David's Weekly - Sep 22, 2023

Plan - Don't Predict

For those observing Yom Kippur, we wish you an easy fast.

In this week's letter

• Webinar Reminder: Estate Planning 101
• Hindsight is 20/20. What about foresight? What are the next trades out there?
• Current Trades: Let's Talk About The Pros and Cons of Arbitrage Strategies

Webinar Reminder: Estate Planning 101

Karen Snowdon-Steacy and I will be covering how a proper estate plan will help to:

• Protect assets now and in the future
• Transfer your wealth upon your death in accordance with your wishes and in an efficient and tax-effective manner
• Provide peace of mind for you and your family

Attendance is growing quickly. Please join us. Sign up through the link .

This week's issue is all about current and future trading ideas as well as the "coulda shoulda woulda" situation which is all about wishing you'd followed through on an investment but only after knowing that it worked. Also known as regret. But if you knew before, what stopped you? So, instead of talking about what we wish we did, let's talk about the challenge of figuring out the next trade. These ideas aren't for everyone and should fit into your overall financial plan.

The message from this letter on the investing side is:

1. Owning longer-duration bonds is a good strategy to consider as rates go down.
2. Arbitrage Strategies, somewhat complex, are generally low-volatility, low-risk trades that can enhance your portfolio. But today, the fact that the return on these trades includes the addition of the (high) risk-free rate, makes them even sweeter.

Hindsight is 20/20. What about foresight? What are the next trades out there?

As we've shared countless times, the crowd is very frequently wrong. For money managers with high convictions that run contrary to the market action, life can be very lonely.

Think about the NASDAQ bubble. While we were watching stocks go up 500% in 3 days knowing that the market action was driven by mania and a shortage of tech stocks to buy, many famous managers, including Julian Robertson were leaning against one of the most famous bubbles ever and then capitulated just before his trade started to work. That is before the collapse commenced and accelerated.

Sometimes people get the trade right, only their timing is off

One colleague who ran a trading desk at a very large US Broker had a massive losing short position against the NASDAQ. His boss told him: "You are either going to get a huge bonus, or you're going to get fired." He didn't get fired.

More recently, when the market was obliterated during the COVID meltdown, being a buyer was perilous and scary. Yours truly was happy enough to start buying the market down 20% while other, very experienced advisors were saying "Good luck with that." But looking back, who doesn't feel like they should have been buying that now seemingly obvious opportunity? 20/20.

Keep in mind, when we talk about doing a trade, it doesn't mean using your entire portfolio on a single trade.

What's the next trade? Here are a couple of ideas:

Ok, so we know now that when governments spray a firehose of cash at markets and provide massive support by buying everything in sight, it's time for investors to buy. And, people eventually get the message - even new investors: when rates go down, buy beat-up, high P/E, interest-rate sensitive (cyclical) stocks. Load up the proverbial truck.

If stocks were boxes, this would have worked well in 2020

We are closer and closer to the other end of the rate hiking cycle. 20/20 told us what we should have done last time, and the time before, and the time before. With the hiking cycle likely approaching the end, what will 20/20 tell us next? And how should portfolios be adjusted? To be clear, we have some idea of what happens to the markets when rates go down, but we have no idea WHEN when it will happen.

What's next after the discount bond trade?

We've talked about the advantages of buying discount bonds for over 2 years now. Most of the returns from discount bonds come from capital gains so that one can receive a safe but tax-efficient return. But when rates start to go down, where do you want to be? The answer is to buy the same kind of bonds that were most hurt when rates went up - longer maturity bonds. In finance-speak, these are called long-duration bonds.

The key aspect of the strategy is the nature of longer-term bonds: they are very sensitive to interest rate changes. Rates going up dramatically lowered the price of the longer-term bonds and negatively impacted conservative, retirement portfolios. These bonds will eventually head higher as rates go lower, bailing out many plans and also enhancing the portfolios of those who get this right.

Bond Duration - Sensitivity to interest rate changes

As we can see above, the longer the duration, the more a bond will go down when rates go up. This graphic is for illustration purposes only.

Another way to think about duration is how long you have to wait until you break even on your bond. If you need years of coupons to cover your initial outlay when purchasing your bond, that means it has a long duration. If your breakeven happens quickly, then your risk of getting in trouble is lower. That's short duration.

Timing:

The thing about the bond market is, you really need to trade before the market adjusts to a new consensus. That means being brave, and sometimes lonely. But, buying longer-duration bonds might very well be a strategy to consider, depending on your circumstances. To chat further about opportunities in that space, please get in touch:

calendar

Current Trades: Let's Talk About The Pros and Cons of Arbitrage Strategies

But, while we're waiting for rates to go down, there is another interesting strategy that is also rather cyclic, and that is merger arbitrage. Say what? We spent a couple of decades trading professionally in the arbitrage space so this is a strategy close to the heart.

Merger Arbitrage

Merger arbitrage is a trading strategy in which you seek to profit from a difference between:

1) the price agreed upon between the parties for a takeover deal, and

2) the price at which the deal is trading in the market.

Say company A is going to buy company B at an arranged price. For example, company A might purchase target company B and, by way of compensation, provide company B shareholders with a certain number of shares of company A.

Simplified Arbitrage Graphic

If B trades in the marketplace for less than the correct price, you can buy A, sell short B (at the right ratio or deal arrangement), and capture the difference between the agreed-upon price and the actual price in the market. The existence of the difference in price between theoretical and actual is largely attributed to "deal risk" which is the risk that the deal breaks. It is also the compensation that arbitrageurs demand to go ahead with the trade.

In addition to the spread, one can capture if successfully trading this strategy, it also provides a lower volatility return than the stock market and has a very low correlation to stock market moves.

Now the kicker - high rates

When one can buy a treasury or GIC at, say, 5%, why would anyone take the risk of getting involved in arbitrage that pays 5%? No one would be interested. However, if the arbitrageur is paid the deal spread and ALSO receives some o that 5% GIC payout on top of the deal risk, things get interesting. In the end, arbitrageurs capture the deal spread and also have the risk-free rate passed through to them. Great trade! By the same token, as rates go back down, that extra that is passed on will also deflate.

Risks

Ok, there are risks and complexities that don't suit everyone. Deals can break up sometimes. This strategy needs to be diversified across many different opportunities to keep the risk for each position manageable. However, there are some very smart fund managers that know this business well and have impressive track records. Interested in options? Get in touch.

With that, we'll wind up with this week's Global Insight Weekly. Enjoy.

By Portfolio Advisory Group

In this week's issue :?

• Hope for the best, but prepare for the … best? The Fed’s recent projections suggest rates have neared cruising altitude and remain on a flightpath toward an economic soft landing. However, the flight may not be without a little turbulence. We explain what Fed’s actions may mean for investors.
• Regional developments: U.S. inflation slows, but price stability doubts remain; U.S. stocks grapple with Fed policy, economic data; Canada’s slowing economy is showing up in credit spreads; Inflation tips the balance as the Bank of England opts to pause rate hikes; Is weak investor sentiment on China and Hong Kong justified?

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