The Globe and Mail, Report on Business
Published November 14, 2009

Here I go again. Just when everyone is starting to enjoy themselves, I'm getting uneasy. It's time for investors to temper their expectations for returns and prepare for some bumps in the road.

This doesn't mean the cycle isn't playing out as it should. The economic numbers and leading indicators have turned up. We are coming from a low base, but that's where every cycle starts. And we are working through the usual amount of skepticism – that “this isn't for real” – and uncertainty about the profit outlook.

So why the dose of caution?

Well, first let me say that there are always bumps for equity investors and we need to be reminded of that after eight months of going straight up. And the managers I talk to say they're having a harder time finding stocks that are attractive based on long-term earnings. What was screamingly cheap nine months ago is, at best, fair value now.

But the key question is whether fair value is cheap enough in the context of some troubling trends.

Lack of a cleansing
There are two ingredients necessary for an economic and market retrenchment to be successful – time and hardship. Both are needed to purge the excesses built up in the previous cycle.

Certainly we've had some hardship, particularly in the U.S. and Canada's industrial heartland, but not enough to provoke fundamental change. We're using the same tired tools to solve our problems – government money and low interest rates. Programs like “Cash For Clunkers” are simply borrowing from the future to make the present a little easier to take.

As a result, in areas like autos, housing and investment banking, the game is on again after a very short respite. It increasingly looks like the last two years will go down as a crisis well wasted.

Reaching for yield
Asset prices based on artificially low interest rates are a poor foundation for the next cycle. On both sides of the ledger we see the distortions that low rates bring.

House buyers are taking advantage of rock-bottom mortgage rates and buying with gusto again. Low rates lead people to believe they can afford homes they can't.

As an aside, I'm amazed when I read about 35-year mortgages at a 1.5-per-cent floating rate with 10 per cent down. Isn't that the kind of business the banks were regretting just a year ago?

As for fixed-income investors (non-bank lenders, if you will), they're sick of earning nothing on their guaranteed investment certificates (GICs) and government bonds. So they're moving up the risk curve and buying corporate bonds and specialty products to generate more income.

As the adage goes, “More money has been lost reaching for yield than at the point of a gun.” Those words always give me the shivers, although the current ‘reaching' is still pretty benign. The yield spread between corporate and government bonds, which reflects the additional risk, is still above long-term averages and wider than it was two years ago.

The starting point
Market cycles are defined as much by where they start as by how and where they end. Depressed earnings, high yields and the stirring of favourable secular trends all make for an attractive starting point.

Unfortunately, earnings aren't really that bad today – profit margins are still near historical highs. Yields are already low. And the tailwinds that aided the last cycle – easy credit, a consumer spending boom and tax cuts – will be headwinds this time around.

Acts of caution
As regular readers know, I never ascribe a high degree of precision to my big-picture views. My goal is modest – get it approximately right. The further investors migrate from the fundamentals and valuation of individual securities, the more difficult it is to consistently get it right. As a result, any actions based on those views should be measured and done in the context of a long-term asset mix.

The dramatic move in the markets, as well as the above-mentioned caution flags, have pushed me to make some changes. I've sold stocks to bring my equity weighting down to the bottom half of my range. I still have considerable exposure to equity markets, but less than I had at the beginning of the year.

I followed the advice we've been giving our clients and put some of the sale proceeds aside to fund short- to medium-term spending needs. For retired clients particularly, it's time to replenish the pot they pay themselves from, as hard as that is to do when money market funds, GICs and savings accounts are paying next to nothing. Good markets are the time to build a cash cushion, so it's available to draw on in less favourable periods.

Within my equity investments, I've moved further into high-quality stocks that should do well in a sluggish environment and rebalanced towards funds that have lagged behind the market.

Investing is about always having a favourable balance between reward and risk. It's about benefiting from being right and being able to live with being wrong. At this point, I don't see enough reward to justify taking maximum risk.