Economic turmoil won't alter basics

You may have heard there is economic and political turmoil in Europe. Does this present a buying opportunity for company shares, or is it a sign you should move more money to the sidelines?

Our approach to managing portfolios is based on strategic investment management principles, as you know. This means the mix of stocks, bonds and GICs, and guaranteed short-term investments should be based on your own situation, not on some forecast or outlook for the markets or the economy.

Why wouldn't you base your asset mix on economic forecasts? Because they are wrong more than half of the time, by many measures.

As well, forecasts are generally widely known. In the opening sentence, I joked about the ludicrous idea a reader of this column might actually be unaware of the economic troubles in Europe. In reality, those troubles are widely known, though perhaps not as widely understood.

The rational market hypothesis and other theories of market behaviour suggest market participants are profit-seeking, will make rational investment decisions, and have access to all information at all times. This suggests individual investors cannot gain advantage by having access to exclusive information. There's a lot to be said for those theories. However, there can be big differences in the way people interpret information and the conclusions they draw.

Often "the market" overreacts to bad news or negative forecasts, thus creating buying opportunities. Less often, the market ignores bad news or stark reality, when caught up in excitement and euphoria, as in 1999 and 2000 when technology stocks were bid up to crazy, unrealistic prices.

In all of these situations, there's some truth in the assumptions, but irrationality occurs in the value -- and therefore the price -- we put on those assumptions. Let's look at some current examples.

An isolated, but instructive case in point is the initial public offering of shares in Facebook. Everybody (and by "everybody" I mean radio disc jockeys, taxi drivers and other pundits) said this was a "can't lose" investment.

However, the rational view suggested it was a company with great potential, but no clear plan to realize that potential, and a highly overpriced stock. (Yes, I said this before the IPO, as well.) That's an example of too much optimism blinding judgment.

Now let's look at Europe. Thanks to the uncertainty, bailouts, downgrades of debt and the expectation of recession, stock prices around the world are generally low in historic terms, based on the measurement of price to earnings. This is the share price the market is willing to pay for each dollar of sustainable corporate earnings.

Stock prices are much lower today than they were in 2007, even though corporate profits are higher, due to market pessimism. When less pessimism prevails, prices will rise, even if profits do not.

At the other end of the spectrum, U.S. government bond prices reached a record high two weeks ago, as measured by historically low interest rates on those bonds. This means the market is willing to pay the highest price ever for the asset that it considers low risk. Good value?

The strategic approach to portfolio design says you should be measuring and rebalancing back to your target investment policy. This is your target mix of short-term investments, bonds and GICs, and stocks, based on your family need for liquidity, income from the portfolio, your time horizon and your risk tolerance.

Low stock valuations and healthy corporate balance sheets would support this approach. For a good argument in favour of owning and even buying stocks, search out an article called Equities: the most despised asset class is poised to surprise, by Tom Bradley at http://bit.ly/KXyqPr .

On the other hand, the tactical approach would ask, "Has the market really priced in the economic and financial fallout that might occur from a government debt default in Europe?" My gut feeling is no, and stocks will become cheaper before they recover to their true value.

While I support the strategic approach that is based on your own situation, my advice is if you think you will chicken out if things get worse in the short term, now might be the time to adjust your strategic target mix to put more money on the sidelines. On the other hand, if you are looking at a five-year or longer time horizon, stay the course.

And on that cheery note, have a great weekend!

David Christianson is a fee-for-service financial planner with Wellington West Total Wealth Management Inc., a portfolio manager (restricted).

dchristianson@wellwest.ca

Republished from the Winnipeg Free Press print edition June 15, 2012 B9