Relax - The sky has not fallen (Part 2)

Supply and Demand

The extreme reduction in the number of investment-grade corporate bonds didn't make the lives of retirement fund managers any easier. They could make up for the shortfall in supply of safe corporate bonds by buying even safer government bonds, but even there, demand was outracing supply. As more and more governments like the Canadians are paying down their debts, the need for financing of deficits by issuing bonds is reduced - the supply is less. Even in the deeply indebted United States, according to Merrill Lynch the rate of growth in Treasury bond issuance has slowed recently to just over 5% in 2006 from a high near 13% in 2003. Globally, estimates of the demand for high-quality government bonds - from the European Union, the United States, Canada and Australia, for example - show a shortfall in supply.

And, of course, those high-quality government bonds came with lower yields. That's a huge problem for the folks who sponsor pension funds, such as provincial, state and city governments, as well as those companies that still offer traditional pensions. If the yield earned on a fund's assets goes down, the sponsor has to put in more money to keep future obligations in line with future assets. And you're talking about a lot more money when involving obligations that may be 10 or 20 years off. That's money that cities, states, provinces and corporations either don't have or don't want to spend on pension benefits.

That was when the whiz kids at the banks and brokers walked in with an amazing deal. Investment bankers should spin speculative-grade credits, whether corporate debt and loans from a buyout deal or mortgages from financially challenged homebuyers, into investment-grade credits. By bundling together groups of credits, or pools of loans, corporate debt or mortgages, the investment banks declared that you would lower the chances of investors taking a hit if a loan or mortgage went bad. In essence, diversifying risk away, they were all into the same asset group - sub prime!

The managers of retirement assets could have said no to Wall Street, as many did. But others signed up to be conned. They heard what they wanted to hear. They ignored their inner voices questioning if straw could really be turned into gold by slicing up a pool of speculative-grade credits. They also decided to overlook the history of other market miracles of financial engineering. There are numerous instances where market inventions failed to behave as advertised.

What Conclusion can we draw?

So what does the recent market pullback mean to you and your portfolio? One thing it does not signal is to panic and sell!

There is a discrepancy between how investors do and how the market does. In fact, there's a difference between how intelligent investors do and how the average investor does. Since you most certainly want to be in the former category, let's discuss some of the principles that can put you there.

Benjamin Graham's "The Intelligent Investor" was first published in 1946, but has been revised and printed many times since. It is a classic, often described by some of the world's best investors, including a gentleman named Warren Buffett, as the best book on investment ever written.

Early in his work, Graham puts it right out there. "We must prevent our readers from accepting the common jargon which applies the term 'investor' to anybody and everybody in the stock market." This is a critical distinction, because issues that concern speculators don't necessarily matter to investors. "Investing isn't at all like speculation, Graham says. It's like being a businessperson."

"Investment is most intelligent when it is most businesslike", writes Graham. "It is amazing to see how many capable businessmen try to operate in Wall Street with complete disregard of all the sound principles through which they have gained success in their own undertakings."

A businessperson understands about cycles in any business, and how to capitalize on more attractive prices for future gains.

So what do we make of the recent pullback in the stock markets? For some, it will be a buying opportunity. But an intelligent long-term investor will see it as just another ripple in a market full of conflicting emotions and opinions, which has no bearing on the long-term value of well-chosen investments.