My friend and former colleague, David Rosenberg (Rosie, as he is affectionately known), wrote a great article on Wed Oct 26th in the Financial Post: business.financialpost.com/investing/investing-pro/david-rosenberg-all-signs-are-flashing-this-market-is-late-in-the-game.
I don't mean to steal from his article but I wanted to simply add a graph, although a difficult one to create, to help explain one theme he talks about - the yield curve flattening.
The yield curve is commonly referred to as the 30yr rate less the 2yr rate. If we line the "2's/30 curve" up with recessions over the last 40yrs, we can see that Rosie is correct - the yield curve flattened before each recession.
Here it is with the recessions in hand-drawn boxes (sorry, it was hard to create any other way):
Now this is based on quarterly data but if we looked a the yield curve on a daily basis, we would see it bottomed out for this move at 141bps in late Aug/16 where today it is at 176bps (long bonds have been monkey-hammered this month).
Also note that the yield curve was way flatter before each recession and, in all but the 2008 recession, it actually went inverted (red parts on the graph).
So I would argue and conclude the following:
(Note that this is just one of many US recession predictors)
As I stare at this chart of the yield curve and past US recessions, I now realize that this topic will be my first one as Rosie and I meet for an overdue drink catch-up next Wednesday. Not sure what his explanation will be but I bet he has one. Unfortunately for him, I get far more benefit from our conversations than he does. Maybe I should pay for the drinks...?
Those were the only four words on a pair of 215 cm skis I had in late high school and University I ski like I manage money...I like to go fast and take some risks but try to always remain in control and do my research (of the terrain or the company) so I am taking calculated risks. That doesn't mean I don't fall down (skiing or investing), because I do. But when I fall down, I usually don't bust (myself or my portfolio) up too badly. Live to ski/invest another day.
So last night, my third son of three who is 16 years old and in grade 11, tells me that he and some classmates are doing the Lakehead University Stock Challenge. They are allocated a certain amount of fictitious capital and can "trade" stocks. Not really part of their Business Class curriculum but good exposure nonetheless.
He claimed that he bought a stock at 9:30am at the open at "60%" and went to sell it at "120%" but Lakehead doesn't allow day trading. It closed unchanged back down to his cost at "60%". First things first...I went through with him that stocks trade in $'s and Cents. After understanding that, in his excitable way, he said, "If only I could day trade". To which his next older brother and I both responded, "Well you can. You just opened up an account at High Rock so you could actually day trade". We told him how that would work...ie...he would call me, put on a trade and then call me back to sell it during the day. I said we could limit the amount to say, $500 per trade. All of a sudden, when he figured it was his hard-earned, real money, not play money, he was like, "No way am I doing that". Well his older brother and I ripped into him with laughter. No risk, no return. No guts, no glory. He'll learn. And if he doesn't, that is ok because he will succeed in life on his smile, good looks and natural charm.
As I have written a few times, I have spent my entire working life taking investment risk and being compensated for it. That is how I made my living/income.
Four mornings a week, I am in the gym early and I run intervals on the treadmill. I know what you are thinking, "Why on earth would you run on a treadmill? They are so boring". A few reasons and in this order: 1) I can keep track of exactly what my intervals are on time, distance, incline etc, 2) I can watch TV where I start out at CP24 for the weather outlook (being a cyclist and a Sportsman), move to CNN (which I can't stand but just in case there is actually some meaningful breaking news like the Pope abdicating his papacy) and then finally to BNN for the bulk of my time on the treadmill. Upon waking up each morning at home, the first thing I do is grab my Blackberry (I know what you are thinking and between Scott and Bianca at work and my family, I may be using an iPhone shortly) and log onto Bloomberg to see what markets have done overnight while I slept (or tossed and turned). BNN gives me a bit of an extension of Bloomberg while I am running where I can see if there are any major changes in certain markets (oil, nat gas, gold, C$, bonds, stock futures etc) since when I left the Blackberry/Bloomberg in the gym locker. Maybe not the most relaxing way to run but....1) what I do for a living is not always relaxing, 2) I need to be "wired in" to what is happening at all times and 3) my run itself is not relaxing, more painful than relaxing.
Now before the BNN live morning show starts at 7am, they run a replay of the previous night's show called "Market Call". I was on this show last April. Catherine Murray (who does a great job) hosts this show where they have a Portfolio Manager on for a full hour and most of the show has guest callers calling, emailing, Tweeting, Facebooking etc to ask the PM questions about all sorts of securities (mostly stocks). The producers try to keep the questions geared towards the PM's wheelhouse. So when I was on, it was more fixed income and Canadian small-mid cap stocks. Interesting experience.
Now I have been noticing something interesting for the past six months since I was on the show in April: at the end of the show, Catherine ask the PM for his/her Top 3 Picks. (When I was on I gave a high yield energy bond Athabasca 7.5% 2017 at $92.25, Canexus stock at $1.52 and a government of Canada bond 3.50% 2045 at 2.10% yield to maturity...you can look at how I did and read the Picks on the article the ROB posted after the show: www.theglobeandmail.com/globe-investor/investment-ideas/three-top-picks-from-high-rocks-paul-tepsich/article29755269/
Now every time a PM makes any sort of recommendation on an investment, BNN covers their butts, as they should, by putting a Full Disclosure page on the screen. The Disclosure screen looks like this:
Why? Because what kind of Portfolio Manager has his/her clients in a security (stock or bond) and doesn't actually own it for themselves or their household family members??? I can't tell you how many red X's I see on this Disclosure table each morning. It is mind boggling to me.
If a PM has done the research on the security and feels confident enough to buy it in client accounts, why on earth wouldn't he/she buy it in their own account?
A key difference at High Rock is the fact that I started our Private Client division to manage my household money and my parent's money...we had two clients. I told my old friend and colleague, Scott Tomenson, what I was doing and he liked what he heard...enough so as to join me and help build our Private Client business. The first tenet of High Rock's Private Client business is, and always will be, that we are managing our own money and that of our clients exactly the same. That is to say, whatever we do we do for everyone...same security, same timing, same price. So when I was on BNN, I got "green" check marks on Guest Position, Household Members...how couldn't I have got the green check marks? Next time I am on, I will tell the Producer that will always be the case. (If you see a green check mark on Investment Banking Client...beware...that means the PM could possibly be conflicted).
So back to my 16 year old son who wants to make money but not by risking his own money to do so. From what I see on BNN almost every morning, I think there is a career in the financial services sector where that is possible. Just look for the "red" X's on the Disclosure Statement.
I feel like I have taught my youngest son many things (and anything sports-related he is already better at than I am) but there may be at least one more lesson to teach him.
By now everyone is probably well aware of the changes that have been made to Vancouver housing and to residential housing across the nation. A simple recap follows, along with how we think this could affect our investing and portfolios.
First, back in late July, the Province of BC put in a 15% Foreign Buyer's Tax to take effect Aug 2nd. As I wrote here in early July, highrockcapital.ca/pauls-blog/open-letter-to-prime-minister-trudeau-and-finance-minister-morneau-on-the-state-of-the-housing-markets-in-toronto-and-vancouver in a Open Letter to our PM and FM, I thought this had the potential to create a huge policy error. A nation running current account deficits as large as we do in Canada, can ill-afford to push foreign capital out of the country. Well, thankfully, it was just the Province of BC that signaled a denial of foreign capital, not the country as a whole. I don't have any statistics , as of yet, but certainly through the sensationalism in the press (and it may very well be true) it sounds like Vancouver area house prices are dropping. If the intended consequences were to hammer domestic home owners, then...solution provided by the Provincial government. Let's see how this plays out.
Just today, Kathleen Wynn came out and said Ontario will not follow BC's lead in strapping on a foreign buyer's tax. Thank God. Maybe the Liberal government of Ontario has seen some hard numbers out of Vancouver. Whatever the reason, I am glad they didn't. Wynn did go on to say they are exploring options and monitoring how the federal government's new mortgage rules will impact housing. Smart to wait.
On to the federal government's new mortgage rules. Earlier this month, the federal government put new rules for mortgage borrowing in place beginning Oct 17, 2016. Old rules stated that those who put down less than 20% Equity on a new home purchase had to pass a "stress test" and have mortgage insurance through CMHC. And those who put down more than 20% Equity were not subject to the same stress test.
The stress test is meant to save home buyers from themselves. That is to say, that the federal government put measures in place to ensure that those who are buying a house, even with more than 20% Equity, will be able to afford all of their monthly expenses especially if rates rise. The "stress test" uses a much higher (off-market) rate than a current mortgage rate. For instance, a 5yr mortgage is around 2.60% but the new rules force borrowers to use the Bank of Canada rate of 4.64% for stress testing purposes to ensure they can afford their mortgage and other expenses if rates should rise. Draconian? Perhaps. If a 5yr Government of Canada bond is around .65% today and a 5yr mortgage is around 2.60% we can say that a 5yr mortgage is ~2.00% higher than the 5yr bond yield. Now if we look at the Forward Bond Curve in Canada, we can see that the 5yr in 5yrs time is trading at about 1.80%. If we add 2.00% for the mortgage spread to that, we would get a 5yr mortgage in 5yrs time at 3.80%; a fair bit lower than the new stress test level of 4.64%. Maybe a bit draconian.
The obvious effect on anyone buying a home with a mortgage is that they will need to a) buy a lower price home and/or b) qualify for less of a mortgage. So if the federal government's stated goal in the first half of the year was to "take measures so that the affordability of a home is accessible for more Canadians who increasingly look at markets like Vancouver and Toronto as significant barriers to achieving their dreams and their successes", have they accomplished their stated goal? I think not. Part of the problem is that the BC foreign buyer's tax was local and, as I suggested in my July Open Letter, that foreign money will just go to other jurisdictions, like Toronto for instance. And also, the federal government's new mortgage rules are put in place across the entire country. How do you feel if you are 30yr old, living in Saskatchewan and have been saving up to buy your first house? Now you probably need to save more and for longer.
A question we get asked by a few clients (I ask myself all the time...and I am a client of High Rock too!) is will housing prices decline? I am not 100% sure but my bet is they likely will (eventually) but I think it will be very local. For instance, I would not be surprised if the Vancouver market declined somewhat but keep in mind Vancouver is a great city...you can ski, golf, sail, bike ride, hike all in the same day and then go to a world class restaurant for dinner. What's not to like?
As for Toronto, as I said in the July Letter, it is the fastest growing city in the developed world, and a world-class city at that. Comparing Toronto to any other large world-class city, especially financial centers, and you will find it is cheap as all-get-out. I worked at Merrill Lynch for almost 18yrs and in my earlier days there I had opportunities to work in London, Hong Kong and NYC. Now I must admit that I live in a nice neighborhood about 7kms north of our office which is downtown with a two-car driveway and a pool. A nice house, to be sure, but I can also tell you that I saved and sacrificed like crazy (and still do) to live in that house and in that neighborhood. Point is, if I were to have worked in any of those other major financial centers that Merrill Lynch was thinking of sending me to way back then, I would have been commuting about 1.5 hours to get something close to what I have 15 minutes away and I would have paid 2-3 times as much. Cheap on a global basis. And the move higher in Toronto housing over the past year is simply a catch-up with other major centers and also to other asset classes, which have been ramped up due to easy monetary policy. Just as an aside, and going back to the example I used in July's Open Letter, I wonder how many investors who own Royal Bank of Canada (RY) stock own it with borrowed money or margin? I think I read a week or two ago that Toronto housing prices are +20% over the past year. Well RY stock is +16.75% on a total return basis over the past year (and BNS is +21%)...about the same as the Toronto housing market. Should the federal government step in and put new borrowing or margin rules in place to ensure that RY (and all stocks) don't "run up" so much in any given year and destroy the dreams and successes of investors who don't own RY or BNS stock? Just a pet peeve I have.
Enough about those views. So what exactly is the federal government doing? I think what they are doing is addressing the Personal Debt to Disposable Income ratio that has skyrocketed to a new all-time high at 167%. Think about it, they can put a ceiling on the housing market while still allowing the Bank of Canada to maintain lower for longer high powered interest rates (ie. government bond yields). Lower high powered rates will help the economy to recover as it keeps the corporate borrowing cost of capital low and new mortgage rules will ensure that the consumer doesn't take advantage of those low rates, at least on home purchases.
To conclude, what does this mean for our portfolios? First, we have no direct exposure to any mortgage lenders, mortgage servicers or mortgage insurers. My view is that mortgage lending volumes will undoubtedly decline. I believe this has largely been reflected in the underlying securities in these various companies but I am not 100% sure how this will all play out. My biggest fear is that housing prices decline more rapidly than anyone (including the federal government) had planned and given the consumer is already leveraged at 167% of disposable income...we would be in a heap of trouble as the housing market is the asset supporting all that debt. So with that view on the consumer, we shy away from the Consumer Discretionary sector. Also, we think that bond yields are likely to stay lower for longer in Canada and we are largely positioned for that, although we did take some profits last quarter as we noted some subtle changes occurring in the way the bond market was behaving. Also, as Scott said in his blog this morning, cash is as asset class that we still maintain a good weight in, so we are naturally defensive. In our Tactical Model, we still press forward with our strategy of owning very specific, well-researched stocks, bonds, convertibles and preferred shares (one very specific one).
Whew, that was a long one.
If you haven't noticed (and hopefully you haven't...far better for you to focus on your day job or your retirement and leave it to professionals like High Rock to worry about), stock markets around the globe are starting to give up ground. To us, it looks like they are breaking down technically.
Among a host of other reasons, which Scott highlights regularly in his blog and our weekly webinar, one reason for the stock market weakness might just be the offshore Chinese Renminbi weakening vs the US$. Higher on the chart is a weaker Renminbi. When the Renminbi weakens (don't forget, it is pegged to the US$) it usually means that Chinese economic growth is weakening and the PBOC wants to weaken off their currency to spur exports. A sign of weakness in China.
As mentioned, I think there is a host of other reasons for stock market weakness like....Fundamentals!!! Remember what those are? Regardless, here is s snapshot of the Dow:
Busy chart. The upward white line looks to be broken. What we will look at now is retracement targets on the downside. The first stop should be at 17,460 or about 540pts lower than today or about 3% lower. then we will look at 17,085 which is 5.1% lower than today and after that, we will look at 16,712 or about 7.2% lower than today.
Is your portfolio ready? We think ours are given our high cash weighting, underweight to global equities, diversified approach with a solid fixed income weight and our tactical trading.
This will probably never happen to me again in my investing career (and I don't mean to be pessimistic or negative) - we had not one, but two, of our portfolio companies see takeovers put in for them yesterday! First day of the final Quarter of the year! Two in one day...how nice is that?
First, our largest position, Canexus (a Canadian chemical co) saw Chemtrade (competitor) put in a formal $1.50/sh bid for all of Canexus. Now we had paired down our stock position two weeks ago when Chemtrade first put in a bid at $1.45/sh (rebuffed by the Canexus Board, for some strange reason). Given the lack of engagement by the Canexus Board, Chemtrade was forced to go "hostile" yesterday morning. So we lightened up in our stock position a couple of weeks ago but added to the new high yield bond that Canexus issued last week. So we own securities across the entire capital structure of Canexus - senior unsecured high yield bonds, convertible bonds and stock (no bank debt). The real play was in the new high yield bonds where we bought a pretty big weight at 100.00 and a week later, on the back of this hostile bid, the bonds are +6.5% to 106.50 as they would become Chemtrade bonds, which is a better credit. In bond terms, that is an excellent return, especially within one week! We also have a pretty large weight in the convertible bonds of Canexus. On a change of control in the ownership of the company, the convertible bonds would be taken out at 100...we bought them around 90 and have been collecting the coupon for six months so we will be up more than 10% on the converts. Again, a low risk trade. The stock has largely played out which is why we sold some on the way up. Complicated? Maybe, but a great trade, so far.
Second, DirectCash Payments Inc. saw a bid come in from a US competitor, Cardtronics. We owned a much smaller position in DirectCash but we were lucky/smart enough to have added a bit more two weeks ago. Why did we add? Obviously not because we thought Cardtronics was going to buy them (we have been thinking that for a few years but had no idea it was coming now) but because of the cash flow analysis I perform on our portfolio investments. In fact, I just said to a prospective client in a meeting last week that DirectCash is a great example of a company that produces enough cash flow (Ebitda 65mm) to support the current Dividend (25mm) after Interest Expense, Capital Expenditures and Cash Taxes and with a dividend yield of 11%, it was time to start adding. Their payout ratio was conservative enough that they could drop about 15mm in Ebitda and still support the current dividend. In the end, a nice trade but not a great trade as we just didn't own enough. Still helps when you just bought stock at $12.87 and it gets taken out at $19 two weeks later. Every bit helps.
Both of these trades are in our Tactical Model. If you have questions (other than, "why didn't you own more DirectCash stock?"..I got that one last night from my wife) do not hesitate to contact me.
Past performance is no guarantee of future performance.