The difference a weekend and a trillion dollar pledge

The following is the 5-day chart of the implied volatility of the S&P 500 index:

Trying to predict this in advance is very difficult and one reason why I generally do not believe people that say “I bought at 25 and sold at 40”. Trading is never that clean – you never know when the bottom will be, and you never know when the top will be. You only have a fuzzy idea whether something has been over-extended, but you never know whether you are correct or whether you will get the timing right.

Everybody is a perfect trader in retrospect.

Most of my portfolio losses from the previous week have reversed today. If I was going to guess, there will be another spike or two of volatility as traders test the waters, but I think this is it for the short term (i.e. back to “business as usual”). In the medium term, I would be very, very cautious. Markets tend to gyrate significantly in economic stagnant periods.

Other than using the spike down to liquidate some US currency into Canadian, and making a very minor trade (using some idle cash that has accumulated in the RRSP account), I’ve been twiddling my financial thumbs. The worst trades you can make are ones where you are forced, or trade for the sake of trading.

The Trillion Dollar Euro Bailout

The European Union Bank is effectively going “all-in” by pledging $1 trillion in collateral to shore up the economies in the Eurozone.

What people should be fully aware of is that while this might delay the financial issues concerning the countries in the Eurozone, this is not going to solve the underlying problems – too many entitlements promised to people and not enough money to pay the corresponding liabilities. The only solutions are to reduce the entitlements (which is difficult to achieve politically) or raise revenues.

Clearly by stalling for time, they are hoping something might happen that would alleviate themselves of the fiscal mess they are in, but by stalling any action that would clean up the mess, it will just make it worse in the future when the proverbial excrement hits the fan.

It is my market opinion that we have not seen the end of this by any means. How to play this profitably is difficult – increasing cash allocation and playing the risk aversion card seems to be wise until such a time it becomes evident that the markets have discounted sufficient risk to account for the soverign debt mess that is looming.

The United States is not immune to this, but economists do know that countries such as the United Kingdom, other European countries and Japan are more likely to face these big macroeconomic/demographic issues before the USA will.

Countries like Canada, relatively speaking, are in decent shape. While old age security payments and guaranteed income supplements will increase as the baby boomer generation retires, entitlement payments are relatively low and can be managed. Our pension plan (CPP) is solvent and funded by real assets generating real returns (although how those assets will perform in a global debt default remains to be seen). The big liability, accrued healthcare spending, is the big political hot potato. The Canadian economy seems poised to take advantage of one major trend, mainly that consumption of energy will continue to increase – our oil industry is going to boom assuming there is no massive deflation of debt and international trade.

I still have no idea whether the deflationary or inflationary theory will win out.

Canadian Interest Rate Projections – May 2010

I figure it would be helpful to see what the Canadian interest rate futures are doing and to make some projections as to what the market is saying about future rate increases:

Month / Strike Bid Price Ask Price Settl. Price Net Change Vol.
+ 10 MA 0.000 0.000 99.375 0.000 0
+ 10 JN 99.150 99.160 99.250 -0.100 14740
+ 10 JL 0.000 0.000 99.365 0.000 0
+ 10 SE 98.730 98.740 98.820 -0.080 22075
+ 10 DE 98.340 98.350 98.410 -0.060 29381
+ 11 MR 98.050 98.060 98.100 -0.050 8873
+ 11 JN 97.740 97.770 97.810 -0.060 2777
+ 11 SE 97.440 97.480 97.550 -0.080 2076
+ 11 DE 97.220 97.270 97.310 -0.070 216
+ 12 MR 96.910 97.150 97.060 -0.250 1
+ 12 JN 96.550 96.930 96.860 0.000 0

My projection for the Bank of Canada overnight interest rate level is the following:

June 1, 2010 (+0.50% to 0.75%)
July 20, 2010 (+0.25% to 1.00%)
September 8, 2010 (+0.25% to 1.25%)
October 19, 2010 (+0.25% to 1.50%)
December 7, 2010 (+0.25% to 1.75%)

What has changed since my last projection is that the initial rate increase in June 1, 2010 will be 0.50% instead of 0.75%. I still see subsequent rate increases of 0.25% at each scheduled announcement. You can probably thank the European debt situation for this change.

Although Canada’s economy is much less linked to Europe than it is to the USA, it is enough to factor into the economic calculation. In particular, the Euro has dropped significantly and this will lessen the competitiveness of Canadian exports into the Euro market.

That said, relative to the US dollar, the Canadian dollar has slipped a little, but this probably isn’t enough to take into consideration other than “wait and see”.

Long-term rate projections, which is more relevant for mortgage pricing, has had rates drop over the past two weeks. 5-year bond rates are 2.74%, while the 10-year is at 3.47%, which is roughly the rates seen in the past three quarters. If the market stabilizes at the existing level, I would not be shocked to see a 5-year fixed mortgage rate offered at 4.00% in the next couple weeks.

Aftermath of the May 6 financial earthquake

I have been diligently scanning the markets with respect to the very volatile trading session on Thursday.

Implied volatility on the S&P 500 is still at around 36-37%, which is considerably higher than the average of 16-17% it was in the month of April. Option traders buying volatility would have done very well, but volatility spikes are just as difficult to predict as price spikes.

I find it odd that income-bearing equity tends to be trading lower, but income-bearing preferred shares and bonds are relatively stable. This could be due to the decrease in the implied future interest rates.

My long-term corporate debt issues, however, have taken quite a haircut over the past few days. I trimmed some of the position last month at yields I thought were pretty low (around 8%-8.5% for 20-year paper), but didn’t sell enough as it is now trading about 150bps higher. One of the advantages of dealing with debt (debt that you know has a very high chance of not defaulting) is that you don’t stand to “lose” that much opportunity cost by waiting – you will receive your coupon payments and wait for a better opportunity to sell when yields go lower, or accumulate if yields go higher.

The net damage report for this week is about 6%, but I do not see any reason why the intrinsic value of my portfolio has dropped any – the investments that I do have should continue to generate roughly the same projected amounts of positive after-tax cash flows. The income being produced is significant and should continue to be this way.

Market history lesson – April 4, 2000

Today’s trading reminded me very sharply of what happened on April 4, 2000 when the Nasdaq fell by about 13% but recovered to end the day nearly flat. The CNNFN article has a few charts.

Ten days later, the Nasdaq was down 20%. The following week, the Nasdaq was up 10%.

For the next few months the Nasdaq gyrated, but peaked at the end of August before resuming its descent in September 2000, all the way until October 2002 when it plunged down to about 1200.

Is history repeating? I don’t know.

Is it a good time to be on margin? Probably not. The volatility will kill you.