Market Outlook December 19, 2011

The good news is that the VIX continues to fall. It is now below 25 (a little), and hopefully it will continue to fall below 20. This would mean that the popular outlook is becoming more tempered and less expectant of surprises. That doesn’t mean the market will necessarily improve, but when investors have less uncertainty, they’re more likely to invest. As they do, increased demand tends to push up prices. This, in turn, feeds the perception that markets are a good investment, further feeding the “virtuous cycle.”

We’re not quite there yet, though. Last week was negative for stocks, while it was positive for bonds. Bonds continue to be favoured by the market, with super-low yields and high prices. Stock markets, on the other hand, continue to display negative momentum, and appear more and more undervalued. This week, the stock market appears almost 9% undervalued, while my fair value estimate has remained virtually unchanged.

I was pleasantly surprised this week by the relative performances of gold and real estate stocks. Since selling gold to buy real estate (XRE), I watched closely to see if it appeared to be the right decision. This last week, gold dropped over 5%, while real estate rose 0.33%. You can view the comparison on Google Finance. This week, I will continue to own XRE.

What Does the VIX Mean?

In a couple recent blog posts looking at the state of the stock market, I have referred to the VIX. It has occurred to me to dig a little deeper to find out what the VIX measures and how it can be interpreted. The results were a little disappointing, but not altogether unsurprising.

First, the VIX is a measure of expected volatility, when I thought it was a reporting of experienced volatility. I didn’t realize that the VIX is quoted in percentage points.  That makes sense, since it’s a measure of the implied volatility found in S&P 500 option contracts. According to Wikipedia (fount of all knowledge), the VIX “translates, roughly, to the expected movement in the S&P 500 index over the next 30-day period, which is then annualized. For example, if the VIX is 15, this represents an expected annualized change of 15% over the next 30 days; thus one can infer that the index option markets expect the S&P 500 to move up or down 15%/√12 = 4.33% over the next 30-day period.”

It was pointed out that volatility doesn’t necessarily mean that markets are expected to fall. A market that is expected to quickly rise will also translate to higher volatility. But what the VIX is reporting is people’s expectations. When people expect the market to rise, they expect it to rise consistently and orderly. When people expect the market to fall (continue falling), they expect the worst.

So the VIX turns out to be similar to a measure of sentiment. During the market crash, sentiment was poor and the VIX was high. Alternatively, when the market appears to be rising, sentiment is good and the VIX is low. But since investors, even professional traders who deal in S&P 500 futures, have been shown to be unable to predict the market behaviour over the coming 30 days, the VIX reflects current sentiment and is unuseful as a predictor of future market returns.


Market Outlook December 12, 2011

First, what really concerns me is that interest rates have fallen lower than I have seen them. Going back to the crisis of 2008, interest rates have not been lower (and they were far higher before the market crash). In fact, I have data back to 2001 on Government of Canada bonds (10 year, 3 year and real return), and this is the lower yield quoted for bonds. The 10 year yield 2.49%, a ridiculously low rate; the 3 year yields just 0.93%. What does it mean? Governments can borrow cheaply, and we’re certainly not at the top of the economic cycle. It means that bond prices are really high, even higher than last time (early 2010) I recommended against buying bonds. In fact, prices are 7.8% higher now than when I wrote that post. (For context, the TSX is exactly flat over the same period, and gold is worth 50% more).

So even though bonds didn’t look attractive 18 months ago, they were a better investment than the stock market. That continues to be the case, although it appears that may reverse next month. When that happens, it will be time to take profit from bonds and start buying stocks again. In fact, in a portfolio diversified between more asset classes than just stocks, bonds and cash, real estate (XRE) appears to have the best momentum. I sold IGT and bought XRE last week (Tuesday morning, unfortunately). XRE performed better than other asset classes over the course of the week, and I will continue to own XRE this week.

My fair value estimate for the stock market rose again this week, although the market price dropped slightly (less than 0.5%). The market now appears to be quite undervalued (almost 6%). Although momentum doesn’t yet favour stocks, the market appears to be attractively priced.

There’s Always Something to Do

Peter Cundill passed away in January 2011 at age 77. A biography was written about him, called There’s Always Something to Do: The Peter Cundill Investment Approach. It was completed while Cundill was still alive, but arrived in the library after his death. I just finished reading it (I had to wait my turn for the only copy) and I thoroughly enjoyed it. I found the title to be ironic, however.

I am personally partial to the value style of investing. It matches my upbringing and training, and it’s familiar to me. I also appreciate the idea that investing is like a puzzle and work in research will be repaid with profits in the stock market. The many anecdotes, of successes and failures, were fascinating.

I immediately noticed two characteristics which seem to account for success. First, Peter Cundill’s heritage was described, and he came from a family who, after they immigrated from Britain to Canada, were entrepreneurial and amassed great wealth. The fortune was lost while Cundill was young, but it is very apparent that he benefited from connections. He was able to begin work with people who were well placed to mentor him and provide him with opportunity. He also had an ability to form a network of people who gave each other mutual help in their work. This is a phenomenon that I have heard and read about, but which I don’t yet understand myself. I believe it’s one of the main advantages that influential people have, which they probably learn in their families.

Second, Cundill continually preached patience. Many of the companies in which he invested took two years or longer, during which the share price sometimes continued to fall, before his decision was vindicated and his investment turned profitable. Given the repeated exhortation to patience, the title may mislead. In life, unlike in investing, there’s always something to do. Cundill was a man who was curious and had many interests. When he wasn’t engaged in investment research, he ran, he exercised, he attended museums, ballets and operas and he read voraciously. But as the investment anecdotes showed, especially in the case of selling the Japanese market short during the mid-1980s, sometimes there’s nothing to do but wait for the market to realize its mistake and adjust prices.

As the biographer pointed out, Cundill paraphrased John Maynard Kaynes’ well-known adage: “Markets can remain irrational a lot longer than you and I can remain solvent.” So I would say that in investing, there is always something to do, if you count patiently waiting for the market to realize its error as doing something.

Market Outlook December 5, 2011

The stock market surged this week, rising over 5%. To put that in perspective, two weeks in a row like that would provide a year’s worth of return (10% growth). But coming after four negative weeks in a row that together saw the market fall -9%, this only starts to repair the damage. Stocks continue to display negative momentum, indicating that the market is not prepared for a sustained upward trend. The VIX, at 27.52, has fallen below the range of 30-35 where it has spent the last few months. This is the first positive sign that the market may continue to rally into the end of the year.

Bonds also rose on the week, despite the fact that they normally move opposite to stocks. The price, when it isn’t influenced by interest rates, which have held steady for months now, responds to shifts in supply and demand. My guess as to why stocks rose and bonds rose slightly at the same time would be that investment managers were moving money from cash (equivalents) to stocks, without selling bonds. For a portfolio balanced between cash, bonds and stocks, I still suggest that bonds appear to be the most dependable holding. For those willing to take more risk, real estate (XRE) now shows more momentum than gold. I will be selling my gold ETF (IGT) and buying real estate (XRE) instead.

Despite the impressive stock market rally of the past week, the market still appears to be undervalued. In fact, my fair value estimate for the market rose, also. This means that even without any earnings growth, the coming year should provide a reasonable 5% – 10% of market growth, as pessimism fades and optimism returns. That’s not a prediction, but from this market level, it’s a possibility. From my experience, the market tends to appear overvalued as long as optimism reigns, as it did from late 2009 to early 2011. While there is always a risk that the market could fall further, it seems more likely that the bad news is factored in and good news will result in positive performance.

Housing Affordability

I overheard a conversation in which one person was lamenting to another that as interest rates rise, housing affordability will worsen and soon only 1% of people will be able to afford to buy a house. I’m sure that was an exaggeration, but I’m still interested to look at the scenario.

How many people pay cash for a house? Not many, I’m sure. Almost all buyers have a mortgage of some size. Recently, the length of a mortgage that CDIC would insure was reduced from 40 years back to 35, but hopefully not too many buyers took advantage of the longer amortization. Let’s use, as an example, an amortization of 25 years. What is likely to happen to house prices as interest rates change?

Let’s assume a $400,000 home (pretty typical in Calgary) and an interest rate of 5%. The 25 year cost, at monthly payments of $2338.36 is $701,508. If interest rates fall to 4%, I would expect the house price to rise to $443,000. In that case, the total cost would remain $701,508, no change for the buyer. On the other hand, if interest rates rose to 6.25%, I would expect the house price to drop to $354,500. Again, no change in the total cost to the buyer. While the house price changes with shifts in mortgage interest rates, there is no real change in affordability on average.

I say “on average” because the total cost depends on the amount of debt, the length of the amortization and the interest rate. Let’s see how the total cost changes for buyers who pay cash, compared with buyers who were “lucky” to get a 40 year amortization. For the buyer paying cash, the total cost is the same as the nominal costs above. A rise in interest rates (from 5% to 6.25%) would result in a price that is $45,500 lower, whereas a lower interest rate (4% instead of 5%) would result in a price that is $43,000 higher. In contrast, the buyer with a longer amortization will benefit in the opposite way. If interest rate were to rise as above, total cost would rise from $925,819 to $966,067, an increase of $40,248. If interest rates were to drop as above, total cost would fall from $925,819 to $888,705, a decrease of $37,114. On average, affordability should remain unchanged while house prices move inversely to interest rates, but the actual change in cost will depend on a buyer’s level of indebtedness.

Real changes in affordability stem  from shifts in supply and demand. As an example, around 2005, Imperial Oil moved their head office to Calgary. At the same time, many Imperial Oil employees moved from Toronto to Calgary. The price of our 1550 sq ft, two storey home jumped from roughly $250,000 to around $400,000. That wasn’t the only source of net immigration to Calgary, but a sudden increase in demand without an offsetting increase in supply caused house prices to jump, driving down affordability for everyone (notably my younger siblings).

What happened during the US housing meltdown? During the period 2000 – 2007, interest rates consistently fell while mortgage terms stretched longer. This pushed house prices up (lower rates), but also brought costs to borrowers down (lower rates). Apparently, many renters became first time owners, increasing the demand. Increasing demand pushed up prices further, but reduced affordability (increasing total cost), causing banks to respond with “creative” mortgages (teaser rates, balloon payments) which further lowered costs to borrowers in the short-term. But once the teaser rates expired, affordability suddenly worsened for owners who were heavily indebted, and when sales (added to new construction) first surpassed purchases, supply began to outstrip demand. That pushed housing prices back down (market mechanism), sparking a panic.

A US-style housing meltdown has so far not affected Canada. The question that continues to surface from time to time is: could it? I can see two scenarios where the danger is a real possibility. First, residents could migrate away from Calgary (and Vancouver, Toronto and other cities that experienced a jump in house prices) back to lower priced markets (such as the Maritimes). This seems less likely as long as the economy recovers and jobs continue to be available in metro areas. Second, as interest rates rise, owners may encounter trouble as they try to renew their mortgages. Higher interest rates mean a higher monthly (and total) cost, but this can be offset by extending the amortization. My guess is that the worst case would be that some people who over-extended their borrowing will continue to own a house with a 35-year mortgage, continually renewing for 35 more years. Short of an economic meltdown (which luckily seems to have mostly bypassed Canada) or a demographic shift (the baby boomers all try to sell at once), house prices seem likely to remain relatively stable.