S&P/TSX 2019 year-end projections and predictions

Article on the Financial Post of various analysts predicting where the TSX will end up in 2019. Right now it closed at 14,222. I’ve put percentages next to the predictions:

Predictions for TSX at the end of 2019:
Laurentian Bank of Canada — 18,500 points (+30.0%)
BMO Capital Markets — 18,000 points (+26.6%)
National Bank of Canada — 16,600 points (+16.7%)
Russell Investments — 16,000 points (+11.1%)
CIBC — 15,600 points (+9.7%)
Sunlife Global Investments — 15,000 points (+5.5%)

I wish this list was more comprehensive. Sadly after doing a couple minutes of scouring the internet, I could not find a decent list of December 2018 predictions made in December 2017 other than Russell Investments predicted in late 2017 that the TSX would close 2018 at 16,900. I’m sure my readers can find a more appropriate list.

All I can say is the following – the numbers above also are based on a price index. The total return of the TSX includes dividends, and this would increase the stated percentages by approximately 3%. So the worst prediction of the six above would show a total return on the TSX of roughly 8.5%.

The TSX’s total return (dividends reinvested), as measured over the past decade, is approximately a shade over +5% compounded annually. Recall that 10 years ago was in the depths of the financial crisis and was one of the best investing opportunities in a generation.

If I was a broad market investor, I’d be concerned at this degree of bullishness.

No interest rate changes in 2019?

Take a look at the current snapshot of short-term interest rate futures (for those that do not know how they trade, ZQ is the 30-day Fed Funds rate futures and BAX are the Canadian 3-month banker acceptance rate futures, our closest proxy – the price is 100 minus the implied rate in percentage, so a price of 97.6 would equate to a 2.4% rate):

This creates some interesting financial bets, such as:

1. Do you believe the Fed will continue raising rates?
2. Do you believe the Bank of Canada will raise rates? If so, you can easily bet on this outcome. The next two policy announcements are on January 9, 2019 and March 6, 2019, and the BAX futures imply a very small chance of a rate decrease, but for the most part expect rates to remain the same (i.e. if you bet on the rates not changing you would stand to profit a tiny bit). The current rates as of today are 2.24% (97.76).

Given what has happened in the markets in the past three months, market participants are clearly pricing in that the central banks are going to stop raising rates. In particular, a quarter-point rise in the Bank of Canada rate will completely flatten the yield curve – currently 3-month treasury bill rates are 1.67%, but a quarter point rise will surely take them up to the 2 to 10-year level which are all currently trading around 190-200bps.

These are very strange times indeed.

The question then becomes a bit strange when one puts yourself in the shoes of the Federal Reserve or the Bank of Canada – do you want to raise rates to the point where you will invert the yield curve? It’s a bit gutsy to do so.

The Bank of Canada, as late as their December 5, 2018 policy announcement included the following sentence:

Weighing all of these developments, Governing Council continues to judge that the policy interest rate will need to rise into a neutral range to achieve the inflation target.

Does the Bank of Canada will believe that rates still need to climb to this neutral range?

For reference, the “neutral range” is defined as such:

The neutral nominal policy rate is defined as the real rate consistent with output sustainably at its potential level and inflation equal to target, on an ongoing basis, plus 2 per cent for the inflation target It is a medium- to long-term equilibrium concept For Canada, the neutral rate is estimated to be between 2.5 and 3.5 per cent. The economic projection is based on the midpoint of this range, the same rate as in the July Report.

The January 9, 2019 meeting is thus to be more interesting than most, considering what has transpired since the last meeting – including the Canada-China trade implications on the detainment of the Huawei CFO.

One of the likely implications of the realization of the cessation of rate increases is that there will once again be a chase for fixed income yield. It would probably open the door for more leveraged spread trading (e.g. borrow CAD at 2%, invest at 6% type trading, with the knowledge that the 2% borrow rate will not get more expensive).

The other observation is that the central banks might pause, but if markets start to normalize once again, may continue the tightening bias. Indeed, the Federal Reserve is still implicitly tightening with the reversal of QE and keeping this chart in mind (FRED Data) makes one realize there is a long way to go before things normalize on the Federal Reserve’s balance sheet.

Markets bounce back on boxing day

I will offer some commentary about today’s market action. I wasn’t expecting to write this so soon.

Back on December 20 (which was less than a week ago!), I wrote the following:

My gut feeling suggests that we need to see more of a washout. We are likely to see a huge market rally at some point in the near future (you’ll see the S&P 500 jump up 5% over the course of a few days), and this will simply punctuate the next part of the downtrend – recall that the biggest rallies occur in these down trending markets. It is exactly designed to coax non-committed capital into the marketplace under a false pretense.

When closing the part day on Christmas Eve, the S&P 500 powered down over 2% and given what has happened during the month of December, I do not think traders wanted any risk positions exposed during Christmas.

Now we’ve got our market rally. It’s happening right now, all in a day. There will be a week or two of more positive market action. We will get a partial recovery and institutions and investors will feel more comfortable again. We are going to hear headlines such as “the economy is fundamentally in great shape”, and “unemployment is low”, and “America is still the economic engine”, etc, etc., but all of this is going to be a complete smokescreen.

Now that the mini-break period is over, today we saw the S&P 500 rocket up nearly 5%. The TSX is closed for Boxing Day, but it is very likely to trade up on Thursday as a result. It will get sold after the morning – when this will start, I don’t know.

In bear markets, the rallies are the swiftest and the most punishing for short sellers. There are a few reasons for this. Rationally, you have some balancing re-allocation from fixed income to equity from portfolio managers that keep fixed allocations of asset classes. The more emotional component is that money flows back into the market to avoid missing out on the bottom (the so-called “buying opportunity of the year”). For the past decade, participants have been conditioned to believe the the markets will bounce back. We saw this in August 2011, October 2014, February 2016 and even as recent as this Spring, where markets took a 10% dip and recovered to all-time highs.

I will claim things are different. What is different this time? The state of monetary policy. I have written about this in detail in previous posts.

Keep solvent. Cash is always a valuable commodity, but especially during these times. Preparing to watch out for forced and spontaneous liquidations will be the best way to make money in 2019, not by index investing. Indeed, those with the buy-and-hold mantra will have their nerves continually tested in 2019 – how much bleeding can they take before they will cash themselves out?

Investing is never easy, nor will it ever be. Looking at the retail side of things, firms that make ETF investing and robo-investing sound easy as opening an account, funding it, and choosing some mix of ETFs make the financial markets look like automated cash machines. Now these same people are realizing that there is indeed a flip side to the proposition – markets can also go down.

Christmas Market Meltdown

First of all, Merry Christmas to my readers. Even if your financial health is suffering due to this very exciting quarter, be thankful if your physical health is in good stead. I won’t blame you if your mental health is somewhat suffering simply due to all of this calamity going on.

My “stock radar” is coming up with so much material to look at right now that, coupled with the other usual obligations that go along with the Christmas season, I am running out of time to properly look at everything.

I’m going to summarize a lot of information in this post and it will be in no particular order.

S&P Volatility

Volatility is anti-correlated to the price index and past history would suggest that if this index reaches to around 50-60 it would probably be a good time to deploy capital. This happened last in early February, but going back in time, the previous opportunity was the Euro-crisis in the Summer of 2015.

S&P 500 itself

Technical analysts will point to a very obvious price target – around 2,100. If this happens, that equates to nearly a 30% plunge in the S&P 500. From a high of 2940.91 (September 21, 2018) to 2351 today, the index has dropped 20%. The big factor is that this has happened in a very short period of time – about 3 months.

TSX

The longer-term chart for the TSX doesn’t look nearly as bad simply because the commodity-heavy capitalization of the index never took off in the first place. Despite appearances, the high was 16,586.50 on July 13, 2018 and at today’s value of 13,780, that’s a 17% drop, so mirroring pretty much the same that happened to the US major index. There’s still another 15% or so from present prices before getting to the commodity plunge pricing in February 2016.

Oil and Production

US producers have crushed everybody else into oblivion. Coupled with an economic slowdown, there is going to be a lot more financial pain in oil markets if pricing does not improve. The commodity price is getting to the point where it is nearing the marginal cost of extraction at the volumes of crude required, but a longer term analysis of commodity trends says that prices can actually go below marginal extraction costs for quite some period of time before normalizing. Just look at the Uranium market as a good example.

Western Canadian select is around US$30, which is a healthy recovery from the dark November days when they traded as low as US$12. The differential has narrowed to US$15/barrel, but this was probably not what they wanted – there isn’t a lot of profitability in Canadian oil at US$30/barrel.

If we are going into a recession and consumption does decline, we are still going to see further pain in oil and gas. That said, a lot of oil and gas stocks, especially Canadian producers, are trading like the businesses are going to go bankrupt. At current prices, some will be, but successful timing of the commodity cycle and maximum pessimism should be rewarded with handsome capital gains. Getting this timing correct is never easy.

Safety of various well-known issuers

Many people out there, especially on the retail side of things, are looking at major Canadian banks (BNS, BMO, etc.) and high-yielding utilities (e.g. Enbridge) as bargains at present. While they sport high dividend yields, they also sport liquidity risk that I do not believe these investors fully appreciate.

A good metric for how dangerous these companies truly are is represented in the junk bond market (e.g. HYG:US) is a reasonable proxy for the junk bond market.

If BBB credits (and worse) can’t get good debt financing, then most other debt-sensitive sectors are going to face higher refinancing costs. Leveraged entities are going to face earnings reductions.

Canadian Convertible Debenture sweep

I’ve done a sweep of the entire TSX exchange-traded debt market. Only two issuers really caught my attention out of the entire universe that is trading. I’ll be doing some more research on it later.

Some other gems that I will mention in the TSX exchange-traded debt space: the fiasco at Zargon, and you can always pick up some debentures of Lanesborough (TSX: LRT.DB.G) for less than a penny on the dollar if you believe Fort McMurray real estate is going to make a swift comeback from the dead. This REIT is so deep into the hole, the only question is how the present controlling management will be able to siphon any value out of it before they pull the CCAA pin and euthanize the publicly trading entity.

In general, I’m surprised how little value there is in this space given the calamity going on in the equity side.

Short-term cash management

US Dollar:
Little duration risk –
BSCJ earning 3.18% (minus MER 10bps), 0.5 year duration
IBDK earning 3.16% (minus MER 10bps), 0.46 year duration

Both these ETFs terminate at the end of 2019 and contain mostly Baa-A corporate debt scheduled to mature in 2019. Duration risk will drop as their bond portfolios mature (good for a rising rate environment, although one suspects it won’t be rising for too much longer!).

Some more duration risk can be had with SHY, 1.88 years, with a 2.65% YTM, and 15bps MER.

Interactive Brokers gives 1.9% on USD, so one takes about a 1.2% pre-tax sacrifice for holding it vs. a near brain-dead bond fund.

Canadian Dollar:
RQG earning 2.54% (minus MER 28bps), 0.65 year duration
XSB earns 2.45% (minus MER 17bps), 2.75 year duration, slightly safer bond selection than RQG.

Interactive Brokers gives 0.71% on CAD, so the spread is about 1.5-1.6% pre-tax.

Home Capital Group and Equitable Bank’s short-term savings accounts give a 230bps yield for on-demand money, so if one is willing to do the paperwork hassle and is willing to take some deposit risk (remember the imminent solvency worries about Home Capital Group earlier this year?), this is not a bad place to park capital in relation to having to suffer through the hassles of trading the above. Indeed, if you feel brave and want to lock in for a year, they will offer 310bps.

Considering the Government of Canada 3-month rate is 1.67% and 5-year rate is 1.92%, this is telling. The competition for deposits is likely to increase and this would explain why banks are not going to do so well in the future.

Canadian / US interest rate environment

BAX quotations have flat-lined. The current 3-month Bankers’ Acceptance rates are 2.23%, and with the March 2019 BAX futures trading at 2.26%, the market is now projecting that Poloz will hold steady on his January 9, 2019 rate announcement. I’m somewhat thinking that the demise of at least one future rate increase is mis-guided, but we will see.

The US interest rate environment has changed dramatically over the past couple weeks. Now the Federal Funds rates are locked at 97.60 (2.4%) through December 2019, plus or minus a very minor chance of one rate increase. The two-year treasury bill yield is down to 2.63%, and the 10-year is at 2.75% – very slim differential.

Future market projections and where to make outsized returns in the future

Am I going to give away all my financial secrets for free? Sorry!

But needless to say, I think there are a few areas with very low-lying fruit that is getting sold off in forced-liquidation type trading. Figuring out when there will be a bounce-back will be difficult. This isn’t a 2016-type environment where you have the federal reserve willing to throw hundreds of billions of dollars into the market – we are facing the opposite environment and thus must act accordingly.

I’ll have my year-end update posted sometime near the new year. Barring a significant market event, Q4-2018 will be my first quarterly loss since September 2015!

A minor tax note for Canadian investors

Canada Revenue Agency rules state that the settlement date, not the trade date, is the determinant of when you have disposed of a security.

Hence, if you wish to liquidate stocks on the public exchanges and have these transactions count for the 2018 tax year, you have until the close of trading on December 27, 2018 to do so for the trade to settle on December 31, 2018.

I would expect given that Q4-2018 has been one of the worst performing in quite some memory, that this would be a consideration for many investors to have the CRA share their losses in 4 months (when filing for taxes) than 16 months later.