Credit market turmoil has continued during the first quarter

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Credit market turmoil has continued during the first quarter of 2008, with several more financial institutions being forced to take huge write-offs and raise new capital to replenish their coffers and restructure their balance sheet. Global markets all dropped in unison in the double digits or thereabouts.

So much for the so-called decoupling thesis, which maintained that non-US and emerging market economies would be unaffected by a US slowdown.

The price performance of the main indices is summarized below:

  First Quarter of 2008
  In local currency In Canadian Dollars
S&P/TSX (Cdn) - 3.49% - 3.49%
S&P 500 (US) - 9.92% - 7.49%
Nasdaq (US) - 14.07% - 11.75%
Europe (EUR) - 15.65% - 6.26%
Nikkei (Japan) - 18.18% - 5.83%

The Canadian market has suffered less thanks to the resources components of the index. Metal and oil prices have been strong during the quarter and there is no telling when the cycle might end.

The gold price went through the “magic” $1,000.00 US per ounce and settled down in the $900s. Speculation abound that the gold price will go much higher due to the coming demise of the US dollar.

The Loonie has been stable around par with the US dollar and there is not much new news on that front. The Euro, on the other hand, continues its ascent, reaching $1.60 US.

As we have said before, we are quite skeptical that the Euro would still exist under its current form in the next 10 years. The mounting tensions between the inflation-obsessed German bloc (including Austria, Luxembourg and the Netherlands) and the Latin bloc of France, Spain and Italy would become unbearable: Spain and Italy are unable to lower interest rates now that the boom has turned to bust. Bound by the Euro, they have been watching their economies teetering on the edge of a recession. Rhetoric from the new Italian government regarding this issue gives us a taste of what is to come. Moreover, a recent poll released by Dresdner Bank showed that 62% of Germans support reinstating the Deutsche Mark as the country’s currency. With no shared language, customs, culture and political system, the Euro zone has never really existed except in the minds of bureaucrats and politicians.

Is a recession coming or are we in one?

While it could be a mentally stimulating debate for some, the answer to this question is quite pointless for the following reasons:

1/. Since the stock market is a leading indicator, it would be impossible to profit from an accurate forecast on the state of the economy. By the time we know it’s a recession, we would have been in it for at least 6 months already and since recessions last on average 10 to 12 months, it is very likely that the market is already looking ahead to a recovery.

2/. We have had 16 recessions in the last 88 years, i.e. 1 every 5.5 years. More specifically, there were 14 recessions in the first 63 years and 2 in the last 25. We think that it is wiser for investors to position their portfolios for the 85% of the time when the economy is growing, rather than trying to avoid the other 15% when it is contracting, which cannot be forecasted anyway.

Patience and Discipline

Most investors know by now that success in investment requires a good dose of patience and discipline. However, few realize how difficult it is to stick with these 2 simple notions, especially when the “whole world” (so it seems when we read the newspapers) seems to think we are wrong at times.

At Claret, we have consciously chosen a “value strategy” based on fundamental analysis of financial ratios. We have not reinvented the wheel since academic research papers throughout the last 40 years confirm that it is a market beating strategy. However, there are periods when our model trails the market by a considerable margin because of the market’s “irrational exuberance” (i.e. internet bubble in 1999-2000, commercial real estate bubble in 1989-1990, leveraged buy out bubble last year and in 1988-1989 and maybe the current commodities run-up…(bubble?)). Eventually, the market will start swinging to the other side, disparities in sector valuations will correct themselves and the value strategy will outperform again although trying to pinpoint the inflection point is futile.

Therefore, patience is required to sail through these underperforming periods and discipline is required to stay with a time tested strategy even when it is tempting to switch to a more exciting world. Market euphoria combined with media coverage is like the Sirens in the Odyssey, beautiful voices but horrendous creatures.

Market risk versus investment risk

Investing in stocks might be a whole lot easier if it weren’t for the stock market. The latter’s behavior is so fickle, so prone to sudden mood changes that it confuses the investor as to what they own and why. Consequently, people concentrate on deciphering the market risk (i.e. all these up and down swings) when they ought to be concentrating on the investment risk (i.e. changes in the value of the underlying business that they own).

Short term performance measurements (and we can tell you that a whole industry has been built around performance measurements) put tremendous pressure on money managers to play the market risk game (after all, their pay depends on it). The tremendous increase in trading volumes proves our point. While we are not saying that nobody can be successful in this trading game, we are sure that, apart from a skillful or lucky few, the majority of investors (brokers and money managers included) are better off not playing this game.

An example of market risk versus investment risk will show you how tricky this game is: you have witnessed the sharp rise and subsequent sell-off in the emerging markets since 2006, a typical case of market risk run amok. The investment risk question now is not whether stocks will jump up or down, but whether the long-range bullish economic forecast remains intact for China, India and Latin America. Tough question to answer indeed!

To keep focus on investment risk, one cannot be fixated on short term results and constant comparison to market indexes. Unfortunately, ignoring market risk means that from time to time, performance will be lumpy. Then again, our goal is to outperform on average and over the long run. Isn’t it?

The Claret Team