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.

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.