7 Simple Lessons from 7 Years in Banking, Finance, Economics & Trading

1.  Fees are the devil, period.  Either learn how to manage your own investments or suck up the fact that you won’t beat the market

(or index funds) over the long term.

2.  Free markets don’t exist.  Every government on Earth has their hands in any pot they can get themselves into.  They are either corrupt or stupid and will waste your money — or worse, prohibit citizens’ ability to acquire goods and services at fair market prices with laws and tariffs — every chance they get.

3.  Slow money is smart money.  Don’t chase fads or trends unless you are an agile, informed and attentive investment professional.  By the time George Costanza or Betty Draper knows about a trend in the markets, the pro’s are positioning on the other side and plan to sell to the latecomers: retail investors.

4.  If it sounds like a gimmick, it is.  Trust you gut.  Most people have the basic instincts required to suss out a charlatan.  If you don’t, as PT Barnum would say, “… a sucker is born everyday” and ignorance is readily exploited.  The pressure and expectations at large financial institutions demand bankers seize every opportunity, whether born from hard word and diligence or counterparty ignorance.  Some more cliches for emphasis: KISS, there is nothing new under the sun.

5. Buying discounted securities and holding until they realize their full value is the only way to ensure you’re investing with a margin of safety and thus can rest comfortably knowing there is a reasonable chance of growing your capital over the long term.

5.  Forecasting is biased, or worse, fabricated misdirection.  Due to perverse incentives at large institutions [both public (central banks, think tanks etc) and private (banks)] or pure guesses.  Some economists and portfolio managers can be trusted but it takes years to figure out who, and WHEN, advice should be embraced.

6.  Financial service providers carefully toe the line between partnership and exploitation.  They will extract as much as they can in fees while tactfully managing loyalty and client experiences.

7.  Much of the dogma (or marketing) in the investment sphere is not supported by recent academic literature.  Efficient markets, risk = return, time in the market vs. time out of the market.    The primary findings by many academics who review investment fund performance: fees destroy most returns, markets (prices) follow a random walk and pricing inefficiencies abound in all corners and in most asset classes.

Disclaimer: I was institutionalized at the Bank for closer to 6 years than 7, but the headline was cleaner with the stretch.  I am an expert in financial markets, but still have tons to learn and if you contest any point please share your thoughts in the comments.

Commodities and Loonies: CAD strong because of ZIRP

Listening to @randycass on BNN and he makes the case that CAD is overvalued since it’s fundamentally a commodity-driven currency. As GDP in Asia and Europe languish the CAD should weaken alongside a basket of hard and soft raw goods.

The fundamental case is sound, CAD correlates positively with various commodities.   This argument alone ignores broader characteristics of the currency; its stale, incomplete and unsatisfying like the online dating profile of an overweight cougar. (Thanks to @David_Stendahl  for this excellent collection of CAD correlation charts).

Investing in sovereign credits are, especially in Canadian government bonds at 10yr hits All-Time-Low Yields, all about the manipulation of interest rates by central banks and the distortion of prices of all debt instruments.

Since the pool of capital (money supply) is increasing globally and being distributed from CBs to Global Mega Banks, it needs to be ‘stored’. As such cash seeks the comfort of Canadian government bonds: AAA, liquid, relatively high-yielding and secure credit instruments that can be reliably bought and sold in large quantities.

This has keep the CAD strong during the on-going, cyclical weakness in Asian commodity-demand. I expect this effect to be transient as China is widely believed to be planning another large stimulus packages. (Lets put this $3 Trillion to work, eh?) If this is announced before the presidential election I believe the market will rally strongly until the outcome of BARRY vs. MITT is known.

Sports Stadia: Seattle Going Down the Rat Hole

Even during wholly prosperous times publicly subsidized sports stadia are a bad idea.  The literature is clear on this as I have shown previously.  Despite the body of work demonstrating that building sports stadia does little-to-nil for the local economy, every few months another politician in North America trots out drivel in favour of robbing their constituencies purse to erect a monument in honour of their ignorance.

When you integrate financial realities of these projects with the current macroeconomic environment of high debt levels (individuals & public/municipalities) and poor household disposable income growth, its obvious that private businesses should finance these infrastructure projects, not taxpayers.

Seattle: Politicians Seeking Fame & Notoriety. 

Private investor Chris Hansen and his yet-to-be-revealed partners have proposed building and operating a pro basketball and hockey arena in Seattle’s SoDo area.

Minor flaw in their plan: they don’t have the money to fund these ambitions.  Rather they are attempting to coerce the public into subsidizing their arena-building endeavour “in the form of municipal bonds totaling hundreds of millions in public debt backed by local governments.”

Analysts from UBS visited the discussion with a lengthy piece on the merits of investing in the bonds that are created to finance sports stadia construction.  Generally, they conclude in an almost conciliatory statement what readers of this blog have long known:

“Unfortunately, independent academic research studies consistently conclude that new stadiums and arenas have no measurable effect on the level of real income or employment in the metropolitan areas in which they are located”

“There is no broad economic benefit from most sports stadia, rather public financing props up the ever-inflating value of privately-owned sports teams”

They go on to discuss the ‘Cycle of Construction’ of sports stadia and describe how politicians are increasingly captured by the sexy appeal of being a ribbon cutter.  Despite most sports stadia being privately owned prior to WWII:

“Many of the stadiums built after the Second World War were abandoned in favor of more modern facilities. By the end of 2012, 125 of the 140 teams in the five largest professional leagues (NFL,MLB, NBA, NHL, and MLS) will play in stadiums constructed or significantly refurbished since 1990.”

The majority of these projects are financed with public funds.  To ensure the public play along in this income-redistribution scheme, the cities pump out feasibility studies propagating mythical economic realities.  The flaw in these studies is explained perfectly:

Feasibility studies for professional sports facilities often fail to account for the substitution effect. Individuals generally maintain a consistent level of entertainment spending so money spent on sporting events typically comes at the expense of cash spent in restaurants, on travel, and at movie theaters.

The substitution effect is particularly meaningful during a deleveraging period in which average consumers have limited disposable income.  The piece-of-the-pie allocated to traditional entertainment is very low for most families in 2012.

That means that after taxes, debt repayment, food and other mandatory costs-of-living these 40-50x yearly events (41 reg seasons game for NBA/NHL teams) far too often run under capacity.  This is why leagues are embroiled in revenue sharing agreements that suck profits out of the successful teams to subsidize the fiscal laggards.

As the majority of revenue for the NHL/NBA is gate-driven its paramount to understand how butts in the seats equal profits.  In other words, household disposable income growth + winning = financial prosperity.

[Aside: In contrast to the NFL who can support its bottom quartile teams with their share of the enormous TV-related revenue.  As some have speculated, you could host NFL games (8-10x annual events) in a 3000-seat TV studio-turned-arena and they would still be the most profitable sports league in North America.]

Cost Centres Breed Taxation

The debts created to build these stadia are repaid primarily by created new taxes.  For example, hotel & rental car surtaxes are implemented on all visitors, and boosted general sales taxes increasingly cast an accretive net over the money spent by non-sports-fan consumers in town for business or leisure.  This additive disincentive is hardly a means to improve commerce in a given municipality over the long run, a fact which is either misunderstood or ignored by the folks who approve these stadia deals.

When the public demands more due diligence, like they have in Markham, the council slams the door on transparency in the name of expedition.  Rather than allow all the members of council to become involved in the process, they have voted for a smaller, more nimble special committee to go ahead and call the shots:

Deputy Mayor Jack Heath expressed anxiety about the “urgent” nature of the project and the tight timeframe required to have the facility finished by fall 2014.
“We need to get going on this,” Mr. Heath said.

The lack of incentives for civic leaders to spend wisely has never been more apparent.  Sports fans and citizens alike should not allow these actors to allocate their tax dollar on toys, when the funds are spent much more productively on roads, bridges and public transit.

I guess everyone is comfortable paying higher property taxes so long as owners and athletes come to town and pocket the difference?  Probably not, but prudence and logic will not stop these impregnable project from being undertaken at the peril of the community.

Two Ways to View Canadian Housing: Bubble & Bubbler

Canadas’ smartest number-crunchers have long known that residential housing prices are inflated.  From June 2011:

“Canada is losing its penchant for wealth accumulation…In late 2006 Canada’s debt-to-income ratio and debt-to-assets ratios stood at 121.3% and 16.2% respectively. These ratios have gradually risen to 153% and 20%.  In more absolute terms, total household debt has risen from $1 trillion in 2006 to $1.51 trillion by 2011.” (3,5)

The Anecdote Cuts Deep

Garth Turner (1) laments the greater fool who waits in a frigid parking lot overnight to sign purchase agreements for maddeningly overpriced, unformed slabs of land and arranged bricks for over $700,000CAD (roughly 10-15x after-tax household income for this area.(2))

“…on lots as skinny as 32ft, in a distant suburb of Toronto.  The event  was remarkable for the thronging, the pushing, the instant buying and the palpable desperation. “It was like everybody was crazy anxious when they got in,” one player told me. “Little women were bodychecking me to get a red dot stuck on a map square. Unbelievable.””

Ravenous buyers are readily exchanging real dollars (mostly borrowed against future earnings) for homes that are merely blueprints.  The attitude of the mob has shifted into a dubious phase in Canada: euphoria.  At their own peril potential home owners are signing away years of their life on a whim, lifted by a cresting wave of loose credit in Canada.

Mr. Turner evokes an apt analogy to Canadian horror stories Nortel & Bre-X:

“The crowd comes to a collective decision, and then free will is lost. Almost always, the crowd gets it wrong.”

Of course the prose of journalists may be persuasive, so we look to data courtesy of a Bank of Canada 2012 Special Report (3) and others.

The Pictures are Loud

Levels of household debt in Canada have trended upwards for 30 years.  Most troubling is the vulnerability of First Time buyers who are loaded up with debt.  The mean real debt load of a typical household led by people aged 31-35 is $120,000 up from $75,000 in 1999 (60% increase).  The characteristics of their borrowing is frightening: slim equity margins (5-10% down payments) and tight servicing/coverage ratios (40% pre-tax income allocated to paying housing costs).  Nothing sums up this jargon quiet like:

Plight of the First Time Buyer in Canada

Numerically most of the credit bubble in Canada is due to mortgages used for residential housing, but a large component is ‘cash-flow lending’ where lifestyle is being supported with easy access to cheap credit.  In Canada this credit is most commonly is delivered with potentially toxic consequences via access to Home Equity Lines of Credit (HELOC).  These ‘gateway loans’ are like marijuana: smart and safe when used responsibly, but ruinous if abused by the wrong individuals.

While borrowers claim to be modernizing their homes through renovations, the data untangles the yarn they have spun to lenders.  The BoC estimates about ~4.25% of total consumption is attributable to home equity extraction.  HELOCs are being used for many purposes (shown above), with the smallest quotient being dedicated to renovations and non-financial investment.  Clearly the borrowers are calling an audible at the line of scrimmage: instead of converting home equity into productive assets, consumption and debt consolidation takes the lions share of the past 10-years worth of home equity extraction in Canada.

A Pound of Flesh

What lurks around the corner during any subtle correction in the Canadian economy is pain and financial stress for many households that are over-leveraged, cash-poor and “house-rich”.  Living off home equity is yesteryears’ dream and todays’ nightmare.

Based on 2009+2010 averages, consumption accounts for about 58% of overall Canadian GDP(4).  BoC then calculates that a housing shock could reduce aggregate consumption between 1.3–3.1%, which loosely translates into a GDP drop of 1% for every 10% drop in housing prices.

My advice is to stay nimble and unencumbered by debt for anyone with budget concerns.  There is a small subset of Canadians who can justify purchasing a home in this environment:

• cash flow strong (1 standard deviation above median household income)
• expanding their family
• plan on staying in the same domicile for at least 10 years.

To those unqualified to join this exclusive group, check out the price for rentals.  Sooner than one might think newly-built condo units will be had for a song in a neighbourhood near you.

Follow me on Twitter: @Royal_Arse

References: 

1.  Garth Turner – “Crazy Anxious” http://www.greaterfool.ca/2012/02/22/crazy-anxious/

2.  Statistics Canada – “Average income after tax by economic family types (2005 to 2009)”   http://www40.statcan.gc.ca/l01/cst01/famil21a-eng.htm

3.  Bank of Canada 2012 Special Issue: “Household Finances and Financial Stability” –  www.bankofcanada.ca/2012/02/publications/periodicals/boc-review-winter-2011-2012/

4.  Trading Economics – “Household final consumption expenditure; etc. (% of GDP) in Canada” http://www.tradingeconomics.com/canada/household-final-consumption-expenditure-etc-percent-of-gdp-wb-data.html

5.  CGA (Certified General Accountants) – “A Driving Force No More: Have Canadian Consumers Reached Their Limits?” http://www.cga-canada.org/en-ca/ResearchAndAdvocacy/AreasofInterest/DebtandConsumption/Pages/ca_debt_default.aspx

FED Loan Officer Survey Analysis: US Strong, Europe Weak

With a focus on the US firms and a glance at those abroad the following report confirms what the concensus on the macroeconomic outlook is for the developed world: Europe in a recession, although not severe, and the US economy is growing, albeit slowly.  Full report on “Senior Loan Officer Opinion Survey on Bank Lending Practices” click here for PDF.

U.S. Businesses:

Breadth in lending is good!

“The net fraction of banks reporting increased demand from small firms rose to its highest level since 2005.”

Easy Money and Demand for C&I loans are both bullish for US economy.

This isn’t an absolute measure of economic activity, but its important to have broad participation in a bull market.  However, this demand increase for small businesses coincided with US Domestic banks “reported having eased terms on Commercial and Industrial (C&I) loans,” which dampens the enthusiasm one might have summoned at the outset.

The reason to focus on C&I loans is shown graphically here: 

Loan growth to businesses closely matches employment growth.  There is little to add to this relationship — modern capitalism in the developed world is reliant on credit expansion.

US Banks reported unanimously:

“increased competition from other banks and non-bank lenders” as a reason for having loosened their terms.”

Keeping up with the Joneses means slender profits for the banks, but a net benefit to the overall economy given surplus access-to-credit for those with impetus to borrow and expand their business.

U.S. Households

Housing Bust and Recovery as told by Loan Officers reporting the demand for mortgages.

Most banks reported lending standards for, and demand from, borrowers for residential real estate loans to purchase homes were little changed.  Any further chatter of the nascent US housing recovery will be extinguished should this metric fail to expand.

Household lending standards eased (HELOC and Auto) which had little impact on demand for these loans, as they reportedly weakened overall.

Foreign banks 

“Foreign respondents reported having tightened both standards and terms.“

These foreign firms (who typically deal with businesses) tightened their standards on C&I loans for the Second consecutive quarter.  More costly credit for businesses in an austere climate isn’t positive for the growth of Europe and Asia.

The accelerated tightening for those with Euro-exposure was aptly summed thus:

“more widespread tightening of standards on loans to non-financial firms with operations in the US and significant exposures to European economies.”

Lenders duck and cover to avoid getting hammered with EU exposure will surprise no one.  That there was an acceleration of this behaviour in light of ECB loosening is mildly surprising and decidedly negative.

However, the demand side didn’t respond with any vigour:  C&I and Commercial Real Estate loan demand was flat abroad.  Avoiding an outright contraction here is vital.  The ECB has made great effort to ensure the tide doesn’t roll out too far….

2012 Outlook

US Domestic banks expect 15-60% expect improvements in personal delinquencies and charge-off rates.  More people paying their debts is sound basis for a bullish macro thesis in the US and some optimistic experts see this as the beginning of a new secular trend.  Lenders display a positive tone on their expectations for repayment from Businesses in the US, meanwhile abroad Foreign lenders are the opposite.

What goes unreported is the relative weakness of the sovereign entities which these Foreign firms are domiciled.  Individual countries within Europe are struggling mightily and knock-on impacts to businesses are being observed in reports like these and markets daily.

Government intervention that was previously heralded in the private sector for resorting calm and order is now the anchor encumbering European economic growth.  Government leaders are at the mercy of Technocrats and Asian/American creditors.  All the parties are searching for answers seemingly adrift in the ocean of noise from the media, their aides/advisers, and the electorate.  These data are signals from the trenches that life goes on, businesses expand and contract and commerce proceeds unabated by our pessimism and fear.

Hot Money & Glacial Migration: US GDP to Melt Your Face Off…Slowly

Regardless of their style smart investors take great care in knowing how the Worlds’ largest economies are functioning at a given time.  Whether you accept the Euro crisis as being wholly unresolved or not, the upcoming volatility will erode economic strength as if leaves were dropping off malignant trees throughout Europe.  The blight of debris covering the underlying soil will smother the growing buds with the haste and devastation of a German Autumn-turned-Winter.

However, drawing from recent history I expect the reverberations to be dampened in the near-term (H12012) as bailout cash is bazooked, firehosed and helicoptered onto Greece via the ECB, which should allow the USA to grow modestly in the interim.  For more on a troubled Europe see this recent analysis from Robert Sinn, the remainder of this post will focus on potential for growth in the US in spite of headline risk elsewhere.

Jelly Bean Jar Contest: Guess the Sum

2011 IMF estimates for Global GDP (nominal, $USD) show the Eurozone controls ~1/4 of the global economic activity ($17 Trillion annually; 25.65% of Global), with the USA close behind producing over 1/5  ($15 Trillion ann., 21.5% share)

Much like Wall Street forecasters, I expect H1 2012 to be slightly positive for the US economy (1.5-2% growth) and there are numerous reasons for this:

• Election Year + Normal positive seasonality
• Tepid Inflation
• Healthy trends in employment and industrial production (expanding PMIs)
• Rotation into growthy sectors, commodity strength on back of soft-landed China?

Additionally, we are 5-to-6 years deep into the US housing crisis and finally seeing some ‘Green Shoots’:  Construction spending is no longer declining and initial unemployment claims continues to leak lower.  Most experts are in agreement that there is no longer significant downside risks to residential housing.

 

This screen shows many in the General Building Materials category are performing respectably in H22011, a trend that should accelerate in H12012 assuming slow, but positive growth manifests itself in the US economy.

We also have indications of growth coming in the form of increased basic materials prices, which traditionally occurs concurrently with positive returns for stocks: http://chart.ly/p4ukkkh

The increase in commodity prices may be attributable to sector rotation as asset managers bail on their high-yielding dividend stocks for more growth-oriented fare.  Whatever the explanation risk appetite is being priced into the market.

The risks are clear: any slip up in Europe causing significant distress to the financial system and subsequently confidence render the above data null.  However, many smart macroeconomic analysts are constructive, if not outright bullish, on the US economy near term and the bearishness coming out of Europe shouldn’t fully dissuade risk-taking activities across the pond.

Related/Sources: 

Robert Sinn: “Sage Weekly Letter” — http://www.robertsinn.com/2012/01/08/sage-weekly-letter-9/

US Total Construction Spending Chart by YCharts

Bloomberg EconBrief — http://chart.ly/users/EconBrief

Wikipedia – IMF Global GDP forecasts http://en.wikipedia.org/wiki/List_of_countries_by_GDP_(nominal)

 

 

Forget Operation Twist, We Need Operation Debt Jubilee

In a recent blog post  @bondtrader83 makes the following commentary on  Operation Twist (emphasis added):

Of the 400bil in purchases [by the Fed], 29% is in the 20-30yr range, much higher than expected.  The 30yr, as expected, rallied hard on the news and as of ~3pm was trading around 3.04% up over three points. As far as MBS goes, the Fed will begin re-investing MBS runoff into new current coupon MBS – presumably they will focus on 30yr current coupons.

It prompted me to post the following in the comments:

Ratio skewed to the long end is a big let down, it stifles the recapitalization effort and hurts traditional banking operations by flattening the curve, no? @FrankSIII views flattening at the long end of the curve as ineffective in stimulating the meager demand for a refi, as most of the eligible borrows have already taken advantage of ZIRP. A marginal reduction in mortgage interest costs won’t provide any tangible benefits to the real economy this go around.

There is no inflation because of the dearth of income growth in Developed Markets. There will continue to be deflation so long as debt servicing plunders the lions share of total income: whether household or government.  Given that markets panicked in full deflation mode at various points this week, we know that QE is BS and its not going to cure the lack of confidence in markets, or the economy in general.

Easier money vis a vis lower rates doesn’t stand a chance at reversing this vital lifeblood of modern capitalism: confidence.  Growth in AMPLE quantities is the only cure for the insolvent Euro banks and as @M_McDonough astutely points out the European PMIs (growth metrics) look like dog shit:

So its jubilee or bust.  We must look at reasonable ways to exercise a GLOBAL debt jubilee. That is the how the Jigsaw Will Fall Into Place.

Bearish on the US Economy Yet? FED Beige Book and One Great Chart

As far as economic forecasts are concerned the Beige Book from the US Federal Reserve offers some pretty telling info (remember the US economy is not the Global markets).
US Economic Executive Summary:

Job growth is weak, income is flat and credit demand is weak; as such residential real estate still in decline. Meanwhile, Consumer spending modestly improved, prices have been decreased (vs. previous Month) for certain goods, cheifly gas/oil. In sum, today’s Beige Book report “implied little abatement of the still sizeable unused capacity in the economy. Thus, the report implicitly continues to argue for maintaining the current highly stimulative monetary conditions.”  Low rates for a long time.

Doesn’t strike you as a particularly bullish report?  Allow @gtotoy to provide some perspective here: http://chart.ly/v7wvk5m

Contrasting the two leaves me thinking this Summer 2011 lull in the markets is indeed the ‘mid-cycle slowdown’ pundits have mentioned ad nauseum.  For more long term perspective, how about a 20-year chart of $SPX from @Xiphos_Trading : http://chart.ly/geuksff 

With all of the stimulus and accomodative government action (ie the EU teeing-up a Can for the Kicking; ZIRP) how could we not re-test $SPY 1500.  If we don’t see it on 2011, we’ll get there for Spring 2012 during the pre-election frenzy.  Obama needs something to get his ass reelected.  

…

For more Beige Book, here is a point-form Summary:

– U.S. Beige Book indicates greater moderation in growth
– Today’s Beige Book report indicated a weaker economic environment relative to June policy meeting. Specifically, the pace (of growth) moderated in 8 districts. In June, a moderation in growth was reported for 4 districts.
· Manufacturing activity continued to expand overall (steady to slowing growth). Some districts reported fewer supply problems to auto production that originated from the natural disasters in Japan.
· US Residential real estate activity was little changed remaining at still very weak levels. Non-residential real estate activity improved in six districts (Commerical real estate doing better as businesses are healthy overall).
· Disappointingly, loan demand was mixed: loan volumes decreasing in St. Louis and Kansas City partially offset strengthening demand in New York, Richmond, and Chicago.
· Agriculture was hit by both drought conditions in four districts and flooding in two districts.
· modest consumer spending growth in a majority of districts thanks to falling gas prices. Most of the improvement was in non-auto retail sales
· The energy sector remained strong with the Beige Book highlighting shale exploration in the Atlanta and Cleveland Districts.
· although most districts saw modest hiring increases, labour market is soft. With high unemployment persisting, it was reported that wage pressure remained subdued in most occupations (aka income is flat; want to see this rising!)
· Overall price pressures were reported to have moderated somewhat consistent with a slightly weaker assessment of the economic growth (less growth, less demand, better prices, more demand, more growth, higher prices, less demand/growth, rinse recycle repeat)

SOURCE: RBC ECONOMICS RESEARCH – DAILY ECONOMIC UPDATE – July 27, 2011