I wrote just yesterday that neither Scott nor I are journalists (although Scott is 10x the writer I am). It hit me up early this morning that I should write down all my bullet points before I start writing a blog because, otherwise, I blab on and forget some important points.
I did just that four days ago highrockcapital.ca/pauls-blog/new-lows-for-deutsche-bank
when I wrote this blog.
I totally forgot to write about the main reason DBK (Deutsche Bank) is getting hit so hard; the US DoJ has asked for a U$14bln settlement for mortgage fraud relating to stuffing crappy mortgages into Fannie and Freddie Mac (Federal agencies, like our CMHC).
I was having a discussion last night on the way out of the office with one of my office mates (and an extremely successful investor that I share a fair bit of research with). His view was that the DoJ will settle for far less than $14bln. DBK has only provisioned for $5bln in a settlement. I sort of agreed with Robert at the time but then when I got home I re-thought that position after a bit more reading. Here is a list of what some US Banks settled on for the same issues:
So, as you can see, two former Investment Dealers (pre-crisis), being Goldman and Morgan Stanley (they are both now banks), settled for about $2.5bln each but the big banks all settled for either side of $15bln. So is it unrealistic to think DBK will not be hung on this $15bln number? Why would they get to settle at $5bln? I don't know the specifics of their transgressions and the extent of their fraud vs JPM, Citi or BofA, but they were.there and they are a big bank. Precedent has been set.
I will need to highlight that precedent to Robert.
So the concern over DBK builds that this settlement holds, they bust their regulatory capital ratios, they need to raise equity capital, that the new bail-in regime (that I have written about before) takes hold and completely dilutes shareholders, and they start losing access to capital, which is integral for every financial company out there. Yikes, sounds draconian.
I do think there may be some systemic risk and contagion but I do not think there will be a "Lehman Event" and a decent-size sell off should be bought.
Finally, the blog I was going to write 3 days ago. Don't get too excited, it's really not terribly technical in nature; more our observation about human investing psychology...but it is vitally important to your financial health.
As I have written a fair bit, I have been trading and investing securities for a living/income my entire professional career (I have never collected a commission cheque) and there is one thing I know I do, constantly; that is, search for the reasons why the market (or an individual security) is going up or down.
When the market is going up, most people seem to coast, focus on other things, go to the beach, go golfing, fishing...whatever past times you may enjoy. When the market is going up, most people get too complacent and sit on their thumbs..."nothing to worry about". But boy oh boy, when the market gets smacked upside the head, we all sit up straight and start Googling like crazy. "What's happening? Why is the market getting crushed?". It is like a frenzied search for information...like some journalist, who has no capital markets experience, but has a BA in Journalism, will have the answers for all of us.
I am in a bit of a different role managing money at High Rock so I do that every waking minute whether it is acute moves, up and down, in government bonds, currencies, commodities, or individual stocks and corporate bonds. "Ear to the track".
So two things we notice when the overall market goes through weak periods (like Jan-Feb earlier this year) are:
We have a fair bit of history/data on both of these events occurring and their timing. It is quite remarkable.
And this is where human investing psychology comes into play. Transferring your portfolio from an Investment Advisor to a Portfolio Management company, like High Rock, when the market is down is analogous to selling a stock or bond when the market is down. Think about it; shouldn't you make that decision and protect some of your profits when the market is up? Why wait until you see losses develop in your portfolio?
And, quite frankly, you shouldn't need to ask the question "why is the market going down?" much at all if you have a well-constructed, diversified portfolio. That is the ironic part...if you find you get "nervous" when the stock market drops, you probably do not have a well-constructed, diversified portfolio. For instance, over half of the client portfolios that transferred in to High Rock the past year had Zero in Fixed Income. If it weren't so sad, it would be funny. No wonder those folks were nervous when the market dropped. I have taken a lot of risk during my investing life but a 100% Equity Portfolio would make me very nervous...especially right now with stocks at or near their all-time highs.
For me personally, and you can ask Scott or my wife, I get more nervous when the market and my portfolio is up...strange, I know but hear me out. First of all, if the market runs up hard, there is inherently more risk in it...isn't that the time to take stock and question how it is that you made all of that money? This is when I look at the risk we are taking...what is working and why, is it specific securities that are working or is it just "the market" and we lucked out? When the market is coming off, I am less nervous...more excited actually, as it provides buying opportunities on stocks and bonds I have worked on and like, but at lower prices which creates a valuation I think provides a better risk-return skew.
Isn't this the time to take "stock" of what's in your portfolio and...go golfing? Let us worry about why the market is dropping.
Once again too busy to write about the blog idea I wanted to write about yesterday. Dare I say, tomorrow? Like yesterday, there is something more important to write about.
OPEC just came out with a statement that claims they will hold production at 32.5mm bbl/d which is about 1.2mm bbl/d lower than they were producing in Aug/16. Some commodity analysts I get research from have already said that oil could be in deficit in mid-2017. Who knows? Don't forget, we are talking about OPEC after all and there is sure to be just a snick of cheating in the black market.
In the meantime, oil has surged about $2/bbl or about 5% and related equities in Canada that we track/own are up 5-15%.
Two things form my view on oil/energy:
With regards to our energy exposure, we have no direct exposure in the actual Fixed Income model, small indirect exposure in the Global Equity model but we do have some good exposure in the Tactical model across some high yield bonds (some of these we consider Tactical, not Fixed Income, to be more conservative in our risk management) (one has almost doubled since we bought it) and some common stock.
And our overall energy exposure needs to be put into buckets: 1) Oil producers, 2) Nat Gas producers, 3) Oil Field Services companies and 4) Drillers (we don't own any drillers as of yet).
Our high yield energy bonds are significantly less volatile than their underlying equities. For instance, a typical Canadian Exploration and Production Energy company's stock might be up +15% today (we own one that is) while its underlying Senior Unsecured high yield bond might be up 1-2%. May not seem great for the bonds but don't forget, that knife cuts both ways too...when the stock is down 15%, the underlying bonds may only drop 1-2%. Therein lies some of the beauty of high yield bonds...we collect a pretty big coupon each day we own the bond which seriously dampens the volatility...and in some cases, you can even make a double!
Past performance is no guarantee of future performance in a portfolio or individual securities.
I was meant to write today on human psychology and the comfort we all feel when markets, and portfolio values, are going up, however, I got tied up with the most complicated excel macro I have ever used. A friend of mine in Miami, who I had coffee with in Toronto late last week, was gracious enough to share a possible trade idea, along with his research. I spent the entire day on it and probably have 13 more days to go but something hit me up that I forgot to mention last week on BNN (and just now on our weekly webinar...my mind was cluttered with this macro).
I mentioned on BNN last week that we had taken some profits in our longer-dated (10yr and 30yr) gov't of Canada bonds. We have had a great call in them the past year and what really drove my decision was that bonds and stocks, which usually move in the inverse direction (ie if stocks rise, bonds, which are seen as a safer instrument, fall in price) have been moving in the same direction for the past month or so. And it is getting rather extreme, in my opinion. See the chart below which shows the S+P in White and the US 10yr yield in Green. The bottom half of the graph is the correlation between the two (inverse due to the fact I am using yield on the 10yr). One would need to go back to 1999 to find a tighter correlation between the S+P and the US 10yr yield.
Part of the reason for owning long-dated government bonds is to provide a "flight to safety" if stocks and other risk assets melt. Not sure we own 30yr gov't of Canada bonds at 1.63% to make much in the way of yield...we own them in case risk assets (stocks) get hammered hard or, more importantly, deflation raises its ugly head. When I see them moving in the same direction, it makes me somewhat concerned.
So I can tell you that we took some profits when this correlation began to tighten up about a month ago, we bought some back at lower prices and now we sit. We are still holding less weight than before this correlation started tightening up a month ago.
I suppose part of the reason why this is happening is quite simply that, as I said on BNN, easy monetary (money) policy is driving all asset prices higher...stocks, bonds, even houses in Vancouver. And as the guest who was on BNN right before me last week, my former colleague and friend, David Rosenberg said, (paraphrased as I did have to go in for make-up when Rosie was talking) "it makes more sense to be investing in more idiosyncratic risk (commonly referred to as alpha) than the general market (commonly referred to as beta)".
So that is where High Rock is taking well-researched risk in our client portfolios...in our Tactical Model which is a model of certain stocks, bonds, convertible bonds and preferred shares. Coincidentally, that is why I spend large parts of my day doing research to support these investments. It is also no coincidence that the Tactical Model is where a large part of our performance year-to-date has been generated. (As I say to my three sons, "hard work pays off"). We will continue with this overall portfolio strategy until the correlation breaks.
If you want to know more about our Tactical Model...call me. It is not for public consumption.
When the market comes off, everyone looks for reasons why. Interestingly, no one seems to ask when the market is going up. I have views on this too but will save for another day...perhaps tomorrow. For today, there is something more important and interesting to write about.
Deutsche Bank (DBK) has fallen to fresh new all-time lows at E10.65/share. That's right, it took out the low from the credit crisis in early 2009. Wonder what happens when it hits single digits?
And to double-check on the weakness of DBK stock, we also track DBK Credit Default Swaps (CDS). I have written on CDS before but know that as the spread moves up/wider, it is a sign of weakness. Again, CDS is a credit derivative instrument that is traded by Institutions and used as a form of a "hedge" on the credit worthiness of the issuer, DBK in this case. Note how DBK CDS is moving wider but has yet to take out the high's from earlier this year. Worth keeping an eye on, for sure:
Why is DBK getting monkey-hammered the past few sessions?
Who knows? I don't exactly spend my days doing fundamental research on large global banks (I do spend my time doing fundamental research on much smaller Canadian companies where I feel we have a competitive advantage). What we do know is that this is a big bank and like all big banks it is bigger today than it was in the years leading up to the credit crisis. What's in there, I have no idea but I bet their is plenty of toxic assets:
Scott has written plenty on part of what has been driving stock markets higher the last number of years, aside from the obvious, which was clearly reinforced yesterday being easy monetary policy from the Fed and other central banks; those being, share buybacks and dividends. Both of these come at a cost to future earnings. And when investors buy a stock, they buy a future stream of earnings that get discounted back to today to determine the present valuation on that individual stock.
Think about it. If a company increases it's dividend or buys it's own stock back, what it is really telling investors is, "we have no other use for our capital right now so we are going to give it back to you in the form of dividends and share buybacks". Capital expenditures (capex) is what companies usually use Operating Cash Flow (OCF) for...ie...to re-invest back into their business for the future. Growth companies typically do not pay a dividend because they firmly believe the best use of any OCF, if they even have any, is to re-invest in their business. Mature businesses are more apt to pay a dividend.
So let's look at Microsoft as an example of a mature business (at least I think it is but who knows, maybe they still consider themselves a growth business?) who has been doling out the cash to shareholders hand over fist. And the reason I use Microsoft as an example is because Tues Sept 20, 2016, right after the 4pm stock market close, they announced a $40bln share buyback over the next year. That works out to about 10% of their outstanding shares. Now what really hit me up was, Microsoft just issued about $20bln in corporate bonds in early August. So they increased debt by $20bln to buy back $40bln worth of stock....is that called increasing leverage?
Whatever they are doing seems to be working. Here is the stock chart:
Part of what is working is the increasing of Dividends:
And another part of what is working is share buy backs:
But to accommodate the stock moving higher through increased dividends and share buybacks, something is also increasing, and it ain't always good - Leverage. Defined as Debt / Ebitda (cash flow), leverage has been increasing rather substantially:
So there you have it, Microsoft is increasing leverage (debt) to pay dividends and buy back their own stock. Leverage, as you can see from the chart above, has increased by almost 3 times over 2yrs (from .7x leverage to 2.0x leverage). Coming from a long-time credit Portfolio Manager who has been modeling and looking at credit metrics, like leverage, for 20 years, 2x leverage is getting up there. Heck, at High Rock in some of our BNS-managed High Yield Bond Funds, we own some high yield bonds where the credit metrics are less than 2x!
But hey, the stock keeps going up. And guess how Management get paid? Ya, it's usually via stock, not on how low they can keep their leverage.
What will kill the music?
Late last night the Bank of Japan (Japan's central bank, the BoJ) came out with their much-anticipated monetary policy decision. As I wrote on Sept 9th here highrockcapital.ca/pauls-blog/what-the-ecb-said-or-didnt-say-yesterday-and-peak-central-bank-liquidity central banks have hit peak liquidity. That is to say, further stimulus is having diminished marginal returns.
So last night, the BoJ came out and left their o/n rate unchanged at -.10%. There was hope by some that they would in fact go even more negative, but they didn't. What they did offer the market, or Japanese banks, was market control/manipulation of the yield curve in the 10+ year part of their government bond market (JGB's as they are called).
Their goal, apparently, is to steepen the yield curve so that Japanese banks, which have been battered by a flat yield curve, would have some reprieve. You see, banks typically fund themselves (take in deposits) in the very short part of the curve (o/n to 3 months) and lend in the longer part of the curve (5+ years). When the yield curve flattens substantially (long rates drop more than short rates) it hurts the bank's net interest margin. And central bankers know that having a strong banking system is integral to economic growth and stability.
What has happened to the JGB yield curve since their announcement late last night? It.....flattened more. Funnily enough, short rates went up by about 4-8bps while long rates went up by only about 1bp. The exact opposite of the BoJ's intentions. Why? Central banks are nudging up to their limits and are throwing all kinds of wet noodles on the wall to see what sticks. Tough to see below but here is the one day change in the entire JGB curve with the dark green being today's curve and the lighter yellow being yesterday's curve. Note the boxes below with the change on the day in the white box in the front end of the curve and the same in the purple box for the longer end of the curve. Not exactly the BoJ's desired policy effect.
So the BoJ may have, for now at least, failed in their goal to provide relief to their banking system. Clearly they continue to fail at resurrecting growth and inflation. That, combined with the highest debt load vs GDP ratio in the world means fiscal policy is not an option.
What does this mean for us at High Rock? As I mentioned yesterday on our webinar, we have lightened up and taken some profits in our 10yr and 30yr Government of Canada positions that we added to in the Spring (they worked very well). As per that Sept 9th blog I wrote above, something changed the past few weeks now...government bonds are trading 1:1 in lock-step with other risk assets like stocks. We will not add to our long bond exposure until we see that 1:1 correlation break and resume its normal relationship.
And of course, we have the FOMC ending their two-day meeting today at 2pm. I will be on BNN at 3:45pm for five minutes with Catherine Murray and I am sure that will be the topic of the day for her.
Right at the beginning of this year, you will recall that the global stock markets and other risk assets got smashed pretty hard. There was some concern that China was devaluing their currency, the offshore yuan. The yuan is "pegged" to the US$ which means that the People's Banks of China (PBOC) keeps the value of the yuan against the US$ in a very tight band.
For many years (over a decade), G7 countries have been putting pressure on China to revalue the yuan stronger. This would enable China to import more goods and services from the US and other nations around the world as, with a stronger yuan, it would make all of those goods and services cheaper for Chinese buyers.
But first, I will make a statement about the options open to policy makers (both politicians who control fiscal policy and central bankers who control monetary policy) to help get their respective countries out of the stagnating nature of the post-credit crisis debt-laden economy:
Lets just deal with (1) for now. Have a look at what China did to the yuan in Jan and Feb of this year. They allowed the yuan to weaken against the US$. (The chart is US$/Yuan so a higher line is a stronger US$ and a weaker yuan). So this was the start of China entering the currency devaluation wars, along with every other nation on earth, save for the USA. Note the up-arrow in Jan/16. The fact that China decided it needed to enter the currency devaluation wars was a signpost to us that the Chinese economy was weaker than most folks thought.
Then we will look at China getting nervous about the pace of decline in the yuan. To "control" their currency's depreciation, they jacked up the o/n lending rates to "punish" the yuan shorts by making it very expensive to borrow yuan. Have a look at these o/n rates getting to 68%...that's right, you read that correctly. and look what is happening again with o/n rates in offshore yuan over the past few weeks on the far right with the red arrow:
And finally, look how nervous the stock market (and other risk assets) got when the o/n yuan rates spiked so high. Here is the ACWI ETF which is probably the best overall metric of the global stock market. It dropped about 15.5% over about a two month period. It obviously rallied back pretty strongly.
I wonder if we are in for another potential buying opportunity?
Does your Stock Broker/Investment Advisor/Financial Advisor (IA) need to call you before he/she does a trade in securities in your account? I am about to tell you why that is an insanely inefficient way to manage risk in a portfolio.
In mid-August, I wrote a series of three blogs that described, in a fair bit of detail, our High Rock Research Process. The last of these blogs can be read here: www.highrockcapital.ca/pauls-blog/archives/08-2016. (As I pull this old blog up, I am reminded of my injuries - which have largely healed a month on - but my precious bike is still not repaired and back in my possession).
Today, I thought I would continue this theme and tell you how we manage risk in our collective client portfolios (remember, at High Rock we manage our own employee portfolios exactly the same as our client portfolios). Also, it is important to note that High Rock is registered in Ontario, BC, Sask and Alta with provincial regulators as a Portfolio Management company which means we have the necessary licenses, based on education and experience, to manage money on a fully-discretionary basis...that is the key here and most Investment Advisors in Canada do not possess this license with their regulator, the Investment Industry Regulatory Organization of Canada (IIROC) which is a self-governing body owned by the Canadian banks/dealers themselves (believe me when I say the OSC sets a much higher bar on registration, oversight and compliance than IIROC does...bit of a pet peeve about it here).
I have been very busy the past few weeks initiating a new research file on a company that is proving to be somewhat complicated. That research was then put on hold as all hell broke loose in the global capital markets, as you are probably aware. So I needed to put my head down, swallow some pride, and make portfolio adjustments (Quickly!) to changes I saw in the market.
So how do we trade at High Rock when we buy or sell securities?
First, we (Bianca) runs a weekly report (as part of our Investment Committee Meeting) that tells us where every single portfolio is in relation to every single security in our model. As an example, I might say, "I want to have a 1% weight in XYZ stock". If we are only at .65% weight in XYZ stock then I will need to make a valuation and market judgement about whether to add .35% weight or wait for a better entry point. We do this for every security in our models so we know the risk at all times..
Over the past week, when I noticed changes in global capital markets (www.highrockcapital.ca/pauls-blog/archives/09-2016), we needed to move quickly on making adjustments in quite a few securities in every single client portfolio. And to do that, we have everything we need at our finger tips: every client portfolio, their risk weightings in every security and the weight to our desired models in every security. Then I go out and buy/sell in block trades (larger size) with some bank/dealer on the street, be it in a stock or a bond. Remember, all of this is possible because we manage money on a fully-discretionary basis. That is to say, we can trade in all client portfolios in an instant...as soon as I feel the need.
These block trades are an extremely efficient way for us to execute trades in our collective portfolios: 1) it is one phone call to one bank/dealer for one price and 2) we get better pricing on block size, especially in bonds.
Although we manage our Private Client portfolios on a Separately Managed Account basis (IE not a Fund) we do manage Funds for Scotiabank. They way we trade in the market between the Private Client accounts and the BNS Funds is exactly the same way though...in bulk. That is to say, we do one larger trade with the bank/dealer and then we (Bianca, again) allocate it afterwards across all accounts. So if we sold 25,000 shares in XYZ, Bianca will then allocate it across all clients, which is why our clients see odd sizes in their portfolios. It also helps that we are well-covered by all the major banks/dealers in Canada and some in the USA on an Institutional basis (the synergies between our Institutional and Private Client Divisions are not fully-appreciated but believe me, it is hugely beneficial, especially when dealing in bonds which are an Institutionally-traded market).
Any idea of how quickly we can adjust our portfolios by trading this way? The answer is; VERY. I was extremely busy reducing some risk in some areas, taking profits in some securities and adding some risk in other securities. All with block trades (more work for Bianca to allocate all of these trades but she is happy to do so). This type of bulk trading helps High Rock capture profits in the marketplace and adjust risk in a very efficient manner.
So back to my original question:
Part of the reason we started our Private Client Division was to get all the synergies of block trading in our own household accounts, especially in bonds.
There is a better way.
Something changed yesterday.
The ECB came out at their scheduled policy meeting and did the somewhat expected - they left overnight rates unchanged. All was good for the first hour after the announcement...then all hell broke lose.
The ECB has had a program of very unconventional Quantitative Easing (QE) in place for some time where they have been buying $80bln Euros per month of all kinds of corporate bonds from the banks/dealers on the street. This current program of QE continues until Mar 2017. Who knows what happens to it beyond then?
So what they didn't say was, what will happen after Mar 2017. their comments, or lack thereof, were all of a sudden taken as somewhat bearish, certainly for global bonds. I think the market was looking for a stronger signal that the QE program would continue beyond Mar 2017, and maybe even be expanded.
What we are seeing here is a peak in Central Bank (ECB and the Fed) liquidity for the global market place. And one thing we know is that equity markets have largely risen on central bank liquidity...how else do you explain it when we are coming on our 6th consecutive quarter of negative corporate earnings in the S+P and stocks are at all-time highs?
Here are two charts: first is the ECB's balance sheet vs the DAX (German Stock Market) and the second is the Fed's balance sheet vs the S+P. Note two things: 1) the ECB was reluctant/slow to use QE after the credit crisis and 2) how the two major stock indices in each zone have followed the central bank balance sheets higher.
Also note, in the case of the Fed's balance sheet and the S+P, (I have shown this chart before), is that the S+P hasn't done a ton over the past two years, other than create some sleepless nights for investors. Funny how the Fed's balance sheet hasn't expanded for two years either, eh?
So the things that have changed are:
We are adjusting our portfolios accordingly. To be sure, there will come a time again when bonds will provide a Flight to Quality (FTQ) bid for safety but I don't think it is right now. First we need to move off of this correlation to risk assets at 1:1.