Monthly Commentaries

Emotion takes the wheel – January, 2008

By the end of January all equity markets had dropped about 5% from the beginning of the year marking the worst January since the 1930s. During the month the equity markets continued their extreme volatility not only from day to day but also from hour to hour. This was the first real bout of investor panic since 2001, with market gyrations dominating the evening news. The only investment in demand was government bonds. History is replete with episodes like this. People want to go to bonds and wait out the market volatility and assess the position. However, history has also shown that these environments offer some of the best opportunities to buy strong investments at deeply discounted values. Unfortunately for the undisciplined investors they move to the sidelines only to see stocks rally. In these uncertain times, diligent research and a disciplined trading strategy can reap significant rewards by taking advantage of the emotional decisions many investors make.

Outside the financial sector, corporations are in the best financial shape in 25 years. During the past 5 years many have paid down debt and have developed strong balance sheets. This situation is in stark contrast to the recession of the early 1990s where corporations had huge amounts of debt. For these strong corporations, this situation is an opportunity. The companies can now put their cash to work laying a strong foundation for growth in the recovery to come. This strong fundamental outlook is being ignored as markets continue to be ruled by emotion. Our strategy going forward is to continue to focus on corporations that have little debt, have no debt rollovers in the next year and do not rely on ‘creating’ earnings through financial repackaging or financing customers. In volatile times it pays to focus on corporations that pay dividends, and have a history of growing those dividends.

While it is possible that the U.S. economy may go into recession (or may already be in one) we think that the coordinated activity of central banks globally to lower interest rates will result in a recovery late in 2008, and as such there is nothing to be gained by going to a larger cash component in our portfolios at this time. Bullish sentiment among investors has not been lower since 1988, suggesting that this is the time to be putting more money to work, not the opposite. Over long periods of time, equity markets generate higher returns than fixed income because equity investors are willing to withstand price movement. However, these price movements can be scary. By taking advantage of emotional moments in markets you set the groundwork for significant returns in the future. Arthur Heinmaa, CFA Managing Partner