There has obviously been a lot of volatility the past two weeks in all capital markets so I thought I might take just a moment to look at the stock market returns around the world (in C$, although it looks pretty much the same in U$) on a year-to-date (YTD) basis.
I have shown this page (taken from Bloomberg) before in a blog back in Sept/17: highrockcapital.ca/pauls-blog/things-i-wonder-about-my-shortest-blog-ever and today will be the same...short.
Without delay, here are some major stock market indices around the world with their return (excluding dividends so not Total Return) for the YTD and in C$ in the last column on the right side:
Notice anything here? You don't need a CFA to find the outlier. That's right, the Canadian stock market is fairly deep in the red after only 6 weeks. The question of "why" is one I will answer with very little detail:
Here at High Rock, we have continued to limit our exposure to Canadian oil and gas stocks even in the face of what look like cheap/tempting valuations. Disciplined Investing. We are also being extremely selective with our Canadian equity investing in other industry sectors as well for fear that overall economic damage is being done that could lead to real economic weakness, which will continue to lead to further economic pain in Canadian stocks.
More red, less green is not what we are looking for.
I am terribly uncreative with titles on blogs but this may be one of my best (sad as it is).
Expanding on Scott's blog on Tues Jan 30th (highrockcapital.ca/scotts-blog/big-drop-in-stock-market-and-uptick-in-volatility-should-you-be-worried) I thought I would show a chart of the Dow on a daily basis so it is easier to see. Below is the Dow for the past four days (Monday Jan 29th thru to today).
On the far left, Monday represented the all-time high (until we make another all-time high because that is what US stocks do at least on a weekly, if not daily, basis!!) but Tuesday saw a big "gap" down where the Dow fell upwards of ~400 points during the day. And what Scott was referring to in his blog was whether or not the market will be able to "fill in that gap".
It is not uncommon for any market to "retrace" or partially fill in big gaps after big gap down days. So here we are on the second/third day after Tuesday's big gap down day. As you can see above, yesterday the market attempted right at the open to fill in that gap. Didn't quite fill it in but did so partially. And today it has tried again hitting about the same high as Wednesday but again not able (so far) to fill in the gap.
Filling in the gap is important because it demonstrates the strength of the overall market. And if you go back and look at Scott's longer-term chart, you will see that this is the biggest gap down we have had over the past six months. And if you look back even further, you will find this is the biggest gap down we have had since before the Great Recession (it is hard to see on a chart but I did look) other than a small (much smaller than this past week) gap down in May 2017.
So that is why it so important to see, at these high levels and after such enormous strength, if US stocks can "stabilize" at these slightly lower levels, recharge and shoot up higher and fill the gap. Or are they tired and the market has run out of buyers. Time will tell but we will mind the gap each day.
Gov't bond yields have pretty much gone straight up since Sept/17 with US 10yr Treasury Bonds (10yrs) at 2.00% in Sept/17 to today at 2.72%. And on days like today, with stocks getting pasted, gov't bond yields continued to climb showing a correlation that does not work in the balanced portfolio investor's favour (stocks down, bond prices down). So why on earth would I want to buy US Treasury Bonds?
First, 2yr bonds are unchanged on the day. This means the curve is actually steepening. When stocks get hit hard, the curve tends to do that as there is a "flight to quality" which means money flows into the front end of the yield curve (2yrs). And if stocks continue to get hammered, we will see the curve steepen a fair bit more. These 2yrs are the US treasury Bonds I will buy for us as they are the most protective in nature.
Second, 2yrs have also been hammered pretty hard lately rising in yield from 1.25% in Sept/17 to the current levels of 2.12%. And as I wrote in early Jan in a blog (highrockcapital.ca/pauls-blog/this-hasnt-happened-in-ten-years) we haven't seen this spread between the 2yr yield and the S+P 500 dividend yield this wide in 10yrs. Also, we are as close to the bull market trendline (goes back even further to 1981) in 2yrs as "damn is to swearing". And as I said in that previous blog, massive pension funds rotating out of stocks and into fixed income securities will be key. Hard to monitor this but a friend of mine at major Wall St firm tells me they estimate that about $70bln rotated out of stocks and into bonds over the last few sessions (month-end rebalancing). Also hearing that inflows into fixed income mutual funds and ETF's the past week has been the highest in 8yrs. See below S+P dividend yield (red) vs 2yr bond yield (green) again below:
Third, I just looked at a chart of US 10yr Treasury non-commercial (hedge fund types only) short interest. I have shown this before but basically what it reflects is the amount of contracts that are short in the US 10yr bond. Being short is a negative bet (sell at a high price with the expectation of buying it back at a lower price in the future). But the thing of it is, the market has not been this short 10yrs in over a year and before that...never. That is to say, last year at this time was the shortest 10yrs have ever been...ever. And the result was a quick move from 2.65% to 2.15% (yields down, bond prices up) in short order. So all those folks who were short got "their faces ripped off" (old trader-speak). See the 10yr non-commercial short interest below:
Fourth, Bob Farrell's (former Merrill Lynch's former Chief Market Strategist when I worked there) Rule #9 of Investing - "When all the experts and forecasts agree, something else is going to happen". Contrarian. If everyone is lined up positioned one way, who will be there to take the other side?
Time to buy some portfolio protection and, at the right time and the right ones, gov't bonds provide the most elegant, cheapest and easiest form of protection I can think of.
The pattern of all assets going up because the Federal Reserve Board (the Fed) has been increasing it's balance sheet since the credit crisis in 2008 from ~$800bln to ~$4.5tln continues to this day...for most assets. Stocks, investment grade and high yield corporate bonds and government bonds (and everything in between) has tracked the Fed's balance sheet higher since 2009. But something may be changing.
The Fed's Balance Sheet 101
The Fed (and just about every other central bank the world over) began this program of Quantitative Easing (QE) in 2009 as a way to stabilize financial markets. QE effectively consists of buying up bonds (and in the case of the central banks of Japan and Switzerland buying stocks as well) and other assorted fixed income instruments like mortgage backed securities, government-guaranteed mortgage bonds, government bonds, etc. The overall effect of these programs was to: 1) stabilize financial markets by being the buyer of last resort and 2) to lower (and keep low) interest rates (gov't bond yields) which help the economy by providing cheap money for borrowers. Goal met. The effect of all this QE is that the balance sheets of the Fed (and all other central banks) grew massively but so did all of the assets they were buying. Cause and Effect. And don't forget, the size of any central bank balance sheet is infinite...so much so that there is an old adage out there that states, "don't fight the Fed"...which simply means...they have a lot of bullets to get what they want!
The new news is that the Fed has now said, loudly and clearly, that their balance sheet will start to gradually reduce in size. This will occur with the Fed simply not reinvesting proceeds from bonds that mature or from coupon payments they get paid on from the bonds they own being reinvested. The overall effect will be a shrinking Fed balance sheet. How will risk assets (and non-risk assets like gov't bonds) respond to this gradual reduction in liquidity?
So far, risk assets have largely tracked the Fed's balance sheet higher. To be sure, there are lots of reasons for some risk assets like stocks to be moving higher the past year, such as: US tax reform, lower regulations, increasing earnings, synchronized global growth, a weaker US$, etc. But at the end of the day, we know that bonds lead all financial markets so it behooves us to figure out what bonds are saying with regards to a shrinking Fed balance sheet.
Gov't bonds prices (green line) began falling (yields rising) late 2016 on the back of the Trump election win. Stocks up/Bonds down - makes sense but are gov't bonds acting as a harbinger of things to come? And if we look at credit (high yield bonds in purple) we can see that high yield prices have climbed steadily for the past two years when oil hitting $26bbl knocked the stuffing out of all risk assets. HY bonds haven't started to roll over as of yet so still a positive sign for risk assets in general. Which leaves us to stocks (S+P in orange) and it sort of looks like a rocket ship taking off for Mars. The white line is the Fed's balance sheet which has been stuck around that ~$4.5tln mark for three years. As you look at this chart, keep in mind that I have "normalized" it so all of these asset classes and the Fed's balance sheet start 5 years ago at an Index starting point of "100".
So the keys to watch here are gov't bonds prices/yields for further erosion in price or rise in yields. It hasn't been a pretty 15 months or so for gov't bonds but again, it really depends where on the yield curve you are invested with 30yr bonds (which High Rock clients own) actually seeing their yields lower year over year. And then credit where we will watch high yield like a hawk (something I do every day anyway given we manage a high yield fund for Scotiabank). Remember - bonds lead.
You never know what an event will be that will sideswipe risk assets (if we did, everyone would know and it would all be priced into the market). The only thing we can do is predict the state of the market and how it will respond to positive or, in this case, negative news.
We get lots of folks asking, "when will this US stock market sell-off?" The answer is simple: "when it gets some positive news and doesn't respond positively". Simple eh?
High Rock Capital is extremely proud to announce that one of our sponsored athletes, Darren Gardner (from my hometown of Burlington , Ont), is on his way to South Korea to the 2018 Olympic Winter Games for Alpine Snowboard PGS!
First a word about exactly what this sport is because not many people know. Alpine Snowboard racing consists of riding a long, narrow board with a super heavy "plate" screwed into the top of it (hence some people call them "plateboards") and minimalist bindings that lock the heel in and snap down over the toe. The boots are made of hardshell plastic (just like a ski boot) but with a slight tilt forward. This looks nothing like a "softboard" that you would find recreational riders on or those who compete in Freestyle in the terrain park (the difference between Alpine and Freestyle is like comparing F1 to Nascar auto racing). As for the actual racing, they compete in two disciplines (although the IOC, in its infinite wisdom, did away with PSL for these games): Parallel Giant Slalom (PGS) and Parallel Slalom (PSL) where two racers go at once through a red course and a blue course and then for the second run they swap courses. PGS has the gates spaced further apart than PSL and so the racers use longer board for PGS and a shorter board for PSL. Racers need to go around "gates" that are "flag-shaped" without missing a gate or "busting" through a gate which would lead to a Disqualification (DQ...not to be confused with my favourite summer-time after-dinner dessert...shameless plug #1 for Warren Buffet and my brother-in-law Tim Scott who is in charge of Int'l Marketing for DQ). This is a timed sport (love events with a clock) and the top 30 combined times "make the cut" and go on to the "elimination" round which ultimately lead to the Final Four for a Big Final (Gold and Silver) and a Small Final (Bronze and 4th Place). It is all very exciting to watch. (Shameless plug #2 - my youngest son, Nicholas, is in his final year of highschool but has been racing competitively in this discipline since he was knee-high to a grasshopper so this is where my basic knowledge of Alpine Board racing comes from. Nicholas races in the NorAm Cup Series against these grown men, Olympians and athletes from as far away as Korea, Japan, China and Australia and so a couple of times each season he gets to race against Darren in a NorAm Cup race. I am obviously very proud of Nicholas but our family jokes that if he races against Darren that Darren has time to stop, eat a cheeseburger, and still beat Nicholas...that is how fast Darren is). And now armed with that basic knowledge, I hope you watch Darren compete in the Alpine Snowboard PGS event next month.
Darren's successes are too many to list but a few highlights are the fact that he has been Canadian Champion the last few years, the overall North American Champion the last 7 years and is now on his way to the 2018 Winter Olympics to see if he can reach the podium. You can learn more about Darren and all of his palmares here: darrengardner.ca/
Besides my son Nicholas being involved in the sport (and looking up to Darren in a pretty big way), you may ask why on earth we sponsor Darren given this is such a fringe sport that most people don't even know exists? First, the Wilkinsons/Gardners are old family friends from Burlington that now stretch three generations. Darren's mother Donna is a High Rock client of ours and his father Bruce is my Dentist (www.gardnerdentalgroup.com/) (shameless plug #3). Second, Darren, coming from good stock, is a great guy. Third, this fringe sport is brutal for funding/sponsorship. Given how fringe it is and how terribly uneconomic it is for the manufacturers and retailers (you can't go into Canadian Tire and buy this type of equipment) athletes like Darren don't even get free equipment from the manufacturers. And from personal experience, I can tell you that all of this specialized equipment is very expensive! Fourth, Darren has real potential here to do something special at the Olympics. Anything can happen but with the right focus and some cheering from Burlington, he has as good a shot as any racer coming out of the start gate. So adding all that up, High Rock decided a number of years ago to chip in and help Darren out with his significant expenses as he pursues his goal of reaching the Olympics. We couldn't be more excited and proud of his achievements so far.
I hope you are able to watch Darren compete (it might be at some unGodly hour given the time differential so maybe set the PVR). In the meantime, check out the slideshow of some very cool pictures of Darren (ok, shameless plug #4, I threw in 2 of Nicholas at the end from a couple of years ago as well. Nicholas's sole sponsors are: Mom and Dad) racing and training all over the world.
Go Darren Go!!
I have written a little bit (in our YE17 Letter to Clients and in blogs) and have also spoken briefly about it in some Weekly Videos (highrockcapital.ca/weekly-video.html) about why Canadian Energy stocks are suffering a lot more than US Energy stocks.
The bottom line is that there are serious headwinds at work that range from NDP governments in both Alberta and BC, First Nations, Environmentalists and the National Energy Board (NEB). I have no idea which of these forces provide the strongest headwinds but they all seem to contribute to the fact that our great country is increasingly stranding our hydrocarbons (oil and natural gas) inside our country where it is unable to be exported to other countries which would pay a significant premium for those hydrocarbons. All due to the fact, if this continues, that we will not have any new pipelines and LNG (liquefied natural gas) plants built in the foreseeable future. This lack of infrastructure leads to serious transportation problems for those hydrocarbons - hence, they become stranded where they were extracted.
First and foremost, I am not suggesting there be rampant development of oil and gas that go unchecked. Surely there is a happy median where development and the environment exist in harmony?
Second, StatsCan doesn't really say what percentage of our Gross Domestic Product (GDP) is related to Energy but estimates have it around ~23%. That is a big number.
As an example of just how dramatically the natural resources business has changed in Canada over the past two years, have a read here: business.financialpost.com/commodities/energy/b-c-is-now-the-worst-destination-in-canada-for-oil-and-gas-investors-and-among-the-worst-in-the-world-survey. It was just two short years ago when we would only look at investments in BC and Alberta believing them to be some of the best jurisdictions in the world for the development of natural resources. Not so much today. Shocking that so much damage can be done in such a short period of time.
So you get the picture...lots of headwinds in the face of energy development in Canada. So what is the result? Not so good. Below is a chart of the difference between WTI (US oil) and WCS (Western Canadian Select oil):
Top half - the orange line is WTI and the white line is WCS
Bottom half - the yellow line is the differential between WTI less WCS
The big gap up in the 4Q17 shows that WTI has risen pretty substantially the last few months but WCS has lagged in a major way showing the gap now out to $25 from $10 last Sept/17. The effect of this means that our oil and gas exploration and production companies (E+P) and all of the oilfield services companies (OFS - companies that offer E+P cos services like drilling. drilling fluids, waste management, transportation etc) suffer. Here is why - if producers can't sell their products at a higher price, they are unlikely to spend more capital on exploration (drilling) and production. So both the E+P companies and the OFS companies get hurt.
As you can see from the chart, there have been periods where the spread was higher but those were periods when there were "temporary transportation" issues. This seems different and the stocks of all these Canada E+P and OFS companies reflect as much. I think this spread can get a lot wider in the coming year. Not good for Canadian Energy stocks and not good for our overall economy.
This ain't good and this is a big part of the reason why we are shying away from Canadian hydrocarbon equity risk right now and for the foreseeable future.
Scott wrote a great blog yesterday (highrockcapital.ca/scotts-blog/wealth-management-what-are-you-paying-for-and-what-are-you-getting-in-return) on the fees that investors pay and what you get in return for those fees. I wanted to touch on two more line items on Fees and explain why the fees High Rock clients pay is lower than most other wealth management services.
First of all, there are typically two types of fees that an investor pays when they have their money professionally managed:
If you own any funds, you should be well-aware of the TOTAL fees you are paying and be sure to ask why.
As Scott said yesterday, our disclosure on Fees could not be more succinct. We have a short Introduction video to our Private Client division on our website (highrockcapital.ca/private-client.html) and around the 4:38min mark you will see our full-disclosure on the fees our High Rock clients pay:
1) They pay us 1.15% as a Management Fee (this pays our operating expenses like rent, systems, modest salaries, food and red wine)
2) We actually don't have to divulge but we go above and beyond the regulatory requirement and state the weighted average MER that our clients will pay at ~.05% (depending on which model the specific client is in). We actually hear from quite a few new clients that their Adviser said "calculating the MER you pay is too complicated". Really? It's a simple weighted average calculation and you have every right to ask for it and receive it within a day of asking for it
3) Total Fees Paid by High Rock Clients - ~1.20% (give or take a few bps depending on model)
In mid-December, I was talking to an Auditor from our regulator, the Ontario Securities Commission (the OSC), and I described to her how we fully-disclose our Fee structure and referred her to the short video above. She said, "Wow, if every Portfolio Manager in the country did that, it would make my job a lot easier". Maybe they should change the rules on fee disclosure?
So lastly, why is it that High Rock clients only pay MER's of about .05% vs other clients, who may have an Adviser "managing" their money, are paying about 2.00%? Simple - High Rock MANAGES money. We started out in December of 2010 as an Institutional Asset Management firm managing four funds for Scotiabank. Personally, I have been managing my household (and my parents) money since Day 1 of my investment career. And my investment career spanned almost 18 years at Merrill Lynch Canada where I was paid to trade securities and manage risk for a living. I didn't get paid a commission, ever. I did get paid a bonus based on well I managed the capital allocated to me and those who worked for me. Tooting my own horn here but...18 years at a bulge-bracket Wall St firm culminating as the Head of Canadian Credit Trading is a long time so I suppose it is fair to say I am a decent investor (probably not the world's best salesman so if you want one of those, you may not find it here). Point being, I am an investor, first and foremost.
Back to the low MER's High Rock clients pay. Given High Rock is an Institutional Asset Management firm, and I have been an investor my entire career, we have huge synergies at High Rock where we don't have to "farm" out our client assets to other Institutional Asset Management Firms. Would I really pay some mutual fund manager 2.00% to manage my money? Albeit some of them are excellent managers, no I wouldn't as I am fully-capable of doing it on my own and saving the 2.00% they would charge in MER's. So our clients own more individual securities (stocks and bonds) on a "direct" basis. Take C$ high yield bond exposure as just an example. We have the capability to buy our Private Clients the exact high yield bonds we want them to own on a direct basis and avoid buying a high yield fund, like AHY.un, that charges 2.00%. And suppose an investor has a 10% weight to high yield (reasonable) and they save 2.00%, then on a net-fee basis, right there they are saving .20% in MER's (10% X 2% = .20%). Now do that math for exposure to Canadian stocks as well...say you have 25% in Canadian stocks = 25% X 2.00% = .50%. Now you are saving .70% total on a net-fee basis. That adds up. The only place we truly need to use low-cost ETF's (we will never own a mutual fund here at High Rock) is to gain exposure to areas where we are not experts like: the Far East, Emerging Markets, Europe and even the USA...although we currently own and have owned some direct US stocks, I am not picking stocks in the Far East, Emerging Markets or Europe...way out of my area of expertise. Our investment process is based on fundamental research and although I do a lot in Canada, I do 0 in any of those other jurisdictions, so we use low-cost ETF's to gain exposure to those markets. And that might add .05% to the overall cost of a client portfolio...almost deminimus in my opinion.
To conclude this long-winded blog, you can watch the short video again in the link above and stop at the 4.00min mark and the 5:00min mark and come to your own conclusion. Take control because it really matters, especially over longer periods of time.
And remember, Scott and I manage our client money exactly the same as our own money so there is an element of clients "piggy-backing" on our portfolios. Be our guest.
The Toronto Real Estate Board (Treb) just released their monthly data for Dec/17 so I thought I would give a quick snapshot on what happened.
As a reminder, residential real estate is such a huge part of our economy that it matters when it comes to estimating economic growth (GDP), what the Bank of Canada may or may not do with regards to raising interest rates, the over-levered consumer, etc. And with new regulations from the Office of the Superintendent of Financial Institutions (OFSI) on mortgage borrowing/lending called B20 coming into effect in Jan 2018, this all matters.
We track, the City of Toronto (not the GTA) across Detached, Semi-Detached and Condos (Apartment style). Here is what happened month-over-month (mom) and year-over-year (yoy) in each housing category:
Conclusion - Supply of New and Active Listings for the month of December was obviously lower than November for seasonal reasons but, as we can see in all housing categories, the yoy supply was higher. The other notable trend here is that Condo dynamics are stronger than Semi-Detached and Detached and I think it is all due to affordability. And with new mortgage rules hitting up starting this month, this trend to more affordable housing will likely continue. Clearly public policy has had and will continue to have a major impact on housing across the nation. We still maintain that over longer periods of time (and perhaps different leaders in government roles) that the intrinsic value lies in Detached (and to a lesser degree) Semi-Detached; simply by virtue of the fact that there is huge supply in the Condo segment while there is completely static supply of Detached (and Semi-Detached) due to public policy in 2005 which will lead to scarcity value.
Welcome back from the traditional holiday period. We wish you and your families health and happiness for 2018.
As some of you may know, government bonds in North America (and around the world) have been rising (prices falling) rather quickly since the Trump election. Money has clearly shifted out of government bonds (arguably the safest of assets) in favour of stocks (arguably the riskiest of assets). But at some point, it makes sense to compare the relative valuation between government bonds and stocks to see where the risk lies.
To make that comparison, the simplest thing to do it to compare the Dividend Yield (cash dividends/share divided by $ price/share) of the S&P 500 (SPX) and compare it to the 2 yr US Treasury Bond Yield. In keeping with the "Holiday Theme", you will see those two compared in the chart below where the SPX Dividend Yield is in Red and the 2 yr US Treasury Bond Yield is in Green.
So, as you can see, this hasn't happened in (almost) ten years. That is to say, the 2 yr Treasury Yield is now higher than the SPX Dividend Yield. To be fair, before the Credit Crisis, that was normally the case but since the Crisis, it has never happened.
What does this mean? It means that government bonds are now starting to offer a yield that is getting competitive with regards to a return. At almost 2.00%, 2 yr US Treasury Bonds are going to start looking enticing for certain investors who have no choice but to invest in bonds, namely Pension Funds, and they are a very powerful force in both stocks and bonds. It also means that the SPX Dividend Yield is getting quite low due to the fact that Stocks are rising while Dividends are not rising nearly as quickly which creates a lower dividend yield.
And if we look at a 30 yr chart of 2 yr US Treasury Bond Yields, we can see the Red trendline that lines up somewhere around this 2.00% area (give or take) as you can see below:
Not sure how this all plays out but one thing to watch very closely will be the flow of funds into government bonds around these levels. Watching flows in the bond market is quite difficult as bonds trade "over-the-counter" (unlike stocks which trade on a public exchange). The only way to watch what happens is to talk to Wall St firms and get some colour on what these mammoth pension funds are doing...they are the key.
Two weeks ago, I came across an interesting article on how the 30 companies that make up the Dow 30 Industrial Average had an effective tax rate that, in many cases, is already darn close to the newly passed corporate marginal tax rate of 21%.
I had a meeting on Monday with this hedge fund manager from New York and we discussed this same topic so I thought I would show you a quick peak from an article in MarketWatch with Factset data. It shows the 30 companies and their median effective tax rate over the last 5 quarters (3Q16, 4Q16, 1Q17, 2Q17 and 3Q17). Here they are:
Hard to read, I know, so expand it a bit but here are some observations:
Well, we all know, from watching the US stock market rise to "newer-highs" on a daily basis as the two levels of US Congress passed their legislation...each day, the Dow would rise and rise. Clearly this tells us the market was building in the expectation of a corp tax cut. But when about half of the Dow 30 already pay an effective tax rate of the new marginal tax rate of 21% of lower, what's the big deal?
To be honest, these effective tax rates include state and local taxes paid as well as federal taxes and taxes in other jurisdictions outside the USA. The idea that these large multi-nationals have kept significant funds overseas due to lower marginal tax rates in those other jurisdictions vs the USA, tells us that they will likely repatriate some of those funds back to the USA over time. The repatriation of this capital from overseas could, over time, lead to capital expenditures in the USA that will drive cash flow, which will be taxed at a lower rate of 21% vs 35%.
The power of fiscal stimulus.