Weekly Comment - July 2, 2019

Jul 02, 2019 | Nick Foglietta


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The road to zero percent interest rates is really a road to financial perdition. You don’t know it yet, but you will, once we get there!

Trade “Truce”

The American/China trade agreement has been like “a carrot dangled in front of donkey” for Wall Street since August 2018.

 

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How many times has the stock market rallied on a near deal news headline or Trump Tweet?

So this week, we get the watered down term of an expected “Trade Truce.”

There should be no surprise that a meaningful trade agreement was not attainable and that both sides needed to come up with something to save political face and financial markets alike.

With the financial markets less likely to respond to headlines and Tweets referring to American/China trade deal headlines moving forward, the question I ask myself is:

Do financial markets have a moment in time where they actually start to move off of corporate earnings and economic numbers?

My guess is…no they don’t.

If one is completely honest, you could argue that markets have not cared about either corporate earnings or economic numbers for the past 10 years. 

Really Nick?  Ok, what has it been about then?

I think this chart is kind of “boom…drop the mic” evidence of how corporate buybacks have been the story of the Bull market in the US. 

The chart is looking from 2014 to 2018, but we already know that 2019 buybacks are on pace to be the highest on record.

The key to continuing corporate stock buybacks is low interest rates.

As a summary statement, as long as interest rates continue to decline, the stock Bull market should be able to hold a trend line higher.  At the least, I believe it can hold its present levels.

As stated before in these weekly comments, I think it gets interesting when interest rates fall back below the 1% threshold and find their way to the zero bound.

At those levels, all BULLISH bets become subject to review!

So, for now, stay invested and try to find investment themes that will be positively impacted by interest rate heading to zero.

Canadian Housing Debt

The following chart shows two data streams that I have not seen broken out from each other before.

Owner occupied debt has held steady while debt taken on to buy investment real estate has almost gone to zero growth.

This is outside of my field of expertise but I would imagine this is probably a healthy development for real estate markets at relatively high prices. 

Hopefully, it leads to more balance for new buyers.

In keeping with the real estate theme, the graphic below shows American data for the likelihood of “renters” moving up the food chain to become “owners.”

The changes are subtle, but significant. 

Fewer people want to become owners of real estate rather than renters. I doubt either these trends will send real estate prices lower…but they will certainly contribute to a more balanced market of buyers and sellers.

Risk vs. Reward

The past couple of comments have focused on the possibility of interest rates heading towards zero or even “negative” numbers in Canada and the US over the next few years.

If zero or negative interest rates were to happen there are two important things to consider for investors:

  1. How much of your “guaranteed” or “safe” money would you leave in those guaranteed investments if you got less than 1% per year on them?
  2. How should you change your investment profile (risk tolerance) to compensate for lower interest rates?

The answer to question number 1 is the criteria used to answer question number 2.

If you say you would roll all of the money you have in safe investments over at 1% or less then you don’t have to even ask question number 2!

But if you would not roll all the money at low interest rates you need to start working on how to shift your asset mix now, before rates hit the lows.

Below is a typical conservative client example:

Client has 60% of their fixed income wealth (not including their home) in GICs, bonds, preferred shares and cash.  The other 40% is in stocks.

The average rate of return on the fixed income is 2.35%. Half of the fixed income money is either cash or comes due in the next two years. 

The rate of return two years from now is assumed as 0.60% for a five year GIC. 

The client decided that she would roll over only half of the present fixed income portion of the portfolio at those low interest rates in the future. What can she do with the other half?

Which brings us to the big question: how much risk should she take?

Let’s spend some time defining how to decide the appropriate level of risk to add to a portfolio.

To begin, we need to understand two financial terms:

Optionality – def. the value of additional optional investment opportunities available after making an initial investment.

Asymmetric risk investingdef. choosing an investment that has a contained downside risk that is much smaller than the potential upside risk.

As long as we do a good job selecting riskier investments that offer us both “optionality” and “asymmetrical returns” we can do a pretty good job quantifying the amount of risk the portfolio is taking on.

Enough of the financial talk…let’s use a real life example.

“Company ABC traded at $80.00 per share in 2017 when it was developing an app that allows people to trade cryptocurrencies on an SEC approved platform. 

At the time, the price target for the shares was $240.00

As the price of cryptocurrencies plummeted in early 2018, so did the shares of ABC Company.

But the company continued to plug away building the app.

Fast forward today, ABC Company has completed the SEC approved app and has launched it in the United States…the only SEC approved platform for trading cryptocurrencies.  Bitcoin and other cryptocurrencies have recovered more than half their values in 2019.

But the price of ABC Company is only $13.50 today!”

Maybe there is some unrecognized value to be unlocked here?

Let’s plug this scenario into our “risk/reward” calculator.

The worst case scenario is the shares can go from $13.50 to zero…a loss of 100%.  Fortunately, an investor has total optionality to sell before zero so a 100% loss is easy to avoid. 

But the upside for this investment is multiple of 100% if the company can execute its business plan. Remember, the old price target was $240.00.

There is our asymmetrical rate of return.  Less than 100% downside vs. possibly 1000% plus upside.

Obviously, the key to investing in this type of company is planning your initial investment carefully.  Don’t invest more than you are willing to lose.

In summary, a small investment in something that might go up 100%, 200% or more can make up for a lot of safe money invested at 1% in an overall return.

Again, below is an example of a portfolio using an asymmetrical risk component:

$1,000,000 portfolio.

  • $400,000 in safe GICs and bonds at 2% yields $8,000 per annum (pa).
  • $200,000 in Preferred Shares, high yield bonds at 5% yields $10,000.
  • $350,000 in dividend paying shares yield 4% + growth for $14,000 pa.
  • $50,000 in asymmetrical risk with optionality yield 30% or 15,000 pa.

Without the risk component of $50,000 (or 5% of the portfolio) the yield on the portfolio rests at about 3.3% pa. Adding the 5% risk component takes the rate of return to 4.7% pa.

That’s a big difference…by only risking five percent of the portfolio’s total value.

The road to zero percent interest rates is really a road to financial perdition. You don’t know it yet, but you will, once we get there!

If you want to talk about these ideas for your portfolio please let me know.