Tuesday, 23 February 2010

Is the Stock Market Over- or Under-Valued?

The giant swings of stock markets up and down sometimes are justified, sometimes not. How to tell the difference is key, since the unjustified movements eventually get corrected. Markets have a decided tendency to return to long term averages when it comes to returns and prices.

Why Should You Care? - A couple of reasons make the question of stock market valuation significant to the investor.
  1. Valuation can set more realistic expectations as to future returns. Researchers have found that periods of too-high valuation are followed by extended periods of lower returns. For example, The P/E Ratio and Stock Market Performance by economist Pu Shen of the Kansas City Federal Reserve, graphs the fact that the higher the stock market valuation according to the ratio of Prices to Earnings (P/E), the lower the returns in the following ten years, or vice versa, low valuations mean higher returns in future. N.B. A look at the graph tells us that the relationship is generally true, a tendency, with quite a bit of variation and it can take years to come about, which means we must admit caution in forecasting the future from today's situation. Yale professor Robert Shiller, published similar results in his famous book Irrational Exuberance.
  2. If stocks are under-valued it may be a good time to buy, or if over-valued, to sell or to wait for a better moment. The book Yes, You Can Time the Market! by Ben Stein and Phil DeMuth shows that it is possible to get a higher long run investment return by using various valuation indicators. The only problem may be that one may have to wait many years for an indicator to turn strongly positive. The extreme example is that an investor would have had to wait a full 17 years between 1984 and 2001 for the buy signal. During that time, the S&P 500 went up enormously. On the other side, the "don't buy" signals of the tech bubble years around 2000 would have been well-heeded.
Current Valuations
Two stock market indices of prime interest to Canadian investors are Canada's TSX Composite and the S&P 500 of the USA. Below is a sampling of recent assessments of the correct valuation of the overall level of stock prices.
  • TSX Composite - InvestorsFriend.com judged as of late December 2009 that the TSX at 11,555 was "about fairly valued" using a bottom-up assessment of P/E. He also concluded that it was priced to return about 7% per year over an expected 10 year holding period, which seems a reasonable return, though it is before inflation and taxes.
  • S&P 500 - Yes, You Can authors Stein and DeMuth figure the current real inflation-adjusted S&P 500 price gives a green buy signal but other indicators like P/E, Dividend Yield and Earnings Yield to AAA Bond Ratios are red. They do say in their book that one indicator being green while others are red still offers a buying opportunity, just not as strong. Shiller's Cyclically Adjusted P/E (CAPE) Ratio, which takes an average of the past ten years of earnings to smooth out recessions and booms, shows the beginning of February ratio to be 19.6 (see his downloadable spreadsheet, updated monthly), which is above the long term average for the S&P of about 16. That means his estimate is that the S&P is overvalued. In early December 2009, when the S&P was at 1102 (vs 1065 on February 11th), Andrew Smithers of Smithers & Company figured that it was quite over-valued according to CAPE and another metric, the q ratio, which compares the replacement value of corporations with their total stock market value.
It can pay to examine and learn from the past. George Santayana's famous words apply also to investing - "Those who cannot remember the past are condemned to repeat it."

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Tuesday, 16 February 2010

Comparing Alternatives for Where to Invest RRSP or TFSA Contributions

Making a contribution to an RRSP or to a TFSA is not the end of the story. That's the saving step. The cash must then earn a return. What are some options and current returns amongst the different possible types of investments (see previous post Investment Building Blocks - Securities for more explanation)?

Inflation surreptitiously eats away at the value of your savings whether or not it is in a tax-deferred RRSP or TFSA. You cannot avoid it. Inflation has been at the lower end of the government's target range of 1 to 3%, coming in at 1.3% in 2009, but the average for the last 15 years or so has been the middle of the range at around 1.9%. It is Bank of Canada policy that inflation be 2%. If your annual return is anything below inflation, you are losing money in real terms, perhaps slowly, but nevertheless surely.

Leaving the money sitting as cash these days gets interest of 1% or so from major banks, even in a savings account (see rates on CANNEX).

CANNEX also provides a complete table of rates on offer in registered plans. Rates again are quite low. For locked-in GICs, you can get:
  • 1-year: 0.4% from major banks, higher rates up to 2.1% from smaller institutions
  • 5-year: 2% from the majors, maxing out at 3.6% from others
Returns on bonds include the interest and possible changes in capital value due to changes in default risk and interest rate risk. The longer the maturity, the greater the risk of interest rate increases. The examples below are investment grade bonds. Lower rated bonds will give off greater yields (see previous post Seeking Safety: Assessing Default Risk). An interesting choice is real return bonds of the Canadian government - the low yield is after inflation, in other words, the bond interest and capital is automatically adjusted upwards in line with increases in CPI, so the yield is protected from the ravages of inflation. A quick way to see a good sampling of current bonds and their yields is to go to this page on CanadianFixedIncome.ca.

Sample Yields as of February 2nd

Canadian Government
  • 2-year: 1.18%
  • 5-year: 2.46%
  • 10-year: 3.38%
  • 20-year: 4.02%
  • 17-year Real Return: 1.44%
Provincial Government
  • 4-year Ontario: 2.52%
  • 8-year Quebec: 3.64%
  • 10-year BC: 3.93%
  • 5-year Royal Bank: 2.88%
  • 19-year Bell Canada: 6.22%
Bond ETFs (contain various mixes of maturities and issuers)

For all types of bonds, get an exact price and yield online through the fixed income section of the brokerage website (the price you pay will be slightly higher and the yield will be slightly less than the CanadianFixed Income figure because the brokerage makes its revenue from the difference since there is no explicit trading commission charged). For less known or popular ones like real return bonds, it may be necessary to phone and speak to representatives at the fixed income desk.

Preferred Shares
There are many individual issues with varying returns, but the dividend yield of the following give an idea of the much more attractive returns available amongst preferreds. See Prefblog for much in-depth knowledgeable discussion of particular issues.
Income Trusts
Many of the business trusts are being converted to straight corporations or being bought out but many others still remain and their distribution yield remains high (see 2009 post Income Trusts: a Neglected Opportunity?).
Though much or most of the return from equities should come from capital gains, the straight dividend yield of equities, as expressed in the general averages for major markets like Canada's TSX index and the USA's Total Market or S&P 500 remains reasonable. The chance of market declines is the ever-present risk, which investors know all too well.
The above options are meant as a starting point. They only compare current cash payouts and not the change in value of the investment, which can drastically alter the net investment results both downwards or upwards. Leave it in cash or GICS, there's no risk, just the certainty of slow losses to inflation. As the saying goes, no risk, no reward.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Tuesday, 9 February 2010

RRSP vs TFSA vs RESP vs Non-Registered Taxable Account?

This is the time of year when many people get around to making their annual contribution to an investment plan. On January 1st, another $5,000 of TFSA contribution room became available to adult taxpayers. January 1st was also the start of another year for obtaining Canada Education Savings Grants through an RESP. The RRSP deadline for 2009 contributions looms on March 1st.

Are you confused about the choices wondering which is best, or do you have limited means and need to choose whether money goes into a TFSA, RRSP, RESP, or perhaps even a non-registered taxable account? Read on for the rules of thumb on which makes most sense under what circumstances.

1) Contribute to Registered Accounts before a Non-Registered Taxable Account
  • tax-sheltered compounding growth in registered accounts is their dominant differentiating advantage. Read The Retirement Savings Debate: Inside or Outside the RRSP Structure? from Philips Hager & North in which they tested and calculated after-tax returns. The Department of Finance reached the same conclusion comparing the TFSA vs a Non-Registered Account. The TFSA, the RESP and the RRSP all take advantage of tax-free growth. The longer the saving and investing period, the more years before the funds will be used, the stronger the effect of tax-sheltering on net, total after-tax wealth for the investor.
  • no requirement to track the cost base for tax purposes in registered accounts avoids some administrative hassle and is a minor advantage

2) Non-Registered Taxable Account is Best for:
  • when registered account contributions have been maxed out
  • as PH&N note, beware of unequal comparisons where some people have claimed an advantage for the taxable account - like using borrowing to invest, which introduces substantial investment risk, not reinvesting the RRSP tax refund, which leaves out a key component of the calculation and assuming unrealistically-low tax rates on the taxable account.
3) Put the First $2500 into the RESP (assumes higher education is one of your goals)
4) TFSA is Best for (see TFSA vs RRSP - Best Retirement Vehicle? by Ed Rempel on the Million Dollar Journey blog):
  • low income earners, especially those under $40,000, and who stay there throughout their life
  • rising income, e.g. those early in their career whose incomes will rise with time or; those who expect a large inheritance that will boost their investment income; the general idea is those for whom the tax rate on withdrawal will be higher than when they contribute are best off in a TFSA
  • very high income earners of $110,000+ (but with either very low retirement savings (under $250k, including pension value, at point of retirement), or with a substantial pension savings amount i.e. over $750k in total value
  • prone to spend RRSP tax refund - to get max RRSP effect you must reinvest the refund
  • plan to use TFSA as an emergency fund - TFSA withdrawals can be replaced later, i.e. the contribution room is not lost, as is the case with RRSPs
  • spouse with low or no income - TFSA enables immediate investment income splitting with spouse, since contribution to spousal TFSA never triggers income attribution back to contributor, but an RRSP has significant such restrictions; a no-income spouse would not earn RRSP contribution room to use anyway.
  • retired but with excess income - i.e. a place to park funds for tax-free growth; this is unlike RRSPs, which must must converted to RRIFs or annuities by age 71 and which means withdrawals / paying tax on income, with no contributions allowed (see Fiscal Agents' Income-Splitting Opportunities and the Income Attribution Rules that May Prevent Them)
5) RRSP is Best for:
  • lower income and/or tax rate on withdrawal; withdrawals are usually lower during retirement, but not always
  • income earners in the $40,000 to $50,000 range and $75,000 to about $90,000 (see CD Howe Institute's Saver’s Choice: Comparing the Marginal Effective Tax Burdens on RRSPs and TFSA)s
  • high income earners, the higher the income, the greater the advantage - true partly because of the higher tax rate being avoided through the contribution along with the tax-free compounding of the amount deferred and partly due to the higher contribution limit on RRSPs ($21,000 in the 2009 taxation year), which allows you to save more
  • investment income splitting with spouse during retirement - after maxing out splitting using TFSAs
  • helping stick with regular saving and not withdrawing un-necessarily or prematurely - the idea of losing RRSP contribution room, or paying taxes on withdrawals before retirement may help avoid dipping into it for discretionary spending; conversely the attraction of the tax refund can help motivate the contribution and the saving that represents.
Handy RRSP vs TFSA Estimation Calculator at TaxTips.ca - enter your own data for your province to verify your specific situation.

6) Taking a Loan to Make the RRSP Contribution Works if,

A Useless Tactic
Contribute to RRSP then Put Refund in TFSA - this does no harm but has zero net value as Is the RRSP Refund as Contribution to TFSA Dipsy-doodle Worth It? on CanadianFinancialDIY explains.

If a choice must be made, then the above can provide a guide. If adequate money is available to fill up the best option, then obviously it is possible to go to the next best for greater savings e.g. if the TFSA or RRSP limits are used up, then go for the other, there are still big tax benefits to be had.

Disclaimer: this post is my opinion only and should not be construed as investment or tax advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a tax professional.

Tuesday, 2 February 2010

ETF Comparison: USA Total Market Equity

The United States is the world's largest equity market and it merits a place in every Canadian investor's portfolio.

The S&P500 is NOT the US Stock Market
The US stock market benchmark is usually taken to be the S&P 500 and that is basically the contents of funds available in Canada on the TSX to the Canadian investor. The S&P 500 is however, a group of large, dominant US companies and does not truly represent the whole of the US equity market - about 4500 smaller companies are missing, which comprise about 20% of the total US equity market value. Smaller company stocks (small capitalization or small cap) behave differently and often outperform those of large companies - e.g. see the Google Finance chart image below which shows US-traded ETFs for small cap (Vanguard's offering , symbol: VV), S&P 500 (symbol: SPY) and total market (symbol: VTI). As VTI's performance suggests, owning a total market fund can be a worthwhile ETF to own.

US Total Market ETFs - the Contenders

  1. Vanguard Total Stock Market Index Fund (Symbol: VTI) - the ETF that has attracted the most investor money by far, more than all other entrants combined. Has the largest number of holdings at 3420 and simply buys every company in the index in its market cap proportion, the so-called replication technique.
  2. iShares Russell 3000 Index Fund (IWV) - another well-established fund, it is the second largest and also replicates its index, which is different and smaller than VTI's.
  3. iShares Dow Jones U.S. Total Market Index Fund (IYY) - another offering by iShares, it uses a different index containing the most companies; instead of replication, it uses the sampling technique, in which they take a representative sample of companies, to track the index
  4. SPDR Dow Jones Total Market ETF (TMW) - despite being the oldest total market ETF by a few months and being offered by ETF leader State Street Global Advisors, and seemingly doing its index-tracking job well, it has not caught on to the extent of the top three funds and has attracted low net assets.
  5. Schwab U.S. Broad Market ETF (SCHB) - the baby of the class with a November 2009 launch, it has built a low but reasonable asset base, perhaps because it has the lowest expense ratio of all at a tiny 0.08%
Key Comparison Factors (click on table below for details):

Similarities abound amongst these funds:
  • passive index tracking - they all seek only to mimic the results of the overall market, not to outsmart and outperform and they thus limit trading only to times when the index changes, which in turn keeps trading commission costs down and realizes fewer capital gains that an investor would have to pay taxes on (see previous post on the Mystery of Fund Capital Gains in 2008 Explained)
  • low expense ratios - every ETF has an expense ratio of 0.2% or less, which is outstandingly good, keeping investor costs down and net results higher
  • low variation of market price from Net Asset Value (NAV) - all the ETFs have a very tight link between the price of the ETF on the market and the sum of the company shares held, which is exactly what should happen - you can be assured of buying or selling the ETF for what it is worth
  • low bid-ask spread - the difference for all these ETFs is typically a cent or so, which equates to 0.1% or less a cost to the investor (see The Bid/Ask Spread and Market Making at InvestorHome for an explanation of how this is a cost to the investor)
  • holdings concentration and by sector - their main holdings are more or less the same companies and in the same proportions by industry sector, which is no surprise since they aim to mimic the same thing; the number of holdings does vary a lot, ranging from only about 1000 in TMW to over 3400 in VTI. The sampling technique of the smaller funds to reproduce the overall index with fewer total holdings seems to work very well.
  • returns - the same to a fraction of a percent annualized, again not surprising considering their common aim
  • distribution frequency - all give out cash on a quarterly basis
  • taxes - all distributions from these US ETFs, including any capital gains, will be taxed in a Canadian investor's hands as ordinary income. The good news is that such passive index ETFs will generate almost no capital gains from their internal trading, which is the reason they are described as being extremely tax efficient (see the excellent PriceWaterhouseCoopers Understanding the Tax Implications of Exchange Traded Funds report found on the ByloSelhi website).

Management Expenses (MER) - SCHB's is lowest by a hair at a phenomenal 0.08%, over Vanguard's 0.09%. The others are very low at 0.2%

Performance - the market performance results are so similar that one cannot tell the ETFs apart over the past five years on this Yahoo Finance chart of the first four ETFs. Despite using different indexes, they seem to be very good substitutes for one another.

Which ETF is Best?
It is only by getting out the fine tooth comb that one can detect an advantage by VTI. Its five-year compound annualized total return, which includes distributions, edges out the others at 1.98% compared to 1.81% for the next best IYY. It's hard to tell for sure but the lower expense ratio is likely the reason. The comparison table highlights in green the boxes where VTI is slightly ahead of the others.

Whatever your preference, all these ETFs are very good choices in my view.

Caveats: Morningstar discusses a few considerations Canadians should take into account when investing in US-traded ETFs.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation and that past performance may not continue, costs may change and other comparative factors like taxes may alter their value to you. Do your homework before making any decisions.