It's therapy time for investors with a phobia of falling stock markets.
Not only can you survive another downturn, you can actually turn it to your advantage.
In no way is the Portfolio Strategy column forecasting a worsening of the declines we've seen since the major stock indexes reached their highs for the year in late September. Ours is not to forecast, but to educate. It's not just the boy scouts who have the motto "be prepared."
Let's first look at what might happen if the stock markets fell sharply. Government bonds would no doubt benefit, just as they did a year ago when they became the favourite parking spot of panicked professional and individual investors. Bond prices soared, and that's meant solid gains for investors holding mutual funds and exchange-traded funds holding bonds.
Government bonds would again be a rock in a stock market downturn, but the returns for investors won't be as dramatic as last time. "I think bonds have pretty well gone as far as they're going to go," said Andrew Pyle, an investment adviser with Scotia McLeod who has a background as an economist.
Mr. Pyle argues that bonds benefited not only from falling stock markets, but also a decline in interest rates that was set in motion by central banks to ease the recession. Today, he argues, rates have pretty well hit bottom and everyone is looking ahead to a time when they start rising again, possibly next summer.
Rising rates would be bad for bond funds. But if we're talking strictly about a stock market plunge, government bonds would offer the potential for mild returns. You want them in your mix of investments, then.
Note that we're talking here about bonds issued by the federal and provincial governments and their agencies. Corporate bonds took a beating in the market plunge last year and, despite a strong rebound this year, they would be hurt by renewed financial market turmoil.
It's worth noting here that lots of investors are parking cash in money market funds. They're safe, but high fees have reduced returns to pretty much zero in many cases right now.
Now for the stock markets. "When things keep sliding, you'll find the four defensive sectors will do the best - telecom, utilities, health care and consumer staples," said George Vasic, strategist at UBS Securities Canada. "The ones that will get hit the hardest are the more cyclical ones like technology, industrials and consumer discretionary."
That leaves three other sectors - financials and energy and materials, both of which can be grouped together as commodities.
Mr. Pyle said Canadian banks may show some resilience in a downturn, which would be a switch because the financial sector led the charge into a bear market. The decline was caused in large by worries that Canada's banks would suffer as much as their global competitors in the financial crisis, and that this in turn would lead to dividend cuts. While the insurance giant Manulife did cut its quarterly payout by half in August, the banks have proved their strength by sustaining their dividends.
"Canadian financials will probably be one of the sectors that hold up well if the markets correct," Mr. Pyle said. "They may give up ground, but I don't think you're going to see a massive pullback."
He's also somewhat optimistic about commodities. Whereas the bear market began with oil coming off a high of $147 (U.S.) a barrel, these days it's close to $80. At the same time, demand for oil and other commodities from China, India and other emerging economies remains strong. In a stock market pullback, then, he foresees investors trimming their commodity holdings but not fleeing them altogether.
Mr. Pyle said he'd be more cautious about commodities if there was a sense that global economic growth was not recovering from the recession, which in turn would mean less demand for oil and metals.
Gold has done well lately, and Mr. Vasic thinks it could stay strong if the stock markets fell hard.
"Gold is somewhat of a hedge [against uncertainty]," he said. "Last year, gold stocks were flat while the TSX was down 30 per cent. They did their job during the darkest hour."
Given how far the market's come since March, now is a good time to rebalance your portfolio by ensuring your holdings of stocks and bonds are what they should be based on your overall financial plan and investment needs.
The billions of dollars sitting in money market funds and savings accounts right now tell us that many investors are light on stocks right now. A market decline would be an opportunity to fix this. It would also present an opportunity for people who actually want to get back into stocks, but are worried that prices have risen too far.
"The market rally was very large, very fast and sooner than expected," Mr. Vasic said. "A market pullback would give people another chance."
He suggested investors use an averaging-in approach, where they make regular periodic purchases through a downturn. What to buy? He pointed to the sectors like technology and industrials that would fall hardest in a downturn, but potentially do best in an economic recovery.
David Baskin, president of Toronto-based Baskin Financial Services, said there are good values even now among blue-chip dividend stocks.
"I've been banging on that drum for a while - Canadian Utilities, Fortis, Enbridge and some of the telcos - you could argue that the market is overvalued, but not these stocks," he said. "Plus, their average dividend yield is about 4.5 per cent."
In fact, the best performer of this bunch is Enbridge, up about 9 per cent this year while the S&P/TSX composite has gained 24 per cent. Over the past three years, however, Enbridge's cumulative gain of 13 per cent compares with a loss of 9 per cent for the index.
Still suffering from a fear of falling stock markets? We all are, so don't sweat it. Just keep in mind that with the right planning, you can survive and position your portfolio for better times ahead.
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If stock markets fall again...
| What Might Happen | What You Should Do |
| Government bonds will do well | Keep some government bonds or bond funds in your portfolio |
| Defensive sectors like utilities, health care, consumer staples and telecom will hold up | Take advantage of falling stocks to make regular periodic purchases of stocks that will do well when the economy improves |
| More cyclical sectors like technology, industrials and consumer discretionary will fall the most | Look at blue-chip dividend stocks that have lagged the overall market |
| Banks could hold up comparatively well | Remember that returns in money market funds are pretty much zero right now |
| Gold stocks should do well | |
| Oil and metal stocks will fall |
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