Category: Finance

Finance and Economics related articles

Canadian preferred share indexes hammered

The Canadian 5-year government bond rate has compressed significantly:

As most Canadian preferred shares are linked to this rate, we are seeing a huge selloff (which interestingly took place about a month before 5-year interest rates really started to drop):

ZPR is a BMO ETF tracking preferred shares. CPD is an ETF tracking a preferred share index holding most of the investment grade preferred shares trading on the TSX (mostly concentrated in Financials and Energy). Holders in these “safe” funds will have had around 13-14% of their capital value evaporate over the past two months of trading.

It is indeed ironic how the equity components of the preferred share indexes have fared generally better – as an example, Toronto-Dominion equity has declined about 10% in the same period of time.

So much for preferred shares being a safer vehicle to invest in!

The big difference this time around is that a lot of the rate-reset preferred shares have already had their yields reduced to a minimum due to the 5-year Canadian bond rate being so low for an extended period of time. Subsequent rate rises will have less impact on the dividend rates paid for preferred shares.

It remains to be seen whether this will continue or not. Back in February 2016, we had seen double-digit dividend yields on very credit-worthy issuers, but this was also when the 5-year bond rate was trading at around 100 basis points.

I’ve also been doing some research on preferred shares that are not held by these two funds. I would suspect that less liquid preferred share series on the main two ETF indexes would be more prone to auto-selloff algorithms when people inevitably decide to panic and try to liquidate everything.

Very often, people hold cash in their portfolios for too long and then get itchy. They then instead think of investing in “safe” preferred shares, or an index, thinking that the 5-6% yield they realize is adequate compensation for the risk in lieu of holding cash.

It is these situations where they rethink this notion and decide to liquidate. Eventually the capital losses become too much to bear.

It is very difficult to time when the maximum moment of panic is, but doing so will result in outsized risk/reward ratios, which is why I’ve been paying careful attention in these very volatile couple months.

Doing a portfolio check on a heavy down day

As I write this the S&P 500 is down over 3% for the day. The TSX is down 1.4% which isn’t so bad by comparison.

An index is simply a collection of stocks. For the two indexes above, companies that have higher market capitalization are weighted high in the index. When an index gets sold off heavily, there is a high probability that the higher capitalization stocks in the index will also be sold off.

When there is heavy market volatility it is usually wise to look at what is going down by the averages, what is going down more than the average and which stocks are holding steady or even rising, especially those stocks that are not included in a major index. It gives you some hints as to which sectors are and are not popular for the day.

Institutional investors are usually required to keep specific ranges of portfolio fractions (i.e. an allocation between equities, bonds and other asset classes). Typically when broad equities drop, managers will dump bonds in order to buy equities to rebalance the portfolio.

Today, contrary to what the market has been doing a few months ago, a selloff in equities is once again correlated to an increase in risk-free bond securities – I note that the 10-year treasury bond yield is down some 70 basis points – which means that what we are seeing in the markets today is a flight to less risky positions. The yield curve continues to flatten – there is a 10 basis point difference between 2-year and 10-year treasuries now.

If equities fall enough, collateral values will also decline to the point where portfolio managers will have to liquidate assets in order to maintain sufficient collateral – i.e. a margin call situation. If enough of this happens, you will start to see significant opportunities appearing on the equity side.

It’s more probable than not that the upcoming December meeting of the Federal Reserve will be the last quarter point interest rate hike before they take an extended pause. If interest rates stop rising, then the next market focus will be back for finding yield.

Another observation is that gold is doing reasonably well. It is a shame for most investors that most gold mining companies are poorly managed.

I’ve still got a lot of dry powder in the portfolio and I’m waiting for worse times. There will be a time to pounce but not yet.

There is one other observation I will make – robo-investing and index investors that choose allocations of various low-cost ETFs are dooming themselves to sub-par returns. Every time I hear people investing in whatever index fund that pledges market diversity (e.g. VGRO is quite popular) I just think to myself if they are truly prepared to earn low single digit returns with the real risk of them seeing 25% peak-to-trough downdrafts.

It was about 10 years ago when the economic crisis was clearly in full swing – Bear Stearns went bust, Lehman Brothers went bust, and anything financial was imploding. The S&P 500 was still at around 870 at this time. It wasn’t for another 3 months before the S&P 500 reached its low (the value being “666” appropriately enough) – you would have still seen a 23% decline in value.

This time around, how much of a value loss can index investors take before the perception of an unlimited wealth creation vehicle evaporates? Today, we are at 8% below the peak of the S&P 500. Canadian investors (via the TSX) have seen a 9% drop from peak-to-trough in the index high.

“This is just another buying opportunity to buy shares cheaply”. Or is it?

As my last note, I will point out that General Electric (NYSE: GE) is down 6.66% today. How symbolic.

The markets will be useless on Tuesday

Every eyeball will be focused on the results of the US Congressional elections.

My prediction is that the Democrats will retain a narrow majority in the House, but specifically with less of a margin to where Nate Silver is currently predicting (which is 234-201). My guess is closer to 220-225 (Democrat) to 215-210 (Republican). Polling in the very politically charged environment is likely to be even more unreliable than ever.

A market surprise event would be if the Republicans retained control of Congress. I would think the potential for surprise would be on a morning pop of the S&P 500, similar to how the market was very surprised when Donald Trump got elected president. A deadlocked congress would likely be good news for Donald Trump’s 2020 presidency bid, if he so chose to run again.

Correlations between rates and equities is reversing

One of the “elephants hiding in plain sight” in 2018 was how the market reacted in February 2018 during the volatility crash:

This chart takes a few seconds to mentally digest, but the key point is that during the beginning of February, the correlation between the 30-year treasury bond yield and the S&P 500 decoupled. Normally market crashes have the tendency of having investors flow capital into long-term treasuries as a safety valve but this did not occur.

What’s happened over the past week is that the 30-year treasury yield has spiked 20bps from roughly 3.2% to 3.4% and the S&P 500 has edged down during that time period. While the equity moves were relatively low (within the bounds of regular volatility), it is increasingly evident that long-term government treasury bonds are no longer being regarded by the market as a haven of safety.

If/when the markets decide to crash, it is quite likely that long-dated treasury bonds will be crashing at the same time and cash/short duration will be the only safe haven when this occurs.

Canadian interest rates are also creeping up as well.

There are going to be bargains here and there, but in general, most investors are going to face some serious headwinds going forward. Cash is king in these situations.