DO CENTRAL BANKS LOWER RATES IN RESPONSE TO FALLING MARKETS?

The Bank of Canada cut its overnight rate by 25 bps (0.25%) on Monday to 4.00%. According to The Bank, the main reasons for this decrease were lower than expected inflation figures for the fourth quarter and increased risk to Canadian exports from a more pronounced housing slump in the US.

The US Federal reserve also announced a surprise, more aggressive, 75 bps cut to their Federal funds rate on Monday. With markets taking a beating (year to date the TSX is down 6.7% and the S&P 8.1%) several blogs have questioned the wisdom of lowering interest rates in response to falling markets.

Given these interest rate cuts, are central banks bailing out investors? Although lower rates will surely help stock markets, the main impetus for providing monetary stimulus is the risk that falling asset prices pose to consumption - as asset prices fall, individuals will feel less well off, reduce consumption to increase savings, lowering aggregate demand and leading to a possible recession.

In short, the Bank of Canada and The Federal Reserve react to falling asset prices (both housing and the stock market in the US case) in order to manage the broader economy.

CANADIAN REITs AT A DISCOUNT

I'll start this post with the disclaimer that I am far from an expert on REITs. I know little on these entities, but I am becoming more and more intrigued by the idea of adding dividend income to my portfolio. However, given Canada's gravity defying real estate market, I have thus far shied away from investing in REITs out of fear of a real estate correction.

Now I've come across a research piece from CIBC that states that Canadian REITs may be oversold. Here are some excerpts:

• Since mid-2007, Canadian REIT prices fell by almost 25%

• That is 10%-points more than the drop in the financial index and three times the drop n the TSX as a whole (Chart 1).

• When evaluated in relation to the net value of their assets, Canadian REITs are now trading at an unprecedented discount of almost 20%. That is three points deeper than the discount observed during the near-recessionary conditions of 2001 (Chart 2).

• REITs are extremely sensitive to swings in interest rates. Interest rates will continue to fall in the coming months due to central bank action.

• It would take a full-blown recession in Canada to justify current REIT valuations. Under any other scenario, REITs appear to be oversold.

R WORD INDEX ON THE RISE

The Economist's R-word index, which tracks the number of stories in the Washington Post and New York Times that use the word "recession", is on the rise. Although simplistic, their index pinpointed the beginning of the 1981, 1990 and 2001 US recessions.

SIMPLE STUPID RRSP - Update

It has been a devastating start to 2008 for the Simple Stupid RRSP. It's currently down 8.4% since its inception in August 2007. XSB (Canadian short bond index fund) is my only investment not in the red.

Surprisingly, I don't feel very stressed and feel this is just part of the volatility that any equity investor should come to expect. In fact, given the current risk for a US recession, the market could easily drop further from where we are now. Graph 2 below displays the year-over-year change for the S&P and TSX during the 1990 US recession. As the figure displays, the TSX fell by 20% from October 1989 to October 1990. The S&P fell by approximately 10% over the same time period.

So what are my plans for the Simple Stupid RRSP? Stick to the plan. I'll be making a contribution over the next month and will make another in the summer. These contributions will be spread equally over the four ETFs I currently hold. Pretty boring, eh?

SIMPLE STUPID RRSP UPDATE & WHAT TO EXPECT IN A DOWN MARKET

The Simple Stupid RRSP ended November down about 1% (since it's inception in August). It was actually down about 5% at one point in mid-November before "recovering" somewhat.

I crunched some numbers for the TSX to put this performance in perspective and found the following. From 1982 to 2006, the TSX has ended the year down seven times during this 25 year period. The average loss for these periods was 8.9%. The largest loss was in 1990, when the TSX dropped 18%. I find these numbers interesting as they give some indication of what to expect in a down market.

MEASURING RISK

ACME's International Market Fund, touts a recent ad, has had average annual returns of 31.52%, 25.59%, and 11.78% over the past one, five, and ten year periods. While knowing past returns is great, what investors' should really be provided with is a proper measure of risk: what is the likelihood, say, of experiencing negative returns?

Enter the standard deviation, a statistical measure that helps quantify how much we can expect an investment to vary around it's mean. For example, take an asset that has an average annual return of 11% (such as the EAFE index from my previous post). Knowing that this asset has a standard deviation of about 20% helps us deduce that 68% of the time it's return will take on a value of 11% plus/minus 20% (assuming this asset follows a normal distribution) . In other words, there is a sixty-eight percent chance that it's returns will be between -9% and 31%. We can also infer that 95% of the time, returns will be the average plus/minus two standard deviations (or between -29% and 51%).

So how risky is investing in the TSX? Looking at the 1982 to 2006 period, the average annual return was 9.9% and it's standard deviation 17.9% (see table below). Consequently, 95% of the time we can expect returns to be between-25.8% and 45.6%. Risky enough for you?

BACKGROUNDER: EAFE INDEX

The MSCI EAFE index is an international equity index which represents 21 countries in developed markets outside North America (EAFA stands for Europe, Australasia and the Far East). Japan and the UK comprise nearly 50% of the index (see table of country weights below). EAFE has been around since 1969, has an average yearly return of 10.97%, and has a standard deviation of 21.40% - making it quite volatile.

Canadian investors can hold EAFE in their portfolios through funds such as XIN or TD's International Index.