Hedging Canadian Market Risks

In full disclosure, it is my intention to be contentious in my views as I am disappointed by the lack of diverging opinions. The Canadian economy is in trouble and it is likely to get far worse than better and it is unlikely that the passage of time will fix the problem. Here are some simple truths you must consider when reading consensus perspectives.

Investor and business confidence toward the economy is one of the most important drivers. Therefore, one has to recognize that Stephen Poloz and the Bank of Canada must instill that confidence when speaking, even during dire times. Equally, the street is full of sell side analysts and economists, which invariably express a glass-half-full perspective. The bottom line is that even if they knew the truth was dire, they would not dare publicly be caught saying so. Therefore, it up to us to read the macroeconomic tea leaves to assess market conditions. So let’s review some of the key considerations.

It is more than obvious that one can turn to the collapse in oil prices as the catalyst. However, the real risks may not be the price of oil itself, but a negative economic feedback loop that could force a broader economic slowdown throughout the entire economy. If the impact of oil was to be looked at in isolation, Canada would likely be able to weather the storm, but when combined with a number of concerning economic considerations, one can see the vulnerability to a contagion effect.

The first consideration is real estate. There have been many skeptics that have been sounding the alarm bells of Canada’s expensive and overheated real estate market, but none were as alarming as when the IMF raises the red flag. The IMF concluded that the real estate in the biggest Canadian cities was the second least affordable market in the world next to Hong Kong. This is particularly concerning as much of the job growth in Canada was attributed to the energy and housing markets.

House prices could in theory be sustained and a soft landing could plausibly occur, but it would rely heavily on stability in Canadian household income and confidence. What makes the situation concerning is the lack of wage inflation and the growing levels of household debt. While the Bank of Canada has suggested that the numbers have stabilized, one still must recognize that the average Canadian household carries 163% of debt to disposable income, one of the highest debt levels in the world. When the Bank of Canada looks to stimulate an economic turn, will the consumer have the confidence and the financial capacity to borrow and spend like they have in the past?

The last consideration is that there is little to no new capital investment initiatives to drive a considerable economic difference for the remainder of this decade. In my opinion, in order to be bullish Canada, it is not just predicting commodity and real estate stability, but rather recognizing where the future growth will emerge and this is where my concerns are focused.

To summarize, you have energy and resource consolidation, an overheated real estate market, a substantial debt burden on the average Canadian and almost no new sources of future growth. With that in consideration, it is hard to see how the Canadian Banks can go unscathed. So many Canadians label banks as conservative and stable securities. While they often do behave that way, one must accept the reality that banks are very highly leveraged profit machines. During periods of economic stability, they cannot help making large sums of money that they distribute generously to their shareholders through dividends. The problem is that when you have a highly leveraged balance sheet, during economic uncertainty, the leverage can dramatically work against them.

While I am not predicting an imminent decline, it is in my opinion that investors should educate themselves on option hedging strategies to manage unexpected risks. While hedging does have a cost, it comes at a benefit of reducing volatility and risk. As an example, we have an investor was to have owned 1,000 shares of CIBC for many years at an average cost of $60. With the stock trading at $95.00, the investor is concerned about the risk into the 3^rd quarter. The investor buys 10 October $84.00 puts for $1.00 or $1000.00. Over that holding period the investor will receive two $1.06 quarterly dividends or $2,120 total. Essentially the investor is using a part of their dividends to remove the risk of a violent unexpected drop and put a floor under the stock limiting the risk to about a 10% draw down . A simple step like this can give the investor the confidence to hold the stock, even in uncertain market conditions. It is up to each investor to decide how to position themselves, but ask yourself a simple question – is the dividend and further upside worth the risk of being without a hedge?