What Brexit taught me about risk

Last week, the UK held a referendum on whether or not to leave the European Union. Setting aside the whole issue of whether or not that was a good idea (I don’t know) or the value of referendums, I learned an investment-related lesson watching the markets react to the surprising news.

I started watching after the voting was complete, but before the count started coming in. I was curious to see what the most likely outcome was, so I looked at polls and the prediction market. The poll that I saw showed that Remain was ahead by 1%, but there was also about 9% undecided. My assumption (erroneous, in hindsight) was that the undecided would be more conservative and would swing toward Remain. The prediction markets made me feel more confident in my assumption. They assigned a probability of approximately 60% to Remain and 40% to Leave. In reality, 6 in 10 isn’t great odds.

Looking at the currency market, after the voting closed but before the results had started to come in, the pound almost immediately began to fall against the US dollar. Either someone (smarter than me) knew something, or nervousness pushed traders to sell off the now-riskier GBP. My conversation with a friend (for your entertainment):

Him “Are you going to bet the farm on the a Remain vote and buy a ton of Pounds?”

Me “I actually would bet on remain. But I don’t think it’s a slam dunk.” Full disclosure: I didn’t bet any money on the outcome.

Him “I think half the results are in and it’s 51.3% leave. Pound is down 14 cents against the dollar. Could it go down 50?”

Me “That’s nuts. It’s hard to believe leave is ahead. The pound could take a serious beating.”

Him “GOOD THING YOU DIDN’T BET THE FARM ON THE POUND”

It’s easy to be overconfident when you have nothing riding on the outcome of a prediction. It made no difference whether I was right or wrong, so I underestimated the uncertainty.

Uncertainty means more than just not knowing the outcome beforehand. Before the vote was counted, we didn’t know which side would win, especially with the polls so close. But uncertainty also means an elevated chance of being wrong. And even with polls that show more concentrated support (eg. Clinton over Trump), there is still the possibility of being wrong (eg. Alberta provincial election 2012).

There is also an asymmetry to the potential outcomes. If Remain had won, the market would have continued it’s slow, positive climb. If Leave had won (as it did), the market would quickly fall (as the UK market did). This is actually typical of the market more generally. Over months and years, it tends to climb slowly, with short period of sharp, quick declines. Because people are generally optimistic and because companies work hard to produce consistent, positive results, the market value of shares climbs slowly over time. There is not much risk of a quick, positive price spike in mature companies. (If it happens, it’s often the result of a miner discovering a large deposit or an innovative manufacturer making a new discovery.)

Because of the market asymmetry and the asymmetry in the expectations for the Brexit outcome in particular, the best strategy, no matter which outcome I thought was more likely, would have been to make a small bet that paid off in the case that Leave won. For example, I could have bought a put option that would allow me to sell the UK index near the current price. If the market rose, I’d lose my small premium. If the market fell (and it tends to fall more aggressively than it rises), I’d get a payoff.

This isn’t a good strategy to follow month-to-month or year-to-year, because it will lead to a “death by a thousand cuts.” It’s also really hard to implement because it requires being constantly pessimistic (which seems to go against human nature) and it will be wrong most of the time (people hate being wrong). But when a big, influential event is on the horizon, or when markets are nervous (elevated volatility) for any reason, this asymmetrical bet on the negative outcome could pay off nicely.

Market Outlook, June 27, 2016

Brexit: 52% of voters in the UK voted to leave the European Union. No one knows how that will shake out, and that’s the real problem. Investors, like all humans, hate uncertainty. The only reason for the price of gold to rise, the price of oil to fall, and the price of most European stocks to fall was uncertainty. There is no immediate reduction in demand or increase in supply, except for traders who don’t want to own risky assets during a period of uncertainty.

I note that North American stocks were affected to a far lesser degree, falling just 1.7% compared to over 8% for Paris. Interestingly, the FTSE 100 (UK index) opened (Friday morning) over 9% lower, but climbed throughout the day and closed only down -3.15% for the day.

At the end of this article, I include a theoretical portfolio. I’ll note here that it shifted out of stocks to all gold and bonds on Thursday morning. This reflects the nervousness in the market, which continues into the coming week.

Interest Rates

yieldcurve

The 3 month T-bill rate is 0.48%, the 1 year T-bill rate is 0.54%, the 3 year government bond yield is 0.65%, the 10 year government bond yield is 1.30% and the long government bond yield is 1.92%. The yield curve is normal. Long government bonds appear very overvalued. There seems to be very little opportunity for profit in bonds. A safe haven, such as tangible assets (eg. precious metals, real estate, etc.), may be a better bet.

Expected (forward-looking) inflation is 1.43%. This is within the Canadian central bank’s target band of 1% to 3%.

The equity risk premium for large caps, in Canada, currently appears to be 2.77%. For small caps, it currently appears to be 2.87%.

Credit Environment

The market prefers government bonds, long bonds and high quality bonds. This can be seen as a flight to quality in response to nervousness. Investors are paying more for safety, which means that yields are falling.
guage1guage2guage3

Currency

The Japanese Yen (FXY), Brazilian Real (BZF), Australian Dollar (FXA), Swiss Franc (FXF), Canadian Dollar (FXC), and Singapore Dollar (FXSG) are looking strong relative to the US dollar. The Euro is flat and the British Pound has taken a beating.
The Canadian dollar has been appreciating compared to the US dollar.

Equities

Where does there appear to be more opportunity right now?
US bonds are rising while US stocks are falling:
guage4
Canadian bonds are rising faster than Canadian stocks:
guage5

Global Markets

  • Austria has changed -7.39% in price since last week’s close.
  • Finland has changed -7.53% in price since last week’s close.
  • France has changed -7.36% in price since last week’s close.
  • Germany has changed -5.78% in price since last week’s close.
  • Ireland has changed -5.79% in price since last week’s close.
  • Italy has changed -11.23% in price since last week’s close.
  • Norway has changed -5.31% in price since last week’s close.
  • Qatar has changed -5.53% in price since last week’s close.
  • Spain has changed -12.35% in price since last week’s close.
  • Sweden has changed -8.38% in price since last week’s close.
  • Switzerland has changed -5.60% in price since last week’s close.
  • United Kingdom has changed -6.60% in price since last week’s close.

Comparing national stock markets, Brazil (EWZ), Peru (EPU), New Zealand (ENZL), and Philippines (EPHE) are rising, while other regions appear to be neutral or falling.

US Stocks

Yesterday’s closing price was 2,037.30. This is -2.21% lower than last week’s price (2,083.25), and -2.53% lower than last month’s price (2,090.10), and -0.86% lower than the price three months ago (2,055.01), and -1.31% lower than the price six months ago (2,064.29), and -3.38% lower than the price one year ago (2,108.63).The average P/E ratio of the S&P 100 (equal weighted) is 21.54. This implies the market is overvalued. There is likely an overly optimistic outlook and risks may be unduly discounted. This implies a forward capital return of 4.64% (before dividends).

The following stocks appear to present short-term (2-6 months) opportunities for price increase (buy high, sell higher):

  • Halliburton Company (HAL)
  • Altria Group, Inc. (MO)
  • At&t Inc. (T)
  • Raytheon Company (RTN)
  • Verizon Communications Inc. (VZ)

These stocks appear to be priced attractively from a long-term (3-5 years) perspective (buy low, sell high):

  • General Motors Company (GM)
  • Ford Motor Company (F)
  • Metlife, Inc. (MET)
  • Conocophillips (COP)

Canadian Stocks

Yesterday’s closing price was 13,891.90. This is -0.88% lower than last week’s price (14,015.10), and -1.51% lower than last month’s price (14,105.20), and 3.47% higher than the price three months ago (13,426.20), and 4.57% higher than the price six months ago (13,284.90), and -2.87% lower than the price one year ago (14,301.80).The average P/E ratio of the TSX60 (equal weighted) is 24.55. This implies the market is overvalued. There is likely an overly optimistic outlook and risks may be unduly discounted. This implies a forward capital return of 4.07% (before dividends).

The following stocks appear to present short-term (2-6 months) opportunities for price increase (buy high, sell higher):

  • Kinross Gold Corp. (K.to)
  • Yamana Gold Inc (YRI.to)
  • Teck Resources Limited (TCK-B.to)
  • Barrick Gold Corporation (ABX.to)
  • Agnico Eagle Mines Limited (AEM.to)
  • Silver Wheaton Corp. (SLW.to)
  • Franco-nevada Corporation (FNV.to)
  • Eldorado Gold (ELD.to)
  • Goldcorp Inc (G.to)
  • Bombardier Inc., Cl. B, Sv (BBD-B.to)
  • Encana Corp. (ECA.to)
  • Transcanada Corp. (TRP.to)
  • First Quantum Minerals Ltd (FM.to)

These stocks appear to be priced attractively from a long-term (3-5 years) perspective (buy low, sell high):

  • Power Corporation Of Canada, Sv (POW.to)

Other Assets

Silver (HUZ.to), Global Infrastructure (ZGI.to), TSX REIT (XRE.to), Gold (IGT.to), Base Metals (ZMT.to), Canadian Universe Bond (XBB.to), TSX Capped Composite (ZCN.to) are performing better than cash.
The gold price is rising, which often indicates nervousness in equity markets.

Portfolio

A theoretical portfolio, split evenly between gold (IGT in Cdn$), real estate (XRE in Cdn$), Canadian stocks (XIU in Cdn$), US stocks (XSP hedged to Cdn$), international stocks (VDU in Cdn$) and bonds (XBB in Cdn$).

As of today, the theoretical portfolio would hold:

  • One unit (20%) of gold
  • One unit (20%) real estate
  • 3 units (60%) bonds

Forecasting refinement – overfitting

In looking to refine my stock market forecasting, I looked at a number of variables to try and find a relationship. I’ve laid them out below, but I’ll spare you the suspense: none of them worked.

That’s not necessarily a bad thing. There are two problems with trying to create a model to forecast stock market movements. The first is that the stock market is where people go to place bets (if you’ll excuse the gambling reference) on the future performance and the future value of stocks. Therefore, the stock market is forward-looking and it is generally considered to be a leading indicator of economic outcomes. The only way to anticipate the stock market is to anticipate business outcomes farther ahead or faster or more accurately than other traders and investors. Those people are professionals and have the resources of large firms at their disposal, so that’s just not going to happen.

The other problem is overfitting. Stock price movements contain information about the aggregate outlook for the company (which changes daily) and for the stock (which fluctuates with supply and demand). The information is a signal, but it is swamped with noise. Stock research, including fundamental and technical, is trying to identify the signal (trend) and ignore the noise. When a model becomes too complex, it is possible for it to capture noise along with (or instead of) the signal, which will lead to faulty interpretation and incorrect forecasting. So I’m happy to rule out potential relationship because it helps me avoid overfitting.

The movement of interest rates affects the financial inputs of businesses, however I found no correlation between interest rate changes and the following month stock market movement.

The change in commodity prices affects the material inputs of businesses, especially manufacturers. There was very little correlation (may explain 2% of change) between commodity price changes and the following month stock market movement. Rather, I found that stock prices and commodity prices tend to move together.

There is a theory that trading volume (supply & demand) produces technical signals. For example, high volume on rising rising prices implies increasing demand and should lead to higher prices. High volume on falling prices implies increasing supply and should lead to lower prices. However, the monthly volume has a low correlation with the following month stock market movement.

The last variable I looked at was employment / unemployment numbers, and I found almost no correlation with the following month stock market movement. Because of the time it takes to compile and publish employment statistics, the numbers are from two months ago, so it would have to influence stock returns three months later, for example through increased savings (from higher employment) or increased selling (from unemployment). This doesn’t appear to be the case.

Model so far:

    • This can be refined, given the month of the year (although it’s been less pronounced recently):
Monthly average increase % positive
January 0.95% 59.46%
February 0.92% 59.46%
March 0.57% 56.76%
April 0.89% 56.76%
May 1.39% 62.16%
June -0.43% 45.95%
July 0.67% 62.16%
August 0.68% 59.46%
September -1.62% 43.24%
October -0.15% 56.76%
November 1.46% 64.86%
December 1.83% 81.08%
 Average monthly increase 0.60%
  • Stocks are likely to rise 59% of the time. May +5%, June -10%, September -15%, October -5%, November +5%, December +15%
  • If last month was positive, this month is 5% more likely to rise (coefficient of correlation of 0.233)
  • If last month was negative, this month is 7% less likely to rise

I freely admit that it’s not a great model. I’d only expect to be right about 3 times out of 5, and that’s only about direction, not magnitude. But sometimes I think it’s better to be aware that we really don’t know, than to think we know and be surprised. It gives us more chance to protect against or prepare for risk.

Forecasting refinement – calendar effects

When I looked at forecasting stock market returns, I began by finding a base expectation: stock prices rise over a month-long period about 59% of the time. To continue the analogy to weather forecasting, we know that weather depends upon the season. Stock returns also seem to depend on the time of year, which is referred to as calendar effects.

Some well-known calendar effects include the Santa Claus rally, the January effect (especially for small caps), and “sell in May and go away”. And, of course, the fact that the worst market crashes have all happened in October. Keep in mind that because these effects are well-known, they are not very pronounced. At the same time, there may be an element of self-fulfilling prophecies.

Looking at the TSX since 1979, these are the probabilities of the stock market rising in each month.

January: 59% (typical)

February: 59% (typical)

March: 58% (typical)

April: 58% (typical)

May: 62% (slightly better)

June: 46% (worse)

July: 62% (slightly better)

August: 59% (typical)

September: 43% (much worse)

October: 57% (surprisingly typical)

November: 65% (better)

December: 81% (much better)

The real standouts are June, September, November and December. I was really surprised that October is essentially typical in how often the month will produce a positive or negative return. It’s just that when it’s negative, it’s a crash. I had never thought of June being as risky as September, or of December as being pretty close to a sure thing.

Over the period of 1979 to 2016, the average monthly return of the TSX is 0.60%. This translates to a yearly return of 7.18%. Looking at the frequency of positive returns gives an idea of the probability of a rising stock market. Looking at the average return for the month gives an idea of how far the stock market rose. Most are pretty close to the average, with the following exceptions.

October has a negative average return (-0.15%), even though it is positive more often than negative. That means that when it’s negative, it’s really bad. September is the worst, with an average monthly return of -1.62%. The only other month with a negative average return is June, at -0.43%, which is worse than October (more often, but to a lesser degree).

My forecast for the current month, June 2016, based on the calendar effect would be 46% probability of a positive return. Add to that the fact that May 2016 was positive (1.44%), and I’ll adjust upward to 51%. I’m willing to lay it on the line: there is a 51% chance that the TSX will end the month higher than 14,063.54.

I fully recognize that’s not really helpful. I’ll continue looking for variables that can help refine my model. Next is the business cycle and sector rotation, but I’m also open to suggestions.

Market Outlook, June 13, 2016

The stock market reached a new high (since August 2015) last Wednesday, at 14,432.95. But some investors must have felt that was overdoing it, because the market dropped on both Thursday and Friday, ending the week down -1.33%.

Visa shares are going to open lower this week: Walmart Canada to stop accepting Visa cards

Interest Rates

yieldcurve

The 3 month T-bill rate is 0.45%, the 1 year T-bill rate is 0.53%, the 3 year government bond yield is 0.55%, the 10 year government bond yield is 1.18% and the long government bond yield is 1.84%. The yield curve is normal. Long government bonds appear very overvalued. There seems to be very little opportunity for profit in bonds. A safe haven, such as tangible assets (eg. precious metals, real estate, etc.), may be a better bet.

Expected (forward-looking) inflation is 1.49%. This is within the Canadian central bank’s target band of 1% to 3%.

The equity risk premium for large caps, in Canada, currently appears to be 3.16%. For small caps, it currently appears to be 0.81%.

Credit Environment

The advantage currently goes to government bonds over corporate:
guageLong bonds over short:guage (1)And high quality bonds over high yield:
guage (2)

Currency

The Brazilian Real (BZF), Japanese Yen (FXY), Singapore Dollar (FXSG), Canadian Dollar (FXC), and Swiss Franc (FXF) are looking strong relative to the US dollar.
The Canadian dollar has been appreciating compared to the US dollar.

Equities

Where does there appear to be more opportunity right now?
US stocks have the advantage over bonds:
guage (3)
And Canadian stocks over bonds:
guage (4)

Global Markets

Comparing national stock markets, New Zealand (ENZL), Peru (EPU), South Africa (EZA), Taiwan (EWT), Canada (EWC), Philippines (EPHE), Hong Kong (EWH), India (INDA), Belgium (EWK), South Korea (EWY), Thailand (THD), Finland (EFNL), Indonesia (EIDO), US S&P 500 (IVV), UAE (UAE), Chile (ECH), China (MCHI), Russia (ERUS), Singapore (EWS), Norway (ENOR), Ireland (EIRL), and Brazil (EWZ) are rising, while other regions appear to be neutral or falling.

US Stocks

Yesterday’s closing price was 2,096.07. This is -0.63% lower than last week’s price (2,109.41), and 1.55% higher than last month’s price (2,064.11), and 3.78% higher than the price three months ago (2,019.64), and 2.37% higher than the price six months ago (2,047.62), and -1.33% lower than the price one year ago (2,124.29).The average P/E ratio of the S&P 100 (equal weighted) is 22.32. This implies the market is overvalued. There is likely an overly optimistic outlook and risks may be unduly discounted. This implies a forward capital return of 4.48% (before dividends).

The following stocks appear to present short-term (2-6 months) opportunities for price increase (buy high, sell higher):

  • California Resources Corporation (CRC)
  • Halliburton Company (HAL)
  • Devon Energy Corporation (DVN)
  • Monsanto Company (MON)
  • Amazon.com, Inc. (AMZN)
  • Unitedhealth Group Incorporated (UNH)
  • Texas Instruments Incorporated (TXN)
  • Wal-mart Stores, Inc. (WMT)
  • Anadarko Petroleum Corporation (APC)
  • Pfizer, Inc. (PFE)
  • Raytheon Company (RTN)
  • Union Pacific Corporation (UNP)
  • Medtronic Plc. (MDT)
  • Cisco Systems, Inc. (CSCO)

These stocks appear to be priced attractively from a long-term (3-5 years) perspective (buy low, sell high):

  • General Motors Company (GM)
  • Ford Motor Company (F)
  • Metlife, Inc. (MET)

Canadian Stocks

Yesterday’s closing price was 14,037.50. This is -1.67% lower than last week’s price (14,276.20), and 1.81% higher than last month’s price (13,787.80), and 4.16% higher than the price three months ago (13,477.50), and 8.50% higher than the price six months ago (12,937.60), and -4.26% lower than the price one year ago (14,662.30).The average P/E ratio of the TSX60 (equal weighted) is 23.07. This implies the market is overvalued. There is likely an overly optimistic outlook and risks may be unduly discounted. This implies a forward capital return of 4.34% (before dividends).

The following stocks appear to present short-term (2-6 months) opportunities for price increase (buy high, sell higher):

  • Teck Resources Limited (TCK-B.to)
  • Kinross Gold Corp. (K.to)
  • Yamana Gold Inc (YRI.to)
  • Barrick Gold Corporation (ABX.to)
  • Agnico Eagle Mines Limited (AEM.to)
  • Bombardier Inc., Cl. B, Sv (BBD-B.to)
  • Encana Corp. (ECA.to)
  • Silver Wheaton Corp. (SLW.to)
  • First Quantum Minerals Ltd (FM.to)
  • Pembina Pipeline Corporation (PPL.to)
  • Franco-nevada Corporation (FNV.to)
  • Transcanada Corp. (TRP.to)
  • Inter Pipeline Ltd (IPL.to)
  • National Bank Of Canada (NA.to)

These stocks appear to be priced attractively from a long-term (3-5 years) perspective (buy low, sell high):

  • Power Corporation Of Canada, Sv (POW.to)

Other Assets

Crude Oil Etf (HUC.to), Natural Gas Etf (HUN.to), Silver Etf (HUZ.to), Global Infrastructure Etf (ZGI.to), S&p/tsx Capped Reit (XRE.to), S&p/tsx Capped Composite E (ZCN.to), Spdr S&p 500 (SPY), Canadian Universe Bond (XBB.to), S&p/tsx Eqwt Glb Bm Hdgd T (ZMT.to), Gold Trust (IGT.to) are performing better than cash.
The gold price is neutral.
The oil price is rising, which increases manufacturing input costs and energy costs and may slow economic expansion.

Portfolio

A theoretical portfolio, split evenly between gold (IGT in Cdn$), real estate (XRE in Cdn$), Canadian stocks (XIU in Cdn$), US stocks (XSP hedged to Cdn$), international stocks (VDU in Cdn$) and bonds (XBB in Cdn$).

As of today, the theoretical portfolio would hold:

  • One unit (20%) real estate
  • One unit (20%) Canadian stocks
  • One unit (20%) US stocks
  • 2 units (40%) bonds

Stock Market Forecasting

Weather forecasting will show the most likely weather for the coming five days, with a probability of its occurrence. For example, a 60% chance of rain means that, under the current conditions, 60% of the time rain will develop and 40% of the time it will not. If you look back at forecasts the predict a 60% chance of rain, it has rained in 60% of the cases.

Would it be possible to create a model that will forecast stock price movements over the coming month? It would be a probabilistic model, similar to weather, meaning that it will be wrong a portion of the time. But the idea is to quantify what that proportion is.

The most basic model predicts the outcome using no model at all, only historical outcomes. As an example, it would be like looking at the Calgary climate, finding that there is rain or snow on 152 of 365 days, then producing a forecast for a 42% chance of rain (or snow). This forecast could be considered accurate, but it’s not very helpful. A similar forecast for stock prices over the coming month, based on monthly returns since 1979, is a 59% chance of positive returns. In 59 months out of 100, stocks have experienced a positive price change. Given this fact, owning stocks is profitable (as opposed to gambling at a casino).

Next, I’d like to refine my model. I haven’t gotten very far. I have found that the current return to bonds is not predictive of future stock returns. The current return to stocks is slightly better. If stocks went up over the past month, there is a 64% probability that they’ll go up over the next month. It is possible to improve returns (ignoring fees and taxes) by only owning stocks in months when the previous month return was positive. I’m not suggesting this is a useful strategy, only that it supports the improvement to the forecast.

There are a number of other variables I will look at. But the noise-to-signal ratio is so high that it’s very difficult to predict future stock prices based on any single or group of inputs. In that way, it’s like trying to predict the weather more than a week in the future.

Market Outlook, June 6, 2016

After pausing for a short period, stocks appear poised to continue their climb. Near-term interest rates have begun to rise (the US Fed is signaling another rate hike some time this year), which is translating into price declines for bonds with maturity less than a year. Rising interest rates, however, indicate a positive outlook for economic growth, which will likely translate into optimism for corporate profits and rising stock prices. Having said that, the summer months are often slow, so it’s not likely to see a surge.

Interest Rates

yieldcurve

The 3 month T-bill rate is 0.44%, the 1 year T-bill rate is 0.53%, the 3 year government bond yield is 0.54%, the 10 year government bond yield is 1.18% and the long government bond yield is 1.84%. The yield curve is normal. Long government bonds appear very overvalued. There seems to be very little opportunity for profit in bonds. A safe haven, such as tangible assets (eg. precious metals, real estate, etc.), may be a better bet.

Expected (forward-looking) inflation is 1.50%. This is within the Canadian central bank’s target band of 1% to 3%.

The equity risk premium for large caps, in Canada, currently appears to be 3.10%. For small caps, it currently appears to be 0.87%.

Credit Environment

Short bonds are faltering and long bonds continue to perform.
Governments are doing better than corporates:guage1Long bonds are in favour far beyond short bonds:guage2High quality bonds are still preferable over high yield bonds:guage

Currency

The Japanese Yen (FXY), Brazilian Real (BZF), Singapore Dollar (FXSG), Euro (FXE), and Canadian Dollar (FXC) are looking strong relative to the US dollar.
The Canadian dollar has been appreciating (a bit) compared to the US dollar.

Equities

Where does there appear to be more opportunity right now?
US bonds vs. US stocks:
guage4
Canadian bonds vs. Canadian stocks:
guage5

Global Markets

  • Brazil has changed 5.72% in price since last week’s close.
  • Peru has changed 5.18% in price since last week’s close.
  • Philippines has changed 5.07% in price since last week’s close.
  • South Africa has changed 6.65% in price since last week’s close.

Comparing national stock markets, Peru (EPU), Philippines (EPHE), New Zealand (ENZL), Belgium (EWK), South Africa (EZA), Denmark (EDEN), India (INDA), Canada (EWC), Taiwan (EWT), Thailand (THD), Netherlands (EWN), Switzerland (EWL), Norway (ENOR), Finland (EFNL), US S&P 500 (IVV), France (EWQ), Hong Kong (EWH), Indonesia (EIDO), Turkey (TUR), Sweden (EWD), Israel (EIS), Russia (ERUS), United Kingdom (EWU), Germany (EWG), Brazil (EWZ), and Australia (EWA) are rising, while other regions appear to be neutral or falling.

US Stocks

Yesterday’s closing price was 2,099.13. This is 0.00% higher than last week’s price (2,099.06), and 2.37% higher than last month’s price (2,050.63), and 4.86% higher than the price three months ago (2,001.76), and 0.94% higher than the price six months ago (2,079.51), and 2.33% higher than the price one year ago (2,051.31).The average P/E ratio of the S&P 100 (equal weighted) is 22.42. This implies the market is overvalued. There is likely an overly optimistic outlook and risks may be unduly discounted. This implies a forward capital return of 4.46% (before dividends).

The following stocks appear to present short-term (2-6 months) opportunities for price increase (buy high, sell higher):

  • California Resources Corporation (CRC)
  • Monsanto Company (MON)
  • Devon Energy Corporation (DVN)
  • Amazon.com, Inc. (AMZN)
  • Halliburton Company (HAL)
  • Cisco Systems, Inc. (CSCO)
  • Allergan Plc (AGN)
  • Lowe’s Companies, Inc. (LOW)

These stocks appear to be priced attractively from a long-term (3-5 years) perspective (buy low, sell high):

  • General Motors Company (GM)
  • Ford Motor Company (F)
  • Metlife, Inc. (MET)
  • Conocophillips (COP)

Canadian Stocks

Yesterday’s closing price was 14,226.80. This is 0.99% higher than last week’s price (14,086.70), and 4.36% higher than last month’s price (13,632.00), and 6.30% higher than the price three months ago (13,383.60), and 5.67% higher than the price six months ago (13,463.80), and -1.29% lower than the price one year ago (14,412.10).The average P/E ratio of the TSX60 (equal weighted) is 23.34. This implies the market is overvalued. There is likely an overly optimistic outlook and risks may be unduly discounted. This implies a forward capital return of 4.28% (before dividends).

The following stocks appear to present short-term (2-6 months) opportunities for price increase (buy high, sell higher):

  • Barrick Gold Corporation (ABX.to)
  • Encana Corp. (ECA.to)
  • Kinross Gold Corp. (K.to)
  • Agnico Eagle Mines Limited (AEM.to)
  • Teck Resources Limited (TCK-B.to)
  • Eldorado Gold (ELD.to)
  • Bombardier Inc., Cl. B, Sv (BBD-B.to)
  • Silver Wheaton Corp. (SLW.to)
  • Pembina Pipeline Corporation (PPL.to)
  • Snc-lavalin Sv (SNC.to)
  • Crescent Point Energy Corp. (CPG.to)
  • First Quantum Minerals Ltd (FM.to)
  • Franco-nevada Corporation (FNV.to)
  • Cdn Natural Res (CNQ.to)
  • Inter Pipeline Ltd (IPL.to)
  • Metro Inc (MRU.to)
  • Arc Resources Ltd. (ARX.to)
  • Cgi Group Inc., Cl.a, Sv (GIB-A.to)
  • National Bank Of Canada (NA.to)

These stocks appear to be priced attractively from a long-term (3-5 years) perspective (buy low, sell high):

  • Power Corporation Of Canada, Sv (POW.to)
  • National Bank Of Canada (NA.to)

Other Assets

Crude Oil (HUC.to), Global Infrastructure Etf (ZGI.to), TSX Composite (ZCN.to), TSX REITs (XRE.to), Natural Gas (HUN.to), US S&P 500 (SPY), Canadian Universe Bond (XBB.to), Vanguard FTSE Dev All Cap Ex U (VDU.to), MSCI EAFE (XIN.to) are performing better than cash.
The gold price is falling, which may indicate bullishness toward stocks.
The oil price is rising, which increases manufacturing input costs and energy costs and may slow economic expansion.

Portfolio

A theoretical portfolio, split evenly between gold (IGT in Cdn$), real estate (XRE in Cdn$), Canadian stocks (XIU in Cdn$), US stocks (XSP hedged to Cdn$), international stocks (VDU in Cdn$) and bonds (XBB in Cdn$).

As of today, the theoretical portfolio would hold:

  • One unit (20%) real estate
  • One unit (20%) Canadian stocks
  • One unit (20%) US stocks
  • One unit (20%) international stocks
  • 1 unit (20%) bonds

Market Outlook, May 30, 2016

After taking a break, stocks appear ready to continue their climb. Bonds are also producing gains. Canadian small caps have done really well over the past few weeks, but appear to be slowing down and are starting to look riskier. Not many companies appear cheap (on sale) at the moment, but that is based on past earnings, which have not been very strong. Investors are watching for an economic recovery, of which the first sign was the US Fed saying that interest rates could be raised.

Interest Rates

yieldcurve

The 3 month T-bill rate is 0.45%, the 1 year T-bill rate is 0.54%, the 3 year government bond yield is 0.69%, the 10 year government bond yield is 1.35% and the long government bond yield is 1.99%. The yield curve is normal. Long government bonds appear very overvalued. There seems to be very little opportunity for profit in bonds. A safe haven, such as tangible assets (eg. precious metals, real estate, etc.), may be a better bet.The equity risk premium for large caps, in Canada, currently appears to be 2.94%. For small caps, it currently appears to be 0.73%.

Credit Environment

Government bonds are slightly more attractive than corporate bonds.
guage1

Long bonds are in much greater favour than short bonds.guage2

High quality and high yield bonds both appear equally profitable at the moment.guage3

Currency

Wisdomtree Brazilian Real Strat (BZF), Singa (FXSG), Briti (FXB) are looking strong relative to the US dollar.
The Canadian dollar has been losing value compared to the US dollar.

Equities

Where does there appear to be more opportunity right now? Bonds and stocks are both in favour, with stocks showing more promise for price gains.
US stocks have the advantage over bonds.
guage4
As do Canadian stocks.
guage5

Global Markets

  • India has changed 5.66% in price since last week’s close.
  • Taiwan has changed 5.06% in price since last week’s close.

Comparing national stock markets, Philippines (EPHE), Peru (EPU), India (INDA), Denmark (EDEN), New Zealand (ENZL), Ireland (EIRL), Belgium (EWK), US S&P 500 (IVV), Netherlands (EWN), Russia (ERUS), Norway (ENOR), Japan (EWJ), Switzerland (EWL), Canada (EWC), Australia (EWA), United Kingdom (EWU), France (EWQ), Taiwan (EWT), Thailand (THD), Finland (EFNL), and Germany (EWG) are rising, while other regions appear to be neutral or falling.

US Stocks

Yesterday’s closing price was 2,099.06. This is 2.49% higher than last week’s price (2,048.04), and 1.63% higher than last month’s price (2,065.30), and 6.10% higher than the price three months ago (1,978.35), and 0.49% higher than the price six months ago (2,088.87), and 1.07% higher than the price one year ago (2,076.78).The average P/E ratio of the S&P 100 (equal weighted) is 22.52. This implies the market is overvalued. There is likely an overly optimistic outlook and risks may be unduly discounted. This implies a forward capital return of 4.44% (before dividends).

The following stocks appear to present short-term (2-6 months) opportunities for price increase (buy high, sell higher):

  • Monsanto Company (MON)
  • California Resources Corporation (CRC)
  • Amazon.com, Inc. (AMZN)
  • Devon Energy Corporation (DVN)
  • Accenture Plc (ACN)
  • Texas Instruments Incorporated (TXN)
  • Halliburton Company (HAL)
  • Lowe’s Companies, Inc. (LOW)
  • Qualcomm Incorporated (QCOM)

These stocks appear to be priced attractively from a long-term (3-5 years) perspective (buy low, sell high):

  • General Motors Company (GM)
  • Ford Motor Company (F)
  • Metlife, Inc. (MET)
  • Conocophillips (COP)

Canadian Stocks

Yesterday’s closing price was 14,105.20. This is 1.33% higher than last week’s price (13,919.60), and 1.58% higher than last month’s price (13,886.40), and 9.68% higher than the price three months ago (12,860.40), and 5.24% higher than the price six months ago (13,403.40), and -3.08% lower than the price one year ago (14,553.30).The average P/E ratio of the TSX60 (equal weighted) is 23.29. This implies the market is overvalued. There is likely an overly optimistic outlook and risks may be unduly discounted. This implies a forward capital return of 4.29% (before dividends).

The following stocks appear to present short-term (2-6 months) opportunities for price increase (buy high, sell higher):

  • Bombardier Inc., Cl. B, Sv (BBD-B.to)
  • Encana Corp. (ECA.to)
  • Snc-lavalin Sv (SNC.to)
  • Eldorado Gold (ELD.to)
  • Yamana Gold Inc (YRI.to)
  • First Quantum Minerals Ltd (FM.to)
  • Crescent Point Energy Corp. (CPG.to)
  • Teck Resources Limited (TCK-B.to)
  • Cdn Natural Res (CNQ.to)
  • Barrick Gold Corporation (ABX.to)
  • Agnico Eagle Mines Limited (AEM.to)
  • Kinross Gold Corp. (K.to)
  • Brookfield Asset Management Inc (BAM-A.to)
  • Cenovus Energy Inc. (CVE.to)
  • Transcanada Corp. (TRP.to)
  • Canadian Tire Corporation, Cl. (CTC-A.to)
  • Sun Life Financial Inc. (SLF.to)
  • Thomson Reuters Corporation (TRI.to)

These stocks appear to be priced attractively from a long-term (3-5 years) perspective (buy low, sell high):

  • Power Corporation Of Canada, Sv (POW.to)
  • National Bank Of Canada (NA.to)

Other Assets

Crude Oil (HUC.to), Global Infrastructure (ZGI.to), TSX REIT (XRE.to), TSX Composite (ZCN.to), US S&P 500 (SPY), FTSE Developed All Cap ex US (VDU.to), Natural Gas (HUN.to), MSCI EAFE (XIN.to), and Canadian Universe Bond (XBB.to) are performing better than cash.
The gold price is neutral.
The oil price is rising, which increases manufacturing input costs and energy costs and may slow economic expansion.

Portfolio

A theoretical portfolio, split evenly between gold (IGT in Cdn$), real estate (XRE in Cdn$), Canadian stocks (XIU in Cdn$), US stocks (XSP hedged to Cdn$), international stocks (VDU in Cdn$) and bonds (XBB in Cdn$).

As of today, the theoretical portfolio would hold:

  • One unit (20%) real estate
  • One unit (20%) Canadian stocks
  • One unit (20%) US stocks
  • One unit (20%) international stocks
  • 1 unit (20%) bonds

Yield curve shape: convex and concave

The yield curve is a graphical representation of the bond yield at different maturities. A normal yield curve will slope upwards, with higher yields for longer bonds. An inverted yield curve will slope downwards, with higher yields for shorter bonds. This implies that the central bank is raising interest rates in response to an overheating economy, and it usually precedes recession. But what I’m interested in is the convexity or concavity of a normal yield curve.

A normal yield curve is generally expected to be convex:

Short bonds and T-bills usually have the lowest rates. 2-year, 3-year and 5-year bonds have relatively higher yields. Then the yield curve flattens from 10-year to long bonds, as they approach the investors’ required long-term return. Given that we are looking at government bonds, the guarantees are assumed to be dependable.

Recently, the yield curve has been concave:

yieldcurve

You’ll notice that rates are very low. Also notice the lack of “hump” on the hill. What gives the yield curve this shape? There are three factors that affect the shape of the yield curve: future rate expectations, term premiums and rate volatility.

Future rate expectations can be calculated from the difference in the yields at different maturities. If the 3-month T-bill yields 0.46% (as currently) and the 6-month T-bill yields 0.55%, that implies that investors expect the 3-month yield to rise to 0.64% in three months because once their T-bill matures, they have to reinvest it at 0.64% to get a total yield over the six months of 0.55%. Currently, the 2-year bond also implies a rate expectation of 0.64% from six months to 2 years. The implied rate expectations from 2 years to 3 years is 0.71%, from 3 years to 5 years is 0.90%, from 5 years to 7 years is 1.70% and from 7 years to 10 years is 2.12%. From 10 years to the long bond (less than 30 years) is 2.31%. We can see from these calculations that investors not only expect rates to remain low, but to remain low for an extended period of time  (at least five years).

There is a term premium that compensates investors for locking their money up for long periods rather than constantly rolling it over. Because of the risk premium, investors will usually require that long terms reward them with higher returns. That is currently the case, and it doesn’t really explain convexity or concavity, only the normal shape of the yield curve. What we can assume, though, is that a concave yield curve is somehow related to reduced (rather than increased) risk premiums in the middle of the curve (5-10 years). Another way of saying this is that a 5-year bond is currently almost as attractive as a 2-year bond, since they have very similar yields (0.75% compared to 0.62%). This may related to the first point, an expectation of low future rates, or it may relate to the next point, the idea that economic outcomes are unpredictable or even unstable, so safety is valuable over the medium term.

Implied volatility seems to have the most influence over the convexity or concavity of the yield curve. “When volatility is high, the curve is likely to be upward-sloping; when volatility is low, the shape of the yield curve is determined mostly by the expectations component, since risk premia are virtually absent.” (http://pure.au.dk/portal/files/34302281/D02_3.pdf) The way I understand this is that when short-term rates are volatile, the yield curve will be more convex (with a hump) because the uncertainty of future rates will cause investors to demand lower prices (higher yields & returns) for longer bonds. (This uncertainty tends to resolve over very long periods, like 10-30 years.) Currently, with low volatility of short-term rates, investors hardly demand any premium for longer bonds. But it may also be that investors bid up the prices (and down the yields) of bonds with maturities of less than 10 years when they feel very uncertain about the economic prospects over the coming 10 years. This would be a “flight to safety,” where investors prefer to own a government-guaranteed investment rather than owning stocks and investing in uncertain future corporate profits.

I would read a concave yield curve as “economic uncertainty” and the related “persistent low interest rates.” Whereas an inverted yield curve warns of economic overheating and an impending recession, a concave yield curve appears to warn of low corporate profits. In that case, bonds are expensive, stocks are expensive and it’s not an easy time to be an investor right now.

Market Outlook, May 24, 2016

The US Fed(eral Reserve Bank) is talking about raising interest rates. Normally, that would cause bond yields to rise and bond values to fall. But bonds continue to perform reasonably, and with stocks taking a breather, bonds appear to be keeping up. In the past, I’ve never had a chance to see a graphical representation of a yield curve, so I didn’t have a concept of what a “normal” yield curve looked like. It’s usually expected to be convex, where T-bills have low yields, short bonds are quite a bit higher, medium bonds are a little higher yet, and long bonds are slightly higher than that. Ever since I’ve been creating a graphical representation of the yield curve (see below), it’s been concave. Last week, I rewrote the algorithm that produces it, in order to increase the number of data points, with the expectation that it would change the shape. The good news is that what I created previously was not misleading. The bad news is that I don’t know yet what a concave yield curve means, other than the fact that rates are really low.

I will also point out that I added a calculation for the current risk premium of equities, both large cap and small cap Canadian stocks. I did this by finding the earning yield (inverse P/E) and subtracting the long bond yield. What is surprising, currently, is that the risk premium for small caps, which should be larger, is actually quite a bit smaller. Therefore, small caps appear overpriced and unlikely to provide enough (excess) return to compensate for the risk.

Interest Rates

yieldcurve

The 3 month T-bill rate is 0.46%, the 1 year T-bill rate is 0.55%, the 3 year government bond yield is 0.65%, the 10 year government bond yield is 1.35% and the long government bond yield is 1.99%. The yield curve is normal. Long government bonds appear very overvalued. There seems to be very little opportunity for profit in bonds. A safe haven, such as tangible assets (eg. precious metals, real estate, etc.), may be a better bet.The equity risk premium for large caps, in Canada, currently appears to be 3.02%. For small caps, it currently appears to be 1.41%.

Credit Environment

Corporate bonds are performing better than government bonds, long bonds are doing better than short bonds and, in the third dial, high quality is doing slightly better than high yield.
guage1guage2guage3

Currency

The Brazilian Real (BZF), and Japanese Yen (FXY) are the only currencies outperforming the US dollar, which has been rising for the past couple weeks.
The Canadian dollar has been losing value compared to the US dollar.

Equities

Where does there appear to be more opportunity right now? Stocks are taking a break and doing barely better than bonds.
US bonds vs. US stocks:
guage4
Canadian bonds vs. Canadian stocks:
guage5

Global Markets

Comparing national stock markets, Peru (EPU), Philippines (EPHE), New Zealand (ENZL), Denmark (EDEN), and Belgium (EWK) are rising, while other regions appear to be neutral or falling.

US Stocks

Yesterday’s closing price was 2,048.04. This is 0.04% higher than last week’s price (2,047.21), and -1.90% lower than last month’s price (2,087.79), and 6.13% higher than the price three months ago (1,929.80), and -1.60% lower than the price six months ago (2,081.24), and -2.54% lower than the price one year ago (2,101.49).The average P/E ratio of the S&P 100 (equal weighted) is 22.00. This implies the market is overvalued. There is likely an overly optimistic outlook and risks may be unduly discounted. This implies a forward capital return of 4.54% (before dividends).

The following stocks appear to present short-term (2-6 months) opportunities for price increase (buy high, sell higher):

  • California Resources Corporation (CRC)
  • Monsanto Company (MON)
  • Amazon.com, Inc. (AMZN)
  • Devon Energy Corporation (DVN)

These stocks appear to be priced attractively from a long-term (3-5 years) perspective (buy low, sell high):

  • General Motors Company (GM)
  • Ford Motor Company (F)
  • Metlife, Inc. (MET)
  • Conocophillips (COP)

Canadian Stocks

Yesterday’s closing price was 13,919.60. This is 0.19% higher than last week’s price (13,893.50), and 0.33% higher than last month’s price (13,874.00), and 9.06% higher than the price three months ago (12,763.40), and 3.31% higher than the price six months ago (13,473.80), and -6.88% lower than the price one year ago (14,947.50).The average P/E ratio of the TSX60 (equal weighted) is 22.88. This implies the market is overvalued. There is likely an overly optimistic outlook and risks may be unduly discounted. This implies a forward capital return of 4.37% (before dividends).

The following stocks appear to present short-term (2-6 months) opportunities for price increase (buy high, sell higher):

These stocks appear to be priced attractively from a long-term (3-5 years) perspective (buy low, sell high):

  • Power Corporation Of Canada (POW.to)
  • National Bank Of Canada (NA.to)
  • Bank Of Nova Scotia (BNS.to)

Other Assets

Crude Oil (HUC.to),TSX REIT (XRE.to), Global Infrastructure (ZGI.to), Gold (IGT.to), Canadian TSX (ZCN.to), Canadian Universe Bond (XBB.to), US S&P 500 (SPY), Silver (HUZ.to), World stocks (VDU.to) are performing better than cash.
The gold price is rising, which often indicates nervousness in equity markets.
The oil price is rising, which increases manufacturing input costs and energy costs and may slow economic expansion.

Portfolio

A theoretical portfolio, split evenly between gold (IGT in Cdn$), real estate (XRE in Cdn$), Canadian stocks (XIU in Cdn$), US stocks (XSP hedged to Cdn$), international stocks (VDU in Cdn$) and bonds (XBB in Cdn$).

As of today, the theoretical portfolio would hold:

  • One unit (20%) of gold
  • One unit (20%) real estate
  • One unit (20%) Canadian stocks
  • 2 units (40%) bonds