Bank of Canada – Interest Rates

(Link: BoC interest rate announcement)

The Bank of Canada surprised somewhat with a non-change in interest rates, but giving obvious forward guidance that rates next meeting are likely to head higher. Today’s BoC meeting is coincidentally aligned with the US Federal Reserve meeting, which also held pat, but announced they were going to stop the additional purchases of government and mortgage-backed debt starting in March.

The two key sentences are in the last part of the Bank of Canada statement:

The Governing Council therefore decided to end its extraordinary commitment to hold its policy rate at the effective lower bound. Looking ahead, the Governing Council expects interest rates will need to increase, with the timing and pace of those increases guided by the Bank’s commitment to achieving the 2% inflation target.

The Bank will keep its holdings of Government of Canada bonds on its balance sheet roughly constant at least until it begins to raise the policy interest rate. At that time, the Governing Council will consider exiting the reinvestment phase and reducing the size of its balance sheet by allowing roll-off of maturing Government of Canada bonds.

This suggests that the target rate will rise (from 0.25% to 0.5%?) on March 2nd, coupled with a slow rollback of their ~$450 billion balance sheet of government and provincial bonds.

The interest rate futures markets were somewhat surprised at the non-rate rise:

… the prices are implying a 1% increase in rates by the end of the year and another quarter-point in early 2023.

One other observation is that the 5-year government bond yield is down to about 160bps – it got up to about 170bps last week which is the highest it has been in some time (great for those rate-reset preferred shares if they’re due to be reset soon – about 50bps higher than they were 5 years ago).

Within the monetary policy report, some items of note:

The neutral nominal policy interest rate is defined as the real neutral rate plus 2% for inflation. The neutral real rate is defined as the rate consistent with both output remaining sustainably at its potential and inflation remaining at target, on an ongoing basis. It is a medium- to long-term equilibrium concept. For Canada, the economic projection is based on an assumption that the nominal neutral rate is at the midpoint of the estimated range of 1.75% to 2.75%. This range was last reassessed in the April 2021 Report.

Notably with the above, the market is predicting an interest rate at the lower range.

Consumer price index (CPI) inflation is expected to be higher than projected in October. The outlook for CPI inflation in 2022 is revised up by about three-quarters of a percentage point to 4.2% and remains unchanged in 2023 at 2.3%. This upward revision mainly reflects larger impacts from various supply issues, notably those affecting shelter costs and food prices.

The projected CPI will continue to make headlines as the monthly reports come in. Considering the huge price spikes on the inputs to consumer supply (energy, wood, metals, etc.) it is difficult to see how costs will not be rapidly increasing in the future – especially considering the other component – which is human know-how – will be rapidly rising in price as well, likely in excess of commodity prices themselves.

And in what I consider to be the award for the month for the “most unnecessarily complex data visualization”, we have the following gem:

Should anybody be shocked that the purple #1 (upper-left hand side) represents “Employment level index, public sector”?

Here is my take-away: The Bank of Canada is heavily anticipating that things will ‘correct themselves’ through two effects – supply chain resolution, coupled with restoration of global conditions (allowing for exports). They assume domestic spending and consumption will resume as the Covid effects abate, and this will drain the accumulation of savings that were distributed in the past couple years.

I don’t see it this way. The separation of employment characteristics, for example, by age/gender and “public sector”, and “mid-high wage”, does not tell the story at all. It is very much unexplained (at least in the eyes of the Bank of Canada) why there are persistent labour shortages. The most obvious explanation is that what is being offered vs. the headaches of employment compared to what such employment purchases is out of proportion. In other words, wages need to rise dramatically, or what the existing wages can purchase need to increase – the latter case is not going to happen due to continual monetary debasement. People are basically deciding to exit the game – and some perhaps are becoming full-time cryptocurrency traders.

The best thing the central banks can do is engage in a massive monetary draining. The bitter pill would last a couple years, similar to what former FOMC chair Paul Volcker did when he raised interest rates into the double digits in the late 70’s and early 80’s. This facilitated a monetary cleansing. The central banks will not do this, one reason being it would collapse the asset markets and given the amount of debt that is collateralized by such asset values, will cause a huge amount of financial disruption.

Markets are feeling a bit like the year 2000

I’ve been on radio silence lately. There hasn’t been much to write about although I am noting the ‘vapour equity’ market has seen considerable supply pressure this month.

The peak of the dot-com boom (at least as far as the stock market was concerned) was in February of 2000 when the Nasdaq peaked to 5000 and you had a whole avalanche of initial public offerings, the most notable one was the IPO of Palm (which was owned by 3Com at the time).

After that it went pretty much downhill as valuations were not supported and liquidity was sucked out of the markets. Old-value stocks (a good example being Berkshire, but pretty much any company with genuine profits that had nothing to do with fibre optics, dot-com networking or e-commerce) managed to keep their value, and in many cases some thrived in the ensuing carnage.

Investors in 2000 that kept their portfolio away from the previous high-flyer sectors would have survived to participate in the next run-up (which, in the USA, was anything related to real estate). Indeed, a successful investor across multiple market cycles must know which sectors to avoid at any given time – clearly taking permanent capital losses (anybody invest in Pets.com? EToys? CMGI?) depletes your ability to invest going forward.

We fast forward to today, where technology, software and anything related to Covid (virtual work facilitation, vaccines, etc.) is plummeting.

There is a lot to review, but I will keep things to Canada. There’s a lot more going on in the USA (e.g. anything that ARKK owns, for example). Anyhow, the most prominent casualty is the high-flyer Shopify (SHOP.TO), which used to be the #1 ranking in the TSX index, but no longer! They’re now back to #3 below Royal Bank and Toronto Dominion.

In the span of 2 months, they traded at a peak of CAD$2,200/share and are now down to about CAD$1,100, which is a peak-to-trough of 50%.  Anybody invested in the company since June of 2020 would have lost money. Imagine if you had bought shares of this thing at $1,800 and now a third of your capital has vanished…

Another high-flyer has been Lightspeed POS (LSPD.TO):

The peak-to-trough ratio here has been even more extreme – from $160/share to about $37 today – a 77% drop.

Another highly touted IPO was AbCellera (Nasdaq: ABCL) – a Canadian company that IPOed on the Nasdaq.  They went public at US$20/share and traded as high as US$70 on the day they went public, but since then it has been a decline down to $8.50 today – nearly a 90% peak-to-trough loss.

Looking at some other recent TSX IPOs we have, starting September 2021:

CPLF
PRL
QFOR
DTOL
EINC
CVO

Bringing up the charts of all of them, it’s not a pretty picture. One other notable broken IPO I examined in the past was Farmer’s Edge (TSX: FDGE) and they are down about 85% from their IPO. Another one which I didn’t write about but was an obvious avoid in my books was Eupraxia (TSX: EPRX) which I have to commend the underwriters for vomiting out that firm to unsuspecting retail shareholders.

There’s a few lessons to take home here, but one obvious lesson is that just because something has dropped by 50% or 80% doesn’t mean it is still ‘cheap’.

Many of these high-flyers that make headlines are trading at ultra-premium valuations. Take Shopify – down 50% peak to trough. While the company makes money it is still nowhere near a reasonable multiple of its existing market valuation. An investor is still paying a huge premium for assumed future growth – and the company has to exceed this in order for an investor to get a payout (never mind a dividend!).

Even in the case of companies like Lightspeed that are down 80%, it is very difficult to determine whether an investor will be seeing any returns at the end of the day – they are still losing money in their operations.

Many people got their start in investing during the Covid-19 era. A lot of them caught the right stock at the right time (e.g. Gamestop) and probably started having dreams of trading their way to riches. Without the underpinnings of understanding the fundamentals of companies, inevitably these hordes of retail investors simply traded companies on the perception of sentiment rather than any earnings power. Without having a general idea of an entry and exit point, one could rationalize GME at $100, $200, $300, etc., or Shopify at $1,500, $1,700, etc., and are effectively trading blind. One can also make a similar argument for cryptocurrency markets – functionally a zero sum game.

A good question for these new traders is – do they have the discipline to get out? Or will they try to hold on and “break even”? Or will they average down as these high-flyer shares crash back down to earth? If the 2000-2003 model is similar this time around, there will be a lot of people that will be holding onto ever depreciating shares and the current wave of hype will come to a close.

Keep in mind the simplicity that math offers – if something goes from $100 to $50, there is a 50% decrease in value. If you purchase at $50 and it goes down to $25, the result is the same – a 50% loss (and if you were starting at $100, that’s a 75% loss). In many of these cases the companies’ trajectory will head to zero, and it doesn’t matter what “discount to the 52-week high” you purchase the stock at, you will face losses if/when it heads to zero.

The safety in the markets are in those companies that are producing sustainable cash flows. You will still take a considerable hit if the company in question is trading at a very high multiple. The maximum safety are in those companies trading at low multiples to cash flows and those that are not reliant on renewing excess amounts of debt financing. There isn’t a lot of safety out there, but astute readers on this site have picked up hints here and there as to what offers a degree of safety.

Divestor Canadian Oil and Gas Index – 2022 Rebalancing

Per the December 14, 2021 reinvestment policy, the Divestor Canadian Oil and Gas Index (DCOGI) has the following reinvestment of cash proceeds as received from dividends, as based on the opening prices of the first trading day of 2022:

Divestor Canadian Oil and Gas Index - January 4, 2022 Re-Balancing

TickerFractionReinvest$PriceSharesResidual$
ARX5%1,908.3411.75162$4.84
BIR5%1,908.346.51293$0.91
CNQ20%7,633.3854.2140$45.38
CVE20%7,633.3816.01476$12.62
MEG5%1,908.3412159$0.34
PEY5%1,908.349.6898196$9.14
SU20%7,633.3832.5234$28.38
TOU10%3816.6941.2592$21.69
WCP10%3816.697.6014501$3.88
XEG27,147.1910.832,506$7.21
ZEO47,693.0447.351,007$11.59
VCN29,228.5943.25675$34.84

(Updated February 5, 2022: Please note that I forgot to incorporate the Tourlamine special dividend of $0.75 in the 2021 results. This has been incorporated into the table and values edited accordingly.)

The total sum available for re-investment was $38,166.89.

The share counts have been revised on the index accordingly.

From February 5, 2021 to December 31, 2021, the DCOGI earned 78.8%, while the nearest comparator, the XEG.TO ETF, earned 68.5%.

While the DCOGI is not mirrored by real money, given the liquidity of all of its components, it is fairly easy to “replicate at home” if you wish.

2022: The year where monetary policy cannot solve everything

It is very important to remember that all of the trading that happens on the financial markets do not create or destroy anything – money and the asset is simply transferred, and the only change is the price that the asset is transferred. There are minor slippages (e.g. commissions and SEC fees) but for the most part, on a daily basis, it is a closed loop system.

The options market is completely zero-sum over the long run – every dollar a participant makes has to come out of the pocket of another participant. When option contracts expire, this is when the ultimately reconciliation occurs to zero the sum of transactions.

The stock market differs somewhat in that, as an aggregate, companies accumulate profits at the end of the day, and shareholders are recipients of these profits. It is a positive-sum game. Unlike option markets, however, equities are perpetual instruments (until bankruptcy or takeover/dissolution) and thus over time, the asset values of market participants should increase at the rate of company profitability, plus or minus the speculative forces we see each day when the market opens.

The lubricant that makes this occur is cash, and this is provided in the form of credit extended by financial institutions and ultimately backstopped by the central banks.

When there is more cash out in the system, it increases the demand for productive assets seeking a return. Likewise, when participants feel insecure or not as risk-taking, the demand for cash depresses demand for assets and will result in a drop in asset prices.

A simple numerical example suffices. If your ideal portfolio fraction is 80% equities and 20% cash and you have a total of $100 in your system, you want to own $80 of equities and $20 cash. If your shares rise in value, you sell a little of it to maintain your 20% cash fraction, while if your shares drop, you buy a little bit of stock to get back to 20%. If monetary policy suddenly infuses you with another $100 of cash, suddenly you will want to buy $80 more in equities to balance your portfolio. The residual cash goes towards an increase in asset value – and you see this everywhere with the stock market and real estate. Increasingly, this cash is starting to diffuse in other outlets, such as cryptocurrencies, NFTs, collectables, used vehicles, and so on.

One of my predictions for 2022 is that liquidity in the form of drenching the economy with cash is not going to solve real world economic problems. It will instead worsen them. Indeed, what we are seeing today is exactly a result of this – it is a world where (thankfully not literally, I am using some hyperbole here) everybody becomes a day trader. Every minute spent tapping a buy or sell on Wealthsimple (or perhaps Crypto dot com) was a minute that may have been spent producing good or service in the economy.

Perhaps day trading is too dramatic an example – and perhaps slightly exaggerated – but we also see this in the real estate market – many are jumping into the real estate agent game – how many times can a land title be flipped in a year?

The phenomena of “no supply at any price” is going to occur with higher frequency in 2022 in the real world. Unlike the financial analogy (e.g. the Volkswagen short squeeze of 2008), this is increasingly going to happen in the real world where only extreme amounts of money can bring supply of specific real-world products. A trivial example currently going on is purchasing a vanilla-styled iPad – they’re not available until the end of February.

This issue of “no supply at any price” will especially occur in price inelastic markets. Energy is one obvious example of a product that will be in very high demand and supply provisions are increasingly becoming expensive (whether politically or geologically) to procure. Another example will be specialized services (e.g. nuclear engineering or other ultra-specialized trades).

Just imagine being involved in a business that involves the assembly of many disparate elements involving multiple suppliers. If one or two of your key suppliers develops 2-3 month lead times, how the heck can you plan on your end the labour component for assembly? It means that you must start stockpiling. This will have a ripple effect return on equity for many businesses, but it will also translate into higher prices. This will go on until there is a demand collapse and only then we will see lower prices.

Late Night Finance with Sacha – Episode 18

Date: Tuesday, December 28, 2021
Time: 7:00pm, Pacific Time
Duration: Projected 60 minutes.
Where: Zoom (Registration)

Frequently Asked Questions:

Q: What are you doing?
A: Year-end results and review and my upcoming predictions for 2022. Barring a market crash (or melt-up) in the last three days of the year, it’s close enough to the year-end to review things. There should be a few minutes left for Q&A, so please feel free to ask them on the zoom registration if any.

Q: How do I register?
A: Zoom link is here. I’ll need your city/province or state and country, and if you have any questions in advance just add it to the “Questions and Comments” part of the form. You’ll instantly receive the login to the Zoom channel.

Q: Are you trying to spam me, try to sell me garbage, etc. if I register?
A: If you register for this, I will not harvest your email or send you any solicitations. Also I am not using this to pump and dump any securities to you, although I will certainly offer opinions on what I see.

Q: Why do I have to register? I just want to be anonymous.
A: I’m curious who you are as well.

Q: If I register and don’t show up, will you be mad at me?
A: No.

Q: Will you (Sacha) be on video (i.e. this isn’t just an audio-only stream)?
A: Yes. You’ll get to see me, but the majority will be on “screen share” mode with MS-Word / Browser / PDFs as I explain what’s going on in my mind as I present.

Q: Will I need to be on video?
A: I’d prefer it, and you are more than welcome to be in your pajamas. No judgements!

Q: Can I be a silent participant?
A: Yes. I might pick on some of you though. Bonus points if you can get your cat on camera.

Q: Is there an archive of the video I can watch later if I can’t make it?
A: No.

Q: Will there be a summary of the video?
A: A short summary will get added to the comments of this posting after the video.

Q: Will there be some other video presentation in the future?
A: Most likely, yes.