Finance – Divestor

Eyebrows are perking up… just a little

Today we are getting some more fear headlines out of the usual places:

The entire commodity complex was on fire earlier in the morning, but ended trading down, along with a rise in volatility.

In particular, gold got a huge bid, but ended up down for the day:

The lesson here is that the nanosecond before a crisis materializes, the only safe asset is cash. It’s not gold or Bitcoin. I don’t know if this is a correct metric or not, but one possible indicator of cash demand is the (TSX: HSAV) ETF. It is trading so much higher than NAV – rationally it doesn’t make a hell of a lot of sense.

Today’s trading action was fairly pronounced in that the commodity complex companies that have been trending from bottom-left to upper-right charts over the past month have been exhibiting whip-saw trading action. It’s as if you have a bunch of hedge fund managers taking a look at their trading screens on Friday morning and deciding this is a good time to take some chips off the table, all in unison – which seems to be the easy trade. Easy trades are most typically not correct.

There are a bunch of other firms on my watchlists, some of which have gone down sharply, that are catching my attention. Not close to buying them, but just paying more attention than I was a couple days ago. When I see synchronized price action (most of it on the downside) like today, it makes me wonder what will happen if we truly had a liquidity crisis in the markets. VIX has perked up a few percent from the previous couple weeks and if those headlines above come to fruition, coupled with other stress in the markets, might create a fertile environment for some tactical capital allocation.

Some quick thoughts at the beginning of 2024

Two data points, I am not adding any value to the universe with this post:

The Nasdaq 100 had a +55% year, while the Nasdaq Composite was +45%.

I don’t think there is any degree of active portfolio management that would match this number.

The correct strategy in 2023 was to put your portfolio into 5 equal-sized chunks, in NVidia, Facebook/Meta, Tesla, Microsoft, Amazon and Apple. (You can sub-in your favourite large-cap darlings here, including Google and the like, but you get the idea).

No sane portfolio manager would do this.

It is very similar to the times in 1999 how if you weren’t in technology stocks (whether large cap, or the trashiest of the trash dot-com companies) in 1999 that you were guaranteed to under-perform.

The question is whether we will see “momentum”, or “regression to the mean” going forward.

I truly don’t know anymore. I note that, separate to the investment world, I have been receiving some email correspondences that are worded like they were generated by ChatGPT. Indeed, when I entered the text of the email and asked for it to form a response, it spit out some language. I then asked ChatGPT to simplify it, and what came out looked like a carbon copy of what said individual emailed to me.

I think from this point forward I’m just going to resort to in-person face-to-face communication.

However, others will opt for the convenience of not having to parse language in their heads, let alone spill it out on a keyboard (or god help those that can use touchscreen phones to do their typing). They will not have to deal with grammar, or even have to think about anything. AI will take care of it.

So perhaps it isn’t too late to buy those deeply out of the money calls on NVidia, it is banking on the intellectual laziness of people – sadly a safe bet.

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In 2024, Canada will have an active stock buyback tax of 2% applied on net share repurchases. While the legislation is more technically worded, essentially “net” in this case means that share buybacks beyond offsetting share issuances (whether through SPOs or option issuances, etc.) will be taxed at 2%. I don’t wish to get into the stupidity of how meddling in capital structure is going to cause perversions (indeed, prior to this, share buybacks are tax-preferential to dividends and this in itself was a perversion), but nothing makes the government more happy to claim to the public they are sticking it to greedy corporations with their share buybacks than applying an additional tax.

While 2% is not a huge penalty to pay, it is one more unnecessary friction impeding the return on and of capital. I am looking at the companies in my existing portfolio and am wondering if the ones voraciously performing share buybacks will be more keen to compensate through the issuance of stock options. Again, 2% is not a huge penalty to pay, but it is yet another annoyance.

Changing Course for 2024

You’ve got to know when to hold ’em
Know when to fold ’em
Know when to walk away
And know when to run
You never count your money
When you’re sittin’ at the table
There’ll be time enough for countin’
When the dealin’s done
– The Gambler, Kenny Rogers

This seems to be the most appropriate song to describe the feeling I am getting at the close of the calendar year.

Probably the biggest sign of whether you have a grasp of reality or not is whether your mental model of the world can correctly predict the future.

Unfortunately, as I have written here before, one does not necessarily need a truthful model of reality in order to survive. Donald Hoffman is a cognitive psychologist that has made some very interesting lectures on the matter and this disconnection between truth, reality and survival – this has always been in the back of my mind.

In particular in our 21st century age of information, mis-information and dis-information at our fingertips, coupled with AI bots, deepfakes, etc., it is getting very difficult to distinguish truth from fiction.

Ironically during the Covid era (from March 2020 onwards) I felt like (who knows whether I actually did!) I had a better grasp of reality than most, and indeed as it translated into the financial markets, it was a very rare time where most participants were so strongly positioned for disaster that it was possible to make reasonable gains when people’s perceptions of reality normalized to some semblance of truth (i.e. we’re not all going to die – just look at a chart of Moderna (MRNA) or Alpha Pro Tech (APT)!).

The financial marketplace is actually a reasonable place to measure the perception of one’s reality against others. Note I did not say “truth” – the old cliche of “the market may remain irrational longer than your ability to remain solvent” is true in many cases, say for those that wanted to short the economically unprofitable cannabis sector in 2016, the dot-com market in 1998, or the short-lived upsurge of plant-based meat companies IPO’ing around 2018-19. Never mind Gamestop! Even if your sense of reality is closer to the truth than others, the market can dictate reality for longer than one thinks.

Going back to present, the Covid effect has slowly abated over time and sometime around 2022 the markets began to be the same old efficient market machine that we have been used to – the primary difference between 2022’s market and onwards was that we exited out of the zero interest rate environment.

In retrospect, I was inappropriately positioned for 2023. It seems increasingly likely that the reality in my brain is not corresponding with what is actually going on out there, and as a result, I need to discard these narratives out of my head and start from the foundation again.

You could already tell that I had significant amounts of self-doubt in the middle of 2022 – where I mercilessly started to cull elements of the portfolio and raise cash, and I was soothed by the fact that cash had obtained a reasonable yield once again. The baseline performance for doing nothing (or rather resting on the sidelines) was actually pretty reasonable.

My doubts on my grip on financial reality have continued to increase even further – one should never invest when you are flying blind. The other rule is a break in thesis – one of my tenants going into the fossil fuel trade back in 2020 was that North American production would not be able to eclipse their Q4-2019’s highs for various reasons (resource exhaustion, drilled and uncompleted numbers low, lack of capital spending, later on – Russia being cut out of the oil equation, costs of drilling, self-induced ESG restrictions, etc.) but this is a failed and broken thesis. US production in particular is now at all-time highs, despite all the narrative.

World demand also continues to be very high but for whatever reason, there seems to be ample production capacity.

My continuing fossil fuel trade in 2023 has been incredibly offside with reality. I consider myself lucky to still be marginally positive YTD performance in what has been a very uninspiring year financially riddled with errors of omission (i.e. not listening to my instincts earlier and getting out at higher pricing).

Instead, what we are going to get might be similar to what happened in 2014, and is typical of cyclical industries – a terrible race to the bottom. Low cost producers and those that can provide additional value (e.g. refineries, mid-stream, etc.) will survive, but returns are likely going to be muted going forward. This is the conventional financial playbook and it is one that is telling me to fold ’em. And that I have been doing.

I did venture away from my Covid playbook a tiny bit in 2023, but not to a significant degree. 2024 will also exhibit a change in focus. The markets have always been about adaptation and survival and I am fortunate to begin the new year with half a clean canvas to work with. I am not in any rush to deploy capital, however – I am not at all sure that my grip on reality or the truth is quite where it needs to be. I am worried that my thoughts are currently too close to the consensus out there. As a result, if there are going to be any movements, they will be baby steps.

Reviewing the past week

The past week was relatively interesting.

The 10-year bond yield went down about 0.25% from the beginning to the end of the week. Likewise, the long part of the yield curve also dropped (prices rose) and a whole flurry of the usual interest rate sensitive subjects got taken up VERY sharply. I’ll just give a few of them, but you get the idea – these four are from very different industries:

(But also take a look at REI.un.to, CAR.un.to, etc. – also dramatically up over the past few trading days).

REITs, lumber, sugar, and fast food. All of these are yieldly and leveraged. Don’t get me started on other components of the fixed income markets either, but I’ll throw in the 30-year US treasury bond yield:

There is a cliche that in bear markets, bull trap rallies are the sharpest. This is usually the case because short sellers are a bit more skittish than in the opposite direction.

My suspicion is that the bears on the long side of the bond market got a bit too complacent.

The calculation of the risk-free rate is a very strong variable in most valuation formulas. If you can sustain a 5% perpetual risk-free rate, there is no point in owning equities that give a risky 4% return. The price of the equity must drop until its yield rises to a factor above 5% (the number above 5% which incorporates the appropriate level of risk).

So what we see here is the strong variable (risk-free rates) moving down and hence the valuation of yieldy and leveraged equities rising accordingly, coupled with some likely short squeeze pressure on the most leveraged entities.

There are likely powerful undercurrents flowing in the capital markets – the tug-of-war with the ‘higher for longer, inflation is here to stay’ crowd competing with the ‘Economy is going bust, the Fed has to lower rates!’ group.

The last chart, however, I must say was not on my bingo scorecard for 2023 – Bitcoin is up over double from what it was trading at the beginning of the year:

I should have just pulled a Michael Saylor and gone 150% on Bitcoin. Go figure.

Negative amortization mortgages

Rising interest rates are going to break things, and this one in particular (Globe and Mail article on negative amortizing mortgages) is going to be interesting.

Snippets:

BMO disclosed that mortgages worth $32.8-billion were negatively amortizing in the third quarter ended July 31. That is the equivalent of 22 per cent of the bank’s Canadian residential loan book. For the second quarter ended April 30, the total was $28.4-billion, equivalent to 20 per cent of BMO’s loan book.

TD had mortgages worth $45.7-billion negatively amortizing in the third quarter, the equivalent of 18 per cent of its Canadian residential loan book. That was higher than the $39.6-billion, or 16 per cent of its loan book, in the fourth quarter of last year.

…

In this year’s third quarter, CIBC had mortgages worth $49.8-billion, the equivalent of 19 per cent of its Canadian residential loan book, in negative amortization. That was higher than the $44.2-billion, or 17 per cent of its portfolio, in the second quarter, according to its financial results.

It appears about 20% of mortgages presently are negatively amortizing. This is presumably due to the interest component of floating rate mortgages rising coupled with fixed payments being insufficient to pay the interest component. This would not apply to mortgages that have their payments vary with rising interest rates.

What will be even more interesting is when fixed rate mortgages renew. Five years ago the lowest rate you could get was 3.19%. Today this is 5.44%. By definition when people renew their mortgages they will continue amortizing their principal, but many of them will be facing increased payments. For example, somebody taking a $1,000,000 mortgage 5 years ago at 3.19% on a 25-year amortization would have a monthly payment of $4,830/month. If, after five years, they wish to renew the remaining principal (approx. $858k) at 5.44% with a 20-year amortization, that monthly payment goes up to $5,843/month. If they wish to keep their $4,830/month payment, the amortization on renewal goes to 29.6 years!

It is a valid point, however, that negative amortization is meaningless without the specific quantum involved. For instance, if your mortgage is negatively amortizing at 5% a year, while your property value is appreciating 10% a year, you are actually decreasing your loan-to-value ratio over time. This headline may be a little less ominous than it sounds without digging deeper into the data – which sadly was not provided.

The debt party will end very badly when real estate valuations collapse (if they ever do). Given the propensity of the Canadian government to functionally open their borders to anybody interested (especially in the form of student visas), the influx of population has provided an increasing level of demand for real estate on a very slowly rising supply base. As long as this remains the case, absent of any dramatic rise in unemployment, it appears unlikely there will be any deep downward catalysts on residential real estate valuations.