Category Archives: Finance

Finance and Economics related articles

Price of Gold

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Being patient with the market is not all that stimulating to write about.

Looking at the price of gold over the past five days, it has been extremely volatile. The 5-day chart (for December gold delivery) is here:

As always, timing is everything. Although I believe gold is vastly overpriced, it is very difficult to compete against momentum and psychology, especially when the US government is still running deficits north of a trillion dollars – currency erosion (including that of most global currencies, not just including the US dollar) is playing a large part in the increase of the price of gold.

To get an idea of traditional valuation it is good to look at marginal cost of extraction in various gold mining companies. Of course, traditional commodity valuation methods only tend to be valid for a long term projection in terms of decades – the gyrations witnessed inbetween are gut-wrenching for most commodities.

An omnious market sign

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The following headline graphic on CNNfn is something that you will not be finding at a market bottom:

VIX might be at 43%, but it seems that it could get even higher to flush out any bullish sentiment left in the marketplace.

This week and the next will continue to be dominated by noise while the key decision-makers have their portfolios on algorithmic autopilot. I believe after the labour day long weekend is when things will get interesting again. Most pension fund managers are probably scratching their head and wondering how they heck they can achieve their expected return on plan assets when their equity components have tanked.

Fixed rate mortgage rates will drop

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Attached is a 1-year chart of the 5-year government benchmark bond yield:

5-Year Canadian Government Bond Yield

With a yield of 1.41%, this is the lowest the 5-year yield has been for decades. The lowest reached during the last economic crisis (January 14, 2009) was 1.54%.

The quick implication is that the 5-year fixed mortgage rate will likely drop. Although we are completely bathed in the midst of a European financial crisis (causing collateral damage domestically, just as the US economic crisis caused damage in Canada), banks are apparently solvent.

What will be an interesting question is whether this recent crush in the markets will cause a decrease in real estate prices or whether prices will continue to remain strong, especially in the Vancouver area. Real estate, gold, and government treasuries are three asset classes that have managed to hold value, while everything else has been dumped. If real estate prices are compressing then banks may tighten credit requirements (e.g. higher down payment, higher rate, etc.)

Still not buying anything

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Despite having over a 70% cash position at present, I still remain highly skeptical of the marketplace. Although I am happy to see things dive down another 4% on the major indicies (2% on the TSX), the root causes of this mayhem have not been addressed at all yet. I still highly suspect there is more to come. There will continue to be gut-wrenching rallies up and crashes down and today is an example of a crash down. The next two hours of trading can change everything, but the mid-term trend is clearly down. Although mathematically volatility is “up and down”, it strongly correlates with a down market when buying volatility futures!

However, when looking at the numbers, today’s dump feels less liquidity-inspired than the previous dump (where everything was getting thrown out the window if there was a bid). I do notice that certain fixed income products have been able to outperform (by falling less) and also Canada has fallen less unless if you are invested in the natural resource sector (commodities have been hammered). Typical defensive issues (e.g. consumer staples) have also fallen less than commodity-linked products.

My entire premise for this market drop is a combination of a grave concern on a macroeconomic scale (i.e. a pending devaluation of the US dollar) with a deleveraging of portfolios – you can only borrow at 1-2% and purchase income-oriented securities for so long before the capital value of such income-oriented securities suddenly take a plunge and then you have to deal with the margin call of the decade to truly pay for it.

While we are on the topic of interest rates, Canadian short term implied rates have also projected a chance of a rate cut by years’ end:

Month / Strike Bid Price Ask Price Settl. Price Net Change Vol.
+ 11 SE 98.780 98.785 98.755 0.025 5322
+ 11 OC 0.000 0.000 98.725 0.000 0
+ 11 NO 0.000 0.000 98.805 0.000 0
+ 11 DE 99.020 99.030 98.910 0.110 16290
+ 12 MR 99.120 99.130 99.000 0.120 21771
+ 12 JN 99.150 99.160 99.010 0.140 11273
+ 12 SE 99.140 99.150 98.980 0.170 4853
+ 12 DE 99.130 99.140 98.950 0.190 2782

A December BAX rate of 99.02 corresponds to a rate of 0.98%, which should be compared to a 1.18% rate for 3-month Bankers’ Acceptances – the markets are predicting a higher chance of a rate cut than not.

The week ahead

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In what promises to be a less exciting week coming up in the market as it continues its summer doldrums, market participants should be aware that most of the brains behind the heavy money funds will be on vacation in August.

It would not surprise me in the least to see some sort of bounceback in the S&P 500 to levels about 5% higher than here, but there are larger undercurrents going on that may continue having the computer traders pound anything that is offering liquidity – mainly the well-known European sovereign debt crisis.

Back in 2008 when Bear Stearns, Merrill Lynch and Lehman Brothers were collapsing, everybody knew what was causing the financial crisis, but nobody had a clue when the damage would stop – in this case, it was in March 2009 when the ultimate lows were reached. I suspect that something like this will be happening again, but it is difficult to tell whether it will be a few months after a main triggering event, or even a few years.

Either way, the root cause of most financial problems stem from debt and leverage. Right now, the problem is that certain banks assumed that their assets (debt in less than reputable soverign nations) were worth as much as they are on their balance sheets, but ultimately they are not.

Looking a little less globally, when less knowledgeable people listen to their “financial advisors” and borrow money at prime (3%) to invest in some bond or index fund which will make them a “long term stable return” of 6%, they will also discover the urge for liqudiation when their leverage factor imparts huge losses on their net worths.

I do not believe it is time to start buying things yet, but the valuations look compelling. Rather, now is the time to research things that will be worth buying when the market decides to take another deleveraging-induced dive.

Something I have consistently found puzzling is that there are a variety of companies that are selling under projected P/Es of 10, which makes them seem infinitely more attractive than the 10-year government bonds that are giving out a yield of 2.24%. Just to use an arbitrary example of Dell (Nasdaq: DELL), we have a company that has a market cap of $28 billion, about $7 billion net cash on the balance sheet, and for the past two years has generated about $3.5 billion in free cash flow (about $1.87/share) and trading at a stock price of $14.87, or roughly 8 times free cash flow generation.

What the bond market is effectively betting is that companies like Dell aren’t going to make as much money as they have been, or that the risk premium afforded to common shares of Dell is quite high. It is not like the company is in the pharmaceutical industry where you have to worry about patent expirations and other time-sensitive risk. It is quite difficult to conceive of scenarios where you would see the diminution of the business – perhaps Amazon will compete? An investor would have to answer this question in order to consider owning the stock, otherwise they are playing poker without looking at their own cards.

In the eye of the financial storm

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Unfortunately this week has been a rather busy one for myself and I have little mental time to properly do some market research even though I am getting bombarded with email alerts for low prices that have been triggered.

“V” type bottoms rarely happen in the marketplace. The only exception I can think of was the March 2009 low and that was after a protracted agony of a financial crisis.

I notice that in today’s (Wednesday’s) 5% plunge in the markets that crude oil managed to hold its ground while the indicies fell. Also, certain issues of stocks that could be considered “higher quality” were not hammered – indeed, some of them rose despite the indexes falling a significant amount.

I am expecting Thursday to be a positive market day, although I say this with the safety and comfort of seeing the S&P 500 futures up 1.7% well before the market is going to open. During financial storms, you always see sharp action in both directions as the market continues to suck in all of those that continue to try to play their risk-on and risk-off charades in a very short time frame. As long as people are still talking about which bargains to pick up in the markets, it is still not time to buy unless if you are worried about covering your short sales.

I remain mostly sheltered with a very large cash position at present.

Bank of Canada to cut interest rates?

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I notice that December BAX futures are pricing in a rate decrease by the Bank of Canada to 0.5 to 0.75%:

Month / Strike Bid Price Ask Price Settl. Price Net Change Vol.
+ 11 AU 0.000 0.000 98.880 0.000 0
+ 11 SE 98.890 98.895 98.895 0.000 23059
+ 11 OC 0.000 0.000 98.865 0.000 0
+ 11 DE 99.140 99.150 99.150 0.000 50455
+ 12 MR 99.140 99.160 99.170 -0.020 32592
+ 12 JN 99.140 99.150 99.170 -0.030 17723
+ 12 SE 99.110 99.120 99.140 -0.040 6277
+ 12 DE 99.050 99.070 99.090 -0.020 1582

Indeed, the only people making any money out of the marketplace right now are those that have been holding onto long-term government bonds, an instrument that almost everybody stated couldn’t go lower in yield.

Highest volitility of the year

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The VIX index (S&P 500 options implied volatility) has officially reached the highest of the year, at 40.96%:

This is still lower than the 48.2% seen during the depths of the early 2010 crisis involving Greek soverign debt. If this issue is worse than the one last year then my 40-45 VIX prediction should be elevated.

(Subsequent Update: 46.80… this can only be described as a slow-velocity market crash.)

The week ahead

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This upcoming week in the markets is probably going to be the most interesting since March 2009 when the S&P 500 hit the famous “666″ mark.

As I write this, the S&P futures are down 1.9%, gold is up a whopping US$59/Oz and oil is down $2.85. There is clearly a large amount of panic being baked in the marketplace. The cause is being attributed to the S&P downgrade of the US soverign debt but this is the trigger, not the cause. There are a lot more macroeconomic problems going on in the world that have attributed for this market meltdown while everybody tries to rush for liquidity.

August volatility futures were sleepy until they exploded in the past week:

I had earlier said that the market panic is likely to be over when it has reached 30-35, but I am now of the mindset that the volatility can get higher before the market has seen capitulation – I’m guessing now around 40-45.

Even when there is capitulation, the bears will likely not be done yet – part of dealing with market downtrends is that there will be significant periods of time (one or two weeks) where you will see sharp market rallies and people with cash on the sidelines will be stepping over themselves to get back into the marketplace. These will simply be more moments to lose money. As long as there are columnists and people on the television that are willing to say that this volatility presents a good time to purchase stocks, I do not believe this downtrend is over – it has just started.

What is incredibly contrary to the market action is the fact that corporate profits appear to be at incredibly reasonable levels compared to prevailing interest rates provided by “safe” (ahem) government bonds. It could be the case the market is predicting that such profits are going to evaporate in the near future or that such profits simply do not matter and liquidity is what is being traded, rather than equities in companies with solid fundamentals.

Investors must be able to be nimble on their transactions and try to buy when supply is at its highest, while selling when the demand has almost peaked. Selling in downturns or buying in uptrends will result in very sloppy executions.

This is reminding me of two other situations in the past. One was in the year 2000, when the Nasdaq went from 5,000 in March and crashed all the way down to about 3,000, only to climb back up to 4000 again in August before crashing to its ultimate low of about 1100 in October 2002. There was one day (April 4, 2000) where the Nasdaq went from 4283 down to 3649 intraday (a 15% drop), only to recover to 4148 at the end of trading (a 14% recovery). This was the most volatile day of trading I had ever experienced and was an omen that there were bad things coming down the pipeline.

Last Thursday was all down, but if my hunch is correct, we are going to see a lot of volatility this week, so be prepared to ride those ups and downs like a professional ocean surfer. Monday is going to start down, but the rallies and downturns are going to be as sharp as a razor blade.

That said, so many people think that the markets will tank on Monday that I would venture they main indices (S&P 500, TSX) will end the day up.