Investoid

As I mentioned in my last post, the US Federal Reserve is under pressure from the financial markets to cut their funds rate by a quarter to half a percent. As a result of an increase in sub-prime mortgage defaults, higher risk debt issues are becoming quite illiquid. This has caused a credit crunch for some firms who rely on junk bonds and the like to finance their operations, while various hedge funds and purveyors of collateralized debt obligations are feeling the pinch from low prices and no buyers.

The fear is that this housing calamity is spreading to the rest of the US economy, thus affecting overall growth and strength in important areas such as consumer spending and business investment. A rate cut would not only spur on these areas, but would re-invigorate the credit markets. With inflation within (or close to) the Fed’s target range, they can afford to cut rates. So, why not do the ‘right thing’ and keep the economy going? In fact, with the market pricing in a half percent cut, wouldn’t keeping the rate the same just be punishing investors already spooked by the recent downturn?

Not so fast. Just because a sub-sector of the credit markets is in trouble, doesn’t mean that the whole system requires stimulus at this point. As this Financial Times articles notes, “this is far from the greatest credit correction of all time”. We are far from a wide-scale crisis at this point. Furthermore, I believe that in our financial markets one person or company’s pain is another’s opportunity. If credit markets are seizing up, it’s because the typical buyers aren’t willing to buy anymore. That doesn’t mean that the securities being peddled are worthless, just that they aren’t in vogue right now. But in these capitalistic markets there are always someone trying to get an edge. I suspect that many hedge funds and other large investment houses are re-pricing these phantom ‘AAA’ rated securities. In fact, there are several companies openly saying that this crunch will be good for business in the long term. Canadian banks also seem to think this is a good thing.

I’m not going to harp on about the Fed being in a moral hazard situation, but if you’re a Mad Money fan get Cramer to answer this: does he really think even a percentage point cut to the Fed rate will save people from losing their homes? Just because the prime lending rate goes down doesn’t mean that high risk rates will go down as much, or even at all. In fact, I would guess that such rates will increase, regardless of what the funds and prime rates do, because of the higher perceived risk of default. And if a person who’s in an adjustable rate mortgage whose teaser rate is about to end and his new rate will be prime + 3% or more, do you really think that a 100 basis point cut will really matter in terms of his monthly payment? Assuming that the person has a $200,000 mortgage on a 25 year amortization and had a teaser rate of 4%, they would have paid $1047 per month. Assuming their new rate is prime + 3%, then at current rates their monthly payment is going to be $1918, while their payment with a percentage point cut would be $1795. Either way, if the person wasn’t ready to pay 90% more in monthly housing costs, I doubt they’re going to be ready for a 70% increase either.

The bottom line is that capitulating to the financial markets desire for continuing cheap money does nothing to wring out the excesses currently in the system. By prolonging their existence, they are more likely to cause long term harm, as we have seen in Japan’s sclerotic economy since their own real estate bust. Because Japanese banks weren’t able to go out of business or even fully disclose their bad loans, the excesses were never fully brought to bear. Only in the early 2000’s did a special task force make Japanese banks own up to their bad debts. Despite their 0% interest rates for many years, their economy has continued to stagnate. I’m not suggesting that this is the only reason for Japan’s continued growth lag, but it is a contributing factor.

I don’t expect the Fed rate to remain at 5.25% on Sept 18, but I think there is a strong case to be made that it shouldn’t be reduced. If the board of governors decides to only cut by 0.25%, expect to find many bargains around the world that day.

The US earnings season is upon us, and corporate profit growth is expected to be markedly lower this time around. Expect it to be a volatile period: some companies will likely disappoint while others will go beyond expectations.

Right now US growth has slowed down considerably, meanwhile all sorts of inflation measures are running above central bank targets (in Canada and many other countries as well). The Federal Reserve is in a predicament: they cannot raise interest rates because any hikes will only worsen housing price (and related industry) conditions, but at the same time inflation is at its highest point in many years.

While some may view the good news in employment a positive sign, I believe that such hiring is primarily due to a lack of productivity growth. When productivity growth diminishes you require additional labour to grow operations, which increases inflation and depresses profits. To me, this is the biggest threat facing the US economy at the moment. While emerging markets can continue to leverage their cheap labour for some time to come, without a catalyst global productivity will eventually stagnate. The information technology revolution was the last great productivity boon - what will come next?

What does this mean for investors? For right now, long term investors have little to concern themselves with. The biggest issue they will face in the coming years will be geographic asset allocation, as emerging markets ride high growth while remaining relatively risky. Short term traders should be looking for companies that are going to blow out earnings expectations, both in terms of results and guidance going forward (a la RIM). Taking a look at the upcoming earnings calendar will help you decide what companies to take a deep look at. As I’ve talked about before, reviewing StarMine’s star analysts can help you with identifying potential earnings surprises.

While I’m no short-term prediction maven, I suspect the major US indices to remain relatively flat in the coming months, since most large caps will likely meet reduced profit expectations in the next few weeks. However, with so much private equity money still out there, expect smaller cap companies to continue to be buyout targets in the next few months. Technology will also likely continue to be a hot sector, basking in RIM and Apple’s strong performance.

Markets around the world have taken a beating these past few days as central banks have been raising interest rates and indicating that more increases are to come. This has spooked the markets, as investors have gotten used to having lots of liquidity combined with low interest rates.

The main reason that central banks have been raising rates is because inflation has been consistently running above their targets. In Canada, the Bank of Canada typically looks at the ‘core’ inflation rate (which does not include food & energy prices) to determine inflationary pressures. This measure has been above their stated target of 2% over the past few months, and as a result they have indicated that they will raise rates “in the near future”.

Inflation and higher interest rates usually signal a bad period of performance for the stock markets. The worst such example would be the 1970’s era of stagflation (low growth and high interest rates), when major indices in North America pretty much went sideways for the entire decade.

While it’s unlikely that we’ll see such high interest rates or inflation again in the near future, higher borrowing costs and inflation are not going to help the overall market. If higher inflation persists for more than a few quarters, then the overall market is likely to stagnate. But that doesn’t mean that all assets will go down or stagnate - in fact, some assets have thrived in inflationary environments in the past. Here are some of the asset classes that have done well in previous inflationary market cycles.

• Commodities: Things such as metals and base materials did quite well in the 70’s, since their rise in price was part of the reason that inflation was running so high. However, we have already seen a huge rise in commodity prices in the past 4 years, which this time around hasn’t led to widespread inflation. This is partially due to the fact that global labour supply has dramatically increased and thus offset the higher cost in materials. While demand may fuel additional increases in commodity prices, this demand could evaporate if the global economy begins to stagnate or even face lower growth due to higher interest rates.
• Gold: This metal has been the traditional hedge against inflation for decades. But despite the runup in price over the past few years, gold has not responded favourably to recent inflation news. Steve Forbes believes that gold’s price is more closely linked to US monetary policy instead of inflation, and his theories seem to fit the recent data. Furthermore, central bankers are not flocking to gold to hedge against currency fluctuations like they used to. Since gold’s intrinsic worth is relatively minute, this may be a class who’s time has gone.
• Real Estate: In the mini-recession of 2001-2 and the concurrent bear market, real estate started to take off due to lowering interest rates. In higher interest rate environments some real estate companies can still do quite well, due to their ability to pass on higher costs to their end users. Real estate has historically shown negatively correlated returns to the overall stock market, so it can be a good hedge against a market downturn. However, like many asset classes, real estate has had a huge runup in most parts of the world, and thus it might not have the same characteristics this time around. I think that well-run REITs in markets that are less cyclical can provide good rates of return in inflationary times.
• Utilities: Utilities in unregulated environments can do quite well in inflationary times, since they can typically pass along higher costs directly to thec consumer. Since utilities typically have little competition, they are under less pressure to keep price increases to a minimum when their costs go up. Private equity groups have been buying up utilities for this reason over the past year or two.

It’s possible that none of the above classes would provide protection against a global slowdown. But rest assured, there will be some type of asset that will be making big gains. There’s a concept called hot money, which means that investors in packs move their money around to catch the next wave of price appreciation. People early in the curve can make big gains, while others are leaving themselves open to big losses. I’m don’t advocate trying to follow the hot money, but understand that no matter the market at least one type of asset will be doing quite well.

I don’t know if inflation pressures will continue beyond the next few months, but it’s good to think about ways to diversify beyond what asset classes have shown strength for the past couple of decades in a low inflation environment. While people with 30+ year time horizons have less to worry about, others closer to retirement may have to look at finding their returns elsewhere if a persistent inflation environment becomes reality.

The Loonie has been hitting 30 year highs against the US Dollar over the past week. There are several factors contributing to the rise in the dollar versus the USD, namely:

• A stronger economy vis-a-vis the US, with our quarterly GDP numbers above 3% while their are lower than 1%
• A potential for higher interest rates in Canada, as our economy is facing core inflation above the Bank of Canada’s target rate
• An overall weak USD environment, with the greenback facing downward pressure against many major currencies

The appreciation of the CAD has implications for retirement portfolios as well as short term investing. There has been some debate as to whether you should think about currency fluctuations if you have a long term view (see this Canadian Capitalist post for instance). While I think it’s hard to determine where the currency rate will be in the far future, I definitely think it’s important to consider the current exchange rate in based on historical context and react accordingly, since there is a fairly high long term volatility in exchange rates.

For instance, I have grabbed the monthly average CAD/USD exchange rate data from UBC’s exchange rate service, from 1971 (when Canada started floating the exchange rate again) to present. As you can see in the graph below, the long term (10+) changes in the exchange rate are anything but steady. They wash out over time for certain periods, but it is definitely not the majority of the time.

The average absolute deviation in average monthly prices over rolling 10 year periods is 16%, with a standard deviation of 12%. The average absolute deviation in average monthly prices over rolling 20 year periods is 24%, with a standard deviation of 10%. This indicates that exchange rates can be quite volatile over the long run.

Despite this volatility, there is an interesting cycle that takes shape. We see a cyclical rise and fall in the value of the CAD over time, with a somewhat random periodicity. Nevertheless there is a clear floor and ceiling in this currency pair’s chart. As a result I don’t think we’ll see an ever-appreciating CAD against the USD. Beyond the technical reasons, I don’t see Canada outperforming the US economy in the long term, due to their higher productivity, innovation, and financial power. But there will be times when commodities have a higher value (like now), which will inevitably give us stronger growth for periods of time. Thus, I see this oscillating graph continuing in the future.

I think we’ll have a strong dollar for at least a little while, but I believe that at some point the trend will reverse and we’ll see a reversal of this trend. As a result I am looking at buying more US assets for my accounts in the near term, since I have a long time (decades) until I will require the funds back in CAD. At some point I will be able to sell my USD assets at a better exchange rate.

For short-term investors with risk capital, going long on the CAD over USD seems to be a pretty safe bet. I would wait for news days that favour the CAD, follow the trend, and close out your positions before the end of the session.

Note:Since forex trading is a highly leveraged game, I have abstained from investing in it as of yet. In time I will investigate it more, but at this point it isn’t on my radar.

The Bank of Canada is indicating that it will raise interest rates in the near future. While inflation has been running above the BoC’s target for sometime, so-called ‘core inflation’ is now also above their comfort zone. Any interest rate hikes will have at least some effect on the economy and the current bull market we’re in.

In general, interest rate hikes are used to slow down a strong economy by making the cost of doing business (and personal living) greater, thus impeding consumption and investment. The bank has a fine line to walk between slowing down growth and causing a recession, the latter of which occurred in the early 1990s when interest rates went quite high to tame inflation.

In the markets, the financial sector is the most affected by interest rate hikes, since it directly affects their bottom line to a high degree. Highly leveraged companies will also face increased costs immediately and/or over time, depending what type of debt structures they have in place (eg. revolving credit, bond issues, etc.).

Since it’s unlikely that the bank will increase rates more than 0.25% in the upcoming move, I wouldn’t change my medium or long term investment plans around it. As I said above, the financial sector is likely to incur some short term pain so there could be some good buying opportunities in that industry. If you’re worried that there will be an elongated period of rate increases, then look for interest rate-insensitive companies, and move into more stable, slow growth companies. If the economy slows, profit growth will as well which will affect higher P/E companies more profoundly.

I met up with my friend who’s a real estate investor in Alberta. He was bought out of the company he co-founded and is now looking to purchase 20 rental properties with the funds. He is still extremely bullish on the local market, and anticipates housing prices to increase at least 20% annually the next two years. He cites the extremely low vacancy rate (which is project to be 0.5% by 2008), continued low interest rates (and inflation), and the political stalemate over tough environmental laws nationally and globally.

As I’ve talked about before, I think the runup in housing prices has been largely based on fundamentals, although there is undoubtedly speculation in the markets. But I think prices will run into affordability issues soon, and consequently much smaller increases. One mitigating factor to this would be the onset of interest only or adjustable rate mortgages, which would fuel demand even more in the short term.

If prices increased 50% over the next couple of years, Alberta would have housing roughly more expensive than Toronto, which I don’t think is realistic in the short term. Plus, you have investors already diversifying out of Alberta due to opportunities elsewhere, like Saskatoon.

I also think there is some political risk of environmental and/or royalty legislation that could slow down, if not stop altogether, oil sands development. Many of the major producers are already complaining that high costs have forced them to re-think any future expansion. Indeed, one CEO lamented that he would not start the project they are currently working on today if costs were this high when they started. Additional costs could push many to re-think their expansions, given the current price of oil.

It will be interesting to see how the market develops during the peak summer months, which will be a good indicator if the market has plateaued or will continue its run.

I came across this great piece by Martin Sosnoff, who runs a $6 billion investment management firm.

Basically, Sosnoff is saying that with so much wealth in the world, that eventually the scarcity of profitable investments will cause deals to go south, inflation to rise, interest rates to go up, and all the market booms will come crashing down.

He uses several analogies from past booms and busts and points out that several of the signs are here today that could lead to a crash (flat yield curve, high liquidity, lots of people using leverage for real estate and other alternative investments, etc.).

It has definitely been awhile since we’ve seen a widespread global slowdown (I’d say the early nineties was the last major recession for most of the world). Since then we’ve seen corrections in various markets, from Asia and Russia in 1998 to North America in 2001-3, but nothing has really brought down the growth from around the world for a long time. We are at a high point of global interconnectivity economically and financially, which definitely is a precursor for a widespread collapse.

I am not sure whether there will be a precipitous decline around the world or not, but I think it’s wise to diversify your holdings accordingly. As I’ve said before, long term and high risk bonds are one of the worst things to be in, since their yields can’t go much lower before they bump into short term Treasury rates. I don’t think it’s time to put all your money into consumer staples and the like, but I would definitely take money off the table from your high risk investments like China/emerging markets, energy, etc.

We’re at an interesting point in the market right now. We’ve had four years of almost unabated growth, then had a mini-shock that has given pause to the markets. Where do we go from here?

I’ve found a couple interesting viewpoints on this topic. The first is this Globe Investor article, which talks about mutual fund net sales as well as overall market sentiment. The highlights include:

• This January/February period had the highest net sales for mutual funds in Canada ever. The last record was in 1997, right before the Asian crisis. Retail investors have historically shown the worst market timing, always piling in at the height of markets.
• There are lingering fears that the subprime lending market meltdown in the U.S. could spread to other sectors, thus dampening the economy and reducing corporate profit growth.

This article by Brett Steenbarger takes a more technical view of the state of the market. He uses historical analysis on the market put/call ratio and the volatility indicator to arrive at the conclusion that US markets are likely not headed for a major bear. He views this point in time akin to the market after a precipitous drop, when investors regroup and look for buying opportunities.

In addition to these viewpoints, I think that the US market in particular has a lot of support in it, due to the huge amounts of private equity on the sidelines looking for deals. One market commentator has viewed this as a “market-wide put”, since companies whose market valuation drops become takeover targets.

If you are a passive investor, then right now there’s little to do or worry about. If you’re an active investor, now would be a good time to look at equities that are a little more defensive with good yields and solid management.

China’s stock markets dropped substantially in the past 24 hours, and the global markets have taken notice. Right now, the TSX is down about 1.5%, while the Dow and S&P 500 are down just under 1%. I thought these drops would be a bit larger, but I think it demonstrates how optimistic investors still are about the unending growth machine that is China.

As the article indicates, the Chinese market and economy have been relatively volatile recently. With growth rates not seen since 1995, the Chinese government is worried about overlending as well as excess capacity.

Is this a buying opportunity for Emerging Markets ETFs, or for our indices as well? While this pullback is attractive, I’d be hesitant to buy on this drop. It could be a harbinger of things to come. I suspect there will be a relatively quick rebound, but I think that it’s prudent to wait and see if any other negative news comes out before diving in. Chinese stocks have had so much of a runup that there could be significant downside. Still, it’s worth keeping an eye on these markets and look for a good buying opportunity.

Fabrice Grinda has wrote a good article on the current state of the world economy, and its current implications on investment. Here are some highlights:

• The US account deficit is being primarily financed by China and the Middle East
• Asset valuations have reached historical highs as a result
• There is a potential for a major correction in the mid term unless oil prices go down or Chinese consumption (as a percentage of income) goes up

I agree with most of his analysis, but I do think there are possiblities that could affect his potential outcomes:

• I agree that oil prices could stay high for an extended period of time due to demand, geopolitical instability, etc., but I could see prices being dramatically reduced if China’s economy overheats. With so many entrepreneurs attempting to capitalize on China’s growth, I could see a scenario where overinvestment leads to a stagnation in their economy.
• It is possible that some Middle Eastern countries will shift their wealth out of the US for political motivations, which would affect the fiscal balances around the globe.

Assuming that Fabrice’s scenario plays out, what does this mean for regular investors? First, the TSX (with its high energy and materials weightings) is likely to continue to do well. Secondly, yields on bonds, REITs and the like will remain depressed from historical levels. On a risk-adjusted basis, many of these assets will be inferior to short term government t-bills. Third, it will make sense to take profit on investments if they’ve appreciated to a point you feel they are fully valued or overvalued. Lastly, do not chase the current ‘hot sector’ with a material amount of your portfolio. If you’re looking to juice your returns with some exotic investments, then by all means if you feel comfortable with such risks, go for it. But as long as this global fiscal imbalance continues, there is a good probability that things could blow up on you. Keep the majority of your investments in solid long term assets.