Category: Finance

Whenever I get confused, I always try to simplify my thinking to basic principles. Sometimes a little too basic, but the foundation of knowledge has to start somewhere. It is always good to refresh one’s knowledge and make sure one doesn’t descend into senility.

So we will get really basic. As in the core of accounting and finance.

Finance and accounting is akin to physics and mathematics.

Let’s do accounting first.

Accounting is governed by two simple sets of equations. One is that assets are equal to liabilities plus equity. The other is that revenues minus expenses equals equity (retained earnings/deficits). The retained earnings line is the linkage between income statements and balance sheets over time.

If you can apply this rigorously, the rest of accounting is a relatively simple exercise of check-boxing and making sure you apply IFRS properly for the billions of different cases (then write your CFE exam and get your CPA designation!). Fundamentally, however, the two sets of equations is all you need. Everything else is layers of complexity on top of more complexity. The art of accounting is translating the literal (what is presented) into the economic substance (the reality) and this is the component of accounting which requires subjective judgement.

Finance is the practice of converting cash streams into capitalized sums and vice versa. The formulas governing this is the conversion of cash flows to a present value, and the present value into a sum of cash flows. Everything you see trading on the stock market comes down to these two tranformations. The subjective judgement in finance is determining these cash flows and the discount rate to apply over the relevant time period.

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I am looking at my long-term CAGR number and my financial objective during the rising interest rate environment was to just keep things steady as the increasing discount rate would inevitably lead to a drop in capitalized values.

For the most part, I have succeeded. Not being an index investor, I was able to avoid negative returns in 2022. For the most part I have considerably de-risked things in the second half of 2022 compared to the second half of 2020.

However, matching my long-term CAGR number in the 2023 environment is going to be next to impossible. High amounts of conventional returns are not going to happen. In order to make outsized returns, I would have to make non-typical directional bets. This means there is an element of gambling, something I do not partake lightly without having the odds seriously on my side. Having a cloudy crystal ball is the opposite environment where I want to be pounding the futures market like George Soros did with the GBP back in 1992.

If I managed client money at the moment, I would have to be justifying an “I am working hard by doing nothing” approach to asset management. I would probably be losing clients’ funds going to greener pastures to managers that put their money into NVidia or Facebook/Meta (both up 89% and 71%, respectively).

One huge cost of twiddling your fingers is the impact of inflation. While in prior years the 2% or so deduction you make to calculate a real return is an afterthought, in the current environment, just earning 5% is not going to keep one’s purchasing power. Finance has turned into one gigantic minority game where the slice of real proceeds continues to get whittled away by the corrosive force of monetary inflation, thanks to our deficit-loving governments.

I have not encountered anybody as paranoid as myself in the marketplace. It is psychologically unhealthy (not to mention making me really bitter and anti-social) but it has enabled me to survive in environments such as those in 2000, 2008 and 2020. Unfortunately, it also has the psychological effect of giving me a huge amount of financial PTSD, prevent me from taking opportunities that I otherwise should have taken had I been more rational.

It leads me to a conclusion that one of the biggest risks that I have of future underperformance is not interest rates, macroeconomics, or the decisions of increasingly authoritarian politicians, but rather the state of my mental health.

If I go bonkers, I’ll end up clicking the wrong buttons on Interactive Brokers, and let me tell you, there aren’t a lot of safeguards to clicking incorrect buttons. Indeed, I think platforms like Robinhood and Wealthsimple intentionally make it really easy for their clients to tap on financially inappropriate things (options, ahem) and lose money.

I’ve put a lot of internal mental safeguards and also some analytical safeguards on preventing this, but to maintain this readiness, I need to have my mental act together.

I wrote an article five years ago about Physical Fitness, Mental Fitness and Financial Performance and this applies more than ever today. Each year of age transforms into one year of further mental degradation.

About a week ago, I ran in Vancouver’s largest 10km race. Although historically the weather has been quite good during these races, this year it was a characteristic Vancouver day – about 8 degrees Celsius and pouring rain. However, this did not stop me:

This matched, exactly to the second, my run time in 2019, which was my lifetime best to date. Perhaps in 2024 with more training I can beat it.

Hopefully this physical measurement can be a proxy for mental measurement. It gives me some assurance.

However, it is not sufficient. The key risk to performance is the inability to adapt to changing circumstances, and avoiding mental traps that enable investing in false narratives. It is something that we all must be ever vigilant as the market does not care about your mental condition. The biggest risk for my portfolio is my mental health.

Most of what I do in finance is self-taught and can be done safely in the confines at home instead of having to go to a university or some institution.

However, once in a blue moon, I like to try something different to get an idea of what may be out there.

IBKR was sponsoring this workshop by this active asset manager, which the name I will leave out. They were doing some tour presumably to promote their own actively managed funds, but the event was in the name of generating income through options and how they used IB’s trading workstation desktop software.

I was less interested in the fund and more on how they used TWS and also who would attend this sort of thing. Who knows, I might learn something. My hopes weren’t high.

Putting a long story short, this asset manager also takes client accounts and establishes long delta and short theta on index products, specifically on SPY and QQQ. They made it seem like voodoo magic. It appears their favourite trade is to buy bull put spreads and short call spreads deeply out of the money to harvest theta, but to actively manage the positions using very short term options (2 day, 4 day, in addition to the usual monthly expirations).

They showed a specific client’s managed account, which had approximately USD$2 million in liquidation value. The account also had $3.4 million in equities (mainly technology stocks), and it was also $1.4 million in margin. Apparently the client gave them a portfolio with a bunch of technology stocks and wanted to generate more income using options. The presenter claimed that because the maintenance margin on the account was well less than 10% of the net liquidation value, that the leverage employed was fine. In addition to all of the technology stocks, the asset manager had positions in what were a huge array of about 30 to 40 spread option positions, mostly on the SPX and of different temporal distribution. Some of these positions were hundreds of contracts, but many of the market prices of the options were less than 50 cents.

Their commission costs must be a fortune.

I also thought when it comes to tax time it must be a total nightmare to manage.

They explained how they were non-directional traders and were managing downside risk, notwithstanding the fact that when they viewed the SPX position on the TWS risk manager, they had a delta of about +2500 (that’s about $1M in notional risk, thus having some downside exposure), and all for a theta of about $1k (the time decay per day).

They made it seem like they were generating money from thin air.

Indeed, if you give me $2 million of client equity and sell deeply out of the money option spreads I can make you a thousand dollars a day – until the SPX decides to melt down one day when Vladimir decides to launch the missiles or something.

The presenter made it much more complex than it needed to be. The reason is that without the complexity, people would probably clue in there is no free ride in the derivatives market.

My biggest revelation was that about 200 people were in the room. I’m not sure whether this is a good or bad reflection on what is coming for the markets. All I know is that this style of trading is most definitely not for me and appeared to be gambling more than anything else, except in a veneer of using some needlessly sophisticated trades.

The fear over financial institutions is ramping up quite rapidly with Credit Suisse (NYSE: CS) next on the media radar for insolvency.

Pretty much every sector of the financial market is having a huge amount of supply pressure added to it, with the exception of gold commodity and long duration AAA debt.

Commodities, specifically oil and gas, are getting absolutely slaughtered over the past week, presumptively due to a forecasting of demand going off a cliff with the rest of the world economy.

Cash is an essential element in the portfolio – it just sits there and is generally disrespected until moments like these where it provides a layer of comfort.

Some surprises in this is that the CAD/USD is not lower than I would have thought given what is happening to fossil fuel pricing and the increase in VIX.

When central banks raise interest rates like they have, it was bound to cause some sort of financial earthquakes, but predicting where they hit is usually done only with the benefit of retrospect. The first casualty is improperly leveraged financial institutions. The spillover effects of this remain to be seen. Cash, however, is a good short-term defense.

Few appreciate liquidity until you don’t have it, and then everybody wants to rush out the exits – this is when you get price crashes.

With major US regional banks trading down significantly (examples: FRC, WAL, ZION, PACW) and with SI, SIVB and SBNY going into FDIC receivership, there will be some other consequences. I’ll write a few of them here:

1. The Fed is offering a “treasuries for par for one year” program. So if you were stupid enough to buy long duration last year, you’ve got a one year term grace period to figure things out – although inevitably your shareholders will have to choke on the loss (unless if the Fed really bails out everybody by dropping interest rates!). This can only be described as a time-limited QE action! However…

2. The yield curve has gone bonkers, with longer-term yields trading significantly down and the Fed Funds rates basically indicating one more quarter-point rate hike and that’s it:

3. Bitcoin and Gold have simultaneously received a huge bid, with BTC up +$4,000 to US$24,000 and an ounce of gold up $50 to $1915. There is obviously a huge pressure in the market for safety at the moment.

What is the big picture here?

1. A bank’s traditional model of riding the yield curve does not work very well in an inverted yield curve environment. The yield curve has been inverted for many months, and customers with zero-interest deposits are not going to be a stable source of capital if you’re running a bank;

2. The question of inflation – the central banks have a mandate to stamp inflation. This is also a function of what the BoC referred to as entrenched expectations of inflation. Ultimately the labour input function of inflation will get stamped down if we start seeing mass unemployment claims come to the fore. I’m suspecting that my prognostications of this happening in January-February 2023 (which I made later in 2022) are simply delayed – I’m going to guess we will see more of it coming, especially in the second half of the year;

3. “This can’t happen in Canada!” – the Bank of Canada in 2008 took considerable measures to backstop the major Canadian schedule 1 banks. The USA has JP Morgan, Bank of America and Citigroup, while Canada has Royal Bank and Toronto-Dominion as key global banks. While the stability of the banking system will be defended at all costs by central banks, whether equity/debt holders or not will take a bath is another question.

Let’s review the business model of a bank. Inherently it is a very simple business. You take deposits from customers and (usually) pay them for the right to hold their money for a time. Say your rate of pay is 2%. Parallel to this, you also lend money out to credit-worthy customers at a higher rate of interest. Say that you lend money out at 5%. In this example, for every dollar your are able to recycle, you get a 3% interest spread. Then you have to subtract all sorts of expenses relating to hiring staff, maintaining IT infrastructure, leasing branches across the country, etc., and after paying taxes on the residual, your shareholders make a profit.

Making a 3% interest spread is not efficient. To increase this amount, you do the procedure twice over – take in one dollar of customer deposits at 2%, and loan out two dollars to customers at 5%. You can do this because you have a deal with the central bank that if you keep a certain amount on deposit, you have a license to create money and leverage it off your net equity figure. If you can pull the 1:2 deal as described on this paragraph, then your effective margin is 6% on a dollar of deposits due to the power of financial leverage.

The magnitude of money you can earn is even greater if you raise a hundred million dollars in equity financing and use that to lend a billion to customers, which is typical for most banks.

Where does this blow up?

One is what happened to SI/SIVB/SBNY – the bank took their liquid customer deposits and dumped them into long-dated government securities which could only be sold for less than what they paid for it, coupled with the depositors wanting their money back, now.

The second mode of failure is if the customers you’ve loaned money to don’t pay back their loans. We haven’t seen this to any material degree (yet). However, if we start seeing defaults on construction loans in Canada, this might become material.

The third mode of failure is more subtle – for a prolonged period of time, you can’t obtain deposits from customers at a cheaper rate of interest than you can loan the money out for. This could happen if would-be depositors start to demand higher rates of interest, coupled with your customer screening division not being able to find credit-worthy customers to lend money to.

4. Financial companies in themselves do not generate wealth in an economy (i.e. manufacturing, farming, natural resource extraction, Netflix, etc.) but they facilitate it. Inevitably if the business that financial companies are financing are unprofitable, financing companies cannot be profitable by definition (businesses won’t be able to pay back loans). Companies that produce economic value, as measured by profitability, will survive this mess, while those participants that are forced to rely on low-cost capital will wither.

5. Hold onto your wallets, this will get pretty wild. I was originally thinking “sell in May and go away”, but perhaps I was a couple months too late with this prognostication.

More later.