Do you need an emergency fund? Reflexions on what to do in a high inflation, low interest environment

Tyler and Claire require $85,000 to renovate their house but started saving late and now want some advice.  So the Globe and Mail enlisted the services of TD Waterhouse investment advisor, Eric Davis.  The first thing, he says, is to establish an emergency fund:

Before they begin their renovations, though, Tyler and Claire should build up an emergency fund of anywhere from $15,000 to $30,000, which could be held in a tax-free savings account, he adds.

The standard wisdom today coming from financial advisors is that everybody needs to have an emergency fund.  Usually this consists of up to as much two-years worth of living expenses to tide one over in case of illness, unexpected expenses such as car or home repairs, or loss of a job.  All is good.  Save for rainy day?  Seems like pretty sound advice, right?

But in my mind, it isn’t sound advice in all circumstances.  Why?  Because the spread between the savings interest rates and mortgage rates is usually about 3-5 %.  So you can get 1% interest in your savings account; but you pay 4% on your mortgage.  Why not make an extraordinary payment on the mortgage, and save 3% in the meantime?  The problem is one of liquidity.  The money one uses to pay down a house is illiquid and you can’t access it in an emergency.  So that is why I recommend instead to get a line of credit, preferably a home equity line of credit (HELOC) because they have the lowest interest rate.  As you pay down the house, the bank will increase the HELOC.  Now use the HELOC only for emergencies and any excess cash can pay down the mortgage, saving you 3% interest in the meantime.  Interest earned is taxable, except of course in the TFSA (Canadian Tax Free Savings Account).  The government gets its cut.  Interest saved is not taxable.  So the home owner makes a double win.

I think it is necessary to be extremely wary of the advice from financial advisors because they don’t work for you.  Do you ever wonder why your advisor will make a trip to your house and spend a couple hours working out a financial plan?  Who pays them?  Our broker from Scotia McLeod did that; and Scotia McLeod earned full standard commissions from us: that means 2% or an $80 minimum per transaction.  One time he wanted me to put a stop loss on RSI.un (Rogers Sugar) saying that I’d made some nice gains, I should try to lock them in.  Well I didn’t want to do it because Rogers was paying a tidy dividend every month.  He insisted and finally talked me into it.  When all was said and done, the stop loss evacuated the stock at a $30 dollar after-commission loss to me, my broker got is his fat fee for selling it, and I lost a source of income.  I wanted the long term position for the dividend, but the financial industry made money churning my position.  Today, RSI has continued to pay (now monthly) and it is trading at 25% higher than my stop loss.  I would have won if I held it for the last six years which was my intention.  But the industry doesn’t make any money when you hold, only when you churn.  This incident is one of the reasons that I become a DIY investor.

Eric Davis would probably offer the couple a TFSA account at an anaemic rate of interest at TD Bank. Such a savings account will help the bank, for banks crave savings accounts, needing of capital these days.  But the inflation rate is greater than the interest rate by at least 2 basis points, and so now Tyler and Claire will lose 2% buying power on every dollar in their TFSA; if hyperinflation hits, and in my mind that is certain, then they could lose double digits or higher–food prices are going up like crazy, I know, I do most of the shopping in my family.  But TD Bank wins.  They will use Tyler’s and Claire’s capital earn  money by lending it to someone else at at 4-5%.  They don’t have to worry about inflation because it is not their principal.  The principal belongs to Tyler and Claire!

I think that its better to pay down the mortgage and make your bank hold your available credit in reserve.  Make them hold the money for you rather than the other way around.  If you need it, you’ll pay a little more than the mortgage rate (my HELOC is at 3% compared to my variable rate mortage at 2.1%), but in the meantime, it has reduced your debt, saving you money.

The long and short of it: 2010 DIY summary

Our DIY investment portfolio has had a strong performance this year.  It is very difficult to determine actual performance because of contributions of new principle, but suffice it to say that our personal wealth experienced a 25% increase since January 1, 2010.  Considering that the TSX was up 14.4% this year, I shall now claim that I beat the index in 2010, and so far since becoming a DIY investor (Nov 2005) that has been the case: the TSX is up 15.8% over the last 5 years, while we are standing at 76% unrealized gain in our current positions (plus considerable dividends and realized gains over that same period). Our net worth has nearly doubled since June 2008 (before the meltdown) and our current rate of monthly increase is at 5.5 times what it was before I became a DIY investor in 2005.  I’ve discussed on these pages the strategies that I’ve employed (see category “investment tips”).  But to summarize below:

Long:  Gold, silver, oil & gas, sugar, loonie, Canada

Short: US dollar

Best moves:  Held Midway Energy (mel), up 48%; held New Gold (ngd), up 255%.  Added Crocotta Energy (CTA), up 53%. Used leverage in US margin account to buy Canadian high yield stocks (pwe, pgh, erf, pvx, avf.un) and traded favorably in and out of these positions.  Received approval to trade options and used them to great advantage–in particular, I greatly benefited from the sale of put options on Canadian oil and gas and gold mining companies (esp. the following–Canada exchange: cpg, dgc, gg, abx, pbn, pbg, day; US exchange: gg, abx, pwe, pgh, erf and ngd).  Increased non-margin credit facility by 230%: these consist of a loan from a relative (10%), two HELOCs (80%) and a unsecured line of credit (10%).  NB: Most of this credit facility is unused and left in reserve to cover put options–this allows me to safely sell more put options and not have to worry if there is a decline in excess margin credit in the portfolio.

Worst moves: Added more Perpetual Energy (pmt), new positions down 28% (overall position is down 35.6% not counting dividends); held Prospex (psx) which went to as high as $2.52, ended year at $1.31. Natural gas: bought Terra Energy (TT–up 0%), added more pmt, psx, Pace (pce).  Sold a covered call on Detour Gold and became more bullish afterward–this resulted in a $4.49 loss to buy back the call.  Failed to pay all taxes on income trust distributions in 2009 because an unintentional oversight by myself and by my accountant–I will seek a new accountant, and I’ve decided to include an income summary with all the paper work that I provide my accountant in the future: the CRA fined me 20% (over $1000–it was nearly $3700 total notice of reassessment) because of a similar oversight in my 2008 return.  The worst part of this whole episode is the fear of being on the radar of the taxman for the next few years.

Is this a recommendation to become a DIY investor?  I don’t know but it is an apologetic, since most financial writers in the official media say that retail investors do poorly and that they can’t beat the index.  After five years of experience and after not merely surviving but thriving in a period that included one of the worst bear markets in history (September, 2008-March, 2009), I have a growing confidence that I can consistently beat the index and make better money at this than at a day job.  While I won’t give a blanket recommendation to everyone to become an DIY investor, Adam Hamilton does recommend that everyone become a trader (see Monty Pelerin).

Deflation or hyperinflation, an investment for both at the same time

During the market crash that began in June 2008 and ended in March of 2009, the TSX lost 50% of its peak value; the US indexes (cf. S&P 500; NASDAQ) experienced similar losses.  Other asset classes such as gold and the loonie suffered similar  losses against the mighty US dollar, as investors took a flight to “safety”.  Arguably this was a period of deflation, when most asset classes plummeted in value while the US dollar itself benefited.  It was also deflation caused by a shrinkage of credit, the sub-prime mortgage meltdown, which had the effect of reducing the quantity of money.

Since the beginning of this deflationary crisis, the US Federal Reserve has taken measures to reflate the US dollar through quantitative easing–which is the creation of new fiat currency.  Yesterday, Bernanke’s Federal Reserve promised to create another 600 billion greenbacks out of thin air, a spelling out of a promise that occurred already a couple weeks ago, causing the dollar to dive against gold, oil and foreign currencies.  This is probably only the beginning of the woes.  Some writers, such as Gonzalo Lira (see e.g., “How The Fed Gave Away $1.5 Trillion Through Stealth Monetization“), are predicting serious hyperinflation beginning in the first quarter of the new year.

Yet surprisingly, there remains a large number experts who believe that our biggest fear today is still deflation.  David Rosenberg issued another warning which appeared at the Business Insider on November 1:  “All This Talk Of Inflation Is Madness, DEFLATION Is Still The Big Threat“.

Clearly the investor needs a flexible strategy that hedges against inflation and deflation at the same time.  I personally believe that inflation is the way its going to go down; it is possible to create too much money and the Federal Reserve in its fear of another Great Depression is creating money to prevent it.  In my view, it does nothing helpful except to reduce debt by debasing the dollar.  All my life inflation has been the major threat and I’ve seen the dollar lose buying power consistently through the decades.  So I don’t really believe in deflation, particularly when Bernake has the creation of inflation as his goal.  He has no power to improve the economy, but he can destroy the dollar.

Yet because of Rosenberg’s (et al.) warning, I think it prudent to have a plan for deflation.  But how does an investor have a working strategy to beat inflation and deflation at the same time?  I’m not leaving my money in cash–that’s what you do when you believe that deflation is the only credible threat.  If you believe that inflation is the only credible threat, then you put everything into concrete assets like oil companies or real estate.  Debt is a marvelous asset class–provided that the debt is invested in a rental real estate (a mortgage) or dividend bearing stocks so that the interest can be paid.  So in fighting inflation I’m doing the following:


1. I maintain mortgage debt on a rental property.

2.  I maintain a stock portfolio which is 100% invested in Canadian oil and gas or gold-mining companies.

3. I maintain a positive Canadian cash balance and negative US dollar balance in my margin accounts.  As a Canadian investor, my total margin is calculated as a composite of the Canadian and US accounts.  I may hold Canadian equities in my US account.

4. I occasionally move assets from US dollar account into Canadian funds.


In order to protect against deflation:

1.  I maintain ample margins in my margin accounts.

2. I have my lines of credit which protect against a margin call.  In case of a Rosenberg-predicted double dip, I have to have something to fall back on, and that’s where the HELOCs come in (both on the rental property and on the primary residence).  Yesterday, I was able to obtain 30% increase in these lines.

3. I will take profits on gains and increase cash positions as market improves (in loonies not greenbacks).

4. In case of market depression, I will use the unused lines of credit to average down on equities.

In many cases, after the 2008 crash, I was able to pick up stocks at well below shareholder’s equity.  For example, I was picking up shares of Midway Energy, which had a book value of $3.40, as low as $0.39, which is an astounding .115 price to book ratio.  In market downturns, the stocks will be oversold, and bargains will be available.  Thus, at least half of the lines of credit must be reserved for purpose of averaging down during a market crash.  The other half, of course, is reserved to meet a margin call.  No debt or obligation (such as a possible assignment on put option) is covered by the margin alone but by cash or an outside line of credit as well.

This is an unconventional strategy.  But these are not conventional times.  Most of the investment strategies that I’ve seen continue to call for a balanced portfolio–balanced between stocks and fixed income investments (bonds, savings accounts, treasury notes, gics, etc.).  Those who were burned by stocks twice in less than a decade are now being told to ease back into “risky” assets because of the fear of inflation (see for example, Rob Carrick).  But I worry that most financial columnists and advisers are not taking the risk of hyperinflation seriously enough, and their readers or clients will be burnt as a result.

Please see my financial disclaimer.

All This Talk Of Inflation Is Madness, DEFLATION Is Still The Big Threat 

Read more:

Aggresivity or Gold: what is needed in the current investment climate

These are difficult times for investors. They are wonderful times for speculators. Speculators will make (and lose) a lot of money over the next couple of years. In my opinion, investors are likely to lose. Prudent investors might better avoid financial assets for awhile. Traditional wisdom is apt not to apply to what is coming.  Monty Pelerin, “Speculators Only”

There is the saying, “Those who remain calm while others panic, don’t know what the hell is going on.” It is a troubled time and I genuinely feel bad for what central banks are doing to people’s savings. But as Pelerin says, speculators will make and lose a lot of money. The biggest winners today are those upon whom Bernanke shines his favor, such as the big banks that borrow money from the Fed and lend it back to the US federal government, which is perhaps the biggest Sopranos-type racket going: but it’s not some kind of under the table payoffs, but it’s being done right in front of all of us and with impunity.

The 2008 market crash has been particularly devastating on people’s savings. They were forced by inflation to buy so-called “risky” instruments, esp. stocks. Then that bubble burst twice in less than a decade. Stung by this double whammy to their savings, many are still too scared to bet on the market again, and so Bernanke, and the other sovereign banks around the world are robbing them blind through their loose monetary policies; the euphemism for excess money creation is “Quantitative Easing”–it used to be called just simply “inflation”.

Loose money is also created by low interest rates.  In Canada, for example, there has been something like a 20% increase in the cost of houses since the summer of 2008, due to the Bank of Canada keeping the rates at ridiculously low rates. So you can’t sit on cash–because the riskiest investment in an inflationary environment is cash in a savings account that pays 1%. Here in Canada since the nadir of the stock market crash, such cash has lost about 19% against real estate and much more against stocks and gold.  Commodity prices on world markets are rising rapidly too.  Or rather, fiat currencies are losing their symbolic value quickly.  A interest bearing GIC, savings account or bond is recipe for a portfolio with a rapidly declining buying power.

I’ve devised an aggressive and flexible investment style to beat the coming inflation, if possible.  The stock portfolio I manage is now almost all commodities (oil and gas, gold mining), 100% Canadian-based (as I live in Canada), and I am shorting the US dollar to buy these companies. I am selling cash or margin covered puts on oil and gas, gold-mining companies (etc.) for income (which gives from 5-10% downside protection) and, because I can’t trust my margin to stay high in market downturn, I am accumulating unused lines of credit (notably my HELOC) as my hedge against deflation,with the view of seizing the day if there is a market crash. I believe the investor must be aggressive and engaged–you can’t have a “lazy” portfolio today (John Mauldin said the same in his most recent interview with Steve Forbes). The goal must be to beat inflation, and the higher that goes, the more aggresivity is necessary. Or if I had to sit out as you suggest, then I would put most of my funds into silver, gold, non-perishable foods, or other commodities–things with durative and intrinsic value (gold and silver are liquid and so are excellent choices, but you have to have a safe place to put it).

Most people’s best hedge against inflation is still their mortgage, as Bernanke’s devaluation of the dollar will also reduce everyone’s debts. It’s the Year of Jubilee, when everyone’s debts will be canceled, especially the Federal government’s. Or as Dickens says, “It was the best of times, it was the worst of times … ”

This post is a revised comment that was featured today at Monty Pelerin’s blog, “One man’s approach to investing in dangerous times“.  Thanks Monty!!

Please read my financial disclaimer, if you haven’t already.

Dennis Gartman’s Eighth Rule of Trading: a commentary

Dennis Gartman’s eighth rule of trading:  “Markets can remain illogical far longer than you or I can remain solvent” (quote attributed to J. M. Keynes)

This depends on the definition of the term “solvency”.  As a function of the solvency ratio, one must be pulling a profit at all times.  However, I assume that Gartman probably means something like this:

The financial ability to pay debts when they become due. The solvency of a company tells an investor whether a company can pay its debts.

The way Dennis Gartman-type trader would become insolvent is through a margin call that could not be met.  But Gartman says never to meet a margin call but rather liquidate positions.  But what if selling assets is insufficient?  The margin account could end up in a negative position and the trader becomes insolvent.  Gartman’s advice is good as far is it goes.  If a trader bets on a position using margin and leverage, he has to know when to leave the position before becoming insolvent.  Say you’ve shorted Berkshire Hathaway because you know that “idiot” is running that company to the ground:  when the irrational market keeps bidding that stupid company to the sky, you better get the heck out of that position before it bankrupts you.  That’s excellent advice.

But wouldn’t it be better to use leverage in a way that leadeth not unto insolvency?  So here is my alternate rule:

Thou shalt not use leverage unto insolvency

Lehman Brothers and Bear Stearns are the negative parables of times–investment banks so highly leveraged that they couldn’t withstand a downturn in the economy.  They had established debt-to-equity ratios of 30 or more to one.  A company or individual that keeps the debt to equity ratio at a more manageable level will not likely go bankrupt except during an Armageddon of deflationary meltdown, if the country loses a war on its own soil, or if communists come to power and seize all wealth.  Warren Stephens, in a Forbes interview, said that his investment bank only leveraged at 2-1, because he learned that one of the most important goals of business is to be in business tomorrow.  I am personally only comfortable with a debt-to-equity ratio of 1 or less.  Moreover, it is not a good idea to depend on available margin alone, unless that margin is extremely ample.  When the stock market crashes, margin credit also plummets.  Therefore, it is good to have a line of credit (e.g., HELOC) to fall back on.  Indeed, for the selling of puts covered by the margin, I immediately subtract the cost of assignment from the available line of credit, while reserving at least half of the line of credit for averaging down.  So it is ok in my opinion to use leverage; it just must be managed in a conservative manner.