2001: It Could Soon Turn Ugly

January 29 2001

2001: It Could Soon Turn Ugly

January 29 2001

Amid the dark clouds gathering over the Canadian and global economies, three Toronto-based financial experts met in a Maclean’s boardroom to discuss investment strategies for the coming year. They were Jeffrey Rubin, chief economist for CIBC World Markets, Wendy Brodkin, president of Goodman Institutional Investments, and Eric Kirzner, a finance professor at the University of Toronto's Rotman School of Management. Here are highlights of the session, hosted by Assistant Managing Editor Berton Woodward and National Business Correspondent Katherine Macklem:

Maclean’s: How will the North American economy unfold in 2001?

Rubin: We’re going to have a significant downturn. Whether it’s defined as a recession remains to be seen. I don’t foresee anything as serious as 1990-91, but I do foresee the worst conditions we’ve seen since. We will have a recession in North America in manufacturing, and the epicentre of that recession is the auto industry. I think we’ll see as much as a 20 per cent reduction in auto production. And given that the auto industry is, from a composition standpoint, twice as important in Canada as in the United States—it’s nearly 13 per cent of our manufacturing and about six per cent of theirs—I can’t see how we’re going to go unscathed even with the protection of the cheap dollar.

I think the U.S. economy will have a negative first quarter, and that Canada will follow suit some time in the second quarter. And the recovery will be tepid, more U-shaped than V-shaped. If it were only a question of interest rates then I think one could be relatively optimistic. I think the Federal Reserve Board will cut interest rates another 100 basis points and the Bank of Canada will follow suit, with a lag. But another factor is energy prices, and they will not decline as rapidly as interest rates. I don’t see oil prices going much below $30 [U.S.]. Natural gas prices have already skyrocketed to an all-time high and I don’t see that coming down either. So energy is going to continue to be a drag on the economy long after interest rates have adjusted.

I suspect by March-April the Canadian data will be as ugly, if not uglier, than what we’re seeing out of U.S. manufacturing. And at the end of the day, not only will the Bank of Canada cut interest rates every bit as much as the Federal Reserve Board, but it will willingly acquiesce to another 10 per cent devaluation of the Canadian dollar. And that’s why the recession, or whatever you want to call it, in Canada is unlikely to be more severe than it is in the United States, in contrast to what happened in ’90-91.

Brodkin: First, I’m going to get my pet peeve on the table. I think a recession will be good for the average person: when there’s a little bit of tightening up and a little bit more unemployment, service levels—for e-commerce, or Eatons or Air Canada— might be a little bit better. The other thing for the average investor is, if interest rates are lowered, we could be looking at a pretty good bond return again, in the area of 10 per cent.

Kirzner: I tend to base my investment advice on longer-term considerations. However, I do share both Jeff and Wendy’s views on interest rates. They are critical to me, and I can’t see anything other than flat to lower rates in the forthcoming year in Canada. It’s positive for stocks and bonds, but for stocks it’s going to balance off—we’ll get a trade-off between falling earnings per share and lower interest rates. A depreciating Canadian dollar is a likelihood as well. 

Maclean’s: So what should a puzzled investor do? Let’s say he is new to it all.

Kirzner: What I want him to do is sit down and work with a financial adviser or, if he has the background, to do it himself and come up with a good, solid asset allocation. Before he does anything, I want him to come up with a suitable mix between safety, income and growth investments and I want him to develop a good understanding of long-term and short-term asset-class returns and use that as a base. 

Brodkin: The financial adviser thing is something I feel strongly about. For the average individual investing their own money, they’re taking on an inappropriate level of risk. The world is just so complicated, there are so many different factors, they need a financial adviser. And I would like to see the day where people use a financial adviser like they use a dentist or a doctor.

Maclean’s: Yet more and more people are investing on their own through the Internet.

Brodkin: Do it yourself. And I was horrified by an article in a recent Canadian investment magazine which was prefaced with: in 15 minutes per year as an individual you can build your own mutual fund and beat the experts. There are Web sites now where they can actually customize their own portfolios by buying blocks of stocks to build their own mutual fund. And this is one of the problems with technology—it’s giving people a false sense of comfort that they have this information and these tools and they can do it themselves, when in fact it’s so complicated that even the experts sometimes don’t know the right thing to do.

Rubin: I don’t know about financial advisers, and I don’t know about the long term. I tend to view all that as fluff. As an economist, I realize that the long term is nothing but a continuum of short runs and if you get the short runs right, the long term will tend to look after itself.

I think investors would be best not to be in the market right now. It may well be, probably better than 50 per cent probability, that there will be very attractive buying opportunities in the Canadian and U.S. equity markets in 2001. But certain things are going to happen before those opportunities will present themselves. People could be looking at a 10-15 per cent decline in the major indices—I’m talking S&P 500, Toronto. Nasdaq, you could be talking more of a 25 or 30 per cent decline. And it may well be that in the middle of the year, or at some juncture when people see the parameters of this downturn, there will be great opportunities to buy the North American market and it might come rallying back.

So let me just focus on the here and now. I think the only sector of the North American equity markets that is recession-proof is the energy sector. Because valuations of these companies in the market right now say that next year oil is going to be 22 bucks and gas is going to be $3 to $4. I don’t think gas is going to go below $5 to $6. In other words, oil and natural gas prices just have to persist at these higher levels for a company’s cash flow to defy valuations.

On the bond side, I think there are opportunities in the Canadian bond market. I’m not so sure that there are such great opportunities in the U.S. bond market because it has already paid itself for another two, three Fed cuts.

Kirzner: I think what Jeff has presented is very incisive and would be valuable for an institutional investor. With all due respect I would disagree with the year-to-year approach. If retail investors had bailed out of the equity market in '90-91 or the next downturn in '94 or during the Asian flu in ’97 or the Volga virus in ’98, with the exception of last April, from which there hasn’t been a recovery, they would have been sorry in every one of those cases. They would have missed one of the greatest decades. And in fact, if you look back over the past 20-30 years, balanced portfolios have done very well. Retail investors who tried to out-guess markets have not done all that well. I think it’s a dangerous tack. 

Rubin: I think the interest of the retail investor is no different than the interest of the institutional investor. It’s called let’s make money and get the highest risk-adjusted rate of return. And what’s appropriate for the Caisse de dépôt or Ontario Teachers’ is appropriate for Jeff Rubin’s personal portfolio. 

Brodkin: Can I try a different tack? I see three different types of investors, and it’s not whether they’re retail or institutional, it’s what their objectives are. One type, which Jeff has been talking about, is the type who’s made money and doesn’t want to lose their money and their risk is defined as capital loss. Now Eric, you can talk about the long term all you want, but if I take $100 and I put it in the market tomorrow and the market drops 50 per cent, it’s going to take me 10 years to make up.

Kirzner: Yes, but remember, I’m not going to let you put all of that money into stocks.

Brodkin: Okay. In any case, an investor who wants to protect their capital because there’s a lot of uncertainty in the market can go into bonds knowing that the expected return this year is going to be about 10 per cent. 

Then you have another investor who says, “I want to make money because I get really jealous when I go to cocktail parties and I hear about everyone else making 120 per cent return.” And there, I think you can go into the equity market but you have to have a lot of time to do it, you have to have a great financial adviser and a great investment manager and you’ve got to be active, active, active. You cannot invest in a way that’s predicated on any of the stock market indexes. Stock-picking is going to count. And the other strategy that’s out there right now that people can make a lot of money in is hedge fund investing.

There’s a third type of investor who knows what they want to do, knows where they want to get to and knows what kind of volatility they can withstand before they get there. So they’ve got an investment policy—Eric’s 20-30-50 balance— and they will keep re-balancing back to that year after year. They could do better but their expectation is that they want to get that average return.

Kirzner: And they’ve done very well over the past five, 10, 15 or 20 years.

Brodkin: Well, who said, if it’s windy enough, even a turkey can fly?

Rubin: I never buy stocks. I buy indices or I buy exchange traded funds or in the case of the energy sector, I know of at least two mutual funds that mirror the composition of the oil and gas index. Particularly for the retail investor, it seems to me there’s less and less need for active stock-picking with the proliferation of exchange-traded funds that allows people to make sector calls.

Brodkin: I’m not advocating that individuals actively stock-pick. They should look for those investment managers who offer products with active stock-picking. And I’ll go farther than that, I’m saying that 2001 is not the year to invest in a manner that mimics an index.

Maclean’s: Let’s look outside North America. Are there any opportunities?

Rubin: Well, this downturn has its epicentre in North America. There are probably going to be a lot of people who think this is the time to go into the euro or the major European stock markets. And I think they’ll be rewarded for a very short period. But I suspect what is happening in North America is going to come with a lag to Europe, and there are historical precedents for believing that when it does arrive in Europe it tends to be of a nastier shade than it is in North America. As for Japan, it doesn’t matter because they’ve been in a recession for the last 10 years. The worst performing stock markets in the world have been in southeast Asia. And if you look at who is most impacted by energy prices, it’s surely southeast Asia. I think you want to stay out of that region as well.

Kirzner: I’ve been following global investing for 20 to 25 years. I’ve seen very little evidence of managers who consistently make good country calls on the global side. Again, I’m sorry, I’m in the long term, Jeff, but that’s where I live. And what I’ve seen in the long term is that globally diversified portfolios deliver the goods. So I don’t try to guess whether it’s going to be Europe next year or it’s going to be the Far East. I’m still a fan of global investing.

Maclean’s: Was tech a complete bubble? Will those valuations ever return?

Rubin: What you’re really asking is, do you expect to see the Nasdaq composite index back to 4,000 or 5,000 in 2001 or 2002 or even 2003? And the answer is no.

Maclean’s: So has all of tech been overhyped? What about the longer-term potential of companies that are physically building the Internet, such as Nortel?

Kirzner: Some good companies are going to emerge out of this. Out of 500 companies that we could talk about, maybe 10 will turn out to be the General Electrics or General Motors of the 21 st century. My problem is, I don’t know which ones. Nortel looks like a good candidate but I can’t say for sure. So I would go back and say, yes, somewhere in my portfolio I’m going to have a small index of high-tech companies and it’s going to be in there for five or 10 or 15 or 20 years.

Rubin: If you want a long-run play— the only long-run investment that I have afforded myself—it’s genomics. I own a product that is a composite of about 23 genomic firms on Nasdaq. I feel confident that in the next five to six years, genomic applications in medicine are going to continue to grow at a very rapid rate. And when you look at what North America spends on health versus what North America spends on e-mail, I think the market is potentially pretty big. So I’ll allow myself the luxury of this one investment, although a really intelligent Jeff Rubin would have sold it in December and would probably buy it back in April. **