Playing defence during a stock market crisis

Originally published in December, 2008, this article still holds good reminders for how to react during a financial crisis. While the market wouldn’t bottom until March 9, 2009, Canadians would have done well if they listened to the advice in this piece. 

Imagine walking into your favourite store to discover that all the things you wanted to buy were on sale. This is how smart investors feel right now. The share prices of many excellent companies are the cheapest that they’ve been in more than a decade.

There is only one catch. While stocks look like bargains in terms of all the standard ratios—price-to-earnings, price-to-sales, price-to-book—that doesn’t mean that you can buy something Monday and expect to make a profit by Friday. Markets don’t usually bounce back quickly from a beating like the one they’ve just endured.

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If you look at recent bear markets, such as the one that occurred in 2001-2002, you find that markets often fall for 18 months before beginning a sustained recovery. They frequently stage rallies, only to fall back even further. And that’s with a standard bear market, such as the ones that follow a conscious decision by policy makers to raise interest rates and puncture an inflationary bubble. The current downturn may have a much longer life than its recent predecessors, because this time the crash was not triggered by deliberate policy, but by an unforeseen credit crisis.

Credit markets are as important to a healthy economy as arteries are to a healthy body, and the current crisis has clogged them to the point of failure. Lehman Brothers’ failure and the massive losses suffered by other financial institutions have reduced bank lending around the world. The credit crisis that has resulted is disturbingly similar to the 1930s depression and to Japan’s lost decade of the 1990s. Nobody is expecting the downturn to be as bad as those decade-long slumps. But it’s impossible for anyone to determine the extent of the damage, or calculate how long the downturn will last.

The good news is that this bear market will eventually end like all its predecessors, and long-term investors should do well. The bad news is that investors may have to wait longer than they would like to reap their reward. So even though equities look attractive, don’t throw caution to the wind. Stick to the basic rules of investing.

The most basic rule is to maintain a diversified portfolio. To my way of thinking, even the most aggressive portfolio should not have more than 65% in stocks and most people should stick to somewhere between 50% and 60%. The remainder should be in bonds, cash or other investments that can provide you with a cushion if stock markets continue to fall.

Second, don’t overestimate your appetite for risk. If you couldn’t sleep during the past two months because of your stock market losses, you had too much money invested in stocks. Adjust your portfolio so you don’t find yourself in a similar situation in the future.

Third, never invest money in stocks that you will need in the next five years. This ensures that if stocks need five years to regain their losses, you won’t have to sell your investment at a loss.

Fourth, let your portfolio decide what you do next. This means deciding how much of your portfolio should be in stocks, how much in bonds, and so on. Adjust things once a year or after a sharp market move to get back to your target.

Here’s an example: assume you have decided on an asset allocation for your portfolio of 50% stocks and 50% bonds and cash. A 45% loss in the stock market—like the loss suffered by many people over the past few months—reduces your stock holdings as a percentage of your overall portfolio to just 35%. So this is a good time to rebalance, by buying enough stocks to bring the percentage back to your long-term goal of 50%.

What should you buy in those turbulent times? I believe that stocks are so cheap that almost any low-cost index fund that tracks a broad market—such as the S&P/TSX composite index in Canada, or the S&P 500 index in the U.S.—should make you money if you hold it for the long term.

If you don’t like volatility, or you’re investing for a shorter period, I suggest caution. The immediate future for Canadian stocks may be bumpy, so stick to mutual funds or index funds that invest in larger companies such as banks and major oil producers. While Canadian banks are being dragged down by worries over the global credit crunch, and oil companies have tumbled because of falling oil prices, all these companies should be fine in the long run.

I would avoid Canadian small cap funds for now, because of the high number of junior oil, gas and mining firms in this sector. Junior companies have uncertain assets and reserves; they also suffer from higher production costs and weaker balance sheets than their bigger competitors. If oil and commodity prices fall into a long slump, many of these junior producers may not survive.

Utility companies that deliver gas, electricity and water are traditionally regarded as defensive investments, because people need to turn on their lights and heat their homes no matter how bad a downturn gets. To find funds that specialize in utilities, you have to venture outside Canada. A couple of excellent exchange-traded funds (ETFs) that trade on the New York Stock Exchange specialize in the utility sector and I would recommend them to your attention. The iShares Dow Jones U.S. Utilities Sector Index Fund (NYSE: IDU) charges a management expense ratio of only 0.5% and gives you exposure to a number of U.S. utility companies. At the time of writing, it was selling for only 12 times earnings and paying a 3.5% dividend yield. If you want a global utility fund, choose the iShares S&P Global Utilities Sector Index Fund (NYSE: JXI), which has similar fees and characteristics.

Another way to play defence in these turbulent markets is to invest in a fund that specializes in dividend-paying stocks. The regular dividend payments provide support for your portfolio even if stock prices stay down. But dividend funds still have their risks. One risk is that an extended recession may force companies to cut dividend payments, making the stocks less attractive. Another risk is that dividend funds, particularly Canadian ones, are heavily concentrated in financial stocks, which are experiencing extraordinary volatility. If you want a dividend fund with less concentration on financial stocks, try Phillips, Hager & North U.S. Dividend Income Fund. It has about 20% of the portfolio in financials (versus 40% to 50% for a regular Canadian dividend fund), and some of its top holdings are offering superb dividend yields.

Health care funds represent another defensive alternative. People still use pharmaceuticals and health care even in a recession. Plus, this sector has been out of favour for so long that it seems ready for a rebound. Canadian fund companies offer many actively managed funds, but most charge management expense ratios of 2% or more, without any compensating increase in performance. I prefer the iShares Dow Jones U.S. Healthcare Sector Index Fund (NYSE: IYH). This exchange-traded fund charges only 0.5% in fees and has managed to weather the recent storm relatively well. Since January, it is down by just over 25%, versus a 40% loss for the S&P 500. I believe long-term investors will be happy with its performance.

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