Annual report of Canada – 2009 to 2010

The Government of Canada released their annual report for the 2009-2010 fiscal year (April 2009 to March 2010). The headline number is the $55.6 billion deficit.

Although the report is a pleasantly short 30 page read, I will concentrate on the expenditure side of the budget. A lot of people have the impression that federal government spending can be easily slashed. Apportioned by percentage, the $244.8 billion of expenditures look like this:

Looking at the pie chart from largest to smallest percentage expenses, one can easily see how cutting expenditures is not politically feasible. For example, a full quarter of expenses are transfers to persons. These include Old Age Security, EI payments, and child-related transfers – all three would likely have massive backlash if there was a cessation of benefits.

The government in the 1990’s, when faced with a deficit crunch (when a third of the revenues went off as interest payments) decided to cut transfer payments – this goes to the provinces mainly to pay for healthcare. Again, this would be highly unpopular if the government did so.

The discretionary expenses that the government has a chance of implementing are on defence, crown corporations, and “the rest of the government”. This is approximately 29% of the 2009-2010 fiscal expense profile. Even if you were to decrease these expenses, it would make little progress at reducing the entire expense profile, which is ballooning as the population ages.

Every Canadian should be able to understand this document, but sadly, few ever read it.

Pay attention to index volatility

Now that Canadians are recovering from their Thanksgiving turkey dinners, it is time to pay attention to the marketplace once again.

One chart I will bring to your attention is the volatility index, VIX. It measures the implied volatility of the S&P 500 index. It is also equated with being the “fear index”. Implied volatility of the marketplace is highest during market crashes.

Historically, when the VIX goes under 18, it does not bode well for the marketplace – it’s a good rule of thumb (the lower the better) to watch out for complacency. Obviously since VIX is not a predictive index, you should not base your outlook on it, but it does convey the information that market participants are not betting on a crash (or a spike up) in the near term.

Traders that expect some form of volatility can bet on both sides of the marketplace – by purchasing a call and a put at a strike price, they will win if the market goes up or down a certain quantity. For example, right now with the S&P 500 at 1164, you can purchase a December expiry (December 17, 2010) call and a put, with a breakeven point of 7% movement (roughly 40 points in either direction). Conversely, you can profit if you sell the same options and the market does not move further than 7%.

Playing options are very difficult since you are fighting very good mathematical models, so I do not recommend them for casual investors. Most option-based literature I’ve found makes it sound like an easy game, but it is truly not. The only thing worse than playing a very difficult game is being mislead into thinking that the game you are playing is easy. This goes for the stock market in general, but especially option trading.

Deploying some capital

After some considerable investigation, my US equity research has finally hit some pay dirt this week, and I have been attempting to get a position in two equities – one relating to the defense industry, the other relating to oil and gas. One of the companies is a well-established player in the industry, while the other one is relatively newer. I would not consider either to be “speculative” in that both firms generate cash, but I do have a good idea why the market believes they should be trading at relatively low levels, and why the market is incorrect.

One has a dividend yield close to 1%, and the other does not give out a dividend. Investors in either company will not be “yield chasing”, so I am happy to not be paying for other people’s yield-chasing demand!

It always seems to be the case that when I place my orders the market suddenly sees my interest in buying a 0.0001% stake in the firm, and then takes the bid up 5%. This is frustrating, but both companies should hopefully regress in price and I will ideally receive a relevant fraction in my portfolio. Both companies have liquid stocks, so somebody of my volume will not move the price.

I will eventually be deploying the rest of my US-denominated currency from bonds to equities, but the bulk of it will happen in early 2011 when I can get rid of the bonds.

I am still investigating a couple other candidates on the US side. I have already rejected many other names – investing in the USA is becoming economically more and more dangerous because of their domestic economic situation. Investors need to be careful of the impact of silly government decisions.

SNC-Lavalin trumps the CPP

In an interesting development, SNC-Lavalin (TSX: SNC) has announced that it will be exercising its right to first refusal in purchasing the CPPIB’s 10% stake in the 407 Highway.

SNC is now forming a new corporation, which will sell shares in a company (Transaxio) that has its ownership interest in the 407 Highway.

The only reason why SNC would do this is if they suspect that the CPP’s purchase was undervalued – so it will be interesting to see what the corporation will trade at when it goes public.

This will also be the first time people can directly take an ownership interest (although effectively a non-voting interest) in the 407 Highway.

Currency devaluations

The US dollar is clearly on a downslope:

With central banks having huge incentives to devalue their currency, it is going to be a classic case of a “race to the bottom”. It is not a surprise to see commodities and gold perform in such an environment.

Canada is in an odd position – with an economy strongly aligned toward commodity prices (energy and mining), it will create strength in the dollar. Exports become less competitive on pricing, which suggests that short term interest rates will not rise because of the cooling effect of a strong currency.

In a more retail oriented environment, this will also mean that imports will be cheaper, and the most Canadian tradition of them all – cross-border shopping – will be cheaper to partake.

Mass devaluation is not quite the same as inflation, but will likely have the same result. The only question is which assets to park your cash into.