A mental break from the markets

I have been taking a mental break from the markets and will likely continue doing so this week.

The only comment I have is that because of the US fiscal situation (which I will consider to be a crisis), companies that are highly reliant on US government revenues are getting hammered. Some of these may make viable investment candidates and would likely warrant some research attention.

Keeping currency conversions factored

It should be on the back of an investor’s mind that the appreciation or depreciation of US currency is a significant factor in commodity pricing – as the US currency as depreciated significantly over the past 10 years, this has lead to disproportionate increases in commodity prices when you scale the charts for Canadian currency. Over the past year, the Canadian dollar has scaled up 10% against the US dollar:

When looking at increases in gold and oil pricing, the change is less dramatic when priced in Canadian dollars:

Spot WTIC Crude in Canadan Dollars
Spot gold in Canadian Dollars

I have been looking at my US dollar exposure and have generally asked myself why I have kept any exposure at all and simply not hedged myself. One reason is that I don’t have a clue how to predict currency movements. There always seems to be more variables at play than one would typically think (interest rate, economic, stability, geopolitical factors to name a few). The other reason is that Canada does 75-80% of its trade with the USA. As long as we have this much economic exposure to the USA, the US currency will always be a relevant factor in a Canadian’s life.

Finally, one might actually think there will be a faint hope and that the USA will get its own domestic economic act together. I know such thoughts are stunning and frightening to even assigning an above-zero probability.

Bitcoins as alternative currency

You can read about Bitcoins on its own site, but summarizing the story, some computer engineers developed a currency that rely on peer-to-peer networking to conduct exchanges and also to generate new currency (which has a hard-coded limit to creation). Your ability to generate currency is directly a proportion of how much CPU power you can generate to solve a mathematical problem. With a typical personal computer, your ability to do this is quite limited. However, people with more powerful hardware (in particular, advanced graphic cards) are able to solve these problems.

What I am finding relatively amusing is that this marketplace has an active following with people actively trading bitcoins for cash and vice versa. Over the past year, the market for this product has increased significantly, with about US$500,000 traded yesterday alone:

A currency is only as good as the confidence that people have in it. In this case, they believe a currency that can be minted only by some algorithmic work is something that inspires confidence because the rate of currency generation is relatively pre-defined. In light of this, it is not that different than any other currency. Gold-backed currencies have confidence because they can be exchanged for bits of yellow metal. Some countries can mine the yellow metal better than others. Canadian (paper) currency is valuable because it can be exchanged to pay governments taxes (fundamentally, this is the only true value the Canadian dollar has).

There is also the issue of “counterfeiting”, even if the bitcoin system is technically secure. One problem is that you can create an identical digital currency and call it something different. So in this essence, counterfeiting is a very relevant concern – not direct counterfeiting, but copy-catting. Bitcoin does have a “first mover advantage” which may mitigate against this.

My last point is that generating CPU cycles is not “free” – not only do you have to keep your computer on to doing so, but the watts required to power your processor is higher when it isn’t idle. There is an interesting article about a person in Mission, British Columbia (a suburb of Vancouver, BC), getting raided by the RCMP because his power consumption was typical to that of a marijuana grow-operation. Instead, he was mining for Bitcoins. As people hit the “Bitcoin lottery” and receive a block of 50 bitcoins, this can be liquidated in the marketplace for approximately US$800-900 – not a bad haul for an expenditure of electricity.

The debate here should not be whether Bitcoins are useful as a currency or not, but the lesson here is strictly one in economics – people see value in very strange things, and when people do see value, there will be markets created. In this case, the product is a currency that is only valuable because of its rarity and difficulty of generation, and is not too different than trading artwork or collectibles which have similar appeal.

I would like to thank Alfred Pang, a personal friend, for pointing out Bitcoin to me many months ago. You may wish to purchase his 99 cent e-book, 100 Things to Do the Day After You Are Fired, for amusement. (I do not receive any remuneration for this link whatsoever). If you don’t feel like paying cash, this also works out to about 0.058 bitcoins (which can be sent to Bitcoin address 1B3brvhfMZVS3sRgJaSUijrT9FMyhhVoAB).

Bank of Canada keeping rates steady

The Bank of Canada has kept the target overnight interest rate steady at 1%. This surprised nearly nobody. Their statement is relatively unchanged from the prior one.

The chart to keep looking at is not the BAX futures, but rather the 10-year benchmark government bond yield:

With the yield spread from short-term rates to the 10-year at about 205 basis points, the bank is unlikely to lift rates anytime soon.

BAX futures are as follows:

Month / Strike Bid Price Ask Price Settl. Price Net Change Vol.
+ 11 JN 98.695 98.705 98.695 0.005 12727
+ 11 JL 0.000 0.000 98.630 0.000 0
+ 11 AU 0.000 0.000 98.615 0.000 0
+ 11 SE 98.630 98.640 98.630 0.000 31347
+ 11 DE 98.500 98.510 98.480 0.020 37387
+ 12 MR 98.350 98.360 98.310 0.040 24564
+ 12 JN 98.200 98.210 98.140 0.060 13081
+ 12 SE 98.040 98.050 97.970 0.070 3855
+ 12 DE 97.870 97.890 97.790 0.090 809

The market has priced in a rate hike by year’s end, but I do not think this projection will come to fruition – come December, the 98.5 price will be likely around 98.7 – a thin value bet could be placed here.

Here we go again – Market volatility

The main US indicies are down under the reports that more European countries are facing debt downgrades – Italy today is the prevalent one.

However, since I think it is safe to say the whole world knew that other European countries other than Greece are going to face similar meltdowns in their finances, investors should be aware that there are other possibilities – such as a slowdown in demand.

Such a slowdown in demand will not be in favour of commodity markets, but will be in favour of anything defensive – consumer staples, utilities and bonds. The insurance sector should also look good, but these companies are difficult to research.

It is also very difficult to make money in these sorts of marketplaces (at least long-only) since indexers will be selling their equity and thus it becomes a game of timing when the supply stops – this could be months down the road. It is a good time to prime that research list and take advantage if we are going to be seeing a significant drop in equity prices.

Soft Drinks and Pseudovariety

Philip H. Howard, a professor at a university in the state of Michigan, wrote a paper dealing with the structure of the soft drink industry. He determined that when you link the variety of brands back to their parent companies, three companies controlled 89% of the scene given a retail sample in Lansing, Michigan (the state capital, metropolitan area population of approximately half a million people).

When reading the paper, strictly from an economics standpoint, leads me to ask two questions:

1. If you are invested in the industry (e.g. in Coke or Pepsi), how likely is it that the industry will continue to be entrenched as-is for the indefinite future? Warren Buffett made a large bet that it will be. How can a company such as Coca Cola destroy its own brand?

2. If you are a potential competitor to the industry, how do you break into the field and still make money? The industry is quite self-protective and will purchase or destroy competitors, as appropriate – they have plenty of tools to doing so, such as purchasing optimal shelf space at grocery chains, etc. Witness Jones Soda (Nasdaq: JSDA) for an example when you get on the radar of the majors.

Note that there are similar industries in nature – in particular, tobacco and liquor distribution come to mind. Tobacco is an industry that is almost impossible for a newcomer to break into the field because of government protection. Liquor is somewhat less restrictive, but the only real breakthroughs have been with beer and wine as opposed to hard liquor.

The US will not default

I was very curious why the markets tanked when S&P put out a notice that their credit outlook on the USA is negative. It is not like the world knew that they were incurring massive deficits and will find it mathematically impossible to bridge the gap without a political stimulus of the world turning off the capital spigot.

The USA also has the advantage of being able to print its own money, and borrow in its own money. This advantage is compared to the Eurozone countries, which cannot print Euros willy-nilly.

Instead of defaulting, it is quite apparent that the USA is choosing to inflate and dilute the value of its currency. This is not a permanent solution – they still must address the fundamental issue, mainly pouring more money out the window than taking in.

Although there will not be a default, holding US cash is a very difficult decision because its purchasing power will continue to whittle away. People have found diversification avenues in commodities, but you have to weigh in a whole bunch of other dynamics that you wouldn’t have to with plain cash – just ask investors in Uranium. Diversification is also available in real estate, but that has not been very good for US investors for the past few years – and indeed, real estate implicitly bets on the ability of the various states to enforce and respect land titles and property rights. This generally leaves the stock markets – where you can take a risk that companies will be able to maintain their cash flows, assuming the US government doesn’t tax it away to pay off their debts.

An interesting starting point is to look at your own personal consumption habits and invest to simply hedge your lifestyle consumption – for example, if you consume gasoline, purchase an oil company that has sufficient reserves. If you use a mobile phone, purchase shares in that telecom company. Assuming you are paying fair value, you will be able to offset cost increases in your consumption with equity valuation rises.

Onset of food price inflation

The best measure for food price inflation is usually through Loblaws’ quarterly releases.

In their year-end release, they have the following comment on food prices:

– the Company’s average quarterly internal retail food price index
was flat. This compared to average quarterly internal retail food
price deflation in the fourth quarter of 2009.

Anecdotal evidence by my food shopping trips to Superstore would suggest that food prices are increasing somewhat. For example, a 4 litre jug of milk is about CAD$4.40 presently, while a couple years ago it used to be around $3.90. The BC Dairy Board might have to do with this price increase. I also notice prices for bread products creeping up to around CAD$3 for a 1.5 pound loaf of good quality bread, although they do have a freshly baked 99 cent French Bread which is a very good value if you can use a knife to slice it. It has been this price for the past five years.

Staple commodities such as grains and sugar have been rising significantly over the past couple years since the economic crisis, and combining this with energy price increases, there doesn’t seem to be a way that costs can be kept down other than with removing labour costs from products. This does not bode well for employment.

Federal Reserve and the long-term bond yield

The US federal reserve today released a “business as usual” statement, leaving their short term rates between 0 to 0.25%. Most relevantly:

To promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to continue expanding its holdings of securities as announced in November. In particular, the Committee is maintaining its existing policy of reinvesting principal payments from its securities holdings and intends to purchase $600 billion of longer-term Treasury securities by the end of the second quarter of 2011. The Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability.

This QE2 (Quantitative Easing #2) capital will fund the US government’s fiscal deficit. Normally when the federal reserve purchases long-dated treasury securities, you would expect the yields of such bonds to decrease, but ever since the last imminent threat of QE2 last October, long-term bond yields have done nothing but rise. The following are 1-year charts of the 30-year and 10-year US treasury bond yields:

If these yields rise further, it affects valuations of other yield-bearing securities since these bonds are considered to be “risk-free”. In addition, the value of companies with long bonds in their portfolios will decline, and companies will be taking comprehensive losses to account for the market value decline in treasury prices.

Will interest rates rise further? Time will tell. Just be prepared for volatility.

It should also be noted that Canadian equivalents are trading at less yield than US counterparts – e.g. the Canadian 10-year note is trading at 3.27%, while the US 10-year treasury note is at 3.43%.