October can be a scary time – especially when it comes to stock markets and money. Historically, the month of changing leaves, carved pumpkins and Halloween has not always treated investors with sweet rewards.
In fact, this past October represented the third-worst point decline in the TSX Composite Index over the past 30 years. Only the Octobers of 1987 and 2000 were worse. Black Tuesday – October 29, 1929 – remains one of the scariest days in market history. Black Monday, the worst one-day decline the world has ever known, is more recent, occurring on October 19, 1987. Even more recent has been the decline in the Nasdaq Composite, largely comprised of dot-com and technology stocks. During a painful, 19-month decline the Nasdaq fell 78 per cent off its high of 5,046.86 to 1,114.11 on October 9, 2002.
Did We Have Any Warning?
The crash in October 29, 1929 had some warning signs. Increased volatility earlier in the year, economic indicators pointed towards a slowdown in May and June, and export earnings had declined – all giving an indication that the economy could be heading towards a recession. It all led to the Great Depression. The crash on 1987 caught investors more by surprise. Most investors who stayed the course saw the value of their portfolio come back to pre-crash values in relatively short order.
Crash vs Healthy Correction
Nothing goes up forever. After a strong performance over the beginning part of this year, it was reasonable to expect some sort of pullback at some stage. These pullbacks are, for the most part, viewed as a healthy component to the stock market. Crashes are few and far between. Certainly extended bear markets can give the same end result of a crash, the difference being that they provide more time for decision making.
The Perfect Storm
October 2005 shouldn’t be a complete surprise. As we approached this October we were in many ways entering the perfect storm – inflation concerns increasing, interest rates rising, Canadian dollar trading in high range against the U.S. dollar, an unusually strong summer, rising energy costs, decreased corporate earnings forecasts, and continued uncertainty regarding the taxation of trusts. Not to mention the natural storms/disasters that have occurred in recent months and concerns over the avian flu. It was reasonable to expect a healthy correction was coming.
The Skinny on Income Trusts
The markets had some pretty drastic declines this past October, which especially impacted income trusts. The tax-efficient equity investments generally offer a higher yield (monthly distribution) to unitholders than the average common stock (dividends). The main attraction of holding income trusts is to receive the regular cash distribution payment that in many cases is treated favourable for tax purposes.
The ability for the trust to pay out distributions on a sustainable basis is a function of the success of its underlying business. Income trusts are more similar to common stocks than fixed income securities as there are no guarantees surrounding the distribution or the principal, nor are there set maturity dates. There is a wide variety of underlying businesses that income trusts are based upon including power distribution facilities, real estate properties, pipelines, restaurants, advertising and resource-based operations.
The primary benefit of investing in income trusts is the ability to fulfill income objectives. The majority of investment returns tend to be generated by the distribution stream while total returns may be enhanced or hindered by capital appreciation or depreciation of unit prices. Over the past few years in an environment of declining interest rates and equity market volatility, there has been strong investor demand for investment income, which has led to higher income trust prices.
Some of the risks associated with investing in income trusts:
- The viability of the business to continue operations. On September 26, 2005 the CFO of Heating Oil Partners Income Fund issued a press release announcing the Chapter 11 filing. In this press release, they cautioned that it is unlikely that unitholders will receive any consideration after the restructuring.
- Distribution levels are not guaranteed. On October 18, 2005, a press release from Clearwater Seafoods Income Fund announced a reduction in annualized distributions for 2005, suspending monthly cash distributions for the remainder of the year. Clearwater’s unit price was punished severely immediately following this release.
- Unit price volatility primarily due do changes in supply and demand and the relative illiquidity of certain income trusts.
- Income trusts are interest sensitive. Changes in the level of interest rates can have a significant effect on trust units. As interest rates increase the demand for income trusts should decline as investors can obtain yield elsewhere.
- Currency risk for those income trusts operating south of the border.
- Uncertainty regarding Government policy on trust taxation.
We believe that the relative weakness in business trusts can be attributed primarily to the uncertainty regarding possible changes in the Ottawa’s policy on trust taxation, as well as increased concern about higher interest rates. The lack of trading volume of some trusts may also result in greater price volatility. Some of this uncertainty should be reduced after the Ottawa releases the results of the consultation process which is expected to be completed by December 30, 2005. The government also announced at the end of September that it will immediately postpone providing advance income tax rulings on flow-through entities (income trusts and limited partnerships) until the consultation process is complete.
Where Is The Treat This October?
As with everything in life, it’s how you look at things. A healthy correction can be a treat. Unless you need the cash in the near term, these pullbacks or “healthy corrections” can be a positive thing, especially if you have cash on the sidelines. If you have cash, this is likely what you were anticipating may happen. Unfortunately, stocks seem to be the one thing that investors are reluctant to purchase when they go on sale. For investors with a long-term time horizon, greater than 10 years, look at the pullback as a part of equity investing and a positive opportunity. Signs of slowing economic growth, rising inflation, rising Bank of Canada overnight lending rates, rising long-term bond yields, as well as uncertainty regarding the taxation of income trusts suggests that the market trajectory remains downwards for the remainder of 2005 in our opinion. This is a good time to look at asset allocation, clean up the weaker names, focus on quality and value.