Divestor – Page 201 – Canadian Finance and Economics

Moment of truth for markets

The S&P 500 is finally trending down after going through a monstrous rally:

This is getting very close to the prevailing trendline. If it breaks then most of the technical traders will take the index down further. What is most fascinating is that the longer term interest rates haven’t gone down over the past 10 trading sessions, which suggests that there has been a decoupling of the “risk-on”, “risk-off” mentality.

Thus, we could be entering into an environment where everything will drop, equities and bonds alike. The only safety will be in cash.

However, my gut instinct suggests that we’re going to get one more good market rally in the summer before a strong concentration in cash is warranted. Currently I am sitting in a 10-15% cash position after raising some money.

Patience and cashing up

There hasn’t been a heck of a lot to report in the markets lately other than the S&P 500 continuing its rise up as the perception of the recovery continues.

That said, I believe it is unstable and historical norms would suggest that if one applies a bit of regression to the mean that we’re probably closer to the inevitable local high than the local low.

This is exactly why I have been slowly unloading some positions as they have gone higher. I’m no longer in a net negative cash position, and the cash percentage will continue to increase as the market continues to increase.

A few other observations.

One is that the Canadian dollar is testing lows. They have traded very narrowly since the 2008-2009 economic crisis and they are at the low end of the range. With the perception of Canada being a commodity market and the perception that our interest rates are not going to be rising anytime soon, this may signal a continued decline of Canadian currency relative to the USA.

The other observation are about long-term bond yields creeping up:

I am not sure what to make of this. Certainly bond traders are adding supply to the market and dumping it into equities, but this is the classic “risk-on” type formula where you have anticorrelation between bond prices and equity prices. Right now equity and any non-fixed income assets are winning.

I look at the year-to-date performance which is still significantly positive and my gut is telling me to cash out and call it a day until rainier days hit the markets. This will continue to happen as markets continue to rise.

Trends in REIT spin-offs

Loblaws (TSX: L) a few months ago announced they were bundling their real estate assets and spinning them off into a REIT. They will retain control of the REIT.

Now, Canadian Tire (TSX: CTC.A) is doing the same thing.

I detect quite a bit of froth in this space.

Financial-engineering wise, this makes sense because the real estate assets are currently overvalued with very low cap rates for such assets, more so than the underlying valuation of the businesses in question (in Loblaw’s case, groceries, and in Canadian Tire’s case, retail junk).

It makes me wonder if an entity such as McDonalds will consider the same – the amount of real estate assets they have is not inconsiderable.

Markets are partying on – when will it stop?

Stock markets are reaching all-time highs. The S&P 500 is well beyond the peak it reached in 2007. Sentiment is positive, what can go wrong?

Please realize I am a horrible chartist and the trendlines drawn are merely approximations. However, over the past three years, the S&P 500 has seen three major periods of rallying and note the dates/values are approximate:

08/2010 to 02/2011 (6 months): 1,040 to 1,340 (+29%)
11/2011 to 03/2012 (5 months): 1,160 to 1,420 (+22%)
06/2012 to 09/2012 (3 months): 1,270 to 1,470 (+16%)
11/2012 to ??/???? (6 months and ongoing): 1,350 to 1,620 (currently) (+20%)

Given historical trends, this rally is about to run out of gas. The party will likely stop sooner than later, so be careful and raise cash.

Positioning for deflation

I’ve been doing some research on which sectors perform best under deflationary conditions.

Obviously, cash is first and foremost as it will generate a natural real return over time without having to do anything, plus the nominal return you get from parking it in short-term funds (the Bank of Canada short-term rate right now is 1%).

Long-term bonds of solvent entities also are a good investment during deflationary conditions.

However, on the equity side things are a little more muted. The only direct play which I know explicitly has taken a position on deflation is the Canadian equivalent of Berkshire Hathaway, Fairfax Financial (TSX: FFH). Prem Watsa was fairly early to the subprime mortgage crisis in the USA but was able to profit handsomely on it, and he seems to be early on the deflationary game as well. His company has also been significantly short on S&P 500 equity index futures which also resulted in their portfolio performance suffering losses they really shouldn’t have been suffering. So while Watsa is likely paranoid, inevitably if you believe deflation is going to hit the marketplace and still need some form of equity exposure coupled with fairly competent management in asset allocation, then Fairfax is probably a good meal ticket. Regrettably, it is trading a shade over book value and historically it gyrates around it so there is likely a better opportunity in terms of market timing.

Interestingly enough, Watsa was also quite early in accumulating his (via FFH) 10% stake in Blackberry (TSX: BB). It remains to be seen whether this will be a win for him.