Finance – Page 51

Market rallies in downward trending markets

It is fairly well known that the largest one-day market rallies occur in the middle of bear market trends. I don’t have the table immediately in front of me, but suffice to say today reminds me of one of those days:

So instead of getting this trickle increase of climbing the “wall of worry”, the rallies are now consisting of manic one-day rallies.

It is thus also not surprising that volatility is trending upwards.

Whatever is happening in the markets is not likely over yet. My guess is that this has to do something with the continuation of the withdrawal of liquidity from the US federal reserve, coupled with trade issues in China and a lacklustre economy in Europe and Japan, with the appreciation of the US dollar vis-a-vis other major world currencies. That was a mouthful?

The only question is that the financial markets make it very difficult to tell which variables are causes of others, and whether the chicken or the egg came first.

Bitcoin valuation review

Here is a chart of milli-Bitcoins to US dollars over the past month:

Anybody having bitcoins over the past month has seen a 1/3rd drop in their US-denominated equity. (As a side note, investors in precious metal gold would have seen a 5% drop in the same time period).

However, the gist of this post is that Bitcoins has long since moved away from the “novelty” factor where people would speculate on them just on the basis of being collectibles (think of Beanie Babies in the late 90’s) and now the market is pricing in true economic worth of Bitcoins – in this case, it is far, far less than what it has been trading for.

Companies and entities that are collecting bitcoins for payment (Overstock.com!) inevitably have to liquidate them or they will continue to face currency risk in transactions.

In addition, it is perfectly obvious at this point that using bitcoins as a currency medium for illicit (silk road, etc.) transactions is just inviting the relevant authorities to digitally track the transactions and make the appropriate associations with the wallets to the identities of the people holding such wallets – the illicit marketeers might as well be writing paper cheques to each other. These illegal trades likely constituted a high amount of the initial bitcoin traffic but this has now ceased.

The only transactions I would see at this point that are economically viable for the medium are currency transactions to avert low denominations of capital controls in countries that are constrained by such measures (think of examples like Argentina, Venezuela and most African dictatorships). I do not see this being particularly viable considering the liquidity of bitcoin markets is nowhere close to institutional levels. In addition, such transactions are indeed illegal in their host countries!

There are structural issues with bitcoin that will continue to hamper its viability, of which I have addressed in earlier posts on this site.

One is that as the blockchain gets bigger and computational difficulty rises, it will become more incumbent upon large digital processors to maintain the transactions. I have already written about the well-known 51% risk where somebody with sufficient computational power over the rest of the network can subvert transactions and simply ruin it for the other 49%. In addition, computational difficulty of Bitcoin continues to increase to levels where it makes no sense except for industrial data-center levels of computational power to operate Bitcoin networks. Ironically, this is not what was envisioned by the pioneers of Bitcoin, which preferred a much more decentralized mechanism to arbitrate the transactions. Instead, concentration will be leading to an obvious state of the union where the 51% owner to the network will be, in effect, the central bank.

Large scale data centers such as ghash.io have pledged to keep under 40%, but why kill your golden goose so prematurely by scaring away dumb money from coming into the marketplace?

There are also more and more other digital currency schemes (Litecoin, Dogecoin, etc.) which continue to trade, but are simply there just to be an alternative to bitcoin – most of the mindshare out there is on bitcoin compared to the alternative currencies. However, with all of these new digital currencies, there are always incumbent advantages – the group establishing the coins will have all the advantages of mining them first, and then with the hopeful attempt to build a marketplace for it so they can just dump it for real currency. Bitcoin has some inherent advantage than other digital currencies simply because the implementation of this was relatively “innocent” compared to most crypto-currencies being created today that are simply there to steal money from other gullible people.

There is the casino-type element of currency trading. I continue to read the Reddit thread and continue to see people with less financial knowledge give out wisdom on Bitcoin. I would be very curious to know the total amount of bitcoin float out there that is simply being held for speculative (i.e. nothing other than for the reason they believe others will believe it is going up) purposes. Now we are reading threads like this or like this, both of which remind me of Canadians that said “I have shares in Nortel purchased at $80, what do I do?”.

Finally, there is the risk that the cryptographic features of Bitcoin that make it very difficult to access other people’s wallets, may be cracked. While this is unlikely, if such a discovery were to be made, it would clearly cause a collapse in the entire Bitcoin system. The only analogy I could make to this in the central banking fiat currency system is having other people being given access to your own bank account at any time without any reversibility (although you can go and find their wallet and spend it right back if you know the algorithm to doing so!). The system would simply collapse.

I can’t see any reason why any Canadian would want to purchase Bitcoins at this time other than for the novelty factor. If you’re planning on buying currency to prepare for the end of the world (whether it be war, hyperinflation or alien abductions), I would not buy something that depended upon a reliable electrical connection, let alone internet connectivity!

Signs of a crash coming up

I don’t like using this sort of language (mainly predicting a crash), but the following are some tea leaves that I am reading in the teacup:

* The market has completely baked in the fact that the money spigots from the Federal Reserve is coming to a close. Yields are rising (take a look at the Bank of Canada).

* Speculative issues (specifically on housing, and small-cap venture type firms) are getting dumped away. Just look at the TSX Venture, or anything resource-based on the TSX (including most commodity issues).

* Likewise, leveraged financial products (e.g. most REITs, financials) are trading down. For example, Genworth MI (TSX: MIC) has traded down over the past month from its highs of about $40/share (where I was fortunate enough to get rid of a bunch of it). I will be able to attribute this due to the implied real estate market risk in Canada, combined with an anticipated increase in interest rates. Compared to the financing firms (HCG, EQB), I would view mortgage insurance as being relatively better in terms of continuing to provide earnings and cash flows. Tangible book value is $34.11 from the previous quarter so the company is still not a huge bargain at present prices.

* The strength in the US currency is now starting to weigh in on commodity prices and this is not good for Canada’s economy in general.

* Liquidity appears to be entirely centered around large cap issues.

So here are some general ideas with the assumption that you’re going to bank on a market crash (or less dramatically, a correction):

* Volatility futures – I bring to your attention the following 3-year chart of the VIX, which is correlated deeply to the implied volatility you get on short-dated S&P 500 index futures:

Be warned that it is not unusual for this index to be well below 20 for extended periods of time (e.g. a long-dated chart is here).

* Buying puts on the Russell 2000 (IWM). If there is a flight to liquidity, almost by definition less liquid small-cap issues are going to receive the brunt of increased demand to offload them into the marketplace, resulting in lower prices.

You do pay for this, however – a January 2015 at-the-money put on the Russell 2000 is at about 18% implied volatility, while the S&P 500 is at 12%. The S&P 400 midcap (considerably less liquid) is around 14.5%.

* Buying long-dated treasury futures.

* Or even more conservatively, just holding onto plain old cash and brace for impact.

In general, it appears that we’re headed to some sort of decompression of the utilization of leverage, which will have ripple effects.

When to buy shares in a company

You’ve been tracking a company for a year and generally know its ins and outs (fundamentals and the way its stock trades).

They report quarterly earnings. It is a bit worse than you thought it would be, but this is due to the industry conditions being as bad as it can possibly get.

The stock initially trades down, but starts trading back up to its pre-earnings market value.

A fairly good sign that bad news has been baked into the company and likely the risk/reward is in your favour.

Market volatility coming up

The charts suggest that volatility is going to ramp up. Investors should ensure that their portfolio components can take advantage of volatility rather than participate in the negative price trend.

My own portfolio feels appropriately sheltered against this, but we will see if it takes any collateral damage. In particular, one company that I own (the one with the highest concentration currently in my portfolio) takes direct advantage of profiting from volatility so we will see if this proves to be an adequate hedge.