Pay attention to the 30-year treasury bond

With all the talk of the US Federal Reserve performing another round of quantitative easing (which amounts to repurchasing medium and long-dated government debt securities in an attempt to lower long term interest rates and frustrate people into purchasing anything else where they can get a decent yield on cash), the markets have started to get a bit antsy on the macroeconomic front.

Since the strength of the US dollar is a huge global variable, whenever the US Federal Reserve does something, the rest of the world, including domestic US investors, will notice. And indeed, the world has reacted by tanking the currency. More interestingly, however, is the rise in treasury yields (lower treasury prices):

In theory when you have the full force of the US Federal Reserve behind a position (in this case, purchasing government bonds), you try to get out of the way. This time, the market’s reaction appears to be one of indigestion – an exit from bonds. This is very interesting and if the trend continues, will have huge ramifications on investor’s calculations as to what exactly constitutes a “risk free rate”.

It is increasingly clear that US government debt is not as “risk free” as people may think, and this risk should be appropriately adjusted in financial calculations.

The easiest way for an investor to directly take a stake in this (other than buying or shorting treasury futures, which is a relatively trivial transaction to perform) is to buy or sell units in NYSE: TLT, which is an ETF that contains long-dated treasury instruments of 20 years and above. TLT is down about 8% from two months ago, when US Treasury bonds were trading at a local minimum of 3.5%. During the pits of the economic crisis, the US Treasury bond traded as high as 2.5% as investors dove for the safest haven.

A question in the financial markets should now be – exactly how safe is the “safest haven”? If the answer is anything other than US government debt, this would explain the currency exodus.

As a comparison, Canadian long term benchmark yields have generally gravitated down from August – reaching a high of 3.72% in August, and currently trading at 3.45%, and a low of 3.33% seen in late September. Clearly, the crisis hitting the US bond market is not hitting the Canadian bond market, at present.

My perception is that if this is the beginning of a “run” on US long term debt, there will be huge financial ripples in the US marketplace – for example, what do you do when you see a corporate long-term bond trading at a yield of 7%, when the 30-year US government debt is trading at the same yield? We are not there yet, but rising US government bond yields will crush the corporate debt market window that is currently open.

Watch out, because I suspect things are getting exciting again.

Canadian dollar at par

The Canadian dollar is once again at par with the US dollar – if you are performing currency transactions, just remember to get the CAD-USD vs. USD-CAD conversions correct!

The currency rise has not as much to do with the Canadian dollar rising as it does with the US currency depreciating – the world is strongly reacting to the imminent quantitative easing 2 that the federal reserve is apparently planning on to spur inflation.

Whistler-Blackcomb going public

Whistler-Blackcomb, owned by Intrawest, filed to go public on the TSX. The salient numerical details, such as the total amount of the offering (rumoured to be $300 million) and pricing of the company’s stock remains to be seen.

Intrawest used to be public, but was taken private in 2006 and is now owned by Fortress Investment Group.

Although I have not completely read the document (and won’t until the issue has a price), of note is that the public entity will hold 75% of the Whistler-Blackcomb partnership (page 128); the corporation will have an additional $261 million in debt taken out; and the entity will generally have historically made about $50-60 million in income from 2007, 2008 and 2009. Note that because the corporation has a 75% interest in the partnership, that some accounting rules will kick in and subtract the 25% minority interest, so the net income figure will be lower.

This offering is being touted in the media as an income play, which is likely why the company is going public right now – to get out while the premium paid for income-bearing securities is red hot.

I have a paper napkin valuation which will likely be lower than what the actual selling price will be. I also think there are a whole host of risks that this venture are correlated to – including the resort real estate business, and BC tourism in general. I believe the company is using the elevated 2010 numbers from the Winter Olympics to tout their equity, which will be a mistake for investors to depend on. The 9 months ended 2010 show a $52 million income year, compared to $58 million the year before. Note the last quarter of the year is a money-loser.

The BP Saga is nearly over

The US government yesterday now allows drilling applications to take place in the Gulf of Mexico. There will be increased scrutiny with respect to contingency plans that will make the already expensive process even more so, but there will eventually be drilling back in the Gulf.

This nearly closes the saga on the BP oil spill – although you hardly hear of any further environmental consequences. The only story left will be a decade of litigation in court to determine who pays for the damages.

Be careful of people touting their horns – what I’m about to write will be a high magnitude of chest-beating.

Earlier, I gave a fairly accurate forecast of the financial consequences. I made a projection on June 16, after BP had cut its dividend, that if you were playing BP, one should purchase BP shares between $25 to $30/share. BP subsequently made it to $26.75/share, which would have resulted in a 65% fill. On July 15, stated that one should exit BP at $45 to $50/share (this is after it spiked up to $39/share), and July 27, I fine-tuned the price model to $42-47/share. I stated that BP should be around that price range by the end of the year.

Currently, BP is trading at $41.50/share, so it is within striking range of this price range where an investor should offload the shares. Indeed, the price risk from the oil spill has been mitigated to a degree from the stock, so investors in BP at this moment should be evaluating the company not with political risk in mind, but operational risk of the various businesses it controls around the world, and of course, the price of oil.

BP still looks undervalued strictly from an earnings and “price of oil” perspective – they have a huge amount of reserves and production going on, and will likely continue to make money in the foreseeable future. Analysts expect the company to earn about $6.51/share in 2011, which gives it a 6.4x P/E ratio, or about 15.7% yield from current earnings. By comparison, Exxon has a 9.7x P/E ratio on 2011 earnings. Even though it is an operational basket case, BP still looks dramatically undervalued.

Always keep in mind that analyst projects tell you what the market is pricing in – so in order to make money from the present, you have to believe the company will make more money than what the analysts are predicting. In theory, the analyst estimates are baked into the current stock price.

One prediction that has not come to fruition yet has been a June 16 prediction that the drillers will fare better than BP – right now, BP is leading the two drillers I selected by about one percent. When re-evaluating the drillers, I think BP is now the better deal.

There is a reason why I do not like large capitalization companies – many other eyeballs have spent time looking at the companies far longer than you have, which makes your potential advantage in properly valuing such companies to be less probable.

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.