Rational Advisor

Santa didn’t bring much in the way of good cheer to the markets in 2008.

Financial markets have, of course, been very bad this year, so investors knew ahead of time that there’d be coal under the tree. But even a lump of carbon actually has some value, and stocks have lost around 40% of theirs this year.

Let’s face it. This bear market started as the perfect storm of popping bubbles—commodities, emerging markets, hedge funds, and real estate.

The S&P 500 is on track to finish the year down 41%.

Meanwhile, the Dow Jones Industrial Average down about 36% for 2008.
The Nasdaq down 42% so far this year.

The TSX of almost 40 per cent from the beginning of 2008, led by steep declines in resource stocks as demand tanked for oil and metals. Adding to the carnage, financial stocks tumbled as banks and insurance companies scrambled to deal with a string of write downs connected to the collapsing U.S. housing sector.

From its high in June when it was all about Potash Corp and RIM, the TSX is down almost 50 per cent from high to low in 2008. So do you really want those ETF’s and index funds now? How abou tthose lower MERs did they help when the markets came down. At least balance funds didn’t fall as much. many only as half as these ETFs.

Losses accelerated in the final quarter of 2008 after U.S. investment bank Lehman Bros. was allowed to fail, making banks even more hesitant to lend, instead focusing on boosting their own capital levels.

Tougher credit conditions helped pushing the big North American auto companies to the brink of bankruptcy by year end.

But the downturn also affected the so-called safe or defensive sectors that investors have turned to in the past to ride out severe downturns.

For example, utilities fell almost 30 per cent while consumer staples lost more than 10 per cent on the year.

There really was almost nowhere to hide,

The best companies were those that sold things cheap - In the US, like Walmart- discount retailer, Family Dollar Store-discount retailers, General Mills - Cereal, Autozone- Capr parts (people preferred to repair their cars instead of buying new ones), Biotech- Amgen, Celgene.

The Losers were primarily financials with the biggest exposure to mortgages.

What we are seeing is the downside of globalization, a synchronized recession in the developed economies, so we’re seeing that the U.S., Europe, the U.K. - they’re all deep into recession leading to other economies being impacted China, India etc. So much for the advantageous of globalization! You’d almost wish there was no globalization, and that each economy was segregated from the others.

Selling pressure could continue in January if, for example, more hedge funds are revealed to have invested with Madoff (Made-off) and skittish investors pull their money from those funds, Day says. In Canada, we have a mini-Madoff type hedge fund scenario in Sextant hedge funds. They seem to have about $90 million missing - I got concerned about this fund when it showed up on top performing charts at Paltraks, Morningstars and in the papers.

Even Cerebus, the hedge fund that bought 80% of Chrysler and lost 16% for the year, has announced that it will at a certain time stop people from withdrawing their money

Even more reason to NOT deal with Hedge funds until the appropriate legislation and rules are in place. I am pretty sick and tired of hearing about these IED
s (Improvised Explosive Devices) of the investment world killing innocent people. Yes, the are IEDs.

Both jobs and consumer spending have been a particular concern for investors. The more people lose their jobs – or fear they will lose their jobs – the more they close their wallets. And consumer spending accounts for more than two-thirds of U.S. economic activity.

The hope now is that forward-looking stock markets will sense an end to the downturn around mid-2009, after big stimulus packages pre-emptively announced by U.S. president-elect Barack Obama take hold.

We may well see the first glimmer of a recovery come from the US. The world needs the US to recover to feel better. US Consumers consume the worlds goods.

Sector wise the recovery may not come from resources, as typically resources don’t lead in the recovery, they’re late cycle performers.

Sectors that are early cycle are typically tech and financials

Techs have had the most cash on their balance sheets, they went through the last crash got all beaten up and had their major lay offs 10 years ago, so they have been a lot more defensive than careful.

They weren’t caught up in the commodity bubble and now they’re leaner, wiser and have some cash in the bank. And when companies need to grow in a challenging market, they don’t do it by hiring a bunch of people, they try to upgrade their technology at the outset.

Financials will be the other key group to watch.

There’s not too much risk of a dividend cut. The strong one’s aren’t going out of business. The banks have an incredibly profitable business model. They just charge higher fees to get out of their messes

Recently we’ve seen a lot of sparring between the Canadian Banks and the Canadian government. The government saying that the banks are not lending as much. I’m on the banks side in this sparring. Banks have demonstrated that they have increased their lending, and yes they are charging more for it - notice RRSP loans are now at Prime and Prime plus one, also variable rate mortgages are prime plus. The real issue, is not their lending, but that demand for loans has come down. Because of this slowdown, less people are buying large items that require financing - like houses and cars. So, it really isn’t the banks fault. If the government wants the banking sector to get better, they had better make it conducive for employers (lower property taxes, incentives etc) to come into Canada and provide more jobs.

Another good thing for investors is that because of a miserable 2008, many people will not want to be in equities, the fear of a repeat is to great for them, they’ll run to GICs etc paying 2%. This is great for investors because it means there is less volume and competition to buy good sound businesses

“Financial markets, however gingerly, are starting to look ahead to a better, if not yet glorious, summer,” CIBC World Markets economist Avery Shenfeld wrote in a recent note to clients.

Fear and uncertainty might lead investors to sell their investments during tough times, putting downward pressure on prices. Trading based on these emotions can be detrimental to a portfolio’s value. By selling during downward price pressures, investors might realize short-term losses. This is compounded as investors wait and hesitate to get back into the market, possibly missing some or all of the potential recovery. The lesson here is that patience can pay dividends. And also Diversification is always important.

One of the main advantages of diversification is reducing risk, not necessarily increasing return, over the long run. While stocks offer the potential for higher returns, the downside risk can also be extreme. A diversified portfolio can help mitigate such extreme swings in value.

Where do we go from here? Probably not lower, in our opinion. We are beginning to see some calm in the markets, as more and more bad news has less and less affect on the markets.

This is the 16th bear market since 1929. Its more-than-50% decline makes it the worst bear since 1945, and the third worst since 1929. But when this bear market finally ends, history says be prepared for a fast and furious partial recovery. In the first 40 days after establishing a bear-market bottom, the S&P 500 has traditionally recovered an average 33% of the point loss experienced during the just-ended bear market.

(source: S&P Analysis) Since November 20th the low, the S&P 500 is up 21% from that point - only once since 1939 has an increase of 20% from a low gone back down (2001-2002, because of 9/11 following the tech crash).

Should Nov. 20 end up being the low for this bear market, S&P Analysis team believes 2009 may end up being a fairly good year for stock returns, if history is any guide. During the first year of a new bull market since 1932, the S&P 500 rose an average 46%. What’s more, the “500″ recovered more than 82% of the prior bear market’s loss, on average, in that first year. They can’t guarantee that the market will respond the same way this time around, but successful investors look at history—and history points to a sharp advance in the first year of a new bull market.

The magnitude of the decline is one of the reasons they believe a bear-market low may have been put in place. The 52% decline is within earshot of the 54% falloff recorded in the 1937-38 bear market—the second worst since 1929. The largest peak to trough decline was 89% recorded from 1929-32.

The S&P 500 fell by more than 20% eight times since 1900. It rose in six of the subsequent years, posting an average advance of 10.4% in all occasions. You have to look to 1931 and 1932 for the exceptions.

This bear market retraced 103% of the advance during the 2002-07 bull market. Traditionally, bear markets retrace an average 73% of prior bull-market gains. And those that retrace more than 60% of the prior bull run have taken back an average 110%. The current 103% retracement is close enough.

The S&P 500 was trading at a P/E ratio on trailing operating earnings per share (EPS) of 11.5 times, equal to the lowest operating P/E ratio in the 20 years that S&P has been tracking operating results. It is also a 40% discount to the average operating P/E ratio of 19.3 times since 1988.

Finally, on Dec. 8, the S&P 500 closed at 909.70, or 20.9% above the Nov. 20 closing low of 752.44. Technically, that’s a new bull market. Even though they would prefer to see this level successfully retested before admitting that they are in the beginning of a new bull market, history indicates that only once since World War II (September 2001-January 2002) did the S&P 500 experience a bear-market rise in excess of 20% that was subsequently followed by an even lower low. All other 20% advances were eventually proven to have been the ultimate bear-market low. Again, you have to go back to the 1930s to find exceptions to this rule.

Of course, these are unprecedented times and the rules are being rewritten every day. In all, however, I believe the abundance of positive precedents will likely have some impact on the rational investors

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