Finance – Page 11

The reach for liquidity

The Federal Reserve has raised 75 basis points since last March and the markets have already gone into a liquidity seeking mode, purely on the basis of setting expectations of increasing interest rates. There is an implied expectation of another 200 basis points worth of increases in the next year but this expectation has already traded down as the markets have tanked.

Recall that the amount of cash in the system does not materially change in any given day. Only the asset price changes on any given day.

When participants want to pay off their debts, they have no choice other than to seek liquidity in their assets – convert the asset into cash. Globally, this has been reflected in the mass depreciation of other currencies, including the Euro and Japanese Yen:

The Canadian dollar, by comparison, has had limited depreciation, presumably due to our trade links and also commodity export:

The underlying point is that the markets are seeking liquidity, and specifically US dollar liquidity. This has had a negative effect on the entire market, including precious metals (Gold and Silver have been sold down during this process – people want the US dollars and not the shiny metal stored in their safes!).

The one commodity that has exhibited signs of stability has been energy – oil and gas has retained most of their value during this market meltdown. This may not continue – if the rest of the market causes consumption of fossil fuels to decrease beyond the ability to supply them to market, then energy prices will drop. There is a huge amount of margin of safety in energy equities at the moment (e.g. Suncor at half of the current price for spot oil is still profitable with dividend intact) but clearly a continued high commodity price environment coupled with low equity prices is the formula to accelerate returns through cheap share buybacks.

Most technology companies, especially unprofitable ones, have been slammed in the past half year. Most of them, even the ones trading 75%-80% below their November 2021 peaks, in my estimation still have rich valuations. That said, markets are volatile beasts and there could be a lot of “regression to the mean” type of investors coming up given the carnage seen in the marketplace. I don’t have much commentary other than that if you were leveraged long on companies like Palantir from last November, chances are at around this point you would have been cleared out of your margin account. Don’t even get me started on the amount of leveraged capital that must have been present and taken a severe bruising in the cryptocurrency space!

What, stocks can go down too??

The jaw-boning of the central banks (every word out of the Bank of Canada and Federal Reserve are both to the tone of interest rates to rise forever) have finally had their desired impact – a suppression of demand in the asset markets, which will likely transmit itself to the overall economy, lessening inflation rates.

They’ll probably shut their mouths at some point in time when enough damage has been done. This is reminding me of the trading that occurred during the year 2000 in the Nasdaq – an incredibly volatile year, and the Federal Reserve at that time had the issue of how to withdraw its liquidity stimulus that it pumped into the market in 1999 (remember Y2K?).

Most of the technology starlings, including Shopify (TSX: SHOP), and the like are all sharply down over the past half-year. Psychologically speaking, for those that have held the stock anytime from April 2020 to today, they are now underwater. For those that bought in 2021, they are down roughly 75% on average. How much pain can they take before cutting out?

This is the challenge of investing in companies with projected cash flows in the far future – with Shopify, you have to take a shot in the dark as to when you’ll actually achieve a return on investment (i.e. the company generates positive cash flows which can be subsequently distributed to investors):

This re-rating of Shopify’s future non-earnings, coupled with the speculatively suppression of higher interest rates, clearly has had a very negative effect.

I am just picking on Shopify because it is Canadian, but this is also exhibited by all sorts of other technology darlings of the past. Today, for example, Palantir (PLTR) has been hammered 20%, on the basis of a very tepid quarterly earnings report (which more or less reported a break-even quarter which had all sorts of ‘adjustments’ to claim a positive free cash flow balance).

Don’t get me started on the effect of rising interest rates on cryptocurrency, where you’re going to have every investor on the planet realize that Bitcoin has a carrying cost (why hold onto BTC for zero yield when you can give your money to the Bank of Canada for a year and get 2.5% out of it for nothing?). You don’t hear too much about the scarcity of available Bitcoins these days! We’ll see if Michael Saylor at Microstrategy (MSTR) is forced to liquidate his stack of 129,218 Bitcoins and if so, that will be the margin call of the year for sure. One look at MSTR’s balance sheet and you do not need to be a Ph.D in corporate finance to figure out that his leverage situation is even more precarious than Elon Musk’s reliance on Tesla stock being sky-high.

In these environments, however, the best cliche used to describe things is that babies get thrown out with the bathwater. There are companies out there in the technology field which get lumped in with all of the ETF selling (go look at the holdings of ARKK here!) that do have value (beyond the obvious such as the Microsofts of the planet which will continue to have vast earnings potential due to their wide moats).

However, current free cash flows speak volumes. Companies trading under 5 times free cash flows are going to make mints for their shareholders by continued purchases of their own equity, and for those companies generating cash, shareholders should be cheering for continued lowering prices to generate excess future returns. Those that have prudently managed their balance sheets will be in a much better position to be opportunistic.

Finally, a word for those thinking that commodity investing is a one-way ride – in markets, nothing ever is! Yes, this includes Toronto residential real estate. There has been a lot of what I call ‘energy tourists’ and they have latched onto many of these stocks during earnings time (fossil fuel companies in Q1 have reported insane amounts of profits). There is an urge by many to over-trade and to shift portfolios away from quality into more speculative names (various < 50,000 boe/d with operations of more questionable characteristics) in order to torque up their return profiles. In a rising market, it is the lower quality companies that tend to exhibit the higher percentage gains, while in a flat or declining market, it is the quality firms that will have the sticking power. Stick with quality. It will let you sleep better at night in times like these, much more so than a pre-build contract for a 450 square foot Toronto condominium.

Bank of Canada – Quick macro look

At the close of the week, the 10 year Government of Canada bond yield reached 3.07%, which is the highest it has been since May 2011!

Going 10 more years back in time, it got up to 6% in 2001. How high yields will go, who knows……

My other comment is regarding the first phase of quantitative tightening. On May 1, the first slab of Bank of Canada-held government debt ($12.6 billion) matured and this is the impact it had on the balance sheet of the Bank of Canada:

Note that individual tax return payments were due to the government of Canada by April 30, hence the increase in its deposit balance with the Bank of Canada. However, the important figure is the $200 billion held in reserve by “Members of Payments Canada” (i.e. the big banks) which is declining. Upcoming maturities are $3.1 billion in June and $16.8 billion in August.

Capital is on its way to becoming an expensive resource once again. Position accordingly.

Federal Reserve quantitative tightening – what my crystal ball says

The US Federal Reserve today announced they were going to raise the short term interest rate 0.5% and start their QT program on June 1st.

Because this was less drastic than the market was expecting, everything is rallying today because of continued easy monetary conditions, which will surely not help inflation expectations any.

My curiosity concerns the quantitative tightening, which proposes a $30 billion per month tapering starting June 1st, and then going to $60 billion per month on September 1st. This is on the treasury bond side, the mortgage backed security side has a different bucket of money to work with, but I will ignore mortgage backed securities in this post and just focus on treasury securities held by the federal reserve.

We look at what happened in 2017-2019 when the last attempt to do this occurred:

On January 3, 2018, the fed had $2.448 trillion in treasuries on the balance sheet. On January 2, 2019 they had $2.223 trillion, a taper rate of $18.75 billion per month.

The fed ended up crashing the stock market on the fourth quarter of 2018. It was a classic liquidity bust.

This upcoming taper will be faster ($30 billion a month), but it also comes from a much larger asset pool ($5.763 trillion). The taper doubles in September if they do not change things.

Compounding the problem is inflation. Back in 2018 the headline inflation was still very muted – talks of deflation were quite omnipresent. This time around, inflation is very much on the radar of everybody.

The federal reserve meets again on June 15 and July 27, where they have all but signaled rate increases (likely 50bps per meeting). This will still render the fed funds rate at a target of 1.75-2.00%, which by all historical standards is quite low, and especially considering the CPI at around 7%, still deeply negative.

My guess at present is that we are going to get a gigantic market rally in the next few months, especially in the stocks that have been taken out and shot over the past six months (looking at technology and software stocks in particular).

Shopify fans, you probably will be able to get some temporary revenge.

However, the will be temporary. While the rally in prices will be impressive, I do not think they will be sustained after the summer.

I am not a good enough trader to try this, but if I were to take a guess at where the speculative winds are blowing, I would long ARKK-type stocks for a couple months and then get rid of them sometime in August.

The TINA trade is breaking

Once upon a time, you had no choice – equities or nothing. This was referred to as TINA – there is no alternative. Bonds yielded you close to zero. (I’m rounding 0.2% to zero).

Today, two-year US government debt is now yielding 2.7%, which is still less than reported headline inflation, but at least it is something.

This is going to suck up liquidity from the market, and it is pretty obvious this has had a significant effect on broad market equities. Suddenly, instead of investing in bond-proxy equities like Microsoft or Apple, you can instead put the capital into everything-but-inflation risk-free government debt and earn your 2.7% yield this way. High-multiple stocks with promises to pay out in the distant future suddenly no longer look as good simply because there is an alternative.

We have a huge wall of worry ahead of us – the US Federal Reserve on May 5th will be raising interest rates and perhaps initiating quantitative tightening, we have China that is now making famous people in the white-bunny with blue stripe plastic suits enforcing Covid rules, we have the Russia/Ukraine dynamic and the threat of nuclear war, etc.

This is reflected in a high price for protection – the volatility index is once again has creeped upwards – paying for those put options is expensive!

With disaster always comes opportunity. I am sounding like a one-tune band, but those companies earning large near-term cash flows will be making their shareholders a fortune by the reinvestment in their own stock (assuming they have the liquidity to do so!). In some cases, the numbers appear to be extreme – if you could reinvest in yourself at 30% returns, would you? I sure as hell would. Some things are trading like as if everybody forgot how to read financial statements and perform the most cursory of forward projections.