Trader’s Narrative

Since some time has passed since my last call on Canadian REITs, I wanted to review it and update my position on the sector.

If you’re new to the blog you probably missed my comment back in early January: Canadian REIT Review. At that time I mentioned that it was irrational for well capitalized companies like the Canadian REITs to be sold off with the rest of risky assets. Remember, not only are these conservatively leveraged, they are diversified and throw off juicy monthly distributions. Of course, a devastating bear market cares little for value. Almost everything was sold indiscriminately as global investors ran like headless chicken to escape further losses.

In early January when I wrote recommending the attractive value evident in Canadian REITs, RioCan REIT, a commercial REIT I highlighted was trading around $14 a unit:

From there it deteriorated further, making a low of $11.50 in March 2009 - along with the vast majority of risky assets. If you were or smart enough to buy at exact bottom, you would be sitting on a 65% gain right now. But if you bought earlier when I wrote about it, it is still a respectable 36% gain. And that’s not even considering the monthly distributions which would pump the total return to 45%.

RioCan, at the March lows, was yielding an astonishing 12%. Of course, because of the pervasive doom and gloom, even the largest and strongest Canadian REIT was suspect. But RioCan has had no trouble in sustaining its distributions due to its top notch management and its heavily subscribed dividend reinvestment plan that allows it to conserve cash by issuing units instead of cash.

In fact, while the US commercial real estate market is seen as the next shoe to drop, Canadian REITs have recovered nicely and are poised for their role as (benevolent) vultures. Sonshine, the head of RioCan raised $150 million, announced a partnership with Cedar Shopping Centers (CDR). As well, the head of RioCan, Sonshine, has hinted of a major upcoming US purchase in the near future.

So all in all, the situation has reversed in all aspects. Now the news is all good and the stock is zooming higher. And as a result, RioCan is now yield just 7.21%. But while things are seemingly rosy, I’m getting ready to leg out of this position. There are a few reasons for that. First, obviously, is the sentiment which has shifted into full sunshine mode.

Second, the rocket ride higher has pushed RioCan to close 26.16% from its 200 day moving average. This is a simple technical barometer which I use to also analyse the general market but it also works for individual stocks. In the past when RioCan has come this far up into thin air territory, it has been unable to sustain its momentum. The last time prices where this far above its long term trend line was back in early 2007, just as RioCan was topping out at $26.

Finally, basic technical analysis reveals that price is now butting its head against the overhead resistance. What was a zone of support has now become a zone of resistance. And while RioCan could technically rise up to $22 a unit, the chances of that are slim. The same chart formation can be seen in almost all of the REITs in Canada. For example, take a look at Allied Properties (AP_un) or Boardwarlk (BEI_un) or Calloway (CWT_un).

Considering everything, putting new capital to work on the long side or continuing to hold here is not very prudent. The probability is that prices will either meander here as they enter resistance or immediately correct. In either case, the ride is over but it was fun and profitable while it lasted.

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.

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’

One of the signs of the tech bubble was how Information Technology as a sector ballooned from less than 6% (in 1989) to 29.18% (in 1999) in relation to the S&P 500 capitalization. Turning that idea on its head, let’s take a look at the financial sector during the past few years as a ratio of the general market.

As a caveat, let me reiterate that bull and bear markets within the financial sector don’t correspond to the general market: Does a bull market need financial stocks leadership? While at first it may be counter-intuitive, the data backs up the conclusion as you can see from the link.

But nevertheless, following the weight of sectors within the total market capitalization can help us in getting oriented. So I looked at the Standard & Poor’s Financials sector which includes the following sub-sectors (and more):

• Banks
• Consumer Finance
• Diversified Financial Services
• Real Estate Investment Trusts
• Insurance Brokers
• Life & Health Insurance
• Multi-line Insurance
• Property & Casualty Insurance

Here is the annual weight of the financial sector and the banking sub-sector relative to the S&P 500 capitalization (the charts below are interactive so mouse over for details). I was surprised to see that the financial sector topped out in 2006 at a whopping 22.27% of the total value of the S&P 500 index. That’s almost 3 times what it was in 1990:

Zooming in, we can see the monthly weight of the financial sector as a percentage of the total S&P 500 index capitalization from the start of the most recent bear market:

At the extreme low, set in early March 2009 just as the rest of the market was making its recent low, the financial sector reached a critical level it hadn’t seen since 1990! Since then it has jumped to 12.6% as the financial sector has lead the recovery in the general stock market. While no one knows if this is the definitive bottom for the banks, we can say that the March lows were a major low where the sector was as unloved as it has been for the past 20 years.

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I wanted to write about this during the holiday season but it being the holidays it got pushed to the new year.

Canadian REITs as a group were pummeled beyond belief during this bear market. Personally I’m surprised to see this because generally speaking they are a solid business model. Not over leveraged, diversified and recession-proof (for the most part).

There is no way that their market valuation should be cut in half - or more! But it goes to the heart of this bear market that even the highest quality securities are being sold off to raise cash, meet margin calls, de-leverage and reduce risk in portfolios.

By now this market dislocation is obvious as Canadian REIT prices have screamed higher in the past few weeks - some rising 25% and others up to 50%. I think they will probably give up some of that increase and take a breather. But considering how extremely oversold they got, they continue to present a very compelling value here.

Here are the 5 largest REITs by capitalization:

• Riocan REIT — (REI.un)
• H&R REIT — (HR.un)
• Boardwalk REIT — (BEI.un)
• Canadian REIT — (REF.un)
• Calloway REIT — (CWT.un)

H&R REIT was under a dark cloud and got taken to the back of the shed in 2008. Their share price fell from a high of $27 in 2007 and a high of $21 in 2008 to just $4.45. Since then doubts about their financial stability have been removed by their announcement of a distribution cut and debenture sale. HR REIT shares have gained almost 100%.

Here’s a chart of Riocan REIT, the largest in Canada. Over the holidays it reached a yield of just over 10%. That’s equivalent to levels which we last saw in early 2001.

At that time, the Bank of Canada interest rate was 5.5%. Right now, the interest rate is 1.5%.

That’s significant to bring into the picture because it shows that 8 years ago, an average investor had alternatives to Riocan REIT which yielded much higher returns than right now.

This just brings home how irrational these valuation levels are for Canadian REITs right now.

Insiders Buying
As you might expect, insiders are not oblivious to this. They have been actively buying shares of their companies even as they have continued to fall.

For example, Calloway Real Estate Investment Trust trustee Mitchell Goldhar bought 37,100 trust units through CWT Investments Ltd at prices ranging from $8.60 to $9.75 each on Dec. 4 through Dec. 10, 2008, bringing these total holdings to 10,889,413 shares.

And Riocan REIT chief financial officer Frederic Waks bought 5,400 trust units at $13.22 each on Dec. 4, 2008, bringing these total holdings to 200,956 shares.

Although you may have missed the extremes, as long as you’re smart about it and don’t chase the price higher, I don’t think you’ve completely missed the buying opportunity here.