Month: March 2020

Some very random scattered observations. It’s been very difficult keeping your wits together in this environment. I’ve had to limit my “screen time”.

TSX Composite is down 31.3% YTD
S&P 500 is down 25.8% YTD
Canadian dollar is down about 10% YTD
Spot Crude (Western Texas Intermediate) is down 66% YTD

The TSX is down more probably due to the energy-intensive aspects of the Canadian stock market.

Crude, in particular, is trading at a curve that is utterly crazy:
Near month (May) $23.75
December 2020 $30.70
December 2021 $35.55
December 2022 $38.50
December 2023 $40.74

Want to dig a huge hole in your back yard, store 10,000 barrels of oil in there (this is about 1.6 million litres, so not a trivial amount!), and then sell it back to the market in a year and a half? If you can do it for less than about $120k, you’ll make a profit out of it…

I am puzzled how Natural Gas, for the most part, appears to be taking things relatively well – perhaps because they’ve already been beat up so badly? AECO daily pricing has held up quite well.

“The World in Data” guy is doing a huge public service by keeping the COVID-19 statistics accurate.

I don’t trust the data out of China (it’s also easier to treat the flu by sending people into virtual prison!) but South Korea’s ability to track and isolate this is quite impressive.

Hong Kong is also another jurisdiction that has very good capacity to deal with these sorts of things.

A silver lining is that we will soon be able to get more data out of Italy and other European countries to reliably tell us what risk factors are in play – i.e. the Chinese data from the studies of the people that died we can test whether they are reliable or not.

We don’t hear much about the inverted yield curve anymore – the 30-year US bond rate is now 1.9% and rising – inflation?

There has been too much on the radar in terms of what appears attractive if your hurdle rate is a 15% return on investment. If you’re looking for some “safe” investment products, I think the debenture complex of Ag Growth International (TSX: AFN.DB.E, F, G) look pretty attractive – they will give you roughly 17%, 14% and 14% CAGR, respectively over 2.8, 4.3 and 4.8 years, respectively. This has to be weighed against buying the equity (currently at $18) which you can make a pretty good argument that it will trade at its previous historical levels at $45 after everything is said and done. You’ll make 50% on the safer debt investment, but you’ll presumably make 150% on equity in a normalization scenario.

I have taken a position in Chemtrade debentures (TSX: CHE.DB.D, specifically) – this company produces sulfuric acid, water treatment chemicals, and sodium chlorate – these chemicals are really basic for industrial processes in electronics, pulp and paper, and other industries. Their equity (in the form of an income trust) has typically been a yield darling, but I suspect they are going to cut even further as a result of Covid-19. But the company does generate plenty of cash and while they are over-leveraged, they will survive this. They have a senior debt to EBITDA covenant which they may get close to but this is rectified by pulling the plug on the distribution. I’ve been watching Chemtrade for ages now, and while I was never thrilled about the relatively high valuation of their income trust (it traded as a yield vehicle) the underlying business is strong.

A comment on Canadian REITs – For the last five years or so, RioCan (TSX: REI.UN) has been trading at a close level to around CAD$27/unit. Today it is $15.69. While obviously there is going to be some lease impairments on companies that simply can’t afford to pay the bills anymore (restaurants, mom and pop shops, and just retail overall in general even without the assistance of Covid-19), eventually this land will get repurposed and produce income yields again. With interest rates being very low, when this rush for cash is abated, these types of income vessels are going to be very popular again. Don’t even get me started on residential entities like CapREIT (TSX: CAR.UN) that are still trading at levels that astonish me. There aren’t that many REITs to sift through, and while I think they are not going to post extraordinary returns when there is the inevitable bounceback, they are relatively “safe” – you can be sure those mortgages will be renewed on even the worst retail properties.

The markets have been limit-up, limit-down so many times over the past two weeks I have lost count when there have been volatility pauses. But these are also markets where if you want to sell, you should only do so on one of those limit-up days, and if you want to buy, you have to do it on one of those limit-down type days. This volatility has been more insane than I have ever seen it, and this includes the global economic crisis of 2008-2009. This probably also means that if you can keep your sanity you might be able to make some money out of it, but it requires a seriously wild ride to get to and from – if you don’t get cashed out.

Almost everything is trading at elevated yields that we have not seen in ages. Dividends are probably going to get cut across the board from a lot of companies, and P/Es are going to be sky-high after Q1/Q2 results get reported.

GFL’s IPO (TSX: GFL) was done at the cusp of the market meltdown, and they’ve held up surprisingly well. Considering that garbage collection is one core duty of society that can’t be stalled out, I can see why. They might stand a decent chance of recovering quite well (I’d choose them over the REITs for example).

Throughout this process the supply chain has been quite resilient. It has only been a week since the lockdown and as far as I can see, things are still available. Aside from some silliness involving toilet paper and other products, goods are still flowing. This is important. There are two large logistic companies in Canada, Transforce (TSX: TFII) and Mullen (TSX: MTL), and both are very well run, and both are trading at lows. While this sector will obviously take damage during the lock-down, it is a privileged sector that currently has priority.

Finally, quant funds have had their models absolutely destroyed, and just like Long Term Capital Management, are being forced to rapidly unwind. Leveraged funds, especially on fixed income, for example, have likely tried to scramble. As soon as this supply pressure abates, there will be upside volatility. Traders that are keeping cash on the sidelines likely won’t have much time to take action in this event – it will probably be just as violent going up as it was down. I’ve been on the wrong side of a lot of this to date, so take these words with grains of salt!

“Cash is trash” (January 21, 2020) are the famous words that were spoken by Ray Dalio just before the point where you actually wanted to have cash. This should have been a warning sign to sell everything.

As much as I like Ray’s writings, I think he was the only person that was more worse positioned than myself during this CoronaPanic. Unfortunately for him (and his hedge fund), he will probably be the profile guy that was similar to Ralph Acampora saying in October 1998 during the pits of the Long Term Capital Management unwind and Asian financial crisis that “we are in a full bear market”, right before the Nasdaq tripled over the next 18 months.

There is also another phrase, which goes as follows:

You don’t have to make money the same way you lost it.

As far as the stock market is concerned, I think this week will feature the maximum of volatility. Since everybody is talking about flattening curves these days, the curve that is being flattened right now is the second derivative of bad news coming out of the CoronaPanic. The whole world knows that the USA is going to receive a whackload of Covid-19 cases and all of these doom-and-gloom headlines are under Drudge (including -10% GDP, millions dead, etc, etc.) which are complete fiction, but this is what the media is designed to do.

So today, at the risk of sounding like Dalio, I’ll make the proclamation that cash is trash. Today feels like a “normal day” in terms of how things are trading, and how the markets are once again facing a ‘wall of worry’ as they inch higher. This confidence will eventually culminate in some form of “fear of missing out”, just after droves of people start liquidating their portfolios – they will see the markets climb up higher and higher, and then curse their fortunes.

You can invest your money now in practically anything that doesn’t involve tourism, extraction of oil, and GICs and in half a year, you will very likely be up. While of course I don’t ever give guarantees, relative to interest rates, large-cap equity is going to make too much of a return on capital relative to government bonds – the risk premium to holding equity right now is huge.

So if you don’t even know where to put your money, there is always the option of the S&P 500, which can easily be done by just purchasing futures and shutting off the media. Most of the large-cap demand will float here regardless. Take a look at the top 50 of the S&P 500 and intuitively other than Chevron and Exxon (27 and 29 currently on the list) all of the other companies you can easily envision not being mortally wounded in any manner post COVID-19.

Now I’m going to talk about currencies and a little political commentary on Canada.

The Canadian dollar has gotten hacked to death, and is sitting at 70.5 cents to the USD, and my guess is that this is going to go lower, probably bottoming out to 65 cents after everything is said and done. The correlation with oil and gas is well known, but also contributing to this is the lack of our competitive capacity – this is what happens when you have a government that is all too eager to subsidize and allocate capital to those companies that provide little in the way of economic substance (what ever happened to these so-called “superclusters” that was part of the excuse to hand billions of dollars to partisan supporters’ companies?). Couple this with uncompetitive regulatory and taxation regimes, and you get exactly that result – a loss in purchasing power. Life will be getting more expensive in Canada, simply because collectively as a nation we don’t have our act together. What happens when you promote one industry over the expense of another is that you still have a lack of confidence in the “favoured industry” simply because you never know when the government of the day will flip the switch and go against you.

Fortunately this can be corrected, but it takes time and a change of cultural mindset, the latter of which unfortunately I do not get the sense is going to be happening. If we weren’t propped up by the USA, it would very likely have slipped into an Argentinian-type scenario (early 20th century) where eventually the erosion of competitive strength results in an economic collapse.

The only good news for individual Canadians is that they can hedge themselves against this by buying American equities.

The US currency itself is not exactly a safe haven in the medium term – they are going to be blowing out records amount of money in the next half year, and this is going to result in some form of depreciation. However, most of this capital is going to get dumped into assets with return features that are inflation-adjustable – those companies that can maintain pricing power in an inflationary situation will be golden. Get ready for the costs of everything going up, much more so than we have traditionally seen in the past. The only solace is you can protect yourself.

You can also buy gold. It should do reasonably well as long as the liquidity crisis is over.

I’ve been slowly adding a lot of diversification to my portfolio. It is very spread out right now. I’ll discuss some positions in future posts.

Brokers deal with margin issues by selling client assets. They get permission to do this from clients when you open up your account, and they can sell your assets without warning. They do this so they can cover the loan they made to you.

What they can’t prepare for very well are gaps or discontinuities in positions that can cause losses in excess of client’s equity.

A great example in the past was when the Swiss Franc decided to remove its currency floor against the Euro, and the floodgates came rushing in. This was enough to bust up FXCM and other banks were forced to take losses (in addition to Interactive Brokers taking a bit of a hit).

We have been seeing limit down situations on the S&P 500 futures and this results in trading that is relatively discontinuous, which makes it very dangerous for brokerages that give out margin.

There is plenty of evidence of people getting cleaned out of positions. You can’t really detect this in most liquid positions (the trading is orderly, albeit the price goes down), but in smaller liquidity issues, it is really obvious when somebody gets cleaned.

For example, at 10:14am today, somebody traded a few hundred shares of PPL.PR.Q today at $7.83 and $7.84. At this price, the current yield would be over 15% for four years, and the rate reset rate at present 5-year government of Canada interest rates would have been about 11.5%. This is a total outlier compared to the rest of the preferred share series.

Lest you think you would be on the other side of this trade, I have typically noticed that market makers in a lot of these instances will beat you by a penny. In the above instance, had you had an order placed at $7.90, for example, chances are the liquidation fills would have taken place at $7.91, gone to the market maker. To a certain extent you can mitigate against this by using hidden orders.

If you are lucky enough to get on the other side of these types of trades, you will do very well (assuming you don’t get cleaned out yourself later!). It is very difficult to predict where the “bottom” will be, getting close enough will still result in gains. From an absolute value perspective, the PPL.PR.Q trade (it was just a few hundred shares so there is no way one could have received it in size) should do relatively well, but who knows – the next mass sell order might be at $6!

This is a very different trigger to a market crash because there is a gigantic element of a change in psychology, all in a very short period of time. The psychology (everything is cancelled, stay at home, don’t go to work, etc.) leads to cultural change, and there is demand to be seen to “do something”, to quell the panic. The psychology is causing the economics to change, which in turn causes the market to change.

When you have a massive dislocation in psychology, coupled with a cultural shift, and disruption in the economic landscape, it is no wonder there is huge volatility associated with it. If you get the medium term correct and don’t get cashed out in the process (i.e. be a victim of a massive margin call), things should go reasonably well if you’re invested in one of the privileged sectors that actually have to do something with the functioning of the overall economy (this means if you own cruise ship stocks, needless to say you’re in big trouble).

The cruise industry will recover to a degree, but it will take a lot of time, and there will be have to be a ton of marketing spent on how the ‘new’ ships being constructed actually have air filtration systems, sanitation standards, and aren’t cesspools of shared viral contamination. This will take years. I do not see a quick recovery in this industry.

Central banks and the federal reserve can fight a financial crisis by perpetuating an “extend and pretend” strategy, where credit is available for anybody and everything that wants it. This is the playbook that is going on right now – you are going to see the financial markets being drenched in liquidity like that which has never been seen since the 2008 economic crisis. We are talking about trillions of dollars in availability. You see on FRED how there is 2.5 trillion outstanding in treasury securities bought by the Fed? That’s going up. Like to around 5 trillion. This is the equivalent of the Federal Reserve dropping short term interest rates to something like negative 4 percent (this is just a ‘gut feel’ number, not a scientific amount). It is a playbook that is going to cause incredible mass distortions when this finally gets sorted out. Nobody is talking about the S&P 500 going to 4000 at this point but in the medium term once all of this liquidity goes somewhere, that’s exactly what is going to happen, conveniently in time for Donald Trump’s re-election.

This liquidity, however, is useless if it doesn’t get to the companies that have short-term liquidity issues (debt rollovers, credit facilities that are about to expire and/or facing covenant defaults given the impending revenue drops) – but this will be arbitrated somewhere in the continuation of “extend and pretend”. But the root cause is a gigantic change in psychology perpetuated by a virus. A financial crisis is caused by some large players that are unable to pay their bills. The Federal Reserve can solve this by giving them money, but they cannot re-program people’s brains into believing a virus won’t kill them.

(As I was writing this, I see the Federal Reserve has just dropped interest rates to zero, ahead of their scheduled policy meeting this Tuesday/Wednesday, coupled with a coordinated press release by various global banks regarding the available of US dollar swaps).

The Federal Reserve has very good tools for fighting a financial crisis. But this is not a financial crisis we are facing – the financial crisis is a result of what is actually being faced, which is a psychological crisis, the perception that there is a virus out there that is going to kill us all. Unlike a scenario where an asteroid is detected to be hitting earth in a year and we are all going to die no matter what, this Covid-19 scenario does have some silver linings:

1. The world’s best minds right now are working on medications to combat this, and the usual 10-year timeline from pre-clinical, to Phase 1, Phase 2a, 2b, and Phase 3 clinical testing, followed by an FDA review panel, will be shortened down to something like a month or two (even if this medication offers the most peripheral clinical benefit, there will be a massive placebo effect that will have a real psychological benefit);
2. I’ve read mixed messages whether Coronaviruses naturally fade away in the spring (as does typical flu season bugs, noting this analogy does not directly apply), but if so, we are approaching it;
3. Most people that get Covid-19 exhibit mild to no symptoms.
4. Even those people that do get really bad symptoms have significant risk factors which would suggest their vulnerability (age 65+, heart/lung conditions or diabetes, but in any instance, it involves people with reduced cardiovascular/respiratory capacity) – these people are the ones that should be really, really careful;
5. And yes, the vast majority of us (we are talking 99.9%+ of the world population) will survive this, and even those that get Covid-19, around 98% or so will survive it, and over 99% if you get it and you’re under the age of 60.

However, we all look at these diagnosis/death curves of countries that are currently in full-blown panic mode (Italy being the prime example) where 3,000 people daily are getting confirmed with COVID-19; and coupled with a massive media attempt to instill panic and fear about how everything is all going to hell – cancellations, toilet paper taken off shelves, and just generally nutty behavior resulting from snapshots of the most extreme of extreme actions taken by people.

I’ve had to shut off or very purposefully moderate my own digestion of mass media news on Covid-19 because it is very difficult to mentally process everything that is getting thrown out there – there is just too much sample bias, and fake news, and the like. It causes panic and emotional feelings are precisely the opposite of what makes for good financial decision-making in the markets. Complicating the matters, however, is that one has to have a good pulse on the emotions of others in order to optimize these financial decisions – if you know that panic will spread even further, then it is rational to wait until that point to dive in.

Usually the VIX is a reasonably good barometer of this.

A comment on media, especially social media. Media invokes a process of social validation. When enough people see something enough times (gotta buy toilet paper!), they tend to believe it, and their behaviour changes in accordance with this, and this in itself is enough to cause a change.

My own personal n=1 sample (and also selection bias, and first-hand bias), you’d think that going to Costco it would have been a zoo, but going to the local Costco today, a Sunday at noon-time, things were shockingly orderly, the guy at the front gate gave me a lysol wipe to wipe down the buggy, and there was toilet paper available (which I did not buy), and the meats and vegetables were all there, and at the shopping exit, I was so shocked that the cashier’s assistant actually helped me unload the cart onto the conveyor belt. What the heck? You’d get the impression that there would be lines and lines to get in, let alone in-and-out like going through a McDonalds drive-through.

About the media – there is no way to build societal resilience against media-induced panic unless if you have a very centralized (read: government controlled) grip on the media, or the population has the mental capacity to consume it wisely (let’s face it – that’s definitely not happening).

This is probably how China and Singapore managed to get a good grip on Covid-19. Particular in the case of China, they didn’t mess around and just shut off everything for a period of time, turned on the mass censorship, and have the enforcement mechanisms to severely punish those that are non-compliant (i.e. lock them up somewhere). Singapore has the same mechanism – if you’re caught, you face severe penalties.

More democratic societies like South Korea and Japan also fared fairly well, but their societies have a certain variety of cultural immunity by virtue of being more collectivist, in addition to having to deal with things such as SARS and the like. They also seemed to be much more prepared in terms of medical protocols in place (for example, South Korea’s testing regime was very aggressive).

China right now is trying to figure out how to use this to destabilize the rest of the western world (as evidenced by the ‘we’ll withhold medical supplies if you forbid Huawei 5G equipment’, and of course the conspiracy theories affirmed by their diplomats about how the USA sent the Coronavirus to China). They’re playing with fire.

I have seen more emails from organizations about Covid-19 than I have ever seen about any public issue before in my lifetime. Organizations that you wouldn’t suspect that would be sending out such mass public emails are sending them, informing the public of what their strategies are. It is very unusual. Just as I was writing this post, RBC sent out an email saying “COVID-19: How RBC is helping our business clients”. This is about the 15th public service announcement I’ve received on the matter from various third parties.

In terms of the world economy, we are seeing borders being shut down. If any companies you own are depending on international trade, there will be exposure, but for the most part, it is people and not goods that are being prevented from crossing borders (this is the case in Canada/USA – I have no idea what’s going on in the EU). The USA is domestically a self-sufficient country in terms of its natural resources, and if it didn’t export a good chunk of its manufacturing capacity abroad, it would also be self-sufficient in terms of manufacturing (which could indeed be ramped up with time).

East Asia is also on high alert, but appear to be mostly through it.

The big geopolitical implication of Covid-19 is likely a forced acceleration of the rollback of globalization to some extent, and this will strongly affect international trade, at least in the short term. Countries with strong domestic economies will fare well (the USA should survive this well). Countries that have significant dependencies will be impacted. Canada, by virtue of having a huge shared border with the USA, should be able to piggy-back on the USA’s fortunes, but this is in spite of the tremendous incompetence we’ve seen in our government to date, rather than because of it. God forbid if the Russians actually invaded us.

What will we expect to see in the next couple weeks? More diagnosed people with Covid-19, more deaths, and more bad news from the media.

However, life will eventually have to return. People will have to go to work. The threat of the USSR launching nuclear missiles on us will be omnipresent, and just like that, the threat of Covid-19 will be accepted as an everyday risk in life, similar to a risk of getting run over on the street, getting cancer, or some other tragedy. The transition will require a change in psychology to get there, and when the media shifts, it will be fairly obvious when it occurs (and the markets, which have priced in this hysteria, will undoubtedly be lower than a 75-value VIX). But right now, panic is the big story. If you don’t get cleaned out on a margin call, at least in nominal dollars, you should do well.

Parameters for investment:
1. Avoid cross-border international exposure
2. Avoid domestic companies that do not have demand destruction (e.g. hotel REITs)
3. Avoid companies with short-term maturities/liquidity risk/covenants
4. Avoid oil producers (for now) – they’re going to get totally gong-showed in this one-two-three knockout session
5. Avoid “people-sensitive” industries that rely on foot traffic (retail, hospitality, sporting)
6. Consider: anything that would be the recipient of government stimulus spending
7. Consider: companies with recurring revenues (creativity software in particular comes to mind, e.g. I would think Autodesk/Adobe would do reasonably well, but these are the largest of large-cap examples)

Stay solvent!