After a tough 11.8 per cent downturn in TSX equity market performance in 2015, investors could be forgiven for expecting normal market cycles to lead to a dramatic recovery as 2016 unfolded.
Unfortunately, in January oil prices continued to drop and stock markets followed, adding to the losses of the previous year.
Time to bail from equities? The Royal Bank of Scotland certainly thought so, dramatically advising the conversion of all financial investments to cash, to wait out what they predicted would be another major Bear market, akin to that of 2008/2009. As oil prices sank below U.S. $30 a barrel, Morgan Stanley reinforced the negative sentiment by predicting oil’s further decline to as low as $20. These two major institutions were not alone in their doom-and-gloom predictions; many analysts and other market pundits followed suit.
As has typically occurred over the decades, these headline-grabbing predictions proved to be dramatically incorrect.
Since, in the first four months of 2016, the directional performance of world markets moved in tandem with Canada’s TSX Index, we’ll use the latter to illustrate. During the first three weeks of January, the TSX fell by another 9 per cent, adding to its 2015 losses. Pity those who acted on the advice of the Bank of Scotland, cashing in all investments. After those first three weeks of swooning, equity markets rebounded, equally dramatically.
Over the three months to April 22, the TSX had recovered 17 per cent, thus neutralizing not only the year-to-date downturn, but also recovering a good proportion of the 2015 decline. As could be expected, the prime driver of markets, over the same period, was a recovery in the price of oil. Far from plummeting to $20, it zoomed from its low of $27, to $43 — an increase of 55 per cent. So much for “expert” advice.
Given the long-proven impossibility of predicting short-term financial market directions, pundits and advisors would better serve the investing public by providing guidance on the construction of investment portfolios which minimize downside risk, regardless of unpredictable changes in the direction of capital markets.
Continuing with our Canadian TSX example, let’s examine more useful advice and practical action for the investor.
While prudent investors limit their Canadian equity exposure, balancing it with U.S. and other International holdings, the impact of ignoring exchange rates on Canadian dollar values can have an even greater effect on a portfolio than equity market gyrations.
On January 11, the Canadian dollar was at its lowest, purchasing only 69 cents of a U.S. dollar. Near the end of April, it purchased 79 cents U.S. — a 14.5 per cent increase in the relative value of Canada’s currency.
What did this currency change mean for a Canadian investor holding U.S. equity investments? If the U.S. holding was not “hedged” against currency fluctuations, the first 14.5 per cent of the U.S. market increase was effectively wiped out because of the stronger Canadian dollar.
Had the investor instead held “currency-hedged” U.S. equity investments, using for example, Exchange Traded Funds (ETFs), he/she would have garnered the full benefit of the U.S. market recovery.
Without trying to do the impossible — time actual market movement, currency-hedging is but one way in which an investor can control market risk. Other avenues include minimizing annual holding costs; ensuring solid income streams (yield); sufficiently diversifying holdings outside Canada; and determining appropriate levels of asset allocation between equity and fixed-income holdings. Prudently incorporated in a portfolio, these actions will limit the downside pressure in any market, while still preserving a solid potential for long-term capital appreciation.
The savvy investor will ignore periodic equity market fluctuations, no matter their cause, and concentrate instead on minimizing controllable portfolio risks.
A retired corporate executive, enjoying post-retirement as an independent Financial Consultant (www.dolezalconsultants.ca), Peter Dolezal is the author of three books, including his most recent, The SMART CANADIAN WEALTH-BUILDER.