Merits of technical analysis

Some people claim they can trade by just reading charts. I am not one of them.

However, marketplaces that are crowded with technical traders will have the ability to be successful in the short run. The technical end of the stock market are zero-sum gamers employing algorithms that take advantage of weaker algorithms.

Thus, I do believe in the validity of technical analysis. I just don’t think many people can do it – at a minimum if you are not cognizant of your “enemies” (i.e. other traders) are up to, then you are the proverbial fish around the poker table.

One branch of physics, called econophysics, heavily depends on technical data to drive conclusions. Back in my university days, I dabbled in an econophysical model which was an interesting study. Some professors have taken it to the next level, and have mined technical data to try to predict market crashes, with partial success.

In absence of fundamental data, the model might be successful in predicting algorithmic activity, rather than being a crash predictor.

The danger of yield chasing

I love nearly everything David Merkel writes, and this is a gem:

The lesson is this: in investing, ignore yield to the greatest extent possible. Focus instead on earning a good return, with safety, and ignoring the payout. It is a little known secret that REITs with the lowest payouts tend to be the best performers over the intermediate-to-long term. It is easier to earn money off of taking equity risk than credit risk.

So, aim for best advantage in investing. Don’t trust yields, but rather look at the underlying economics of the business that you are investing in or lending to. Yes, it is a lot more work, but it is work that you should be doing.

One issue I have with a lot of “Dividend stock investors” is that they do not look at the underlying fundamentals of the company to determine whether yield (and growth of that yield) is sustainable. During the Canadian Income Trust mania (roughly in 2003-2006 before the government shut the whole operation down) you had corporate entities converting into a trust that had absolutely no chance of being able to sustain such distributions. To list all of the offenders in this post would be burdensome, but one of my “favourites” (not that I had ever invested in it, but because they were a local business I paid attention to them) was Hot House Growers Income Trust.

HHG went public in late 2003 after they had a good year. They had distributions which were higher than their net income and they had a significant amount of debt. They began to suffer operationally (too many people were crowding into the business sector) and a couple years later they collapsed and had to be taken over by the surviving entity, Village Farms, which is a penny income trust that will not be giving any yield because their business still has too much debt. They are still publicly traded, although they will likely have to recapitalize again to pay for their debt.

People were buying income trusts in droves simply because they saw the yield and did not consider the return on investment, i.e. whether you would be able to retain the capital in the investment.

My own income trust investments are quite “yieldy”, but their underlying business fundamentals are solid, and generate significant net income (not just cash flows) to sustain the business, after required capital expenditures. Probably the easiest screen you can perform is making sure that net income and cash flows are above the yield (dividend/distribution) rate and ask yourself if the business that is underneath it all can be sustained for the indefinite future.

The other question you should be asking is whether the company has the ability to invest capital that is left over after distributions and debt payment into other capital projects that will continue to give yields that are above the current cost of capital. If so, such companies should not have excessively high payout ratios.

Most dividend stock investors have the right idea, but they don’t do the rigorous research to ensure that they will be paid out without taking a disproportionate risk of capital loss – instead, they just look at the yield/dividend number, and just care that it has gone up historically over a period of many years. This blind-style of investment is akin to driving while looking at the rear view mirror.

BC Property Tax Deferment

The BC government in the previous budget is now enabling people that own homes and financially supporting somebody that is 18 years old or younger to defer their property taxes, at the rate of interest of the bank prime rate. Previously only seniors (55 and older) were able to exercise this option.

Essentially homeowners are given the option of borrowing money (the amount of their yearly property taxes) at the prime rate, and will only have to repay this amount when your property is transferred (i.e. you sell the place).

Almost everybody that is financially sophisticated that is eligible to do this should be exercising this option. Getting money at the prime rate outside a mortgage is not that easy, and at the prime rate you can very likely make an investment that would give a higher rate of return.

The trick is making the interest amount tax-deductible, and if you use the deferred property tax amount for income-generation purposes then in theory you should be able to deduct the interest.

British Petroleum and the drilling companies

I have done nothing other than look at the summary financial statements of BP, but on paper they look undervalued. The mess in the Gulf of Mexico, however, will be costing them considerable amounts of money. I’ve projected a couple years of earnings ($40 billion) that will likely go down the tubes as a result of this environmental incident.

The market will take BP down to the point where nobody will expect, and when everybody has written off the stock, that is usually the time to buy. In essence, this is a psychological play, so it involves more game theory than financial analysis since it is likely that BP will remain a continuing entity in the future. Their balance sheet is fine – about $40 billion in debt and $7 billion in free cash flow ($20B income) in 2009, so they won’t be facing any solvency issues.

The better question is whether one should invest in the drilling companies. It is likely lease rates will drop since offshore drilling will have significant demand drops and the market has already been pricing this in. As an example, Transocean has also been slaughtered.

I generally do not look into companies that are not trading in Canada or the USA, and BP is a British company, so I will not be considering them seriously. However, the other companies (e.g. the aforementioned drillers) I will be investigating. Since there are so many eyeballs on this sector, there must be other circumstances (e.g. panic) that would be required to ensure that you are getting good value for your investment. It is also exceedingly difficult to predict when to catch the falling knife and the investment to invest in BP is essentially that – you need to place your purchase orders when everybody has gotten their hands so bloodied up trying to catch the knife that they have given up trying.

I would not bother thinking about this until BP has cut their dividend.

Eating a little bit of crow on interest rates

I strongly thought the Bank of Canada was going to raise 0.5%, and the futures markets were not inconsistent with this belief, but instead, they raised 0.25%. Global factors (including Europe) is likely the reason why they went for the more conservative rate hike. They have also said that future rate hikes are not going to be as quick as the markets anticipated:

In this context, the Bank has decided to raise the target for the overnight rate to 1/2 per cent and to re-establish the normal functioning of the overnight market.

This decision still leaves considerable monetary stimulus in place, consistent with achieving the 2 per cent inflation target in light of the significant excess supply in Canada, the strength of domestic spending, and the uneven global recovery.

Given the considerable uncertainty surrounding the outlook, any further reduction of monetary stimulus would have to be weighed carefully against domestic and global economic developments.

Now that I have completely destroyed any credibility that I had on the issue of short term interest rates, I will give my new projection:

July 20 (raise 0.25% to 0.75%)
September 8 (raise 0.25% to 1.00%)
October 19 (raise 0.25% to 1.25%)
December 7 (raise 0.25% to 1.50%)

Between now and the end of the year, the prime rate will rise from 2.25% to 3.50%, and your average variable rate mortgage of prime minus 50bps will go from 1.75% to 3.00%.

There is no indication that these quarter point rises will stop in 2011; although the markets are now hinting the short term rate will level off around 2.75% (prime rate of 4.75%). This will clearly be conditional on how fast the economy recovers and the onset of inflation.