Yes We Can!

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"Yes We Can!!"

November 07, 2008

One could not help being impressed by the oratory skills of President Elect Barack Obama as he jumped the last hurdle in his race to the Whitehouse. In an election that was financed by over three million supporters, Obama used his understanding of community organizing, and engaged the new internet community to enlist a new generation of voters and drive the largest voter turnout in years. 65% of voters aged 18-25 voted for Obama as he resonated with a message of Change. Despite his success at the polls, Obama was the first to remind us that the next stage involves even more daunting hurdles, with potentially the most challenging economic environment in a century, a global environment in need of real action, damaged international relations and declining influence. Unlike any President since John Kennedy, Obama started by asking for the commitment of every American to help not only themselves, but each other as well as the global community. Following three months of doom and gloom, he reminded his nation that in their history they have overcome so much already, as testified by his election as the first black President, and that anything is possible if they work together. His policy initiatives will likely be made easier by Democrat control which was also achieved in both the Senate and the House of Representatives. Obama has demonstrated a fine mind and an attitude of determination which backs his belief that in the face of these hurdles change is possible and he inspires engagement and commitment with the assurance “Yes we can!”

Volatility and Risk Management

The markets were not excited by Obama’s election, and declines were experienced based upon the continuation of concerns in the economic markets. We are in a period of extreme volatility with individual stocks moving 20-30% down one day and then back up 15-20% the next. As we continue to research and analyze how to best advise clients in the current climate I have recently become aware of the work of Professor André Perold, who is the George Gund Professor of Finance and Banking at the Harvard Business School. A member of the faculty since 1979, he has served as the Senior Associate Dean: Director of Faculty Recruiting, Chair of the Finance Faculty, and Director of Research. He received his Bachelor's degree from the University of the Witwatersrand, Johannesburg; and his Masters and Ph.D. degrees from Stanford University. Of course we remain unbiased by his South African roots!

Perold has compared the conventional “static asset allocation” model with a buy and hold approach, to a “stable risk allocation” model in which asset allocation shifts in a climate of real or anticipated volatility. His conclusion is that it is possible to provide more consistent risk adjusted returns with the latter model. Note that this does not mean that there will be higher returns, but that relative to the risk being taken the returns will be more consistent.

Interestingly, this is what we have tried to do for clients over the last six years. Clients will recall the many suggestions from us over the years to shift out of the US as the dollar was dropping, out of Global Bonds as the CAD strengthened, into real return bonds when inflation was a concern, to high yield cash accounts as the yield curve flattened, into greater fixed income and cash positions and emerging markets and precious metals as the sub-prime unfolded, and more recently to trim even those exposures in the face of the global credit crisis. In each case that we have made recommendations we have done so with equal respect for the road ahead and the history in the rear view mirror.

Asset Allocation and Risk Management

Asset Class	Large Accounts	Small Accounts
Bonds	28.60%	18.50%
Cash	12.80%	14.00%
Equities	57.10%	66.50%
Other	1.50%	1.00%

In researching for this paper I reviewed a number of specialized advisor and industry websites to identify what new thoughts are emerging for portfolio structure and risk management. To my surprise the US site Advisor Perspectives which aggregates the portfolio recommendations of advisors who subscribe to their information shows that as at November 2, 2008 current client asset allocation for large accounts of $1,000,000 and above as well as small accounts of $50,000 and less, the equity exposure is relatively unchanged from August. Surprisingly most advisors and their clients’ holdings are ignoring the fact that this is not a normal cyclical downturn, but is rather a systemic failure. Interestingly the smaller accounts on average have higher equity exposure. Using Perold’s approach in the current market volatility would reduce the equity risk exposure, something that we have been committed to encouraging.

Assessing Risk and the Potential for Volatility

With one in every five mortgages in the US currently in default, and potentially 40% worth less than their outstanding debt the US consumer is not in a position to continue to support the wanton spending spree of the last five or six years. Since 60% of US GDP is comprised of consumer spending, real contraction of the economy is likely before the sun rises in this market. In October MacDonald’s processed more credit card transactions than any other business in the US, pointing to the fact that more and more people do not have the cash to spend even on the cheapest of meals! A contraction in consumer spending will impact retailers, and by extension manufacturers in short order. October was the worst decline in new vehicle sales in 30 years, and this week Nortel is reported to be cutting a further 3000-5000 jobs based upon declines in sales orders in the telecom industry. Earnings outlooks are being slashed daily and are dragging down even stocks that have outperformed the analysts’ expectations.

It is interesting to observe that in a falling market with falling Central Bank lending rates that we are seeing surging credit risk spreads for corporate bonds. Current spreads are over 15% reaching the heady heights of the junk bonds crisis, with existing corporate bonds having been discounted significantly to reflect this yield. This is a double edged sword for non-registered accounts with interest yield being taxable while the real value is declining. There is much marketing promotion based upon these yields and claims that at current levels corporate bonds and high yield bond funds should form a part of everyone’s portfolio. While this case exists we have some real concerns that there may be an underestimation of the defaults that are sure to come in the face of reduced consumer spending and declining corporate profits which in turn will be further impacted by rising borrowing costs upon debt renewal. Just this week Barclays Bank PLC entered into a debenture agreement in which it will pay 15% interest and the lender has conversion warrants at a discount of 20% of the trading price. Dependent upon your risk tolerance some exposure may make sense, but this is not the time to bet the farm on high yield bonds.

Implications of Individual and Market Psychology

This week I have heard four statements that have concerned me. The first was “I want to hold until the fund comes back to the original cost then I will sell”. The second was “we haven’t actually made a loss unless we sell”. The third was “I just want to stay the course, markets always come back” and finally “They are too big to fail”. Tackling these in reverse order my answers are simple Washington Mutual and Lehman Brothers were giants, but they failed. Markets may recover but the NASDAQ never recovered from its bubble and many of its stocks have vaporized. The same is true for the Japanese Nikkei, which are both systemic corrections more akin to what we are seeing now. While it is true to say for tax purposes that we have not made a loss until we sell, lower stock values generally point to lower dividends and lower income, so the impact of loss is real even if unrealized. Finally our egos which do not want to admit to being wrong frequently causes us to hold losing stocks beyond their best by date. Compounding this problem is the “casino psychology” of increasing our bet so that we can make greater returns when “our number comes up”. Many Canadian held Nortel and added to those positions in the decline of its value from over $120, but today it trades for less than $2, AIG is the same and more will follow.

With some evidence that most advisors and their clients are still heavily weighted in the markets it is evident that “capitulation”, the turning point in the market where the “hurt” forces people to reduce their holdings, has not yet arrived. Combine this with the fact that while loans to AIG may be helping Wall Street the trickle down to Main Street is also not yet evident. Real Estate values in the US are projected to decline by another 15% to 20% from their current levels, depending on the analysis and source. What they all appear to agree upon is that until real estate values stabilize consumer confidence, which is at a record low, is unlikely to rebound. The Internaltional Monetary Fund (IMF) today said they expect the developed economies to shrink over the next year and possibly two. As a result our view becomes daily more defensive as we believe that markets will most likely behave more like 1929-1932 and still have a way to fall.

Our Value Proposition going forward

The current defensive position has reduced by over 50% the asset based compensation that we receive to support and service our clients. This may help explain why the other advisor asset allocation models remain so unchanged over these last few months, notwithstanding the greater volatility. We believe that our value proposition is defined in four parts:

1. Life Planning and Education to provide clients with the background and details to articulate their life and legacy objectives and understand their options and challenges to empower them to make informed decisions.

2. Integrated Financial Planning to bring together the cash flow required to support the desired quality of life through effective tax structuring and financial product integration, and addressing both incapacity and estate planning goals

3. To develop a portfolio strategy to manage risk-adjusted returns and that responds to economic and market conditions and is customized for the family’s risk model and financial plan

4. To research and recommend appropriate financial products including best of class managers and monitor their performance and continued suitability within the integrated financial plan

As we go forward the question is “Are we able to continue to deliver on each of these services?” The answer simply is “Yes we can!” However we would not be able to sustain these indefinitely based upon the current compensation model based exclusively upon residual asset based commissions so we are evaluating models that can continue to support the full spectrum advisory services that our clients value. I would like to thank those clients who have expressed both appreciation and concern for our team as we do our best to serve you all.

As we reflect on Remembrance Day of the sacrifices of the men and women around the world to overcome tyranny and oppression and the challenges for their families left behind, we see the spark of the good that is in mankind that is necessary to face the great challenges, to care for the neighbour and the stranger creating the belief that this world can overcome. Yes we can!

Best Regards,

Malcolm Ross, Victor Whang, Violet Smith

604.331.2521, 604.331.2524, 604.331.4465

DISCLAIMER: E&OE: Investment Fund values change frequently and past performance is not indicative of future performance. No guarantee is given or implied and there is risk of loss as well as the opportunity for gain when investing in mutual funds.

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