by Gordon Pape
What's really happening in the markets now? And what should we expect down the road? Here are the answers.
It's an old maxim that fear and greed are the twin forces that drive markets. But what exactly does that mean in terms of how investors react in specific situations?
One of the clearest analyses I've seen of the fear/greed phenomenon was presented by Marc Cevey, CEO of HSBC Global Asset Management (Canada) Ltd. when we shared the podium during recent presentations in Toronto and Vancouver.
Mr. Cevey, who is a CFA, showed a chart which illustrated typical investor behaviour during periods of risk avoidance like now (the fear factor) and times of risk appetite (the greed factor) which will re-emerge once the current bout of uncertainty and volatility runs its course.
During risk avoidance periods, here's what happens:
Bond yields fall. Investors pile in to perceived safe havens, such as U.S. Treasuries, driving bond prices higher and interest rates down. The result this time around has been historic lows, with the yield on seven-year U.S. bonds falling to 1.415% on Nov. 23 when the Treasury Department sold off $29 billion worth of notes. Canadian bonds have been similarly affected although our interest rates are slightly higher. The decline in yields has driven up the price of older bonds, which explains why the DEX Universe All Government Bond Index was up 8.26% this year as of the end of November.
Equity prices fall. Just as people pile into bonds, they pile out of stocks, driving down prices in the process. That's what happened in 2008-09 and to a lesser extent this year. With just one month left in 2011, the S&P/TSX Composite Index is off 9.2% for the year (to Nov. 30) and it would have been much worse had it not been for the big Wednesday rally. Most European markets have fared even worse with the Frankfurt DAX off 12.7% and the Paris CAC 40 down 17.7%. Only the Brits, who had the wisdom to stay out of the euro, have fared better with the FTSE 100 down 7% for the year. Among all the world's major indexes, only the Dow Jones Industrial Average is in the black for the year with a 4% advance.
Strong currencies rise. Any flight to quality benefits strong, liquid currencies. The U.S. dollar is the almost universal first choice of frightened investors because of its universal acceptance and liquidity. The Swiss franc has been pushed so high that in August the government moved to curb foreign demand by increasing the money supply and pledging to keep interest rates close to zero. The Japanese government has also been forced to take steps to curb investor appetite for the yen.
Commodity prices fall. A slowdown in world growth, or even the fear of one happening, inevitably hits commodity prices and, as a corollary, the value of resource stocks. This is one of the main reasons why the resource-heavy TSX is down this year. The S&P/TSX Capped Metals and Mining Index has lost 26% in 2011 while the Capped Energy Index is down 16%.
Capital flows out of emerging markets. Almost everyone acknowledges that emerging markets in general and the BRIC countries in particular will be the main growth engines for the next decade or more. But investors don't want to be there when times are tough. That helps to explain why these markets have been much harder hit this year than those of developed nations. Hong Kong's Hang Seng Index has lost 17.5% so far this year while the Mumbai Sensitive Index is down 19.6%. Brazil's BOVESPA has fared only slightly better, losing 16.1%.
Now here's what will happen when investors once again develop an appetite for risk.
Bond yields will rise. The scramble for safety will end and bonds will become less attractive. As a result, yields will rise and bond prices will fall accordingly. Investors who are overexposed to bonds, in particular to long-term issues, may suffer capital losses.
Equity prices will rise. Undervalued stocks will be scooped up, driving markets higher - perhaps much higher as happened in 2009. People who bailed out of stocks entirely and put all their money in low-yielding GICs will be gnashing their teeth.
Commodity prices will rise. As the world economy gathers strength, commodity prices will rebound. A lot of money will be made in oil, coal, copper, and base metals.
Resource-based currencies will strengthen. The loonie and the Australian dollar will be back in favour and the higher commodity prices move, the greater the demand will be.
Capital will flow into emerging markets. Once again, people will want to be where the action is and that means new demand for shares in companies that are based in, or do considerable business with, China, India, Brazil, South Korea, Singapore, etc. Stock market direction will reverse and move sharply higher.
So there you have it: today and tomorrow. Now if only someone could work out a formula for determining exactly when that shift will happen, investing would be dead easy.
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