Interest rates and Macroeconomic ramblings

This is a rambling post, so be cautioned that there is little rhyme or reason to the thought pattern here.

I look at the following chart of the 30-year treasury bond:


The risk-free return is very low at present. Relative to other sovereign entities (e.g. Euro-zone, Japan, Canada, etc.), however, the US 30-year bond actually still looks cheap and this can explain why it is the best performing asset class in 2014 to date.

As an exercise to the reader, please reconcile what we are seeing in front of us:

– S&P 500 is at all-time highs (approximately 1,900 as I write this)
– The economy appears to be plodding along at a low real rate of return
– Inflation is rising but not at ridiculous proportions (yet)
– US currency appears to be making a comeback
– Short-term rates are still basement low (fed funds target is 0-0.25%, but the effective daily rate has been closer to around 0.09%)
– Long-term treasury rates are relative low (see above chart)
– US government is still projecting $500 billion deficits although this is quite better than previous years; other liabilities (e.g. social security) and various other entitlements (e.g. pensions) generally remain huge liabilities and difficult to get a good rate of return
– Almost every retail Joe that is not involved in stock (lottery) picking is dumping their money in a variety of index funds that invest in the same things in the same proportions (Typical Canadian allocation: 40% TSX 60, 30% S&P 500, 30% some fixed-income ETF)

The demographic story is that the bulk of the population pyramid is entering in the stage of life where they are transitioning their capital into income-bearing instruments, which accounts for the very high cost of yield at present.

It remains very difficult to say whether we are entering in the Fairfax world of upcoming deflation despite everything (which would guarantee low interest rates for some time to come), or whether we’re entering some sort of inflationary world (because of all of the available credit, which would presumably translate into spending and consumption).

Although my style of investing does not depend on macroeconomic outcomes, it is always nice to know where you have the winds at your back. In terms of the big world-picture view, it is difficult to tell where these winds are blowing at present.

The only real convictions I have at this point is a general aversion to commodity-related products and a realization that those that are paying for yield are likely paying a premium beyond what the risk/reward ratio would suggest.

In other words, you are more likely than not to find the “hidden gems” amongst the list of zero-dividend yielders (or very low) on the equity side. Due to the “rising tide lifts all boats” phenomenon that we are encountering at present, until we see defaults of junk debt issues that go out for insanely low coupons and high durations, finding these gems is not easy. Most of them have been bidded up.

This leaves potential investment candidates in very un-ideal categories: the nearly illiquid and special situations (e.g. spinoffs, emerging from Chapter 11/CCAA, SEC/SEDAR “fine-tooth comb required because GAAP financials simply don’t explain the story” companies, closed-end ETFs, etc.). Not a lot of pickings here.

Positioning for deflation

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.

Negative interest rates

Negative interest rates have a very odd effect on the financial math. Certain European countries are selling short-term debt at negative yields, which is somewhat odd. Specifically if you bought a bond from Germany with a 2-year term, you would receive a yield to maturity of -0.06%. If you just held your Euros under the bed, you would receive a yield of 0%.

This is somewhat of an interesting statement by the market in that holding Euro cash is more risky than holding German debt. The decoupling of sovereign debt and its underlying currency is quite steadfast in Europe, while it is highly unlikely you will see such an occurrence in Canada or the USA unless if investors have a good reason to believe that the Canadian dollar or the US dollar will be broken.

I will not talk at this point about Quebec separation and the impact to the Canadian dollar.

The EU bailout comes to an abrupt finish

I believe it was George Soros that was quoted that the recent bailout agreement with Greece would last “between one day to three months”, and it appears the answer will be less than a week. With the Greek government exercising a political move to have the bailout criteria go to a public referendum, it once again ratchets up the risk of a sovereign default and extends the drama and impact on the financial markets.

Even if this wasn’t the case, I would think that the next focus would be on Portugal’s solvency.

How long can the people of Germany and France allow their governments to subsidize the lifestyles of people in other countries? This is essentially the political question – admission to the Eurozone will inevitably have to be revoked if countries go beyond a certain metric regarding their financial performance.

If there is another push on credit, we’ll be seeing the usual happen – US dollar up, US treasury bond yields down, and commodities taking a nose dive – the typical “risk off” trade. Everybody investing in the markets at this time is forced to become a macroeconomic/geopolitical analyst to explain some of the risk in the securities they are investing in today. There will probably be continued aftershocks as this drama continues to unfold.

Kicking the can forward

Now that the European debt situation is seemingly resolved, the markets are now on rally mode. Credit is loosening again and this gets reflected in the price of debt and equity.

How long will be it before the other countries in Europe line up at the trough?

The fundamental problem is debt accumulation and it is not solved by a one-time papering over – somebody has to pay for it. It is just a matter of when.

Of course this is sour grapes because of my high cash position, and I do suspect that plenty of others are on the sidelines. This is especially for pension fund managers that have to make their mandated 7.5% return on assets while sitting on a mount of 10-year treasury bonds yielding 2.2%. They are forced to buy equities since there is no other assets that can possibly generate a higher return.

Commodities are also making a return, assisted with the US dollar depreciating again over the past month.

This is almost turning out to be a mirror image of the 2008 financial crisis – in October of 2008, the world’s problems were solved with things like TARP and QE, but it took another six months for the markets to fully digest it and reach a panic low. It is something I am open to believing may happen again.

The largest rallies happen with short squeezes

While the Canadian markets were closed due to Thanksgiving, the US equity markets skyrocketed up 3.4% on the S&P 500. There was no particular news other than nothing catastrophic happening over the weekend, but it has been my experience that sharp rallies up tend to be due to traders caught on the short side that suddenly buy into the markets.

I also remain fascinated with the history of the markets from 2008 to 2009 – about how most of the actual crisis was over in October of 2008, but the reverberations and pessimism came to a crescendo in February and early March. This was despite the fact that TARP and practically every liquidity measure conceived had been implemented and all that was left was for that excess liquidity to end up shoring credit across the entire marketplace.

The whole world knows about Greece, but calculating the after-effects of a default or restructuring is the tricky part – if credit goes into a deep freeze once again, we will likely see a miniature version of that crescendo. It could also be the case that we have seen it – if that is the case then the time to buy is now – but you’ll never know it until after the fact. This is indeed gives markets such an impression to outsiders that it is all luck. I remain pessimistic, however, mainly because the underlying cause of the problem – profligate spending by governments – has not been resolved. Any recovery is likely to be temporary at best until economic foundations can actually heal.

Items to watch out for in the upcoming week

All eyes continue to remain on the macroeconomic situation in Europe.

There is also the the other continuing drama in the Middle East area, but it is always difficult to determine whether it is media sensationalism working its ugly head or whether there is something genuine brewing there.

I note with interest half-way through the market session that commodity stocks are getting hammered. In particular, I observe that most of the oil/gas majors (e.g. Suncor (TSX: SU), EnCana (TSX: ECA), Canadian Oil Sands (TSX: COS)) are trading down despite the underlying commodity (West Texas Intermediate) remaining seemingly range-bound around the $90 mark.

I also believe the market is seeking resolution to the Greek debt crisis (specifically the formal point in time where the EU gives up on them), but just like how the resolution of the US debt ceiling failed to provide relief for more than a trading day, I do not believe the resolution of the Greek crisis will resolve the EU situation – in particular the key countries are Italy (10-year yield chart) and Spain (10-year yield chart) – if their yields go higher then the crisis will morph into something much larger. Italy did, however, pass a measure which closes the theoretical gap in their own deficit. The usual European bank suspects (Societe Generale, Deutsche Bank, etc.) are all trading down around 5-10%, pricing in some future problems.

Also, for the first time since the 2008-2009 financial crisis, Goldman Sachs (NYSE: GS) briefly traded under $100. Their preferred shares (e.g. GS-PB, callable, perpetual with 6.2% coupon) are still trading at around 99 cents of par value, so that side of the market is not seeing much fair, just the equity. If you go to page 157 of their last quarterly SEC filing, they managed to vaccuum up money out of the market in 48 of 63 days – this is significantly worse than their previous track records. For example, in the previous quarter (page 139) they made money on 61 of 62 days in the market. Think of who you are competing with if you are involved in the short-term trading business – at least in a Las Vegas casino if you shop around correctly you will get about 99 cents of equity on one dollar bet in a hand of blackjack. Against Goldman Sachs Casino, you will be lucky to see 90.

Anecdotal measures of inflation

The Nomad Lawyer (Paul Lukacs) notes the following in his web posting:

When I visited Hong Kong in December 2010, the cost of one Mrs. Fields cookie was 11 Hong Kong dollars (US$1.43).

In early spring, the price rose to 11.5 Hong Kong dollars (US$1.49).

This week, the price rose to 12 Hong Kong dollars (US$1.56).

That’s a lot for a small cookie.

Applying some Canadian grade 11 math, the compounded annualized rate for the 8 months of price change is the following:

exp(ln(1+[{1.56 – 1.43} / 1.43]) / [8/12]) = 13.94%


I find these anecdotal measures of inflation to be more realistic than government-released statistics. Although the US Dollar has depreciated about 7% against the world basket of currencies, increases in sugar and flour prices (derived from wheat) have also skyrocketed.

Inflation, whether the US government reports it in its statistics or not, will be the only politically practical way the they can ever pay off its mammoth debt. There are too many entrenched interests to allow other options at present. The result is the currency depreciating, which will increase commodity prices (as they are US dollar-linked). This depreciation also highly affects the competitiveness of Canadian exports to the USA, but also gives net importers (such as most consumers) higher purchasing power – most cross-border shoppers know this.

My own personal anecdotal explorations of inflation are usually at the supermarket. I notice a jug of homogenized milk (albeit protected by the BC Dairy Board in the province I live in) is about $4.50 for 4 litres. Bread costs are creeping up at around the $2.70-$2.80 level for a 680 gram loaf (although you can still find cheaper options). Coffee has skyrocketed on a per pound basis. I also notice those concentrate juice mixes in the freezer section have been downsized in volume but still sell for roughly the same price. There are signs of inflation everywhere similar to Mrs. Fields Cookies that was noticed by the Nomad Lawyer.

What to do when facing portfolio losses

This is going to be a rather disjointed post, but it will attempt to explain the psychology of losses, misconceptions and dealing with panic downturns.

What’s happening, and what will be happening?

The S&P 500 began the week at around 1300 and ended the week at around 1200, a drop of about 8%. This is the biggest downturn in the markets since the 2008 economic crisis. For anybody that began investing since March 2009, this is also the first real instance of losses (whether realized or not) that they are facing. Year-to-date, the S&P 500 is down about 5%. For Canadian investors, the TSX composite is down 10% over the past 5 days and year-to-date it is down 10%.

The cause of this market dump is not entirely clear – it is attributed to the events going on in Europe (in that Italy is the next domino to fall in the Euro debt pyramid) and also the rather lacklustre resolution to the US fiscal situation – although they bought themselves $2 trillion in permitted debt, the US government is still spending cash like a drunken sailor at a casino and they have not even come close to addressing the fundamental issues in their fiscal structure (mainly spending too much money).

These situations are not exactly unanticipated by the marketplace, but it has come to the forefront to such a point that the markets have taken swift action by jettisoning nearly everything and going into the warm and fuzzy safety of liquid AAA debt. Government bond yields have all across the board sunk to lows that have not been seen since the 2008 economic crisis. I am also of the opinion that the S&P downgrade of the US government is irrelevant. It is counter-intuitive that bonds are trading so highly when there is so much debt issued, but where you will see the future depreciation is in the currency, not the bonds – your cost of holding US bonds is paid for in currency depreciation rather than low yields.

The most frequently asked question is – is this a time to purchase stocks? My hunch is that while we will see rallies in the marketplace over the next few months, the prevailing momentum has clearly turned negative and it continues to be a time to be risk adverse. I could be wrong – this could have marked some sort of panic low and we all move up from here on in, but markets typically do not work that way – we have had a two year rally (March 2009 to 2011) that was primarily fueled by federal reserve action (QE, QE2) and now that the money spigot has run out, we are going to see a normalization of the markets.

I have managed to survive the 2000-2002 and 2008-2009 market drops with losses, but without the 60% wipeouts that the indicies took during these periods. There are a few rules that I have about these sorts of situations. One is somewhat obvious, but cash is king. If you do not have enough cash to pay for what you need (for retail investors – your expenses, for institutions – redemptions!) then the decisions you will take will be risk-adverse to the point that you will compromise your ability to obtain returns for whenever the recovery occurs. Cash is important, even when it yields nearly nothing.

Another rule is that sustained market downturns tend to go on longer than most people would otherwise anticipate. This downturn really started in April of this year, but it was only until now that there was a sharp and significant decline.

Finally, another rule of market declines is that you will see sharp rallies upward during market downtrends. These rallies are quite deceptive – they have a tenancy of sucking in money from people that feel like they are missing out, but they do not call them “sucker rallies” without a reason – they are very dangerous to participate in unless if you have an explicit objective of making a quick 5% before bailing out and realizing gains.

The Divestor Portfolio

I have made some pretty bone-headed decisions over the past couple months and as a result, I am about 9% down for the year (roughly equal to the indicies, although I do not measure myself against the indices) so I am not happy with my performance considering the amount of cash I have in my portfolio. There were a few transactions that attributed for a good chunk of the loss. I have ended the week with significant amounts of cash. There is no longer safety in anything except cash – even companies with the most ridiculously undervalued metrics (e.g. trading below book value, P/E of 8-10) are being throw out of portfolios simply because they are liquid and can be converted into cash.

Usually I am better at side-stepping these sorts of market situations. Not last Thursday, and I was very upset at my inability to doing so.

“I can’t sell because I will take a loss”

It is strange that market downturns provoke a lot of discussion amongst friends that invest. The most common mode of incorrect thinking is that “I don’t want to sell XYZ because I will take a loss.” You inquire further and you find out that some shares that they bought back in January slid 4% below their cost basis on Friday. Portfolio holdings should always be measured against current market value. The only difference that cost basis makes is the tax treatment of the disposition – there is no other reason why an investor should care about cost basis.

I find it very interesting that people cannot be psychologically programmed to ignore the concept of “selling at a loss”.

I personally find it easy to mercilessly jettison losers out of the portfolio knowing that my government will be subsidizing me for some of it when I write off the capital losses against capital gains. Sometimes you just have to raise your arms up and come to the conclusion that your analysis was incorrect and that the stock you bought for $20 is not worth nearly what you paid for it even when it trades at $17. Remember Nortel in October of 2000 when it was trading at around $130/share and then had a horrible earnings report and tanked to roughly $90? If you had bought shares of Nortel at $130 but had the market take you out for $40, maybe it is a sign that Nortel was worth far, far less and the market has not realized it yet?

This reminds me of a story that goes as follows: Let’s pretend you bought some shares of a company for $10,000. In a week from now, the shares have gone up to $100,000. Then a week later, the shares went down to $11,000. You sell the shares, and then say to yourself “Man, that was a great $1,000 I just made there!”.

The reality is that you should always be looking at the market value of what you are investing to determine whether it should be in your portfolio or not. Did this company have value at $10,000? Did this company have value at $100,000? Basic portfolio management is that while you should let your winners run, you should also take some money off the table and trim the position if the company trades above your fair value range.

Why fundamentals generally do not matter in panic downturns

Markets that experience deep and volatile downturns exhibit irrational behaviour. The reason is because equities and debt trade mostly on the basis of liquidity rather than any underlying value. As most transactions these days are conducted by algorithmic trading, liquidity is a critical provision that these programs take into consideration. Anybody displaying a bid of size on a relatively illiquid security is likely to have their orders filled in. Likewise, these algorithms also value liquidity, which is why large cap stocks tend to see more gyrations rather than a steady decline down.

In market downturns, everything gets taken out and shot, no matter how “safe” they may seem, or how ironclad their financial statements are. If you look at every equity on the Canadian and US markets, there are only a very few equities that managed to preserve their value during the 2008 economic crisis.

Yield chasing / Leverage

A lot of people are discovering why chasing yield is a painful exercise – you might pay $50 to get that $2.50 annual dividend, but it isn’t going to do you a lot of good if the capital value permanently drops to $40. With interest rates as low as they were, it seems mathematically easy to borrow money at dirt-cheap rates (e.g. US cash at 1.5%, Canadian cash at 2.5%) and invest them in preferred shares and skim the yield difference, but what happens if the capital value of those preferred shares starts to drop? Likewise, low yields have forced capital to find their way to the commodity markets – with oil dropping $10 over the past week, what will the impact be on investors in commodities and related equities?

There is a vicious circle with deleveraging – people need to sell assets to raise cash to reduce their leverage ratios. However, the act of selling forces asset prices down, which requires people to deleverage more, etc. It all usually ends up in a big purge – and we saw some of that purge happening last Thursday when the indicies dropped 5%.

Making up losses

One of the worst tenancies for gamblers is that they feel compelled to make up their losses by making heavier subsequent bets. This is a sure-fire way of losing capital because such betting is usually fuelled emotionally, plus it is done at a time that is usually unfavouble for such betting (such as in the middle of a market downturn trend).

Psychologically speaking, the tenancy to get to the break-even point is very powerful, but one must mentally realize that the capital that you have remaining doesn’t have to be deployed in the same vehicles that you lost your money with (e.g. averaging down) or just after the time the capital was lost (e.g. Thursday). Investing should be done when the conditions are ideal and right and that includes looking at the external marketplace and also inside your own head to make sure you are thinking clearly.

Real estate

I have no idea whether a sustained market downturn will impact the Canadian real estate market. However, one wonders whether the values of real estate (especially in Vancouver, one of the most over-valued real estate markets in the world, primarily due to a massive influx of capital from China) will depreciate as the “wealth effect” reverses.

Final note

I do not think this is over yet. There is a lot of baggage to be dealt with the sovereign debt situation which may not be fully appreciated or realized in the markets yet. While corporate valuations (especially in the large cap sector) appear to be ridiculously low, it is still no reason why stocks can’t still be jettisoned in the name of deleveraging and liquidity-raising. However, given my performance to date this year, I could be wrong. I certainly have been over the past few months.