Born from the Wisdom of Hindsight

Now what can we do given the addition of a world wide credit malaise which has put financial markets in jeopardy and severely depressed our securities investments meant for our financial well being?

As this is written in early February (09) most, if not all of the dimensions of the financial crisis seem quite clearly defined with monetary and fiscal stimulus well underway - such that an ultimate economic recovery is surely in the cards and we should no longer be in a ‘cliff hanger’ predicament.

In fact many vital ingredients necessary to establish a market recovery are in place. We now have a strongly advancing money supply in the US not only replacing system liquidity after dramatic wealth destruction but sufficient to fuel a strong recovery once this monetary expansion ignites. As well, the market has experienced a number of ‘capitulation’ days (‘investors throwing in the towel’) such that most of the selling urgency is spent. The Advance/Decline line (number of advancing stocks over declining) has developed a positive up trend  which is believed will hold comfortably above prior lows in a ‘final event’ of stock market indices testing their November lows which now may be underway.

Indeed to finish the ‘Bear Market’ we just need confirmation by an ‘ignition rally’ of several days accompanied by unusually high volume to formally launch a new ‘Bull Market’ or alternatively we might ease into a new ‘Bull’ with a period of stability by market consolidating sideways with quiet determination to slowly begin to advance signaling a pervasive shift in market sentiment.

“When a stage is reached where all that’s bad that needs to be known is known, then what’s good to be known begins to be known and grows to become well known.”

But what about our poor portfolios?

Well, the best thing to do at a market top is to sell and liquidate almost everything or at least protect positions with ‘stop loss orders’. The worst thing to do during a market bottoming is to sell without replacement. It is prudent to retain cash reserves until completion of the bottom process is confirmed by a second rally after pulling back from that first ‘ignition rally’. Or if no ignition rally, await a rise in long term momentum indicators as mentioned below.

Where individual securities are still in position each should be surveyed as to their ability to recover and attain current targets. Are they ready to participate in return to strength within their industry and how far off is that industry’s recovery and what is the history of participants’ price recovery in advance of the industry recovery.

Stocks that are otherwise perfectly healthy usually strengthen with a return of general market strength and particularly when recovery of their industry is seen to be visible or even felt able to become visible. Therefore, to retain valid viable holdings, and be willing to switch out of those that are not into others that are, is a good strategy as the market bottoms out.

Other than an ignition rally as I have mentioned, there are various confirming ‘momentum indicators’ such as a 200 day moving average turning up after being crossed over by a rising 50 day moving average, or an upturn by the venerable ‘Coppock Curve’ which is a combined front end weighted moving average of an 11 month and 14 month rate of change of a market index. I keep the Coppock Curve up-to-date on my website along with several other  market timing indicators. There are others provided by various websites that you can investigate too.

In regard to adding new income producing positions when deploying your cash reserves there have emerged several senior grade securities with lowered price due to the market’s decline resulting in much higher dividend yields.

As well there will be several good quality income trusts of mature stable companies that will carry on as trusts. My understanding is: while their distribution will be lower in result of the taxable portion of distributions paid by trusts being taxed at the trust level - income less deductions can result in tax very much lower than the nominal 25% corporate rate. Funds remaining for distribution to unit holders will be taxed in their hands in non-registered accounts at the rate applicable to Canadian dividends and hence will benefit from the standard dividend tax credit when legislation takes effect in 2011.

While many trusts will have converted to corporations their dividend payout will remain at an attractive level. Additionally, a goodly number of Energy Income Trust Funds have large ‘tax pools’ available to apply against future taxable income hence will very likely be able to maintain their relatively high payout for several more years beyond 2011. So all is not lost from the attraction of Income Trusts as an investment option.

Relatively new alternatives have arrived in products invested in portfolios of mutual funds that guarantee the highest value attained by the fund during a specified period to maturity... notwithstanding a lower stock market at maturity.

Also, insurance companies have introduced an annuity product that pays based on the higher of highest market value of the underlying fund or total of deposits plus annual bonuses (ranging from 5 to 7 percent).

“No one rings a bell at market tops!” Well, this is not quite true. Actually there are all sorts of bells ringing. There develops a widespread euphoria in all our sentiments reinforced by market commentators. There are a series of ‘corporate takeovers’ of senior companies. Stories of dramatic price rises by several junior mining stocks abound, and often there is a bubble such as the ‘tech’ bubble in 2000. Finally, moving averages of major market indices flatten out and eventually turn down, or alternatively, there is an event or breaking news item having long term implications that results in a sharp steep sell off. Often the ‘Advance/Decline line’ has turned south for a few months in advance of all this. Of course the largest risk is the interpretation that a sell off is just a correction and there’s still more upside. When the upside is attempted and it fails to achieve a new high or does so just barely and turns down again you can suddenly find yourself unexpectedly in a ‘bear market’ caught with a portfolio of declining stocks !

What should one do when a topping out is occurring? Sell or protect all stocks. It is as simple as that... “Well, I’ll just keep my preferred shares and bank stocks as they are pretty safe, aren’t they?” NO they are not. They will decline along with the rest of the market. Actually, bank stocks are about as volatile as they come. Oh yes, another ‘leading’ market top indicator after an extended rise in bank and insurance shares is the standard response with authoritative conviction by well regarded conservative money managers... “ Well, we like financials here...” Take care when you hear that! Your only guaranteed safe harbour once the market has topped is short term government bonds or treasury bill money funds.

The really important reason to sell out a top, over and above protecting against loss, is having a strong cash position ready to deploy once the market has matured its bottoming process. This is the real way to invest for the long term. The old adage of ‘buy and hold for the long term’ has lost its luster and lost a lot of investors’ loot to boot!

Sincerely,

Tom Rogers

February 12, 2009

Opinions contained in this message are those of the author and are not given or endorsed by his employer, Beacon Securities Ltd.

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