Wednesday, February 21, 2018

What if the Trans Mountain Pipeline will not be built? Goodbye Canada!

I guess, Murray Edwards saw this coming and lives now in London, England.

Canadians have always had a self-destructive tendency and now with the emotional opposition to pipelines and the anti-business attitudes of its governments, Canada is well on its way of destroying its economy.  Yes, only Alberta seems to be mired in the economic doldrums.  So much so that Rachel Notley is even waging a trade war against her fellow NDPers in B.C.  Her strategy of implementing carbon taxes in return for pipelines has failed. She probably will lose the next election and Alberta will be even more bitter about leftist governments than ever before.

Canadians may say that our economy is doing great right now, but that is only due to a housing boom that made people in Toronto and Vancouver millionaires and created lots of construction jobs. That will change; leave it up to your governments.  As a landlord I love it, because with evermore obstacles for first time buyers in real estate, those governments have created an even larger number of underfunded millennials than there are now underfunded baby boomers. Renters, you are welcome here. But when the housing boom goes, so will Canada’s economy and auto industry. After all, who can afford shiny new cars if there is no real estate to secure the car loan?  Read all those excuses lately that your house is NOT an investment; that renting is better than owning?  Humbug!  That is nearly as stupid as the looser statement: "Oh, it is only money." As a minimum your house is a forced savings plan!  Of course, like any investment, you must buy at the right price.

So, maybe we can count on the coming boom in commodities?  Canada effectively destroyed that for itself!  So what else is there to make a living from?  Right, I move my money out-of-Canada.  That is the new long-term goal. Maybe I will move myself out of Canada, but I still think it is, despite the Liberals and NDPers, one of the best countries to live in – but then I have never visited Argentina. Alberta, being the most entrepreneurial and probably the province with the most right-of-centre government for generations to come, will likely retain some of its economic leadership as the king-in-the-land-of-the-blind. Alberta on the boundary between mountain and prairie is a province with the best natural setting. Here you really know when it is summer or winter and everything in between.  Quebec is beautiful as well, but the population is the most spoiled in Canada – so no way I want to live there! (I am sure I will get a comment from some Quebecers who will say that they are glad I won’t live in their province – to each his (or its) own). Did you notice how consistent my brackets (parentheses) are? Must be all my computer programming! 😊

So really, where can one make money these days in Canada? Taxes are likely to go up in support of a flagging economy and all those people off the payroll. If you think robotics will cause job losses, just wait a few years.  I am going overseas with my money.  I think South America is beautiful and in full emergence.  Still a lot of drug cartels but maybe that will decline with legalized drugs in the rest of the Americas and of course in Europe.  How is that for economic growth – Canadian dope heads?

So, I am going to put my money at work in the U.S., Europe, and emerging markets. Bonds? No way because governments and Wall Street will continue to spend more than they make. BTW did you know that in Baltimore, U.S., the top personal tax bracket is 54%? Maybe after a major financial debacle will reason return to Canada and possibly the U.S. They say, if you don’t like your job, quit because life is too short.  I say, if you don’t like your degenerating country anymore, quit because life is too short.  Maybe my son who bought himself a piece of land in Canada’s boon dogs sees it right!  I am glad I steered my daughter away from geology into accounting. She probably ends up becoming a civil 'servant’ with defined benefit pension plans and a well-paying job living of the rest of Canada.  After all, if you can't beat them - join them! (Lots of exclamation marks too in this post). 😊

Canada will always have a soft spot in my heart; especially Alberta. But not for my money! See you guys during a nice Canadian summer in the mountains because I am sure that with a declining economy you have saved the environment. Now just try to make a living! In winter, I am moving South or to the Mediterranean. I just must find a way of getting my money out of my RRSP with minimal taxes. Unfortunately, I learned too late in live what a sham a RRSP is.  RRSPs are good for the unsuccessful!

Sounds a bit bitter?  What would you like me to say to make you feel better and more comfortable?  Something like: Goodbye suckers! No, that would be ungrateful. And I am not, because Canada gave me and my family a good life. I tried to warn you… The reason there are not more rich people is not that it is so difficult. It is because people are undisciplined and lazy; they count on the government to take care of them from cradle to grave. As said in earlier posts, not taking responsibility for your own life comes at a high cost; not only in terms of money but also in terms of personal freedom.

BTW  If many U.S. citizens don't know that Ottawa is the Igloo capital of Canada then I have the right not to know that Baltimore is a city rather than a state! 

Saturday, February 17, 2018

Science is about thinking outside the box – so much for scientific ‘consensus’

Whether it is toeing the line with the #metoo movement; political correctness or climate change, so many issues are politicized rather than based on reason. Scientists are often quoted as objective sources of knowledge but really, nobody is truly objective. There are so many motivations for choosing one direction or another that range from your emotional tendencies to your political views or cultural upbringing.  The West has been obsessed with diabetes, blood pressure and diet for decades. Can we be certain that when medical associations shift a criterion such as a blood sugar level up or down that it is not motivated due to its connections with the pharmaceutical industry? The latter would benefit hugely from more people on diabetic medicines.  Don’t we all fear to go to the car mechanic, because there seems always something that might need more work? Even if it was just changing the air filter. There is an entire industry out there that makes a living accusing the pharma industry of not solving the diabetic condition and thus ensuring continued pharma clients for many more years if not decades. Many of these accuser groups tell you it is just a matter of diet and that if you buy their diets your diabetic problems will be gone within weeks.  The same is the case for blood pressure where criteria have been adjusted to identify more patients with potential health problems and who consequently need more ‘medical coaching’ and more medication.  The Type I and Type II diabetes criteria have now become so nonsensical and confusing that patients have no idea what they really suffer from. Because type II is also related to genetics not necessarily lifestyle or diet. What is the truth?

The Mayo Clinic has even life expectancy forecasting apps on their website based on the most generalized statistics one can only dream of in nightmares to suggest that lifestyle must be changed.  Next thing you read is that high cholesterol is more related to genetics than diet. Butter, eggs and even bacon is ‘good’ again!  Many obese people don’t have diabetes and many ‘skinny’ people have diabetes and high cholesterol. Oh no… it is your age!  If you don’t get older then you wouldn’t need to be concerned about the leading cause of death, whichever that is these days.  I am sure someone has a remedy against aging – for a price! Your insurance premiums are based on statistics and on those same criteria that our medical associations point to identify your health risks.  If all this work was really without fault, then why do we continuously change our story?
Do you know how many emails I get from financial research every day? Research that points out trends that lead to new highs because of yet another obscure price pattern they discovered that has led to profits in 23 years over the last 30 years?  These are the same ‘statistical methods’ as our medical friends use and by now we know that most are a function of the eye of the beholder. I run statistical data for my geology projects and I realize how often I see trends I ‘want to see’ and how much of the data changes in meaning when I plot it on a different scale or in a different way.  I have been in the geology profession for close to 40 years and I realize how little I and we know.
But every new observation is published by the media as the new ‘It’! Yet another threat to your life or your lifestyle has been identified. North Korea’s impending nuclear attack of the U.S. and with a likely chance that Canada could be hit as well!  So, the government should be investing in NORAD ASAP. Especially since military spending was cut down to less than sustainable under Obama!  Oh the World health organization has just announced how many people are going to die from the latest flue scare and that you should avoid eating lettuce from Mexico that has been irrigated with virus loaded, sewage extracted water.  But o wait… scientists have discovered salmonella in a Brooks, Alberta meat packing plant and you are recommended not to eat chicken for the foreseeable future.  We are manipulated by fear mongering based on quasi-scientific data!  You are manipulated by one sided arguments where politicians influence you in believing one side of the argument rather than the other based on pure dogma. School funding is based on what politicians believe their future voters should believe. The Calgary School Board lately invited David Suzuki to speak on the climate change issue and his so-called scientific ideas!  Any CEO who dares to deviate, as David has stated in the past, should be send to jail. Pure evil are those who doubt the argument of global warming no matter how many times the story was changed; yet 20 or 50 years from now the globe will undoubtedly be 0.87654 degrees warmer than today!
Do you know how ludicrous it is to represent the global temperature by one average temperature and then to predict that said temperature is increasing by 0.87654 degrees over the next two decades and as a consequence sea-level will be rising and the shorelines of Mexico will go underwater? I am sorry if I spoiled your vacation plans but in a few years your time-share along the South American Pacific won’t be there anymore. Its all based on climate science which really has no reliable data going back more than 30 or 50 years!  Why do you think they try to interpret temperatures from historical pictures such as skating on Dutch canals in the 1600s during the little ice age?  Have you ever tried to calculate the world’s average temperature from last year’s skating photos on the Rideau Canal in Ottawa?  Or from growth rings of the tree trunk in your backyard?
So here is the scientific consensus of all the scientists who have been bought or manipulated by the United Nations.  Yet here is also Patrick Moore, past founder of Green Peace, as well as several biologists who have concluded that life on this earth needs a minimum amount of CO2 in the atmosphere to flourish. That CO2 levels in today’s atmosphere (as one would expect during interglacial periods) tend to be too low and that life on earth may be extinct in two million years no-matter how much CO2 China is blowing into the atmosphere.   There is also yet, another group of scientists, probably just as evil as Patrick Moore and probably also funded by the biased oil industry or the Americans who manipulate Canadians not to build pipelines, so we, Canadians, can’t sell to Asia or worse sell to China but rather sell at a severe discount only to our ‘friends’ in the South. This other group of Scientists – often shunned by politicians and the press - have been studying sun spot activity and its effect on global climate. These scientists have found that the Little Ice-age in the 1600s was related to cyclicity in sun spot activity – or better several cyclical patterns of sun spot related types of cosmic radiation. They predict a cooling of the climate and another small ice age within this decade. A lot has been done on climate – some far earlier than that so-called 'Inconvenient Truth’ which proved to be full of misleading stats.
I have a dream that one day, the public will wake up and realize how much it is manipulated by special interest groups who fund all kinds of politicians to scare us into decisions that many of us would normally not make.  Some stuff is obvious such as the fact that cities and other large accumulations of human activity do influence our immediate surroundings; we know that radio-activity from Fujiyama showed up on the west coasts of the North American continent some time later; just like debris from the large 2004 Indonesian Tsunami drifted across the Pacific.  So yes, we do influence the world around us. But is this all CO2 related? Does this mean that all climate-change-deniers are evil-reactionary-white-man-dominated capitalists? If one refuses to sign a declaration supporting abortion on the education funding application for one’s religion based private school , then there won’t be funding from the Liberal Government. In the future will the next government only fund schools that are supporting abortion?  What about freedom of speech and opinion?
Really with all this extremism are we surprised that we now have a bitter fight between the socialists running B.C. and those running Alberta? More and more executives are now speaking out about Canada’s anti-business policies and yes, the U.S. with that Bully in power will leave us behind in the dust of their economic boom. This is what happens when people think they understand science and polarize their opinions declaring the other side as ‘evil’. In the middle ages, Europe was manipulated into burning antagonists on the stake without due process all in the name of a God; whether he or she exists has not even been decided upon 400 years later.  These days anyone with suspicious political ideas away from the streamlined, politically manipulated ideas of the mainstream have their reputation go up in flames without due process often in the name of polarized dogma or unproven science.
Why does society have to be manipulated and scared into voting in favor of one group of fanatics or another.  It is obvious that we cannot pollute without constraint or we will poison ourselves. You don’t need to look farther than China! Especially with world population continuing to expand. But do we have to be so polarized to find ‘common’ ground? – well after the ‘enemy’ has been silenced. Some claim more people are killed by avoidable doctor’s mistakes than by traffic and guns! So much for science! Or should I say statistics? Another statistic that shows how often science may go wrong is that 16% of people in hospital die following misdiagnosis! What about the accurate science of opinion polling?
Most great scientific discoveries have not been made with ‘consensus’ from the scientific community, if there is such a thing, except in the deluded minds of our political leadership. After all, dissidents won’t receive funding! Most discoveries such as ‘continental drift’ (now known as 'Plate Tectonics’) went against the prevailing thinking of the scientific community of the day, that was in our geological example the 1950s. Was it not Galileo who argued that the world was not the center of universe and was he not tried by inquisition?  Talking of thinking outside the box!  Neither have scientists been free of political bias. Socrates died because of his political views (poisoned). So science is often not entirely objective and it is about thinking-outside-the box – daring to think differently that often leads to great new discoveries.  Just like in investing, the consensus is often wrong if not manipulated!  Next time you so heatedly discuss issues maybe ask yourself how much do you really know about the topic? Even after working on such a topic for many decades rather than reading occasionally about it in the newspaper.

Last week there was the trial of a Saskatchewan farmer and the death of an indigenous intruder.  The public had already formed a judgment and the moment that the judiciary came out with a different verdict cries of indignation went up, including that from this country's populist prime minister, about how the justice system should be changed and that this was clearly a race-based judgment.  I have experienced Canada’s court system (although not the criminal court) on several occasions. I am shocked with the indifference of these courts and rulings that are seemingly nearly arbitrary like throwing the dice or based on how long you can afford to go on.  I have learned that in Canada contracts are often not worth the paper it is written on. So my remedy is simple: avoid getting into the court system where the bad guys have already the loot and you the victim can only expect to get a high lawyers bill. Choose with whom you do business carefully. I know, HR departments would scream ‘nepotism and bigotry’ but in real life it is best to do only business with people you like and trust. Sorry, if I don’t jump up and down in eagerness doing business with a complete stranger or someone whose gut I hate; just for the sake of not appearing to be in conflict of interest or to be politically correct. Because I know that if things go wrong I usually end up with the short end of the stick anyway. I prefer that things don’t go wrong and thus to avoid our horrible justice system. And if that is what some call politically incorrect then go and scr… Oops!

Thursday, February 8, 2018

Price patterns for gold? Really?

Figure 1. Gold price over last 15 years in U.S. dollars
So after a nearly 10 year rally, gold had gone up from around (U.S.) $300 to $1000 in 2008. Then during the stock market lows of 2009, it fell to around $750 or by 25%. The next thing is a humongous rally to $1850 or a nearly 250% rally. So yes, gold seems to fall initially during market crashes. It is not a fool proof hedge. Today’s stock market correction sees gold prices and oil prices fall along with the market. Oil should be tied to the economy which is doing well, yet its price has fallen over 10%. Gold is not supposed to be correlated to stock market prices. Pricing trends are often in the eyes of the beholder. If we get today a repeat in the gold price pattern as we saw in 2008, gold may well be up over the coming year. But to be honest, I have no idea how this all will work out.

Figure 2. Gold price over last 100 years plus marked the 'Great Inflation Cycle'

In 1977, Nixon decoupled the U.S. dollar from gold (the U.S. had then too much debt - what else is new). What happened next seems pretty obvious from the above chart..  Is the gold price only a reflection U.S. dollar inflation as many gold bugs claim?
Figure 3. Inflation adjusted gold price (Priced in 2015 dollars or so)
Not really. The patterns in inflation adjusted (constant 2015 dollars) figure 3 show  clearly a different price driver(s). Something with 30 to 50-year long cycles. I guess the pre-1950 peak in inflation adjusted pricing reflects the Great Depression and the Second World War although the U.S. government kept (as shown in graph 2, the nominal gold price steady between the Great depression and 1950. So why did gold sky rocket in purchasing power? Great Depression deflation? Or was this pure a fear trade or something related to supply and demand?  Looks like a major crash around the mid-seventies after gold peaked at $800  or $100 nominally. The following real peak was in 1982, when it was $2000 or $800 nominal. Whatever the cause of the 1970-1982 cycle: another major upturn in inflation adjusted gold prices started around the changing millennium. If the 1970s cycle foreshadows the new cycle started around the year 2000, we may be in for a big ride and I suspect that is related more to the difficulties today in finding new meaningful new gold mining prospects rather than anything else. So, yes gold prices seem not to reflect stock market trends, however, it may be set for a major upturn regardless of inflation. 
My point is, that you may come up with many explanations about gold prices; but gold does as gold does and it may not be in sync with stock markets. As such, it is a good diversifier and may rise during times of crises such as the World War II or during the great inflation cycle from 1970 - 2008, or now at the start of a new era of rising interest rates and inflation and with a lack of new gold mining prospects. Or, maybe markets are too complex to identify a single or even just a view causes for price movements and you just own a bit of gold as insurance without worrying too much why its price moves.  You don't want to be too smart when investing - it usually just gives a headache, creates overconfidence, and delusional believes in a fantasie.

Sunday, February 4, 2018

‘Put-option’ insurance protection for the Melt-Down

Click on image to maximize

Earlier we discussed that portfolio insurance may provide you cash during a downturn without having to sell off parts of your portfolio.  You get this ‘insurance’ through buying a put option. In case of protecting your U.S. portfolio, rather than buying put options of every single U.S. stock holding you own, it is probably more affordable to buy a put option on say a Dow Jones index ETF. Example:  Dow Jones SPDR (pronounced [spider]) ETF.  This ETF trades around a share price of $260 (all dollars in this post are U.S. dollars).  You can buy a ‘Put’ option for around $12.70 per share or $1270 per contract (which is for 100 shares). So you could insure a portfolio worth  $26,000 (100 ETF shares) by purchasing 1 put-contract for $12,70 per share or $1270 per contract.  If the share price fell by 10% to $234, the value of your option would increase by (260-234 = $26 per option).  This increase is also referred to as the option’s intrinsic value or premium. Thus, the value of the entire contract would increase by 100 x 26 = $2600. 

If your portfolio was diversified and reflected the exact share price of the Dow Jones, then it would have fallen from $26,000 to $23,400 and the increased put option contract value $2,600 would have covered the loss exactly. Eh…. But we also paid for the contract $1,270 in premium, so the profit on the options is NOT $2600 but $1330!. We will get back to that.

Say the market fell not 10% but 50%!  Then your share value would have fallen to $130 and the option contract would have an intrinsic premium of $260-130 = $130 per share or 100x$130 = $13,000 per contract. With the contract’s original purchase price still being $1270.  So with a 10% fall the premium would have reduced option profits by nearly 50% but with the 50% loss it reduced your option profits by less than 10%.  Consider the $1270 your 'deductible'!
But this 'put option' insurance deductible is kind of strange. Because you may be able to earn it back in part or better, make a bit of a profit on it. You see, the $1270 represents the 'time value'  of our insurance.  You can cash-in your option during any time of its term by selling your put option. You could sell or exercise it on expiry and you would only receive the intrinsic premium; in our 10% decline example that would be $2600 and since you paid $1270 in premium you’d ‘only’ made $1330.  But what if the crash happened only 2 months into the 12-month term of the option (which expires in January 18, 2019)?  If the market would fall even further during the remainder of the option term, it would increase even more in intrinsic value. Thus the option has remaining time value!  Even better, since the market fell so dramatically (increased market volatility is the official term), other investors are now willing to pay nearly anything for insurance – that is called the implied volatility premium of the option.
So, if you think you are near the bottom of the market and you’d want to start buying stock again, you can sell your options for its intrinsic premium plus the remaining time value of the option and, depending on the market’s fear level, the implied volatility premium. Thus, if you sold you’d receive $2600 plus extra premium which may well be a lot more than the $12.70 you originally paid!  Say your remaining time value and implied volatility adds another $15 value to your total option premium and you’d sold your put options 2 months into the term at a time of significant market despair for a total of $26 plus $15 = $41 dollars.  That would be a total of $41 dollar or a profit of 100 x $41 = $4,100! That is the beauty of this kind of ‘put-option’ insurance: your ‘deductible’ may become part of the profit!
Suppose you have an $100,000 portfolio in U.S. stocks. With the Dow Jones decline of 10%, you’d lost $10,000 so now comes the high school question: ‘How many apples… eh contracts should you have bought to cover that loss?  Answer:  $10,000 divided by $1330 is 7.52 contracts.  So, you need to buy 7 or 8 contracts (you cannot buy fractional contracts) to protect your entire portfolio. That is nearly 10% ($10,000) premium if you’d want to protect for even a small correction of 10%.  But we are only interested in a crash of 30% or worse. If that happened during the term of your insurance, you’d only needed around 4 contracts (maybe 5) and your premium would be around $5,000 or 5% of your portfolio value. And don’t forget the potential of the ‘profitable deductible’! However, the latter is purely speculative and at this point, I don’t account for such a windfall.

Before moving on, you may wonder if you can only break-even when buying 'put-option' insurance. Not at all. This is what makes option strategies so interesting - you can design your option strategies to do nearly anything short of making good coffee. Although you could use the profits to buy a very good coffee maker machine! 

On the spreadsheet above, I created a scenario that not only have your portfolio break-even but it also makes a 10% profit! But realize, none of this is risk free and the more you bet against the market the more you risk!
Buying ‘put-option’ insurance is not a one way street. Because if the market doesn’t fall, the premium you paid is gone! Say the market rose 10% over the term of the option. That is your portfolio rose by 10% from $26,000 to $28,600? Well, your total return would suffer because out of the $2,600 profit you will pay $1,270 premium and thus your return is only 5%.  On the other hand, you’d probably didn’t only get $2,600 appreciation but also received another 2.6% in dividend yield, so your profit would be capped at around 7.5% compared to nothing if you had not participated in this market. By now, you must get a good idea about what ‘put-option’ insurance is all about. Another post will follow to discuss the limited upside of such an insured portfolio.

Friday, February 2, 2018

A Canadian case for owning gold

I never invested a lot into gold. But over the last four or five years, I have become more involved.  Gold does many things for an investor. For example during Black Swan times gold often goes up; it is not ‘correlated to the stock market’. As such, gold maybe a a safer hedge than bonds against a stock market crash, although it has been observed that gold goes down during the initial crash. However, with the bull market in bonds coming to an end, I am afraid that bonds may not offer the protection during crashes that it used to provide.  In fact, combined with low interest rates, bonds have never attracted me, especially not on an after inflation and after tax basis. 
What if interest rates are high? Say 15%; yummy!  Well that only happens when inflation is high as well. So you have to look at REAL interest – which is usually between 2 and 4%.  So at 15%, you typically have 12 or 13% inflation. But that is not the worst of it; because you may be in a high tax bracket which many successful people are. I plan for success not failure!  So you have 15% interest and get taxed at a 50% rate; i.e. the government claws back 7.5% of the interest it paid you and then, after 12% inflation your return is? Right negative 4.5%.  Well success with that!  And don’t think that an RRSP helps, because when you take that interest out of the RRSP after many years you still pay top margin tax rates of 50% on everything you made!  Not to mention that any capital gains you may have made over the last 20 or 30 years of falling interest rates will NOT be taxed at half your tax rate (50%) as when you held it outside an RRSP, but you will get hit by the full 50% tax rate.
Thank you very much!  The only place bonds and other fixed income might work is in the TSFA but historically stocks do better so why bother? If you are in the mood of buying government bonds to guaranteed loss of money then go ahead.  That is why I love Kevin Leary’s view; he considers real estate part of the fixed income. Real Estate typically is 6 months or longer out-of-sync with the stock market and the economy (the latter two are not necessarily the same – that is why  having a career is a form of diversification!). Back to gold.
Gold is protection against fiat money failure and in case everything goes to ‘Hell in a handbasket’, gold has proven to be a valuable form of money.  Remember how many Jewish people used gold or jewelry as a way to get out of Germany and occupied Europe during World War II?  Gold has been a safe haven for more than 5000 years. Bitcoin may today be an potential alternative but I am far from sure about that. When I say ‘gold’, I include silver and to a much lesser degree platinum.
But here is another reason for investors to hold gold. Gold is a commodity and as such it is often inversely correlated to the U.S. dollar. Guess what happens with the value of a U.S. portfolio of stocks when the U.S. dollar falls?  Exactly, gold goes typically up and the portfolio in currency terms goes down.  Lots of people buy currency hedged ETFs but really if you own gold you are already protected. If, as Canadian you experience a rising Canadian dollar,  gold is there to offset the currency effect on your U.S. dollar net worth! So that would be another good reason to hold gold and I bet it is more predictable and reliable than bitcoin in a heart beat. "Oh, disaster Gold fell over the last 6 to 12 months from $1300 to $1200 dollar!"  Oops that is less than 8%.  Last year the Canadian dollar swung from U.S. $0,72 to U.S. $0.83 that is close to 15%!  I am sure you get my point.

Sunday, January 28, 2018

Insuring against the Melt-Down

Yes the good times are rolling. How long will the Melt-Up last? No idea. 6 months; 18 months?  I do know that the higher the markets go, the higher the risk. Contrary to the beliefs of many, risk of reduced profits and losses increases with market pricing. Also, the opposite is true: the lower market prices have fallen the less risk for even lower prices.  This is obvious, except to many investors – especially retail investors who always seem to get involved in expensive markets out of fear of missing the boat.  Bad luck if you just bought in, you probably have missed the boat or just got in when things got wobbly in today’s bull market.

Stock investing is about volatility – a word many have recently forgotten.  Still remember the pain from 2008-2009? Ouch it still hurts but really if you had held on in those days, you would have tripled your portfolio value from portfolio levels at the through of that market and you would have even made respectable gains compared to the peaks of 2007 – possibly with the exception of investors that stuck to Canadian markets. That is where international diversification comes in and I have written already quite a bit about that in previous posts. 
Basically, we are talking about market volatility that makes us sick in the stomach, but it also provides the opportunity to buy stock on the cheap. Wouldn’t it be nice if you had a pile of cash near the bottom of a market while you never sold a single stock during that downturn? Well, as said many times before, volatility is an illusion if you consider that long-term stock returns are 6 or 7% plus inflation using Jeremy Siegel’s research. However, wouldn’t it be nice if, like many professional investors, we could generate a lot of cash from market volatility?  Officially that is called portfolio hedging or portfolio insurance.  And as all insurance it is not free. You will have to pay insurance premium and that will lower your overall portfolio performance. But what if that could also result in a lot of cash and a more stable portfolio value?  Hmmm, you can do a lot to hedge your portfolio’s stability like building a cash hoard or accumulate gold or buying bonds that hopefully go up during the next crash. Diversification of your assets may help. Yet even when holding only quality stocks, during bear markets your portfolios will go still down but maybe not by as much as the overall market. 
So, we are insuring against volatility and now we are trying to reduce that volatility and building cash to create an opportunity to buy even more stock on sale. Say you own a house worth $100,000 (well that would be a shack). Now somebody knocks on your door. You open the door and a shady guy stands there and says: “I will buy your house or better your shack for $150,000 at the end of next year." You know, with the current state of real estate there is a good chance it will be worth that much; but what if the market actually drops because of all those new mortgage rules and foreign ownership taxes?   Hmmm you think to yourself. That offer is $50,000 above today’s prices and I am not sleeping well these nights because of all the profits I already have made on paper.  You look at the shady sucker and get a brilliant idea. “You know what fellow, I might lose out on a lot of profit. Last year my shack went up $50,000 and this year the real estate board forecasts that it could double again!  I’ll sell you the place for $150,000 a year from now if you pay me today $10,000.” The shady character says, "$10,000?? That’s outrageous because if the market doesn’t go up to $150,000 I lose all $10,000. What if I paid you $2,500?”  You: "But you have an excellent chance, according to the real estate board, to turn around and sell my shack for $200,000!” You haggle all night at the door and agree on a $5,000 call option premium.  Because that is what you are doing. You sell to someone the right to buy something (your shack) anytime over the next year (the option term) for a certain price (the strike price) for a premium of $5000. The deal expires at the end of the year, i.e. the expiration date. If you do the same with shares in a company this is a ‘call option’. If you do it with oil or grain or sugar it is called a ‘futures contract’.
If you are afraid for the value of your shack to fall over the next year; you could have bought from someone the right to sell the Shack for a pre-set price (strike Price) anytime during the year (term of the option) for a premium, of say $500. This is called a ‘put option’.  Selling call or put options is a low risk way of earning income (premiums) on shares you own or wish to own.  You can also speculate in options, which is a high-risk strategy a bit like playing the casino. But the real purpose of options is to mitigate risk.  The farmer BUYS a put option?  Well if the price of the harvest falls below the strike price, the put option buyer MUST buy the harvest at the strike price because that is what the farmer paid him the premium for. The farmer bought himself or herself (we have to be non-sexist) insurance to guarantee the sell price for the upcoming harvest. You can insure yourself against a falling stock market by buying put options for your portfolio or for parts there of. 
Let’s assume that you own a basket of U.S. stocks and the market is going higher and higher. Rather than buying a put option (insurance) for each stock you own, you buy put options for the entire market as represented by the Dow Jones SPDR ETF (symbol DIA-N) currently priced at $260 per share (that saves on commission and makes it all simpler).  Options are not sold on a per share basis but on a full lot basis, i.e. 100 shares.  An option contract is ALWAYS for 100 shares even though the option price or premium is listed on a per share basis.  So, if you buy an option for DIA_N priced at an option premium of $12.70 per share; the price for the contract is 100x $12.70 or $1270.

Now, you may ask what kind of an option do I get for $12.70 per share?  Well, the option market sets the option price or premium kind of like an auction. When I last checked the market, I wanted to buy insurance (Put options) for 100 DIA-N shares at today’s share price of $260.  Thus, the strike price for the option is $260; if the price of the DIA-N falls to $250 then, because I have the right to sell those shares to the seller of the put option for $260, the option’s value is $10 per share; the difference between strike price and market price is called the option’s implicit value. The implicit value changes during the term of the option.  I will also pay premium depending on the length of the term of the insurance.  Because what if during the insurance term the DIA-N price fell further to say $200?  Then at the end of the term you lost even more $260 minus $200; the first $10 and another $50. $60 would be the new intrinsic option premium.  Thus, the longer the term of the insurance the higher the risk for the insurance seller and thus the higher the premium for his put option.  The difference between the strike price and the actual market price of the DIA-N is called the IMPLICIT value of the option and the extra premium charged for the time that the insurance lasts is called the TIME value of the option.  
The higher the risk the seller perceives, the higher the premium. If there is, in the eyes of the seller, no chance the DIA-N falls all the way to $250 then he/she would sell at a much lower premium than if the seller was sure that the DIA-N would within the year fall indeed to $250 or worse to $200. This risk estimation (implied volatility) is also build into the option premium. Thus, the total option premium comprises Intrinsic  Value plus Time Value plus Implied Volatility.  After all, you may want to buy insurance, but the seller of that insurance is not necessarily an imbecile. He wants to make money too. He may just have a different outlook on the market than you and wants to get paid for the risks he takes.
Who cares why somebody sells the insurance, as long as you are covered!  But you must understand at least a bit where the seller comes from to know whether you pay a decent insurance premium. So what do you pay today for an put option with strike price of $260 for the DIA-N that expires in about a year?  Well, I checked my on-line discount brokerage where I have permission to buy and sell options. The premium is $12.70 so that means I can buy an put option contract for 100 shares for $1270.  This ensures that 100 shares now trading at 100 x $260 = $26,000 won’t fall in value because if they do, the option seller will still buy them from me for $260 per share anyway.
Aren’t you smart?  No way of losing.  What if I don’t want to lose but also want to make money in such a falling market?  Say the DIA-N falls to $200 but I want my $26,000 in U.S. stock portfolio to increase in value by 10% to $28,600 regardless, can I do that?  Sure, you can – just buy more put options. At option expiry a $260 DIA-N is worth $200 or the option pays out $60 per option.  To earn $2,600 in profit you must buy $2600/60 is another 43.3 options or pay an additional premium of 43.3 x 12.70 = $550 dollars. Wow… How can I lose?  Well, what if the market doesn’t go down?
If the market goes up rather than down will you lose your insurance premium. You paid $1270 plus an optional $550 in premium and because the market went up you didn’t need the insurance and the options are, like any insurance, worthless at expiration. Say the market went up by 10% instead of falling. Your shares are now worth $28,600 but you paid in premium $1820 dollars!  Your portfolio has now only increased to $28,600 minus $1820 or $26,780. That is not a 10% but a 3% return. That is the price of avoiding volatility! And the longer you have your insurance the more premium you pay.

You are now protected on the downside, but your upside is limited.  Just like the farmer selling his/her harvest you are ensured the minimum price of $26,000 worth of investments. Which is sweet during a down turn and even provides you cash.  With the decline in market value, the value of your options go up and you do not want to sell your portfolio. No Problem, you just sell the put options near expiry for close to the implicit value plus maybe a bit of remaining time value and implicit volatility premium. That way you still own all your shares, even collected dividends and you converted the options in cash which you could use to buy more shares near the bottom of the market. And when the market recovers during the next bull, wow you’d look like a genius!
My strategy is to buy my insurance in chunks, so I may buy a bit now at prevailing market valuations.  Then six months from now if the market went up, insurance for DIA-N with a strike price of $260 would be a lot cheaper based on intrinsic  value and a shorter expiry term i.e. time value.  Or I could buy options at the then prevailing market value of DIA-N shares and thus lock-in some of the profits made on paper over the last 6 months. I also could extend the insurance term by buying options that expire 12 months from then instead of the remaining 6 months expiry of earlier bought options. Or... I could do both; increase the strike price and the option term.  The combination of choices is endless so don’t get confused because that may create more risk than you bargained for. 

This was quite a complex posting with many ins-and-outs. The next blog will show you the numbers in spreadsheet of our simple scenario of buying $26,000 portfolio insurance in the form of 1 contract of DIA-N put options at a $260 strike price expiring in December 2018 for $1270 or a price of $12.70 per option.

Preparing for the Melt Down

Gary Shilling, a well-known investor, notes that academic studies indicate that average stock performance is based on 3 main components: 50% from market performance; 30% from industry sector selection and only 20% from individual stock selections. “If you’re right on the economy and industry sector, you’ve got the lion’s share there”. 

 Sallie Krawcheck, another well-known investor answers the interviewer’s question: So you don’t buy individual stocks at all anymore?   “Nope”.  …..  “No. I just view myself as a recovering research analyst. I am no longer enamoured with the undertaking.”

Most investors lose money by aggressively aiming at market out-performance, but this is for most not achievable. From personal experience I can tell you that my outperformance at various times was plain luck. Now, it is true that the best way to grab opportunity is when it falls in your lap. So you have to position yourself to be lucky and the odds take care of the rest. But this may be true for the best investors of this planet but not for the average investor, who may hit the home run only a few times during their life. For us, average market performance is plenty.
I work in the oil industry and it has been good for me as a career. But I was never good at investing in junior oil companies. In fact, the reason that my net worth growth only slowed down somewhat during the current oil price downturn was the fact that I had very little invested in the oil industry.  I was definitely below the sector allocation of the TSX.  Yes, I had nearly half of my net worth portfolio in real estate and a significant part of that in a personal residence in a highly desirable area of Calgary; I had invested in hospitality outside Calgary; in senior housing and a little in rental apartment units which were hardest hit in rental income. Overall, my portfolio barely declined; to the contrary it went up because I have invested a significant proportion of my portfolio invested in the U.S. – often ETFs and only the bluest of blue chips.

It is a boring portfolio with most of my experiments in a smaller discount brokerage account. I missed most of the TSX bear market in 2016 and have increased investments in Europe and a miniscule amount in China. Yes, I have outperformed the TSX but underperformed the U.S. indexes by a mile. Who cares; we all grow our net worth based on personal circumstances. My best advice is to let your winners run and hope to never sell and cut your mistakes short. Dare to admit you were wrong. Yes, it may deflate your ego a bit. In fact, a bit less ego is beneficial for most of us.
Yes, I have bought a bit more commodities and commodity related stocks lately. These cyclical industrial sectors have been in a nasty bear market for years now and there is significant upside (in my ego driven opinion). If you as a Canadian bought ETFs of Canada’s stock market you are not very diversified. So as a Canadian investor you may be forced to buy individual stocks to achieve diversification. You should set up your own sector allocation – in fact one of the most diversified markets in terms of industrial sectors is the U.S. so may be start with the sector allocations of the Dow or the S&P500.  All those indexes have pros and cons. But it is a starting point for stock portfolio allocation.  Not for your total net worth portfolio which includes cash, real estate, your career, and maybe some esoteric stuff such as art or collector cars.
So, let’s use the S&P500 sector allocation as a guideline and buy Canadian stocks based on that. So much in banks and insurance; so much in telecom; so much in pharma.  You may soon find out that Canada’s banking sector is very good but that it is tough to find good pharma stock. Thus, you may have to adjust your Canadian stock portfolio asset allocation. Real Estate should not be a problem with companies like Brookfield that trade in Toronto. Focus on companies that pay good quality dividends – nearly half of your stock profits come from dividends and dividends provide cash flow during tough markets.

Next, we move international, Warren Buffett likes to invest only in companies he understands. That is not quite possible unless you are Warren Buffett. But I would like to apply this rule to asset allocation. You are probably most familiar with Canada and as such you don’t have to be an extreme allocator by only investing Canada’s portion of the world economy (2% or so) in Canadian stocks. I don’t and that is not strictly home-bias. But I do aim to place more and more assets internationally.  It is true, I don’t blame Canada’s poor stock market performance on Justin Trudeau; it is also our market make up and neither do I credit our good economic performance to Justin. Maybe some is also due to Steven Harper’s economic decisions. Most of it I attribute to Canadians and Canada in general. Neither do I think that the current U.S. stock market outperformance is just because of Trump and has nothing to do with Obama or the insuppressibly U.S. entrepreneurial spirit. Besides, what is more economically stimulating than putting your investment money back into your home economy. I am one for sure that would be scared to put big money in China’s dictatorial system. There is not such a thing as that business is not personal. You bet it is. There is nothing wrong with having 30% or a bit more of your stock portfolio invested in Canada.
But with me already putting 50% of my net worth assets in Canadian or better yet in Alberta real estate would it be wise to put a large portion of my money also in Canadian government bonds and in Canadian stocks?  I don’t think so. That, and also thanks to Justin and Rachel, I am more and more tempted to put my stock portfolio elsewhere or in Canadian dividend paying companies with a more global portfolio. Brookfield, Sunlife (I had my fill with ever-disappointing Manulife), Brookfield; Algonquin; Alterra now Innergex Renewable Energy; Power Corp; Vermilion and many others. Right now I am, more or less, comfortable holding 30% of my paper securities (including bonds which are only a minor proportion of my portfolio) in Canada. I suggest an equal amount in the U.S. – for now and 20 -30% in Europe. Not more than 10% in China and other emerging markets.  Cash is cash even if held as a money market fund in one of my brokerage accounts. We discussed cash before and I am comfortable to aim for having 1 to 2 years cost of living in cash as a minimum and 15% cash as a maximum. Don’t forget if you have a net worth of say $ 5million that would be more than $750,000 in cash and short-term interest paper. You don’t need that much just to live off for 2 years – I certainly don’t. Always think in terms of a total net worth portfolio that is real estate; stock and bond portfolio; gold and cash. Speaking of Gold – holding gold bullion is like holding cash. Holding a gold ETF convertible into gold bullion such as Central Fund of Canada, I compare with a money market fund.
So as part of preparing for the just started Melt-up and the coming Melt-down, I suggest you go through your net worth portfolio and see where most of your risk lies and get rid of it over the coming months.  Next check your diversification of assets and your regional diversification in your stock portfolio.  By the way, I consider your career also part of this diversified portfolio in particular part of your industrial sector diversification. If you work in oil and gas; don’t also have 60% of your portfolio invested in oil and gas companies – no matter how well you know the industry. The road is littered with terminated oil and gas executives and self-deluded CEOs.  When checking your portfolio risk and diversification, please leave your ego at the room entrance. Nothing is so healthy as a deflated ego after a big investment loss; only then it is too late!