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Equities versus Commodities

Equities are overvalued! Bonds are overvalued! In the minds of many investors everything is overvalued given central bank distortions, yet there may be an exception. Look at commodities. The difference between financial and real asset could not be larger. Financial assets have steadily moved higher while commodities have fallen or at best moved sideways relative to risky stocks in the last 5+ years. This relationship has applied to all equity indices around the world to varying degrees. 

One can argue that commodities are more closely tied to current economic growth while equities are tied to valuations of long-term discounted cash flows as one explanation. Equities have positive carry while commodities as measured through futures have seen mixed carry with market contango for the last few years; however, there are now switches to backwardation in some markets. The business cycle relationship with commodities suggests that these real markets peak late in the cycle not when there is a new surge in growth. Still, on a relative performance basis, commodities as an asset class looks like a better value.

Canada. Time for a refresher course?

The adage that “trees don’t grow to the sky” is being put to the test in the Great White North.   Despite a pullback in Toronto-area home prices in recent months, the Canadian housing market stands out even in this bull market-in-everything world:  The Canadian Real Estate Association’s MLS Home Price Index has risen by 130% since the beginning of 2005, more than double the 53% rise in nominal GDP over that period.  

As night follows day, rising prices are met with increased supply.  Thus, Bloomberg reported on Friday that Canadian developers are undertaking a record number of multiple-unit construction projects as they seek to participate in the boom.  Robert Kavcic, economist at BMO Capital Markets, commented that: “Canadian home building activity remains rock solid. Builders in the biggest cities appear to be responding to supply shortages as best as possible.”  The severity of these shortages, in Toronto at least, is disputable. Supply of new listings in Canada’s largest metro area has jumped by 37% year-over-year in November.

Local regulators have likewise moved to slow down the housing market’s ascent.  Canada’s Office of the Superintendent of Financial Institutions (OSFI) is introducing new regulations, set to take effect on Jan. 1, which aim to tighten lending standards. 

It may come as no great surprise to learn that the great Canadian housing bull market has been built on a foundation of debt.  Consumer debt as a percentage of disposable income has undergone a near-constant uptick since the turn of the century, reaching a fresh high water mark of 167.8% as of the end of the second quarter, compared to 144% in the U.S. in 2007. The encumbrances are particularly concentrated in home equity lines of credit, or HELOCS.

HELOCs, as a percentage of GDP [13.5% as of year-end 2016], are roughly three times higher in Canada then in the US at the peak of our housing bubble in 2006. In addition to consumption (“using your house as an ATM”) and borrowing to avoid delinquencies on other debt, Canadians have been using HELOCs to fund mortgages in the shadow banking market and buy additional speculative properties.
“People in Canada have been borrowing against their home equity line of credit - to lend to subprime borrowers directly.” Indeed, this linked piece from the Toronto Globe and Mail provides a detailed roadmap for readers who wish to use their home equity for investment purposes, in service of “leveraging their real estate assets to increase their net worth.”

Back in June, executives at Home Capital Group, Inc. agreed to pay upward of C$30 million in settlements over alleged disclosure violations related to mortgage fraud in 2015.  On Nov. 30, Reuters reported that “compliance officers at the Financial Services Commission of Ontario had evidence that syndicated mortgages were being marketed and sold in ways that broke the law . . . From 2011 to 2015, senior FSCO investigators rejected or ignored compliance officers’ multiple recommendations that the agency investigate or take action to rein in the marketing and sales of Fortress [Real Developments] syndicated mortgages.” Last week, Montreal-headquartered Laurentian Bank disclosed that it will need to buy back as much as $180 million of mortgages after discovering “documentation issues and client misrepresentations."
François Desjardins, president and CEO of Laurentian, defended his bank: “We’re very different organizations and this is a very different situation than what happened at Home [Capital]. This, to us, is really a process and paperwork issue that we have to resolve.” This morning, Laurentian issued a follow-up press release stating that: “Given recent reports in the media, the Bank wants to clarify why it does not believe these matters are material to its business, capital, operations and funding.”

Some see things differently and saying that:

The mortgage inconsistencies reported at Laurentian Bank (the third major Canadian financial institution to fess up to this problem) underscores what we have long believed to be a systemic problem with Canadian underwriting practices. 

Canada hasn’t seen a true credit cycle in nearly three decades, which warps the judgment of market participants and regulators alike.

Time for a refresher course?

The AI, robotics and VR technologies will grow into the major innovative players of the 21st century.

A while back I wrote about a new sector—artificial intelligence, robotics, and virtual reality and how these innovative technologies were set to transform numerous aspects of modern society—manufacturing, labor, health, energy, leisure, and of course transportation. 

I suggested that the low-priced ETFs—ROBO and BOTZ—were a more conservative way and my choice to trade the companies that introduce these technologies. My preferred ETF was ROBO, thanks to its slightly higher volume.

Since that post, ROBO has been racing to new highs with the other major technology sectors. Correspondingly, like the others, it has declined in the last couple of weeks. 

The run from June lifted ROBO about 25 percent to $42.50. So far, the decline has brought it back about 4 percent. In contrast, SMH, the semi-conductor ETF, is down about 11 percent.

The AI, robotics and VR technologies (along with renewable energy) will grow into the major innovative thrusts of the 21st century. The impact on the modern world will be tremendous, with huge potential for good or bad. Already, the talk is about taxing robots. New companies with breakthrough technologies will become major corporations as the sector grows. 

Until the companies in this sector mature, and the enviable shake-out occurs, I prefer the ETFs. At this moment, price is short-term oversold, and testing its breakout zone between $40 and $41. If it finds support, there’s a chance for a year-end rally.