End of year actions and rambling thoughts

Major holders of institutional money are likely on “autopilot” for Christmas so it is likely no major changes in investment policy decisions will be made until the new year, short of some geopolitical calamity.

Canadians have until December 29 to sell securities that are sitting in a loss position to claim a capital loss. Americans have until December 31st.

The real question I’m grappling with is how much more can monetary and fiscal policy continue to drag the powder keg up the hill before something breaks and it all comes tumbling down. Japan has shown the western world the way how you can run massive deficits for a very long period of time without catastrophic consequences. It might go on longer than most people think.

With the rampant speculatory valuations seen in many sectors (for two great examples, look at Peloton (PTON) and Chipotle (CMG) – yes, fast food that should be trading at over 100 times normalized earnings), there is quite clearly a degree of misallocation that hasn’t been seen in quite some time. The origins of such speculative fervor can likely in part be attributed to the supply-demand dynamics with passive indexation coupled with momentum – for example, the larger your market cap is, the more you will be included in the respective indicies. This creates price insensitive demand, and this is all too willing to be sucked up by the marketplace.

This could be the stock market equivalent of Chinese condominium towers being built in the middle of nowhere – to be sold as “stores of value” in absence of other opportunities. Maybe if you’re lucky, in a few years you can AirBnB and make a few RMB of income with it.

You can’t short them (what’s crazy can get crazier), you can’t long them (don’t know when the music will stop), all you can do is get them out of your mind. The mental return on brain damage is too low, although there is a huge gambling appeal which is witnessed by the whole locked-down millennial world discovering Robinhood and thinking they are stock-picking champions as they swap CERB money with each other, with the market makers skimming pennies a transaction. You don’t have to read me anymore, just pay attention to everything these TikTok millionaires do.

Relative performance managers that are indexed to the S&P 500 will have had to reach a +14% hurdle so far in order to justify their pay. Hypothetically, if they put their entire portfolio in Apple for the year, they’d be sitting on an 80% gain. Considering Apple is about 6% of the index, it makes you think about the other parts of the S&P that must be underperforming Apple. Something makes me think Uncle Warren B. was onto something when he ploughed nearly a hundred billion of his capital into Apple stock – it was his version of going into Bitcoin.

Managers indexed to the TSX will have seen a +3% gain this year. Your ticket to glory was Shopify, which did reasonably well during the COVID crisis, but had you held on from the beginning of the year to present, you would be up triple your original investment. My god, what do I do all this investment research for when these superior returns are just staring you so blatantly in the face?

I’ve done a cursory scan of the entire TSX on the loss side and earmarked and looked into a few issues that are of interest, but I’m not at all close to pulling the trigger on any of it.

In fact, when I look at my own portfolio, the most clearest speculative component is the one that is doing the best percentage-wise from cost. The most obviously “value” stock is not doing that well at all (you can probably take a guess which one this is).

For the past couple weeks, I have been trying to visualize how 2021 will emerge.

With infection rates, coupled with vaccinations to bring the SARS-CoV-2 episode to a close in 2021, people are going to have outlets for their money from avenues that were previously inaccessible. Travel, entertainment, socialization, etc., will continue to be demand sinks for consumer capital and this may have impact on the asset side. One big looming question is upon the restoration of the full slate of economic services available, will there be demand, especially after government stimulus programs run out? Or will there be wave, after wave, after wave, as long as central banks functionally pay for it by interest rate suppression? How long can this last?

Mutant SARS-CoV-2 Viruses, Perceived Risk, Actual Risk

This will be a slightly longer than usual post.

Here is a picture of the new strain of COVID-19 that the media is pumping up:

While this initially sent the markets into a panic (coupled with politicians panicking and shutting off the UK to the rest of the world), this global exercise in preying upon an utter lack of virology and immunology continues, and the true messages are coming out in the marketplace – it’s a nothing. You’d expect Carnival (CCL) or Royal Caribbean (RCL) to be a few percent down, but they’re not – down about 1% as I write this, which is market noise considering the S&P 500 is down for the day.

There are a significant number of people that actually think the news is a reliable source of information. Society has generally rewarded those that can think critically, but in this particular era, those that can are rewarded with mental health (i.e. you don’t have to live every day in fear of dying) and disproportionate gains in the financial marketplace.

So here is the story as I see it.

I am making an assumption that SARS-CoV-2 has to be the most globally tracked virus on the planet since HIV. Being a virus, it does mutate. Most people interpret the word “mutate” to be some sort of fictional character you see on fantasy movie, but a stealthy one that can’t be seen.

I’ll use HIV as an analogy for mutations. This was relevant for HIV as various anti-HIV drug cocktails started to lose their effectiveness as the surviving strains of HIV were resistant to various medications (this has more or less been eliminated with Viread and successors to the point where HIV concentrations are undetectable).

For SARS-CoV-2, just like all viruses, it has been mutating since day one. You can view a fancy map (you might want to do this on a higher powered desktop computer) of the various permutations.

Unlike the time when HIV was a real problem, today we have the advantage of rapid sequencing machines that can give a near real-time readout of viral genomes. Go look at the SARS-CoV-2 genome here.

I’m not a biologist or virologist or geneticist, but I understand enough of what I’m seeing to make a computer science analogy that what you’re looking at is assembly code for a program (virus). Even though I understand code and how assembly/machine language works from a very high level, if you give me a bunch of assembly code, I’ll have no idea what the heck it does (especially on x64 architecture!). Likewise, when looking at the various A-T, G-C base pairs, no clue.

A mutation changes the code slightly. Unlike in computer science where changing a line or two of code could break a program entirely (and indeed, the impact of such a change by a competent programmer can be predicted before hitting the “execute” button), in the biological world, changing a few lines of code has unpredictable impacts. In most cases, there is nothing seen.

Since I am using a lot of analogies in this post, it would be like measuring the performance response of your Toyota Corolla from the driver’s seat when you use 87 octane gasoline vs. the expensive 93 octane stuff.

The mechanism which SARS-CoV-2 is targeted with the Pfizer and Moderna vaccine uses a modified form of its spike protein in a manner which trains your immune system to recognize and fight it. Because the spike protein was identified early, they were able to create a vaccine in relatively quick order, early in 2020. It is only the clinical testing to prove effectiveness (and picking a proper dosage amount) that took time.

I would suspect that any mutations of the SARS-CoV-2 virus that changes the fundamental form of the spike protein to ‘evade’ immune response can also be identified fairly quickly and targeted with a vaccine. A virological cat and mouse game, so to speak.

Where else does this occur?

One example is with the seasonal flu shot vaccination.

Various strains of the flu (H1N1, H5N1, etc.) are picked based off of scientific judgement. Sometimes they pick wisely, sometimes they don’t. Unfortunately, it’s difficult to predict and measure after the fact.

It is like running an election campaign, and trying to ask yourself whether using message X helped you gain votes, lose votes or having no effect at all. You can’t “backtest” the election and run it again.

The claims of this new SARS-CoV-2 viral strain “may have increased the virus’ transmissibility by 70%” is most likely sensationalist, and a convenient political line to justify further sanctions on the populace. The underlying fact is that the virus has been mutating all the time.

Transmission is one factor, but more important is the severity the virus causes when you have it. Mutations, however, would have just as much of a chance of being less damaging than more damaging. In most cases, there is no impact clinically, similar to how HIV mutations caused AIDS.

Finally, we look at the overall clinical impact of SARS-CoV-2 infection.

British Columbia (and many other provincial/state jurisdictions) report COVID-19 statistics (search for “situation report” on this link).

In the most recent report, dated December 18, 2020, we have the following infection / ICU / death statistics to December 12, 2020:

There are differences between various regions (e.g. Alabama state will have a different profile than Washington State, in weather, demographics, etc.) but in all jurisdictions across the planet there is a very obvious trend – the number of people that SARS-CoV-2 kills is in line with the overall age morbidity. Hence in the chart above, the median age of death in British Columbia to COVID-19 is 86.

What we have been seeing over the past 9 months is healthcare dictated in a large part by political decree. Lockdowns, mandatory masks, and banning of spin and hot yoga, to name some. To name all of it would be the equivalent of the 613 decrees on the interpretation of the Jewish Torah. All of this is happening in real-time before us. Good luck being in perfect compliance!

Not surprisingly, when you get politicians making centrally planned decisions on how to deal with things, you get a very lowest common denominator response (i.e. everybody stop doing everything, except those that have curried the most favour with government). Political decisions made during this situation have likely added negative value to the whole overall situation, with relatively arbitrary and in many times contradictory instructions (e.g. the rationalizations of school openings vs. no outdoor social gatherings even of three people… oh, but it is OK to go walking together, as long as it isn’t a “social gathering” and you keep 2 meters apart!). No wonder why many people are going mentally ill – most are law-abiding citizens, but their minds can’t get around the fact that inherently the instructions are inconsistent and sometimes contradictory. Politicians behaving hypocritically adds fuel to the resentment fire.

Mainstream western societal culture has an expectation of zero risk. While this has driven safety improvements of all sorts, there is a diminishing return to the drive toward zero risk. An interesting paper to read is about risk and safety. When “one death is too many” is deemed to be the standard to live up to, you can be sure that this standard will be extremely expensive to implement.

Those jurisdictions with less exacting standards will inevitably gain huge competitive advantages of those that do not. There is obviously an optimal point of safety vs. cost, and we make this tradeoff all the time implicitly (e.g. when we get behind the wheel of a car, we are taking more of a risk than we perceive), but since COVID-19 is so front and center, there is a mass availability bias effect which overestimates the perception of risk.

There is a huge disconnection between the perception of risk and actual risk. People (and this includes governments, which are run by human beings that have the same flaws and have huge incentives to causing the fewest ripples which may compromise their position) react on perceptions, not actualities.

In the financial marketplace you can make a fortune when there is a situation where the perceived risk is high, but the actual risk is low. In fact, that is one of the main purposes of investment research – getting a feel of which risks and how much risk the market is pricing into a security versus your assessment of the actual risk of the financial instrument. When the perception of risk goes lower, the price will rise, regardless of whether the risk has changed or not.

My anticipation is that this “mutant strain” is a media construct that is designed to increase the perception of risk. The actual risk has not changed that much. From SARS-CoV-2, it remains very low.

Keep your wits and critical thinking minds on, since I do not anticipate this getting better until around April, and then there will be other fires to fight.

Availability Bias and financial markets

Seemingly half of the economy (tourism, restaurants, entertainment/sports, etc.) have been taken away with the onset of COVID-19.

So what else can people do when they are locked away in their basements? Invest in Bitcoin.

Because I mentioned Bitcoin, I will show you a chart on how much you’ve missed out:

Do you feel jealous? Resentful that others are making money while you’re not?

Just because I brought up the issue, it went into your attention and naturally you gravitate towards an availability bias – it is on your attention so it is of higher concern.

Here’s another issue.

Back on November 27th, you could have picked 9, 15, 35, 41, 42, 45, 46 on the Lotto MAX and claimed $55 million! You missed out! Feel regret? You can take solace in the fact that others did not win on the missed fortune that was available.

Or perhaps Trillium Therpeutics (TSX: TRIL) or AcuityAds (TSX: AT)?

You’re missing out!

What about Galaxy Digital (TSX: GLXY) or Electrovaya (TSX: EFL)?

Are you feeling resentful you’re not making these 500% gains in the markets?

I hope you see where I am getting at here – there are 1,340 securities on the TSX (common stock, preferred shares, warrants) that are trading. 617 of them had a positive price return. 413 of them had a price return of 10% or greater. Likewise, 416 of them had a price return of -10% or lower.

Everybody likes to talk about the grand slam home run that won the world series (here is a video for you Toronto people, albeit one away from a grand slam), but few talk about the hitter that can hit a consistent 0.300, or even worse, the person that gets called up from the minor leagues and gets 1 hit for 28 at-bats before the person he replaced got off the disabled list and said person got sent back down again.

While Bitcoin and Telsa are highly entertaining, they suck up attention in a manner that breeds resentment. Minimize the human psychology behind it by thinking about the feasibility of predicting the next Lotto MAX numbers (and all the more power to you if you can crack that algorithm!).

Canada carbon tax – all about politics

Canada’s political environment is really easy to model – whatever is in the best interests of Ontario and Quebec tends to become national policy, irrespective to the impact it has on jurisdictions west of Ontario.

Let’s look at the proposed national carbon tax, which will take the carbon tax from $30/tonne CO2-equivalent in 2020 to $170 in 2030:

2019 – $20/tonne
2020 – $30/tonne (+10)
2021 – $40/tonne (+10)
2022 – $50/tonne (+10)
2023 – $65/tonne (+15)
2024 – $80/tonne (+15)
….
2030 – $170/ton

To put this into context, at CAD$40/ton, a gigajoule of natural gas has a carbon tax of CAD$1.99/GJ applied to it. At CAD$170/ton, that is CAD$8.44/GJ. The AECO market price for natural gas at the moment (note, it is December when there is peak demand) is CAD$2.53/GJ. The projected carbon tax at the end of the decade will be over three times the commodity cost. Needless to say, this puts Canadian companies that rely on natural gas consumption at significant cost disadvantages over jurisdictions that do not impose such taxes (the United States, for one).

Let’s take a look at electricity generation, for example.

On the electricity generation side, we see that 99% of Quebec’s electric generation comes from non-carbon taxed sources – Hydro (94%) and Wind (5%). Ontario’s non-carbon taxed electricity (91%) is Nuclear (57%), Hydro (24%), Wind (8%) and Solar (2%).

Electricity generation is about a third of energy consumption. A really good illustration is provided by the Lawrence Livermore Labs (this was linked to from one of Peyto’s president’s reports):

You can find detailed Canadian data here, albeit not in such a convenient manner.

One issue is that it takes a lot of energy to extract energy (and resources such as iron ore, copper and pretty much anything else in the ground), and of course this puts Alberta, Saskatchewan and British Columbia at a significant disadvantage with this cost regime.

The political aim with this carbon tax continues to be levying a tax that purports to be country-wide, but the impact is concentrated on a regional basis which conveniently happens to be in areas where there is the least support for the ruling party in government.

For those of you that claim there is a corresponding payment to individuals, while this might be true at first, it is performed to get initial acceptance while the proverbial frog boils in the pot. The rebate will be whittled away and eliminated over the coming years in the name of equality. This will come in the form of income testing these “climate action incentive” payments. Eventually the threshold will be lowered to the maximal vote-buying point and any pretense of the tax being “revenue-neutral” will be eliminated, similar to what happened in British Columbia when they dispensed of the notion in 2017. I wrote about the myth of carbon tax revenue neutrality for another publication back in December 2018.

As an example, in British Columbia, it is estimated in the 2020/2021 fiscal year that the carbon tax will raise about $2 billion in revenues, or about $400 per British Columbian. About $300 million in total is estimated to be directly paid back to people (initially called the “Climate Action Dividend” but renamed “Climate Action Tax Credit” as the word “dividend” appears to be dirty with the current BC NDP government) – normally this Climate Action Tax Credit is $174.50/person that earns less than $35,748 (or family income of $41,708), but this was topped up to $218 due to COVID-19. For relation, the median family income in BC is around $90,000.

In terms of the net carbon tax revenue, the $1.7 billion the BC government collects is free for them to do whatever they want. Nationally, it will work the same way, at least for the provinces that do not levy their own carbon taxes.

The decision to raise carbon taxes across Canada does not cost the ruling Liberal party much politically, but will allow them to raise disproportionately high revenues from those areas and enable the redistribution to their vote-friendly base, namely Ontario and Quebec. Such is the nature of politics and power.

The push for yield at any cost – and a snippet on perception

It is amazing how markets cycle from panic to mania so quickly. It is a lot quicker now than it was a decade ago – one theory is that this acceleration of sentiment is fueled by social media.

I’ve been reading a bit more about perception and reality (e.g. ages ago, I linked to a TED talk that discusses the non-correlation being able to see reality and survival) and this is quite apt to describe what is going on in the financial marketplace.

Many participants in the market depend on “sources” such as BNN, CNBC, Jim Cramer, Reddit, Discus forums, Youtube, and for a very rare few, yours truly to come to their investment conclusions.

They are all trying to figure out how to put cash to use, because cash in a 10-year treasury bond yields 80 basis points at present. A million dollars gives you $8,000/year in (pre-tax) cash, which is a pittance compared to alternatives. Going one step up, you can find a 5-year GIC at 175 basis points, but again, it isn’t going to get you very far.

When markets appear to be stable, people reach for yield. A “reach for yield” market is exhibited when you see garbage rise, and a lot of sectors start incurring speculative fervor. We’re clearly in one of those market environments at present, a short temporal distance away from the March 23rd CoronaCrisis crash which lead everybody to the exits (yours truly was madly investigating opportunities) where quality was being thrown out the window. How times have changed – on very quick notice.

Institutions are in the same boat. They have to make their mandated returns otherwise pensioners don’t get paid and underperformance will cause capital to shift to those that bought and held Tesla at the beginning of the year.

I look at this Globe and Mail article about institutional managers buying Canadian apartments:

While many property deals are private transactions, Mr. Kenney cited some recent sales in mid-town Toronto that were completed at capitalization rates around 2 per cent, an astonishingly low level.

I ask myself what can justify 2%. For instance, CapReit (TSX: CAR.UN) in their last quarterly report stated their mortgage portfolio is an average of 1.93% at a term of 9.3 years.

While it isn’t clear whether the definition of cap rate in this instance included mortgage interest expenses (“cap rate” is not a standardized accounting term – you can make this number go up or down depending on how much leverage you employ), 2% is indeed a very low rate of return. Indeed, for it to make financial sense, you have to anticipate some degree of capital appreciation in the underlying property for the investment to make sense.

This low spread is not limited to real estate, it also includes the stock market.

(For the comparison above with CapREIT, I’ll tip the hat to Tyler (his Twitter) who has been discussing this concurrently and independently of the writing of this post, great minds think alike I guess!).

Let’s look at the S&P 500 top components. Apple, for instance, stock price $124, and the past year of 10-K earnings show $3.30/share, and relatively stable. So a bond-like earnings yield 2.7% for Apple stock. MSFT is $6 EPS and $214/share or about 2.8%. Facebook is about 2.5%, and so on. Of course in these cases you can make an argument that earning yields will grow over time and there is some franchise value. But it is shockingly close to these Toronto-area apartments that are selling for a current 2% (although given the choice of an investment in Apple or a Toronto apartment, I’d take Apple any day of the week).

Yields are very tiny now, and investors are going to chase them. High quality, such as Apple, will be rightfully expensive. But this yield chasing will make its way down the quality chain and companies that have no right to be chased down to 4% earnings yields will be done so because there is a huge liquidity avalanche out there that is looking for a home.

Realize when stocks trade, there is no cash or stock created or destroyed in the process; it is merely a transfer between buyer and seller. The amount of cash is the same, and this cash will circulate, being handed from account to account, while in the meantime the counter-transaction to that is the transfer of assets at higher and higher prices, until such a point that the amount of baked speculation on future yields will go to a low point.

If you believe those Toronto apartments will rise in price 10% a year for many years ahead, it would be completely rational to buy them even at single-digit negative cap rates, especially if you anticipate being ample future liquidity in case if you change your mind.

Likewise, for Apple, you could bake in a whole set of variables to justify purchasing it at a 200bps earnings yield, or 150bps, etc., citing a never-ending stream of inflation-shielded future cash flows. Indeed, that $124 stock price at 200bps would warrant an Apple stock price of $165, or a 33% gain from the current price!

I have no idea when this speculation house of cards will end, and can only conceive of a few scenarios of how it ends (one obvious “how it ends” would be the onset of inflation beyond that of asset prices – you’d see a 30-40% stock market crash). It is a very dangerous game of participants bidding asset prices higher and higher in the search for yield and appreciation. Apple today at 270bps sold to the next guy at 265bps, then to 260bps, etc., until the demand for that cash gets directed to some other supply that is not Apple equity.

Back in the dawn of the COVID-19 crisis when everybody thought we were going to die (April 5, 2020), I openly speculated the following:

This might sound a little crazy, but I can see the S&P 500 heading to 4000 before the end of the year.

Recall at this time when I wrote it, the S&P 500 was trading at around 2,500. Predicting a 4,000 index (a 60% rise) is crazy. I don’t think anybody on this planet did that except myself. We are living in a crazy world, where many are indeed going insane with COVID lockdowns and massive disruptions of a “normal life” that people are realizing is not coming back. And while the S&P 500 index will probably fall a hundred points short of 4000 before the new year, realize that going forward this is what it takes to be successful – not seeing reality as it is, but rather being able to adapt to what are inherently crazy circumstances in the minds of market participants.

Even if you see reality for what it is in the markets, it is not sufficient for your survival – you must understand the perceptions that surround the other participants.