I broke the same investment rule again….

I once again broke my investing rule of trading only once per quarter (if at all). What to do when two rules conflict with each other? I tried to err on the side of lower risk. I re-balanced early as one asset class breached a target threshold.

More here.

Why I am not changing my portfolio even though the yield curve has inverted

On Friday it was reported that the yield curve in the US inverted for the first time since the last (great) recession. This is supposed to be a reliable harbinger for a future recession in 12-18 months.

What does it mean when the yield curve inverts?

It means the US short-term interest rate (as measured by the 3 month Treasury Bill rate) is now higher than the long-term interest rate (as measured by the 10 year Treasury Bill rate). An inversion like this is generally regarded as a negative market/economic sentiment that can affect economic and market behaviour.

The yield curve inversion has sent some scurrying to make changes to their portfolios by raising cash, selling riskier stocks and becoming more defensive (buying utilities, telcos, REITS and consumer staples equities).

Why I am not scurrying to do anything on the news:

  1. I already have some cash (about 10% of my portfolio, including high-interest savings and short-duration bonds maturing later this year)
  2. I already have good exposure to defensive equities: ~18% utilities + ~11% consumer defensive + ~6.5% communications services + ~3.5% real estate = ~39.0% defensive
  3. I have less than 50% of our total portfolio in equities so a market downturn should be offset somewhat by non-correlated holdings in fixed income, cash and bullion (this was true in 2018, when my portfolio returned ~+1% in spite of equity drawdowns in Canada and the US)
  4. If I sell something to raise cash there could be tax consequences in our non-registered accounts, due to potential capital gains being taxed
  5. I don’t know which non-defensive equities to sell to raise cash – I like all my holdings for the long haul or I wouldn’t own them
  6. Recessions tend to be short and I believe my long-term portfolio is structured well for riding out short-term events
  7. An inverted yield curve has reportedly accurately predicted upcoming recessions eight times (by some sources) since 1968 but, if on January 1, 1968, I bought and held the S&P 500 (^SPX) I would have made a return of 2.81K% in spite of the eight recessions (including the Great Recession of 2008-09)
  8. According to Forbes, the chance of a recession in the next year is always about 27% (based on their data pointing to 16 recessions since 1960) and today the chance is 30%, hardly more than average
  9. If the chance of recession is 30% next year there is also a 70% chance there won’t be a recession next year which means, based on probabilities alone, I should be buying risk-on stocks
  10. If the US Fed surprises by lowering interest rates, that could change the situation immediately
  11. I don’t know how to time when to start re-buying the risk-on equities I am supposed to sell now – presumably when the yield curve corrects to non-inversion

I am not saying a recession won’t happen in 2019-20. It may well.

What I am saying, as a long-term investor who buys, holds and monitors a portfolio of retirement assets designed for all markets, who relies primarily on asset allocation rules when making security weighting decisions, and who makes limited and selective trades intended to improve overall portfolio quality, I don’t react to news like this.

Do you?

 

 

 

More on sequence of returns risk

Sequence (of returns) risk is something I mentioned in my recent piece about my upcoming third quarter portfolio review. Sequence risk is a major factor in my planning as our household heads into retirement in the near future.

Looking at the current valuation of the S&P 500 vs. underlying gross national product is a bit sobering.

More on this here.

Previewing my next quarterly household portfolio review

September brings my next quarterly portfolio review and my next, self-imposed, securities trading window (I only trade four times a year). I have been giving a fair bit of thought this summer to what’s next for our portfolio.

Here’s a preview of my thinking….

 

 

 

 

 

What US macro risks are investors facing these days?

It’s been over a year since I last wrote about macro risks emanating from the US and how they might affect Canadian investors.

Given how many changes are taking place in the macro environment recently, and how influential the US macro situation is for Canadians, I thought it would be interesting to do an update. The idea is to try to identify major driving factors that might affect US, Canadian and global equity markets in an effort to reduce the “surprise factor,” which may in turn lead to bad investment decisions (out of fear or panic).

So what does the macro risk profile look like south of the border? No one really knows for sure of course, but it is interesting to contemplate, especially if you have any US holdings in your portfolio.

Let’s take a look at some of the frequently-cited risks that may affect investors and try to determine if relative risk levels have increased or decreased since my last effort at this in January 2017.

I have listed them from what I propose are the highest to the lowest risks.

Notation used:

⇑ = risk is increasing

⇔ = risk is not changing

⇓ = risk is decreasing


Tax Risk = ⇑ (increased risk rating since Jan/17)

Definition: the risk that an investment will lose its value or return on capital because of taxation (most investments are subject to this risk)
My take: Recently, Trump decided to impose new taxes, in the form of tariffs, on steel and aluminum, and on various goods manufactured in China. China is already beginning to retaliate, raising the prospect of a trade war. It is unclear if Trump will lay on even more tariffs. It remains to be seen what the economic impact of new tariffs will be but the general consensus appears to be net negative due to rising costs of goods for consumers. Corporate and limited personal income tax cuts were delivered in December 2017 so that matter is settled for now.


Political Risk = ⇑ (same risk rating as Jan/17, but the overall risk is likely higher)

Definition: the risk that an investment will lose value because of political action in a country where one has investments, including one’s own country
My take: While his core support seems to be holding, the US president remains erratic and sensational in policy pronouncements, his cabinet turnover is record-setting, new cabinet and legal advisory appointments are arguably increasingly controversial and recently look like they are veering hard to the right of political spectrum and more confrontational in tone. Relations with Iran may become increasingly strained while relations with North Korea could possibly (but not likely) improve (the new national security advisor, John Bolton, advocates war with both countries). The president continues to accommodate, even congratulate Russia while many observers suggest this is inappropriate given demonstrable evidence of Russian interference in the last US election among several other concerns. The Mueller investigation continues to slowly gain momentum on three fronts: Trump’s possible (likely?) obstruction of justice; Trump/team conspiracy with Russia to tip the last election; and Trump/family financial dealings, including potential money laundering. New revelations about Cambridge Analytica’s role in the 2016 election and potential connections to Russian interference are gaining a bit more traction. The trial for Paul Manafort, Trump’s former campaign chairman, begins in July and further indictments by Mueller in other cases remain likely. The ongoing investigation means a constitutional crisis could easily be triggered if Trump does indeed fire the Special Council as he reportedly intended to do last summer, and may be more inclined than ever to do given his recent appointment of Joseph diGenova, who claims the domestic security establishment (a.k.a. “deep state”) in the US is trying to frame Trump. The possibility of impeachment is likely remote still, but increasing. There are mid-term elections in November which could lead to one or both Houses of Congress flipping to the Democrats, thus hobbling Trump’s agenda and making him accountable. Given all this uncertainty, I believe political risk is elevating in the US and by extension the world.


Market Risk = ⇑ (same risk rating as Jan/17, but the overall risk is likely higher)

Definition: the risk that an investment can lose its value in the market (applies to equities and fixed-income investments)
My take: Given the US market had been climbing steadily since November 8, 2016, the recent pullbacks have been long overdue. Most market gyrations tend to be short-term in nature and are of little consequence to long-term investors. Many commentators still claim the market is over-valued based on historical price/earnings ratios. Overall though the backdrop of corporate earnings, economic growth and planned orderly increases in interest rates contribute to medium term optimism in equity markets. There are no compelling hints of a recession yet on the horizon. Having said that, volatility has been increasing so far in 2018 (the ^VIX is up 125%), in large part due to increasing political, inflation and tax uncertainties. Market risk is being reflected CNN’s Fear and Greed Index (7% out of 100%) and in the recent drops in major indexes. Of the three major US indexes, only the NASDAQ is in the black so far this year. I would suggest market risk is rising due to heightened uncertainty in the political and tax environments discussed in this post and the recent increase in volatility.


Legislative Risk = ⇔ (reduced risk rating since Jan/17)

Definition: the risk that an investment will lose value or benefits because of new legislation (all investments are subject to this risk)
My take: This risk is related to political risk. The most recent spending law (as of writing today still unpassed before a midnight deadline) appears to be ignoring fiscal conservatism. Regulations related to offshore drilling, the environment and banking have been changed and, again, in the short to medium term are being well-received by investors. Longer term, these changes could be damaging to the US economy by contributing significantly to increased US fiscal indebtedness, reckless banking practices, over-stimulation of the economy, environmental degradations and potential knock-on inflationary impacts. NAFTA talks drag on, with some signs the US may be softening its position, especially in the auto sector. If a new deal is not struck soon, there will be little time for Congressional ratification, leaving the future uncertain. We don’t know what else could be forthcoming in the legislative and regulatory environment, but presumably not too much will change before at least the fall mid-term elections. If in fact a Democratic House of Representatives emerges, this would likely provide a damper on Trump’s legislative agenda.


Interest Rate Risk = ⇔ (reduced risk rating since Jan/17)

Definition: the risk that an investment will lose value due to a change in interest rates (applies to fixed-income investments and sometimes to equity investments depending on investor expectations for interest rate changes)
My take: Interest rates are still on track to rise three times this year (once already this week) even with the appointment of a new Fed Chairman. With two more rate increases promised in 2018, on top of this week’s rate increase, the market should be prepared. Wage inflation, in large part due to low unemployment coupled with economic growth, could also be a driver of higher than expected interest rates later this year, which could be bad for equity markets. We saw the market react to some of these expectations earlier in the year. Due to the combined effects of tax cuts and increased deficit spending expected this year, the US federal debt will climb, which is not positive for rates longer term. This is a tough one to forecast at the best of times but on balance it would seem interest rate risk in the short to medium term has decreased since January 2017.


Purchasing Power Risk = ⇔ (reduced risk rating since Jan/17)

Definition: the risk that an investment will lose its purchasing power due to inflation (applies particularly to cash and fixed-income investments)
My take: This risk is somewhat related to interest rate and tax risks in that the main concern would be higher-than-expected inflation, driven by wages, higher health care costs and possibly new tariffs, but counterbalanced to some degree by lower personal and corporate taxes. If Trump’s policies end up being inflationary then purchasing power may erode. This would likely take some time to happen. On balance the risk of higher inflation, from a very low level since the 2008/09 financial crisis, has probably increased, but for the short to medium term does not appear very likely to happen. The recent tax cuts, especially to individuals, will marginally add to purchasing power in the short to medium term and low unemployment could eventually cause wages to go up, improving purchasing strength of individuals.


Liquidity Risk = ⇔ (same risk rating as Jan/17)

Definition: the risk that an investment will not be easy to sell when needed (applies to some equities that don’t trade in large volume, fixed-income investments and real estate and other property that may be hard to sell quickly at an equitable price)
My take: I don’t see any reason to think liquidity risk has changed since January 2017– at least not in the short term. If some of the other risks in this post materialize, this could change, and possibly quickly. I leave this risk at the mercy of “black swans” without changing the risk rating from January 2017.


Reinvestment Risk = ⇓ (same risk rating as Jan/17)

Definition: the risk that an investment will be reinvested at a lower rate of interest when it matures (applies to fixed-income investments)
My take: If we expect interest rates to continue an orderly climb higher in 2018, new money that is being invested in fixed income should attract higher rates. If one deploys fixed income funds to rate reset preferred shares and/or bond funds or bond/GIC ladders of short to medium term duration (e.g. five years or less) then reinvestment risk should be falling.


Are there any actionable ideas here?

I believe that several risks I am tracking are falling, but the three risks that I believe are increasing (political, taxation and market) could have major impacts in the short to medium term. Longer term I remain somewhat optimistic.

But….

With rates rising south and north of the border, and related sector rotation, there has been pressure on utilities, telecoms, consumer staples, materials and energy this year. Bond prices are slightly weaker so far this year as rates rise. I recently added to both utilities and bonds.

If the technology sector continues to outpace this year, I will at some point likely need to re-balance to reduce the percentage this sector represents in our portfolio. It is roughly 20% now and rising.

As stated over a year ago when last reviewing macro risks, I continue to balance short-term risk with longer term secular trends. Since January 2017 I have bought an ETF for robotics. I continue to hold biotechnology and water-themed ETFs and I continue to hold Shopify in the e-Commerce space (although I trimmed it somewhat last year). I am researching both alternative energy and cybersecurity as other possible investment themes for new cash in the future (and likely will be writing articles on them for Canadian MoneySaver).

In conclusion, it remains pretty much stay the course for me. I have an expectation that things will be more volatile in equity markets in 2018 compared to 2017. So I remain prepared for that eventuality. Otherwise, who knows?

Be greedy when others are fearful?

Just a quick post to point out that for the third time so far this year, CNN’s fear and greed index is down below 10 (on a scale of 0 to 100). This suggests, by its seven measures, investors are “extremely fearful” of the US equity markets right now.

Hmmm. What’s on sale in the markets? (Hint: telecoms, consumer staples, energy, utilities and materials).

What just happened to markets?

Headline stories about the stock market pullback this week were largely focussed on the drop in the Dow Jones Industrial Average (less so on other indexes, but they were not immune). The year-to-date total return marked by the DJIA on January 26 was +7.77%. By the close on Friday, the DJIA had settled to +3.34% YTD, a drop of around 4%.

This is a relatively large drop given the low volatility and upward trending we’ve seen in markets in the last couple of years. By historical standards this is a mere blip, and 3.34% YTD total return still represents, annualized, over 35% growth!

I was in my car last night and caught a story on the news radio about the stock market pullback. The commentator didn’t really have a very clear rationale for drop – something about markets and the broad economy not being correlated….. The broad US economy is doing well, creating jobs and growing, but markets took a big pause.  Hmmm. I didn’t find that very satisfying.

A few minutes earlier I had read in WaPo the main reason that markets pulled back, and especially on Friday, was to do with the 10 year benchmark interest rate surpassing 2.8%, on its way perhaps to 3%. The case was made that a 3% benchmark rate will send a signal to some investors that bonds might be more attractive than stocks on a risk-adjusted basis.

I read another article this morning in the NY Times that makes a similar point and goes on to say there may actually be a connection between the pullback and the broad economy: expectations are that the broad US economy is going to grow at, say, 1.5% not the 3% promised by Donald Trump.

So maybe there is a decent connection between stock market indexes and the broader economy after all. Given how expectations affect spending and investment decisions so heavily – both in markets and in the economy at large – this really shouldn’t be a surprise. And the 10-year interest rate moves in large part due to expectations about inflation rates and the cost of money in the future. Inflation expectations may be climbing.

This tells me, perhaps, that expectations could well be shifting to lower future growth rates in the economy and to lower investment returns from markets. Nothing says these expectations will be proven correct, but it is worth noting.

It is also worth reminding that last year’s market performance is no guarantee of future performance. But even at a 3.34% total return YTD, the DOW isn’t exactly off to a bad start.

Three things to watch for markets in the near future

At the time of writing, pre-market stock trading in the US is showing minor declines on the three major stock exchanges.

The US government shutdown is but one factor, even if an extension is voted in for the next three weeks.

NAFTA negotiations are about to start their sixth round on January 29th in Montreal. Reports have it that US/Canada relations are acrimonious and may lead to the US serving notice of withdrawal.  In a recent move, Canada has filed a World Trade Organization (WTO) complaint against the US. Donald Trump is signalling his considerable displeasure with Wilbur Ross as Commerce Secretary.

A third factor coming back on the horizon is the US debt ceiling, which is expected to be reached in early March 2018. Some are expressing concerns that it is aligning closely with budget debates.

With an erratic White House at the “helm” and over-stretched stock market valuations in the US and Canada, what could go wrong?

Here comes the US debt ceiling again, and the possibility of a government shutdown

I have mentioned a white swan event here before. But it was avoided for the time being.

We may see one or more again.

December 2017 will be a busy month legislatively for the US federal government. Along with tax cut legislation, Congress and the president must deal with the debt ceiling and the possibility of a government shutdown due to lack of funds.

December 8 is an important date to resolve the funding issues. The end of the year is the president’s imposed deadline for tax cut legislation.

Failure on any of these major initiatives will be embarrassing at best and potentially be very damaging to the US economy and market confidence at worst.

US markets are near or at all time highs and volatility is very low.

One could argue market sentiment is a bit too complacent right now.

If stocks go down, what’s your plan?

My thoughts from early 2016, when markets were pretty soft are here. While early 2016’s pullback seems like a long time ago, my perspective hasn’t changed all that much since.

Has yours?

 

Dotard vs. Rocket Man: Do the markets even care?

There has been lots of media coverage about the war of words between Trump and Kim (of North Korea). If a war does break out, some speculate as many as 25 million people could be casualties.

Do the markets even care? It would appear not so much, as new highs are being reached in the US. Asian markets are a bit more restrained.

If you are curious about the impact of wars on financial markets, 5i Research published a link from the CFA Institute that helps explain the historical response here.

In short, sad to say, a war between the US and North Korea might present a buying opportunity for stocks if they pull back short term.

The white swan swims upstream – for now

Not long ago I wrote a post about a possible “white swan” event. It was in reference to the risk that the US could have trouble raising its debt ceiling by the end of September.

The surprising deal between Trump, Democrats and presumably some moderate Republicans has pushed the risk out by three months.

For now, that is good news for markets.

There is even a movement afoot to eliminate the debt ceiling as we know it today, thus ending the recurring brinkmanship over raising it.

That too could be good for markets.

So, we’ll see if the white swan returns in December.

Ben Carlson of “A Wealth of Common Sense” thinks Canadian house prices are in a bubble

I was intrigued today when I saw a blog post by Ben Carlson (someone I follow and respect) from yesterday about Canadian real estate prices.

In his post he references an article he wrote for Bloomberg in June called: Canada’s Housing Bubble Will Burst.

His central evidence is that since the sub-prime mortgage fiasco blew up in the US in 2006, Canadian house prices have climbed 56%, while US prices have not yet recovered to their 2006 levels (still down 13% from their peak).

Let’s unpack this a bit:

  • Average Canadian residential real estate prices are disproportionately influenced by the Vancouver and Toronto markets, which have both posted major increases between 2006 and 2016
  • Down payments are generally much higher in Canada than they were in the US pre-2006 – we generally don’t have NINJA (no income, no job or assets) loans like those commonly available in the US at the time
  • The Canadian real estate finance market is much more tightly regulated and supervised than the US’s was in 2006
  • Most (all?) of the housing-related debt has not been collateralized and sold off to unsuspecting investors as toxic, sub-prime loans masquerading as high quality debt
  • The bubble in Canadian real estate, to the extent it exists, is largely confined to greater Toronto and Vancouver, and both markets have shown some signs of cooling in the last year since governments intervened with new taxes on foreign investment
  • An increase of 56% in average Canadian residential real estate prices from 2006 to 2016 represents an annual compounded increase of 4.55% per year (well above inflation, but hardly off the charts)

Due to some of the major differences in the Canadian and US residential real estate markets, I find it to be a somewhat irrelevant comparison to say: On a real basis, Canadian housing prices experienced a much smaller, shorter decrease in prices during the financial crisis and a much larger, longer increase in prices during the recovery.

There is no doubt that some real estate markets in Canada are very, very expensive, especially relative to incomes and consumer debt levels (something Ben Carlson points out too).

Caution is absolutely warranted!

But some commentators have been calling for the Canadian real estate bubble to burst for many years. Some investors and short-sellers have been shorting Canadian banks and alternative lenders like Home Capital Group in anticipation.

Specifically in the case of Home Capital Group, Warren Buffet begged to differ.

I am not saying a crash is not possible, but it seems to me, especially outside of greater Vancouver and Toronto, a milder correction or even just a slowdown is more likely.

With respect to Ben Carlson, I think saying no one knows when insanity like this will come to an end is a bit overstated.

I could be wrong though and prudence is always wise.

 

 

 

 

Markets (and maybe some companies) are amoral

One thing I think is becoming patently clear these days is that markets are amoral (who knew?).

I choose that term carefully: markets are unconcerned with the rightness or wrongness of something.

When Donald Trump was elected president of the USA, major US market indexes moved forward in a highly positive manner (the “Trump Bump”).

Why?

The promise of deregulation, tax cuts and infrastructure spending (not so much ripping up trade agreements) are bullish for profits.

Markets don’t care about what Trump stands for (or if he stands for anything at all for that matter) as long as the perception is he and the Republican Congressional majority will deliver the goods.

Now that Trump appears to be lurching from one political crisis to another (Mueller investigation, failed health care repeal/replace, North Korea, Charlottesville, etc.) markets still don’t care. As long as there is a belief that deregulation, tax cuts and infrastructure spending are on the way, politics don’t appear to matter.

Major business CEOs (including Merck, Under Armour, Intel, 3M, Campbell Soup, United Technologies and Johnson & Johnson) began defecting en masse from two of Trump’s business councils due to his public remarks about events in Charlottesville since last Saturday. Today these councils were disbanded (or, perhaps disbanded themselves).

Some or all of the business leaders may have opted out for moral reasons (the prevailing reason offered). These business leaders do not want themselves and their companies to be associated, in their customers’, shareholders’ and employees’ eyes, with the increasingly widely-derided “equivalence thesis” advanced by the president about violence in Charlottesville.

Maybe many businesses are also somewhat amoral. The CEOs on these councils, and the shareholders they represent in their businesses, generally have a profit motive as their primary (but not exclusive) reason for existence.

Do these defections also suggest some of these business leaders have lost confidence that Donald Trump and his Republican Congressional majority will deliver all the promised deregulation, tax cuts and infrastructure spending?

If some of the biggest US businesses have lost confidence and concluded their profits (and reputations) may suffer under Donald Trump’s presidency at this time, what does that mean for markets?

We’ll see as this drama continues to unfold Stateside.

 

What could go wrong between Donald Trump and Kim Jong-un?

While I am a financial blogger I can’t ignore the latest war of words (at least so far) between Donald Trump and Kim Jong-un.

The latest rhetoric: “fire and fury like the world has never seen” and “shameless defeat for America and its final doom” hurled respectively by these “leaders” is not going to help politics nor markets.

From a market perspective, there are some worrying signs:

  • CBOE S&P 500 Volatility Index (^VIX): +44% in 1 day; +54% in 5 days
  • Dow Jones Commodity Index Gold (INDEXDJX:DJCIGC): +0.84% in 1 day; +1.16% in 5 days
  • S&P 500 (^SPX): -1.45% in 1 day; -1.37% in 5 days
  • CNN’s fear and greed index went from 64 (greed) a week ago to 31 (fear)

The VIX is probably the most telling of these indexes. Volatility has been relatively low in 2017 to date, but that could change quickly given the unfolding of global events.

What does the long-term investor do under the circumstances?

I think the most prudent thing is to hold the course and maybe double-check one’s own investment policy statement for reassurance.

It may not be a bad idea to refresh your “wish list” of possible buys. If volatility increases, there may be opportunities to buy high quality companies on sale.

Do you have any companies you’ve wanted to own but have been unwilling to chase in these relatively over-valued markets?

If my asset allocations get out of whack due to a stock market pullback, I have some ideas where I’d like to deploy capital if bargains emerge.

Let’s hope things don’t spiral out of control. If the rhetoric continues, let’s further hope stock prices are the only victims of this escalating war of words between the “psychopath” and the “smart cookie.”

If only these two “leaders” could pause a moment and realize they have more than rhetorical style in common. Perhaps this whole conflict could be better settled by Trump and Kim playing a round of golf – something they both claim to be amazing at.

PS – Is this the end of the so-called “Trump bump” in markets?

 

From Trump Bump to Trump Short?

An article in today’s Washington Post by Sebastian Mallaby speaks to the possibility of a market adjustment if it becomes more likely that Donald Trump can’t deliver on his promised tax cuts, deregulation and infrastructure spending.

The main reasons why the new version of the “big short” might occur as cited are:

  • the US stock market is up about 15% since Trump’s election but Trump has brought about considerable uncertainty
  • between his issues with potential Russian collusion, firing former FBI Director Comey, investigations into former NSA chief Flynn, showing indiscretion when meeting with the Russian foreign minister and ambassador in the Oval Office and failing to hire an economic team, what could go wrong?
  • immigration clamp-downs are harming the ability of businesses to hire people, hints of protectionism may lead to reduced trade and the possibility of Trump railing against specific companies could hurt share prices

To quote more directly:

The way the Trump Short is priced now, traders almost double their money if the stock market falls by 8 percent between now and year’s end. If that sounds attractive to enough speculators, they could create a self-fulfilling prophesy, causing the stock market to tank. In some ways that would be healthy: The market would be adjusting to reality. Trump’s hopes of a business-led growth boom would then be exposed as wishful. And his budget, which presumes a magical economy to pay for tax cuts, would look even less credible than it already does.

Who knows if the Trump Short will occur? Very few predicted stock markets would rise before Trump got elected in the first place. If it is shown the emperor has no clothes, one would think markets would fall. Then again, maybe not, since it might mean Trump could be on his way out and greater sanity might prevail. That could be good for markets this time.

 

 

Comparing the risk/return profile of a portfolio. How to go about it?

A comment on a previous post I made about how I structure our household portfolio (i.e., owning some growth/high risk stocks along with some blue chip dividend growers/payers, bonds and cash) prompted me to look into how to determine the risk/return profile of our portfolio.

In my reply to the comment, I posed the question: “Is a 50% allocation to high risk stocks combined with a 50% allocation to cash more or less risky than a 100% allocation to dividend aristocrats and 0% allocation to cash?”

The results may not be that surprising. More on this topic here.

 

Again politics may play a big role in markets this year

Much has been said about the failure of the TrumpRyanCare bill last week. Most concerning is the open question the White House and Congress must now face: can they govern America?

The split in the Republican party that became patently obvious last week has at least three factions: freedom, mainstream and moderate. It would appear only the mainstream supported TrumpRyanCare. It is clear freedom and moderates did not, and likely in fairly large numbers (30+ votes). By pulling the vote the Republicans are trying to hide how big a margin was not in support.

This says nothing about the possible split in the Senate, which has its own factional characteristics.

Why does all this matter? As Eric Pianin and Rob Garver correctly point out in their article in The Fiscal Times today, there are several other policy initiatives coming up that may face a similar fate as health care: tax reform, increased spending, the border wall and most importantly the debt ceiling.

The debt ceiling may be the real sleeper in this suite. Already arriving upon America, it will enter life support (once again) until the fall due to extraordinary measures taken to keep the dollars flowing for now.

As the Pianin and Garver piece states:

The debt ceiling is a bête noire of the most conservative members of Congress, many of whom expressed a willingness to let the country default rather than increase the level of the Treasury’s debt. Now secure in the knowledge that they were able to face down Trump on the issue of health care, they may well be emboldened to buck the president and Congressional leadership even more aggressively.

If the splits we’ve seen in the Republican party persist there is a heightened risk that governing America may be at a serious impasse and this almost certainly will have a profound impact on arguably over-valued equity markets.

Fasten your seatbelt. It’s quite possibly going to be a very bumpy ride into the fall.

Beware of market sentiment

I sometimes find it hard to believe that US stock markets, bond yields and the US dollar can jump on headline news like this:

Trump vows ‘phenomenal’ tax announcement, offers no details

There may be a couple of hurdles to the president’s plan:

Despite the likelihood of disagreements in Congress before tax reform can be enacted, the U.S. dollar rose along with bond yields and stocks in response to the news.

Under U.S. law, only Congress can substantively change the tax code, which has not been overhauled thoroughly since 1986. Tax legislation must begin in the House of Representatives.

It is far from clear there is congressional agreement on any tax plan the executive branch might put forward.

The White House and House Republicans have been in discussions about a House tax reform plan that includes a controversial border adjustment proposal. The measure has come under fire from retailers, oil refiners and automakers who fear its 20 percent import tax could raise consumer prices.

I submit this as evidence that there is virtually no one left who still thinks markets act rationally with full information. It would seem speculation and exuberance rule the day.

Why does it seem like the market “prices in” news long before it is a reality, and “prices in” reality again when it occurs (even though the news was supposedly already priced in)? Are market sentiments so short-term now that a long-term view no longer makes any sense?

Read the full referenced article here on Reuters.

Growth might be overbought – euphoria in the US?

I have been posting here that I am skeptical about the growth hype that has surrounded Donald Trump’s election to the presidency in the US.

In fact, I believe many risks have increased for investors since November 8, 2016. I posted to that effect here on January 21.

Today I read in Dealbook how Seth A. Klarman, the 59-year-old value investor who runs Baupost Group, a $30B US hedge fund, is being rather cautious.

In his letter to investors a couple of weeks ago, which apparently has become highly sought after, he writes: “Exuberant investors have focused on the potential benefits of stimulative tax cuts, while mostly ignoring the risks from America-first protectionism and the erection of new trade barriers.”

He goes on to say: “The erratic tendencies and overconfidence in his own wisdom and judgment that Donald Trump has demonstrated to date are inconsistent with strong leadership and sound decision-making.”

He makes the points that investors generally don’t like uncertainty and Trump brings lots of it to the table.

He also warns about the risks of growing indebtedness and inflation.

For the record, Klarman is an independent but supported Hillary Clinton in the last election.

Only time will tell if he’s right. But the article is well worth a read as Klarman also comments on where opportunities may lie going forward (hint: value stocks).

Flying under the radar (sort of) – the beginnings of the next financial crisis?

Last Friday, while Donald Trump’s immigration ban was consuming most of the oxygen in the press, Trump ordered a review of the laws and regulations that govern the U.S. financial system. It appears the goal is to gut 2010’s financial overhaul law, known as Dodd-Frank. This could be the beginning salvo of potentially reckless de-regulation that could lead to a future financial crisis. It might help the banks in the short term but, if history rhymes, it could lead to heightened new risks in the financial system medium to long term.

Trump also signed a memorandum that could delay a Labor Department rule that would require financial professionals advising on retirement rules to act as fiduciaries for their clients, thus putting client interests first. This rule was set to go into affect April 1. Presumably this means financial professionals can continue, if they choose, to put their own interests before those of their clients!?!?

While it will likely take a while for Dodd-Frank to be neutered, if/when it happens, it will be well worth watching to see what the long-term impact is.

A lot of retail investors (north and south of the border) were seriously hurt in the 2008/09 financial crisis. Here’s hoping the table isn’t being set for another similar drubbing.

Canadian investors have a lot at stake in how the US economy and stock market performs – whether they own US securities or not. So stay tuned!

 

Be fearful when others are greedy….

Just a quick update today to remind investors of one of Warren Buffet’s most famous quotes: “Be fearful when others are greedy and greedy when others are fearful.

The reason I mention it is because the recent performance of major indexes in the US and Canada (since November 8, 2016) has been a bit lofty to say the least. The TSX Composite, S&P 500 and Dow Jones Industrial Average have risen 6.78%, 7.79% and 10.05% respectively.

Meanwhile, the US volatility index (VXX) is down 42%.

CNN Money’s Fear and Greed Index is registering a “greed” reading at 58/100.

The Schiller Price/Earnings Ratio is at 28.45 vs. a mean of 16.72 and a median of 16.09.

Be careful out there and make sure your long-term positions are in solid, high quality holdings.

What risks are investors facing these days with a new US president?

With the swearing in of Donald Trump as the 45th US president, does the macro risk profile change for Canadian investors, and especially those with US holdings?

No one really knows for sure of course, but it is interesting to contemplate.

Let’s take a look at some of the frequently cited risks that may affect investors and try to determine if relative risk levels have increased or decreased since the election/inauguration. I have listed them from what I propose are the highest to the lowest risks.

I don’t mean to sound alarmist. I am only trying to pragmatically understand what may have changed.

Political Risk = ⇑

  • Definition: the risk that an investment will lose value because of political action in a country where one has investments, including one’s own country
  • My take: I don’t think there can be much doubt that political risk in the US has increased. Much has been made about the erratic and vague policy statements by the president, his appointment of an eclectic, contradictory and sometimes controversial cabinet and group of advisors, and the president’s harsh words about some of the domestic and international political accommodations of the past (e.g., levels of US conventional and nuclear forces, NATO obsolescence, Israel, the one China policy, the Iran nuclear deal, relations with Russia, the European Union, Brexit and trade deals and policy like NAFTA and with China – and so on). Unless we see more clarity, predictability and cohesion in the new administration’s direction, I believe political risk will remain elevated in the US and by extension the world.

Legislative Risk = ⇑

  • Definition: the risk that an investment will lose value or benefits because of new legislation (all investments are subject to this risk)
  • My take: this risk is related to political risk, and with the prospect of new legislation coming in the US to ease environmental and banking regulations, volatility and oversight reduction could increase investor risk by creating global pressures for the US to conform to global climate pacts and by potentially leading once again to careless, reckless or even negligent financial practices in the US banking sector. On the other hand, financial and energy stocks in the US might continue to benefit in the short to medium term.

Market Risk = ⇑

  • Definition: the risk that an investment can lose its value in the market (applies to equities and fixed-income investments)
  • My take: given the US market has been climbing sharply since November 8 a pull-back is more likely now than before. Pull-backs are a normal occurrence in the market so the risk may not have substantially changed compared to “normal.” Most market gyrations tend to be short-term in nature and are of little consequence to long-term investors. Many commentators claim the market is over-valued based on historical price/earnings ratios, and more so as new market highs are achieved, but I am a bit skeptical at the moment. Corporate earnings seem to be improving, tax cuts/holidays, modest new infrastructure spending ($100B per year in the US) and de-regulation have been promised. These are bullish for markets in the short to medium term. If something whacky happens in one of the other categories of risk discussed here (like a particularly egregious tweet from the president), or a new crisis emerges (e.g., a major terrorist attack in the US), or interest rates rise faster than the forecast three times in 2017, things may change. Are the odds of one of these market-moving events increasing? Possibly, but none of this is overly predictable. I’ll go out on a limb and say market risk is rising due to heightened uncertainty since we don’t yet know what we’re dealing with in the brave new world we’re in.

Interest Rate Risk = ⇑

  • Definition: the risk that an investment will lose value due to a change in interest rates (applies to fixed-income investments and sometimes to equity investments depending on investor expectations for interest rate changes)
  • My take: with three rate increases already promised by the US Fed in 2017, the market should be prepared. However, concern is being expressed in some quarters that inflation may return (due to infrastructure spending at a time of slightly rising wages and theoretical near full employment in the US) thereby forcing faster-than-expected rate increases. Some of the new administration’s assertions also suggest that US federal debt will climb which is not good for rates longer term. This is a tough one to forecast at the best of times (for example, in December 2015 there were supposed to be four rate increases in 2016, but only one eventually came to pass), but on balance it would seem interest rate risk has increased.

Purchasing Power Risk = ⇑

  • Definition: the risk that an investment will lose its purchasing power due to inflation (applies particularly to cash and fixed-income investments)
  • My take: this risk is somewhat related to interest rate and tax risks in that the main concern would be higher-than-expected inflation. If the new president’s policies end up being inflationary (fiscal spending or new tariffs on imports), then purchasing power may erode. On balance the risk of higher inflation, from a very low level since the 2008/09 financial crisis, has probably increased.

Liquidity Risk = ⇔

  • Definition: the risk that an investment will not be easy to sell when needed (applies to some equities that don’t trade in large volume, fixed-income investments and real estate and other property that may be hard to sell quickly at an equitable price)
  • My take: I don’t see any reason to think liquidity risk has changed since the election – at least not in the short term. If some of the other risks in this post materialize, this could change, and possibly quickly.

Reinvestment Risk = ⇓

  • Definition: the risk that an investment will be reinvested at a lower rate of interest when it matures (applies to fixed-income investments)
  • My take: if we accept that interest rates are likely going to climb higher in 2017, new money that is being invested in fixed income should attract higher rates. If one deploys fixed income funds to rate reset preferreds and/or bond funds or bond/GIC ladders of medium term duration (e.g. five years) then reinvestment risk should be falling.

Tax Risk = ⇓

  • Definition: the risk that an investment will lose its value or return on capital because of taxation (most investments are subject to this risk)
  • My take: if the promised corporate tax cuts and foreign holdings tax holiday in the US materializes, I think corporate tax risk is falling. This may be the “easiest” risk of all to predict. I am not aware of any significant new taxes being discussed, other than new tariffs on imports if the offshore production of goods is deemed to be job-destroying in the US. In the short term new tariffs could be good for US growth. Longer term not so much (and there may be a significant inflationary knock-on effect).

Are there any actionable ideas here?

Since I believe macro risks are slightly elevated, but essentially unpredictable, I am mostly going to stay the course. But….

One area I will continue to pursue is to make sure my bullion (but not bullion equity) holdings are as close to planned allocations as possible (they are a bit low right now). Bullion to me provides insurance against political, market and purchasing power risk.

With US interest rates rising (and Canadian rates staying flat or even falling), I expect, on balance, to see strength in the US dollar. I plan to look at purchasing US dollar denominated investment grade corporate bonds in our bond ladder as I replenish this year. Currently all our bond holdings are Canadian denominated so this is a departure from past practice. If nothing else, this will provide a diversification benefit.

I also plan to try to continue to balance short-term risk with longer term secular trends. I plan to do this by tilting our portfolio a bit more towards emerging areas like robotics, disruptive technologies and water, as discussed previously.

Finally, I may continue to hold slightly higher than normal cash levels for the next quarter or two as I watch the US situation play out.

In conclusion, I am planning to “tweak” our portfolio a little bit, but I must emphasize that none of the risks I’ve discussed are very predictable. Things can change any time. I found it thought-provoking to review the macro risk profile at this juncture.