Investment Management and Financial Planning Thoughts

Markets are starting the day off in the red. Despite this energy, materials and the Canadian dollar are all higher and we are seeing sizzling growth in Canada which puts pressure on the Bank of Canada to raise rates. Yields on overnight index swaps which trade based on expectations for the Bank of Canada's key policy rate, suggest the market sees the tightening cycle starting in July. In the U.S. we had lower than expected jobs numbers in March. An interesting article in my CFA Newsbrief from the Washington Post said there is an increase in productivity in American employees. Business's are producing 3% fewer goods and services yet Americans are working nearly 10% fewer hours due to layoffs and cutbacks. This has the potential to stiffle hiring and keep the unemployment rate elevated. Further fuel for a muddle through economy as John Mauldin puts it.

Investment Management and Financial Planning Thoughts

Markets started the day off in the green this morning after U.S. consumer confidence rebounded in March and home prices rose in January for the 8th straight month. Markets have shifted to the red as financials and energy have slipped a little. With all this data currently pointing to economic recovery the real question is what happens next year when stimulus is removed and interest rates are on the rise. Last week Mark Carney acknowledged inflation is running higher than predicted in Canada due to a higher level of economic activity. In the U.S. Bond investors are signaling rising rates. Credit Suisse pointed out that although bonds inflows are higher than equity mutual fund inflows, much of the new money is going into inflation protected and short term bonds signalling inflation fears and rising interest rates. For a second opinion on how to manage your investments in rising interest rate environment visit us at yourlifeyourplan.ca.

The end of the road for XBB

The iShares CDN Bond Index Fund (XBB) consists of about 300 investment-grade Government of Canada, provincial, corporate and municipal bonds. Federal bonds make up about 46%, provincial bonds make up about 24% and corporate bonds make up about 30%. The weighted average term to maturity is 8.58 years, the weighted average coupon is 5.18%, the weighted average yield to maturity is 3.27% and the weighted average duration is 5.87 years.
On March 30, 2009 XBB closed at 29.20 and today it is trading at about that price. Worst case scenario you would have collected a 5% coupon. Over the last year, the price of XBB has fluctuated between $28.86 and just above $30, mostly above the 200 day moving average however it’s time appears to have been equally split above and below the 50 and 100 day moving average. Today the price is well below its 200-day moving average. It is interesting to see that the 200-day moving average has increased since last March, which is viewed as a positive trend. Of late the technicals are bearish from a moving average, relative strength and MACD perspective. On the other hand, this could also be setting up to be an oversold position if we get more fear in the markets.

The fundamentals do not look particularly strong for XBB. Most economists expect interest rates to rise in Canada within the next year due to inflation. In a speech to the Ottawa Economics Association, Mark Carney agreed that inflation is running higher than predicted. In addition a Bloomberg article “Swaps jump as job gain signals central bank move: Canada Credit” reported that “The one-year overnight index swap rate, a security based on what investors expect the central bank’s rate will average over that period, advanced 4 basis points, or 5.8%, to .725 on March 12…. solidified bets for the first bank move in July”.

Canada may be ahead of the U.S. but we will also be impacted by what happens in the U.S. so it is worthwhile looking at what is happening there. According to US Global Investors in advisoranalyst.com, U.S. Treasury bond yields rose this week with long term yields hitting the highest levels since last summer and Treasury supply continues to hit the market with $118 billion auctioned this week. Credit Suisse put out in their chart of the day “Bond Investors Wary of Rising Rates”, “the ever-lasting flow of funds into bond mutual funds has left market-watchers to wonder why, given increasing inflation expectations…much of the new money has actually been going into TIPS and short term bond funds. At the same time, long term bond funds have been the least popular since 2008.” BCA Research confirms this point that “TIPS have enjoyed a long run of out performance.” That being said, in the short term BCR Research’s view is different on inflation expectations in the U.S.

An increase of 1% in the interest rate will wipe out the coupon i.e. reduce the price of XBB by 5.87%. With interest so low, you may want to avoid jumping into this vehicle or getting off at the next stop because the end of the road may be near.

K96.3 FM Kelowna's Classic Rock - Ralies & Reversals Investment Advice

Well global equity markets are starting the week off on a positive note after an up week last. I'd look for more of the same this week and the weeks to come, but it will be a grind, with periods of consolidation.

The thing to keep an eye on is interest rates, which appear to be on the way up. As a result, bond markets have been selling off of late, particularly U. S. treasuries, which are also seeing lacklustre interest at recent auctions. Related to this theme is the massive wall of corporate maturities coming due in the next couple of years which will need to be refinanced in competition with government deficits and the rolling over of existing government debt. High yield bonds may have outperformed stocks last year and year-to-date, but that is going to change.

That's it for today's report. We'll be covering the issue of rising interest rates for awhile. You can also follow what we have to say via our blog at yourlifeyourplan.ca.

GB

Investment Outlook: Interest Rates, Bonds - The Canary In The Coal Mine

"High fiscal deficits and higher outstanding debt lead to higher real interest rates and ultimately higher inflation, both trends which are bond market unfriendly." - IMF

The stock market rally off the March 2009 low caught most investors off guard. By year end the S&P 500 finished up over 26% while the TSX Composite index bested 35%. What you may not know is that corporate bonds, specifically high yield bonds, performed even better, and so far to the end of February 2010, they're leading the way again. A recent live webcast with PH&N's Hanif Mamdani, manager of their Lipper award winning high yield bond fund, suggests the party's not over, although, we are approaching the dawn.

In advance of the presentation, I forwarded to Hanif a copy of a recent New York Times article by Nelson Shwartz titled: 'Corporate Debt Coming Due May Squeeze Credit' and asked him to comment. The point of the article is that there is a record amount of corporate debt coming due in the next couple of years, close to a trillion dollars, which will need to be refinanced in competition with record government deficit spending and existing debt, which will also need to be (re)financed.

Hanif acknowledged that this is certainly a risk along with a large and unexpected rise in interest rates. I would argue that the two are not mutually exclusive. Check out this excerpt from Bill Gross of Pimco:

"In the U.S. in addition to the 10% of GDP deficits and a growing stock of outstanding debt, an investor must be concerned with future unfunded entitlement commitments which portfolio managers almost always neglect, viewing them as so far off in the future that they don’t matter. Yet should it concern an investor in 30-year Treasuries that the Congressional Budget Office estimates that the present value of unfunded future social insurance expenditures (Social Security and Medicare primarily) was $46 trillion as of 2009, a sum four times its current outstanding debt? Of course it should, and that may be a primary reason why 30-year bonds yield 4.6% whereas 2-year debt with the same guarantee yields less than 1%.

The trend promises to get worse, not better. The imminent passage of health care reform represents a continuing litany of entitlement legislation that will add, not subtract, to future deficits and unfunded liabilities. No investment vigilante worth their salt or outrageous annual bonus would dare argue that current legislation is a deficit reducer as asserted by Democrats and in fact the Congressional Budget Office. Common sense alone would suggest that extending health care benefits to 30 million people will cost a lot of money and that it is being “paid for” in the current bill with standard smoke, and all too familiar mirrors that have characterized such entitlement legislation for decades. An article by an ex-CBO director in The New York Times this past Sunday affirms these suspicions. “Fantasy in, fantasy out,” writes Douglas Holtz-Eakin who held the CBO Chair from 2003–2005. Front-end loaded revenues and back-end loaded expenses promote the fiction that a program that will cost $950 billion over the next 10 years actually reduces the deficit by $138 billion. After all the details are analyzed, Mr. Holtz-Eakin’s numbers affirm a vigilante’s suspicion – it will add $562 billion to the deficit over the next decade. Long-term bondholders beware." (Go to Pimco's website to read Bill's 'Investment Outlook ' in full. Another great article to read is 'Don't Be a Fool: Watch the Bond Market, Not Bank Lending or Velocity' by Damien Hoffman, Wall Street Cheat Sheet)

This is one ball you don't want to take your eye off of.

GB

Investment Management and Financial Planning Thoughts

Markets are on the rise today. Eurozone leaders agreed to create a safety net to help Greece and U.S. data showed consumer sentiment rose more than expected in March. Commodities are higher. Gold is having a nice bounce after recent weakness. Investors are are buying gold for a couple of reasons. First the European agreement on aid for Greece has helped the Euro which is stronger against the U.S. dollar. Secondly, demand for gold out of India is typically stronger in April and demand out of China is improving. According to Scotia Capital nearly all gold stocks have sold off and are at attractive levels for investment.

Today's Investment Management and Financial Planning Thoughts

The news driving the markets today are two things, European leaders appear to be nearing consensus on support for Greece and initial jobless claims fell in the US. Markets are higher with support for commodities and the Canadian dollar.
In my research this morning I came across an interesting report from Credit Suisse. When the crap hits the fan in the markets correlations "go-to-one". This reduces the diversification benefits of a balanced investment strategy. They found correlations across all asset classes are remaining elevated suggesting macro trends are driving performance. This is in contrast to all other market indicators normalizing as things improve.

K96.3 FM Kelowna's Classic Rock - Rallies and Reversals Investment Advice on the Radio

Today markets are lower so far on a few drivers. The first is falling commodity prices. The price of oil, gold and base metals are dropping along with the Canadian dollar. It's trading below 98 cents. Needless to say the US dollar is higher and the Euro is dropping relative to the US dollar. Sovereign debt concerns are driving this and it's Portugal this time. Their credit rating was lowered leading to focus back on Greece. It doesn't help matters that Germany and France are suggesting IMF involvement in the possible Greece rescue. The third pull downward on the markets is the data on home sales in the US. Home sales fell for the 4th straight month in the US. The housing market appears to be struggling despite government support. Sales haven't been responding to the extention and expansion of their tax credit. The Fed will also end purchases of mortgages ralated securities next week. US mortgage applications fell for the 2nd straight week. On a positive note, Canada is experiencing a housing boom according to The Canadian Press in Canadian Business.

k96.3 FM Kelowna's Classic Rock - Rallies and Reversals Investment Advice on the Radio

In the U.S. today, markets were up on data showing existing home sales declined less than expected in February, however healthcare stocks gave back some of the gains from yesturday. The House passed legislation that is expected to bring insurance to 32 million , according to the Economist. The Economist also noted that "Obamacare does much to expand coverage, but little to rein in healthcare inflation."

Credit Suisse put out a piece on how Health care stocks might react in the near term to this new legislation. They expect HMO's rally to fade as they rallied last week and this group sees costs from reform 1st. They also expect Hospital's rally to fade as benefits won't start till 2014. C.S. expects Pharma to rally as they were the anti ralliers last week and expect Biotech to rally. Legislation was generous to them and they are a ripe group for merger and acquisition activity in the small to mid cap space.

K96.3 Kelowna's Classic Rock - Radio Rallies & Reversals

Back on March 8, I told listeners to look for equities to move higher and take out their January highs, and for the CDN$ to push for parity with the US$, and that's exactly what we got. Looking forward, the technicals, with the exception of volume, tell me there is more upside; However, relative strength is in overbought territory so expect periods of consolidation such as last week, with the 50 day MA holding as support. Fundamentally, this rally's days are numbered and perhaps this is reflected in the downward trend in volume and the rounding out in the charts.

For investment opportunities, one theme to follow is mergers and acquisitions; For threats, keep following the sovereign debt story plus the growing spat between the U. S. and China over the value of the yuan. The last thing the global economic recovery needs is a trade war.

That's it for today. Keep tuning into Rallies & Reversals as we explore these issues further. You can also read Rallies & Reversals on Castanet or follow our blog at yourlifeyourplan.ca.

GB

The Canadian Dollar is on a Big Mac Attack

The Canadian dollar has been on a tear towards par again. The last time that happened was in 2008 when markets hit all time highs. The Canadian dollar almost reached $1.10 in 2007. Are we headed for the same value or is the Canadian dollar overvalued?

From a technical perspective, the Canadian dollar has a lot of strength and momentum supporting it. In the last year, it has risen from 85 cents to a high on Friday morning of 99.35 cents, however finishing the day lower on more worries about the global recovery. The current price has held above the 50 and 100 day moving averages for quite some time now and both relative strength and MACD are positive. Technically, the Canadian dollar is bullish and has been for the last year, despite the odd dip below it’s 50 and 100 day moving averages.

The fundamentals are a much more complex discussion because there are many variables that weigh into this multifactor model with unknown outcomes. Some of them include global economic recovery, demand for the U.S. dollar, demand for commodities, inflation, interest rates and our fiscal position (which happens to be strong). To give you a sense of how sensitive the Canadian dollar is to some of these variables, we can just look at Friday’s trading pattern. Canada reported stronger than expected retail numbers last week and this gave rise to fears of inflation and, therefore, speculation that the Bank of Canada may raise rates sooner rather than later. In response, the Canadian dollar rose in early trading on Friday. By mid-morning the Canadian dollar had fallen a cent because of more fears of credit problems in Greece, therefore slower global economic recovery, less demand for commodities and a rising U.S. dollar. According to RBC research, some supportive factors include stronger leading indicators of the global economic recovery, commodities trading higher, healthy fiscal situation in Canada, low interest rates, relatively stronger housing and financial sectors, foreign demand and business optimism. The negative factors include pricing for perfection so it is sensitive to weakness in energy prices and the economic recovery, risk of U.S. trade protectionism, trade deficit and overvaluation on a PPP basis.

What should the Canadian dollar trade for relative to the U.S. dollar? The 12-month forecast from RBC is $1.12 and from Scotia it is $1.05. Despite this forecast, RBC wrote one of the negatives is that the Canadian dollar is 16.4% overvalued on a PPP basis. According to The Economist “Big Mac Index”, the Canadian dollar is 13% overvalued. In “Exchanging Blows”, March 17, 2010, it was discussed that The Big Mac index is based on the theory of Purchasing Power Parity where exchange rates should equalize the price of a basket of goods across various countries. In this case, they use the price of a Big Mac in the US as the base measure. According to The Economist, the price of a Big Mac in the US is $3.58 and the price of a Big Mac in Canada is $4.06, 13% more, suggesting that the Canadian dollar is that much overvalued. At the extreme, the price of a Big Mac in China is $1.83 suggesting the Yuan is about 50% undervalued and the price of a Big Mac in Norway is $6.87 suggesting that the Crone is 92% overvalued. There is much debate on how reliable the Big Mac Index is but nevertheless it is a measure with a relative base. It does support the argument that despite the problems in the US, the US dollar remains the currency we measure everything against and it is the currency of reserve. Canada will feel the U.S. hunger pains or gorging but for now it appears that the Canadian dollar is having a Big Mac Attack!

Technical Analysis - What Works?

Spring has arrived and Sunday mornings are once again reserved for football. A few more years and it will be the senior league for me, although technically I think I qualify now. After each game, I generally require a beer to wash down a couple of tylenol pills and ice packs strapped to my ankles and knees to assist in minimizing any inflammation. Since I can't move, this is usually a good time to park myself on the couch and catch up on some easy reading.

Today's easy reading includes a summary of a paper written by Nauzer Balsara, Jason Chen, and Lin Zheng which was published in the Journal of Asset Management, vol. 10, no. 2(June 2009):97-123 titled 'Profiting from a Contrarian Application of Technical Trading Rules in the US Stock Market' (The summary can be found in CFA Digest, November 2009, vol. 39, no. 4). Technical Analysis is an important part of our investment management process, but there is an ongoing debate as to whether or not it adds any value in identifying trading opportunities as opposed to just buy-and-hold (a. k. a. buy-and-hope). As part of a process that includes both quantitative and fundamental analysis within a core/satellite investment strategy, we think technical analysis adds/protects a lot of value.

In this case, the authors first investigate whether the DJIA, NASDAQ and S&P500 follow a random walk (if so,this should make it difficult for technical analysis to work). Next the authors define their trading rules for 3 technical strategies: moving average crossover, trading range breakout and Bollinger bands. For each case, the authors evaluate the regular and contrarian application of the rules by using three performance metrics: average returns to all trades, probability of success, and payoff ratio.

The authors were not able to reject that the markets follow a random walk. What is interesting is that the contrarian application of the trading rules of all three technical strategies produced consistently positive excess stock returns relative to the buy-and-hold portfolio; however, when the conventional application did work, the payoff was high.

If you'd like to learn more about our investment management strategy and processes, give us a call.

GB

The Best Time to Trade

"Trade like a mercenary guerrilla. We must fight on the winning side and be willing to change sides readily when one side has gained the upper hand." - Dennis Gartman

Back on March 3, 2010 Credit Suisse published a chart showing intra-day trading volume and volatility. Both volumes and volatility follow a similar pattern intraday - high at the open/close and lower mid-day. However, volatility seems to be skewed towards the open while volume is skewed towards the close. So when is the best time to trade?

I guess that depends on what kind of trader you are and what you're trading in. Some traders prefer lots of volume with lower volatility, which would suggest the best time to trade is towards the end of the day. Ultimately, the author (Ana Avramovic) suggests there may be no best time to trade for a variety of reasons.

At Bell Allard Delcourt Asset (BADASS) Management we're very disciplined about when we trade: intra-day, intra-week and intra-month. If you'd like to learn more, give us a call.

GB

Adding XSB to your fixed income quiver

The choice of ETF’s in the fixed income arena is continually expanding as we face uncertainty about markets, the economy and interest rates. One thing for sure is that if interest rates rise, bond prices will fall and your fixed income portfolio will drop. The question is how will you manage this supposedly secure portion of your portfolio? There are a number of choices - you can adjust duration, shift sectors, ladder your portfolio or trade it. Let’s explore XSB.

The iShares CDN short bond index (XSB) replicates the performance of the DEX Short Term Bond Index and consists of a range of investment grade federal, provincial, municipal and corporate bonds with a term to maturity between one and five years. There are 182 holdings with a weighted average term to maturity of 2.89 years, duration of 2.7 years, a weighted average coupon of 4.25% and a weighted average yield to maturity of 2.24%. This is as of March 12, 2010.

Over the last year XSB has traded anywhere from about $29 (support) to $29.58 (resistance). Although 2% volatility is not a lot to work with, there appears to be a range it is trading within and something to work with from a technical perspective as we move into a changing interest rate and economic environment. Over the last year, the current price has traded as many times below the 50-day moving average as above. Today, the current price is $29.21which is below the 50-day moving average ($29.28). Both MACD and relative strength indicators are bearish.

Looking forward, we have some arguments that may warrant a closer look at using XSB as a vehicle to trade. The summer is typically a period of seasonal strength for bondholders, as investors sometimes sell in May and go away for the summer. So far XSB has shown some signs of negative correlation to the TSX. Secondly, there is talk of interest rates increasing as early as June or July. You will want to hold shorter-term bonds. XSB has duration of 2.7 years, which means if interest rates rise by 1%, the price of the bond pool will fall by 2.7%. Thirdly, fixed income will be difficult to make money in as interest rates rise. Pimco, the world’s largest bond-fund manager argues that you need to be active. They filed with the Securities and Exchange Commission to roll out six new bond ETF’s. This is an indication to me that they want to offer investors more choice and flexibility in fixed income to address the challenges of managing fixed income portfolios in a rising interest rate environment.

Using XSB can be a double-edged sword. It is an open-ended fund with no fixed maturity like an individual bond so the price can go down for an extended period when interest rates rise. When an individual bond matures you receive your principal plus you have received the coupon while you owned the bond. The positive side of owning XSB is that it is liquid so you will have no problem buying or selling it.

Reality of Real Return

In the past 20 years interest rates have fallen and fixed income investors have done well. We are faced with record low interest rates and most economists would agree that the outlook for interest rates is higher. This will have a negative impact on your bond portfolio. The questions are, when will governments raise interest rates and how should you manage your fixed income portfolio in rising interest rate environment? I would say you have a number of choices, however, your approach should be flexible and active. Over the next few weeks I will explore some fixed income choices in a series looking at investing in a rising interest rate environment.

The objectives of iShares CDN Real Return Bond Index Fund (XRB) are to provide income by replicating the performance of the DEX Real Return Bond Index which is a market capitalization index of mostly Canadian federal and provincial real return bonds. It has 13 holdings with a weighted average term of 21.07 years, a coupon of 3.57%, a weighted average yield to maturity and a weighted average duration of 15.77 years. Duration is a measure used to identify the impact that a rise in interest rates would have on the price of a bond or pool of bonds. So for example, with duration of 15.77, a 1% increase would mean a price decline of 15.77%.

Over the last year the XRB has risen in price from a low of about $18 in March 2009 to a recent high of about $20.75 in late January/early February. Since crossing the 50-day moving average in March last year the current price has been steadily increasing, despite the odd dip below the 50-day moving average. On February 8, 2010 the current price broke below the 50-day moving average and then broke below the 100-day moving average on March 5, 2010. Not only is this a technically bearish signal but also relative strength and MACD are also bearish from a technical perspective.

In the past year, XRB appears to be positively correlated to the S&P/TSX. Not the case in the past month. So what has happened? Scotia Capital reported that the bond market sold off as investors had a renewed appetite for risk and equities rallied. Government of Canada bonds weakened on the back of strong corporate earnings and a much better than expected Q4 GDP. XRB may have also been affected by the view that interest rates could rise in Canada in the 2nd half of 2010. It is worth noting that XRB holds mostly government bonds and 98.40% of its holdings mature in greater than 10 years. As mentioned above the duration on XRB is 15.77 years so any news of rising rates would scare off investors. The other variable that will affect this fund is inflation. Real Return bonds have a portion of their value pegged to the inflation rate. This should work in a positive way if we expect inflation to rise. The most recent debate has been whether inflation or deflation will be a problem and I think the jury is still out, however neither seems to be taking the lead. Mixed data has given the governments the ability to message inflation is not a risk at the moment so rates don’t need to rise until later. It is rare that interest rates move higher unless they are accompanied by inflation but it is also possible that rates could rise even without inflation. After assessing this fund, it appears that like the markets there are a number of factors beyond inflation influencing where this fund will go. In a rising interest rate environment it is a legitimate choice for fixed income as long as you are active with it and you understand all of the variables that influence it’s price changes.