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Andrew Allentuck

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The fallen

Andrew Allentuck

Stock market investment theories seldom endure very long.

The reasons for the brief half-life of investment fashions like the December effect that is supposed to raise the value of small cap stocks at year end is that, in anticipation of them, investors pile into the chosen stocks ahead of the craze and raise their prices before the time the effect is supposed to happen. The effect is dissipated and the theory no longer works.

The ongoing bear market has put many theories to shame. Among the fallen:

Geographic investing — the idea that global markets do not all rise and fall together. The core of the concept was that markets like Thailand's or Russia's were growing so fast that they could keep up their momentum even if New York or London faltered.

The idea turned out to be utter nonsense, says Dan Stronach, head of the Stronach Financial Group in Toronto. "No country has escaped from the carnage of the present

global bear market." Indeed, most of the worst damage has been in foreign markets.

Canada's 38.2-per-cent drop in the S&P/TSX Total Return Index for the 12-months ended Feb. 28, 2009 makes us a strong survivor. The MSCI World Index of all major stock markets dropped 46.8 per cent in the same period with some indices, such as the Hang Seng, which was down 47.3 per cent, and the Milan General Price Index, which was down 51.6% in the same period, faring far worse. Globalization worked like a case of the plague with one market's downfall infecting others. No market was immune, though rates of decline did vary.

Next flop: industrial diversification. The theory is that what happens to banks does not necessarily happen to biotech or big pharma, auto parts and gold. Let's bury that one too. In the fall, panicked investors sold everything they could to pay off loans that we called by banks going through near death experiences. As mutual fund expert Dan Hallett, president of Dan Hallett & Associates Inc. in Windsor, Ontario, notes, sector diversification did not protect portfolios from harm. "Even gold was sold off when there was a demand for liquidity, though it did rebound." In the stomach churning pit of the market's decline, almost no stock was immune.

Defensive stocks — life preservers in tough times. Not really. Pharmaceutical stocks, often seen as defensive, tanked, though not as much as the broader market, in the 12 months ended Feb. 28. Various companies faced litigation risk or problems keeping their pipelines well stocked with new pills. Even Johnson & Johnson (JNJ-NYSE), a rich, huge company with a highly diversified mix of drugs and home and beauty products, lost ground, going from $70.00 (U.S.) in late summer to a recent price of $52. Even Genentech Inc.(DNA- NYSE), a brilliant biotech, slumped from $100 (U.S.) in summer to $70 in late fall, though it has since recovered to $95.

Demographic investing — bet on yuppies buying houses or baby boomers buying retirement condos and you won't go wrong. Nope — didn't work. The idea of the "New Economy" turned out to be an old horse with a fresh saddle. The concept was swept away in the next craze — the dot com mania in which companies that were burning up capital were more desirable than old economy companies that actually added to their capital. We all know what happened to the dot coms.

What will work in future is likely to be some really old ideas with renewed validity. "Fancy theories of asset variance don't work for long," Mr. Stronach explains. "The old concept of diversification still works. The classical categories of stocks, bonds and cash each have different drivers of returns. When stocks are rising and interest rates are going up, bond prices tend to decline as old bonds with relatively low coupons become less appealing to investors. When interest rates are falling in tough times, stocks tend to do poorly, returns on cash held on deposit or in treasury bills or other short term instruments also decline. And when interest rates soar, as they did in the late 1970s and early 1980s, returns to cash rise dramatically even as bonds and stocks fall in value,

he says. These are classical relationships and not theme of the moment fashion statements, he adds. And they have never stopped working.

A portfolio divided into a third stocks, a third bonds and a third cash all held in mutual funds would have had a far better time in the meltdown than one filled with nothing but stocks. In the year ended Feb. 29, 2009, the stocks would have lost a third of

the 38.7 per cent average decline of Canadian equity funds or 12.9 per cent. Cash would have returned 0.5 per cent in money market funds and bonds would have returned 0.20 per cent. Put it all together and this portfolio would have lost 12.2 per cent in the period. Not a great result, but far better than the 19.2-per-cent loss by Canadian hedge funds in the period.

It should be pointed out that, in hindsight, a pure short strategy would have beaten every long strategy and market ideology. But shorts can lose not just all their investment, but everything they have if they are forced to cover in a strongly rising market. The wise investor never loses sight of the risk that a concept bears.

Andrew Allentuck writes about investments for The Globe and Mail, and reviews books on finance for globefund.com and globeinvestor.com. He is also the author of several books.

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