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.

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A HELOC Strategy: How to use a home equity line of credit to create investment income

Jonathan Chevreau of the National Post is one of the best financial columnists in Canada and I admire him because of the practical information that he provides to Canadians wanting to know how to invest their retirements savings.  He now has a column about HELOCs — home equity lines of credit:  Be wary of home-equity lines of credit.  Chevreau writes:

Veteran mortgage broker Michael Maguire has seen too many clients with balances at or close to the limit. Lenders portray HELOCs as assets, but they are debt products, making them potentially dangerous for those not disciplined in handling money. “Most seem to find it too easy to borrow and end up living at their limit,” says Mr. Maguire, of London, Ont.-based Mortgage Wise Financial.

I agree.  One should never use a HELOC to create consumer debt or bad debt (see my post, “Is debt sin?“).  But it is an excellent product for the small business owner.  I know a local businessman  in my neighborhood who bought the commercial unit in which he has his store with a HELOC.  He has a low interest rate (it was prime) and he can pay it off or draw from it depending on the cash flow of his business.  It is has been an extremely useful debt product for his business.

When the credit crisis hit in earnest in the Fall of 2008, we opened up a line of credit, and it has been a major boost to our investments.  I was able to pick up some serious value on the TSX in stocks whose distributions were many percentage points above the interest rate.  This helped me to formulate a strategy for investing.  As a conservative investor, I try to keep my line of credit low, at no more than about one-fifth of the credit limit so that  if the market goes down, there is still sufficient credit to “average down” by picking up larger positions of the same stocks as the prices plummet during a bear market.  Thanks to the HELOC, I’ve now been able to establish a steady income based on these distribution paying stocks (mostly in the Canadian oil and gas sector).

There are some serious risks:  (1) Most of these distribution paying stocks began to lower their payouts almost the moment I started using the HELOC because of the drop in commodity prices.  But then their share prices plummeted too as direct result.  Consequently, I was able to pick up even more shares at unbelievably low prices and to keep the income well above the interest payments.   (2) The interest rates could climb.  But from the time I started this strategy until today, interest rates have gone down and stayed at historical lows.  In anticipation of interest rate hikes, I regularly pay down the line of credit as fast as possible.  When it’s at zero for a while, then my risk appetite increases again.  (3) The share prices of my stocks could plummet.  But by using only a fraction of the HELOC, I pick up more positions as the market goes down.  So when the prices went down it actually helped me even though it created initial unrealized losses.   Eventually, from March 2009 until today, we’ve been in a relentless bull market–so that with a couple of exceptions, everything has gone up, up, up.  (4) Since your home is the collateral for this debt product, one has to be restrained in using it for fear of becoming homeless as result of bankruptcy.  This is another reason for using only a fraction of the credit limit.  (5) My stock portfolio is not diversified.  It is therefore highly susceptible to the volatility in the commodities market.  This choice is made because some Canadian equities in the oil and gas sector pay well, especially in the income trust sector.  Many of these will convert to dividend paying stocks in January 2011 because of rule changes and this may result in a lower yield.

Since this strategy aims at establishing an income, I’ve only done a very minimal amount of trading (i.e., “buy low, sell high”).  It is therefore a strategy of investing which is much closer to what is called “value investing” than “day trading”.  Here is a list of companies that I’ve established long positions:  erf.un, cpg, nae.un, pmt.un, day.un, bnp.un.  Those which are weighted heavily in natural gas have done less well than those which concentrate on oil.  But fortunately, the gas-weighted companies like pmt.un and erf.un have hedges that have made it possible for them to maintain their distributions at a high rate in proportion to their share price.

If there is a lesson in this for those who aspire to be righteous investors, it is to first establish equity:  the bank will not lend at the lowest interests rate without the security of some form of collateral, which usually means home equity.  This means for many years making the sacrifice of not spending money on every whim in order to pay down the house mortgage as soon as possible.

Here are some numbers to give an example of how the above strategy can work:

Using a HELOC, $31,200 spent on CPG (TSX) would buy 800 shares $39.00 per share.  The interest in the first month at 3.25% (current TD Canada Trust HELOC rate) would be $84.50; the dividend from 800 shares of CPG at .23 per share is $184:  Thus, the net in the first month is $99.50 or .32 % of the total capital put at risk.