Double Blind

A very brief analysis of the Iranian election situation – Ahmadinejad won 62/36 in the run-off election in 2005; 2009′s results are allegedly 63/34/2/1 in a 4-way contest.

This is not entirely outside the margin of expectations – the possibility of a “silent majority” effect may strongly be in play. Without knowing anything about Iranian election procedures or the intricacies of the various provinces, the 2009 results as-is are plausible. The power of incumbency is never to be underestimated in politics.

One thing I do know, however, is that when looking at polling data as such, you might as well throw them out the window.

I am very glad in Canada that we have a very distributed vote counting system, and this distribution enables a much less corruptible voting process. I am very much against the usage of voting machines in elections, unless if there is an auditable paper trail involved, and that voting be conducted in many different polling locations. I would absolutely never support general election voting over the internet, or where votes are concatenated and counted in one physical location.

One of my more boring investments is in corporate debt of RR Donnelley and Sons (RRD) – they are a provider ($11 billion in revenues over the past year) of miscellaneous business services. Although their sector will get hit due to the economic downturn, the company will survive. I do not know how their equity will do, but their debt should fare well. My investment was during the great corporate debt liquidation sale in March 2009.

Recently, the Canadian company, Quebecor World (operating in a similar sector as RRD), went belly up, and filed for Chapter 11 bankruptcy (and the equivalent process in Canada). RRD’s management decided they saw an opportunity and put in a bid (on June 2nd, and a subsequent higher one on June 8th) for Quebecor World’s assets, around $800M cash and 15% of RRD.

Quebecor World rejected the increased offer. RRD then said “Thanks, but that’s it for us”, and moved on.

It is likely that the creditors wanted to take over the company themselves as they saw more potential value in owning it themselves vs. letting a competitor take it over.

It is a good sign of management that they are able to take opportunistic bids in situations like these, but also be able to pull the plug when they realize that they may be paying too much for the assets in question.

I’ll continue collecting my coupon payments on my bonds.

For some strange reason, ING Direct is offering a 1-year GIC, if held in an RRSP only, with an interest rate of 3%.

3% is a significantly better-than-market interest rate (which would be around 2% or so – anything else is a promotional rate).

I don’t know why they don’t offer it for other accounts (e.g. TFSA) as it would be a good vehicle to store risk-free cash at this time, but if you’ve got some RSP money with ING (that you wouldn’t otherwise earmark for anything more risky), might as well put it in the 3% GIC instead. Their short-term rate on cash is currently 1.35%.

I do not project future 1-year GICs being offered at anything higher than 3% for the next year.

There are two basic games of game theory that everybody should get to know very well: The Prisoner’s Dilemma, and the Ultimatum Game. Both of these are very important politically.

In the case of trade with the US, 85 to 90% of Canada’s exports are destined to America. Very recently, US legislation has mandated that stimulus funds be spent on “domestic” purchases only; implying that if Canadian or foreign entities were to tender for the various contracts that would go for various products and services, they would be denied strictly on the basis of being foreign to the USA.

The municipal agencies in Canada voted on a resolution to threaten that if something is not done about this in 120 days that there would be action taken on our end.

This is the start of a potential trade war looming, mainly because the US has defected on their contract in the prisoner’s dilemma (by going protectionist) – when the US and Canada co-operate (essentially freer trade), both sides get more of a collective advantage than if they both decided to not co-operate (put tariffs and restrict foreign competition). One side benefits extremely at the expense of the other if they have a closed trade system, but the other country has a free trade system.

Using the Prisoner’s dilemma analogy, the USA is now snitching on the police, while Canada is keeping their mouth shut. This current arrangement works minimally to our benefit – we stand to profit if the US either stops snitching (a strongly positive outcome), or we start snitching ourselves (a relative-to-current-position outcome, but negative relative to the other outcome).

There is no easy way out of this unless if the top executives (mainly the Prime Minister and the President) mandate from above that this is to stop. If not, then both countries are going to be in quite a bit of trouble in the future, and this does not bode well for the Canadian economy, given our exposure to US trade. They will suffer, but not nearly as much as us if global trade goes into the tank.

The last great depression was also extended beyond what it could have been if global trade was not seriously disrupted in the process. It appears that history just might be repeating itself.

Economic statistics coming out of the USA highly suggest that the recession is turning into a depression – unemployment rates are up to 9.4% and do not show signs of abating:

Although unemployment is a lagging indicator (i.e. it is an indicator of a consequence of an economic slowdown), the only thing out there that would suggest a pick-up in the economy is commodity and equity market pricing. This in itself may be incorrect.

In addition, a couple economists collected some statistics comparing the 1929 great depression to the present economic situation – what is interesting is that while the underlying economic variables move at their “slow” pace, the stock market appears to be the only thing that is moving much more quickly compared to 80 years ago. This would make sense, considering the speed of how information travels a lot faster now than it did back then.

Canada, back then, took much more of a hit, and a longer hit. I wonder if things will be different this time around. When one compares the Canadian economy in the 1930′s compared to the economy today, there is still a huge influence of the primary industries (mining, petroleum, logging) on the economy. If the commodity markets are incorrect (i.e. priced too high) it will be very bad for Canada. I also have no idea how more “diversified” Canada’s economy is relative to the 1930′s.

If indeed we are in an economic depression and we have only seen the tip of the iceberg, it would highly suggest that equity markets and prices are overvalued.

The markets have gotten very weird.

Here is the front end of the Fed Funds Futures rates (click for a better look):

Right now the market is saying that there is a 50% chance that the Federal Reserve will tighten up rates by October 2009.

There is no way that this can happen, especially with the fed still engaging in quantitative easing.

The markets are also saying that by December 2009 that the Federal reserve will be raising rates to at least 0.5%, with a possibility of a 0.75% rate.

Again, this is hugely unlikely.

The only way the federal reserve will raise interest rates, or even bring up a hint of increasing rates, is if economic figures start turning positive (i.e. less jobless claims, more employment) or inflation starts hitting the economy – neither which have been seen.

The risk-reward ratio is not the most rewarding (i.e. it would be a 1:1 bet on a raise not happening in October) but it warrants a further look.

Canadian three-month rate futures are at 2.56% for March 2011, and 3.3% for March 2012.

I made a very stupid trade two days ago and it ended up costing me some money, so I will document it here to demonstrate my stupidity to the rest of the planet.

There is a very famous phrase in the stock market that most amateurs don’t really adhere to – “Let your winners run”. The converse of this is exceedingly bad advice – “You never go broke taking a profit”. While there are exceptions to almost every rule, knowing when they apply can only be learned through experience rather than reading a textbook (or weblog entries like this one).

Taking profits early is usually an adverse decision because most people end up sacrificing a huge amount of potential future gains. This happens more often than the position reversing itself and turning into a loss – by virtue of taking a position and having it be a winner, it is more likely than not to continue being a winner in the future because the market has proven you correct.

What this means is that trading out of a position is a lot more difficult than trading into one, when the position is a winning trade. Every decision that is made requires a better reason than your competitor (the counterparty), and if you’ve gotten into a winning position, it means you made a correct choice. Getting out of a position also requires a correct decision, i.e. a bet the security will no longer be a winning one.

Much more time is spent on research to get into a position; the same amount of research is rarely done to get out of a position, so exiting a position is usually a lot more haphazard, and more poorly done.

My track record shows that I am exceedingly good at getting into positions, but I am bad at getting out of them, in that I have typically gotten out of them far too early. Some gems of mine that I’ve gotten out of too early have been Gilead Sciences from a split adjusted $4 to roughly $12 – taking a 200% gain sounds nice, but now at $44, Pharmaceutical Product Development from a split adjusted $2.50 to $6 (now at $20), Biogen from $8.50 to roughly $14, etc. These were all mistakes of trading youth (you might notice that these trades were all done in the late 90′s and early 2000′s) which I have continually attempted to rectify.

One trade that did go exceedingly well was Corvel, where I averaged about $12 (split-adjusted) and got out around $36. The company is exceedingly well-run and if their stock goes sufficiently lower again, I will consider it.

One aspect of portfolio management that I have done rather well at has been avoiding market meltdowns – both during the tech wreck in the early 2000′s, and more recently in the financial market collapse in the second half of 2008. I have always been a paranoid money manager, so I think by virtue of this I have survived to this day. The next rule that everybody should follow is that “It is much more important to not lose money than to make it.”

Going back to the bone-headed trade I made, in late March, I entered into a position to predict that the short term interest rates in the USA would be higher than 1.25% in 2010. The reason was simple: Inflation. It was (and still is) imminently clear that the US is going to be blowing a lot of money out the door and if this money hit the economy (which is the critical assumption, that it won’t mostly go toward debt repayment), then you will have to see short term rates rise due to inflation risk.

The following is a chart of the entry (A clarification for the reader – in these charts the position I am taking is betting on a decrease in the futures price, thus if the chart goes lower, I make money. If the chart goes up, I lose money. The fed funds future contract is traded as 100 minus the expected short term interest rate in percent – so a price of 98 means you are betting on 100-98 = 2%):

Fast forward a couple months, and I start thinking that my thesis is not going to work because there are some indications that despite quantitative easing that consumers are parking money in debt (as seen in increased savings rates). If this occurs, then the economy won’t be as inflationary as expected, and also the economy would be performing worse, which is the recipe for continued lowered interest rates. Since the Federal Reverse has historically moved in very measured steps (raising rates a quarter point, or half a point at their meetings when they do raise rates), math would suggest if they started raising rates sometime in the spring of 2010, I was looking at a marginally profitable trade (rates around 1.5%).

I also didn’t like the fact that I weighed the probability of a Japan-like scenario, where short term rates were held to zero for years, and still expect a reasonable (albeit less than 50% chance) of it happening – which would result in a loss. Essentially the economic landscape hasn’t changed in two months, and since the duration of my bet from that point was 18 months, the risk increases. When the risk of my position goes up, it means I have to reduce the position to a more appropriate fraction of my portfolio. My maximum loss would have been 6-6.5%, and reducing the position would have reduced the maximum loss to about 3.5-4.0%. So I decided to partially liquidate my position.

Unfortunately today, the market has moved massively in the direction of my favour, as seen by the following chart:

While I am still taking advantage of this rise in interest rate expectations for the end of 2010, I am rather unhappy with respect to how I reduced my position, at almost precisely the most incorrect day to do so. The difference between a liquidation today vs. a liquidation two days ago was a material amount of money that could be utilized better elsewhere (e.g. a vacation). Although the liquidation itself resulted in a realized gain (small four-digit amount of money), a liquidation today would have resulted in a mid four-digit gain relative to a liquidation two days ago.

Was my thought process correct? I think it was. However, my execution was horrible. Although the fed funds futures 18 months out are relatively illiquid products (one effectively pays a 0.015% spread ($60) to trade them), in the future, a stop-loss methodology would likely have had better results.

This was a lesson that I learned and I hope not to repeat the same mistake again in the future. Although it cost me a few thousand dollars in unrealized gains, I have still participated. I have also reduced my portfolio risk to the point where I will be perfectly happy to take these positions to 2010 expiration.

I am also happy that these days, a retail nobody like myself can fully protect himself against macroeconomic movements. I can hedge myself against nearly any conceivable economic movement that occurs, whether it be interest rate risk, or changes in commodity prices. The only economic variable that I cannot hedge myself against is a change in taxation.

Some pathologists did a scientific dissection of eight hamburgers, taken from the common fast food joints in America. They did some scientific analysis on the meat portion and this paper was the result. Unfortunately they don’t specifically name franchises, but you can be sure that McDonalds, Burger King and Wendy’s are three of them.

Not surprising is the result that half a hamburger is nearly water. About 12% of content is meat.

What was surprising was that two of the burgers had bone inside them, and two burgers had substantial plant material inside them – one burger even had 2.1% meat content. I’d be really curious to know which franchise that burger came from.

When scientifically analyzed, fast food is really gross. However, it gets that way because the processes used to create them ensure that they can be created consistently with low wage labour. In this respect, the creation of fast food is an amazing science.

For the bet I made on the prediction that US short term interest rates would be higher than 1.25% in the end of 2010, I had a portfolio leverage of 6.2% per percentage point of interest; I have scaled this down somewhat to 3.7%. This was scaled down in a way that resulted a realized gain, as the futures are currently saying that short term rates at the end of 2010 is likely to be around 1.5%.

There are a lot of conflicting variables, and I was uncomfortable with the leverage that I had taken. As long as the US treasury continues to attempt quantitative easing and other stimulatory measures, it would suggest that short term rates are here to stay for the next 18 months – the way to protect oneself would be through currency or long-term rate hedges.

My webhosting account is due to expire in August. It costs US$8.95 per month to renew it for 12 months, US$7.95 per month to renew it for 24 months, and US$6.95 per month to renew for 36 months. The time period is added onto the previous expiry, so the time between now and August is not wasted with an early renewal.

The first decision is obvious – by renewing for 36 months, I save 22.3% over the 12 month price, and 12.6% over the 24 month price. The actual savings is slightly less because of the use of capital you have if you had renewed for a shorter term, but I deemed this immaterial. My choice was to renew for 36 months.

The other decision was not so obvious – when do I renew? The primary decision was related to the Canadian currency. It is currently 0.925 at the moment, or about 1.08 Canadian buying one US dollar. Considering that this is the highest it has been in a year, I figured I might as well hedge my currency risk with renewal and bite the bullet. So I paid US$250.20. A 10% rise or drop in the Canadian currency would have resulted in a shift of about CAD$24.60 in future expenses.

While this post may seem trivial, it is not if you are running a business that deals with foreign currency transactions that deal with higher dollar values. Imagine if you knew that you had upcoming expenses or revenues denominated in US dollars, or any other foreign currency, but you have to account for them in Canadian dollars. You are forced into playing a game of deciding what the optimal point is to convert – whether it is today or tomorrow.