Trader’s Narrative

Today the Bank of Canada decided to maintain their historically low interest rates at 0.25% but they did sound cautiously optimistic:

Recent indicators point to the start of a global recovery from a deep, synchronous recession. Global economic and financial developments have been somewhat more favourable than expected at the time of the July Monetary Policy Report (MPR), although significant fragilities remain.

A recovery in economic activity is also under way in Canada. This resumption of growth is supported by monetary and fiscal stimulus, increased household wealth, improving financial conditions, higher commodity prices, and stronger business and consumer confidence. However, heightened volatility and persistent strength in the Canadian dollar are working to slow growth and subdue inflation pressures. The current strength in the dollar is expected, over time, to more than fully offset the favourable developments since July.

Source: Bank of Canada

Unlike Australia, who has already started ended their easing cycle, they believe that inflation is not a danger and won’t be for the foreseeable future. Not only is it being kept in check by the frail economic recovery, the annoyingly strong Canadian dollar promises to keep a lid on it, if it does creep up.

Add to that the intoxicating cocktail of a commodity based economy, a strong real estate market (see below), strong fiscal discipline, and a famed (and quite boring) political stability that rivals Switzerland and you have the makings of a love affair:

One of the main reasons for our resilience has been the health of our real estate markets. I must confess that I was surprised to see the subdued reaction of the Canadian real estate market to the crash of its US counter part. After all, the two economies are intertwined like no other two countries in the world. However, for all our inter-dependence, there are significant differences. Canadian bankers never quite got the hang of laughing in the face of infinite risk or perhaps our regulators have yet to be so completely and embarrassingly captured as they are in the US.

Whatever the root cause, the Canadian real estate market has bounced back after a very late and shallow decline. As well, while our mortgages do default, the rate is extremely low and has barely experienced an uptick worthy of note:

Source: Globe & Mail

Canadian REITs gave long term investors quite a scare late last year as they were dumped along with everything else. However, while their price may have declined, their value continued to be very attractive. When I featured RioCan (REI.un) in November 2008 it was trading at $13 Cdn and yielding 10% - since then it has risen to $18 Cdn - and that’s not even considering all those juicy monthly distributions.

Meanwhile, Canadian equities have risen 27.3% in 2009 and slightly over 50% since their spring lows. But here’s the curious thing. While most major stock markets around the world have recovered from their shallow retracement in late September and gone on to newer highs for the year, the Canadian S&P/TSX index has not. That non-confirmation is slightly unnerving, especially when you consider just how much the Canadian equity markets have going for them.

Equities, as an asset class are supposed to beat everything else in the long run. But how long is the long run supposed to be?

Is 10 years enough to be considered long run? For the past decade, equities, as measured by the S&P 500 index have been the worst asset class:

The ultimate shaming is that even a risk-free money market rate beat the dividend reinvested returns provided by US stocks. As for the other asset classes, they left equities in their dust. For me, the most surprising is the high return provided by long term government bonds. Of course, by far the best asset class was gold.

The last time we looked at this metric was in February (thanks to a chart from the New York Times). Then, the 10 year inflation adjusted return was -5.1%.

Here’s a chart of the S&P 500 index showing how we’ve see-sawed above and below the 1000 level more than a few times:

And while this is pretty horrific to anyone who was invested in equities for the past 10 years and actually expected the proverbial 10% p.a. return, it may not all be gloom and doom going forward. That’s because such negative returns over rolling 10 year periods are actually quite rare. Looking at a graph of the 10 year returns of the S&P 500 index, you notice that whenever things get this ugly, forward returns are very good. You can check out the chart in the commentary I wrote back in late November 2008: Why Long Term Investors Should Consider Buying.

That was written when the S&P 500 had an 8 handle. It dropped significantly lower so anyone with a long term time horizon would have gotten in early. But they would still be doing well right now.

If you’ve read Irrational Exhuberance, you may recall reading about Robert Shiller’s aspirations to create liquid markets to allow for hedging of real estate assets. Now, that dream is reality. Shiller’s company MacroMarkets has created two products which allow anyone with a brokerage account to trade the wider US housing market.

Although they may look like ETFs, these are really derivative constructs, so tread carefully. Technically they are an ETP or Exchange Traded Product and come with a hefty MER of 1.25%. By now, we’ve become used to double and triple leveraged ETF products. So it won’t be a stretch that the MacroShares ETPs are triple leveraged to the underlying index they track.

The MacroShares products, UMM and DMM, have been trading for 5 days, and already made a 19% move:

The MacroShares Major Metro Housing Up (UMM) and the MacroShares Major Metro Housing Down (DMM) will be tracking the S&P/Case Shiller 10-city composite index. Although you may think at first that it would only be necessary to have one product, which can be held either long or short, it is necessary to have two because of the nature of the asset.

The MacroShares don’t actually hold houses as assets, but rather short term Treasury bills. They track the value of the S&P/Case Shiller Index through a simple mechanism: they shift assets between each other to reflect the underlying changes in the index every day.
Continue reading ‘Trading The S&P/Case Shiller Home Index’

On a grand scale, you could argue that the level of the stock market is set by two forces: the supply of ‘paper’, which comes from initial public offerings (IPOs), secondaries and other corporate actions, and on the other side, the demand of stocks which is not only influenced by the sentiment of investors but also by valuation and perhaps most importantly, by the supply of money in the economy.

The amount of money sloshing around the economy matters because eventually it has to find a home. In the past decade we’ve seen it rush into two markets, causing sequential bubbles in tech stocks and real estate.

One way to look at the relationship is to chart the change in change of money supply and see how it corresponds to the market and the economy. The chart below shows 35+ years of monthly data but before you can make sense of it, some explanation is needed:

Data: St. Louis Fed (FRED database)

M2 is a widely used measure of the money supply but since inflationary and deflationary periods can warp it, we look at inflation adjusted M2 (using CPI numbers). This gives us ‘real’ M2 which is more useful to compare across time. But we also have to account for the number of people in the economy because everything else being equal, on average, the more people we have the more money is used by them. So we divide the real M2 by the estimated monthly US population to get per capita, ‘real’ M2.

Then finally, we are interested in the annual rate of change that occurs in the real per capita M2 money supply, which gives us the chart you see.

The middle line represents zero, so anything above that means that the rate of change in money supply is positive and the Fed is pumping money into the economy (and vice versa). Obviously, the more extreme the move and the more the line stays above the 7 year moving average, the more significant it is.

From the latest data available (January 2009), the annual rate of change is higher than it has ever been - even higher than the early 1980’s. This means that eventually, as it works its way through the economy, there will be more and more money chasing fewer shares, driving up the level of the stock market.

Credit for this measure comes from an article by Norman P. Poiré, published in Barron’s on August 28th, 2000. If you aren’t a subscriber, you can read the article on Poiré’s website.

There are very few moments in market history when absolutely everything is being sold: stocks, bonds, commodities, REITs, etc. We are going through one of these rare times right now and it can be gut wrenching. Forced liquidation in a bear market can be so brutal, it makes surviving to be able to take advantage of the next bull market a challenging goal.

One of the bastions of stability and what I considered one of the safest investments around, Canadian REITs, have now seen such forceful selling, they look as if they are toxic assets. Take a look at how it left behind the downward trend line and simply dropped off a cliff:

You have to remember these are shopping malls, offices, apartment buildings, manufacturing facilities and warehouses. Basic real estate that is being used day in and day out. And it is being paid for by long term tenants. Sure, there is softening in the Canadian real estate market but it won’t impair what really matters, the income potential of the assets.

In fact, going back I can’t find any time that any of my REIT holdings have ever cut their distributions. While Canadian residential properties did participate in the global real estate bubble, REITs are grounded because they have to meet and exceed their financing costs. So they operate within tight financial confines and although their asset base may fluctuate with the market, their incomes and expenses are both well defined going ahead for many years.

Here is the biggest component of the REIT index, the bellweather Canadian REIT, RioCan:

Right now it is yielding almost 10% - the last time it had this yield was way back in 2001 at a much lower price. This is of course, assuming that the yield is safe and won’t be cut.