After more or less heading upward since the summer doldrums, equities veered off Rally Road into a shallow ditch late last week. Most markets took their worst drubbing in months, as resurfacing fears mingled easily with new worries. The usual suspects included European debt miseries, sputtering growth, economy-cooling policies in China (where stocks plunged more than 5 per cent Friday alone) and continuing friction over currency values and trade imbalances.
In the U.S., the prospect of more monetary easing cheered equity players for weeks. Fed chief Ben Bernanke publicly noted the importance of higher stock prices for consumer confidence. And then, just as the Fed's stimulus plan got under way Friday, investors sold. Talk about a tough audience.
Bullish types would describe the week that was as a temporary pause, after a flood of capital poured into the markets from previously gun-shy investors tired of earning precisely zero on their cash.
More than $15-billion (U.S.) poured into global equity funds in the latest week, the highest level since late in the second quarter of 2008, according to EPFR Global, which keeps tabs on international mutual fund flows. U.S. funds alone pulled in $7.1-billion, a 15-week high. But some $8-trillion is still sitting doing nothing in U.S. money-market funds and short-term bank deposits. So there's a lot more where that came from.
Investors have been trying to play catch-up after sitting on the sidelines since the Great Meltdown. Quarter after quarter of better-than-expected corporate earnings may have finally convinced them to disregard the persistent warnings of the bears that this is an overvalued market ripe for a fall over the edge.
But even if the bears weren't still prowling the landscape, jumping in and out of the market would not be the wisest of strategies, suggests Peter de Auer, a veteran Canadian money manager who never did join the cash crowd. The trick to playing changes in market direction, he has decided, is not to play them at all.
I recently wrote about a value manager who likes nothing better than excess cash in volatile times to pounce on market opportunities. Mr. de Auer is another deep-value stock-picker, but that's where the similarities end.
"We've concluded that there are aspects of the investing environment [including market turns and price levels]which cannot be predicted by anyone consistently," says Mr. de Auer, president of Cluster Asset Management and a former prominent pension fund manager. "People just keep getting it wrong. Our philosophy is that the only strategy that works is to be fully invested at all times."
Mr. de Auer hunts for big-cap Canadian equities that have been beaten up and then neglected by the market. Recent favourites include Manulife, EnCana, Research In Motion and Torstar. Out-of-favour laggards are growing scarcer, but there are still some out there, he says.
The Big Bounce
When markets head south, investors get intensely uncomfortable, putting pressure on managers to sell. But most wait too long and don't get back in early enough to capitalize on the turnaround. "The biggest single increase occurs in the recovery from the bottom. So if you're not in, you're going to get in after the bounce, which is usually very large."
This is of no small concern to any investor, but particularly to people running pension money during a time of low interest rates, says Mr. de Auer, who headed Ontario Hydro's pension fund in the late 1980s and early 1990s.
When stocks plunged into a sinkhole two years ago, endowment and pension funds took heavy losses. Those that sold on the way down "crystallized" those losses and left themselves little chance of recovery if they socked the proceeds away in cash accounts.
"The alternative policy is to say we have a loss from marking the equity component to market, but when the recovery sets in, as it always does, we're going to recover a significant part of the loss."
Now that the market has indeed regained lost ground, that strategy looks a lot better than the meagre returns from cash.
Historically, to get the real rates of return needed to meet liabilities, pension investments have had to exceed the rate of inflation by 250 to 300 basis points, depending on the fund's actuarial assumptions. (A basis point is 1/100th of a percentage point.) "You can't do it with cash today. You effectively can't do it with government bonds. And corporate bonds are not quite there. Inevitably, to significantly outperform the [low-rate] environment, there is no other place except going back into equities in a big way."
But for any investor, that means living with more stomach-churning volatility. As Mr. de Auer observes, citing a well-worn quotation: "Everything is in a state of flux, including the status quo."