General

Amnesia and the Inevitability of Cycles

By Noah Solomon

Special to the Financial Independence Hub

Cycles are inevitable. They have persisted since markets have existed and will endure for as long as humans engage in the pursuit of profit. In prolonged up cycles, people are euphoric, bid up prices to unsustainable levels, and sow the seeds for subsequent misery. Similarly, severe price declines result in unsustainably pessimistic sentiment, pushing prices down to bargain levels, thereby sowing the seeds of the next up cycle.

Neither bull nor bear markets continue indefinitely. Despite this incontrovertible truth, every time an up or down cycle persists for an extended period and/or to a great extreme, the “this time it’s different” crowd becomes increasingly pervasive, citing changes in geopolitics, institutions, technology, and behavior that render the old rules obsolete. But then it turns out that the old rules do apply, and the cycle resumes.

The persistence of cycles is in large part the result of the inability of investors to remember the past. According to legendary economist John Kenneth Galbraith:

“Extreme brevity of financial memory…. When the same or closely similar circumstances occur again, sometime in only a few years, they are hailed by a new, often youthful, and always supremely self-confident generation as a brilliantly innovative discovery in the financial and larger economic world. There can be few fields of human endeavor in which history counts for so little as in the world of finance. Past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present.”

Will the True Driver of Market Cycles Please Stand Up?

Without a doubt, macroeconomic factors such as interest rates, inflation, fiscal policy, GDP growth, unemployment, etc. exert a significant influence on the ebb and flow of markets. However, in our view, fluctuations in psychology have the greatest impact on cycles. More than any other factor, changes in sentiment are what cause shifts between hospitable to treacherous markets, and therefore between gains and losses.

In market cycles, most excesses on the upside and the inevitable reactions to the downside (which also tend to overshoot) are the result of exaggerated swings of the pendulum of psychology. Even the father of value investing and Buffett mentor, Benjamin Graham, acknowledged the tremendous influence of psychology in his allegory about “Mr. Market.” Depending on his volatile mood swings, Mr. Market will buy assets at unrealistically high levels or sell them at bargain basement prices.

The following graph offers a succinct and accurate portrayal of investor psychology at different parts of the cycle.

In bear markets, the dominant psychology in the markets is represented by line C, where investors demand generous risk premiums to compensate them for taking risk. In these environments, valuations are undemanding, prospective returns from bearing risk are high, and chances are good you that will be rewarded for taking risk.

As the cycle progresses and markets begin to rise, the dominant psychology shifts to line B, which represents the “happy medium” where investors are neither overly pessimistic nor blindly optimistic. In such environments, people require adequate compensation for taking risk, valuations are neither depressed nor excessive, and you can expect returns that approximate the long-term historical average.

Lastly, during the latter stages of bull markets when prices have risen significantly over a period of several years, the general mindset of the investing public shifts to line A, where investors become euphoric and adopt a lopsided desire for return with little regard for risk. In such environments, people require scant compensation for bearing risk, valuations become unrealistic, and losses become more likely than gains.

In essence, the pendulum of investor psychology is heavily influenced by the recency bias of what has happened over the past several years, swinging between collecting gold bars in front of a wisp during the bad times (line C) and picking up pennies in front of a steamroller at market tops (line A).

S&P 500 Index: Investor Psychology and Subsequent Returns

The table above demonstrates that the mood shifts of investors can have a dramatic impact on returns. With respect to the current environment, we are more confident about where we are not than where we are. It’s difficult to make the case that market participants are despondent and are demanding huge risk premiums for investing. In our view, market psychology is currently somewhere between lines A and B.

Except for the short lived Covid-induced swoon of early 2020, governments and central banks have been successful in maintaining the bull market that began in March 2009 after the global financial crisis. This has increased confidence in the Fed put and emboldened investors. Although nobody can know for certain whether it is possible to engineer a perpetual party by plying its attendees with ever-increasing stimulus, we wouldn’t bet the farm on it!

The Elusive Happy Medium: Average Doesn’t Mean Normal

In the real world, things generally fluctuate between “pretty good” and “not so hot.” But in the world of investing, investor psychology seems to spend much more time at the extremes (lines A and C) than it does at a “happy medium” (line B). At any given point in time, markets are more likely driven by greed or fear rather than greed and fear. Either “Risk is my friend. I need to buy before I miss out” or “I just don’t want to lose any more. Sell before it goes to zero” are far more likely to dominate markets than equanimity. Continue Reading…

Sustainable Equity Strategies for a Global Recovery

Image iStock/Franklin Templeton

By Mel Bucher, Co-Head of Global Distribution, Martin Currie, Edinburgh, UK

(Sponsor Content)

The investment choices we make can have a profound effect on the world around us. Investing according to sustainable principles allows investors to align their environmental, social and governance (ESG) goals with their investing choices.

Also, we believe sustainability can be a driver of long-term portfolio performance. As global equity markets recover from the COVID-19 pandemic, more Canadians want to invest in opportunities available within a wider sustainable context.

One new option is the sustainability investment expertise that Martin Currie brings to Canada.

Martin Currie may be a new name for many Canadian retail investors. Our firm is a Specialty Investment Manager of Franklin Templeton, based in Edinburgh, UK, and we focus on actively managing portfolios of the listed public equities of companies that generate long-term value from sustainable ESG polices. Our ESG framework helps to identify any material ESG issues related to a company’s cash flow, balance sheet and profit/loss account over time and whether these ESG issues could affect value creation. Having ESG analysis fully embedded in the research process enables our investment teams to uncover material issues.

Martin Currie’s leadership in ESG was recognized with the UN’s Principles for Responsible Investment A+ rating for 2017, 2018, 2019 and 2020.

This article considers our sustainable investing strategies in global equities and emerging markets equities, both of which are now available to Canadians.

A global equity strategy in a global recovery

We expect the strong comeback of the global equity market to be sustained under fairly benign inflation conditions and with asset prices supported by monetary policy. Our global equity strategy is well positioned in this environment.

The Franklin Martin Currie Global Equity strategy invests in companies with exposure to three established growth megatrends:

1.      Demographic change (e.g., aging population, urbanization, healthcare)

2.      Resource scarcity (e.g., electric vehicles, alternative energy, infrastructure)

3.      The future of technology (e.g., outsourcing, cloud computing, security).

We believe these themes will drive long-term structural growth in the global economy. The portfolio seeks diversified holdings with exposures to the megatrends to capture growth.

Global equities for growth, at the right price

The portfolio holds 20-40 stocks of sustainable, well-managed growth companies that dominate their respective industries and have high barriers to entry. They hold pricing power and face a low risk of disruption. These firms have potential for long-term structural growth and value creation. Companies undergo a systematic assessment of their industry, company, portfolio and governance/sustainability risks.

These equities may not be cheap, so the portfolio managers are highly selective about acquiring companies at the right valuations. The goal is to find equities that combine strong industry, financial and governance attributes at the right price.

This global equity strategy is now available to Canadians through the Franklin Martin Currie Global Equity Fund and Franklin Martin Currie Sustainable Global Equity Active ETF (FGSG). The mutual fund’s U.S. equivalent is a 4-star Morningstar-rated fund* in the International Unconstrained Equity category.  

Unique Approach to Portfolio Analysis and Construction

Martin Currie’s sustainable emerging markets strategy Continue Reading…

The dangers in the “Explore” part of a “Core and Explore” Portfolio

By Michael J. Wiener

Special to the Financial Independence Hub

Many people advocate having a portfolio made up of mostly a core of low cost index funds along with a small “explore” part for taking concentrated risks on favourite investments.  This can work well enough if you’re realistic about it, but most investors cross the line to self-delusion.

Ben Carlson does a good job justifying the existence of explore-type investments in his article The Case for Having a Fun Portfolio.  After all, people are entitled to spend their money however they want.  Not every expenditure has to be part of a logical long-term plan.  We can buy a beer, or a motorcycle, or some favourite stock if we want.  So what if the long-term expectation is that the explore part of people’s portfolios will underperform indexes.

All the logic makes sense up to this point.  But just about every stock-picker I know can’t resist taking this a step further.  “Besides, the stock I picked is going to do great.”  In their hearts, they know their stock picks are going to outperform.  Past results don’t seem to deter them.  They wouldn’t bother with the explore part of their portfolios if they truly believed they would lose money over a lifetime of picking stocks.

All the evidence says that professional investors today set good relative prices so that individual investors who choose their own stocks are essentially making random picks.  The odds are against the small guy, but hope springs eternal.  I prefer to find hope in other pursuits.

Michael J. Wiener runs the web site Michael James on Money, where he looks for the right answers to personal finance and investing questions. He’s retired from work as a “math guy in high tech” and has been running his website since 2007.  He’s a former mutual fund investor, former stock picker, now index investor. This blog originally appeared on his site on April 26, 2021 and is republished on the Hub with his permission.  

A sampling of comments from the original post: Continue Reading…

Getting your Fixed Income Fix with BMO ETFs

This article has been sponsored by BMO Canada. All opinions are my own.

Fixed income doesn’t get enough attention on this blog, mostly because I’m still in my accumulation years and invest in 100% equities across all my accounts. But most investors should hold bonds in their portfolio to reduce volatility and so they can rebalance (selling bonds to buy more stocks) whenever stocks fall.

In this post we’re going to take a deep dive into BMO’s line-up of fixed income ETFs. We’ll see that there isn’t a one-size-fits-all approach to investing in fixed income, and that investors can capture yield using a wide array of products and strategies.

DIY investors should be familiar with BMO’s suite of fixed income ETFs. It’s the largest in Canada with more than $23 billion in assets. At the top of the list is BMO’s Aggregate Bond Index ETF (ZAG) with total assets of $5.86 billion.

Robo-advised clients also have BMO fixed income ETFs in their model portfolios:

  • Nest Wealth clients hold BMO Aggregate Bond Index ETF – (ZAG)
  • Wealthsimple clients hold BMO Long Federal Bond Index ETF – (ZFL)
  • Questwealth clients hold BMO High Yield US Corp Bond Hedged to CAD Index ETF – (ZHY)
  • ModernAdvisor clients hold BMO Emerging Markets Bond Hedged to CAD Index ETF – (ZEF)

BMO Fixed Income ETFs

Investors are nervous about holding bonds today. Interest rates are at historic lows, and when rates eventually rise, we’ll see bond prices fall – especially longer duration bonds. We’re also seeing higher inflation, which causes interest rates to go up (and bond values to go down).

Q: Erika, investors are concerned about low bond returns, particularly from long-term government bonds. How should they think about the fixed income side of their portfolio?

A: Investors should think of fixed income as a ballast in their portfolio. It helps reduce overall volatility (chart below). Correlations between US Treasuries and stocks (represented by the MSCI USA index) have been negative over the last two decades. All that to say, when stocks fall, bonds tend to do well.

BMO figure 1

What the new Higher Stress Test means for Homebuyers

Image courtesy of Loans Canada

By Sean Cooper

Special to the Financial Independence Hub

Ever since the start of COVID, the real estate market has been on fire. To help deal with the record level of activity in the real estate market and also keep things balanced, a new mortgage stress test was introduced June 1st. In this article we’ll look at the new mortgage stress test and how it affects you.

What’s the Stress Test?

The stress test is a measure that anyone buying a home, refinancing their mortgage or switching mortgage lenders must pass. Pretty much the only time you don’t have to pass the stress test is when you’re renewing your mortgage with your existing lender. Whether you’re buying a home with less or more than 20 per cent, it doesn’t matter. You’re affected by the stress test.

The stress test was introduced several years back to help protect homebuyers from becoming overleveraged and taking on too much mortgage debt. Prior to the stress test, you only had to prove that you could afford mortgage payments based on the mortgage rate when you first sign up for your mortgage. However, with Canadians spending more and more on homes and the threat of higher interest rates looming, the Canadian government decided to introduce the stress test in early 2018 out of precaution.

To pass the stress test, you need to show that you can qualify at the greater of your mortgage rate plus two per cent and the stress test rate (currently at 5.25 per cent). With mortgage rates currently somewhere in between the mid one percent’s and the mid two per cent’s for both fixed and variable rate mortgages, you’ll almost always have to qualify at 5.25 per cent as things stand today.

How has the Stress Test changed?

The new stress test rules came into effect June 1st. Prior to the introduction of the new stress test rules, the mortgage stress test rate was 4.79 per cent. That’s because it was based on the average of the big banks’ posted mortgage rates. However, the government decided to change how the stress test was calculated. Continue Reading…