Edge | Financial Crooks

As soon as markets start to go up and stay up for a few months in a row, someone starts predicting that they will crash. And when the TSX and NYSE hit new “record highs” the buzz became almost deafening: Now a MAJOR market meltdown was inevitable–it was just a matter of when. But why? Why do people assume that markets reaching all time highs mean a crash is coming: if the stock market is supposed to return an 8% or higher average, doesn’t it mean it MUST set new records and fairly steadily?

Why Does Anyone Invest in the Stock Market?

Investing for Income

Some people invest in companies listed on the stock markets to get dividends and distributions. Their investment choices are driven by a need for income.

Not all companies offer dividends or distributions though. Why would people buy shares in those companies?

Investing for Capital Gains

Many other people are investing in companies’ stocks to try to win a capital gain. They want to pay $20 for a share and sell it to someone else for $40, or more. They are willing to buy shares that don’t pay anything to investors but which may be worth more in the future than they are now.

Obviously, sometimes these investors are unlucky. The perceived value of the company drops and if they sell their shares they realize a capital loss.

Shouldn’t the Stock Markets Indices, Over Time, Go Up?

If you go to a site like Yahoo Canada finance, or sign in to a brokerage website, you should be able to look at a graph of the S&P TSX Composite Index over several years. Go to https://ca.finance.yahoo.com/q/bc?s=^GSPTSE&t=my&l=on&z=l&q=l&c= and if necessary click on: Max

It should have jagged peaks up and sharp valleys down, but there should still be an overall trend in an upwards direction. Or at least there should be if you believe that investing in the stock market should yield you a capital gain, over time, if you invest a tiny bit in every company in that market index.

If you look at the last 10 years of the S&P TSX Composite, you will likely notice it spiked up to a nice point at about 14 000 in 2011 and it’s currently (in September 2014) at 15 000 and still climbing. In 2008 it also reached over 15 000. On January 1, 1985 it was under 3 000.

The overall trend from 1985 till now is up.

So why, just because we are finally trading in the 15 000 plus range, are people shouting it’s going to crash?

For people who had all of their money invested before May 2008, and who invested for capital gains not for dividends or distributions, it must seem like the party is just about to start. For years they’ve waited patiently, pocketing any useful distributions and dividends, but biding their time waiting for some big ticket capital gains.

Unless there’s some “invisible ceiling” at just over 15 000 why should anyone be panicking?

Doesn’t Couch Potato Index Investing preach that you don’t try to time the market, you just buy steadily and hang on for the ride? I’ve never read an index investing article that said there is a maximum the market is allowed to rise.

Why I Am Still Investing a Bit a Month Every Month Into the Index Funds Mirroring the Stock Markets

I’m not the usual type of investor. I’m very conservative and very risk averse. So my portfolio stands on a wide, thick platform of fixed income securities. Enough, in fact, to provide a modest retirement income if all of our other investments failed.

Most of our new money, however, is going into the equity markets.

We are still vacillating about whether to invest the majority of it into income-generating investments or into “buy the entire market” index investments.

While we are deciding, we are putting some of our new investment funds into both. It’s wishy washy but it beats having everything sitting in cash.

So every month, we put a bit more into the stock market in the form of “buy the entire market” “ultra low fee” ETFs.

And I don’t see any reason to stop doing that just because the markets are at “all time highs.” If they never pass today’s “all time high” then there is no actual capital gain ever to be made by investing in index funds. A whole branch of the investing industry is mistaken. They will all lose money and never be able to speak on CTV or CBC again.

That seems unlikely to me. Yes, there may be a market pullback or even a radical plummet. But if you believe that capital gains can be made by investing in an index-matching-style then sooner or later, the money you invested in an index should return to parity and should, ultimately, increase in value.

I don’t like the uncertainty. I don’t like wondering if I might be buying just at the time when the rug is about to be pulled and the market will tumble into a trench it will take years to climb back out of. But that’s the uncertainty I have to accept if I want to invest in index-linked products in order to (theoretically) capture some capital gains worth more per dollar invested than my fixed income investments can yield.

Wish me luck!

Related Reading

Why Couch Potato Investing Doesn’t Work … for Everyone

Join In
Do you index or couch potato invest? Do you have faith that the S&P TSX Composite must eventually keep rising about 15 000 and in fact above 16, 17, 18, 19 and even 20 000? Or are you selling out, buying food and ammo, and building a bunker out of gold bricks? Please share your views with a comment.

Our investments are mostly a mixture of fixed income and equities. Our fixed income is invested in GICs, HISAs and bond funds. Our equity holdings include “buy the entire market” ETFs and dividend-paying ultra-conservative stocks. Recently, I have been trying to decide what else to invest in to provide a steady income stream without being overly aggressive on yield or excessive on risk. An opportunity came up to buy some preferred shares in a major Canadian utility and I did so. Now I’m stepping back a few paces and trying to evaluate the merits of that investment versus how risky it is and decide whether to continue to hold my preferred shares or sell them.

Leaving the Nest: The First Flutters Away from GICs

For most of my “investing” life, guaranteed investment certificates have paid a reasonable rate of return. Being ultra-conservative and ultra-risk averse, I happily sacrificed growth for security. I’ll never be a multi-millionaire with this strategy but then I don’t need millions to live the lifestyle I want.

Only once we had enough saved in GICs to ensure a modest retirement income, did we start deliberately investing in the murky world of equities.

So I am still learning about what types of investments we can make and how risky they are.

My First Purchase of Preferred Shares

A few months ago, I purchased my first preferred shares. They were issued by a company with an excellent credit rating and a long history of paying its dividends in full and on time. The yield at the time I bought them was a bit over 5%.

Since then, I’ve brooded about whether they are a good choice for me. Here are some of the pros and cons of investing in these particular preferred shares:

Pros for My Preferred Shares

The yield on our investment is over 5% a year.

I bought them at a price below the “call” price. That means the issuer cannot buy them back from me for less than I paid for them. I can only experience a capital gain if the issuer “calls” the shares.

I have a chance of making a small capital gain if interest rates stay low and I sell the preferreds. In fact, these shares have already seen a capital gain of 1-2%. It’s even possible for the price to rise above the call price of $25 although it’s not likely to rise very much higher than that.

The utility that issued the preferred shares has been around for a very long time and is very stable. The risk of the company being unable to pay their dividends on time is very low. The risk of the company going bankrupt is extremely low.

The dividends for these preferred shares must be paid before the dividends for common share holders can be paid.

The payments are cumulative. That means if the issuer fails to pay a dividend one quarter it must eventually make up that missing payment.

The dividends issued by these preferred shares are eligible Canadian dividends from an eligible Canadian corporation. That means that the income is taxed at a lower rate than, say, interest paid on a GIC or a bond if I hold these shares in a taxable account (which I do.) So the amount of money I get to keep from these 5%-yield preferred shares is higher than the amount I get to keep from a 5%-yield GIC. It isn’t any higher, though, than the amount I would get to keep from dividend payments from common shares of say, BCE. (According to Tom Slee a preferred like this yielding 5.1% is about equivalent to a bond yielding about 6.75% in a taxable non-registered account.)

Interesting Fact about Preferred Shares

Historically, according to BMO preferred shares do not show a strong correlation to common shares or to fixed income investments. In other words, if common share prices drop or rise significantly, preferred share prices don’t usually move significantly in the same way each time, nor do they react predictably to bond prices and yields.

This historical indifference, though, could change.

Cons for My Preferred Shares

The maximum achievable capital gain is very small because the issue can be “called” by the issuer at various prices. By 2016, the issuer can call it for $25 per share. That means buyers are very unlikely to pay more than $25 a share as the date for that call price approaches.

I don’t have an option to convert the preferred shares into common stock in the utility.

The dividend will never increase.

Inflation may rise so the value of my dividend may gradually diminish.

Even if interest rates increase and yields on other investments increase, the dividend on this investment will not increase.

If interest rates rise and the yields paid on other investments rise, I won’t be able to sell my preferred shares to recover my initial capital investment.

For example, say I bought my preferred shares at $24 and they pay $1.20 a year each. If new preferred shares are issued at $24 paying $1.80, then no one will want my preferred shares. Well, they might if I drop my price from $24 to, say, $16. Then for each $24 a person spends they get $1.80 a year, whether it’s from 1 of the new shares or 1.5 of my shares.

So I would experience a capital loss of $8 per share if I had to sell. That would wipe out any dividends earned for nearly 7 years! (even longer if you include a factor for inflation.)

Why Some Common Shares are Preferred over some Preferred Shares

Many of the above factors are why BCE common shares are so popular right now. They are paying about a 5% yield on shares that have the possibility of almost unlimited capital gains, which cannot be “called” at a fixed price on a schedule by the issuer, and for which the annual dividend can and likely will be raised (based on BCE’s dividend history.) Of course, the price of BCE common shares depends on the performance of Bell itself. The company could tangle itself up like Nortel did and its common share value could plummet. It’s not as safe or regulated as the utility whose preferred shares I bought.

Some Preferred Shares May Still be Preferable to an Annuity

These type of preferred shares might also be a better investment than some annuities. With an annuity, the income is also fixed at the time of purchase and often is not indexed to inflation. (It may be higher than 5% though.)

When the last survivor dies, generally the principal of the annuity dies with him or her. There is usually no principal returned to the estate.

If someone dies who holds preferred shares, however, the shares might still have a capital value. It might only be 1/4 or 1/2 of what was paid for them, but it’s still a cash value.

Note that much of the income from an annuity is often insured so that it will continue even if the issuer goes bankrupt. None of the income from the preferred shares is insured and if the issuer goes bankrupt then the income from the preferred shares will be lost. They are not interchangeable investments.

What Will I Do with My Preferred Shares?

My shares have paid me a few dividends and right now stand to win a small capital gain if I sell them.

If interest rates rise and companies start offering investments that pay a higher return than my preferred shares pay, then I may face a substantial capital loss.

A 5% return is not all that high when inflation is running about 1-2% a year.

I think I will probably sell my preferred shares sooner rather than later.

UPDATE: Sold! And yes, I feel good about the decision. I made a small capital gain and received some great dividends. Now I’ll look for a home for the capital that feels more comfortable to my risk-averse soul.