Stock Market Crisis: How Concerned Should You Be?

What are investors to do with the news of the most significant negative developments in the stock market in a decade? Is the worst over . . . or yet to come? To help you sort it all out, The Knowledge Bureau has solicited insights from three experienced industry experts with feet on the street in New York, Vancouver and Winnipeg:

KB LISA LANGLEY: What is happening with Merrill Lynch, Lehman Brothers in the US?

LL First Merrill Lynch has merged with Bank of America, which they are calling a uniquely timely strategically complimentary combination of two organizations who aspire to be a global premier financial services provider. The value of the deal was positive for Merrill Lynch (a premium to current price) and though there will surely be redundancies, an ML advisor commented this morning that he felt it was very positive.

Lehman Brothers had over 750 billion USD in exposure and there just wasn't a buyer who could absorb the hit. This is just the beginning of the process as their book gets re-priced. Employees went in to gather their things and walked down the streets with their boxes in their arms. The word "calamity" is being used a lot.

Now the Fed is urging a consortium to provide $75 billion in loans to AIG, a company which was one of the largest market caps.

KB What does this mean to the Canadian investment industry?

LL The credit crisis is all about issuer strength now, and investors have less faith in credit ratings. The ability to provide a true value to all investment instruments of all types is critical. The strength of the Canadian national banking system and the reduced exposure to the credit crisis will help, however, there will be impacts. Pension funds are facing hits, as commodities drop now the effect is doubling up on the credit crisis shake-up.

KB What does it mean to Canadians with investments in the US?

LL Diversification by asset class and by region/country has always been important. As long as the positions held are in strong organizations, there are definitely some buying opportunities and certainly some areas of strength. US Bank went up today. The overall news is dim, but there are pockets of good news.

Due to the regulations requiring segregation of securities for brokerage firms, individuals have not lost their capital. The securities in the accounts of individuals have not been lost and this has been repeatedly covered in the US media.

KB What could happen if there is a run on the banks in the US?

LL The Federal Reserve acted quickly to back up Fannie Mae/Freddie Mac and they have a significant position in these two organizations. There will not be a run on US banks. I expect there will be consolidation of organizations across the sector.

KB How will all of this affect current and future retirees?

LL Retirees need to examine their comfort level with the current structure of their portfolio. There is a lot of discovery continuing in the market right now, and we will continue to hear more. So it is important for retirees to make sure they have a risk tolerance level suitable to their specific situation and a portfolio structure that reflects those objectives. All segments of the market have not been affected. Investors should meet with their advisors and develop an understanding of where they stand. Examine opportunities carefully, and make sure you understand the issuer strength of what you are invested in.

KB What should people do, if anything?

LL Professional advice is worth its weight in gold, especially now. Make sure you are investing with a long-term approach and a risk tolerance you can live with. Meet with your advisor and understand what you are holding in your portfolio.

KB DOUG NELSON: How do Monday's events affect advisors and their clients?

DN We are currently seeing the bursting of two bubbles: real estate and then financial products related to real estate. Many financial firms are a party to complex financial instruments that invested in these areas. Many / most of these investments were leveraged significantly.

These were investment structures that were created by the investment banks, hedge funds and others. The value of these instruments has declined significantly as the real estate market declines in value and as the default rate on mortgages rise.

The question is: "what are these assets really worth"?

Since financial institutions are legislated to keep their balance sheet within certain ratios, the decline of these assets means that the institution needs to find new assets or reduce liabilities. But there comes a time, as we have seen, that the institution has lost the "confidence" of the market and the stock begins to see significant declines to almost unbelievably low values. The big problem, even though the company has seen such a significant decline in its value, is "what is the real value" and "what is it on the hook for as it relates to their obligations to some of these financial instruments".

The million dollar question is the ripple effect. For one, we are seeing unemployment on the rise. This may see a further decline in consumer spending which in turn affects manufacturing and real estate. This may then impact demand on commodities which would affect the value of the Canadian stock market and Canadian economy. The ripple effect may continue to the European banks that were also party to these types of contracts.

So: "what is NOT effected" when the financial sector melts?

KB What does this mean to the Canadian investment industry?

DN One of the major investment themes of the past 18 months has been the relative value of the U.S. market vs. the high driving commodity based Canadian market. Many money managers and advisors have begun to further "diversify" into the U.S. and globally. Any money manager that has done so will have seen a significant impact on returns. Alternatively, any money manager in Canada that remained focused and overweight in commodities, has also felt a significant decline since, in particular, the middle of June. This series of events may mean that the Canadian markets could be in a significant period of under-performance for the next few years.

KB What does it mean to Canadians with investments in the US?

DN Any U.S. investment held by a Canadian has not seen any significant gains for the past 10 years. In fact, when you factor in currency the return has been negative. This point is exasperated further by the recent events.

KB What could happen if there is a run on the banks in the US?

DN This is anyone's guess and I don't want to speculate. No doubt fear of further loss will be a major concern to any investor. A run on a "retail bank" is a significant crisis of confidence that will need to be avoided at all costs. We have already seen the impact of a "run" on the major "investment banks". If there is no confidence in a financial institution, how do they ever attract new deposits, investors or institutional clients?

KB How will all of this affect current and future retirees?

DN We know historically that anyone retiring at the end of a market cycle, such as what we are experiencing today, has a much greater possibility of running out of money some time in retirement. The best advice for those thinking of retiring today is to consider postponing retirement for 1 to 3 years until this situation is sorted out. Alternatively, some may wish to consider life time annuities as a way of providing consistent, secure and lifetime income. Annuity income in Canada is insured up to $2000 per month by the Compensation Corporation (CompCorp.) in Canada.

KB What should people do, if anything?

DN The time for "action" is probably over. The time to have been more defensive has probably passed. Yet, people should "learn" from this situation. They should recognize that large companies do fail. They should recognize that leverage creates "immeasurable" levels of downside risk. They should recognize how important it is to be aware of market cycles and the seasonality of different subsectors of the market. They should also recognize how important it is NOT to chase returns or assume that "things will always go up". The key here is to own liquid investments, to assess the level of risk in the portfolio frequently and in a systematic manner, and to never get complacent.

KB CAMERON HUTT: Is there a historical perspective to this activity?

CH What's happening right now is unprecedented in the case of Lehman Brothers. You may recall in 1998, Long Term Capital Fund, a global source of investments to banks and brokerages went bankrupt; they had to make up losses, and the future of financial services was questioned at this time. Like many did a decade ago, we are now embarking upon the same questioning about this week's extremes.

KB Some clients may be worried about a run on the banks. Should they be?

CH This a liquidity issue for the firmsóTier 1 capital may not be onside immediately and when this happens firms which don't have the cash on hand will play down and falter. To deal with this many will issue paper (preferred or new commons) to create new moneyóthis dilutes shareholdings but keeps regulatory Tier 1 ratios onside.

So largely its business as usualówe are experiencing very bad losses never seen beforeóin Canada as well as US (with asset backed commercial paper in Canada or subprime issues in the U.S. held through subsidiaries). Canadian based banks that have had a lack of involvement in the U.S. have faired much better.

Of all the markets Canada has faired very well compared to US and European equivalents. Still off 11% as a group, could be a buying opportunityóthis might be a good time to start. However Canada is not immune to U.S. markets, so enter cautiously.

KB Should Canadians with US investments be worried?

CH Yes. This has been a very poor investment and might be even pooreróit's very hard to watch, one would certainly rather be in cash, investing in these levels. Portfolios could lose more. Junior investors will sell and more seasoned will not sell as quickly.

KB Should they sell?

CH Try to reduce exposure to high risk areas and make your portfolio more immune to further declines. Holdings in brokerage firms, banks: try to reduce now.

KB What advice would you give to retirees?

CH Try to reduce risk in the portfolio, don't start to try to play the game. Principle protection really important. Bond yields are so low but better than a decline in principle. Reassess your asset allocationóbalanced portfolio is best. See their advisors.

KB What about day traders?

CH Good luck!

KB Advice for Advisors?

CH Many don't know how to deal with this, especially those new to the industry in the last 5 years. Advice to new players: think long term. Even in the case of bankruptcy there are often companies looking for takeovers, acquisitions. There are glory days ahead. If this is a forest fire (necessary to burn deadwood) this cleansing process is really good for markets to flourish again.

KB What about the "Do nothing" folks?

CH If there is no need for income from the portfolio and you have a long term perspective, it will work out for you. You are likely in a good spot if you are reasonably diversified and have a proper asset allocation. Three to five years from now things won't seem so bad.

KB Last thoughts on Investor Behaviour in times like these?

CH If you have properly managed portfolios, sit tight and hold on while you temper your mood. But if there is a betting game in specific sectors, then reassess, be proactive and reduce exposure, albeit at a lower level.