Markets are partying on – when will it stop?

Stock markets are reaching all-time highs. The S&P 500 is well beyond the peak it reached in 2007. Sentiment is positive, what can go wrong?

spx

Please realize I am a horrible chartist and the trendlines drawn are merely approximations. However, over the past three years, the S&P 500 has seen three major periods of rallying and note the dates/values are approximate:

08/2010 to 02/2011 (6 months): 1,040 to 1,340 (+29%)
11/2011 to 03/2012 (5 months): 1,160 to 1,420 (+22%)
06/2012 to 09/2012 (3 months): 1,270 to 1,470 (+16%)
11/2012 to ??/???? (6 months and ongoing): 1,350 to 1,620 (currently) (+20%)

Given historical trends, this rally is about to run out of gas. The party will likely stop sooner than later, so be careful and raise cash.

Positioning for deflation

I’ve been doing some research on which sectors perform best under deflationary conditions.

Obviously, cash is first and foremost as it will generate a natural real return over time without having to do anything, plus the nominal return you get from parking it in short-term funds (the Bank of Canada short-term rate right now is 1%).

Long-term bonds of solvent entities also are a good investment during deflationary conditions.

However, on the equity side things are a little more muted. The only direct play which I know explicitly has taken a position on deflation is the Canadian equivalent of Berkshire Hathaway, Fairfax Financial (TSX: FFH). Prem Watsa was fairly early to the subprime mortgage crisis in the USA but was able to profit handsomely on it, and he seems to be early on the deflationary game as well. His company has also been significantly short on S&P 500 equity index futures which also resulted in their portfolio performance suffering losses they really shouldn’t have been suffering. So while Watsa is likely paranoid, inevitably if you believe deflation is going to hit the marketplace and still need some form of equity exposure coupled with fairly competent management in asset allocation, then Fairfax is probably a good meal ticket. Regrettably, it is trading a shade over book value and historically it gyrates around it so there is likely a better opportunity in terms of market timing.

Interestingly enough, Watsa was also quite early in accumulating his (via FFH) 10% stake in Blackberry (TSX: BB). It remains to be seen whether this will be a win for him.

Price of gold

Gold got hammered today:

gold

What is interesting is that you’re going to start hearing people talk about marginal cost of extraction and about how that figure is a floor for commodity pricing.

It is not.

While marginal production cost is one component of commodity pricing, markets can go deeper below the cost of production because commodity markets measure instantaneous supply and demand. Eventually there will be some equalization but it does not have to be immediate – in fact, it can take a gut-wrenchingly long time to moderate to prices where costs are reflected.

I believe with the perception that gold is a safe haven from all the currency printing that is going on that there is a significant amount of the marketplace that is essentially going to be trapped in the commodity and the real question is going to be: when will this washout in-progress end? Markets usually trend longer and deeper than most people anticipate.

Most commodities (except for natural gas) are down across the board. If this trend continues, it will have a material impact on countries with commodity exposure – this includes Canada. As such, I am comfortable with my relatively large (2/3rds) US-denominated exposure. I also have no direct exposure to commodities.

Genworth MI’s sensitivity to unemployment rates

Genworth MI took a dive today because of the rise of unemployment in the Statistics Canada March release of the labour profile. Employment of full-time workers went down 54,000 workers.

mic

A rise in unemployment will increase the frequency of claims on mortgage insurance, while a decrease in property value will result in an increase in the severity of claims.

I believe the market is over-reacting to this news, but it is true that the default and delinquency rates for Canadian mortgages at present is quite low compared to historical norms.

On the brighter side, a lower share price makes the share buyback option more attractive.

Genworth MI upcoming quarterly report

There is a strong possibility that Genworth MI (TSX: MIC) will make some sort of announcement this month, specifically with respect to what they are going to be doing with their excess capital.

A chart of MIC shows that it has gone nowhere over the past month, but this has been since quite a run-up since last August when it traded all the way down to about $16/share.

mic

At the beginning of January 2013, MIC had about 210% of the minimum capital test that is required and the company has an internal target of 190%, which means that they had about $287 million in excess capital available. This does not include the additional capital that has accumulated in the first quarter of 2013.

Having this extra capital (noting that $337.87 million was in very low-yielding cash and short-term equivalents at the end of 2012) is lowering the return on equity, reducing portfolio yield and is producing a drag on performance. The cash can be safely returned into the hands of investors.

There are four options available, noting that it is unlikely that acquisition is a possibility given the very narrowly-defined scope of the industry the company is in:

1. Buy back shares: Likely through a dutch auction tender and at a higher level than existing market value. They have done this two times in the past.

On July 15, 2010, they announced a $325 million buyback between $24 to $28/share and on August 24, 2010 they announced that $26.40 would be the tender price. The stock closed on July 15, 2010 at $23.07/share and the day after it opened trading at $24.25. The market price on August 24, 2010 was $25.79/share. Genworth Financial proportionately tendered its shares to keep its 57.5% ownership stake in MIC.

On May 5, 2011, they announced a $160 million buyback between $26 to $29/share. The market value was $25.25 on the day of the announcement, and the stock opened at $25.55 the day after. On June 27, 2011, they announced that $26 was the price and the closing market value that day was at $25.77/share. Notably after this buyback, the market value fell in the subsequent months.

Given the current market value of the company, if they were to proceed with a similar tender, it would be almost on similar terms as the previous one, with perhaps a tender range between $26 to $29/share. This would be close to book value and this would achieve about a 10% reduction in share count and subsequent 11% increase in earnings per share.

2. Give a special dividend: A special dividend of $287 million would be equivalent to a $2.90/share dividend. The only special dividend declared to date was announced on November 3, 2011 of a $0.50 dividend, payable on December 1, 2011.

3. Some combination of the two;

4. No decision, keep the cash, and wait for less stormy days later.

Influential in this decision will be the needs of the parent company, Genworth (NYSE: GNW), whom is looking much more financially stable than it was back in 2010 and has no pressing need for an infusion of capital either way.

My guess at present is that Genworth MI will launch a tender for its own shares this month. They are still trading under my own estimate of its fair value.

As readers are aware, I have been long on Genworth MI since last July.