Reprinted courtesy of the National Post
by Tom Bradley

At this point in the stock market cycle, there’s lots to debate and little to resolve. There are, however, features of bad markets that are irrefutable. In a column early this year I started to compile a list of bear market truths. I’m going to build on it.

Everyone becomes an economist

As I noted in February, nobody has a clue where markets are going at any time. There are too many factors driving stock prices, only a fraction of which show up in media and research reports.

In more volatile, emotional times, however, commentators and investors get more confident for some reason. At dinner parties you’ll hear, “This market is definitely going lower. I can feel it.” Or, “We’re at the bottom and I’m buying.”

Everyone becomes an economist in bad markets and tends to forget what they don’t know.

Higher expected returns

Markets overreact to short-term news and macro-economic concerns. You just have to compare a stock index to charts showing corporate profits and economic growth. All three follow the same up and to the right pattern, but while profits and GDP wobble, stocks gyrate.

The reality is, the long-term value of a diversified portfolio changes very little with the news of the day. Companies are valued on their future stream of cash flow and dividends. The next few years, let alone few quarters, account for a small part of that value. New information may increase or decrease the long-term potential for an individual company, but it’s much harder to move the dial for a broad mix of businesses.

The implications of this concept are profound — when stock prices go down more than is justified by a change in fundamentals, the projected return of the portfolio goes up. In weak markets investors should be raising their expectations for stock returns, not lowering them as is so often the case.

At Steadyhand, we provide clients with a five-year projection for market returns. It’s not meant to be exact or definitive, but rather a guideline for planning purposes. Over the past two years, our range for stocks has been a modest four to six per cent per annum due to high valuations and growing debt loads, which steal economic activity and profits from the future.

In response to the stock market weakness, however, we’ve now moved the range up two points to six to eight per cent, which is closer to the historical average of eight to nine per cent.

New narratives, old facts

What’s fascinating about bad periods is how the narratives change, often with little or no change to the fundamental outlook.

Consider how the commentary on Apple has swung seemingly overnight. In August, the company hit a trillion-dollar valuation on the back of strong profits, skyrocketing cash levels and seemingly unstoppable growth. Now the dominant narrative is that iPhone sales are peaking, growth has come from unsustainable price increases and it’s no longer a clear-cut technology leader.

In bear markets, the pendulum can swing quickly. Companies’ warts are no longer airbrushed away. They’re in clear view.

A new boss in town

Weak markets are a necessary part of investing. Investors can’t benefit from the good times, like the last nine years, without also going through tough periods. The dips only hurt long-term returns when you let the market take over the management of your asset mix. Let me explain.

If you or your portfolio manager haven’t done anything to your portfolio in the past few months, then your asset mix has changed. Stocks have decreased as a percentage of total assets due to price declines, while cash, GICs and bonds have increased. Mr. Market has made this change without being asked. To prevent it, you either need to do some rebalancing or use contributions and withdrawals to get your mix back to where you intended.

It’s a truth that your long-term returns are destined to be subpar if you consistently go down with more stocks than you go up with.

What’s the plan?

A former colleague once said to me, “You trust your investment plan the least when you need it the most.”

Down markets have the most potential to impact your returns, good and bad. It’s not a time to toss out your strategy and cede control of your portfolio to Mr. Market or worse yet, your emotions.