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Fairfax CEO Prem Watsa warns investors face 'huge' potential for pain

Fairfax Financial CEO Prem Watsa laid out a litany of risks in his latest letter to shareholders. From plunging commodity prices, to Canada’s housing market and frantic policymaking in China – he’s telling investors it could all come to a head early this year.

The bearish outlook shouldn’t come as a surprise. Watsa is renowned for warnings about the markets; indeed, Fairfax disclosed in its year-end results that its equity exposure is fully hedged.

Although Watsa said in his letter to shareholders the hedging strategy hasn’t always been a winning strategy, he argued there’s a significant disconnect between market performance and economic fundamentals.

“As we have said, it is better to be wrong, wrong, wrong, wrong, wrong and then right, than the other way around!,” he wrote.

Watsa pointed out the double-digit declines in major commodity prices such as oil and copper since the peak in 2011, and declared Canada will not be spared by that rout.

“Canadian housing prices, particularly in Toronto and Vancouver, have gone up significantly, driven by lax policies at CMHC, “ he wrote, in reference to the country’s top housing watchdog.

“Canadians have accessed their increasing real estate wealth through lines of credit easily available from the banks. Sounds familiar? This is exactly what happened in the United States before the financial crisis in 2008/2009.”

One of Watsa’s starkest warnings focused on mutual funds chasing returns by investing in emerging market bonds, which he deemed “another bomb waiting to explode.”

“For example, Venezuela has some $115 billion in U.S. dollar bonds outstanding with $8.6 billion maturing in the remainder of 2016,” Watsa wrote. “Oil and gas accounts for 25% of its economy and 96% of its exports, and inflation is running at 181%. A default would have a significant impact on bond mutual fund redemptions which would cause major losses to the retail investor – and potentially a run on these funds.”

Watsa’s concerns about the stability of global financial markets left him shocked when he found out that a friend’s 90-year-old grandmother was relying heavily on dividend-paying common shares for retirement income.

A financial adviser had helped invest 85 per cent of her savings in stocks – a risk exposure that would have been unheard of a decade ago.

And she’s not alone. In an environment of low interest rates, stocks that pay a healthy dividend can be a compelling alternative to the shrunken returns on bonds and guaranteed investment certificates. But even the shares of blue chip companies are not always stable – the S&P/TSX composite index has declined about 9 per cent in the past year. At times, investors may wrestle with the urge to sell at the wrong time.

“What happens with these low interest rates is that you have people searching for yield and taking risks that they may not understand, that they may not know,” Mr. Watsa said.

Not everyone agrees that stocks are for the dogs. Globe and Mail Personal finance columnist Rob Carrick recently looked at retirees who have turned to stocks and stomached the churning market conditions, all to make enough money to live on. The column also explored annuities, where a purchaser pays a large sum of money up front in an insurance contract that guarantees a flow of monthly income for life.

Mr. Watsa favours neither of these options, though he concedes that there is no perfect solution. His suggestion is to try to live on less income, or even to take some money out of the market and spend it instead.

“There’s no easy answers here. In the past, the cardinal rule was don’t eat into capital. You invest your money, you get investment income – spend it, but don’t encroach capital. The problem is, that doesn’t work today,” he said.

And even dividends aren’t always a sure thing. Mr. Watsa points to natural-resource juggernauts such as ConocoPhillips, Rio Tinto Group and BHP Billiton Ltd. – all of them have cut their quarterly payouts since the start of the year amid industry pressures.

Fairfax, which was founded by Mr. Watsa, is known for making contrarian investments. He has generated spectacular profits from some of his bets, such as a large position in credit default swaps that soared in value after the U.S. housing market collapsed.

Other bets have yet to pay off, such as investments in BlackBerry Ltd. and one of Greece’s largest lenders, Eurobank Ergasias SA.

For older investors, there might not be time to recover from the damage. Mr. Watsa’s worry is that a market downturn could mimic the stock market crash of 1929, where it took more than two decades for the Dow Jones to reach precrisis levels. And unlike the 2008 financial crisis, Mr. Watsa said, central banks are now mostly out of ammunition. “We just want to make sure people realize there are risks.”

In the meantime, Mr. Watsa wrote in his annual letter to shareholders that he will be trying to get his friend’s grandmother to see stocks his way. “I have not given up on changing her mind – but it will not be easy!” CTV Two CTV News CTV News Channel BNN - Business News Network CP24