Bank of Canada will raise interest rates on June 1

The Bank of Canada released its monetary policy announcement today, and it contained the following paragraph:

In response to the sharp, synchronous global recession, the Bank lowered its target rate rapidly over the course of 2008 and early 2009 to its lowest possible level. With its conditional commitment introduced in April 2009, the Bank also provided exceptional guidance on the likely path of its target rate. This unconventional policy provided considerable additional stimulus during a period of very weak economic conditions and major downside risks to the global and Canadian economies. With recent improvements in the economic outlook, the need for such extraordinary policy is now passing, and it is appropriate to begin to lessen the degree of monetary stimulus. The extent and timing will depend on the outlook for economic activity and inflation, and will be consistent with achieving the 2 per cent inflation target.

This means that at the next Bank of Canada meeting on June 1, they are likely to raise interest rates. The futures say it will likely be a 0.75% hike up to 1% in June, and then the rate increases will be 0.25%. My new projected schedule of rate increases will be as follows:

June 1, 2010 (+0.75% to 1.00%)
July 20, 2010 (+0.25% to 1.25%)
September 8, 2010 (+0.25% to 1.50%)
October 19, 2010 (+0.25% to 1.75%)
December 7, 2010 (+0.25% to 2.00%)

Buying stocks on margin is dangerous

Time Magazine had an article about two university economists proclaiming that young people should go on margin when investing in stocks. They came to this determination after mining the 130-year set of historical data, and taking into consideration 45-year investment periods. They suggested a 2:1 ratio.

So for example, if you had $5,000 sitting in the bank, you should go and purchase $10,000 in stocks. I would not suggest this.

David Merkel (who incidentally writes probably one of the best pages on the internet regarding real-life economics) blasts the argument for many reasons. I want to elaborate on the first counter-point, mainly that mining historical data is not sufficient to determine a future course of action.

Whenever you walk into the office of a financial adviser (salesman) person at a retail bank, the most frequent chart you will see on the back wall is the Dow Jones composite index, roughly from 1900, in non-logarithmic format (designed to make the 1929 and 1987 market crashes look like nothing). They will usually give you a pitch how the stock market, on average, has gone up 9% (in nominal, not real terms) a year since eternity and therefore, your money should be invested in some equity fund that the adviser will presumably make a healthy commission selling.

The assumption that the markets will continue going up 9% a year in the long run is incorrect. If you believe this, you will lose money.

Throughout history, markets in countries have a frequent habit of collapsing. Around 1900, the top three capitalized stock markets were in the USA, United Kingdom and Russia. Not many people would have guessed Russia, but we all know what happened after – they were utterly destroyed after the Bolshevik revolution in World War 1. In fourth place was British India, and that country looks completely different (consisting now mainly of Pakistan, India, Bangladesh) than what it was back during the dying days of colonialism.

It is very difficult to predict whether the USA will still be around in 100 years, let alone compound market gains by 9% a year.

The other comment I will make with respect to buying stocks on margin is that even if you know what you are doing, it is very psychologically difficult to watch positions go underwater when on margin. Typically you will be receiving a good (low) price during periods of very intense volatility, and it is very unlikely that you will be receiving the “best possible” price had you looked at a chart 6 months in retrospect. There are far too numerous examples of this in my own life, but one was during the middle of the financial crisis in March 2009, when ING Group’s hybrid debt was cratering:

Recall that par value on the above issue is $25, and the coupon is 6.125% given out quarterly. Looking at my own trading records, I see I purchased shares between $6.26 and $4.70, which would have equated to a 24.5% to 32.6% annual yield (assuming they do not default). The best price I could have received is $2.83, or a whopping 54% annual yield! Looking at the chart it is very easy to say “Sacha, why didn’t you put your life savings on margin into the thing at $2.83/share?” – in retrospect, I would have loved to, but there are a few complexities to take into consideration:

1. When you place your order, you implicitly acknowledge that it will likely go lower before it goes higher;
2. You have no idea how low the low will be.
3. If the issuer defaults, you are in deep do-do.

Now, I remember when placing my order that I thought I was already getting a good deal, but underestimated, by some 40%, the extent to which the market was willing to take this thing down.

Imagine if I had the snippet of knowledge that on April 16, 2010 that this would be trading at $18.91 a pop and went on 2:1 margin at a price of $4.70/share. I would have had my account liquidated on a margin call well before the bottom was reached. Even if I knew what the “true value” of something was, by using excessive margin, you are giving the market the ability to wipe out your investment before you can realize its true value. For stable asset pricing and stable yields, the argument to use margin is more coherent, but when you introduce volatility, margin will absolutely kill you.

This was a one-security case, but even when diversifying the portfolio a bit, you still would not have been able to avoid margin call issues simply because the whole market was being flushed in March 2009.

Telling young people to employ margin based on historical market data analysis is absolutely foolhardy and will only result in losses. It is difficult enough to be able to invest in equities and doing it on margin will just compound the agony even if you’ve done your research correctly and have a general idea that you are purchasing stocks below their fair value.

So for my final parting shot of the day, when a young person buys a condominium and makes a 10% down payment, and mortgages the rest, they are making a 9:1 leveraged bet on their concrete box in the sky. Does the past 10 years of Canadian real estate price history data suggest that you should be making the minimum 5% down payment and go on 19:1 margin?

The following quotation is golden advice:

One final note: when I wrote at RealMoney, I took a contrarian view that for average investors, no one should be fully invested. Even the great Ben Graham never exceeded 75% invested. My view is that average people must limit their risks or they will not be able to sustain their investment plans. A 50/50 or 60/40 balanced fund approach is best for the average person — they will never get scared enough to abandon it.

By always keeping some black powder in the keg, you will be able to pounce on opportunities that others cannot because of their leveraged circumstances. Late 2008 and early 2009 was a time to be doing this, and there will be times in the future where keeping a stack of cash will be of great benefit. I don’t sense that “now” is one of those times to be deploying cash, but certainly if we are in a 1970’s type market, we will be seeing 30-40% market gyrations both to the upside and downside.

China’s booming real estate market

I always have a sneaking suspicion that the Vancouver real estate market is a proxy for Chinese real estate, given the heavily ethnic Chinese population concentrations (especially in Richmond, east Vancouver, and around the Metrotown area in Burnaby).

The government of China released an economic report, assuming it is to be believed, that states the following:

3. Investment in fixed assets increased rapidly and that in real estate continued to accelerate. In the first quarter of this year, the investment in fixed assets of the country was 3,532.0 billion yuan, a year-on-year growth of 25.6 percent, or a drop of 3.2 percentage points as compared with the growth in the same period last year. Of this total, the investment in urban areas reached 2,979.3 billion yuan, up by 26.4 percent, or a drop of 2.2 percentage points; that in rural areas was 552.8 billion yuan, up by 21.0 percent, or a drop of 8.4 percentage points. Of the total investment in fixed assets in urban areas, that in the primary industry, the secondary industry and the tertiary industry went up by 9.7 percent, 22.4 percent and 30.0 percent respectively. The investment in eastern, central and western regions grew by 24.4 percent, 26.2 percent and 30.0 percent respectively. In the first quarter of this year, the investment in real estate development was 659.4 billion yuan, up by 35.1 percent year-on-year, or a rise of 31 percentage points.

Also in the report is the following GDP summary:

According to the preliminary estimation, the gross domestic product (GDP) of China in the first quarter of this year was 8,057.7 billion yuan, a year-on-year increase of 11.9 percent, which was 5.7 percentage points higher than that in the same period last year.

11.9 percent growth. Massive.

Since China’s GDP is around $4.72 trillion if you annualized the above number, this is a huge amount of growth in terms of absolute numbers – about $502 billion. Since the USA’s GDP is about $14.2 trillion, it would be equal to about 3.5% GDP growth in the USA.

To put this in another perspective, Canada’s GDP is about $1.4 trillion and it would be as if Canada’s economy grew by 36% for the year!

China’s economic growth is explosive, and whenever you have economies that are on fire to that extent, the boom and bust cycles will be profound.

Trimming the long-term corporate debt position

Although not a huge fraction of my portfolio, I have trimmed some of my long-term corporate debt position in Limited Brands 2033 bonds, at a yield to maturity of 7.8%. I will be trimming more if the yield goes down to around 7.6%, and eliminate it entirely if the yield goes down to around 7.4%.

The risk-free rate (US government treasuries) for a 23-year maturity is about 4.5%, so the yield spread of 3.3% is not sufficient compensation in my eyes for the level of risk taken.

Limited Brands is a company that is in excellent shape after the 2008-2009 recession. They have about $2.7 billion in debt, compared to $1.8 billion cash on the balance sheet, and yearly free cash flow of about $900 million. Their “big name” store is Victoria’s Secret and they also operate Bath and Body Works. Although they have excellent prospects looking forward in terms of liquidity and solvency (and they have announced they will be giving out a $323M special dividend and a share buyback program, which is not good for bondholders although it speaks to the financial capability of the company to make such a move), I will lower my exposure to their debt as prices continue to rise and look elsewhere to get a better risk/reward ratio for my capital.

I think there is a good a chance as any of US bond yields rising considerably over the next few years, so this trade is also an adjustment with respect to my macroeconomic view of the world. It does lower the yield of my portfolio, but I am happy to keep the cash. It will stay as cash until such a time where I can determine where to deploy it in an efficient manner. Given what I see out of the markets, I don’t anticipate this will be a quick process.

Shaw Communications – Moving into Wireless

An article questions Shaw’s slow entry into the Canadian Wireless market.

RBC Capital Markets analyst Jonathan Allen said the delay gives other new competitors time to gain traction before Shaw is even in the market.

…

“It’s difficult to say whether Shaw launching with LTE is the right move,” Allen wrote in a research note, noting Shaw would be among the first globally to choose this network standard.

My opinion is less questioning – waiting is completely the correct decision. The reason is that there is no first mover advantage in this second expansion of the Canadian wireless domain. With incumbents (Telus, Bell and Rogers being the big three) having a dominant advantage in terms of size, capital and capability, it will be difficult for newcomers to quickly penetrate into the marketplace. My guess is that Shaw will be carefully looking at how Wind Mobile, Public Wireless and Mobilicity perform before doing their own launch.

In the strategic sense, Shaw must get into the wireless space – they have a huge customer base with their cable and internet services, but their expansion into the phone space has been slow, mainly because landlines are now obsolete. A wireless expansion that bridges the internet and voice service seems to be quite a logical move. Their system needs to be able to deliver enough reliable bandwidth to provide both voice and highspeed data service. They will also have the ability to bundle this with their cable packages, and as a result may have better success with market penetration than other providers.

In terms of valuation at a glance, Shaw’s equity appears to be fairly valued. I don’t see a compelling story that would boost their equity price dramatically – it would be an economic miracle if they doubled in five years from their current market capitalization of $8.1 billion. They also are capitalized by $4 billion in debt, supported by roughly $600 million of yearly free cash flow at present. Construction of a wireless network is likely to cost a lot more, so it remains to be seen whether they will decrease the dividend or raise more debt capital to finance it. Shaw does have the advantage of having their billing and customer support infrastructure established, which is something the other new upstart providers are struggling with.

As a company, I have always liked Shaw’s positioning and corporate direction. As an investment, I have never found them compelling. Their common shares will represent a good store of value in terms of their ability to drive cash flows from Canadian’s desire to receive cable and communication services, but I will not project much in the way of capital gains.