After more than twenty years in the investment business, I’ve learned that it’s anyone’s guess where the market is headed in the short term. That’s not because analysts aren’t paying attention - they are, believe me. It’s just that in the short term, market movements are largely random. Analyzing a single stock, or the whole stock market, can give you a lot of information about its past performance; but what it can never tell you is the price someone might be willing to pay next year for this stock or that commodity. However, this doesn’t stop many pundits from trying. TV’s Jim Cramer, on CNBC’s hit show Mad Money, took the bait this past June, telling his audience that they should sell everything and put the money into commodities. Ever since then, sad to say, commodities have largely been in free fall.
These days, investors can be forgiven for looking around nervously for the exits. The past year has seen huge drops in stock markets in the U.S., Europe and Japan, plunging by 20%-30%. Even China, land of the economic miracle, has given up more than half its market cap in the last year. In the United States, the economic horror story is the subprime mortgage crisis, the result of very dodgy lending of mortgage money to subprime borrowers (that’s bank-speak for “people who can’t pay the money back”).
Those subprime loans aren’t the main problem, though; they pale in comparison to the banking practices that manipulated them on such a massive scale. The loans were used as building blocks for derivative instruments that leveraged them twenty, thirty, even forty times over. The whole lending business south of the border turned into a giant game of musical chairs, with each level of lending essentially passing the buck to the next. When the music stopped, because of declining American real-estate values, the whole flimsy financial house of cards came tumbling down around investors’ ears. Everyone panicked and ran for the fire exits. Unfortunately, those exits were only big enough for a small number of those looking to get out.
Where does all this depressing news leave us? Well, maybe we can turn for advice to one of the European giants of banking and investment of the eighteenth century, the famous Rothschild family. It was Baron Meyer Rothschild who, in the wake of the Battle of Waterloo in 1815, made a killing buying real estate when everyone else was panicking. He’s credited with the popular investment adage, “Buy when there’s blood in the streets.” What he meant, of course, was that when all other investors are in terror of their lives, unable to even think about making a profit-that’s the time for the smart businessman with the tough nerves and the cool head to acquire assets like there’s no tomorrow.
This charming tale has survived the years because of its blunt truth. For the contrarian investor, the time to buy may very well be just when CNBC is telling everyone, “Sell now, the end is near”. There’s no question that panic is in the air with the current liquidity crisis. If Baron Rothschild were alive today, he’d probably comment gleefully that there seems to be a lot of blood in the credit markets these days – and then he’d head for those mean streets and start buying up a storm.
What do I recommend? Well, it’s always easy to say what not to do when the future’s uncertain; deciding on the right course is always more difficult. So let’s say you’ve decided not to be panicked into selling, and you want to take a calculated risk and do some buying instead. What’s your best option? While buying stocks these days is probably a good idea, you also want to look to credit markets. Fewer people are familiar with them, so investors who want to take advantage of the present instability have several interesting choices.
Bank preferred shares, for example, have been hit very hard. These are a form of fixed-income investment that pay regular dividends and rank ahead of common stocks. Right now they’ve taken a 20%-25% price haircut, and pay the interest equivalent of 8%. But if you consider that 10-year Canada bonds pay you only 3%, and 30-year bonds only 4%, then preferred shares look pretty good by comparison.
Right now, market liquidity may be in short supply, but there’s no shortage of volatility. The trick is to find the right instruments to allow you to take advantage of that volatility. One example is callable yield bonds, which offer yields of 10%-12% as a result of the high-option premiums used to build them. They work particularly well when stock market trends move sideways, or even marginally lower. They use the option premiums to give investors high income, and provide a significant amount of protection against market declines.
Of course, all these investments come with risks attached. It would be imprudent to just dive in without taking a hard look at their suitability for the individual investor. But while you think about what’s right for you, open your mind to what the Baron knew about investing almost two hundred years ago: when things look their worst, that’s often the safest time to buy.
Alan MacDonald is an investment adviser who helps high-tech entrepreneurs make smart decisions about money. Contact Alan at Alan.Macdonald@RichardsonGMP.com or through www.alanmacdonald.ca
