Tuesday, June 1, 2010

Two Steps and a Stumble

Do American rules work in the Canadian Economy? 20th century market technician, Edson Gould, devised a rule about interest rate increases: they call it Two Steps and a Stumble. In Gould’s day, if the US Federal Reserve Board raised interest rates twice (two steps), the stock market would fall (“stumble”).

Today the Bank of Canada raised interest rates: that was step one. I wonder if Gould’s guideline applies to the Canadian Stock Market now. In my book, Beyond the Bull, I observe that the rules of the stock market seem to change over time. What worked in the 1990s might not work now. Gould was a market technician from the 1920s to the 1970s. This quotation will give readers some flavour for his era: “The Dow Jones Industrial Average came down from 120 in the summer of 1931 to 40 in the summer of 1932, doubled to 81 in September, kicked back to 50 in February, 1933 and doubled again to 110 by July, 1933.” - Edson Gould. What a time that must have been! Today’s stock market volatility seems tame compared to the 1930s.

Will the rules or guidelines of a bygone era help investors today? If the Bank of Canada (B of C) raises its rate again (step two) will it trigger a decline in the stock market?

The B of C raised interest rates to protect us from inflation. If house prices go up, that’s inflation. If food prices go up, that too is inflation. When energy prices, consumer prices, metals prices – when prices go up, that’s inflation. The Bank of Canada just raised interest rates to protect us from rising prices.

When the stock market goes up – is that inflation? If your RRSP is invested in stocks or equity mutual funds, and they go up in price, is that inflation? Maybe inflation is not all that bad.

If Gould was right, two increases in interest rates triggers a decline in the stock market. That means your stock market investments are at risk. Is it correct for the B of C to raise interest rates knowing that it puts RRSPs and pension plans at risk?

Running the Bank of Canada is a tough job. When you mess with interest rates, it helps here and hurts there. Damned if you do and damned if you don’t.

But most readers are not running the Bank of Canada. You’re running your own personal finances. What will you do?

Most readers will do nothing. Most did not learn from the 2008 – 9 stock market slam-dunk. Most Canadian investors would rather ponder the strategies of the Bank of Canada rather than ponder their own strategies. And if the stock market does stumble, most investors will suffer their losses and blame someone else for their demise. And most will say: “Don’t worry, it’ll come back some day.” To the “Don’t Worry Be Happy” crowd, we say: read the second paragraph above, the excerpt from Edson Gould’s article about the stock market in the early 1930s.

Our advice? Reduce risk. Own fewer equities than you normally own. These are dangerous times for stock market investors.

No comments: