Patient, disciplined investors will win through in the end

February 2012, BayBizNews, Hawke's Bay Today

Last year the focus of global financial markets was firmly fixed on the American economy.  Recent economic data suggests that the underlying American economy is now actually in reasonably good shape and the global problem child has become Europe.

Unlike most economies, the layers of bureaucracy that lace the European Union (EU) make the process of agreeing and implementing sound action plans more difficult.  The intense media focus on the financial situation in the eurozone has understandably made some investors nervous.  Markets will continue to speculate about possible outcomes to this crisis.

It is important to remember that all scenarios being discussed in the media - from the subtle to the extreme - are public knowledge.

The first stage of the global financial crisis, from 2007 to 2009, focused attention on the plight of much of the developed world's banking systems and the use of highly leveraged and opaque derivative instruments.

This second stage, dating from early 2010, has centred on the subsequent damage to many already stretched public-sector balance sheets of bank bailouts and the consequences of extremely loose government fiscal policy in the preceding decade.

While the governments of the United States and Japan face major medium-term fiscal challenges, Europe has been the epicentre of market concerns.  In the past year or so Greece, Ireland and Portugal each have received financial assistance to cope with large debt loads.  In more recent months, the concern has spread to Italy and Spain.

Many of the governments have agreed to introduce austerity measures in return for promises from the European Union, the European Central Bank and the International Monetary Fund for continued short-term financing.  Policymakers, meanwhile, have approved changes to a special bailout fund to stem the risk of further contagion.  Greece has won a new assistance package of up to 130 billion, but at the expense of a 50 per cent discount for bond holders.

The world's major central banks announced steps to prevent a credit crunch among the banks in Europe.  This helped to calm global markets, and led to the Australian stockmarket rising 7.6 per cent over the week.

No one can determine what will happen next but there are some possibilities:

• It will be a long road - it will be years before the eurozone and other developed nations such as the US can constructively escape from their straitjacket of debt.  But it is important to remember that there is no direct link between a country's economic growth and the performance of its stockmarket.
• The market has already effectively valued Greek sovereign debt as if it has defaulted.  Whilst the EU would like to avoid this outcome, the odds of it happening are high.
• Bondholders who invested in Greek debt should bear the pain of default - this is how capitalism works. However, this must be balanced against the need for financial stability and ensuring a properly functioning banking system.
• One scenario which has been canvassed is that the euro currency may cease to exist. If this occurred, this should not affect the ability of any governments to repay their loans.
• The market has priced in the expectation of further bad news to some extent. So there is a possibility that bad news reported in the media may actually result in stockmarkets rising if the news isn't actually quite as bad as expected.  It is important to understand that recent market volatility is not an indicator of lower expected returns in the future.  Simple economic theory tells us that the expected returns of stocks actually goes down in good times, and goes up in bad times.  That is why disciplined investors who remain patient when times are bad inevitably experience strong returns when markets recover - though we can never be certain when this will occur. 

It is likely that uncertainty of outcomes will prevail at present. Investors in stockmarkets must accept that markets go up and down.

On 25 November 2011, newspapers in Sydney quoted the CEO of Commonwealth Bank saying that GFC 2 could be on the way.  This headline may have caused some concerned investors to sell down their stock portfolios.  However, over the next six days the stockmarket actually rose by 8.4 per cent.  This is a reminder that knee-jerk reactions to headlines and opinions can cost investors dearly.

For most investors, rather than worrying about international events they have no control over, the focus should be on generating cashflow over their time horizon, to ensure they can enjoy the lifestyle they desire.

Disclaimer

The opinions expressed in this article are those of Stewart Group’s advisers and should not be considered as advice. Investors should obtain professional advice regarding their own financial circumstances and objectives before making any investment decision.  Under the Financial Services Act 2008 a copy of our Disclosure Statement is available on request and free of charge.