Where do we go from here?

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Bear markets traditionally end with a term we call “capitulation selling.” Investors, fed up with underperforming securities, finally sell out their portfolios and switch to safer asset classes or assets that provide a guaranteed rate of return.

The S&P/TSX composite index hit an all time high on June 18 last year and, since that time, we have experienced the worst bear market since the crash of 1929. The big question is, have we hit bottom or are we going through a bear market rally? Other terms include, “bear trap” or “dead cat bounce,” describing a brief rally from a temporary bottom that gives investors false hopes.

We can’t know for sure but, with interest rates at near record lows, guaranteed investment products may be a bigger mistake than staying in the stock market. At the time of writing, five-year GIC rates are hovering around three per cent, while the dividend yield on five of the big six Canadian banks are over five per cent. For retirees and retiring boomers, the exception to this argument requires a discussion on insured annuity products: call a licensed insurance specialist for advice.

In late April, the Bank of Canada cut its key lending rate to 0.25 per cent and announced that it planned to hold this rate until mid-2010. It cited slower than anticipated global growth rates and lower inflation rates. According to the experts at the Bank of Canada, their revised economic “growth” rate calls for a three-per-cent contraction for 2009, and recovery not starting until the fourth quarter this year. It’s a bold statement and begs the question: what do we do now?

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While we can’t pinpoint a market bottom until after the fact, if we want to butcher a metaphor, for those still hanging in, you’re wearing the ruby slippers and have dealt with the wicked witch of the East (hedge funds unwinding their Japanese loans a.k.a. the yen carry trade) and hopefully the wicked witch of the West (Wall Street’s ill-fated adventure into bogus asset-back commercial paper), so all that is left is letting the wizard (not sure if it’s Mr. Geithner, Mr. Bernanke, or President Obama) get us all home safely.

Stock markets don’t go down forever. However, if you want to remain defensive, look for stocks and sectors still paying dividends. The Ishares Canadian Financial Sector Index Fund (symbol XFN) represents one such sector. I believe it hit an all time high on October 31, 2007 at $28.12 and then hit a recent low of $11.60. This index pays a quarterly dividend of $0.205 and, since hitting a March low, it has rallied to above $17. While there is no guarantee that dividends won’t be lowered, with 24 stocks in the index and a current yield in excess of 4.75 per cent, it’s a sector that gives me some comfort in this volatile environment.

If you want to look at something that might have a little more diversification, the Claymore Canadian Dividend and Income Achievers ETF (symbol CDZ) should provide investors with a greater cross-section of high dividend-paying corporations and trusts. It reached an all time high of $23.07 on October 31, 2007 and an all-time low of $11.08 on March 9 this year (both of these funds reached highs seven months before the market peak in June, 2008). Its dividend yield is a respectable 6.25 per cent.

One other sector you should look at is the corporate bond world. With fear and panic running through not only the stock market but also the debt market, we have witnessed the flight-to-quality syndrome where institutional and individual investors shun everything that doesn’t have a government guarantee. The traditional yardstick or yield differential between government and corporate bond yields has widened considerably. It means that as confidence returns, yield spreads will narrow and corporate bonds should rise in price relative to government ones. Have your investment advisor recommend a selection of corporate bonds or find a five-star bond fund.

Finally, don’t be afraid to look at corporate preferred shares. On the balance sheet, preferred shares form part of the shareholders’ equity account. The term refers to a class of shares that have priority to receive dividends that are usually fixed for the life of the preferred shares. In this respect, they are similar to bonds because they provide a fixed rate of return with an attractive tax-enhanced yield. In the short run, preferred shares pay a better return than the common shares but, over the longer term, as a company grows, the dividend on its common shares eventually exceeds the preferred-share dividend. Now, at certain times in the business cycle (read desperation), corporations issue preferred shares with benefits attached. The last time this occurred was in the 1980s. Corporations needing to raise equity found that investors shunned preferred shares because they dropped precipitously in price when interest rates rose to 18 per cent. To sell preferred shares, corporations added benefits such as conversion and retraction features; this allowed the holder the right to either convert the preferred shares to shares of the common stock (a real benefit as the stock market rallied) or turn the preferred shares back to the company for cash.

Luckily, we are in one of those times again and corporations, especially banks, have issued preferred shares with a dividend reset option. In the industry, we call them fixed floaters. In essence, the preferred share pays a fixed rate for a preset period, like five years. At the end of the first five years, the dividend is adjusted according to a defined formula, such as the Canada five-year bond yield plus four per cent. This provides you with a very attractive benefit.

Suppose, five years from now, we face a period of hyperinflation (not an unrealistic assumption given the bucket loads of money being passed out by central banks around the world) and interest rates rise to 10 per cent. A fixed floater, as described above, would pay 14-per-cent interest for the following five years! However, it’s imperative that you talk to a financial advisor before you buy or be prepared to research and understand the terms found in the prospectus.

In conclusion, I think we have seen the bottom but, in case we haven’t, seek out high dividend-paying stocks, high-quality corporate bonds, and fixed floating preferred shares. Remember, everything in moderation.