This has been a wild week in the markets. I was away on vacation for March Break last week but I was still able to watch the markets and they seemed fairly tame over the week. Then on Friday when I was traveling and wasn't able to watch the markets the rumblings of trouble started. Bear Stearns lost close to 50% of its value over the course of the day on what appeared to be no news. Then on Sunday we get the shocking announcement that JP Morgan is buying Bear Stearns for $2 a share (the Thursday closing price was around $54) and the Federal Reserve is providing the support to make that deal happen. The Federal Reserve also cut the discount rate on Sunday. On Monday the markets (predictably) tore down the prices of financial stocks around the world. As Gavin Graham points out in this article (thanks to Canadian Capitalist for the link) the market is doing a fairly good job of mis-pricing Canadian financial stocks but things have managed to get slightly better by the end of the week. Gold broke through the $1000 mark since the fiscal sky was falling and it must be the only safe haven (ok, whatever). On Tuesday the Federal Reserve cut the overnight rate by 0.75% which was a disappointment to the markets (imagine that!) since they were hoping for a full 1% cut. That sent the US dollar up and commodities down. By the end of the week financials recovered slightly and commodities (including oil and gold) were down from their Monday levels.

What a wild ride. I just wish I had more cash available and actually had the guts to pull the trigger on some financial stocks on Monday.

This is just a test to see if I can get a Google Docs spreadsheet embedded into this post... Let's see if this works:



I'm thinking that it isn't going to work...

Wow it does! Ok, that makes my next series of posts much easier...

We have now made it though the first month of 2008. The last two weeks have been a real roller coaster ride in the markets. But how bad has it really been? It is easy to get sucked into the media hype over the decline in the markets but if you take a step back and look calmly at the behaviour of the markets you can see that it hasn't been all that rational. So let's do that.

Let's take a look at the TSX. On December 31, 2007 it closed at 13833.05. By the close on January 3 it had climbed to 13978.20, a little bit more than a 1% gain. The real trouble didn't start until January 15. On January 14 the TSX closed at 13698.23 or just under 1% lower than the December 31 close. Over the week from the close on January 14 to the close on January 21 the TSX lost a total of 1566.11 (the January 21 close was 12132.12) a whopping 11.4% decline over 5 trading days.

That's the bad news. On January 22 the US Federal Reserve made a surprise 0.75% cut to the overnight rate before the US markets opened (the US markets were closed on January 21) and the Bank of Canada cut rates 0.25% in a scheduled policy announcement. The markets responded. On January 22 the TSX closed at 12640.87 a 4.19% climb in one day (the increase was over 5% if you looked at the low of the day on January 22). The TSX continued to climb over the few days after January 21 closing the week out at 12894.83, a 5.86% decline from the January 14 close but a nice 6.28% gain from the January 21 close.

There were numerous opportunities in the market if you could see past the irrational market. A lot of the Canadian banks were trading at extremely low levels. If you had the stomach to buy almost any Canadian bank on January 21 by now you could easily be sitting on a 5-7% gain. It is true that there is a good chance the the US economy is headed at the very least for a slowdown, if not an all-out recession. The Canadian economy could follow suit but we don't have quite the same issues that the US economy does. The sub-prime mess is a US problem for the most part (at least from a Canadian consumer standpoint, some Canadian companies decided it was a good idea to take on some of that sub-prime risk and reap the short-term rewards that came from that).

I'm not saying that we have seen the bottom of this market, in fact I think we have a pretty good chance of seeing close to 12,000 on the TSX in the next couple of years but if we do I think that will provide more opportunities for investors with a long-term time horizon.

Last week the TSX lost over 5% of its value and so far in 2008 (to the close on January 18) the TSX has lost over 7.5% of its value. The financial sector seems to be taking the brunt of these market conditions, the iUnits Financial Index ETF is down over 8% in 2008 (again up to the close on January 18).

Today the US markets are closed and that may turn out to be a good thing. The TSX has started the morning off in a foul mood, dropping more than 500 points or 4% in the first 10-15 minutes of trading.

To me it looks like there are a lot of bargains out there right now but I have a feeling that there will be better bargains in the coming weeks. I don't see this downward pressure letting up any time soon.

The really nice thing about the state of the market is that it is going to allow me to test my income strategy. I am hoping to see about a 30% increase in the income from our portfolio in 2008. I think that we are going to have an opportunity to see what adverse market and economic conditions do to an income-oriented portfolio.

All in all this looks like it is going to be a wild ride.

I think it is time to revive my model portfolio. Since it has been about a year since I last posted about the model portfolio let me go over the goals of the model portfolio. The model portfolio is meant to track what would happen to income levels of a static portfolio from year to year. My main investment goal is to build up a portfolio of income generating stocks that increases from year to year at a rate at least equal to my personal rate of inflation.

"Personal rate of inflation" is another post for another day but the basic idea is that it really doesn't matter what the posted rate of inflation is. The posted rate might be accurate, it might not be accurate but it almost certainly isn't the right number for every single person in the country. So if you track your expenses from year to year over the long term you should be able to figure out how much more it costs you every year to maintain your lifestyle. This is your personal rate of inflation.

So getting back to my investment goals. I want to have a portfolio that generates enough income to support my lifestyle and increases that income at a rate at least equal to my personal rate of inflation. The problem is that I don't have a good idea of whether a specific mix of stocks is going to meet this goal. I also don't want to wait until I have collected that specific mix of stocks to figure out if there is a good chance that it will meet that goal or if it needs to be tweaked a little bit. I also want to know what happens to income generated from a model portfolio over at least one economic cycle, hopefully more than one.

So this gives rise to the model portfolio as another piece in the puzzle of financial independence. The model portfolio provides a way to track whether a specific asset mix will provide an income stream that increases at a minimum of our personal rate of inflation. I believe that it is very possible to have a portfolio of income generating stocks that increases the income it generates from year to year at a rate that significantly beats inflation. The hard part is getting to the level of income that will actually support your lifestyle.

Here is a recap of the posts I have already made about the model portfolio. I need to cover a couple more sectors (Health Care, Telecom and Consumer Discretionary) and the stocks in those sectors and hopefully I can have that done around the start of the year as well as provide an update on the income generated by this portfolio (and I need to come up with a better name because I don't want to give the impression that this is my actual target asset allocation because it isn't).

Model Portfolio Introduction
Model Portfolio Rationale
Finance Sector review
REIT Sector review
Pipelines and Utilities Sector review
Energy Sector review
Industrials Sector review

I think my goal in 2008 will be to provide at least quarterly reviews of/updates on the portfolio and maybe even do a little bit of an analysis of the earnings of a few of the companies in the portfolio.

One of the foundations of personal finance is the notion of paying yourself first. What does this mean? The suggestion is that you should treat the funding of your portfolio just like you do any other bill with the goal of putting in at least 10% of your before tax income.

When I first started full-time post graduation work I was making a fairly decent salary but I wasn't able to even come close to saving 10% of my before tax income. I was lucky if I could save 5% of my after-tax income. I'm sure there are many people in the same situation.

So how is it possible to get to the point where you are actually saving 10% or more of your before tax income? You need to view the 10% level as a goal. It isn't something that you have to do all at once. You can work towards that goal over as long a time as is necessary to reach it (within reason of course). One very simple way of reaching the goal is to save your raises and your bonus. Say you are currently making $40,000 a year and you get a 2% raise. That means that you will be making $40,800 now. Let's also say that you were only saving $50 a month ($600 a year or 1.5% of your before tax income) before you got the raise. After the raise you should be taking home a little more than 60% of that $800 or around $480 a year, $40 a month. Since you were managing to survive on the $40,000 you were making before you got the raise, there shouldn't be any reason that you couldn't survive on that much after the raise. So that extra $40/month could go right into savings and you have increased your savings rate by 80% to a whopping $1080 a year or 2.65% of your before tax income. If you get a bonus during the year you could funnel as much of that as possible (say 50% to your savings account and 50% to do with what you please, it is a bonus after all you may want to enjoy it a little bit).

By being consistent with putting your raises and a portion of your bonus into savings over time you can reach the goal of paying yourself first and saving at least 10% of your before tax income. It may take six, seven, eight years but it is possible to get there and it should be quite painless as you shouldn't notice the extra money going into savings since you never got used to spending that cash in the first place.