Correlation: Or How I Learned to Stop Worrying About the Market and Love Diversification

140617strangelove
The look of a nervous investor who needs more diversification

This year has seen further gains in the stock market both in Canada and the United States. But after five straight years of gains (the US is having its third longest period without a 10% drop) many are calling for an end to the party.

Calling for a correction in the markets isn’t unheard of, especially after such a long run of good performance. The question is what should investors do about it? Most financial advisors and responsible journalists will tell you to hold tight until it 1. happens, and 2. passes. But for investors, especially post 2008, such advice seems difficult to follow. Most Canadians with any significant savings aren’t just five years closer to retiring than they were in 2008, they are also likely considering retirement within the next 10 years. Another significant correction in the market could drastically change their retirement plans.

Complicating matters is that the investing world has yet to return to “normal”. Interest rates are at all time lows, reducing the returns from holding fixed income and creating a long term threat to bond values. The economy is still quite sluggish, and while labour numbers are still slack, labour participation will likely never return to previous highs as more and more people start retiring. Meanwhile corporations are still sitting on mountains of cash and haven’t really done much in the way of revenue growth, but share prices continue to rise making market watchers nervous about unsustainable valuations.

In short, it’s a confusing mess.

My answer to this is to stay true to principles of diversification. Diversification has to be the most boring and un-fun elements of being invested and it runs counter to our natural instincts to maximize our returns by holding investments that may not perform consistently. Diversification is like driving in a race with your brakes on. And yet it’s still the single most effective way to minimize the impacts of a market correction. It’s the insurance of the investing world.

This is not you, please do not use him as your investing inspiration.
This is not you, please do not use him as your investing inspiration.

The challenge for Canadians when it comes to diversifying is to understand the difference between problems that are systemic and those that are unique. The idea is explained well by Joseph Heath in his book Filthy Lucre. Using hunters trying to avoid starvation he notes that “10 hunters agree to share with one another, so that those who were lucky had a good day give some of their catch to those who were unlucky and had a bad day…the result will be a decrease in variance.” This type of risk pooling is premised off the idea “that one hunter’s chances of coming home empty handed must be unrelated to any other hunter’s chances of coming home empty handed.”  Systemic risk is when “something happens that simultaneously reduces everyone’s chances of catching some game.” This is why it is unhelpful to have more than one Canadian equity mutual fund in a portfolio, and to be cognizant of high correlation between funds.

The question investors should be asking is about the correlation between their investments. That information isn’t usually available except to people (like myself) who pay for services to provide that kind of data. But a financial advisor should be able to give you insight into not just the historic volatility of your investments, but also how closely they correlate with the rest of the portfolio.

Sadly I have no insights as to whether the market might have a correction this year, nor what the magnitude of such a correction could be. For my portfolio, and all the portfolios I manage the goal will be to continue to seek returns from the markets while at the same time finding protection through a diversified set of holdings.

 

Why Apple is a Good Lesson on Investing

Over the last few years some elements of the stock market have seemed fairly crazy. Tech stocks, often belonging to social networking sites like Twitter, have had an unbelievable run. Meanwhile Apple Computers (a favourite of mine) have frequently been heavily criticized for declining revenue growth and slowing sales numbers. Business commentators like to point to the growth in Google’s Android phone platform and its large share of the mobile phone market as proof that Apple’s days as a global leader are past.

However with Apple’s most recent earnings report out there are some important things to take note of. The chief reason that we invest in companies is because they make money, and Apple is currently one of the most profitable companies around. How profitable? Take these statistics published today in Slate.com.

If Apple’s iPhone was it’s own company it would be larger than 474 companies on the S&P 500 index and would have revenues in excess of Amazon, Coca-Cola, McDonalds, Google and E-bay. iphone.png.CROP.promovar-mediumlargeThat’s just its phone division. The iPad, whose sales numbers are definitely plateauing if not declining is still a valuable business netting $5.9 billion in revenues, greater than Facebook, Twitter, Yahoo, Groupon, and Tesla combined. ipad_1.png.CROP.promovar-mediumlargeMac Computers, which earned less than the iPad division, still garnered an impressive $5.5 billion. Even the iPod, now almost totally forgotten in the midst of smartphones and iPads still earned an impressive $442 million, 77% than Twitter’s $250 million in quarterly revenues.

Apple’s stock has periodically taken a licking, but has been beating its way back to its previous high (partly due to a recent stock split and dividends periodically being paid), but its story is an important cautionary tale.

Apple Stock Price
Apple Share Price History

Good investing comes from choosing companies that produce revenue and retain growth potential, in other words focusing on the fundamentals of investing. Despite naysayers, that’s exactly the kind of company Apple has been. So why does Apple get so much negative attention? Because predicting the fall of a Goliath is exactly the kind of thing that makes news. Whether it’s true or not is irrelevant in the news cycle, but it is a source of bad investor advice, and should serve as a cautionary tale to investors considering taking financial advice from business news.

Market Inefficiencies are Making You Fat (But Maybe Also Wealthy)

If you wish to prove that the world is more prosperous today than ever before, you merely need to look at the statistics of global obesity. With close to 400 million people world wide affected by Type-2 Diabetes and costs to global health care nearing $470B (USD) obesity is the unfortunate side effect of rising standards of living.

Canadians and Americans spend around $130B (USD) on fast food annually. That’s a lot of money, and you can imagine that much of it happens at lunch. Across many major cities, workers flee their office towers and head towards food courts to satisfy their hunger. Something else that both Canadians and Americans spend a lot of money on is weight loss, to the tune of $44B a year. So to recap, Canadians are spending lots of money on fast food, and lots of money on trying to lose weight.

Obesity is easily one of the major social issues that occupies our conscious. Perhaps because so many of us are now overweight, because the costs are so high, because the science is so confusing, or because we have such a warped image of beauty,

It's time to end the unreal expectations of beauty for men, most of us just won't have claws.
It’s time to end the unreal expectations of beauty for men, most of us just won’t have claws.

Canadians are eating too much and regretting it later to the tune of billions. Whatever the reasons it is now common to say that obesity is at epidemic levels.

One of the more popular reasons cited for this epidemic is that not only are our eating habits so poor, but that we aren’t really clear about what is in our food. Most recently this has been the focus of the Katie Couric documentary FED UP, which took aim at the sugar industry and how much sugar has been added to our foods without our knowledge. And there is some strong evidence that sugar may be one of the chief culprits behind obesity, type-2 diabetes, and a host of other illnesses now largely associated with prosperous societies.

We might expect that our “efficient markets ” would respond to the incredible demand for healthy foods by providing more nutritious fast foods, like Freshii. Freshii is a highly successful fast food chain that specializes in salads, wraps and other healthy food options. At lunch time in most food courts the lineup for Freshii is easily one of the longest, and yet the number of fast food places that imitate their business model, or compete directly is shockingly low. The theory that markets naturally respond to the needs and wants of the consumer seems to fall flat here.

One explanation is that the markets are responding to the desires of the consumer, and consumers don’t really want healthy food, but prefer hamburgers and french fries. Another theory is that if there aren’t any healthy food options around, people will choose only what they have available to them (hamburgers and french fries). I choose to assume another explanation. That is that businesses are incredibly conservative and typically don’t like to disrupt a known and profitable business model in favour of one that is largely untested. Entrepreneurs tend towards being “disagreeable” (to borrow a term from Malcolm Gladwell) and don’t mind risking failure to try something new.

This lag between successful companies and upstart firms like Freshii has been demonstrated by other companies (and most recently challenged in the New York Times) like Apple, and even Ford Motors. Henry Ford famously said that if he had asked what his customers wanted, “they would have asked for a faster horse.” Markets may ultimately be responsive to consumer needs, but not efficiently so. And within market inefficiencies we often find opportunities that are being ignored. While that can be good for the watchful investor, it seems to be bad for our waistlines.

My Car Runs on Geopolitics – Why “Fracking” is an Important Investment for Your Portfolio

frackingI’m an environmentalist. But as a Financial Advisor I consider that some of the best opportunities I can provide to my clients is exposure to the burgeoning US and Canadian energy markets. That’s right I’m a big proponent for one of the most ecologically damaging and publicly derided forms of energy extraction.

However, next time you put gas in your tank consider this: 7000 fighters are currently making a mockery of whatever pretense Iraq was making at being a legitimate country. ISIS, the Islamic faction currently pushing into northern Iraq from Syria with aims to establish an Islamic Caliphate in the region has been routing Iraqi government forces. An army a quarter of a million strong, equipped with the latest in weapons, tanks and aircraft are losing regularly to a rag tag group of extremists equipped only with machine guns.

Meanwhile in the Ukraine we have fresh assurances that Russia will abide by a new ceasefire between Ukrainian government forces and rebels loyal to the Russian government. While Russia may have undone its own objectives of building a rival economic group, they have successfully reminded everyone why Russia, no matter how weakened it may be, is a powerful force that controls a great deal of energy needed for global consumption.

Across many of the nations that produce some form of energy (oil, natural gas, coal, etc.) there are very few that can claim to be a democratic, civil society not embroiled in some kind of sectarian civil war. But as of this year the United States has become the world’s largest producer of energy, outpacing Russia and Saudi Arabia, and that promises to change the way we think about economies and economic opportunities going forward.

production

In many developed countries there is a great deal of hand-ringing about the sudden rise of hydraulic fracturing – a relatively recent method of energy extraction that is reducing the cost of production and breathing new life into American manufacturing. “Fracking” comes with a number of environmental downsides, some of which are both scary and quite dramatic.

But energy is the life blood of civilisations and a steady supply of affordable energy is what gives us the ability to grow our economies and invest in new technologies. Sometimes this means making hard choices about how we allocate resources, and what the long term impacts of certain industries to our environment might be. But affordable energy, in the form of both oil and natural gas, provided from countries like Canada and the United States doesn’t just help bring back domestic manufacturing. It also economically weakens dictators and states that ignore human rights and puts power back in the hands of liberal democracies to enforce sanctions.

In other words there are numerous political and economic benefits that come along with cheaper Western energy. While this doesn’t address our environmental problems it’s important to love your monsters. The tools that give us our wealth and prosperity shouldn’t be abandoned just because they pose challenges, rather it invites us to both reap profits and seek new ways to conquer those problems we face. That is at least until either Google or Tesla solve all our driving problems.

Ninjutsu Economics – Watch the Empty Hand

First, an apology that we have been on a break from our website. Over the last month we’ve had lots going on that has distracted us from doing our regular writing, but we’re back now for the rest of the summer!

Since 2008 there has been two great themes in investing. One, is the search for yield, or income, from safer investments. The second has been the imminent arrival of a rising interest rate environment which threatens to gobble up everyone’s money. If you aren’t too familiar with monetary policy or even how low interest rates work on the economy, don’t worry. What you need to know is this:

In really bad economic times Keynsian theory states that the government should help the economy by creating inflation through stimulus spending and keeping borrowing rates low. This is often done by printing large amounts of money. The availability of cheap money has an inflationary effect on the market, and the economy is believed to rebound more quickly than it would have if it had simply let businesses fail and people be laid off work.

The flip side is that many believe printing money can lead to serious and even extreme hyper-inflation (not entirely unfounded) that in the long term can be extremely detrimental to the financial health of people. This is the fundamental tension in modern economics that is nicely summed up in the below parody video of John Maynard Keynes vs F.A. Hayek. Should markets be steered or set free? Or put more bleakly, should economies be allowed to collapse or should they be saved in the midst of an enormous financial meltdown?

In the past few years there has been an enormous amount of money printing going on (Keynsian) but at the same time governments have been trying to reduce their debts and deficits (Hayek). But the money printing has many people worried. The printing of billions of dollars globally has many inflation hawks declaring that the end of America is nigh, that the currency will soon be worth nothing and that the older traditional economies are doomed to fail. This concern has seeped into the general consciousness to a great degree and it’s not uncommon for me to get questions about whether the United States is on the verge of some new financial collapse.

I tend towards the contrarian angle however, and encourage you to do the same. So much energy and time has been focused on the threat of inflation, few seem to be watching the encroaching danger from deflation.

What’s deflation? It’s like inflation only much worse, since no one knows how to fix it. Deflation is a self fulfilling prophecy where a decreasing supply of circulating money leads to a drop in general prices for everything (this includes labour and products). On the surface that doesn’t sound too bad, but since people tend to earn less in a deflationary environment your existing debt tends to become ever more burdensome. In the same way that the collapse of the American housing market made many homes less valuable than the mortgages on them, deflation just does it to the whole economy. Japan has been in a deflationary situation for nearly 20 years, with little sign of relief. Even last year’s introduction of the unprecedented Abenomics has yet to produce the kind of inflationary turnaround that Japan is in such desperate need of.

When I look to Canada (and more specifically Toronto) I tend to see many of the signs that deflation looms in the shadows. Borrowing rates are incredibly low, largely to encourage spending. Many small retail spaces sit empty, squeezed out by  rising lease costs. Manufacturing sectors in Ontario continue to suffer, while wages remain stagnant. Canadians are currently sitting with record amount of debt and most growth in Canadian net worth have come through housing appreciation, not through greater wealth preservation. In other words, the things that contribute to a healthy economy like rising incomes and a growing industry base are largely absent from our economy. The lesson here is that when it comes to markets, we should worry more about the issues we ignore than the ones we constantly fret over. It’s the hand you don’t watch that deals the surprising blow!

By the Numbers, What Canadian Investors Should Know About Canada

I thought I had more saved!I am regularly quite vocal about my concern over the Canadian economy. But like anyone who may be too early in their predictions, the universe continues to thwart my best efforts to make my point. If you’ve been paying attention to the market at all this year it is Canada that has been pulling ahead. The United States, and many global indices have been underwater or simply lagging compared to the apparent strength of our market.

But fundamentals matter. For instance, the current driver in the Canadian market is materials and energy (translation, oil). But it’s unclear why this is, or more specifically, why the price of oil is so high. With the growing supply of oil from the US, costly Canadian oil seems to be the last thing anyone needs, but a high oil price and a weak Canadian dollar have conspired to give life to Canadian energy company stocks.

YTD Performance of Global Indices as of April 25th, 2014
YTD Performance of Global Indices as of April 25th, 2014

Similarly the Canadian job market has been quite weak. Many Canadian corporations have failed to hire, instead sitting on mountains of cash resulting in inaction in the jobs market. Meanwhile the weak dollar, typically a jump start to our industrial sector, has failed to do any such thing. But at the core of our woes is the disturbing trend of burdensome debt and the high cost of homeownership.

I know what you want to say. “Adrian, you are always complaining about burdensome debt and high costs of homeownership! Tell me something I don’t know!” Well, I imagine you don’t know just how burdensome that debt is. According to Maclean’s Magazine the total Canadian consumer and mortgage debt is now close to $1.7 Trillion, 1 trillion more than it was in 2003. That’s right, in a decade we have added a trillion dollars of new debt. And while there is some evidence that the net worth of Canadian families has gone up, once adjusted for inflation that increase is really the result of growing house prices and recovering pensions.

Today Canadians carry more personal credit card debt than ever before. We spend more money on luxury goods, travel and on home renovations than ever before. Our consumer spending is now 56% of GDP, and it is almost all being driven by debt.

Canadians have made a big deal about how well we faired through the economic meltdown of 2008, and were quick to wag our fingers at the free spending ways of our neighbours to the South, but the reality is we are every bit as cavalier about our financial well being as they were at the height of the economic malfeasance. While it is unlikely we will see a crash like that in the US, the Canadian market is highly interconnected, and drops in the price of oil will have a ripple effect on borrowing rates, defaults, bank profits and unemployment, all of which is be exasperated by our high debt levels.

Environmentalists Don’t Get Economics, and That’s Dangerous for Everyone

From the Toronto Star
From the Toronto Star

The Keystone Pipeline has enraged many people since it was first announced. Traditionally framed as a conflict between environmentalists and oil executives, the Keystone Pipeline is 1897 km of 36 inch pipe running from Hardisty, Alberta to Steel, Nebraska and for several years it has existed in limbo. Caught in the cross hairs of politicians, environmentalists, various national interests and corporations, it has been six years of waiting and becoming more unlikely that it may ever get built. A definitive win for the champions of the environment.

Or is it? In simple terms, NOT having a Keystone Pipeline does indeed impede the growth of Tar Sands industry, hampering the longer term ability to send extracted oil to be refined. But it doesn’t stop it. In fact, not building doesn’t stop the oil companies from shipping at all. The Keystone Pipeline has become a symbol of social angst about the environment, but in its place a number of much more terrible and dangerous options have been pursued. For instance, if you live int he city of Toronto you may have noticed that the CP Rail line that runs through the heart of many residential neighbourhoods is actually carrying hundreds of thousands of oil tankers destined for the same location as the proposed pipeline.

In response to constant deferral Canada’s rail lines have picked up the slack, moving as much oil around as the proposed pipe would have. This first came to my attention around a year ago at a lunch where a portfolio manager for an energy fund was explaining that even though Keystone had stalled, a new pipeline had indeed opened. The difference was that it was actually the railway system. Since then it has slowly been gaining wider acknowledgement that in place of a relatively safe oil pipeline we instead now have hundreds of trains travelling through neighbourhoods and schools and towns carrying vast amounts of highly toxic oil, among other dangerous things.

All this leads to the hard truth about difficult economic decisions. Sometimes the big bad business is still making the best decision. Opposing development, no matter how well intentioned, rarely changes the underlying needs that feed those projects. Worse still, not recognizing the economic drivers behind controversial projects like this only leads to the kind of unintended blowback that creates future messes. For environmentalists the likely outcome will have been to have slain a largely symbolic dragon, while in reality they have set the stage for future environmental disasters on a much greater scale than they had ever intended. They haven’t changed the direction of the energy market, or the need for oil. But they have undermined a good economic proposal in favour of a bad one.

Crude Oil YTD

Canada’s Economy Still Ticking Along, But Don’t be Fooled

Money CanThis year the Canadian markets have been doing exceptionally well. Where as last year the S&P/TSX had been struggling to get above 2% at this time, this year the markets have soared ahead of most of their global counterparts. In fact the Canadian market triumph is only half of this story, matched equally by the disappointing performance of almost every significant global market. Concerns over China have hurt Emerging Markets. The Ukrainian crisis has hindered Europe, and a difficult winter combined with weaker economic data has put the brakes on the US as well.

YTD TSX Performance

But this sudden return to form should not fool Canadians. It is a common trope of investing that people over estimate the value of their local economies, and a home bias can prove to be dangerous to a portfolio. Taking a peak under the hood of Canada’s market performance and we see it is largely from the volatile sectors of the economy. In the current year the costs of Oil, Natural Gas and Gold are all up. Utilities have also driven some of the returns, but with the Materials and Energy sector being a full third of the TSX its easy to see what’s really driving market performance. Combined with a declining dollar and improving global economy and Canada looks like an ideal place to invest.

TSX Market Sectors

But the underlying truth of the Canadian market is that it remains unhealthy. Manufacturing is down, although recovering slowly. Jobs growth exists, but its highly anemic. The core dangers to the vast number of Canadians continue to be high debt, expensive real-estate and cheap credit. In short, Canada is beginning to look more like pre-2008 United States rather than the picture of financial health we continue to project. Cheap borrowing rates are keeping the economy afloat, and it isn’t at all clear what the government can do to slow it down without upsetting the apple cart.

For Canadian investors the pull will be to increase exposure to the Canadian market, but they should be wary that even when news reports seem favourable about how well the Canadian economy might do, they are not making a comment about how healthy the economy really is. Instead they are making a prediction about what might happen if trends continue in a certain direction. There are many threats to Canada, both global and domestic, and it should weigh heavily on the minds of investors when they choose where to invest.

 

Toronto has a Real Estate Problem

imageIt is a common family tradition for my father and me to head down to the St. Lawrence market in Toronto for a bacon sandwich and then grab a coffee before heading off to the bookstore. As my family has grown it now frequently includes our significant others, especially my daughter Sophie who with her own limited chomping power continues to devour an ever growing portion of my breakfast!

However our trips to the bookstore have been dwindling in recent months. Nicholas Hoare, a staple on Front Street closed it’s doors in early 2013. The next nicest bookstore to head to is Ben McNally’s, up on Bay by Adelaide. But this year’s inclement weather has meant we frequently didn’t bother to make the trek.

Bookstores in general in Toronto aren’t doing so well. Last month we lost 3 bookstores; the Cookbook store, the Annex location of Book City, and The World’s Biggest Bookstore. Even Indigo/Chapters are feeling the pinch. This loss has been noted in several newspapers, but nobody is sure what to do.

Ben McNally, when I stopped by his store last week, told me that we don’t have a book problem in Toronto, we have a real estate problem. Inflation in Canada is around 1%, but every year rents go up on retailers. Small businesses, whether they be local grocers, tailors or bookstores operate with fairly fixed margins, but find that their rent is frequently the source of where they are being squeezed. They do consistent business with loyal customers, but can’t increase their sales fast enough to keep up with their rents.

This is an experience mirrored in residential property as well. A new report found that 50.6% of young Canadians in Ontario between the ages of 20-29 are still living at home. What’s keeping these young Canadians at home? There are many factors, but the most common is cost. The cost of living is simply out-pacing what you can earn.

There are two lessons here:
1. It pays to get kids saving and planning their savings early. Not just RESPs, which are savings parents put away on behalf of their kids, but getting kids to save and invest their money once they start working, especially if they can’t afford to move out yet. A solid financial plan will give them a better shot of keeping up with rising costs.

2. There is only so much financial planning can do. At some point cities and councilors and neighborhood associations are going to have to wrestle with the fact we need lots more building to go on within cities to keep living standards affordable and attainable. Maybe that can be an election issue.

You Would Probably Make a Terrible Stock Picker

Mærsk_Mc-Kinney_MøllerYou would probably make a terrible stock picker. You really would. Why you ask? Because the world is big and complicated and its hard to hold on to more than a small piece of it at any one time.

Picking stocks isn’t exactly all the rage, but with the sheer volume of discount brokerages and online trading platforms there’s clearly enough interest in the DIY method of investing that it’s easy for people to either manage an entire stock portfolio or dabble in the occasional stock tip. Is this a good idea? Cost wise it’s hardly prohibitive, but from the standpoint of whether this makes for smart investing I have my doubts.

Why? Well, for one thing even the professionals get things wrong sometimes. But the investment industry is staffed with analysts that specialize in entire industries, looking to understand companies from different points of view that reveal opportunities for growth, value or misplaced market opportunities. These people spend their careers trying to understand companies and the industries they are part of.

By comparison the DIY investor tends to act on the things they think they know, and perhaps even the unknown knowns. All of this can lead to serious errors in judgement and costly mistakes in their investments. Are you right to think that Apple is on the decline because it isn’t innovative enough? Or that Microsoft has already lost because of declining computer sales. Is Tesla really worth as much as 50% of GM? Is that hot mining stock you heard about really as good a bet as you think?

In my time working at a mutual fund company I was most impressed when I spoke to portfolio managers who  talked about why they looked at companies and industries that no one else did. How much time did you think about mattress companies? How often were you reviewing currency trends between Mexico and India (yes that’s a thing)? How much do you really know about a company?

For example, have you ever heard of A.P. Moller-Maersk? It’s okay if you haven’t, but you might be surprised to learn just how big a company it is. Maersk is a Danish corporation that’s core business is global shipping. It’s so large a firm that it accounts for 20% of Denmark’s GDP. It owns and operates countless subsidiaries, including banks, energy companies and supermarkets. It’s full list of associated companies is 12 pages long (Company Overview), showing firms from Angola to Canada, the United States to  Japan, on the Middle East and through every Emerging and Developed market you can think of. Maersk commands a shipping fleet of six hundred vessels, making it the world’s largest. It’s revenues in 2011 were $60.2 billion, just shy of Microsoft’s. In 2005 it launched one of its biggest ships, called an E-class, that could carry 15,000 containers. In 2013 Maersk started using its Triple-E Class ship, so large it carries 18,000 containers.*

image.axd

I fully admit to knowing very little about such a large company, and it surprises me that a firm with such reach seems to fly just below the radar. But my job is to help people save for retirement and work with their individual financial situations. That’s why I trust professional analysts and portfolio managers to understand the nuances of the companies that make up the investing world. For the DIY investor all too often rumour and news reports substitute for real knowledge. The good fortune of a stock going up instills courage in stock picking prowess, while a declining market either confuses or robs an investor of their confidence and possibly their savings. Investing is a tricky business, and one where we should seek help when its offered.

*All the information regarding Maersk’s business comes either from their website or the excellent book Ninety Percent of Everything by Rose George, which I highly recommend.