What to do when your shares rise

Long-time readers should be able to see this chart and know what security I am talking about, but I have purposefully omitted the name and ticker and price scale just to illustrate. The security in question is quite “yieldly” so it is susceptible to the huge increase in demand we are seeing for income-bearing securities.

Here is a 3-year chart:

Here is a 6-month chart:

Finally, here is a 1-day chart (approximately up 7% for the day):

There is seemingly no fundamental news involved, which makes me suspect this was purely technical trading occurring. The volume was not excessively high compared to average volume.

Question – do you sell the spike? Do you get greedy and see what happens the next week?

Fundamentally speaking, the security involved is priced slightly above my fair value range. It already consists of a relatively large fraction of my portfolio, so choosing to lighten up is the obvious answer. I can’t help but think, however, that by getting “greedy” that I can get an extra 10-20% out of this that I would otherwise have not received by using a more fundamental trading method. By scaling out of your positions slowly, exiting piece by piece as the price goes higher, you can participate in some upside, but continue to reduce your risk as the price continues to rise.

2010 capital gains are starting to be a big concern for me tax-wise, but fortunately there are some units of this security in my RRSP that I can start off with on a tax-free basis.

Inflation and the markets

There hasn’t been too much going on in the markets – the undercurrents feel very swift, however. There is the specter of the looming currency wars, which seems to be the 21st century version of trade protectionism – where all currencies have a race to the bottom.

This is likely to result in the increase in commodity prices, and we are already seeing this in items like sugar, grain, etc. Increased commodity prices is the first step in the erosion of purchasing power of cash.

Whether the statistics are reported by the consumer price index or not is irrelevant – it is clear that the purchasing power of currency is dropping, more than what most people perceive. Not helping matters is very loose monetary policy, where institutions can borrow money for very low rates and then lend it long – this inflates asset prices as capital searches for yield.

The games that sovereign governments are playing are only going to accelerate as debt loads continue to increase – there is no way, for example, that the USA has a reasonable chance of balancing its books, or even paying off the debt without a massive restructuring. The least painful and least politically costly way of doing this is to inflate the currency.

Both retail and institutional investors have to be very cautious that the game with currencies and asset values will result in a lot of pain for all involved, as it will accelerate market volatility. The only apparent escape is to purchase assets that have a claim to cash flows derived from an inescapable consumer need, such as fuel or food. Even in those two cases, you have to purchase a future claim to a cash flow at an acceptable price, which is ever fleeting in today’s marketplace.

It is ironic that the best claims to future cash flows I have found are in non-dividend or very low-dividend bearing securities. Almost anything giving off cash has been bidded up to unacceptable levels.

The only argument against all of this is that you would suspect that government bond yields would be increasing when the markets sense such “stealth” inflation is occurring, but this has not happened yet due to the federal reserve’s quantitative easing program, which has created an asset bubble.

Encana – cutting back capital expenditures

Encana (TSX: ECA) is a very large natural gas producer. In their recent quarter, they announced they will be cutting back capital expenditures and reduced expectations due to lower natural gas prices. Hydraulic fracturing is saturating the marketplace, leading to reduced prices. This is well known by the marketplace, and as such, Encana’s stock was only down by 3% today on the news.

The two charts will explain the story, one is of Encana’s stock price, and the other is the spot rate for natural gas, and one will see the correlation:

One can easily see the connection. Encana is a type of company that will not have its equity double in value in a short period of time, but it does represent a fairly good store of value in terms of the vast reserves it can control (especially reserves in politically stable climates such as Canada). It also represents a fairly good proxy for the price of natural gas.

One of the worst ways to play an increase in natural gas, however, is through the Natural Gas ETF (NYSE: UNG) which I have written about before. I will let the chart do the speaking here:

Bank of Canada leaves target rate at 1 percent

The Bank of Canada has left the overnight target rate at 1%. The announcement is here.

Key quotation:

The global economic recovery is entering a new phase. In advanced economies, temporary factors supporting growth in 2010 – such as the inventory cycle and pent-up demand – have largely run their course and fiscal stimulus will shift to fiscal consolidation over the projection horizon. While the Bank expects that private demand in advanced economies will become sufficiently entrenched to sustain the recovery, the combination of difficult labour market dynamics and ongoing deleveraging in many advanced economies is expected to moderate the pace of growth relative to prior expectations. These factors will contribute to a weaker-than-projected recovery in the United States in particular. Growth in emerging-market economies is expected to ease to a more sustainable pace as fiscal and monetary policies are tightened. Heightened tensions in currency markets and related risks associated with global imbalances could result in a more protracted and difficult global recovery.

To translate this into everyday English, the Bank of Canada believes that the growth in the economic recovery is now leveling, and that it is not entirely certain what the next stage will be. They are reading the same tea leaves that everybody else is reading.

Inflation in Canada has been slightly below the Bank’s July projection. The recent moderation in core inflation is consistent with the persistence of significant excess supply and a deceleration in the growth of unit labour costs. The Bank judges that the output gap is slightly larger and that the economy will return to full capacity by the end of 2012 rather than the beginning of that year, as had been anticipated in July. The inflation outlook has been revised down and both total CPI and core inflation are now expected to converge to 2 per cent by the end of 2012, as excess supply in the economy is gradually absorbed and inflation expectations remain well-anchored.

The Bank of Canada will be putting the brakes on further interest rate increases until 2011 at the earliest. I do not project a December rate increase.

Three month corporate paper is yielding 1.17%, and three-month treasury bills are yielding 0.89% yesterday. Today, this will decrease a little bit.

More important are the spread to longer term bonds, which 5 years will yield you 1.95% and 10 years will yield 2.76%.

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.