One other conviction that I have compared to the host of “I don’t know”s I gave in my 2011 year end report is that everybody is chasing yield. In a low interest rate environment, capital is shifting towards securities that can spin off safe income – just imagine if you are a pension fund manager and need a targeted return – formerly you could bank on 30-year treasury bonds giving you a ~6% yield in the first five years of the century, but the zero interest rate policy has pushed down yields to currently 3%. If your mandate is to make 8%, formerly if you had a 50/50 bond/equity allocation you would need to make 6% on the bonds and 10% on the equity. With bond yields presently at 3%, the same allocation forces you to make 13% on equity – a much more difficult task for a fund manager. Suddenly placing bets on that speculative pharmaceutical research firm seems to make financial sense.

How do you make up the yield difference on the fixed income side? By investing in treasury bond-like securities and this means climbing up the risk spectrum – provincial/state debt, municipal debt, corporate debentures, and even preferred shares.

Everybody is chasing yield and prices today reflect this. Just be warned that the markets might face a Europe-type situation where the underlying entity no longer can pay out such cash flows – even when European banks are getting interest-free loans, they are still choosing to put their capital into safer 10-year German bonds at 1.9% compared to Italian debt (7.15% currently). Measuring the ability of corporations and sovereign states to actually pay the income is always a vital calculation. As the cliche goes, it is about return of investment, not return on investment.

This could be an explanation why certain large cap stocks are trading at very low P/E ratios – albeit, it makes no difference (taxation differential between dividends and capital gains notwithstanding) whether a corporation makes a 10% after-tax return and retains it, or gives it out in a dividend. Somebody would look at both companies and likely favour the one actually giving out the dividend. The true answer is whether the company can deploy its retained capital as profitably.

The opportunities presenting themselves currently seem to be very narrow and opportunistic and off the radar. It’s not like buying shares of Starbucks under $10/share back during the economic crisis.

After this post, it is quite likely I will not be posting again on this site until 2012. The reason is simple: I am taking an extended vacation. I will generally not be in front of a computer during most of this time!

I won’t even have access to my portfolio, but at 72% cash, it is unlikely to cause any heartburn in the event that the European Union fiscally has a true blow-up and takes down the whole financial system in the process.

I do have some positions in companies that I have programmed a “trading autopilot”; these transactions will occur automatically given a set of conditions, both time and price. Interactive Brokers in this respect is quite friendly.

Have a Merry Christmas and Happy New Year!

Reviewing my predictions for 2011 (at the end of the 2010 annual report), I had the following predictions:

Predictions for 2011

Take these predictions with a grain of salt:

* The US Federal Reserve raises the short term rate by the end of the year. Thus, it follows that:
– The US Dollar will rise relative to the Canadian Dollar in 2011 (close of 2010: 0.9945 USD = 1 CAD).
– Spot Gold ends lower at the end of 2011 than the beginning of 2011 (close of 2010: US$1421/Oz).

* An equal-weighted basket of the five big Canadian banks (BMO, BNS, CM, RY, TD), purchased at the December 31, 2010 closing price, will underperform a 1-year CAD treasury bill yielding 1.4% on December 31, 2010. (NOTE: dividends and interest are not reinvested in this prediction).

* My unconventional prediction for 2011 is that US cash will outperform the S&P/TSX Composite Index (link) starting February 28, 2011.

All-in-all, not bad. While the federal reserve did not raise short-term interest rates, they did conduct “operation twist” (selling short-term maturities and buying long term ones) which did raise short term rates (e.g. 3-month LIBOR went from 0.3% to 0.48% currently). The US dollar is about 2% stronger relative to the CAD currently; while spot gold is approximately 20% higher than at the beginning of the year.

Currently an equal-weighted basket of the five big Canadian banks will have lost you money – Year-to-date and adding in dividends, BMO is up 4%; BNS is down 11%; CM is down 6%; RY is down 12%; and TD is down 1%. Right now the banks will have earned you a 5% loss; a 6% spread over a T-Bill.

Finally, the S&P/TSX has performed at -15% since February 28, 2010. The US dollar has gained 6% since February 28, 2010 over the Canadian dollar.

There is about a month and a half left to the end of the year, so these results will likely change.

It looks like the risk-off trade is “on” again!

This risk-off, risk-on type market environment reminds me of this very classic scene that people of my era would remember, except dealing with wax:

Risk on… risk off. Master this and win the tournament, or rather have the pleasure of stuffing your wallet at the expense of other people that have decided to get bullish.

Here are a few things I am asking myself – I do not think these are unique to myself at the moment:

1. How low can 10 and 30-year bond yields go? 1.81% and 2.87% are the current yields, respectively. Why would somebody want to lend the US government money at this rate when the entity they are investing in has its only escape route in debasing its own currency?

2. How low will commodity markets go? Copper has cratered about 25% over the past two months, silver has been taken out and shot in the past week, and even gold is starting to wobble. How much pain can investors in commodities take before they start getting cold feet and bail out en-mass more than they have done currently? My suspicion is that this is the beginning.

3. What should be on my watchlist that will do the best in the event of a recovery? In the 2008-2009 crisis I concentrated heavily on corporate debt investments, but I suspect that whenever the bottom of this market is hit that investors in equities that are zero yield will fare better.

Too many questions, not enough answers. My outlook still continues to remain negative and requiring defensive action and also of the belief that we will continue to see sharp rallies and even sharper declines. There still isn’t enough panic out there. Although VIX is a quantitative measure that a good sector of the population uses, there are some other metrics out there that still show there is complacency.

People looking for a safe outlet for capital in the marketplace are not going to see anything except in the form of cash and cash equivalents. Typically commodities were used for the safety outlet, but notably today we see that the S&P 500 is down about 2.8% and gold is down about 4.5%.

Notably, today is the first day where the safe haven of gold is getting compromised in a market downturn. Previously gold used to hold its own against down equity market action.

One day does not make a market, but this trend is something to watch.

Technically you also see safety in 30 and 10-year government treasury bonds (Canadian or US, take your pick), but getting a 1.8% yield for the next 10 years is quite obviously a temporary solution for capital. While this might work best for a fund manager, for an individual cash is much more practical.

Notably, the Canadian dollar got pounded over the past couple days – currency traders have seen a 4% decline in the Canadian dollar:

US dollar strength to a lesser degree has also been witnessed in other major world currencies, including the Euro and Yen.

I continue to remain very skeptical of the markets and am still in a preservation of capital mode – today is the first day in awhile that I’m looking at the dry powder keg and thinking of how I will be deploying it. But that time is not now. The only minor exception I made was in the preferred shares and debentures of Yellow Media (per my previous post) simply because the liquidation of those securities by its existing investors is a mostly independent event of the present market meltdown we are currently witnessing.

It is very difficult to be an index-beating active investor without the ability to side-step market crashes. By side-stepping crashes you can keep your capital freed up for those very brief and opportunistic time that the market is desperately asking for your capital. The market signals this to you with low prices, intense volatility, high bid-ask spreads and desperation. The last real time this happened was in late February/early March of 2009. There was a one week window of opportunity that you had where you could catch the bottom. It is very easy to identify in retrospect, but very difficult to get correct in real-time. Excessive outsized returns over a relatively short period of time (i.e. 200%+ returns on investment) can only be realized with ridiculously low entry points, which in turn requires financial nerves of steel to be the only buy hitting the “buy” button when the rest of the world is liquidating.

If your capital gets caught up in a market crash, it is a simple matter of mathematics to prove why you will not be able to gain much – in the 2008-2009 financial crisis, your average index investor was down 60% from peak to trough, which means in order to just break even you had to see a 150% return from the trough. If you can limit your damage to 10-20% of your portfolio and invest your capital at a more opportune time, it obviously will do wonders to your overall performance, just as how I nearly doubled my capital base in 2009.

A recent 21st century innovation is also that if you carefully analyze the tape, you will also see probable computer program traders that are set on a “fast liquidate” setting by relentless bid hitting. While it doesn’t have to take four years of electrical engineering education to perform a formal analysis of the trading signal, having some quantitative aptitude does assist in the process.

You can get a hint of what you are competing with simply by doing some mental work on how you would program such a trade algorithm, but Interactive Brokers conveniently has some simple algorithmic trade types that give you an idea if your mind blanks out.

It is time to do research on quality securities that will get needlessly hammered by a market downturn, but not nearly time to buy – yet.

Here’s a hint: I would not look at commodity companies.

Due to some unfortunate button-clicking coupled with some failed attempts at restoring a recent backup, the cosmetic layout of the site will be somewhat spartan (even more so than its usual spartan form) until such a time I can get around to putting in something more modern. Sorry for the inconvenience.

Hopefully most people using this site do so through their RSS readers (http://divestor.com/feed) and thus they will hardly notice anything.

I have not been an active writer in the past couple weeks, in part due to taking an extended break, but in part due to the fact that I am trying to await this financial storm and pick a point of maximum negative sentiment, which will be at the point where the perceived risk is the highest, and hence lowest price. My history suggests I am fairly good at picking bottoms, but I do not believe that time is at present. I am sitting at a 75% cash position.

Volatility is very high – in the past month there were many days where the absolute percentage change in the major indicies was greater than 2% – timing the gyrations is an impossible task. Implied volatility on the S&P 500 has also been around 30 to 45%, and the volatility of the volatility has been high. Suffice to say, anybody trading this market will have to have nerves of steel and very well-functioning computer models.

There are a few indications out there that things are worse than what markets are currently pricing in. Right now, we have a Canadian 10-year bond yield trading at 2.21% and the US bond yield at 1.92% – the both of which are lower than the 2008-2009 financial crisis. The bond market is pricing in a financial disaster that is awaiting us.

Remarkably, major US financial firms such as Goldman Sachs, Bank of America, JP Morgan are trading at yearly lows, which suggests that equity markets are banking on something bad happening. It is suggested that most of this is a result of what is happening in the European Union. A very quick proxy for the disruption in the European financial markets is looking at junior bank debt – an example of which is ING Group’s hybrid debt (NYSE: ISG – and take a look at the 5-year chart to see the impact of the 2008-2009 financial crisis). Equity in European banks are also more volatile than the debt securities, e.g. Deutsche Bank (NYSE: DB).

Political analysis is an area that gives me an advantage over the market, but there are two well-known events that have already been somewhat factored into the marketplace: Finland recently elected a new parliament, but the True Finns party basically ran on an election platform of “Don’t bail out the EU” and managed to gain a whopping 15% in representation in parliament. The other event was in Germany, where the existing CSU/CDU government (which has previously been on the side of trying to preserve the Euro and support a bailout of bad soverign debt of some form) has lost significant voter support in their recent batch of local elections against the SDP.

Since there is only a monetary and not political union, it makes it highly unlikely that the European Bank will be able to facilitate any quick fixes to their financial situation, relative to the problems in the USA with the federal reserve. However, the spillover to international financial institutions is continuing to be felt. My guess is that there needs to be a mass liquidation of some sort, similar to what happened in early August when somebody obviously hit the “sell everything” button on their billion dollar portfolio.

The central bank of Switzerland (Swiss National Bank) earlier in September also declared war against all currency speculators with it announcing that it will not tolerate less than a 1.2 Swiss Franc to Euro ratio, citing a gross overvaluation of its currency. Some traders must have received the margin call of the year when you look at this chart:

The Canadian dollar, in relation to all of this and relative to the US dollar, has remained around the 1.00-1.05 ratio against the US dollar. I do not have strong feelings about the Canadian dollar, but I would suspect it will remain vulnerable against US currency, which despite all of the country’s dysfunctionality, remains a short-term safe haven. Since Canada’s economic fortunes are strongly linked to commodity markets, there is vulnerability and correlation to a slowing world economy and commodity pricing – hence, not as diversified as the US currently is.

Are Canadian Banks (TSX: BMO, BNS, CM, RY, TD) vulnerable? You would think with the leverage on their balance sheets (e.g. a very quick look at BNS, you have $20B in tangible common equity leveraged against $560B in tangible assets, or a 1:28 ratio – I realize this is a very elementary analysis that ignores a whole host of other mitigating factors including the fact that consolidated statements are inappropriate for this type of conjecture) that if there is a minor amount of loss that they have to take against these assets (4%) that you are going to wipe out the bank’s equity. The risk-reward for Canadian bank equity seems to be highly skewed towards not being worth the risk.

Generally, forward valuations appear to be extremely attractive, especially in the large cap sector. However, these valuations do not take into consideration the deleveraging that we are seeing and the impact of market psychology when you have a stadium of financial participants that are all trying to reach for the exits at the same time. The easy play seems to be investing in low-P/E, low-P/B companies, but even these entities are going to get trampled if/when the stampede occurs. There no long appears to be any risk-free assets other than cash – and even that has the risk of being whittled away by the significant inflation that is being imparted with quantitative easing and its various forms. The state of world economics at the moment appears to be a game of financial musical chairs where you have a hundred players reaching for eighty seats, and the music is about to end.

In terms of translating this into investment possibilities if/when we see another 2008-2009 style meltdown, I will leave this for another post.