It’s been a long, hard slog through the dark night of 2008. Our global financial Golconda collapsed into a wasted heap of trashed returns and shattered expectations, and millions of people are readjusting their retirement expectations just as the world recession is beginning to hit Canada.
Can it get any worse? Probably not. And that just might be the best news out there.
That it’s always darkest just before dawn is a hoary old cliché, but it also kind of happens to be true. We suffered through the stock purge that was the Great Deleveraging of 2008, and businesses and consumers are continuing to navigate a nasty downturn in the real economy. But the fact is, investors also have to ask when markets — overreactive beasts by nature — will eventually, by necessity, become a buy.
Keep in mind the forces working to generate a recovery. Central banks have already applied an unprecedented level of stimulus to the economy, not only through rate cuts but also through the “quantitative easing” of money supply that Federal Reserve chair Ben Bernanke has undertaken. The inauguration of Barack Obama, meanwhile, signals much more than a cultural shift in America: the incoming administration is now promising to create four million jobs, which would do much to buttress consumer spending. Here in Canada, the government is expected to bring down a budget containing significant stimulus measures that might help restore market confidence. Patricia Croft, chief economist with RBC Global Asset Management, expects Ottawa to drop $30 billion worth of stimulus into the Jan. 27 budget.
And what about all that cash stacked up on the sidelines? Almost 40% of mutual fund assets in the United States are in cash and short-term T-bills. That suggests the big flight to safety has been fully booked. Even as inflation plunges, investors are losing money as bond yields hit 50-year lows. There could be a natural pressure building to move that money back into riskier, higher-return assets. And so while the real economy crumbles, some of the latest talk on the street is that if everything goes according to plan, then maybe stock markets are looking through the recession and getting ready for a bit of a boom. “It’s important to remember that there is a difference between the financial economy and the investment markets,” says David McCaslin, senior vice-president of asset strategy at Greystone Managed Investments Inc., based in Regina. “The market always recovers before the end of a recession, and this time won’t be any different. We think this is going to be sooner rather than later.”
McCaslin is not alone in that assessment. It’s worth remembering at times like this that the market is a massive forward-discounting mechanism. That is, prices reflect not today’s corporate earnings environment, but estimates of stock values some months out. The consequence is that stock markets historically begin turning anywhere between four and 14 months before the end of a recession. If a real economic recovery gets underway — say, as early as the second or third quarter of this year — that could mean we’re in the opening phases of a new bull market already.
Swiss investment bank UBS recently suggested as much in a report that pointed out stock market “valuations have fallen too far,” and that price-to-equity levels have fallen 40%, leaving them appropriately valued for a boom. Jeff Rubin, chief economist and market strategist for CIBC, agrees. He thinks markets are getting set for a big upswing through 2009: “The bad news is that we are in a recession, and a fairly deep one at that. The good news is that the stock market has already discounted a depression.” Rubin is calling the S&P/TSX composite index to finish the year above 11,000, which would represent an upsurge of about 26% from its mid-January value.
That would certainly be a relief to those who have suffered terrifying losses in stock portfolios across all sectors and industries — wiping out years of returns. The question is, how can an investor tell when markets are pricing in a sustainable recovery? Is there any way to know when to get in, yet avoid catching the proverbial falling knife?
Sadly, no, says Myles Zyblock, chief institutional strategist at RBC Capital Markets. Accurate market timing is a rough game, prone to missed calls. How do you know, for example, if the market is turning up four months before the end of the recession, or eight? You don’t. What you can do, says Zyblock, is keep an eye on indicators like the Institute for Supply Management manufacturing index and the Conference Board’s index of leading indicators, which track changes in economic output. By focusing on shifts in the real economy rather than movements of asset prices, investors can be more confident that any rally they’re buying into is a real one, and not another false start. “There is more insurance built into this than any market signal,” Zyblock explains. “If you were reacting to market signals [asset prices] alone at any point through the last year, you could have been pulled into the market on several occasions.”
Zyblock says he likes these so-called real indicators because they are released monthly, they have good track records and their data sets both go back a long way — 60 years in the case of the ISM. That means there are historical patterns to discern. And while the ISM can sometimes be “noisy” — that is, it can jump around month to month, giving a false positive signal — it can help give you a handle on the real signal when it’s overlaid with the Conference Board index, which takes in 10 different economic measures. “When both of these indicators are going up, it’s a sure sign the real economy has bottomed,” says Zyblock.
Even though they are leading indicators, investors who wait for them to turn upward will likely miss the early part of a market recovery by two or three months. But what you gain is the confidence you’ve likely avoided another false start. “I’m willing to give up some upside for downside protection,” Zyblock says. “Maybe the market has stopped going down. Maybe a new low was set Nov. 20 — let’s hope that’s the case. But the stock market remains at risk until things in the real economy begin looking up.”
As it is, the ISM is still plummeting — it dropped again in December to its lowest reading since 1980. World trade is still falling, and we’re only now getting into the bloody slaughter of corporate earnings that is bound to follow the remarkable slowdown in the economy in the last months of 2008. The growth rate of the real economy is still collapsing. The latest Canadian jobs report showed the unemployment rate rose to 6.6%, while some economists suggest the recession is just hitting Canadian shores. So significant risks likely remain. Zyblock suggests a sustainable stock recovery is still at least six months out. “There is no hint of a recovery in either one of these indicators yet,” he says.
So what to do? Take the risk and jump in now for big gains, or wait for the real economy to show positive signs of a recovery and play it safe? If you’re too shell-shocked or embittered to try to time the market, then consider this sage advice from Bill Wheeler, a longtime money manager and chairman of Vancouver-based Leith Wheeler Investment Counsel Ltd.: “I don’t think there is evidence that market timing works. We called it right back in the ’80s, and we were really pleased with ourselves. But when we looked back on the numbers, we found out that we would have made just as much staying invested all the way through the cycle. That was a real eye-opener. There is a lot of cash on the sidelines. Stay invested and enjoy the upside.”
The good news is that when a market recovery comes, be it sooner or later, it should be healthy. Sure, we may see problems later in 2010 or 2011 if interest rates rise. But that’s another story. For now, Wheeler suggests valuations on a price-to-book and price-to-earnings basis are generationally cheap. “I’ve only ever seen valuations like this a couple times in my career,” he says.
And that could be the best news of the year.