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.

Quick market update

The Federal Reserve has raised interest rates another 0.25% to 2.25% to 2.5% with the target being 2.4%. This is a change from 2.00% to 2.25% with a 2.2% target rate.

Also, the quantitative tightening will not be tightened further – the amount of treasuries in the Fed’s balance sheet will continue to reduce by $30 billion and mortgage backed securities by $20 billion monthly. Previously the Federal Reverse increased the reductions quarterly.

So there is obviously an inflection point on the rise in interest rates and the quantitative tightening. According to FRED data, the level of treasuries held by the Fed will still be above 2012-2013 levels before they engaged in another round of quantitative easing.

Using the “hand in the vice” analogy, the vice is being tightened, but now at the same constant rate instead of the rate going faster. It will still result in some bones being crushed. We are easily seeing who some victims are (typically entities reliant on debt renewals – money is getting tighter). Junk bonds are going to be no escape.

Canadian interest rates typically have kept in “lock-step” with US interest rates and I would expect to see another quarter point increase on January 9th. I wouldn’t expect the Federal Reserve to act again on rates until their May 1st meeting unless if the stock market crashes or normalizes.

Market volatility has really increased since the beginning of October and one observation is that I am really surprised how much the fixed income component of my portfolio (specifically preferred shares) has depreciated during that time period. 5-year government bond yields have dived over 50 basis points over the past couple months, which is not good if you have rate reset shares coming up.

I have been researching companies like crazy at this period of time since a lot has been hitting my radar. You outperform the market by investing at panic bottoms.

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.

My liquidity position is excellent to take advantage. I’ve been waiting for this opportunity for some time. I am in no rush at the present moment to get in – it’s too early. More pain needs to be felt by the marketplace.

Canadian Bank Stocks

Bank financial institutions usually make money by borrowing short and lending long (i.e. having their cost of capital at the short-term interest rate, while earning money with the long-term interest rate).  The flattening yield curve is making it more difficult for financial institutions to capture this spread and this is reflected in what we see in Canadian bank stocks.

Looking at the six majors (TD, BNS, RY, CM, BMO and semi-major NA), they are all down for the year.  Looking at the juniors (CWB and LB), they are also down, especially in LB’s case (which has some other business operation issues that I will not get into this post, but suffice to say there is a reason why it is trading at less than 75% of book and a P/E of 8).

There are also other quasi-banks (e.g. EQB, HCG, FN – yes, I know FN is not a bank, etc.) that appear to be doing reasonably well despite their obvious reliance on the stability of the Canadian mortgage market.

Some people are advocating that this is a good time to get into the sector as traditionally most of Canada’s big banks have proven to be stable in history, and the big banks are making record amounts of profits.

Assuming you had to be locked into an investment in these Canadian banks, the proper question to answer is whether these institutions will continue making money at the rate they have been making it historically that justify their valuation.  They look cheap from a historical perspective, but just relying on historical analysis is a very dangerous method of investing.  There is a lot of competition in the financial sector domain and I am not sure whether forward looking, profitability will be as strong as it has been in the past half decade.  The easy money appears to have been made.

In general, I would not be surprised at all to see the major banks tread water price-wise for the next few years or even see investors today take small unrealized capital losses over that time frame while clipping their 4-5% dividend coupons.

Finally, I will clarify this post does not take into context the insurance sector (e.g. MFC, SLF, etc.) which has their own dynamics.  I also do not hold anything mentioned in this post, although I have taken a hard look at LB and CWB recently.

Canadian preferred share indexes hammered

The Canadian 5-year government bond rate has compressed significantly:

As most Canadian preferred shares are linked to this rate, we are seeing a huge selloff (which interestingly took place about a month before 5-year interest rates really started to drop):

ZPR is a BMO ETF tracking preferred shares. CPD is an ETF tracking a preferred share index holding most of the investment grade preferred shares trading on the TSX (mostly concentrated in Financials and Energy). Holders in these “safe” funds will have had around 13-14% of their capital value evaporate over the past two months of trading.

It is indeed ironic how the equity components of the preferred share indexes have fared generally better – as an example, Toronto-Dominion equity has declined about 10% in the same period of time.

So much for preferred shares being a safer vehicle to invest in!

The big difference this time around is that a lot of the rate-reset preferred shares have already had their yields reduced to a minimum due to the 5-year Canadian bond rate being so low for an extended period of time. Subsequent rate rises will have less impact on the dividend rates paid for preferred shares.

It remains to be seen whether this will continue or not. Back in February 2016, we had seen double-digit dividend yields on very credit-worthy issuers, but this was also when the 5-year bond rate was trading at around 100 basis points.

I’ve also been doing some research on preferred shares that are not held by these two funds. I would suspect that less liquid preferred share series on the main two ETF indexes would be more prone to auto-selloff algorithms when people inevitably decide to panic and try to liquidate everything.

Very often, people hold cash in their portfolios for too long and then get itchy. They then instead think of investing in “safe” preferred shares, or an index, thinking that the 5-6% yield they realize is adequate compensation for the risk in lieu of holding cash.

It is these situations where they rethink this notion and decide to liquidate. Eventually the capital losses become too much to bear.

It is very difficult to time when the maximum moment of panic is, but doing so will result in outsized risk/reward ratios, which is why I’ve been paying careful attention in these very volatile couple months.

Doing a portfolio check on a heavy down day

As I write this the S&P 500 is down over 3% for the day. The TSX is down 1.4% which isn’t so bad by comparison.

An index is simply a collection of stocks. For the two indexes above, companies that have higher market capitalization are weighted high in the index. When an index gets sold off heavily, there is a high probability that the higher capitalization stocks in the index will also be sold off.

When there is heavy market volatility it is usually wise to look at what is going down by the averages, what is going down more than the average and which stocks are holding steady or even rising, especially those stocks that are not included in a major index. It gives you some hints as to which sectors are and are not popular for the day.

Institutional investors are usually required to keep specific ranges of portfolio fractions (i.e. an allocation between equities, bonds and other asset classes). Typically when broad equities drop, managers will dump bonds in order to buy equities to rebalance the portfolio.

Today, contrary to what the market has been doing a few months ago, a selloff in equities is once again correlated to an increase in risk-free bond securities – I note that the 10-year treasury bond yield is down some 70 basis points – which means that what we are seeing in the markets today is a flight to less risky positions. The yield curve continues to flatten – there is a 10 basis point difference between 2-year and 10-year treasuries now.

If equities fall enough, collateral values will also decline to the point where portfolio managers will have to liquidate assets in order to maintain sufficient collateral – i.e. a margin call situation. If enough of this happens, you will start to see significant opportunities appearing on the equity side.

It’s more probable than not that the upcoming December meeting of the Federal Reserve will be the last quarter point interest rate hike before they take an extended pause. If interest rates stop rising, then the next market focus will be back for finding yield.

Another observation is that gold is doing reasonably well. It is a shame for most investors that most gold mining companies are poorly managed.

I’ve still got a lot of dry powder in the portfolio and I’m waiting for worse times. There will be a time to pounce but not yet.

There is one other observation I will make – robo-investing and index investors that choose allocations of various low-cost ETFs are dooming themselves to sub-par returns. Every time I hear people investing in whatever index fund that pledges market diversity (e.g. VGRO is quite popular) I just think to myself if they are truly prepared to earn low single digit returns with the real risk of them seeing 25% peak-to-trough downdrafts.

It was about 10 years ago when the economic crisis was clearly in full swing – Bear Stearns went bust, Lehman Brothers went bust, and anything financial was imploding. The S&P 500 was still at around 870 at this time. It wasn’t for another 3 months before the S&P 500 reached its low (the value being “666” appropriately enough) – you would have still seen a 23% decline in value.

This time around, how much of a value loss can index investors take before the perception of an unlimited wealth creation vehicle evaporates? Today, we are at 8% below the peak of the S&P 500. Canadian investors (via the TSX) have seen a 9% drop from peak-to-trough in the index high.

“This is just another buying opportunity to buy shares cheaply”. Or is it?

As my last note, I will point out that General Electric (NYSE: GE) is down 6.66% today. How symbolic.