Category: Investing

No this is not about the Trailer Park Boys, but about a new article that William Bernstein of Four Pillars of Investing fame has written here on his website.

He talks about the possibility that we are in a bubble based on a number of factors including over valuation of worldwide stocks and the realization of Hyman Minsky’s criteria for a bubble – liquidity and displacement. By displacement he’s referring to a transformative technology (ie the web) or new financial ideas. Bernstein says that this displacement is occurring with the onslaught of new ETFs on which Larry McDonald wrote about. Personally I would have to respectfully disagree with Bernstein for the simple reason that ETFs have been around since 1990 so they really aren’t a new invention. Index funds which are pretty closely related to ETFs have been around since the mid-seventies. Admittedly there are some exotic flavours of ETFs coming out which leads one to believe that maybe we are in a bubble because apparently any type of investment will sell these days as Canadian Capitalist covers here.

In the end he concludes that the odds are not more 50/50 that we are in a bubble. One of his ideas in his book is that a major bubble only occurs once every generation or about every 30 years because everyone forgets about the last big bubble. In this case it has been too soon since the dot bomb for another bubble to occur.

On the other hand he also mentions in the article “the better you are at tuning out the opinions of others and making judgments for yourself, the wealthier you will be.” So perhaps we just have to make up our own minds on whether there might be a bubble occurring.

Everything I’ve read about the stock markets being efficient makes sense to me. Tons of people spend lots of time, money and energy trying to make money buying and selling stocks. This would naturally lead towards the belief that arbitrage (the chance to make money through a price discrepancy) is impossible, or would only be present for very small amounts.

Efficient market hypothesis

Some people take the perspective that you can rely on this to always buy and sell at a fair price. If a stock drops 25% the day after you bought it, there’s nothing you can do, as its new price is what it’s worth. Tomorrow it could go up or down. Same if the stock went up 25%, there’s no reason to “lock in your gains” as the stock doesn’t know that you own it and it’s pretty well impossible for you to know what will happen next (before the price reflects any news or possibilities).

Financial Jungle wrote a very insightful post called “Must All Trades Be Zero-Sum” where he argues that because investors have different circumstances, how could the market efficiently price all stocks for all of us?

As a simple example, Canadian dividends are given a very generous tax consideration for Canadian citizens. As I write this, the market feels that Bank of Montreal (stock ticker symbol BMO) is worth $21.03 / share. How can it be worth the same price to me, with a juicy tax credit credit, and to an American who is going to get taxed differently on it?

For that matter, how can it be worth the same price to someone in the lowest tax bracket in Canada vs. someone in the highest tax bracket (who would obviously place more value on the credit)?

Beyond this, institutions should have their own set of considerations for what to buy.

Different investment goals should affect the price, but obviously don’t. I’m a buy-and-hold, long-term, dividend-income investor. I’m going to value a stock for different reasons than a day trader would.

I’m certain there is a way to figure out what you value, then determine where the market undervalues this.

Great food for thought Financial Jungle, thanks for your post!

This is the last post in the “Leveraged Investments” series. Check out the previous post entitled “Exit Strategies”.

There’s been a lot of posts on leverage lately in the blogworld so I didn’t think it would hurt to have one more…

Also – I’m in no way advocating anyone use leverage for investments unless they are comfortable with the extra risks.

As Financial Blogger and Tom Bradley pointed out, leverage is an instrument that almost everyone uses when they buy their house. Although most people buy a house to live in, not as an investment, it’s an example of where people are using leverage and they might not even realize it.

If you ask people on the street about how they feel about borrowing to invest they might give you a lot of negative feedback. I suspect this is a holdover from times when margin accounts were the only way to borrow for investing. The problem with margin accounts is that if your investments drop in value enough then you have to come up with cash to pay the difference which is why certain investors were running out of windows in 1929.

My opinion is that leveraged investing can be a useful tool but definitely entails extra risk. However it occurs to me that sometimes the idea of leveraged investments can be a question of semantics.

Consider the following:
Person A gets a $200k mortgage on his house with a 25 year amortization. After five years, his mortgage is $185k and he also has $10k in cash that he has saved. This person decides to invest the $10k into a dividend stock, let’s say…BMO. So now he has a $185k in mortgage and $10k of stock.

Person B also gets a $200k mortgage on his house with a 25 year amortization. After five years, his mortgage is $175k but he has no extra cash to invest because he has been making extra mortgage payments. This person decides to borrow $10k from his secured line of credit and buys $10k of BMO as well and gets the tax rebate on the interest paid.

According to popular wisdom, person A is the epitomy of responsible investing using good old cash to buy his stock. Person B on the other hand has made a deal with the devil and plunged into leveraged investing.

So what’s the difference between the two? The only difference I can see is that Person B can write off his interest on his investments and Person A can’t. Obviously there are interest rate differences but I’m ignoring those since they shouldn’t be too significant.

Moral is – if you don’t make extra payments on debt and use cash to do investments then you would be better off to put that cash into the mortgage and then borrow it out again for those investments and get the tax rebate.

And yes, I realize that this logic was the genesis of the Smith Maneuvre but rest assured that I don’t recommend that particular strategy.

Woot! As I checked my E*Trade account this morning, I see that I’m up a super-sweet $72.60 as a dividend payment from Rothmans (I feel like I should go buy some smokes for impressionable teenagers with the cash 🙂 ). I was wondering how it would work, since I hadn’t seen any of the cash (the dividend was supposedly paid on the 15th, I guess it took them a couple of business days to get it into E*Trade).

This certainly cushions the dip that my stocks have taken recently (according to share prices, I’m down $439.01). Factoring in the dividend, that’s a cool -$366.41 (but I’m hoping to make it up in volume ;-).

As I asked previously, I have no idea how it would work from a tax perspective if I withdrew the $72.60 from my account (currently it immediately went to pay down my margin debt). I think I’ll leave it in the account (pay down the debt), just to keep things simple for now…

I decided to make Bank of Montreal (BMO) the first stock that I bought for my leveraged investment portfolio. I also own small amounts of BMO in various mutual funds but the 100 shares of BMO I bought recently represent the first time I’ve directly owned part of a company.

The reasons I bought BMO were mainly because it was one of the big five banks with proven dividend increases and it had the highest dividend yield of the banks. In my mind it is a very safe investment because it’s unlikely that any of the big banks will ever fail.

Having said that, BMO recently just lost $680 million from commodity trading losses, which sounds like there might be some fraud involved. This sort of debacle raises the question, are the banks really as safe as we think they are?

In this case, BMO had no problem coming up with other earnings to make up for the huge loss so I’d say they are still pretty safe, although I’m guessing there was some fancy accounting footwork going on to be able to still increase their profits.

I was reminded of another bank that had some trading losses not too long ago. Barings Bank of London failed in 1995 because of a rogue trader named Nick Leeson who lost $1.4 billion speculating on futures contracts. This is roughly $2 billion in today’s Canadian dollars which is a lot more than the $680 million BMO loss. I don’t know how big Barings was in comparison to BMO but I do know that it was the oldest merchant bank in London (est. 1762). Apparently Leeson was a regular back-office worker who managed to trade large sums of money on the banks behalf. He eventually got caught and served time in jail. You can find out what he’s up to now on his website. I’m not sure if he has a personal financial blog as well 🙂

I think the important thing to learn from Barings & BMO (and Enron and so on, and so on) is that diversification is important. It doesn’t matter if you own the best stock in the world, all it takes is one big fraud and your losses could be significant.