6.3 per cent. Two years earlier, 2000, the sector was in third spot with a gain of 5.9 per cent. But in 1999 global income was a cellar dweller with a loss of 10.3 per cent, which follows a fourth place finish in 1998 with a gain of 23.8 per cent.

Now let’s open the dressing room door of Team Large Cap Canada. This laggard club only won the return race once between 1986 and 2005. That was in 1996 when domestic large caps gained 28.4 per cent, the best returning of the broader global market indices.

Interestingly, Team Large Cap U.S. ranks roughly the same among the global indices between 1985 and 2005. The difference lies in degree – at least on the gain end. In 1997, right after the gold medal performance of Canadian large companies, the U.S. big cap stocks were winners, turning in a whopping 39.1 per cent gain for the year.

Diversifying, across borders, sectors and company size, is a brilliant strategy. However, forget trying to predict which geographical area, size or type of company is going to be on top in a given year.

In fact, of 10 major global market indices, every single one has put in at least one gold, silver or bronze performance between 1985 and 2005 and every single one has suffered a bottom three finish as well.

The lesson is quite simple. Spreading your investments more broadly will increase your performance over time but, more importantly, the strategy will reduce risk.

Thanks

Rational - I used to be indecisive. Now I’m not sure.

I have learned that if you upset your wife she nags you…..
If you upset her even more you get the silent treatment.

This week I am in Nova Scotia.

But before I leave here are some interesting points on what’s going on

Interest Rates

What does a quarter point do?

Is it meant to provide confidence? Is it a quarter point because they think they can ward off a recession? Which is silly, because it would be the first recession in history that was ever pre-empted by a quarter percentage point rate cut.

I am concerned that investors will wake on Wednesday morning after the Fed announcement feeling let down and wondering when the next cut is coming.

Are they going to give me another couple of quarters or another 50 basis points?.

And I think if there is a lack of confidence in the market that they are going to get that, then you go into October with all the issues that October is going to bring - further credit issues for the mortgage issuers and further economic issues. Another thing to consider is the exit time for people in hedge funds is around the corner, this could be large.

The only thing that would make a difference would be if the Fed obviously telegraphed that more cuts are on the way - which is what I don’t think they’re going to do.

But markets could very likely be running smack into further headwinds with the third-quarter reporting season right around the corner and the likelihood of further pressures on the U.S. economy as mortgage defaults rise - issues unlikely to be fixed by a quarter-point rate cut.

The second-quarter season didn’t cause many hiccups because it wrapped up before the squeeze on financial markets flared up in early August.

We completed that earnings season before a lot of this mess hit the fan - but now we’ve hit the fan.

For starters, there has got to be an impact on financial sector performance. Issuance of paper, issuance of securities that are asset linked and all that where firms had been getting a lot of revenue - there’s a possibility that revenue growth is not going to be affected, maybe negative growth.

Canadian manufacturing firms will have their own special set of problems because they have had to deal with a dollar around the 97 cent US level.

And the Canadian marketplace could be in for extra added pressure if commodity prices flat amid lower growth.

The currency’s gains have also come on the back of a limping U.S. dollar.

The softer-than-expected U.S. retail numbers further weighed on the US$, increasing expectations that the U.S. Federal Reserve will cut its key funds rate from the current 5.25 per cent level when it meets next week.

That would narrow the Canada-U.S. rate gap in favour of the Canadian currency as the Bank of Canada is expected to leave its key overnight rate steady at 4.50 per cent when it next sets policy on Oct. 16.

The Canadian dollar’s recent strength has renewed talk of parity with the US$, something that hasn’t happened since November 1976.

It would be a fool who said that it wasn’t possible, because it’s trading so closely off commodity prices that all it takes is to have a day with a surge in commodity prices and we’d get there.

But I don’t think it would be sustained there, because I think ultimately we come back to the productivity gap and we still have a very substantial productivity gap with the U.S.

Domestic data showed Canadian labour productivity rose 0.2 per cent in the second quarter. That contrasts with United States, where productivity in the second quarter surged 0.9 per cent in its strongest performance since the third quarter of 2005.

So what this means is that the economics does not justify a high C$, it’s high because of commodity prices - read below about Oil.

House Prices

The average price of a resale home in Canada’s major markets fell in August for the second month in a row amid slower sales, new figures show.

The average price in 24 major markets was $325,881 last month, compared with $332,442 in July and $335,180 in June.

The figures were released Friday by the Canadian Real Estate Association (CREA) and are based on sales through the MLS system.

August’s decline was due largely to drops in Alberta, where the average price in Calgary fell $13,000 to $423,801 and Edmonton’s average slipped $8,100 to $345,809.

Canadian home price increases are not sustainable in the long term, a report from the Bank of Nova Scotia economics department says.

“Affordability is becoming increasingly stretched for many would-be buyers after almost a decade of rising home prices. More recently, economic risks have increased in the wake of the intensifying financial market turmoil stemming from the U.S. subprime mortgage problems.”

Additionally, “from a long-term perspective,” there is growing overvaluation in some parts of the country, “a precursor to a period of softening conditions,” the report says.

Scotiabank surveyed 15 cities, and all except St. John’s, N.L., have inflation-adjusted prices above their long-term trend. The national average deviation was eight per cent, ranging from one per cent in Ottawa to 25 per cent in Edmonton.

“Some deviation from underlying trends is to be expected at the late stage of a housing boom,” the report observed.

“At the peak of the prior two housing cycles in 1976 and 1989, national home prices were 12 per cent and 18 per cent, respectively, above their long-term trend. The smaller degree of overshooting this time around, and the sustainability of price appreciation, may reflect in part an undervaluation of Canadian real estate prices in the late 1990s and into the early part of this decade.”

they cautioned: “The further domestic home prices climb above underlying economic fundamentals, the greater the risk of an eventual correction.”

Oil

Oil’s rapid rise from $69 (U.S.) a barrel less than a month ago has been propelled by falling U.S. oil inventories, concerns about growing demand and speculative buying by large investment and hedge funds. But several analysts are now sounding alarms, arguing that oil’s rally isn’t supported by fundamental reasons.

In recent days, the Organisation of Petroleum Exporting Countries (OPEC) has said it will increase output, which should reduce some of the supply concerns, and the International Energy Agency has cut its global demand forecasts. Oil inventories are falling in the U.S., but remain at record levels. And gasoline demand has slowed down with the end of the summer driving season.

The combination of comfortable inventories in the upstream crude-oil market and weak product demand growth at the far downstream end of the petroleum complex suggests overall price weakness, not strength.

Perhaps the most important read on Oil, was in this weeks Barron’s

Where Is Oil Headed? A Contrarian Says $45
Interview With Mike Rothman, Senior Managing Director, ISI Group
By SANDRA WARD

AS THE ORGANIZATION OF THE PETROLEUM Exporting Countries convened last week in Vienna, we naturally turned for the inside scoop to Mike Rothman, head of integrated oil research of the ISI Group, an economic research and investment-strategy firm based in Manhattan. A regular at OPEC meetings since 1986, a top-ranked energy analyst and a consultant to governments, Rothman is nothing if not in the know. Before joining ISI in 2005, Rothman was the former chief energy strategist at Merrill Lynch, where he worked for 20 years. It has been his contrarian contention the past few years that the dynamics surrounding the spike in oil prices have been out of whack with certain fundamental industry truths, and a day of reckoning is at hand. Here’s his case for $45 oil and why investors should be underweight the energy sector.

Barron’s: What’s the view from the OPEC meeting? The Saudis agree to increase output and crude goes to new highs.

Rothman: That’s not the story. The story is not the increase, the story is why the Saudis are pushing for an increase in production. A big part of the answer is that it seems that the Saudis want to try to take the froth out of the oil price because they are concerned about what higher prices have done to supply and demand. Over the past year, Saudi Arabia has had to cut its production by almost a million barrels a day to accommodate the impact of non-OPEC supply growth and because of weaker-than-expected world oil-demand growth. It wasn’t that they were depriving people of barrels, but OPEC had less demand for their oil — and the bulk of the cuts occurred in Saudi Arabian production. The Saudis are about to bring on a big field in the fourth quarter, Khursaniyah, that’s an 800,000-barrel-a-day project, and they are looking at demand numbers that are being revised downward. World oil-demand growth hasn’t been at nearly the pace people thought it would be.

What are your forecasts for demand growth?

My forecast for the fourth quarter, excluding Angola and Iraq, is for about 26.6 million barrels a day. Their production right now is about 26.8 million barrels a day.

Mike Rothman
Zero growth?

From these levels it doesn’t look like they have to raise output. Mind you, it’s not the consensus view. The consensus view, which is from the International Energy Agency, is that demand is going to be about a million and a half higher than what I am talking about, and most people use the IEA forecast. OPEC is producing at a level that even their internal supply-demand model suggests is probably the right number for what they would need to supply — in other words, what the market is going to demand. Qualitatively, you should know nobody is being deprived of barrels. Now, with the Saudis pushing for a higher quota, it is not about making barrels available to meet demand. It’s about sending a signal or trying to lever down oil prices. The reason they want to do that is because the higher average price levels we’ve seen for the last couple of years have affected demand growth, and they have affected supplies from non-OPEC countries and for alternative energy supplies. The Saudis are the ones bearing the brunt of that because as demand for their oil has dropped, they have been the ones that have had to cut back.

There was talk they would delay increasing output because of concerns about the impact on prices.

That issue, of how do you engineer a soft landing, is really a tricky issue because the amount of speculative paper in oil has increased dramatically. The level of open interest in crude on the New York Mercantile Exchange has tripled in the last three years. The over-the-counter market, according to data from the Bank of International Settlements, suggests outstanding positions in oil about 20 times as big as the Nymex. Now we didn’t have a big OTC market back in ‘85, ‘86 or ‘88 or ‘94, nor in the ‘98-’99 price crashes, so the big concern right now is when the unwind happens, it could be terribly disruptive. If you look at an oil-price chart back to 1983, when crude started trading on the Nymex, all you will ever see in the price patterns are V-tops and V-bottoms. What happens when hedge funds who have been net long in crude since October ‘03 decide to go short or sell? You can understand the concern. It’s not just about easing prices; there is the potential for a blood bath.

So how do you explain crude prices rising to new highs after the Saudis announced they would increase production?

It would be an understatement to say I was taken aback by that. In a few days, the market went from expecting no hike in production, to expecting a largely symbolic increase, to getting a final agreement to inject 500,000 barrels a day above existing levels — which is the equivalent of a 1.4-million-barrel-a-day boost in quotas. The big question at the meeting is, “What is bolstering the price?” I’m not sure, except the market seems to still believe the world is running out of oil.

What about the demand from China and India and the notion that supplies have peaked?

The data doesn’t show it. If you look at the International Energy Agency industry data and you do an apples-to-apples comparison of non-OPEC supplies, supplies from all of the countries outside of OPEC, you will see growth rates are running substantially higher than people believe to be the case. Growth in non-OPEC supply this year looks like it will be about 1.3 million barrels a day, and that number is about twice what people believed would be the case. And the Saudis clearly have the barrels available. They are bringing on new fields. Khursaniyah is coming on in the fourth quarter, Nuayyim next year and Shaybah next year and Khurais in 2009. These are fairly big additions.

So what are people missing?

I have never seen the gap between reality and the perception of reality as big as it is right now. The perception of what I call Chindia, the idea that demand growth globally is robust and is going to be led by the emerging-market economies of China and India, is still strong. It is a great idea. But when you look at the data, you will see it doesn’t match, and when you talk about peak oil and see what is happening to non-OPEC supply, there is a problem because supply growth this year is going to be one of the largest in almost 30 years, and next year looks like it is going to be similar to this year. Guys like me care about the totality of non-OPEC supply growth, even biofuels, or non-oil fuel, which are a subset of the non-OPEC supply curve. Biofuel supplies, which include soybeans for diesel fuel and corn for ethanol, will be up this year roughly 350,000 a day versus last year. That’s a big number, about 40% in terms of its volume. It is going to be up by a similar volume in 2008. This is in response to higher average oil prices and concerns about availability.

Why the big disconnect between perception and reality?

I’ve got to tell you I don’t know what the answer to that is. I do feel like I’m going through the reverse of what I went through in 2000 through 2003. In 2000, I was described as a “foaming at the mouth” oil bull. At Merrill Lynch we had a view the oil price would average in the mid- to upper 20s. We thought OPEC would adjust production, and when we spoke with investors about our views, they looked at us as if we were taking drugs. The catalyst that actually repriced energy equities and moved the whole back end of the oil-price curve was when Royal Dutch Shell wrote down reserves in early 2004. That was the catalyzing event.

I don’t think people are aware that demand has really fallen off so much. The rate of global oil-demand growth has really slowed pretty dramatically since ‘04. I’ve had to make a large downward revision for the second quarter, and it looks like I am going to have to make another one for the third quarter. A chart of the OECD [Organization for Economic Cooperation and Development] countries shows demand growth has been negative, with the exception of a small gain in the second quarter; that’s the first time since 2005 that there’s been some growth in demand, and it was modest. That’s the worst showing since the ‘80-’82 recession.

What about demand in the U.S.?

We have seen a very recent significant slowdown in U.S. oil-demand growth. Also, jet-fuel demand historically has been a leading or coincident indicator for the economy, and jet-fuel demand has turned negative. That is not an economic forecast. But when jet-fuel demand is really soft, you have got to worry about whether something’s going on with the economy.

Well, is demand slowing because of high prices or because the economy is slowing?

That is hard to say. Guys like me count barrels. But when you see oil-demand growth slow, you figure there are two things going on: There is substitution and there is conservation. People try to do more with the same number of barrels or they use alternatives. They may use more coal. They may increase their burn of natural gas in place of oil. They drive less. They may car pool. I’m not going to sit here and make up answers that I don’t know. I just know that the rate of oil-demand growth has really been much lower than what has been forecast. I know I have had to make very big negative downward revisions in demand over the last three years, and it tells me that higher prices affect consumption. Three of my five kids drive, and last summer two of them stopped driving because I wouldn’t buy their gasoline.

But in the bigger picture, global demand was supposed to be so strong that it wouldn’t affect oil prices.

That’s the “Chindia” story. I don’t debate that demand in developing countries will grow. But the argument is that it is going to grow as it did in ‘04, at 15% or 16%, regardless of oil prices.

And you say 2004 was an aberration?

I haven’t seen anything like it in 26 years. It wasn’t even clear that what happened in ‘04 truly represented consumption. We don’t know if some of it was stockpiling for precautionary reasons by developing countries. When you measure oil demand in a developing world economy, you’re looking at disappearance, because the data for actual consumption by countries is very difficult to come by, and in many cases nonexistent. Then the question is whether that volume makes sense given other types of data. All I know is that for the last three years, I’ve revised my numbers down for China. It is not that they are not having oil-demand growth, but it is not 15%. It is 5%. It is 4%. It is 6%. It is 3%. It ain’t 15%.

So if you were the “foaming at the mouth” bull back in 2000, what would you call yourself now?

It is very hard for me to say that I am a bear when I think oil is going to land at $45 to $50; historically, oil prices eventually settling at $45 to $50 is quite high. But compared to what the market is pricing and compared to probably most of my contemporaries, my forecast makes me a bear. We recommend underweighting the sector right now.

I’d say nearly a 50% price drop is bearish.

The concern is about the magnitude and speed and timing of the unwind given a precipitous drop in prices. It will be painful for companies. I have seen this movie before. There are a huge number of similarities between ‘99 up to now and the ‘73-’80 cycle.

Thanks, Mike.

http://online.barrons.com/article/SB118981090977228146.html?mod=article-outset-box&apl=y

Conclusion

Equities are likely to remain volatile until there is more clarity on the degree of exposure of financial institutions to subprime debt and the impact of tightening financial conditions, weak housing and rising delinquencies on corporate earnings and GDP growth.

However I expect equity markets to stabilize with the U.S. Federal Reserve cutting rates and other central banks remaining on hold and intervening, as needed, to unfreeze liquidity. This, combined with attractive valuations and healthy earnings, should enable stocks to recover their July-August losses and end the year higher.

Despite increasing concerns of a housing-led U.S. recession, growth and inflation outlook remains supportive of equities. While the subprime problem and the liquidity crisis are likely to slow U.S. GDP growth, they are unlikely to push the U.S. economy into a recession or slow global growth significantly.

In addition, inflation is easing, providing central banks room to cut rates. The current market environment is more favorable for large dividend oriented equities than in earlier crises with more-attractive valuations and healthier earnings.

Bonds are likely to continue to benefit from the flight to quality as credit and stock markets remain volatile with fear, uncertainty and risk-aversion persisting. Bonds are also likely to benefit from slower U.S. and global growth and Fed rate cuts. In the Future, as demographics means more people are retiring, Pension funds will need to increase their bond exposure, so the demand for good bonds will go up.

It is my experience that you have three primary concerns when it comes to your investments: 1) Catastrophic losses of principal; 2) Outliving your money; and 3) Knowing who to trust. Am I right? I know those fears are increased by extreme market movements like we have experienced in the last few weeks. True?

So I thought it might be helpful to give you some perspective on market volatility from various authors who I know and respect. From Dr. Benoit Mandelbrot1, in The (Mis)behavior of Markets:

From 1916 to 2003, the daily index movements of the Dow Jones Industrial Average do not spread out on a graph paper like a simple bell curve. The far edges flare too high: too many big changes. Theory suggests that over time, there should be fifty-five days when the Dow moved more than 3.4 percent; in fact there were 1001. Theory predicts six days of index swings of more than 4.5 percent; in fact, there were 366. And index swings of more than 7 percent should come once every 300,000 years; in fact, the twentieth century saw forty-eight such days.

What this mjeans - There is far more volatility in the markets than most people realize. That is Dr. Mandelbrot’s central message. Rather than ignore this risk, investors should take advantage of it.

From Nassim Nicholas Taleb2, in Fooled by Randomness:

Prices swing more than the fundamentals they are supposed to reflect, they visibly overreact by being too high at times (when their price overshoots good news and when they go up without any marked reason) and too low at others. The volatility differential between prices and information meant that something about ‘rational expectation’ did not work.

What this means - Prices swing more than the underlying fundamentals because markets are driven by the human emotions of fear and greed. Neither of these have anything whatsoever to do with the underlying fundamentals.

From Ed Easterling3, in Unexpected Returns:

The average annual change for the Dow Jones Industrials Average stock market index, as a simple average, is just over 7% over the past century, 1901-2003… Over that period, what percentage of the years would you expect the annual change would occur in the range of -10% to +10%? Most investors seem to guess a number between 60 to 70 percent—that a clear majority of the years would be inside the range. What range would be required to include half of the years inside that range? … It is very surprising to most investors that the yearly range in the stock market has been inside the range of -10% to +10% only 30 percent of the years. Remarkably, to include half the years inside the range, it has to be expanded to -16% to +16%.

Of course, that also means that 50% of the years had a return of greater than ±16%, too. For an investor who looks at his or her portfolio value as a measure of success, those swings would be pretty scary. For a cash flow investor, who measures success by the amount of income a portfolio can generate, and by extension, the sort of lifestyle the portfolio can sustain, those market swings should be irrelevant.

Finally, there is this from Peter Bernstein in, Against the Gods: The Remarkable Story of Risk,

For true long-term investors—that small group like Warren Buffet who shut their eyes to short-term fluctuations and that have no doubt that what goes down will come back up—volatility represent opportunity rather than risk, at least to the extent that volatile securities tend to provide higher returns than more placid securities.

This is the approach I take to volatility. Volatility is my friend, not the enemy.

Rational

A young lady visited a computer dating service and made her request.
She asked, “I’m looking for a spouse. Can you please help me to find a suitable one?”
The matchmaker said, “What exactly are you looking for?”
“Well, let me see. Needs to be good looking, polite, humorous, sporty, knowledgeable, good at singing and dancing. Willing to
accompany me the whole day at home during my leisure hour if I don’t go out. Be able to tell me interesting stories when I need a companion for conversation and be silent when I want to rest.”
The matchmaker entered the information into the computer and, in a matter of moments, handed the results to the woman. Buy a TV set!

Just arrived back from Niagara, and am off to Winnipeg today, to see my good friends ABe, Todd and his group. While there, I will be doing a couple of presentations.

But, I wanted to share key notes from the Niagara conference

From the Tax talk

- Amazing the top tax bracket is now around $120K, just ten years ago it was $61K.
- Dividends will overtake capital gains as the most efficient route to earn income. It will be better than Capital Gains, so we can expect a lot of interest in dividend bearing investments

- Lots of confusions around Corporate classes investments and the new T-class investments - mainly smoke and mirrors. What investors fail to recognize or comment on, is the tax legislation changes in proposal. Once the Conservatives come out with the elimination of capital gains if reinvested in 6 months, then the advantage of Corporate classes is non-existant. Corporate class structures are also not fiar on all unit holders as the activity and cost generated from one investor affects others.

- Dividends have to be paid out in corporate classes, so there is no tax avoidance.

- Don’t think the government doesn’t know about all the games being played on corporate class structures, eventually, if not sooner they will get to them as well

- T-swps are essentially, different ways of getting your own money back. There are some good uses, as long as they are disclosed.

- Advisors are even more important, because the system is so complex, and the products so numerous. As the general population ages, it is even more imperative to understand allthe different choices, legislation and taxation changes. Anyone who thinks it is simple and are doing it themselves, are deluding themselves.

Economic commentary notes from different speakers

- last 2 years were the 2nd lowest volatility periods, all we are getting is a return to more normal volatility levels
- The credit crunch is good as it brings risk back into view, investors were deluding themselves that everything is great. They are also deluding themselves in Canada, that everything here is great, and nothing can touch them.
- Inflation is not a risk for the US
- There are tremendous attractive valuations, companies have great balance sheets - some of the strongest ever.

- Dividend companies usually take leadership of the markets at these times - times of volatility.
- out of the last 11 bull markets, for 9 of them there was greater than 20% increases over the following 12 months after the first interest rate drop.
- The Ed Hyman model, has been good at predicting the economy for 100 years, it nows shows US GDP growth at 2%, which is good for equities.
- Canada is not a great place to be in, during times of corrections - it is too cyclical and worst than most other countries, so be careful of an exposure to Canadian cyclical stocks.

From W. Mitchell author of “It’s not what happens to you, it’s what you do about it” - a great book to read.

This was an amazing talk, from someone who has had two life threatening accidents. Has a quilt work patched up face, his body was 60% burned in an auto accident. Who ten after recovery learned to fly a plane, and then it stalled, leaving him without hands and feet, paralyzed from the waist down. All things that happened without notice.

He took all of that, and did not let it affect him mentally. He became the CEO of Vermont casting, which was sold to Teachers Pension Fund - he became a very wealthy person. Despite people saying he looked like a monster, and avoiding looking at him. Most people would have wanted to die.

- “Has anyone been to prison, well I have lived in one, and I escaped, the prison was my own handicaps, and thoughts of what people thought of me. The prison was my own physical limitations.”

- The Power is when one person decides to take action Now!, not wait for the right time, or when everyone else wants to step in. His life was saved, because one car salesman ran out with a fire extinguisher and saved his life while others just watched the ball of fire that he was - too afraid to go in to save him.

- There is no passenger on the spaceship earth, we are all the crew. We all have to do our piece.

- When you row a boat all of the oars have to be in the water, so work as a team.

- Everyone says “take it easy”, but did anybody get ahead by ever “taking it easy” life is hard, but taking it on head on is worth it.

- It is your life, your choice - take responsibility for yourself, it is not someone else’s job.

- We spend a lot of time in our life looking at the rear view mirror, if only I did this, if only I had married that person, if only I had studied that, if only….

- In car,s the windshield is bigger than the rear view mirror - why? it should be the same with your lives.

- The truly successful person is the one who enjoys the scenery on a detour - life gives us lots of detours, enjoy them. My life gave me lots of detours, I enjoyed them.

- I don’t know how to change yesterday, forget it, let it go. Concentrate on today and tomorrow

- The more time I spend thinking about yesterday, in the less time I look through the windshield.

- When you have a result that you did not want, you have a choice, to get grumpy or to do something. Think about how you can salvage the lesson from the catastrophe.

- Too many times we look at failures and build our prisons - escape from the prisons.

- Life has given you a toolbox, what are you doing with it.

- Never say Why me! God Why me!, I could have said the same, I could have said, why burn my face, why take my hands, why take my legs. I had a choice, and I choose to win.

- What are you putting off? Why not do it now.

- Remember to keep you aors in the water all the time.

Thanks

Rational

At our conference, two of my favorite people got awarded lifetime achievement awards - they were Abe H, and Gus Q

These individuals have been my role models when it comes to integrity, trust and doing the right thing.

I cannot say enough about how much they have don efor others, and how even during difficult times, they have stayed true to their principles and disciplines. Even when some thought they were stupid (inside joke for Abe)

They are anything but dumb, and have been successful, not only in their businesses but also in their rich family lives.

Both indivudals started of with very little, and through perseverance, and hard work have enriched many lioves.

One line that can some them up, is that by helping others they themselves have been rewarded.

God Bless both of you and your families.

Other congrats go to Rob H, Todd P. Wayne B, Kevin S, Mark P and Richard H - the up and coming Abe H’s and Gus Q’s.

Congrats also go to the other award winners, and in fact, all advisors that put their clients interests before themselves. This is a very evil world that constantly tempts you to do what is quick, dirty and selfish - Stay strong, in the end - we can all be Abe H’s and Gus Q’s - rich in family, rich in Life.

My life is greatly rewarded by my friends

Rational

Just came back from our National conference in Niagara - there’ll be more updates on my views on that.

But, one advisor cornered me, and asked a really good question

“Alan Greenspan, says we are in a similar environment to the crashes in 1998 and 1987 should I be worried?”

I never had time to give a full answer, so here it is

Former U.S. Federal Reserve chairman Alan Greenspan added to the misery in the markets when he compared the current turmoil in the financial markets to previous crises that shook the U.S. economy and reverberated around the world. Mr Greenspan’s comments come about a month ahead of the 20th anniversary of the stock market’s crash on October 19, 1987.

“The behaviour in what we are observing in the last seven weeks is identical in many respects to what we saw in 1998, what we saw in the stock market crash of 1987, I suspect what we saw in the land boom collapse of 1837 and certainly [the bank panic of] 1907,” Greenspan said at a Washington event, according to the Wall Street Journal.

The 1998 reference was to the collapse of a huge hedge fund, Long Term Capital Management.

In both 1987 and 1998, stocks fell sharply starting in July or August and, although markets seemed to stabilize by September, they abruptly plunged again, and didn’t come out of their tailspins fully until October. Whether stocks will suffer a similar fate now, or escape it due at least in part to timely Central Bank action is the big question on investors’ minds. In the previous two cases and again this time around, market downturns turned into routs as computer-based stock-trading models blew up in the faces of the investors who used them.

The crash of 1987 took place during the original buyout boom, which bullish investors said would keep stock prices high for years. And 1998 was the year Long-Term Capital Management almost imploded, forcing the US Fed to step in to calm credit markets. Big corporate buyouts, such as TXU’s $32 billion buyout and student lender SLM’s $25 billion deal, have formed part of the backdrop to this year’s trading. So have battered hedge funds: Two funds at Bear Stearns lost almost all their value after investing in securities linked to low-quality mortgages.

ln 1998, the Fed wound up intervening three times, because its first attempt proved insufficient. In 1987, the Fed didn’t intervene until after the crash, although when it did step in, it succeeded in stopping the bleeding. This time, as in 1998, the Fed has tried to intervene before things get worse. But unlike Greenspan in 1998, Bernanke has taken a gradualist approach. He has cut the rate the Fed charges to provide cash to the banking system. But he has avoided cutting the more broadly influential federal-funds rate, which governs banks’ prime lending rates. A cut in the federal-funds rate would more directly help small borrowers, but the Fed fears it also could rekindle inflation.

As in 1987 and 1998, one of the most unsettling aspects of the recent sell off is that stocks are falling and people don’t fully understand why. A big reason in each case was the role of computers programmed by people who were supposed to be market geniuses. This time it was hedge funds using mathematical models, whose forced selling contributed to huge market swings and massive trading volumes over the past few days. The hedge funds, many of whose models were strikingly similar, had to unwind unsuccessful trades involving millions of shares after troubles in the mortgage markets bled into the stock market. The sight of unknown sellers using computers to sell millions of shares of many different stocks, while buying millions of shares of other stocks, led to panic among other investors.

It caused so much mass buying and selling that the market couldn’t easily handle it. It was almost like trying to get a stampede of elephants through a small door. There was a similar break down in computer models in 1987 and 1998.

The models on which investors relied in 1987 were known as portfolio insurance. The portfolio-insurance models called for investors to protect themselves from losses by making sales in stock-futures markets if their actual stock holdings fell a predetermined amount. The models, which were based on detailed analyses of market history, didn’t take into account what would happen if everyone using these models all tried to do it at the same time. Markets couldn’t absorb all the sales demands, and the selling pressure helped cause the 1987 crash.

The models du jour failed in both 1987 and 1998. I remember being amazed at the stock gains earlier in 1987, despite rising interest rates and inflation. Only later did I realize that people had felt free to behave recklessly because they had “portfolio insurance.”

Indeed, in all three years, market turmoil was made worse by overconfident investors using borrowed money to purchase risky and “hot” investments. The unwinding of all of that leverage, or borrowing, can be brutal because as these “hot” investments fall, investors are forced to sell stocks to pay back their loans, creating a downward spiral.

In 1998, the blowup that forced the Fed to act came at a multibillion-dollar hedge fund called Long-Term Capital Management, which had become the dominant player in the Treasury-bond market. In the summer of 1998, LTCM was making highly leveraged bets against Treasury bonds and in favor of other bonds, including those of Russia. Its models showed the risk of losing money that way to be minuscule. When Russia nonetheless defaulted on its debt payments, LTCM faced bankruptcy until the Fed helped persuade a group of banks and brokerage firms to rescue it.LTCM’s models were created by Nobel laureates.

For a while, the incident soured many investors on computer models and borrowed money, but with time and people’s short-term memories, new models emerged and began showing large gains. In response, investors pulled billions in investments away from traditional diversified portfolios, who simply tried to select quality investments. The latest vogue was for quantitative, market-neutral hedge funds, which were supposed to avoid market gyrations by betting on gains in one large group of stocks, bonds or currencies, while simultaneously hedging their risks by betting on declines in other large groups.

At dinners with other investment firms, I would hear people talk about how they have ‘quant’ models, or that they were long-short managers or market-neutral managers. They would look at me, because of my views like I was a dinosaur. Now I realize that what sounded impressive was not much more than a thing we saw played out in 1987 and 1998.

Another big lesson of all three years is that it is the debt markets that often pose the biggest threats to stability in the stock market. In 1987, it was rising interest rates that eventually sent stocks plunging. In 1998, it was the risk that the collapse of LTCM could roil the bond markets. Lately, it has been securities backed by high-risk home mortgages that had found their way into a wide variety of investment portfolios. The mortgage securities were so widely held that, when they went bad, they caused credit markets to freeze up, hurting other, higher-grade bonds.

As in 1987, huge investment funds (now called “private Equity”) used junk bonds in recent years to take over companies once thought too big to be acquired. In 1987 and again this year, the market suffered once buyouts started to face trouble. My view of booms is that they generate looseness in standards for loans because there is a general sense of optimism. That is what we saw in the late 80s.

Also supporting stocks in 1987, as well as in recent months, were a strong world economy and healthy corporate profits, which investors expected to last for years. Both times, the sudden stock declines shook those hopes. In all three cases, markets turned increasingly volatile. Sharp drops earlier on proved to be temporary affairs, helping create a false sense of optimism.

To be sure, there are also some big differences. One is valuation — stock prices compared to companies’ underlying value. Valuation looked excessive in 1987, with stocks trading at more than 20 times corporate profits. Price/earnings ratios were similarly high in 1998. This time around, the ratios remain in the teens, close to the post-1945 average of about 16.

The real excess this time has been in lending markets, where investors bid up mortgage-related securities and junk bonds to unheard-of levels, and where investment banks invented novel bond-like securities. One reassuring difference is that, in the previous crises, problems developed in the bedrock Treasury-bond market. This time, Treasury bonds remain an island of relative tranquility.

Another hopeful sign: In both 1987 and 1998, the market’s woes were severe but brief. Despite the sharp market drops (more than 36% in 1987, and nearly 20% at one point in 1998), the Dow Jones Industrial Average finished both years with gains. It was up 2.26% in 1987 and 16.1% in 1998, and the S&P500 index, and S&P/TSX were up both years as well.

Although memories of the 1987 crash still make some investors shiver, that day — Oct. 19 — actually marked the bottom of the bear market. The next day, stocks began to recover, beginning a new bull market. One reason for the quick rebounds was prompt action by the Fed, and another was that the economy avoided recession in both 1987 and 1998.

But the fast rebounds led to more excess, and more abuse of borrowed money. The buyout boom resumed in 1988 but went bust in 1989, when a proposed buyout of United Airlines fell through and the junk-bond market plunged. The Dow industrials fell into a bear market in 1990, as recession arrived. The consequences of the post-1998 tech-stock excess were worse: the 2000-2002 bear market.

Besides valuation, Fed intervention and the economy, investors need to watch for other corporate and hedge-fund blowups to get an idea what might lie ahead. The longer it takes to work these problems out, the more likely credit and stock-market problems will be to spill over into overall economy, causing a slowdown, or worse, a recession.

“When the market does recover, it should recover quickly, more like 1987 and 1998 than 2000,. I don’t think the hedge-fund blowups are over yet. It is undoubtedly the case that we will be reading about more now. It is not just the Bear Stearns one and the Goldman Sachs one. Undoubtedly, a lot of those funds were more highly leveraged in some of those investments that now are no longer profitable. A number probably bought mortgage-backed securities that they didn’t completely understand.

The current panic is, by my count, the fourth of the past 10 years.

Here’s my list of the major financial panics of the past decade:

The Asian currency crisis of 1997.

The Long Term Capital crisis of 1998.

The Nasdaq bubble of 2000.

And the current contender, the subprime crisis of 2007.

On the surface, these panics seem significantly different because they all have involved different players and different market vehicles. The Asian currency crisis saw a huge devaluation of the Thai baht, the Indonesian rupiah, the Korean won and other East Asian currencies. It also saw a devastating stock market crash and stalled economies throughout the region.

The Long Term Capital crisis the next year was exacerbated by Russia’s default on its debt and was the result of an over-leveraged hedge fund, Long Term Capital Management, getting swamped when currency prices moved against it. At one point, the fund had borrowed $129 billion on assets of just $4.7 billion.

The 2000 Nasdaq crash was a classic stock market bubble built on ever more feverish expectations for huge growth in revenue and profits.

And the current panic is rooted in a boom in home prices that produced a boom in mortgage lending to ever less and less qualified borrowers, who are now defaulting at levels above those projected by the banks that originated the mortgages and the investment banks that packaged them for resale.

But here are the similarities below those surface differences:

Each was rooted in a surplus of global cheap money. Inflows of overseas capital inflated economic-growth rates in East Asian countries, sending stock prices in those countries higher and attracting more capital, because investors were more than willing to finance the large current-account
deficits being run up by these countries. Long Term Capital’s investment strategy required massive leverage because the profit from each transaction was relatively slight. The Nasdaq bubble required rivers of cash to chase stocks as they climbed ever higher. And the current crisis saw mortgage
lenders recklessly chase marginally qualified borrowers so they could generate more mortgages to sell to insurance companies, pension funds, hedge funds and foreign banks hungry to put mountains of cash to work at slightly higher rates of return.

Each required a massive mispricing of risk. Investors put so much money to work at relatively low rates of return because they underestimated the risk involved in those investments. East Asian economies were growing at 8% to 9% a year, it was believed, so their stock markets were low-risk investments. A similar thing is being seen today with China and India.
Long Term Capital took on only tiny risks in each of its bets, so the aggregate risk appeared low. Nasdaq stock prices were high, but not riskily so in comparison to projected growth. Individual mortgages to less creditworthy borrowers might be risky, but when bundled together the resulting securities, they were low-risk.

And each cycle led the world’s central banks, often led by the U.S. Federal Reserve, to limit the fallout from the panic by flooding the market with cash, thus setting up conditions for the next turn in the cycle. The International Monetary Fund led bailouts for the stricken East Asian economies. Thailand, for example, was at the receiving end of a $20 billion bailout effort. The Federal Reserve put together a $3.6 billion bailout of Long Term Capital to stabilize the financial markets. The Fed cut interest rates and cut them again — finally to just 1% — after the Nasdaq crashed in order to stabilize the economy. The move created a boom in housing prices that would keep consumers spending even if they’d lost money in the stock market. In the current panic, the Fed has cut rates for loans of member banks to inject cash into the markets.

Go further and I think you’ll find the global trends that produce and reproduce these similar panics.

First, the financial markets are being asked to redistribute massive amounts of cash. Higher oil prices have produced a gusher of cash flowing from the developed economies to the oil-producing economies like Canada. All that cash has to be reinvested somehow, often in the financial assets of the developed economies, thus completing the cash cycle.

But that’s only a part of the global gusher. The massive trade surplus reaped each year by China — and to a lesser extent by other developing economies — has to be recycled, too. And again, much of this money goes back into the developed economies because even a developing economy such as
China can’t — or won’t, by government policy — absorb all this cash.

Reinvesting this much cash without inflating asset values in some part of the market is probably impossible given investors’ propensity to chase returns.

Second, the globe is at a demographic turning point. Like an individual in middle age, the globe as a whole is in its prime earnings period. Taken as a whole — largely thanks to China and the developing world — the world is a net saver. That saving adds to the global cash flow. But everyone from the
savers (China) to the relatively older spenders (Europe, Japan and the U.S.) feels the need to get the most return on each of those investments. That has produced a global search of any potential extra penny of return and an understandable willingness to underestimate the risk of reaching for that extra return.

And third, with the aging of their populations, the economies of the developed world are slowing, both absolutely and relative to the younger and faster-growing economies of China, India and the rest of the developing world. That may be completely natural in the life of an economy, but that doesn’t mean it sits well with the governments of those aging, slower-growing developed nations. Engineering economic growth and preventing recessions has moved up on the agenda of every central bank in the developed world, whether they admit it or even recognize it themselves.

That means more active efforts to help the economy after a bubble bursts and more willingness to turn on the cash spigot to head off any slowdown.

These underlying trends mean that the boom-panic-boom-panic cycle isn’t going away anytime soon. The world is likely to see another decade or two of positive global cash flows that have to be recycled before aging catches up with the globe as a whole. The search for that extra 10th of a percentage point of return will go on with current or heightened fervor. And any slowing of growth in the developed world will be met with a wave of cash, and, if growth starts to flag in the more developed parts of the developing world, we can expect central banks there to turn on the cash spigot as well.

That cycle, including the panics that scare us so much, is likely to be normal for quite some time.

So how do you live with this kind of financial market?

Three general rules will help:

Watch risk like a hawk. Think about it all the time, don’t ignore it. I think you’ll get the biggest return from studying risk.

Make sure you have the appropriate asset allocation for your risk tolerance. In a market subject to booms and panics, asset classes that don’t move with the market averages will be sources of extra return. Don’t be upset when you get a negative performance from an asset class, sometimes, that the best thing, it’s reducing the risk from an appreciating asset class.

Good and independent management — real honest-to-goodness independent investment management that comes from doing their homework, and have demonstrated this in the past booms and bust is critical.

Lastly, have an sound investment advisor that has a sound intellectual framework. Ignore advisors that have the latest greatest thing!

So, I hope it is like 1987 and 1998! It will get the speculators out, and leave the real investors in.

Rational

A great article in the Financial Post about the problems with a 40 year amortization

40 YEARS OF DEBT

Garry Marr
Financial Post

Saturday, September 08, 2007

CREDIT: Peter J. Thompson, National Post
Mortgages with 40-year amortizations are shaking up the market. Some say they are the only way to afford today’s home prices. Ron Cirotto, of www.amortization.com, calls that “bullshit.” “There are a lot of people buying a house who shouldn’t be buying the house they’re buying.”

Do not pay until 2047. It has a nice ring to it for Canadians seduced into home ownership but unable to afford the price tag that comes with buying property. No money for a down payment? Little cash to make monthly payments? No worries. The Canadian real estate industry has come up with the perfect product — the 40-year amortization.

Instead of planning to pay off their mortgage in 25 years, Canadians are now turning to products that give them at least an extra decade to pay their debt — subject to massive interest payments over the course of a loan.

Benjamin Tal, a senior economist with CIBC World Markets, says the change in the way Canadians pay off their mortgage is the most significant innovation to hit the industry in almost three decades.

“This has happened in just the past 16 months,” says Mr. Tal, who doesn’t believe the changes are necessarily bad for consumers or the housing sector.

In addition to lengthening the amortization period, the Canadian market has also been recently introduced to interest-only loans and zero-equity mortgages. Consumers can effectively borrow 103% of the value of their home because borrowers tack the cost of mortgage insurance on to the total loan value.

Mr. Tal, who is the process of compiling a report on how the new products have changed the market, says interest-only and zero-equity loans are probably less than 1% of new business. It’s the long-term amortization that has caught everybody’s fancy.

What he finds amazing about the shift towards paying off your mortgage way ahead in the future is that it has occurred almost overnight, even though this is not the first time banks have tried to attract consumers with longer amortization periods.

“They were available in the early ’80s and nobody was interested. The attitude toward debt is totally different now,” says Mr. Tal, who adds his study will show a “significant” amount of new money is geared toward that 2047 mortgage-burning party.

Those extra 15 years of mortgage debt will cost Canadians. The Canadian Real Estate Association says the average sale price of a home was $311,495 in July. If you bought that house with 0% down and a 25-year amortization, the total interest would end up being $277,993 over 25 years, based on monthly payments and an interest rate of 5.85%, a typical discounted rate today. Extend the amortization period 40 years under the same terms and you end up paying $488,116 in interest –more than the price of the house.

Paying that much interest is just throwing money away, says Ron Cirotto, who runs the Web site www.amortization.com. He has spent years trying to convince Canadians to pay down their mortgages and can’t wrap his mind around the new amortizations.

He laughs at the suggestion the 40-year amortization is giving Canadians more flexibility when it comes to making lower monthly payments. “I’m not sure you can call it an advantage to pay interest for another 15 years,” says Mr. Cirotto. “To me it’s bullshit. The best way to save money is not to have any mortgage.”

He has an answer for the people who say the only way they can buy a house is with a 40-year amortization: Don’t buy a house! “There a lot of people buying a house who shouldn’t be buying the house they’re buying. They need to buy a smaller house. People turn down their nose at smaller houses. They need to lower their expectations.”

Much of what is happening in Canada has been lender-driven, agree many in the industry. The preferential loans terms are a by-product of increased competition from mortgage insurers and financial institutions.

In Canada, anybody with less than a 20% down payment on a home (the federal government reduced the requirement from 25% earlier this year) must get mortgage insurance if they are borrowing from a financial institution covered under the Bank Act. For years, the billion-dollar mortgage insurance market has been controlled by Crown corporation Canada Mortgage and Housing Corp. and Genworth Financial Canada, but this year the federal government allowed AIG United Guaranty Mortgage Insurance Company Canada to enter the market. Two other companies have applications to join the field.

Brian Bell, vice-president of corporate development with AIG, says there is little doubt his company’s move into the marketplace shook things up. “We hadn’t seen a lot of product innovation in a long time. This [past year] was a point of time where there was a lot of opportunity to bring new products to the marketplace,” says Mr. Bell, who estimates half of the new mortgages his company insures have amortizations of 35 or 40 years.

He says in today’s market, where housing prices are up 10.6% in the first seven months of the year compared with 2006, consumers have little choice but to stretch out their mortgages. “The 40-year amortization is the only way to get people qualified.”

He doesn’t believe the new loan terms will mean Canadians buying now can expect to be finally paid off in 2047. “The average Canadian pays very quickly,” says Mr. Bell. He notes most Canadians pay a mortgage with a 25-year amortization in 12 to 14 years by increasing their payments once their incomes rise. He figures the mortgage with a 40-year amortization will probably be paid off in 20 years.

While people in “tight spots” are using the new products, Don Lawby, chief executive of Century 21 Canada, says the Canadian market bears no resemblance to the United States and its subprime scenario.

For instance, says Mr. Lawby, who also owns a mortgage company, few consumers have loans with balloon payments. These types of mortgages require almost no payments over the first couple of years, but a one-time balloon payment later on.

For people taking that type of mortgage, the hope is that prices will rise and they will cash out on their home — and pay down any debt — before any balloon payment is due. Instead, housing prices in the U.S. are falling and consumers unable to make the huge interest payments are defaulting on their loans. Because those loans were so risky to begin with, they were only sold in the U.S. subprime market, which has since imploded.

“That’s significantly different than the products available in Canada,” says Mr. Lawby. He adds even zero-equity loans with 40-year amortizations are hard to come by.

Yet, the biggest difference between the two markets is that Canadian borrowers usually plan to live in the home they buy. It’s not just an investment property.

“We’ve never seen, in my 33 years in this industry, what’s taking place in the U.S. I’ve never seen lending practices like they’ve had the past three years. Much of it was second and third investment property,” says Mr. Lawby. “We’ve lent money to people with 5% down, but we’ve been doing that since the 1970s. We’ve gone through periods where house prices dropped in 1989 to 1993. There were foreclosures but it wasn’t dramatic.”

—

MORTGAGES BY THE NUMBERS

$311,495

The average sale price of a home in July, according to the Canadian Real Estate Association.

$277,993

The interest on a $311,495 house with 0% down and a 25-year amortization, based on an interest rate of 5.85%.

$488,116

Extend the amortization period 40 years under the same terms and the interest paid is more than the price of the house.

Rational

While short term the markets may remain volatile, it’s important for investors to remain focused on the things they can control, which includes the quality of their investments and the diversification of their portfolios. Short-term issues will come and go, but quality and diversification above principles will be key to reaching your long-term goals in our view.

As expected, the Bank of Canada left interest rates on hold at 4.5% after raising rates in July. However, the Bank changed its wordings regarding future rate increases. In the past, the Bank noted that given the strong economic conditions, future rate increases may still be needed to contain inflation. With the current issues in the credit markets, the Bank noted that this could lead to slower economic growth, and ultimately decided it would be prudent to leave rates unchanged. Thereby implying that future rate increase may not be in the picture.

If there’s one positive in this week’s market action, it’s that the sell-off isn’t any kind of mystery. The market endured numerous days in August when stocks were sold indiscriminately because of vague rumors of hedge fund problems, subprime blowups and frozen credit-market assets, forcing investors to dump what could be sold - highly liquid equities.

This week? This week there was a terrible US jobs report, and it has people thinking more about the possibility of a recession, so investors were selling stocks. And it comes at a time when the collective mind of the markets were already abuzz with nervousness. Six months ago this same report probably wouldn’t have any effect on the market, but when the market is skitzo anything like this is going to send it for a spin.

Investors reacted to news that the U.S. economy lost 4,000 jobs in August - the first monthly drop in payrolls in four years.

Employment figures for the previous two months were also revised downward by 81,000 jobs.

Let me see, the population of the US is around 300 million, 4,000 jobs were lost, - No kidding – Real Estate is down, therefore the construction industry is down – what did you expect, of course there would be job losses. Who were the bozo analysts that didn’t expect job losses (They were the one’s working at the brokerage houses – trying to pump up how good things were)

4,000/300 million = 0.001% - freakin insignificant – can you hear me laugh.

Even if it was 4,000 per month it would only by 0.016% of the total population

Not a reason for the markets to panic. But then, when people are panicking any excuse will do.

With so much of Canada’s economy linked to what happens in the U.S., the Toronto stock market also fell back, even though Canada’s job report for August was stronger than expected.

That greatly boosts the likelihood of an interest rate cut of up to half a percentage point by the U.S. Federal Reserve on Sept. 18.

Normally, the prospect of lower interest rates would boost the market. But the depth of the weakness underlined by the jobs report had some whispering the “R” word - recession - and that led to selling as soon as the markets opened.

However, a negative jobs report doesn’t necessary portend a recession. A negative non-farm payrolls report has predicted twelve of the last four recessions.

What’s needed is for the US Fed’s to put a message out there of reassurance that they still know where the economy’s headed.

And that may involve letting down the markets, possibly by not cutting rates as aggressively as some investors now expect.

I think the market’s going to be disappointed with what Fed does in September; they’ll only do a quarter-basis-point cut this month, while the markets want half a percent.

Yet this bull market might not be over. The stock market is having a difficult time digesting the news from the subprime-mortgage market; the oscillations in the credit and money markets, and now, Friday’s surprisingly bad report about August employment

The big fear on Wall Street is that the growing mess in the mortgage market may trip up the second-longest uninterrupted bull market in history, after the run-up from 1990 to 1997. But would that be so terrible?

There have been 10 official bear markets [a drop in equities of at least 20%] since 1946, based on the S&P500 index [and 23 bear markets over the last 80 years]. Those last ten plunges, on average, have erased nearly a third of the market’s value over 490 calendar days, according to S&P. Even worse, the market has needed an additional 669 days, on average, to make up those losses.

But what if the market sell-off doesn’t go that far? Since 1928, there have been 87 corrections [a loss of 10% or more], according to a recent tally by Ned Davis Research. That works out to slightly more than one a year, though since the end of World War II, there have been significantly fewer such downturns. So a correction of 10% a year should be expected. Notwithstanding these 10% corrections, the markets have progressed further up.

More important, corrections are far less destructive. For instance, since 1946, corrections in the S&P500 have driven down stock prices by about 14%, on average. Given that equities are already off by about 5% since July 19 - and have fallen as much as 11.9% if you count intraday highs and lows for the S&P500 - the market may have already sustained a good percentage of its potential losses. (Again, this is if we’re headed for a correction and not a bear market.) Historically, corrections have lasted only about a third as long as bear markets. In fact, the 16 corrections in the S&P500 since 1946 have lasted an average of only 148 calendar days. And several recent corrections have been far shorter.

For example, the three corrections in the late ’90s - in 1997, 1998, and 1999 - lasted only 51 days, on average. By comparison, the sell-off that began on July 19 is already 45 days old. Since 1946, it has taken the market just 111 days, on average, to rise to pre-correction levels. So it’s about eight and a half months total on the way down and then back up. One of the most opportune times to add is at the mid point.

There are a lot of things that are good in todays markets as compared to other corrections or bear markets. We have low stock-market valuations, healthy corporate fundamentals and negative sentiment signals, such as high put-call ratios, which usually are a contrarian signal. Also, positive technical signals abound, including insider buying..

Stocks are trading at 15 times forward earnings, and their attractiveness compared with a 10-year US Treasury’s yield below 4.5%. This suggest that a rout in the broader market is unlikely under all but the most dire economic circumstances.

Investors should take some comfort in that, given that they are supposed to be in equities for the long term. At the very least, the speed at which markets historically recover should give investors confidence not to react so hastily to the current troubles.

To be sure, no one is wishing a correction on this market. But corrections are a healthy means of relieving the excesses in the market and of restoring a healthy respect for risk. That has already happened in this sell-off. Over the last month, shares of high-quality blue-chip domestic stocks have held up better than small-cap stocks. And mutual funds that invest in the stable developed markets of have lost less than funds that invest in emerging-market stocks.

Whether or not we’re technically in a correction, a sell-off of this magnitude was long overdue. It’s been about four and a half years since the last correction. The last official correction was from Nov. 27, 2002, to March 11, 2003. Over that short period, the S&P500 slumped 14.7%. But that correction, in particular, offers investors a good lesson. Even though you may be scared to stay the course amid rising volatility and falling stock prices, keep in mind that corrections can shift back into bull markets just as quickly as bulls slip into corrections.

What are we to make of all this? One obvious conclusion is that focusing too intently on the day-to-day gyrations of the stock markets can be damaging to your health, both mental and financial. Anyone who makes hasty sell decisions in the midst of a mid-day market slide is likely to regret it later, perhaps within hours.

The more fundamental lesson, I suggest, is that if you have a sound plan stay with it. I know its tiresome to keep hearing that good companies are still good companies, even when their share price drops, but its true. The Banks are down from their June highs. Does that mean they are on the skids and you should get out fast? Hardly! The same could be said of many other blue-chip stocks.

Please don’t misinterpret my words. I am not advocating complacency. Quite the contrary. I expect the market turbulence to continue for the next few months and I would be amazed, and delighted, if the TSX manages to avoid losing ground between now and the end of October. We’re entering into what has historically been the worst time of the year for stocks the financial equivalent of hurricane season, so be prepared.

If you feel that you have a portfolio that can ride out these storms with minimal damage, then sit tight and wait for better times to return. But if you’re even a little concerned about your current holdings and your asset mix, take time now to reassess the situation, discuss it with your financial advisor.

Rational

Paulson warns market turbulence isn’t over yet - Associated Press

September 7, 2007 at 12:51 PM EDT

Treasury Secretary Henry Paulson said Friday that it will take time for financial markets to work through the current credit problems and some companies won’t make it.

Paulson said he has seen some “modest improvement” since the credit crunch hit with full force in mid-August, but he cautioned that there would be more bad news to come.

“There will be news that isn’t always good news. There will be some organizations that won’t make it. There will be some losses,” Mr. Paulson said. “But I feel quite strongly, we have a resilient economy and we are going to work our way through it.”

Mr. Paulson, who was the head of investment giant Goldman Sachs before joining the administration a year ago, said that he had seen a number of periods of market turbulence stemming from increased fears about credit quality, citing 1987, 1994 and 1998 as the most recent examples.

He said the biggest surprise may be how long it has been since the last such turbulence in 1998 as part of the Asian financial crisis and the near-default of Long Term Capital Management, a big U.S. hedge fund.

“If you look at history, it is not unusual … for there to be turmoil in the markets every five, six, seven years,” he said. “The thing that is sort of unusual is how long it has been since the last period of real turmoil which was 1998.”

[Rational - the above line was the key line to re-read. This happens and it happens often!]

Former Federal Reserve Chairman Alan Greenspan said in a Thursday speech that the current market turmoil was in many ways “identical” to periods of market turbulence in 1987 and 1998.

“The behaviour in what we are observing in the last seven weeks is identical in many respects to what we saw in 1998, what we saw in the stock market crash of 1987, I suspect what we saw in the land-boom collapse of 1837 and certainly the bank panic of 1907,” Mr. Greenspan was quoted by the Wall Street Journal as telling an academic conference.

Asked about those comments, Mr. Paulson said there were “obviously some similarities” to the market turbulence in 1998 and 1987.

Mr. Paulson, interviewed on the White House lawn by Bloomberg Television, said the loss of 4,000 jobs in August was not entirely surprising after 47 consecutive months of job gains.

But he said a strong underlying economy and a strong global economy should help the United States avoid a recession.

Rational - there you have it, the head of US finances, tellling you , it’s normal, it’s happened before, and they will avoid a recession - the skeptic in me says - What-did-you-expect-him-to-say! Of course he’s going to be gung-ho! But atleast he admitted that there’s more volatility

I found this a very interesting read. It was from this weekends Sept 08 Financial Post, and written by Dr Livio De Matteo, Professor of Economics at Lakehead University - a very smart guy!

Here it is

The recent global stock-market drops, combined with the news that median housing prices in the United States have declined for the first time in decades, have created grave concern. Nevertheless, these events are not that unexpected. After a decade of low interest rates, it is no surprise that investors poured their money into real estate and the stock market. Given the global economic boom and the threat of inflation, it was only a matter of time before credit began to tighten and prick the growing bubbles in real estate and stocks. In the case of the United States, the proliferation of low quality debt via the sub-prime mortgage market aggravated the prospect of rising rates. Not raising interest rates in the foreseeable future may stave off pain for a little while longer, but the end of cheap credit is near.

While the tumble in global stock markets affects Canadian investors too, to date our housing market has continued to exhibit strength. However, Canadian housing prices over the last decade have risen to the extent that we may also need to be concerned, given interest rate trends. In Canada, the average MLS residential price rose from $150,720 in 1995 to reach $249,311 in 2005 — a 65% increase. In many cities, the price increases are so steep that homeowners are experiencing massive wealth effects as their homes appreciate, while first-time buyers are increasingly unable to afford a home. In Toronto, the average MLS residential price rose from $195,311 in 1995 and reached $336,176 in 2005. In Calgary, the average MLS residential price rose from $132,114 in 1995 to reach $222,860 in 2004 and $250,832 in 2005. In 2006, it has been estimated that average prices shot up a further 37%. Winnipeg had an average house price of $82,994 in 1995 and by 2005 had an average of $137,263 — a percentage increase that matched the Canadian average.

The lowest interest rates in 40 years fuelled this boom, and as prices and mortgage sizes have risen, financial institutions have “helpfully” come up with new affordability strategies, such as putting only 5% or even a zero down payment and extending amortization periods beyond 25 years. Despite the advertising enticements that maintain we are richer than we think, the fact remains that the road to debt, like the road to hell, is paved with good intentions. In the United States, the housing boom has peaked and prices have begun to come down, not only in local markets but nationally, which, combined with the huge mortgage levels, bodes ill for the average American homeowner. In markets like Toronto, the cost of household debt servicing– that is, the share

of gross pay accounted for by mortgage payments, property taxes and heating costs — is in the 40% range, which limits discretionary spending.

Another interesting measure to examine the sustainability of the housing boom is to borrow the concept of the price-earning ratio from stock markets. A price-earnings ratio is the ratio of the price of an asset to its earnings flow. The lower the price-earnings ratio, the less you are paying for an asset relative to what you can earn from it. In the case of housing, a crude P/E ratio can be constructed by taking the average MLS residential price and dividing it by the average annual rent for a two-bedroom apartment. Rent is a measure of the potential cash flow from the housing asset. What the P/E ratio does is relate the market valuation of the worth of the housing asset to the actual income or return that the asset can generate. If market valuations of housing prices are related to the income flow, then the ratio should stay constant, but if prices become disconnected from income, then the ratio should change fairly dramatically. Declining P/E ratios can represent undervaluation, while rising P/E ratios can represent overvaluation.

For example, in Toronto, the residential housing P/E ratio remained at about 20 from 1995 to 2001 and then jumped to 27 by 2005. Calgary’s P/E ratio was about 19 from 1995 to 2000 and then jumped to 26 by 2005, suggesting the Calgary market may also be over-heated. These markets both pale in comparison to Vancouver, which already had P/E ratio of 31 in 1995. This actually declined to a range of 26 to 28, but then soared after 2003 and reached 35 by 2005. On the other hand, in 1995, the residential real estate P/E ratio for Winnipeg was 12 and remained thereabouts until 2003, when it rose to 14 and by 2005,Winnipeg’s P/E ratio reached 17. Even in Saskatoon, the P/E ratio had risen to 21 by 2005.

Does this mean anything? Maybe no. After all, this is only a crude estimate of a residential P/E ratio and many factors affect prices and rents in the housing sector. However, in stock markets, whenever the P/E ratio for the market has risen substantially above 25 there has often been a correction, meaning a sharp drop in the prices of shares. The P/E ratio for Canada as a whole is about 28, suggesting that the real estate market may be overvalued. Overvaluation is less of an issue in markets like Saskatoon and Winnipeg. In light of the turmoil in the U.S. economy and the tightening of credit markets, which foretell a rise in interest rates, the question is not if but when the housing boom here will end.

Okay, now you have been warned - But, many of you will ignore this and carry on as if you are smarter than this dude!

Rational

We are once again getting whacked across the side of the head, it seems like this market is trying to teach us lessons that they tried to teach before, but many ignored them.

Here are the main four lessons as I see them

1. Limit your investment to exciting but risky investments.

In recent years, investors have become infatuated with fringe sectors like emerging-market stocks, emerging-market debt, commodities, gold, oil, hedge-funds and junk bonds. There’s nothing wrong with having a small stake in any of these investments. But think long and hard before allocating more than 5% of your portfolio to any one of these sectors.

2. Your asset allocation mix should fit your risk tolerance.

Every investor should have exposure to the good Canadian equities with sound fundamentals, to high-quality bonds and to developed foreign stock markets. These three core holdings should probably account for 70% or 80% of your investment portfolio, and maybe more. How you divvy up your money among these three core holdings will depend on your tolerance for risk and your need for returns. That brings us to another lesson that gets driven home every time the market tumbles: There are, within reason, no bad investment mixes — just investors who can’t live with them. In settling on your target percentages, think about what mix you can live with when markets turn volatile. Don’t just look at the upside.

3. Being too confident and cocky hurts returns.

Investing is always an uncertain enterprise. Yet many investors are regularly able to shed all self-doubt and make the most outrageously bold investment bets - More Oil, since it’s going to $100, and Iran’s going to bomb the world! More Canadian resources, because China will increase their demand for Canadian resources forever! More Indian and Chinese exposure becasue these two coutnries are so fiscally prudent, and have the best accounting systems in the world!. In early 2000, investors bought tech and ended up as Wall and Bay Street road kill. A few years later, many people were absolutely certain that the stock market was a loser’s game. Then share prices came roaring back. By 2005, folks were adamant you couldn’t go wrong with real estate in the US and even today Real Estate in Canada is a no-lose proposition. Today, many condo flippers in the US are suffering the consequences and REITs have taken it on the chin. The markets are trying to tell us something here — and they aren’t telling us to chase performance. The message: Not only do we need to think about risk as well as reward, but also we shouldn’t be nearly so confident in our superhuman predictive powers.

4. Remember the fundamentals.

When investments are hot, it can seem like there’s no limit to the possible gains. Yet there are always limits, like I’ve said countless times, trees do not grow to the sky, economic fundamentals always win out in the end. The broad market’s share-price gains frequently outpace the economy’s growth rate over the short run. But unless investors are willing to pay higher and higher price/earnings multiples for stocks, that can’t go on forever. Home prices can climb faster than household incomes. But that isn’t sustainable over the long run.

Learn these Lessons well, because if you don’t you’ll be taught them again and again, and again.

Have good investments with sound fundamentals
Have a mix of equities and bonds based on your risks assessment on a worst case scenario
Don’t change that mix, rebalance back to it often
Stop being cocky just something did well.

Rational