Thursday, August 22, 2013

Canada's stock market is like the canary in the coal mine!

Today the world economy is clearly on the path of recovery. Economic numbers from both Europe and China, especially when combined with those in the U.S. support this. Yet Canadian investors have yet to benefit. While the U.S. stock market is clearly in bull market mode and with Europe’s stocks also ahead, here in Canada we seem to live in perpetual malaise.
In general terms, we can predict the cyclicity of stock markets and it can be roughly subdivided in five (5) stages:
1.       Crash – accompanied by emotions of denial evolving into desperation

2.       Bottom and initial recovery – Desperation combined with Value Investor heaven.

3.       Recovery – at this point only Value Investors and ‘Buy & Hold’ investors are in the market (this is where we are in Europe and Asia).

4.       Advanced recovery – the easy gains have been made and the general investor public returns to buy stocks (that is where we are right now in the U.S.).

5.       Euphoria – Everybody feels like a genius ‘the market can only go up’; ‘New economy’ – time to take profits and build up ‘cash for the coming crash’.
So where does Canada fit?  In spite of all the talk about globalization, not all local economies are created equal. The U.S. is a service and manufacturing economy predominantly and lately it has become more diversified due to the energy revolution and commodities are becoming more important.  But rather than hoping for higher commodity prices, the overall U.S. economy benefits from cheap commodity prices (low natural gas and oil prices in particular).   Although they produce commodities, farming (grains, vegetables, and fruit) and to a lesser degree ranching (cattle and other livestock) also benefit from cheap potash and energy prices.

Europe’s economy is another commodity consuming economy that is weighted towards services and manufacturing. Europe also does best when commodities and interest rates are low. Now that it has put some Band-Aids on its credit markets Europe is clearly recovering.
China and some other emerging economies are, in spite of their huge populations, strictly manufacturing and exporting economies. They need consumer demand from the rest of the world AND low commodity prices. Although gradually turning into consumer economies like the west, these emerging economies are still heavily dependent on growing demand from Europe and the U.S. whom together constitute close to 50% of the world economy – especially when you include Japan!
Only when the manufacturing and export economies do well will demand for commodities increase. Canada did great coming out of the 2008 financial crises but stock markets overshot economic reality in 2011 when the TSX reached a peak of 14,000. I warned in this blog that we had moved too fast based on my rough estimate that our market is likely approaching ‘crash territory’ at a TSX of 18,000 to 19,000 and that a TSX at 14,000 was way too early in the stock market cycle.
Canada was rewarded with a relative mild recession in 2008 thanks to our great fiscal position at the time – budget surpluses and acceptable government debt levels. We also had the strongest banking sector in the world.  But elsewhere the financial crisis did hit much harder and demand for commodities crashed. That is why Canadian markets have flattened in performance since 2011.  Our banks were fully valued. But other financials such as insurance companies (Great West Life, Manulife, etc.) were suffering because of artificially low interest rates and poor stock markets.  And the resource industry… just went into shambles. In particular gas which not only suffered declining demand but also the ‘benefits’ of the new energy revolution. It is a wonder that oil prices haven’t collapsed like natural gas. Just imagine what oil prices could be if the world economies are running full tilt!  
I still think that for good world economic growth not only interest rates determine how well we’re doing; energy pricing is nearly as important, or if you a follower of Jeff Rubin energy prices are MORE important than interest rates.  On this blog we feel that oil prices of $125 or higher will destroy economic growth – in the future this price cap is likely to go up with worldwide inflation.
But just like, as described in an earlier blog, the Chinese and other emerging economies cannot do well when Europe and the U.S. aren’t; Canada with its dependence on the resource industry needs all three big economies to do well. Canada does well in the last stage of the world’s business cycle.

I think the statement that the 21st century belongs to China is greatly exaggerated. That country has tremendous problems to overcome.  Europe, the U.S. and of course Japan are hard to beat. But we need prosperity in all these economies before Canada (and Australia) will fire on all four cylinders. When this happens, let your Canadian profits run but use trailing stop losses because the world will be close to a crash – my guess is that we’ll be there in 2016 and that 2014 and 2015 will be terrific years for Canada.

For now, my investment emphasis lies on the U.S. and I have diversified a bit Europe.  Investing in the raw stock markets of emerging companies is too much for my stomach. I wish those who venture their all the luck.

So Canada is a bit of the 'Canary in the coal mine'. When Canada’s stock markets are booming and oil prices hover around $125 per barrel then hold on to your hat because the crash is coming near.

Sunday, August 4, 2013

Should I rent or own my residence?

This is another of those perpetual investment decisions everyone faces in their life. My answer is: ‘It depends’.
First of all, buying real estate is an investment – often a big investment. It takes time to make it worth your while. If you buy a house you pay lawyers, transfer taxes (unless you live in Alberta), in some cases you pay GST, etc. When you sell, you pay lawyers, real estate commissions and all kind of taxes. Typically, the first 6 to 8% of your property's appreciation goes towards paying for those transaction costs. That means, with a typical appreciation cost of 3 to 5% per year, that the first 2 years of appreciation (if it is straight line) goes toward paying the transaction costs. I use as rule of thumb that real estate investments should be held at least five years and probably forever. Thus, if you are in that stage of life where you don’t know where you want to live or work then rent rather than buy. Does that make sense?
In everyone’s financial decisions there is the choice: buy a liability or buy an asset. A liability is something that costs money and other than enjoyment of ownership it provides no growth in your net worth. An asset is bought to create increased net worth.  A personal car is a liability; a real estate property is an asset.
To make matters a bit more complex, a car required for work is an asset as it allows you to earn money. But would you buy a $200,000 car or one that is priced based on how much you will earn from work. I would say the price should be as cheap as the circumstances allow.  We all know that a car depreciates every year and it costs money to maintain. So if your monthly pay cheque is $1000 would you take on $700 in monthly car payments and other costs? Not likely – you would probably buy the cheapest piece of junk that you can get as long as it brings you safely from point A to B.
If you bought anything more expensive, the car would no longer be an asset, it would become a liability. You may actually want to own a more expensive car but that would be for your personal enjoyment.  You would conclude that to make money from your car, you’d do with a $600 clunker but there is more to life than sitting in a cramped piece of junk. You want a radio in the thing. In fact you desire a Bose system! The increased car expense is due to your lifestyle choice and now your car is now not quite an asset and not quite a liability.
If you buy a rental property, you expect to make rental income offset by maintenance, property taxes,  advertising, etc. These operating expenses are strict necessities to create maximum profits from this asset. Now, to whom would you rent it to? 
A tenant would be renting the place based on various factors. The place could be fabulous providing a lifestyle fit for a prince! Alternatively, the place could be functional and provides the tenant a place to eat and sleep while the rest of his time the tenant plans to work.  In the first case, the princely lifestyle is typically intended for the tenant’s enjoyment and the place is a liability for the tenant – the rent is mostly consumerism.  In the second case, the rent is kept to a minimum, the place is required by the tenant to do his job and maximize his savings. The place is an asset for the tenant.
A functional home (?)
Now, who do you, the landlord, think would constitute the most reliable tenant for this property? Who would stay at the place for years while you collect rent without worry?  The answer is: You! You are the most reliable tenant.  You already made at least a 5 year commitment to own the place – anyone else who gives you a five year lease? 
And if you chose the place as an asset needed to do your work, renting it from yourself, would augment your net worth because it represents the lowest cost of living, while it provides you with land lording profits as well.
Now, if you were the tenant who wanted the princely lifestyle, you’d still make the land lording profits but the tenancy is mostly a liability. It is consumerism that does not add to your net worth!
When contemplating buying your residence, analyse it as if it was a rental property. Then switching to the position of tenant, ask yourself what lifestyle you want – what is the utility/consumer ratio that you’re after?  Are you mister frugality; are you living pleasantly but below your means, or are you splurging like a Saudi Prince?
You see, now the question of ownership can be just as easily answered as if you buy or lease a car. My choice: I’ll own my residence but I don’t want a place that is too spacious and expensive. I want a place where I can enjoy my neighbors, entertain friends and family while living comfy but… well below my means.

Saturday, August 3, 2013

Bread baking silliness

Today I fulfilled a dream! I baked my own healthy, whole-wheat, multi-seed bread with no artificial ingredients, lard or chemicals! WOW! I baked it in an electric oven not one that uses natural gas and that destroys the environment.
Hmmm… maybe I shouldn’t have used an electric oven after all. I just learned that in Alberta, close to 80% of electricity is generated from coal. Talking climate change! Hmmm… they say that all those foods grown on the land are in fact nothing but energy converted into proteins! It takes natural gas to make fertilizer; the farmer used up precious water to irrigate the land; he used oil to run his tractors and combines.
Oops, I hope they used wind or water to grind the flour because otherwise I caused unending damage to the environment, to my children, to future generations and to society in general. L
I hope the farmer didn’t use genetically modified grains bought from some nasty, capitalist chemicals company. Come to think of it, the harm I have done baking my own bread!

The union representatives are knocking on my door, I have robbed the livelihood from one of its members, a poor, disadvantaged immigrant from Nigeria! There are former wheat board members protesting in my back yard; apparently I supported the Harper Government and undermined the poor disadvantaged Canadian Farmer. Well, those farmers that demanded protection from foreign competition, not the farmers who wanted to do their own marketing.
You know, I feel so bad about all this. I don’t to deserve to live. I feel like jumping of a bridge, but the fire department’s unions inform me that I will affect their workload and their family life! The damage to the bridge and pavement place an enormous burden on the capital budget of my hometown and society in general.
I wish I had never been born… well thanks 'you know who' that at least I live in a free democratic society where the government protects me every day by scanning my private e-mails. Well so much for baking my own bread!

Photographed and Skydrived from my Windows Phone!!

Diversification and Investment Timing

Most investment literature follow the mantra on the impossibility of timing, whether it is from Peter Lynch of the famous Fidelity Magellan fund and author of the book ‘One up on Wall Street', contrarian investor David Dreman, or Jeremy Siegel author of ‘Stocks For The Long Run’. So why are we still talking about timing our investment acquisitions?  BTW Jeremy Siegel thinks it likely that the Dow will reach 18,000 by 2014 – click the blue link for a video.

Investing is all about buying at the right price and guess what? When you are at the pricing bottom of any investment market the price may not only be right, it may be ridiculously cheap. So there is a timing element build into investing.
Also, when prices are low market risk for a further drop is low while at high valuations market risk for an upcoming crash is high. Ironically, many pundits will shout hysterically to ‘sell, sell, sell! The market will fall even more!’ at times of market bottoms (because that is how they get their much desired media coverage) and they tend ‘en masse’ to cheer, stating ‘This time it is different; we’re living in a new economy; the market will go much higher!’ near market highs.
Warren Buffett consistently states that investors should NOT overpay; he even comments on his own company – Berkshire Hathaway – often telling the public whether its stock is overvalued or not. So Mr. Buffett and many other legendary investors tend not to make major investments when markets are expensive; sometimes they don't buy for a very long time. Often they ‘underperform the markets’ during years of overpricing while you’ll hear the ‘investment gurus of the day’ shout in the media that ‘Good-old Warren is passé!’  You can bet your last dollar that that is not the case but instead that you’re in an overvalued market.
So, how come that these super investors can wait for years until they get an investment at the right price?  Should you wait and put all your cash into a non-interest paying bank account until the next market crash and bottom?  How many years would that take and what are the opportunity costs of such a strategy?
If you only focus on stock market investing, a strategy of dividend reinvestment may outstrip the profits from a strategy of staying out of the market until the price is right. One of the earlier postings on this blog shows you the math.
However, what when you diversify beyond the stock market, i.e. when true diversification comes in?  When you’re investment targets are not just stocks and bonds, but also real estate, gold, etc. Then there are probably enough market segments that typically are reasonably priced or that are at a market bottom. Professional investors refer to those phenomena as the correlation between asset classes.  If one asset class, say gold, is down you may find another (say oil and gas stocks) is also down; these asset classes correlate well. On the other hand, the gold asset class is often up when manufacturing and financial stocks are down. In that case both asset classes are poorly correlated.  The real estate asset class trails the highs and lows of the stock market by about six months. During stock market crashes, interest rates are often lowered by the central banks and bond prices go up.
Thus, when you are truly diversified, chances are that you don’t have to wait for a long time to see one asset class or another trading at reasonable or at outright cheap prices. Of course, you need to have an idea as to what a ‘reasonable valuation’ represents in both stocks and bonds or real estate. Steve Sjuggerud an analyst at Stansberry Research recently suggested a metric that can be used to value all asset classes more or less with the same yard stick. This may work for you as well. The idea is quite simple: determine based on net cash flow, and in case of stocks that includes the amount of stock buyback programs, how fast it takes for your investment to be paid out.  In case of stocks, take the current stock price and divide it by the sum of the dividends paid to the shareholder plus the amount of money used for that year’s stock buyback program. In Real Estate divide the purchase price of the property by its Net Operating Income.
For example Microsoft pays out $0.92 per year on dividends; stock-buy-backs are roughly 2% of all outstanding shares per year – valued 2% of the current share price = $0.60. So Microsoft returns to its shareholders about $1.52 per share per year. At the current share price of around $30 (let’s keep the numbers simple) a shareholders receives his current investment price of $30.00 per share back in $30/$1.52 = 19.4 years.
If you invest in a one-year GIC that pays an interest rate of 2% per year, then it will take 1/0.02 = 50 years to get your investment money back through interest payments.
The typical rental property in Calgary generates net operating income at 3-3.5% of the property value, this is also referred to as the cap rate. That means you have to collect rents for 1/0.03 = 33.3 years or 1/0.035 = 28.75 years to earn back your initial investment price. Shown below is the payout time of these investments in a small table. Now you can choose on a ‘comparing Apples to Apples’ basis which is currently the best investment. Right, in this case Microsoft  provides the best opportunity.

Asset Class
Payout time (years)
Payout time after tax
Microsoft Shares
19.7 (in TFSA) or 39.4
50 (in TFSA) or 100
Calgary Rental Property

If you want to get even more sophisticated in your selection then use the after-tax return. Real Estate rental income can be offset by capital cost allowance or depreciation – this is only a form of tax deferral until the property is sold. However if you don’t sell the property during your lifetime you won’t have to repay those deferred taxes except upon your death. Have you read my thoughts about immortality?  :) 

Dividends are tax advantaged but are tax sheltered in your Tax Free Savings Account (TFSA). Dividends in an RRSP are basically tax deferred and due when you withdraw funds from your plan.  I assumed in the table above a 50% marginal tax rate.
Now if there was a real estate crash in Calgary and prices fell 35%, the cap rate would skyrocket from 3.5% to 5.4% and the pay-out time would decrease from 28.6 to 18.6 years. So would you then buy Microsoft or Real Estate?  I’m sure you’re getting the point. If Microsoft fell from $30 to $25 dollars its payout would fall to 26.45 years. Did you know that Microsoft traded in 2008 as low as $18?
I guess you’re getting the point. Although it may be near impossible to time market highs and lows,  focussing on the valuation of an investment and using metrics such as payout-time can help you buy the best asset(s) at the best ‘time’, i.e. when there’s ‘blood in the Street!’
Here are some more Jeremy Siegel videos (watch out for when the videos were recorded).