Monthly Archives: May 2010

Bank of Canada Interest Rate projections

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The June 3-month banker’s acceptance futures are trading at 0.89% at present.

This suggests that the short-term interest rates (the target overnight rate) will likely raise 0.5% to 0.75%. However, the banker’s acceptances generally are a quarter point over the prevailing target rate, which suggests the market is pricing an approximate 40% chance that the Bank of Canada will only raise 0.25%.

One month T-bills are at 0.23%, 3-month T-Bills are at 0.47%.

My justification for a 0.5% raise is simple – they want to make a statement.

I rarely have strong feelings about currency trading, but my guess is that the Canadian dollar will spike briefly on the announcement and then will go through a decline.

Most of the media thinks that the Bank of Canada rate increases will result in currency appreciation, but they will get the opposite results – low interest rates causes a lot of currency holding through carry trading. Since traders are on the margin side, a higher rate will result in currency outflows. It is likely the US dollar will be the one to rise relative to the Canadian dollar, so I’d get your cross-border shopping in sooner than later. You can also do “cross-border shopping” by buying US equities. The markets suggest that the US federal reserve will start raising rates around the beginning of 2011.

Canada ends the fiscal year with $47 billion deficit

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The 2009-2010 year-end fiscal monitor is finally released. I will make some year-to-year comparisons.

From April 1, 2008 to March 31, 2009 the government posted a $2.2 billion deficit. In 2009-2010, the government posted a $47.0 billion deficit.

Revenues were down about 5% year-to-year, mainly attributable to a decrease in personal income tax and corporate income tax collections. The corporate side would have been a lot worse if it wasn’t for a huge recovery in the later part of the 2010 fiscal year.

The one interesting item is that the proxy for general consumption in the country, the Goods and Services tax, had a decrease of 0.2% year-to-year in revenues, so this is virtually unchanged. Similar to corporate income taxes, there was a huge surge in collections in the last part of the fiscal year.

On the expense side, government expenses were up approximately 17%. The bulk of this is attributable to the “economic action plan”, i.e. the stimulus package. The stimulus package, as projected in the 2009 budget, was approximately $23 billion, so one can infer that if it weren’t for the stimulus, the deficit would have been around $24 billion – a fairly manageable number.

Most notable is the 35% increase in Employment Insurance premium payments – mainly a function of increased unemployment, but also factored into this were government legislative efforts to enhance EI benefits for those that paid into the EI program for a lengthy period of time (7 years or over) receiving an extended amount of benefits.

My quick guess for 2010-2011 is that we will continue to see significant growth in revenues from the three main sources – personal income tax, corporate tax and GST collections in the 2010-2011 fiscal year. On the spending side, we will continue to see spending as well, and probably see a posted deficit of around $35-40 billion. This cannot continue indefinitely, otherwise Canada might face its own entitlement crisis. Although relative to other countries we are in better shape, we should be returning our fiscal balance to a mild surplus position and save some capital for future rainy days – which is more than likely to occur for the duration of this decade and beyond as the baby boomer generation retires.

Timing is everything – and a brief trading lesson

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Don’t believe anybody that says that market timing is not an important element of successful investing. Timing is a crucial part of it – basically you have to know when to buy (identifying when the prices are low) and know when to sell (identifying when the prices are high). I have historically found it more difficult to know when to sell than when to buy, presumably because markets crash quicker and harder than they go up. I have been actively working on this part of my investment experience for the past few years. I still do not feel comfortable with my exit tactics.

It is a very, very frustrating part of investing when you know you had the timing correct, but were unable to execute on any trades. Two days ago, on May 25th, I wrote:

I am generally of the opinion that the markets at this time are greatly oversold, with presumably most of the selling done across the Atlantic Ocean in Europe by panicked investment bankers and hedge funds. Unfortunately (or fortunately), I am still looking for areas to safely deploy cash.

I had placed a smattering of orders, starting at roughly 3% below the May 25th market close, but they probably won’t be executed now since the markets seemingly have reversed. I wanted to get about 10% equity exposure to the fossil fuel industry and I only have about 5% exposure on the debt side. Since the whole Canadian crude market has skyrocketed in the past couple trading sessions, I’m going to have to re-evaluate the short-term entry or hope for one more shock-wave coming out of Europe (which would be nice). My general thought is that while I don’t believe in the “10% of your portfolio in Gold” inflation-hedging technique, I do solidly believe that having a claim to future cash streams from Canadian oil and gas companies with significant reserves will be a good capital preservation technique over the long run – at least until crude prices rise to the point of unsubsidized alternative energy production costs.

After describing my inability to execute on what should have been a short-term winning trade, now is the time for a trading lesson to describe why the process I employed is correct.

Whenever I place orders, it is always with limit orders, and broken into price increments that are scaled below the initial point. I very, very rarely buy at the ask and sell at the bid unless if dealing with illiquid securities and somebody posts something juicy.

As an example, if a share is trading at $10/share and I was interested in purchasing 1,000 shares and thought market volatility would take it roughly 10% below current price levels before bottoming out, a simple execution would be to break it into five branches, such as the following:

Buy 200@9.80, 200@9.60, 200@9.40, 200@9.20, 200@9.00

The total cost of the order, excluding commissions, would be $9,400; a lot cheaper than just putting in an order for 1000@10. However, the cost of such a decision is that you may not get your desired quantity (or any at all) if there is not sufficient volatility in the marketplace. In the case of my fossil fuel equity trades, this is exactly what happened – market volatility took the market price up and not down as I expected.

Inherent with the breaking of such orders is the assumption that you don’t know what “the bottom” will be. I have learned many times over that predicting the exact bottom is impossible and that breaking orders into smaller quantities is the best way to capture value from this admission.

Using a real brokerage (e.g. Interactive Brokers) keeps trading costs of breaking orders into small bite-sized amounts cheap; a price-making order on the TSX incurs around 52 cents of commission for 100 shares. The increase in commission is inconsequential to the likelihood of saving capital costs with the lower-priced purchases. Even using a less sophisticated brokerage, you can still obtain significant price savings.

This same heuristic can also be employed with an exit of a position.

Note that it is very easy to modify this into a workable algorithm. When working with institutional quantities (e.g. millions of dollars), you typically employ algorithms to randomly time entries and exits depending on ambient market conditions and the volume seen in order to get the best execution on the entire order. When working with large amounts of dollars, masking the intention of your order is critical in order to be able to successfully accumulate or distribute share holdings.

One major advantage a retail investor has over the institutions is the ability to get in and out of positions with the click of a mouse button, as opposed to employing complex algorithms to do the same over the period of days or weeks.

Apple vs. Microsoft

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It was only a couple months ago that I wrote about how Apple and Microsoft’s market capitalizations are closing in on each other.

Today, Apple for the first time has a market cap higher than Microsoft, at $222 billion for Apple and Microsoft at $219 billion.

The real issue with the two companies is that Microsoft is really living off of its legacy product lines (Windows and Office) while Apple has come out with a huge stream of technological innovations, mainly the iPod and iPhone product lines (which secretly get the users to lock into their business model, similar to how software in the 90′s was “for Windows” only).

At this time, I don’t see how Microsoft can demand a market premium for its position – on the retail end, Windows has not fundamentally changed in 15 years (Windows NT 4 was the quantum leap product, and Windows XP was a great retail refinement of the Windows NT core). Microsoft Office has not fundamentally changed since the release of Office 97; everything else subsequent has been cosmetic in nature. With competitors chipping away at the cost premium that Microsoft charges (typically to large-volume corporate licensees), their ability to extract margin out of the marketplace with upgrades and obsolescence upgrades is limited. Microsoft will continue to produce cash like no tomorrow, but it is tapped out in terms of growth. Microsoft shares, as a result, trades like it – analysts expect $2.31/share in FY2011, while the stock price is $25.01/share – a yield of 9.24%.

Apple, on the other hand, has plenty of room to invade the computer marketplace, and combined with their mobile device market seemingly can command a high premium and has room to grow. As a result, they are given a premium in the stock market – analysts estimate $15.42/share in FY2011, on a stock price of $244.11/share – a yield of 6.32%.

Although Apple has competitive issues (i.e. Google is trying to invade the territory), it remains to be seen whether it can keep Google and other competitors at bay. Certainly its marketing arm continues to create users that have an almost religious-like adherence to its products.

I don’t have a position in either company and don’t plan on establishing one.

Flight to safety

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The US held a 2-year treasury bond auction today and some $42 billion was awarded at a yield to maturity of 0.769%.

In Canada, the 2-year government note is trading at 1.69%.

I can’t think of a single rational reason why a retail investor (that has a lot less than $42 billion in the bank account) would want to purchase these types of securities when there are relatively risk-free alternatives (such as “near guarantee” GICs and corporate bonds of issuers that would only default in the event of an economic apocalypse).

Canadian oil companies

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In today’s trading there are a few oil and gas companies that are tripping my price range thresholds – i.e. they might be worth further research and consideration.

I am generally of the opinion that the markets at this time are greatly oversold, with presumably most of the selling done across the Atlantic Ocean in Europe by panicked investment bankers and hedge funds. Unfortunately (or fortunately), I am still looking for areas to safely deploy cash.

The impact of touting a stock

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Jim Cramer is very well known to anybody in the financial domain as a former hedge fund manager, but also a hothead on CNBC television hosting a daily show called Mad Money, where he praises and pans every stock on the book. He knows, and the audience should know that his show is purely for entertainment value (Cramer is really an excellent host that seems to never run out of his child-like adrenaline surges), but a whole bunch of amateurs take him seriously.

It used to be when his show came to the air that whenever he made recommendations that the stocks would go up, significantly, in after-market trading, only to recede to their previous levels a couple days later. Traders would usually target this phenomenon and try to capture the demand by short selling and taking profits later.

If anything, it was a very fascinating exercise of how sharks try to eat fish, akin to a poker game – that type of stock trading was definitely zero-sum, and Cramer had the ability to attract a lot of amateurs that were also trying to make the fast dollar off of each other. It was undeniable that in the first few months of the show, Cramer had the ability to move stocks and somebody was probably able to consistently take advantage of it (e.g. being associated with somebody directing or producing the show, for example).

So it was with interest when a fellow named Controlled Greed, who has 5,514 subscribers according to Google Reader, on May 22 mentioned that he took a position in the previous week some illiquid smallcap company (XETA). It has a market capitalization of 39 million and an average volume of 6,700 shares or roughly $25,000 traded a day.

Most notably, on no news, the stock opened up Monday about 5% on 1900 shares. So his article did attract a few market buyers, which I found to be fascinating.

My econophysical studies of situations like these suggest that “immediate popularizations” of stocks has an impulse function effect on the share value, but the value of the impulse declines substantively as the value of the popularization exponentially decays, and eventually reaches a null point (where it is indistinguishable from background noise) a few days later (the decay rate being variable). But you have to wonder how many of those 5,500 readers now stick XETA on the watchlist, waiting for some sort of substantive news. I will not. One of my rules is that by the time you read about any obscure stock pick on any popular medium, it’s already too late.

Canadian Interest Rate Predictions

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The last three weeks of market volatility have had a profound effect in driving demand for risk-free, liquid government investments. The Bank of Canada has been a recipient of some of this inflow, as demonstrated by the 5-year benchmark government bond rate:

Speculators would have made a fairly good gain had they bought around 3.1% and sold today at around 2.6%. Of course, the best trades are done in retrospect, so this is just like saying that I could have picked the last 6 digits of the lottery and won a million dollars. Whether the yield will go lower or not remains to be seen.

What this does mean, however, is that 5-year fixed rate mortgages are likely to drop from their existing levels of around 4.54% (at ING Direct) or 4.39% (a typical mortgage broker) to something down 25 basis points or so. I would expect the 5-year rate to be around 4.25% for most retail customers. I generally ignore the posted bank rates since they are always inflated and when negotiating, they usually have a standard rate that is a good percent and a bit below those rates. Competition has whittled that process down to a formality of just asking, but I am sure there are some financially uninformed people that believe the posted rate is the only one they can get.

The Bank of Canada will be raising the target (short term) rate on June 1. This is inevitable, but the question is whether they will be raising 50 basis points or 75 basis points. Right now the 3-month banker’s acceptance futures (the only short term interest futures instrument actively trading in Canada) is implying a June rate of 0.81%.

My prediction is that the Bank of Canada, on June 1st, will raise the overnight target rate 0.5% to 0.75%.

Since this is mostly baked into the markets, the effect this will have on longer-term rates is nil. However, for those that are on variable rate mortgages, they will be paying 0.5% more since the prime rate will go up a corresponding amount. On a $300,000 mortgage, this would mean $1,500/year in payments or about $125/month additional.

My projection for the end of December will be 1.5%, down from 1.75% as projected a month earlier. My prediction is that rates will go up another 0.25% on July 20, 0.25% on September 8, no change on October 19 and up 0.25% on December 7.

The reason why you hold cash

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The reason why you hold cash, as opposed to yield-bearing investments, is to take advantages such as times as this one and be able to purchase securities at low prices.

Right now, the markets are trading heavily down, presumably as a function of some fallout of the European economic situation and a not-so-hot US jobs report.

In the 21st century world, at least in western countries, the reality is that employment is not a proxy for corporate profitability. An investor invests to get a claim on a company’s cash flows or assets.

The following is a monthly chart of the S&P 500 volatility index, which is at around 45 right now:

The volatility of the main indexes are such that are equaling what happened during 9/11 and the Enron/Worldcom blowup. The only bigger spike in volatility was when Lehman Brothers went belly-up. This European sovereign debt crisis is nothing close to what happened during the Lehman Brothers time (late 2008). Although Greece is a canary in a coal mine, it is not that important in the grand scheme of economics.

The one thing I do know about markets is that there will never be a grand pronouncement that this volatility spike is ending. It could go to 50, or 60, or 70, but it could just float down from this point. One never knows. If I was going to guess, this financial soap opera has another month of legs left in it.

What a good investor does, and a good investor holds onto cash for this reason: to pick off the targets on your watchlist, that are being sold by international financial institutions carte blanche, that are trading well below what your assumed fair value for the securities are.

Cyclical nature of commodity markets

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A third-hand report about Canadian Natural Resources stating that capital costs to hire critical contractors (e.g. for drilling and such) are increasing and leading to significant project budget overruns.

This is the nature of commodity markets – when prices are high, all companies rush in to expand projects and try to increase capacity so they can sell more product. When they are finished, they dump into the marketplace, depressing prices. Because of the fixed capital investment, it makes better economic sense to keep pumping product out even when the price of the underlying commodity does not make economic sense if you were beginning the project from scratch. As an example, if you include all fixed costs and it comes to $60/barrel, if you expect oil to be above $60 then it makes sense to build the project. If marginal costs of extraction are $40/barrel after that point, then it makes sense to keep operating even if you are below the break-even point for the entire project.

This is how you get commodity busts – even below the cost of marginal extraction. It happens when all of the producers have put in their fixed-cost investments, and it is more profitable for them to mine the product than to idle their machines.

Figuring out when this happens on a global scale is very, very, very difficult to perform. It requires a lot of industry-specific knowledge and a lot of data mining, and a lot of gut instinct. There is also the demand-side of the formula – if you expect consumption to increase faster than the supply expansion then you can still anticipate price increases. However, the big downside risk to the crude oil mining industry is not the increasing cost of providing supply, but rather determining if sufficient demand exists to warrant high future prices. Executives of oil companies are more or less trying to predict whether oil prices will continue to remain high two or three years out, when capital project decisions today are made.

Companies like the newly public Athabasca Oil Sands will not begin production until around the 2014 time-frame; they are incredibly leveraged to oil prices.

The futures markets do give a small hint of what is to come – January 2015 oil futures are at $86/barrel, compared to $72/barrel for July 2010 prices.