Waiting and watching

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Pay attention to the S&P 500.

spx

My underlying impression at this point is that asset values are generally being propped up by the fact that there is really nothing else to fuel speculation into. The actual value within the index is not tremendously overvalued at the moment, but it is frothy.

I believe we’re setting up for a moment where both equity and fixed income are going to get hammered simultaneously, which is not a very common market event – normally the two assets are anti-correlated.

The only safety will be cash. Equally acceptable will be short-term treasuries although considering the yield (nearly zero) of anything less than 1 year of term, is more or less a proxy for cash.

That said, when analyzing the data and also analyzing sentiment, my guess at this point is that we’re going to get one more intermediate market rally. However, this will continue to be a good opportunity to liquidate holdings and raise cash.

Moment of truth for markets

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The S&P 500 is finally trending down after going through a monstrous rally:

spx

This is getting very close to the prevailing trendline. If it breaks then most of the technical traders will take the index down further. What is most fascinating is that the longer term interest rates haven’t gone down over the past 10 trading sessions, which suggests that there has been a decoupling of the “risk-on”, “risk-off” mentality.

Thus, we could be entering into an environment where everything will drop, equities and bonds alike. The only safety will be in cash.

However, my gut instinct suggests that we’re going to get one more good market rally in the summer before a strong concentration in cash is warranted. Currently I am sitting in a 10-15% cash position after raising some money.

Patience and cashing up

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There hasn’t been a heck of a lot to report in the markets lately other than the S&P 500 continuing its rise up as the perception of the recovery continues.

That said, I believe it is unstable and historical norms would suggest that if one applies a bit of regression to the mean that we’re probably closer to the inevitable local high than the local low.

This is exactly why I have been slowly unloading some positions as they have gone higher. I’m no longer in a net negative cash position, and the cash percentage will continue to increase as the market continues to increase.

A few other observations.

One is that the Canadian dollar is testing lows. They have traded very narrowly since the 2008-2009 economic crisis and they are at the low end of the range. With the perception of Canada being a commodity market and the perception that our interest rates are not going to be rising anytime soon, this may signal a continued decline of Canadian currency relative to the USA.

cdw

The other observation are about long-term bond yields creeping up:

tnx

I am not sure what to make of this. Certainly bond traders are adding supply to the market and dumping it into equities, but this is the classic “risk-on” type formula where you have anticorrelation between bond prices and equity prices. Right now equity and any non-fixed income assets are winning.

I look at the year-to-date performance which is still significantly positive and my gut is telling me to cash out and call it a day until rainier days hit the markets. This will continue to happen as markets continue to rise.

Trends in REIT spin-offs

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Loblaws (TSX: L) a few months ago announced they were bundling their real estate assets and spinning them off into a REIT. They will retain control of the REIT.

Now, Canadian Tire (TSX: CTC.A) is doing the same thing.

I detect quite a bit of froth in this space.

Financial-engineering wise, this makes sense because the real estate assets are currently overvalued with very low cap rates for such assets, more so than the underlying valuation of the businesses in question (in Loblaw’s case, groceries, and in Canadian Tire’s case, retail junk).

It makes me wonder if an entity such as McDonalds will consider the same – the amount of real estate assets they have is not inconsiderable.

Markets are partying on – when will it stop?

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Stock markets are reaching all-time highs. The S&P 500 is well beyond the peak it reached in 2007. Sentiment is positive, what can go wrong?

spx

Please realize I am a horrible chartist and the trendlines drawn are merely approximations. However, over the past three years, the S&P 500 has seen three major periods of rallying and note the dates/values are approximate:

08/2010 to 02/2011 (6 months): 1,040 to 1,340 (+29%)
11/2011 to 03/2012 (5 months): 1,160 to 1,420 (+22%)
06/2012 to 09/2012 (3 months): 1,270 to 1,470 (+16%)
11/2012 to ??/???? (6 months and ongoing): 1,350 to 1,620 (currently) (+20%)

Given historical trends, this rally is about to run out of gas. The party will likely stop sooner than later, so be careful and raise cash.

Positioning for deflation

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I’ve been doing some research on which sectors perform best under deflationary conditions.

Obviously, cash is first and foremost as it will generate a natural real return over time without having to do anything, plus the nominal return you get from parking it in short-term funds (the Bank of Canada short-term rate right now is 1%).

Long-term bonds of solvent entities also are a good investment during deflationary conditions.

However, on the equity side things are a little more muted. The only direct play which I know explicitly has taken a position on deflation is the Canadian equivalent of Berkshire Hathaway, Fairfax Financial (TSX: FFH). Prem Watsa was fairly early to the subprime mortgage crisis in the USA but was able to profit handsomely on it, and he seems to be early on the deflationary game as well. His company has also been significantly short on S&P 500 equity index futures which also resulted in their portfolio performance suffering losses they really shouldn’t have been suffering. So while Watsa is likely paranoid, inevitably if you believe deflation is going to hit the marketplace and still need some form of equity exposure coupled with fairly competent management in asset allocation, then Fairfax is probably a good meal ticket. Regrettably, it is trading a shade over book value and historically it gyrates around it so there is likely a better opportunity in terms of market timing.

Interestingly enough, Watsa was also quite early in accumulating his (via FFH) 10% stake in Blackberry (TSX: BB). It remains to be seen whether this will be a win for him.

Price of gold

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Gold got hammered today:

gold

What is interesting is that you’re going to start hearing people talk about marginal cost of extraction and about how that figure is a floor for commodity pricing.

It is not.

While marginal production cost is one component of commodity pricing, markets can go deeper below the cost of production because commodity markets measure instantaneous supply and demand. Eventually there will be some equalization but it does not have to be immediate – in fact, it can take a gut-wrenchingly long time to moderate to prices where costs are reflected.

I believe with the perception that gold is a safe haven from all the currency printing that is going on that there is a significant amount of the marketplace that is essentially going to be trapped in the commodity and the real question is going to be: when will this washout in-progress end? Markets usually trend longer and deeper than most people anticipate.

Most commodities (except for natural gas) are down across the board. If this trend continues, it will have a material impact on countries with commodity exposure – this includes Canada. As such, I am comfortable with my relatively large (2/3rds) US-denominated exposure. I also have no direct exposure to commodities.

Genworth MI’s sensitivity to unemployment rates

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Genworth MI took a dive today because of the rise of unemployment in the Statistics Canada March release of the labour profile. Employment of full-time workers went down 54,000 workers.

mic

A rise in unemployment will increase the frequency of claims on mortgage insurance, while a decrease in property value will result in an increase in the severity of claims.

I believe the market is over-reacting to this news, but it is true that the default and delinquency rates for Canadian mortgages at present is quite low compared to historical norms.

On the brighter side, a lower share price makes the share buyback option more attractive.

Genworth MI upcoming quarterly report

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There is a strong possibility that Genworth MI (TSX: MIC) will make some sort of announcement this month, specifically with respect to what they are going to be doing with their excess capital.

A chart of MIC shows that it has gone nowhere over the past month, but this has been since quite a run-up since last August when it traded all the way down to about $16/share.

mic

At the beginning of January 2013, MIC had about 210% of the minimum capital test that is required and the company has an internal target of 190%, which means that they had about $287 million in excess capital available. This does not include the additional capital that has accumulated in the first quarter of 2013.

Having this extra capital (noting that $337.87 million was in very low-yielding cash and short-term equivalents at the end of 2012) is lowering the return on equity, reducing portfolio yield and is producing a drag on performance. The cash can be safely returned into the hands of investors.

There are four options available, noting that it is unlikely that acquisition is a possibility given the very narrowly-defined scope of the industry the company is in:

1. Buy back shares: Likely through a dutch auction tender and at a higher level than existing market value. They have done this two times in the past.

On July 15, 2010, they announced a $325 million buyback between $24 to $28/share and on August 24, 2010 they announced that $26.40 would be the tender price. The stock closed on July 15, 2010 at $23.07/share and the day after it opened trading at $24.25. The market price on August 24, 2010 was $25.79/share. Genworth Financial proportionately tendered its shares to keep its 57.5% ownership stake in MIC.

On May 5, 2011, they announced a $160 million buyback between $26 to $29/share. The market value was $25.25 on the day of the announcement, and the stock opened at $25.55 the day after. On June 27, 2011, they announced that $26 was the price and the closing market value that day was at $25.77/share. Notably after this buyback, the market value fell in the subsequent months.

Given the current market value of the company, if they were to proceed with a similar tender, it would be almost on similar terms as the previous one, with perhaps a tender range between $26 to $29/share. This would be close to book value and this would achieve about a 10% reduction in share count and subsequent 11% increase in earnings per share.

2. Give a special dividend: A special dividend of $287 million would be equivalent to a $2.90/share dividend. The only special dividend declared to date was announced on November 3, 2011 of a $0.50 dividend, payable on December 1, 2011.

3. Some combination of the two;

4. No decision, keep the cash, and wait for less stormy days later.

Influential in this decision will be the needs of the parent company, Genworth (NYSE: GNW), whom is looking much more financially stable than it was back in 2010 and has no pressing need for an infusion of capital either way.

My guess at present is that Genworth MI will launch a tender for its own shares this month. They are still trading under my own estimate of its fair value.

As readers are aware, I have been long on Genworth MI since last July.

Q1-2013 Performance Report

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Portfolio Performance

My very unaudited portfolio performance in the first quarter of 2013, the three months ended March 31, 2013 is approximately +15%.

Portfolio Percentages

At March 31, 2013:

101% Equities
8% Warrants
-9% Cash

USD exposure as a total of the portfolio: 66%

Portfolio Commentary

I had good performance during the quarter, and I am painfully aware that +15% on a quarterly basis is obviously an unsustainable amount of performance. While I can’t promise anything, it will likely not be repeated next quarter. The performance is also tempered with the fact that the S&P 500 was also up 10.0% for the quarter and there was a moderate degree of leverage applied to the portfolio so the performance number is not as good as it seems at first glance. The TSX Composite was up 2.5% during the same period, but since I am not invested in any resource commodities and the TSX is heavily weighted in commodities and financials, I am not using the TSX as a comparative benchmark at present. Foreign exchange was also mildly beneficial to the portfolio.

Other than the sale of Rosetta Stone (which I discussed earlier – and looking like it was divested too early at present!) and the acquisition of some warrants that have a strike price that is significantly in the money, the portfolio has had very little change. For the most part, it continues to be invested in companies that are trading under tangible book value, although one of these companies has appreciated above tangible book value from the previous quarter.

Most of the common shares in the portfolio are of very boring insurance firms. I am patiently waiting for them to trade at a modest premium over book value, plus paying attention to other valuation metrics (i.e. earnings and reserving). They should get there whether the overall markets do well or poorly. Of particular interest is Genworth MI (TSX: MIC), which continues to have skittish investors bailing out of it with fears of the Canadian real estate market getting too hot for comfort. Even if Genworth MI decided to close up shop and run down their mortgage insurance portfolio, they would still appreciate from current prices and converge to book. Clearly they are not going to do that, but they will be reducing underwriting volumes as transaction volume decreases. MIC also has a huge cash buffer and it remains to be seen what they will want to do with this excess capital.

The warrants are simply a proxy for a common share holding by virtue of the in-the-money strike price and long expiry. This is effectively acting as embedded leverage without having to expend the capital to do so. The entity in question does give out a mild common share dividend, but management’s historical approach with excess capital has been such to buy back shares, which is beneficial for the warrants (compared to increasing the regular dividend). The underlying company’s common shares are trading under tangible book value.

There is one significant and speculative position in a company that I believe will have a very good chance of exploding on the upside when it gets traction and I am simply being patient with it. For speculative types of companies (especially with financial metrics that do not fit in with a typical value investing perspective), there are a few factors that need to line up into place. The company needs to be targeting a market that clearly has future potential for profitable revenue growth, the story needs to be simple enough when it gains traction for others to easily “buy into” it, management needs to be competent and have a good sense of direction and care about shareholder value, and finally, management ownership needs to be significant. Typically when you get these factors (and some others) you will have a better chance than just throwing darts at a newspaper.

Outlook

The outlook that I issued a couple quarters ago materially stands. There is some deep psychology games going on in the marketplace with respect to the relationship between equities and bonds. When looking at the past figures with respect to fund inflows, there seems to be a warming up toward the equity side again, and when this gets too bubbly then we still start to see some more volatility in the markets again.

Looking at the chart of the S&P 500 and historical patterns would suggest we are due for some corrective action and whenever this occurs, one would want to have cash to take advantage of such opportunity. The trick, as always, is in the timing.

Although I have a slight margin position as present, the equities I have invested in have a significant margin of safety embedded in them which is why I am not too concerned about a correction, if one indeed occurs.

One of the boring insurance firms in the portfolio is less than 5% appreciation away before I’ll consider to start selling it. The next closest insurance firm that is on the selling block is when it appreciates by about 15%. Whenever I buy or sell stocks, it is usually through layered transactions. I am not in a rush to hit the sell button, although when I do look at all of their three-year charts, they are sitting nearly at highs. Sounds simple, but one should sell when prices are high and buy when prices are low – and right now, prices do not appear to be low.

Also, for some strange reason, I have been somewhat fascinated at looking at the price of gold chart. I note that the Gold ETF (NYSE: GLD) has had some material drawdowns in gold lately – from December 10, 2012 when they had 1353.35 tonnes of gold in the trust to the 1221.16 tonnes – a 9.8% drop in holdings. The underlying commodity spot price has only gone down 6% since that time.

The other development is that the spot natural gas price appears to be showing signs of life. Perhaps the cyclical supply-demand aspect of this commodity is moderating? A cursory scan of the usual natural gas stocks appears to show signs of life.

Real estate is another angle that people pursue to try to increase yield in their portfolio. The biggest Canadian REIT, RioCan (TSX: RCI.UN), reported year-end equity of $6.88 billion, and its current market capitalization is $8.25 billion. At the end of 2012, there are 31 separately traded REITS on the TSX (less if you exclude the REITs that have common management) and 13 of them have a market capitalization of over $1 billion. It does not take an eternity to look at them and come to the quick conclusion that people are paying dearly for yield.

The most painful thing to hold these days appears to be zero-yield cash, which makes me suspect that in the days where Euro-nations are restricted in taking out 300 Euro per day from their bank accounts, perhaps accumulating cash right now is not that bad a move. In any respect, I would expect the portfolio leverage to decrease and a cash balance to once again build up over the next few quarters, especially if we continue to see the appreciation that we have seen this quarter. Maybe if I got another 15% quarter, I could then sell everything and call it a year and wait for the market to crash. There is a huge amount of “borrowed time” feeling with the current market. Sell now and wait for a 20% drop? Or get greedy and see how much longer the momentum upwards will last?

Either way, if prices rise, I will be continuing to sell parts of the portfolio and start to cash up.