The case for caution

In 2009, investors faced the the worst bear market of the post-war period.

And advisors had a Herculean challenge in trying to determine whether it was a good time to seek out bargains in stocks or if caution should reign. There were money managers who remain positioned for the latter.

For Christine Hughes, senior vice-president at AGF Funds and lead portfolio manager of the AGF Canadian Balanced Fund, caution paid off. Hughes took her cues from the bond market, which informed her decisions to take defensive positions before the worst of the downturn hit.

As a result, she preserved much of the capital in her fund and maintained positive returns on a three-year basis — an impressive feat when compared to her peer group, which was down more than 5% on a three-year basis. From 2008-2009, the fund was down only 6%, versus the group average of more than 20% in losses.

Hughes said the indicators in the bond market that suggested she play defence had not changed. Despite a flood of taxpayer money from around the world, she said the credit markets remain essentially dysfunctional.

She points out that banks were paying the highest rate ever to swap out credit risk. In other words, the bailout money wasn’t fixing the core problem with the financial crisis — banks still weren’t financing other businesses.

“Bonds have everything to do with the stock market. The health of the bond market drives the stock market. The stock market is just a bunch of companies; they get their money from the bond market,” she says. “Every time you have an inverted yield curve, the equity market gets hung up, or worse, you end up with a bear market.”

Hughes also points out the banks were hoarding the money they are receiving from the government, using it to shore up their own capital reserves and unwind their leveraged positions.

“The banks in the U.S. had a leverage ratio of 30:1 or higher. Traditionally, banking has been a 10:1 ratio of total loans to assets, of assets to equity. It takes time to fix this. It’s not an event; it’s a process. This is why I still have a conservative asset mix. I’m lighter in equities than benchmark, which is 60%. I’m about 33% equities. I think that’s where things should be, given what’s going on in the bond market.”

What’s problematic for many managers, Hughes points out, is the fact that their statistical modelling and historical performance data is based on roughly the last 40 years. She says you have to look at the Great Depression and Japan’s “Lost Decade” to find data points that correlate to what was happening then.

“Both those times proved that solving the crisis was a process, not an event. It doesn’t take a year — in the case of Japan, it took a decade to solve,” she says.

“Markets tend to bottom at single-digit trailing earnings — that’s trailing earnings, not forward earnings. We’re in the mid-teens right now, so I don’t think that’s cheap for equities,” she adds. “You can’t assume we’re in any environment that existed in the last 40 years. We’ve blown through all of those in many different statistics, whether its credit spreads or stock market activity or the effectiveness of monetary policy. There are tons of data points to show that this time, it is different. If it is different and you expect it to continue to be, you have to look beyond the last 40 years.”

Throwing a wrench into the crisis was the amount of money that governments was spending. The March 2009 announcement by the U.S. Federal Reserve to buy Treasuries and mortgage-backed securities was viewed as basically printing money, which has no underlying value, other than the U.S. dollar’s primacy as the world’s reserve currency.

Jamie Horvat, senior portfolio manager of the Sprott Gold and Precious Minerals Fund and the Sprott All Cap Fund, points out that something had to give on the U.S. currency. Most likely, it was to be a run-up in hard asset prices — as was already witnessed in gold prices.

This creates pitfalls for investors who choose to take too strong a weighting in cash or fixed income to ride out the bear market. Over the short term, this makes sense as the equity markets struggle to deleverage. When a bottom is hit, there is a growing belief that an inflationary cycle will kick into high gear. This would quickly erode cash holdings.

“There had been this argument going on about whether we should be more concerned about deflationary depression or the longer-term inflation implication of debasing currencies versus all hard assets over time,” Horvat says. “In either of those scenarios, if you do go into a depression and contract in real terms, a couple of things that should do well for you are cash and your hard asset holdings.”

Horvat pointed out the Fed’s policy of “quantitative easing” would eventually drain the value of cash savings.

“The statement that the Fed would buy $300 billion [in Treasuries] over the [last 6 months of 2009] really woke up the market that currencies were being debased globally against hard assets again,” he says. “This is similar to what happened between 1970 and 1976 or 1933 to 1937. I believe you want to be positioned for this debasement and stagflationary environment, where you go along and have low growth but the price of goods continues to go up because you’re debasing currencies.”

He adds, “We’ve saw a bit of that with the oil, [which] found a floor at $45 to $50. Copper ound a floor of $1.60 to $1.80. [This suggests] ultimately we will be able to reflate [prices] and muddle out of this, but savings will be eroded, as they always are.”

(03/23/09)