Double Blind

I have just put a trade on a futures contract that will be on the fed funds futures rate in November 2010 and December 2010. If the average fed funds rate in November 2010 is lower than 1.25%, I will lose money. If it is greater than 1.25% then I will gain money. The rate is $4167 per percentage point.

Likewise, I have done the same thing for December 2010; except the interest rate I am betting on is 1.26%.

I am making a few assumptions in the hopes that this trade will be profitable.

First assumption is that the economy will make a visible recovery by the end of 2009. This will put upward pressure on inflation and interest rates will have to rise to compensate. The feds will raise interest rates by a quarter point in every fed meeting and will not stop until inflation has been stopped.

Second assumption is that (nominal) interest rates cannot go below zero percent (otherwise the federal reserve would be paying people to borrow money from them). This caps my loss at $10,459 in the event that interest rates do go to zero and stay there. Interest rates for March 2009 was 0.185%.

My guess is that interest rates by the end of 2010 will be somewhere around 3-4%.

This is also my personal hedge against inflation. I did some math and calculated that doing this was going to be better than purchasing gold, with far less risk.

This post pretty much says it all, but I’ll cut and paste the relevant graphic here. (Click for the bigger version).

The other issue with chart reading is you have no idea how high the ramp will go (or even if it drops again), and you don’t know where the bike is going to “land”. The only way you get that information is once the event is over, but you can’t make a profit by reading historical charts. The only reason why this information is at all relevant is because others believe in it, which can influence trading decisions.

Dividend capture is the process of purchasing a security to receive its dividend and selling it shortly after. The theory is that you will be able to realize a net amount of income higher than had you not entered into the transaction.

For example, if a stock is trading at $10 a share, and it gives out a 50 cent dividend on March 31st, if you purchase the shares on March 30th for $10, and sell it on March 31 for $10, you can pocket the 50 cent dividend for “free”. This was one of the financial scams that Wade Cook talked about – he really was quite good at coming up with schemes that sound good but didn’t work in reality.

What happened in the above example is that the market does the job of effectively subtracting the amount of the dividend of the trading price of the stock. So on March 30 if the stock closed at $10, the stock would typically open at $9.50 the next day. So you would be left with $9.50 in stock, and $0.50 in dividends. The other factors are paying trading commissions, and actual trading execution. If anybody seriously tried this strategy it will not work – you would lose money.

Finally, another difference is tax implications – you would receive a capital loss of $0.50 and dividend income of $0.50. In Canada, you can only offset capital losses with capital gains – so if you have no capital gains you are out of luck. Dividend income is taxed better than ordinary income if the dividends were from Canadian sources, but for foreign sources, dividends are treated like ordinary income.

However, if you own a dividend-bearing security and want to convert income to capital gains (a favorable tax transaction), the opposite may be true – selling the security before it goes ex-dividend and buying it back after it trades at a lower price.

For example, if you held securities that would give a $1,000 dividend (assume this is income), it may be worth it to sell the securities and buy them the next day after the security has gone ex-dividend. This way, instead of paying taxes on $1,000 income, you would pay taxes on a $1000 capital gain (effectively like $500 income). At a 30% rate this would save $150 income – so assuming one can structure the transaction for a cost less than this it would be a net positive. This works assuming the securities you have bought are roughly at the cost basis of what the market is currently at.

Of course, the Canada Revenue Agency tends to think of these sorts of things, and they have a rule called the General Anti-Avoidance Rule (GAAR) which more or less states that if you make a transaction strictly for the purpose of avoiding taxes, that the tax benefit from the transaction be disallowed. You can read their IC88-2 information circular for more details and realize that a lot of this material is still left to be challenged in court.

You could make the claim that you were avoiding market risk for two days or that you were trying to take advantage of anticipated sellers of the security after the security goes ex-dividend or something, but then again, you probably wouldn’t want to spend $50,000 in legal fees trying to prove that to the tax court of Canada.

On the Drudge Report, he linked to an article that said there may be progress with cold fusion. In classic sensationalist form it was titled “Scientists in possible cold fusion breakthrough…”.

I will not comment on the viability of cold fusion (OK, just one word: unlikely), but the true barometer whether the public think that fusion research has any credibility will be seen in the price of oil. Essentially if energy-positive fusion (i.e. it takes less energy to make a fusion reaction that will produce more energy than what went into the process in the first place) is viable and scalable (up to the gigawatt level), the price of oil would crash to 5 dollars a barrel in less than a month.

An implicit risk in investing in oil companies is that somebody or some group out there might actually invent some insanely efficient way of generating energy and in sufficient scale to make a difference – like with fusion.

On paper, if fusion was viable, you could probably power North America with a couple power plants located next to the ocean. For reliability, availability and maintainability reasons there would be multiple plants scattered across the coast, but energy would be so cheap that it would create a whole host of inventions to take advantage of it – and likely render the internal combustion engine as much as an antique as somebody pulling out their vinyl records or 8-track player today.

Robert Rapier (his pen name) is an excellent analyst, and he also works in the industry. Here is his take on the next five years of oil prices. This more or less mirrors what my opinions on the oil markets will be.

The only way you can hedge yourself against this is by purchasing equity stakes in oil companies. When they profit from higher oil prices (assuming they don’t get punitively taxed in the process) you will profit as well and be able to retain your purchasing power of gasoline.

Nothing can compete with gasoline in the liquid fuel space, strictly in terms of sheer energy density.

2009 has been a record year for the flu. Once in January, and twice in March – the last training I had was exactly one week ago and it went relatively well after reaching over the ‘energy wall’. Unfortunately one day after that, I must have got caught something and it resulted in major headaches and sweatiness (but no fever, oddly enough – my temperature was a smooth 37 degrees). As a result, I generally couldn’t function properly during half the day although a few times a day a good “window of opportunity” without headaches came, and I was mentally productive then. But I mostly stayed in bed and tried to fight it off that way.

The miracle solution I found out was taking a couple Tylenol or Advil (whichever was handy at the time) and it would provide some relief in an hour, but it had the side effect of making me even more sweaty, even when I wasn’t physically doing anything. It was like my body had a problem with its temperature regulation or something.

Either way, today I finally snapped out of it and went running on the treadmill for the first time in a week.

It wasn’t pretty – I initially did a 15 minute warmup (after taking a suggestion of a previous commenter here) and then ramped up to a 5-minute run and 1-minute walk routine. I got through about 3 cycles of this before my body just gave up and I decided to walk a bit and then resume the run. I did a cumulative amount of 30 minutes of running, but it was interspersed with walking breaks. I just felt like I was completely out of gas, but I’m guessing this is because I didn’t get a good night’s sleep yesterday and my general lack of training for the past week.

I’m generally getting concerned that these sickness-related interruptions to my training schedule is going to seriously compromise my ability to beat my last year’s time. I don’t have a lot more time to train (four weeks until race day), so if I get sick once again I’m probably toast on my attempt to beat my time.

I am 13% up month-to-date, which has outperformed the S&P 500 in the same time period (7.6%). However, I feel that I am not capitalizing enough on this recent surge up in the marketplace. Note the word “feel” is usually very inconsistent with rational thinking when it comes to the market. My strategy is working when I look at it rationally, but it doesn’t feel like it is working.

My portfolio at the moment is structured in significantly lower risk investments than equity (consisting mainly of asset-backed trusts, of which the assets are long-term corporate debt) and as a result, my performance had I bought the equity of these firms vs. the debt is lower than it should be.

However, when one looks at the risk-adjusted returns, I am reasonably sure if I don’t do something stupid and start selling off securities that I would be looking at a good year financially – both in terms of income from investments and unrealized capital gains, and all of this with little equity risk. It is relatively “easy” when the cost base on most of these investments implies a current yield on capital of around 20%, but this is what a financial crisis is good for. If necessary, if the market disappeared for these securities, and I was not able to liquidate them, I would easily willing to hold them until 2028/2033, as the case may be simply because I have exchanged a dollar today for 20 cents each and every year in the future, plus a 3 dollar payout at the end of 19/24 years.

I still have a lingering feeling that I should be able to do better in the future, but getting “greedy” and taking stupider risks (i.e. moving heavily into equities) may not be the smartest of moves, as my fundamental baseline projection was that the markets would see-saw for the year and net returns would be roughly zero as dilution and higher credit costs get factored into the bottom line earnings per share for companies. There will be a lot of whipsaw of prices as the sentiment shifts from euphoric (as it is currently) to something more sedate (when banks announce another wave of financing required to stabilize their balance sheets).

Investing is very difficult because past information on trading prices is mostly irrelevant.

It is very easy to say “I wish I had put my life savings in Bank of America at $2.54 per share, and sold it today at $7.80 and tripled my money like hitting blackjack twice in a casino”, simply because such an execution would have been impossible. There is no way of knowing whether $2.54 is the bottom, or whether the stock will go all the way down to $1/share before bouncing up (assuming it even bounces). I have looked at some of my entries into the fixed income security markets and could have received prices 10 or 20% lower (and in one not-so-greatly timed case 40%), but it is impossible to know how low a panicked investor will take a security. An excellent and real-life example is the following:

This is a chart of one of ING Groep’s (the large Dutch bank) hybrid security – above common stock in seniority but lower than bonds. Essentially it can be treated as a bank preferred share, but it is bond-like in that it gives out interest. The risk to investors is that ING Groep can defer interest payments for up to five years. ISG gives out about 38 cents each quarter, or about $1.51 a year (coupon rate is 6.125% for those that care), and its “par value” is $25/share. I did my due diligence on ING and saw how they got caught up in the financial crisis, and also saw how they got themselves bailed out of it by the Dutch government in a rather well-structured deal. The important part is that the Dutch stake was senior to common shareholders, but junior to the hybrid securities, so a common share dividend suspension will not necessarily hurt the hybrid security owners.

I came to the conclusion, after doing a massive amount of research, that ING would continue to pay off. This was the beginning of February. So I told myself “OK, I think something else will hit the fan, but I will start acquiring units if ISG trades from 6.50 to 4.50, since there is no way that this thing can trade greater than an implied yield of 33% a year.”. Low and behold, a week later, the stock crashes, and I get a fill in for my full position, averaged at around 5.50 per share. That’s about 27% a year assuming they continue to pay off (plus a huge capital gain later when the markets stabilize).

Of course the market had other ideas – they took ISG all the way down to $2.84 a share before the last dumpers to the market abated. At that price, you could have covered your capital costs in two years, and currently be sitting on capital that is worth roughly 3 times what you paid for.

Why didn’t I just set a huge order at $3/share? Because I had no idea that it would go that low, and because I have a strong rule of not concentrating too heavily on very speculative issues – certainly the market was signaling a very strong predicted chance that ING may decide to conserve capital by just not paying off their hybrid security owners. I didn’t think it was as likely as the market, which made it a proper bet. But my bet was poorly timed – if I had set my parameters to $5.50/unit to $3.50/unit, I could be sitting on double my money right now instead of a 50% gain.

Finally in a day like today, ING equity is up 24% while the hybrid security is up 8.5%. 8.5% is still not bad, but it makes you feel like you’re missing out on something (when rationally this is the less riskier decision made – less capital appreciation for a higher chance of being able to get those income payments).

This is why I ask in the title of this post, “How much is too much?” Even right now the securities current yield is about 18.4%, and this is a very high number, and the market still thinks there’s a considerable chance that ING will pull the plug on the interest payments. I still don’t think so, and I think the market is wrong, but it’s a risk that I find acceptable to take since I don’t have 100% of my portfolio in this thing.

This is what frustrates a lot of people in that looking at stock charts and previous quotes brings up a very human emotion of “I could have done that”, when in reality there is no way you can lock gains in by trading from past charts.

Scam artist booksellers (best example is Wade Cook) try to write books that, at its core, advocate trading using past information.

Most mutual fund advertising is the same. This should be point number five on Raven’s list why mutual funds are horrible investment vehicles.

There are a few macro-scale events that are going on at this moment which have financial implication.

One is that the US is taking a very active effort to unclogging the debt that has built up in its banking institutions – the latest plan (of which we know the surface details, but not the detailed details) is to find a price mechanism for the toxic securities, and some sort of risk-sharing arrangement.

I think there will be some sense by the market over the next six months that the “worst is over” (it is not conceivable that we will see another big bankruptcy like we did with Lehman brothers) but it is difficult to predict whether this will be a bear market rally and there will be another wave of “all hell breaks loose” in the US financial system.

Another metric to look for is the price of energy – spot oil prices now are 54 dollars a barrel and climbing. The Suncor-Petro Canada merger is a sign of the times – Suncor is trying to mitigate its oil sands projects with a stable producing industry (compared to its own oil sands which really are only massively profitable above 70 dollars a barrel), while Petro Canada is looking for more upside with Suncor. I think this is an excellent merger for both companies.

One consistent theme is the following – “cash is trash” – with short term interest rates so low, money is being given for free for investment purposes. Three weeks ago was really the time to lever up, but there’s probably quite a bit of upside left to go.

Has this administration done anything good since it has taken over on January 20, 2009? I know two months is only 5% of the 48 month term of a president, and he’s probably getting used to the position (i.e. governing is a lot harder than election campaigning), but I’m trying to think of anything that he’s done that could be considered beneficial. Going to Canada, visiting Harper and picking up beaver tails in Ottawa?

The guy that writes Dilbert, Scott Adams, is a very smart fellow. His weblog reads like Anthony‘s, which makes me wonder how good Anthony would be at writing comic strips.

If someone is explaining a subject to you by listing lots of facts and examples, without explaining any of the twelve concepts, you probably aren’t learning anything useful.

In physics this is trying to communicate a formula with physical examples – like going to a bowling alley to explain momentum and Newton’s laws, when you can just say momentum is conserved and force is equal to mass times acceleration. Two “twelve concepts” of physics is right there, at least at speeds well below the speed of light. :)