Bank of Canada Interest Rate projections

The June 3-month banker’s acceptance futures are trading at 0.89% at present.

This suggests that the short-term interest rates (the target overnight rate) will likely raise 0.5% to 0.75%. However, the banker’s acceptances generally are a quarter point over the prevailing target rate, which suggests the market is pricing an approximate 40% chance that the Bank of Canada will only raise 0.25%.

One month T-bills are at 0.23%, 3-month T-Bills are at 0.47%.

My justification for a 0.5% raise is simple – they want to make a statement.

I rarely have strong feelings about currency trading, but my guess is that the Canadian dollar will spike briefly on the announcement and then will go through a decline.

Most of the media thinks that the Bank of Canada rate increases will result in currency appreciation, but they will get the opposite results – low interest rates causes a lot of currency holding through carry trading. Since traders are on the margin side, a higher rate will result in currency outflows. It is likely the US dollar will be the one to rise relative to the Canadian dollar, so I’d get your cross-border shopping in sooner than later. You can also do “cross-border shopping” by buying US equities. The markets suggest that the US federal reserve will start raising rates around the beginning of 2011.

Canada ends the fiscal year with $47 billion deficit

The 2009-2010 year-end fiscal monitor is finally released. I will make some year-to-year comparisons.

From April 1, 2008 to March 31, 2009 the government posted a $2.2 billion deficit. In 2009-2010, the government posted a $47.0 billion deficit.

Revenues were down about 5% year-to-year, mainly attributable to a decrease in personal income tax and corporate income tax collections. The corporate side would have been a lot worse if it wasn’t for a huge recovery in the later part of the 2010 fiscal year.

The one interesting item is that the proxy for general consumption in the country, the Goods and Services tax, had a decrease of 0.2% year-to-year in revenues, so this is virtually unchanged. Similar to corporate income taxes, there was a huge surge in collections in the last part of the fiscal year.

On the expense side, government expenses were up approximately 17%. The bulk of this is attributable to the “economic action plan”, i.e. the stimulus package. The stimulus package, as projected in the 2009 budget, was approximately $23 billion, so one can infer that if it weren’t for the stimulus, the deficit would have been around $24 billion – a fairly manageable number.

Most notable is the 35% increase in Employment Insurance premium payments – mainly a function of increased unemployment, but also factored into this were government legislative efforts to enhance EI benefits for those that paid into the EI program for a lengthy period of time (7 years or over) receiving an extended amount of benefits.

My quick guess for 2010-2011 is that we will continue to see significant growth in revenues from the three main sources – personal income tax, corporate tax and GST collections in the 2010-2011 fiscal year. On the spending side, we will continue to see spending as well, and probably see a posted deficit of around $35-40 billion. This cannot continue indefinitely, otherwise Canada might face its own entitlement crisis. Although relative to other countries we are in better shape, we should be returning our fiscal balance to a mild surplus position and save some capital for future rainy days – which is more than likely to occur for the duration of this decade and beyond as the baby boomer generation retires.

Timing is everything – and a brief trading lesson

Don’t believe anybody that says that market timing is not an important element of successful investing. Timing is a crucial part of it – basically you have to know when to buy (identifying when the prices are low) and know when to sell (identifying when the prices are high). I have historically found it more difficult to know when to sell than when to buy, presumably because markets crash quicker and harder than they go up. I have been actively working on this part of my investment experience for the past few years. I still do not feel comfortable with my exit tactics.

It is a very, very frustrating part of investing when you know you had the timing correct, but were unable to execute on any trades. Two days ago, on May 25th, I wrote:

I am generally of the opinion that the markets at this time are greatly oversold, with presumably most of the selling done across the Atlantic Ocean in Europe by panicked investment bankers and hedge funds. Unfortunately (or fortunately), I am still looking for areas to safely deploy cash.

I had placed a smattering of orders, starting at roughly 3% below the May 25th market close, but they probably won’t be executed now since the markets seemingly have reversed. I wanted to get about 10% equity exposure to the fossil fuel industry and I only have about 5% exposure on the debt side. Since the whole Canadian crude market has skyrocketed in the past couple trading sessions, I’m going to have to re-evaluate the short-term entry or hope for one more shock-wave coming out of Europe (which would be nice). My general thought is that while I don’t believe in the “10% of your portfolio in Gold” inflation-hedging technique, I do solidly believe that having a claim to future cash streams from Canadian oil and gas companies with significant reserves will be a good capital preservation technique over the long run – at least until crude prices rise to the point of unsubsidized alternative energy production costs.

After describing my inability to execute on what should have been a short-term winning trade, now is the time for a trading lesson to describe why the process I employed is correct.

Whenever I place orders, it is always with limit orders, and broken into price increments that are scaled below the initial point. I very, very rarely buy at the ask and sell at the bid unless if dealing with illiquid securities and somebody posts something juicy.

As an example, if a share is trading at $10/share and I was interested in purchasing 1,000 shares and thought market volatility would take it roughly 10% below current price levels before bottoming out, a simple execution would be to break it into five branches, such as the following:

Buy 200@9.80, 200@9.60, 200@9.40, 200@9.20, 200@9.00

The total cost of the order, excluding commissions, would be $9,400; a lot cheaper than just putting in an order for 1000@10. However, the cost of such a decision is that you may not get your desired quantity (or any at all) if there is not sufficient volatility in the marketplace. In the case of my fossil fuel equity trades, this is exactly what happened – market volatility took the market price up and not down as I expected.

Inherent with the breaking of such orders is the assumption that you don’t know what “the bottom” will be. I have learned many times over that predicting the exact bottom is impossible and that breaking orders into smaller quantities is the best way to capture value from this admission.

Using a real brokerage (e.g. Interactive Brokers) keeps trading costs of breaking orders into small bite-sized amounts cheap; a price-making order on the TSX incurs around 52 cents of commission for 100 shares. The increase in commission is inconsequential to the likelihood of saving capital costs with the lower-priced purchases. Even using a less sophisticated brokerage, you can still obtain significant price savings.

This same heuristic can also be employed with an exit of a position.

Note that it is very easy to modify this into a workable algorithm. When working with institutional quantities (e.g. millions of dollars), you typically employ algorithms to randomly time entries and exits depending on ambient market conditions and the volume seen in order to get the best execution on the entire order. When working with large amounts of dollars, masking the intention of your order is critical in order to be able to successfully accumulate or distribute share holdings.

One major advantage a retail investor has over the institutions is the ability to get in and out of positions with the click of a mouse button, as opposed to employing complex algorithms to do the same over the period of days or weeks.

Apple vs. Microsoft

It was only a couple months ago that I wrote about how Apple and Microsoft’s market capitalizations are closing in on each other.

Today, Apple for the first time has a market cap higher than Microsoft, at $222 billion for Apple and Microsoft at $219 billion.

The real issue with the two companies is that Microsoft is really living off of its legacy product lines (Windows and Office) while Apple has come out with a huge stream of technological innovations, mainly the iPod and iPhone product lines (which secretly get the users to lock into their business model, similar to how software in the 90’s was “for Windows” only).

At this time, I don’t see how Microsoft can demand a market premium for its position – on the retail end, Windows has not fundamentally changed in 15 years (Windows NT 4 was the quantum leap product, and Windows XP was a great retail refinement of the Windows NT core). Microsoft Office has not fundamentally changed since the release of Office 97; everything else subsequent has been cosmetic in nature. With competitors chipping away at the cost premium that Microsoft charges (typically to large-volume corporate licensees), their ability to extract margin out of the marketplace with upgrades and obsolescence upgrades is limited. Microsoft will continue to produce cash like no tomorrow, but it is tapped out in terms of growth. Microsoft shares, as a result, trades like it – analysts expect $2.31/share in FY2011, while the stock price is $25.01/share – a yield of 9.24%.

Apple, on the other hand, has plenty of room to invade the computer marketplace, and combined with their mobile device market seemingly can command a high premium and has room to grow. As a result, they are given a premium in the stock market – analysts estimate $15.42/share in FY2011, on a stock price of $244.11/share – a yield of 6.32%.

Although Apple has competitive issues (i.e. Google is trying to invade the territory), it remains to be seen whether it can keep Google and other competitors at bay. Certainly its marketing arm continues to create users that have an almost religious-like adherence to its products.

I don’t have a position in either company and don’t plan on establishing one.

Flight to safety

The US held a 2-year treasury bond auction today and some $42 billion was awarded at a yield to maturity of 0.769%.

In Canada, the 2-year government note is trading at 1.69%.

I can’t think of a single rational reason why a retail investor (that has a lot less than $42 billion in the bank account) would want to purchase these types of securities when there are relatively risk-free alternatives (such as “near guarantee” GICs and corporate bonds of issuers that would only default in the event of an economic apocalypse).