Newsletter March 4, 2007

InvestorsFriend Inc. Newsletter March 4, 2007

Recent Market Action and Direction

Stock Markets world-wide suffered a noticeable decline last week. Closer to home, the TSX was down 3.7% and the Dow Jones Industrial Average was down 3.3%.

No one likes to suffer losses but in the grand scheme of things this was not a big market decline at all.

Those who are not stock investors might be feeling glad that they missed out on this week’s pain. But if they realize that they also missed out on the the huge increases in the stock market indexes over the years, they might not feel so glad.

For those invested in stocks the question now is:

(The following is based on what I posted for our paid subscribers on Thursday night)

To Sell or Not to Sell?

With the market “correction” this week most investors are wondering if they should reduce their equity position and perhaps at least partly step aside from the markets for now.

This is an tough question and there are no universal answers.

Firstly, no one knows if the market correction will deepen or has already ended.

The S&P 500 P/E (Price divided by Earnings) ratio is 17.2 as of today. That’s above long term averages which might suggest that markets are somewhat over-valued. But with today’s low interest rates a P/E of 17.2 is certainly not grossly overvalued. The market is very unlikely to crash like it did in the early 2000’s. At that time the S&P 500 P/E ratio was around 30 and the market was grossly over-valued.

Factors which could drive markets down include: high oil prices, the market’s moderate overvaluation, terrorist attacks, international market events such as the drop in China’s stock market, lower consumer confidence, declining housing prices, a recession, bank loan losses brought on by lower housing prices and/or recession, lower earnings expectations, higher interest rates, and lower earnings reports (and this is not an exhaustive list).

Factors which might drive the market up include: bargain hunting, continued excess money from inside and outside North America looking for a home, mergers and acquisition activity by corporations, private equity and pension plans taking over companies, continued high or increased consumer confidence, lower oil prices, a recovery in housing prices, continued low interest rates, and the absence of recession (and this is not an exhaustive list).

The market has now risen for four and one half years since it bottomed in late 2002. Huge earnings growth and lower long-term interest rates supported this rise. But now earnings are growing only slowly.

On balance we should not expect a strong year in the markets. A 10% gain is probably the most we should hope for and a 10% drop is perhaps almost as likely. A 20% drop may be unlikely but is not out of the question.

But markets will go up in the long-run. If you pull your money out of stocks you risk missing the possible upside.

Young investors who are just starting out should rejoice that stocks are cheaper. You will be be buying stocks for many years to come and if the market crashes that is simply an opportunity to buy stocks at a better price.

Wherever the market is going to be in five years or ten years, will depend mostly on earnings and interest rates at that time. If the market goes down 100 points tomorrow or goes up 100 points, that does not change where it will be ten years from now. For most investors, who tend to leave money in stocks for the long term, whether stocks are a good investment or not depends more on where markets will be in five or ten years and does not really depend much on where the markets will be in one month or in 12 months.

Any investor with a fully balanced portfolio may want to simply ride out any correction.

Sound advise might be “Don’t just do something, stand there!”

However, investors who perhaps have a very high exposure to stocks given their age and circumstances might well want to sell some stocks now and move some money into cash. And selling now at a point that is several percent below recent highs may still look like a good idea if the market soon happens to correct more sharply.

The bottom line is that I can’t tell people whether they should reduce their overall exposure to stocks or just ride out the dips. That is a very individual decision.

In my own case when the week started I was over 90% in equities. And at 46 I do have some years of saving ahead of me. At the same time I have accumulated enough investments that if I were to take a 10% decline or greater it would be pretty painful. In my own circumstances I felt it was prudent to sell into the correction and increase my cash position.

Thursday morning with the market down almost 200 points (DOW) in the early going I did sell some shares. Possibly I over-reacted, but I simply wanted to get into a reasonable percentage of cash. My cash position is now about 33%.

I think that is a reasonable level of cash. But I reserve the right to move into even a higher cash position if it looks like the “correction” is going to deepen.

I am not in any way in panic mode. I expect there could be volatility and I am prepared to accept losses. At some point the market will bottom (if it has not already) and with a reasonable cash position, I would then hope to Buy at lower prices.

Should Mutual Fund Investors Switch to Using Exchange Traded Funds (ETFs)?

Kathy, a subscriber to this free newsletter emailed me as follows: “recently there have been people on ctv talking about not doing The RRSP thing, the planner of course makes all of the money, they talked about putting their money into indexed funds. I’m not familiar with these, can u elaborate for me. Thanks”

That is a good question, academics and others often suggest that the average investor would be better off to switch from mutual funds to Exchange Traded Funds (ETFs). As Kathy mentions, they argue that the fees are much lower and they also argue that the average mutual fund does not do as well as the index after fees.

For some (but not all) mutual fund investors, ETFs might be a better choice.

But there are lots of barriers to making this switch to ETFs

First, most investors who invests only in mutual funds and not in individual stocks probably do not know what an ETF is. (Like a stock  mutual fund an ETF holds a portfolio of stocks. A key difference is that the stocks are not picked by a manager using judgement of which stocks will do well. Instead, in an ETF the stocks are selected to match some “index” such as the overall Toronto Stock Exchange index or the Dow Jones Industrial Average. The fees are typically very low compared to mutual funds. ETFs trade like stocks on the stock exchange.)

Second, most mutual-funds-only investors would not know which particular ETFs to buy.

Third, the advisors that these mutual fund investors rely on are very often not authorized to sell ETFs (only advisors licensed to sell individual stocks can sell ETFs).

The typical mutual-funds-only investor, in order to invest in ETFs would have to open a self-directed brokerage account (for example, at a Bank). Or they could open a full service brokerage account, although that usually requires at least $100,000 in investments and the fees will likely be comparable to those on the mutual funds.

In this situation the average mutual-funds-only investor really has no practical ability to invest in ETFs unless they first become educated enough, and are willing to spend the time, to make use of a self-directed discount broker service.

InvestorsFriend offers a subscription based stock rating service that can contribute greatly to the needed education.

For more information in how to get started investing in individual stocks or ETFs, see our article on getting started investing in individual stocks and ETS.

For a more detailed discussion of mutual funds versus ETFs click here.

Also as subscribers to this newsletter you can access our exclusive article that discusses the valuation of various Canadian ETFs and gives you their specific trading symbols.

A lesson in risk tolerance

I suppose we all got a bit of a lesson in risk tolerance this past week. Most equity investors would likely claim that they are fully aware that the stock market can easily drop 10% at any time. And they will likely say that they know the market can drop a lot more than that at times, and do so very quickly. But when a loss actually happens, it is hard to take and suddenly we may find that we are not as risk tolerant as we thought.

Personally, I rode out the last major correction in the early 2000’s and it worked out well for me in the long run. But of course afterward I wished I had pulled out some money in the early days of that slide. I lost some money at the time but did regain that and much more since. The market crash of the early 2000s ultimately gave me the chance to invest new money at lower stock prices.

This time I am less prepared to ride out any large market decline. My portfolio is now larger year and it would not be as feasible to make up ground through new investments at the bottom. I figure the best way for me to benefit from any possible sharp market decline this time will be to make sure I have a reasonable weighting in cash now to take advantage if the correction becomes quite a bit more severe which it certainty could.

I raised my cash position quite a bit after the correction got rolling this week. I am now about 33% in cash, whereas traditionally I have been closer to 5% in cash and 95% in equities.

I think this week’s action did put my risk tolerance assumptions to a test. I admit to feeling less tolerant of risk than I have in the past. But by the end of the week with 33% in cash I really don’t feel too bad about this week and I feel I am prepared to take the risk of further losses in return for the rewards that I believe that stocks will ultimately deliver over the years.

Was Any Money Really “Pulled Out” of the Stock Market This Week?

Headlines may indicate that the market fell as investors pulled money out of the market. It is certainly true that some investors sold stocks and moved into cash and therefore pulled money out. But they did not sell their stocks to “the market”. They also for the most part did not sell the shares back to the companies. (There are always some stock buy-backs happening, but that is a very tiny fraction of the stocks sold this week. And any money flowing out of the companies for stock buybacks was probably more than offset by new stock sales by companies including that associated with stock options being exercised). Investors, in the vast majority of cases, sold their stocks to other investors. Therefore the money these investors “pulled out” was matched dollar for dollar by the purchasers putting money in. In aggregate across all investors no money was pulled out of the market. Investors selling stocks does not really result in any net new money “on the sidelines” since other investors bought those shares.

Consider increasing your automobile liability insurance to at least $2 million

If you are an investor then you probably have a positive net worth, which is perhaps considerable. And if you are a young investor your future earnings are worth a lot. The last thing you would ever want to have happen is to lose some or all of your wealth (even your future earnings) due to getting sued regarding an auto accident that you caused.

If the insurance where you live is “no fault” you may not need additional liability service. In Alberta, where I live, I believe that if someone was severely injured in an auto accident, that person could sue whoever caused the accident. And if the damages were beyond the standard $1 million policy, they could sue the driver personally. They might not bother to sue someone with no money, but if the driver had assets or future earning potential they might come after it all.

It’s hard to say how much liability insurance you need on your automobile. But I believe that the standard level has been $1 million for about the last 20 years. In Alberta, the legal minimum you must have is only $200,000.  Two insurance companies told me that the usual maximum available is $5 million. With the escalating costs of long-term care and the possible need for an injured party to use private healthcare, $1 million strikes me as too low. And $5 million may not even be enough. I am in the process of getting an increase to $2 million, which cost me and additional $143 for  two drivers and two vehicles, which I thought was reasonable.

Also I finally decided to consolidate my home and auto policies with one company and the savings from that will be enough to pay for my higher liability coverage.

In summary, if you have $1,000,000 or less in liability insurance coverage on your autos, consider increasing that to at least $2 million. But consult with an insurance broker or company before making any decision.

Consider an Umbrella Policy with your Home Insurance

It recently came to my attention that it is possible to purchase an umbrella insurance option that increases the maximum liability coverage available on your home and auto by an additional $1 to $5 million. Typically, you have to have your home and auto insurance with the same company in order to get this. I am told it also covers liability for your actions that occur in places other than your home and auto and in fact anywhere in the world. I believe that this type of coverage is well worth investigating. Check with your insurance company or agent before making any decision.


Shawn Allen
InvestorsFriend Inc.

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