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.

Yesterday we looked at the strange behavior of US mutual fund holders in shunning equities and stampeding into bond funds. That lead to lively discussion with different comments on what this means. Leaving aside the various arguments on whether this is a good or bad omen for the stock market, let’s explore the US retail investor’s sudden love for bonds.

We’ve just woken up to the realization that we have our own “lost decade” for stocks. From 1999 to 2009 the worst asset class you could have chosen would have been equities. In contrast Treasury bonds returned 110%, second only to gold.

But similar to the importance of timing the stock market, when you purchase bonds is pivotal to success. While we use metrics like P/E ratios or price dividend ratios to gauge the stock market, the bond market is much simpler. According to a study by Vanguard, all we have to do is look at the current yield. If it is low, the future returns will be similarly low. If high, then future returns from bonds will also be high.

You can download the report from the Free Trading Resource section (Reports & Articles folder: “The Historical Impact and Future Implications of Extraordinary Markets”). Here is how they explain their historical study:

…we put the historical yield levels for the 10-year constant-maturity Treasury bond into quintiles and show the range of returns over the next 10 years for those initial yield levels. For example, with an initial yield between 7.8% and 14.0% (quintile 1), the subsequent 10-year returns have been between 6.6% and 12.3% per year. Intuitively, these high returns stem from the fact that higher initial yield levels have been followed by systematically declining interest rates over the subsequent 10 years.

Here’s the resulting chart:

In late 2008, during the darkest days of the financial crisis, the 10 year Treasury bond yields sunk to 2.2% (5th quintile). The current yield on the 10 year is 3.44% which puts it in the 4th quintile. Based on historical data (from January 1928 to December 2008) the median return for the decade ahead is only 3.2%. And if you really want to get technical, you would subtract a reasonable inflation rate - say 2%? - which would bring the return to almost zip.

This study proves what we all know intuitively. Current rates are extremely low and the probability is therefore skewed towards rising rates, which means lower future returns. The higher the rates rise, the lower that return. So if you really believe in the inflation boogey man, you would be actually avoiding bonds not running into their arms as the average US retail investor is doing right now.

Instead of buying bonds, if you expect runaway inflation, you should be buying Treasury inflation-protected securities (TIPS) - bonds whose coupon increases along with inflation, and decreases with deflation.

A surprising number of retail investors are doing exactly that right now. Here’s an excerpt from a recent article from the Wall St. Journal:

Richard Seelig, a retired high-school math teacher in Pelham, Mass., bought shares of the iShares Barclays TIPS Bond Fund last December for his Roth individual retirement account. “I looked at the amount of money the government was spending that it didn’t have, and I thought, well, that is going to come back to haunt us,” he says.

But we are not in an inflationary environment right now. The yield gap between TIPS and normal Treasuries is 1.8% implying that that is the inflation rate in the US right now. But that may be deceptive for two reasons. Everything we’re seeing right now in terms of economic measures is signaling strong deflationary pressures. And two, the strong retail demand for TIPS has pushed their prices higher.

Even as retail investors rush to put their money into TIPS, there is no guarantee that they will see a payoff. This is because as inflation is sighted by the Federal Reserve, they will raise interest rates. And as interest rates rise, the value of bonds will decline.

So current buyers of TIPS are not only betting that inflation will be higher than 1.8% in the future, they are also betting that the Federal Reserve will be a pushover. That assumption may come back to haunt them.

If the above arguments are not persuasive, here’s another. Based on the historical data for US bonds, Prof. Jeremy Siegel has plotted a cumulative return for this asset class over the very long term (chart to the left). Total bond returns move in slow, multi-decade arches swinging above and then below a regression line (red). Right now, the cumulative return for bonds is extremely high relative to their historical trend. A reversion to the mean will happen. The only question is when and how fast. For more information on this valuation approach, see this article from MarketWatch.

Two Wrongs
If the shunning of equity funds by US mutual fund investors is bullish in your opinion due to contrarian analysis. Then it is difficult to not be labeled a hypocrite if you also believe in a future inflationary Armageddon. Either the “dumb money” retail investor is wrong in disbelieving the equity bull market, or they are wrong in expecting inflation.

While I completely understand and empathize with the traumatized psychological state of the average US retail investor, tragically, it looks as if they are jumping from the frying pan into the fire.

Late last week we got the latest figures from the Reuters/University of Michigan survey. Consumer sentiment continues to recover with the preliminary June 2009 number at 69% - compared to 68.7% for May 2009. The consensus of economists was for a larger recovery but there is no doubt that US consumer sentiment is slowly recovering from the drubbing it got a few months back. Things were so extreme that we hadn’t seen such low consumer sentiment since 1980!

But there was another data point that got my attention from the Reuters/University of Michigan survey. There was an increase in the number of people expecting an increase in interest rates from 36% in May to 53% in June.

With those that expecting the opposite shrinking from 19% last month to just 10% now. This differential is the largest since August 2007 (red arrows in chart):

Keep in mind that bond yields and bond prices move inversely. So a fall in yield would be accompanied by higher bond prices.

As you can see in the chart, the red arrow doesn’t coincide exactly with the 2007 summer peak in yields but then again, if we go back we find that the chart consistently trends downwards. In fact we could look back 10, 15, 25 years and more and still find that yields in a downtrend. Of course within this macro-trend there have been some very sharp counter rallies - of which the early 2009 rally stands out.

Last Friday we looked at the unprecedented earnings collapse that has fueled this bear market. The chart below is the flip side, showing the impact on the S&P 500’s valuation through the Price/Earnings ratio:

Source: Chart of the Day

While the P/E ratio is a familiar rule of thumb that helps us to calculate the relative value of the stock market, like any metric it has a handicap. Looking at the chart, it is clear what that is for the PE ratio. Just imagine how ridiculously meaningless the ratio would be if we actually see negative earnings as many are predicting we will, for the first time ever!

But there’s no reason to panic, running out into the street screaming at the top of your lungs. The fact that the S&P 500’s price earnings ratio is 122.45 right now, once again proves that the price dividend ratio is a superior measure to price earnings. Dividends are a much better way of measuring value because unlike earnings, they are not prone to creative accounting and are considered sacrosanct.

While the P/E ratio is finding irrelevance in the stratosphere, the price dividend ratio is 38.6 - click previous link to see a historical chart of the price dividend ratio. And click this following link to see a chart of the price earnings ratio before the silliness began.

As S&P 500 earnings have collapsed from $62.28 - a year ago - to the present’s miserly $7.21, dividends have been much more robust. Dividends were $28.93 in May 2008 and currently they are $22.87 - a fall of just 21%. The Dow Jones Industrial dividend has fallen even less, 3.6%.

In the end, this is why we use many different methods to measure and analyse the market. Sooner or later, any one of them will go bonkers and provide useless output. At that point, it is important to realize that and not follow it over the ledge like lemmings.

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.