Nowhere to run… nowhere to hide
This downblast has been severe and, perhaps, formative in the minds of a new generation of investors. It has been six months, officially, that the markets have been cruel. In this kind of situation, the optimists must always be wary of “false bottoms” – uplifts in the markets that are unsustainable and followed by another, and bigger, drop. Along with everybody else, we have been trying to see through the clouds to some blue sky on the horizon.
The interplay of international stock markets, industrial sectors, foreign exchange rates and bond yields
International diversification is part of investment strategy. International market correlations are measured and scored numerically between 1.0 (perfectly “in sync”) and minus 1.0 (perfectly out of “sync”). The recent argument has been that globalization has increased these international correlations. The following chart shows select country returns (in local currencies) for calendar 2008. While they are all negative, and largely so, there is significant dispersal of negative returns around the globe.
Foreign exchange rates play a large role in international investing. When an investor buys into a country, he also implicitly is buying that country’s currency. At the end of an investing year, the investor’s return is equal to that foreign market’s return, plus-or-minus the exchange conversion back into the investor’s home currency. In any given year, the cross-currency exchange movement between two countries can be significant. The following chart shows 2008.
Canada’s currency run-up occurred in 2007, and it reversed in 2008. For Canadian investors who had invested abroad through 2008, this was a good thing, because they were invested in those international currencies that appreciated against the Canadian dollar. The foreign currency gain mitigated the market pain (loss!) being invested in any of the world equity markets. Here is the previous chart, re-worked in Canadian dollars for the international Canadian investor who enjoyed these currency gains.
At Trivest, we focus a lot on international industry sector diversification, and we have sophisticated proprietary systems to manage that for every client. The principle here is similar to international geographic diversification, and perhaps even stronger. In the economic cycle, different sectors tend to take their turns in the limelight, as either leading or lagging economic performers. The next leadership position is not “broadcast” in the markets, and thus prudent sectoral diversification should guarantee “being there” when that turn comes. The following chart shows 2008 sectoral returns in Canada, the U.S. and the World for a Canadian investor.
In the global context, the Canadian stock market is quite thin—and heavily tilted to energy, materials and banks. As those sectors go, so largely goes the Canadian stock market. Those sectors enjoyed a run before 2008, thus previously giving Canada its turn in the limelight. Globally, the current downdraft is giving the health and consumer staples sectors their turn in the limelight. Domestically, the health sector is not a strong suit in Canada. The thinness of the Canadian market in many sectors underscores the need to invest internationally (incurring along the way the afore-mentioned currency ride!) in order to diversify well across all of the industry sectors.
At Trivest, we also pay a lot of attention to the asset allocation ascribed to “fixed income”, or bonds. This is the foot soldier part of the portfolio, that trudges along slowly but surely. With all geographic markets, and almost all industry sectors, punishing with negative returns in 2008 (some very large!), it is the fixed income portfolio that provides respite. Using our portfolios that have December 31st, 2008 reporting, we see that the fixed income component is providing a significant safety margin to shore up the bad equity component.