Financial Bubble Still Here with Yet More to Unravel?

Is there such a thing as a secular financial bubble? Has the financial sector become bloated out of proportion to the economy over the last few decades and is there be a contraction in store, abrupt or prolonged, back to a smaller financial sector? Was the crisis of 2008 merely the start?

I'm not sure of the answer but a couple of data points have stuck in my mind recently:

1) Below is a copy of two charts from the paper Fundamental Indexation by Rob Arnott, Jason Hsu and Philip Moore. Note how the Financial sector, both on a cap-weighted market value basis, the upper chart, termed the Reference Portfolio and on a fundamental accounting basis, the lower chart, has expanded steadily since the 1970s and now has become the dominant sector of the US equity market. By comparison, the Tech bubble was a fleeting aberration, now absent from the trends. In the same charts, updated to June 2007, found in their book The Fundamental Index, there was only a slight pullback in the share of the Financial sector in the Fundamental chart while the market value chart looked the same. Unfortunately, there are no numbers visible so it is hard to compare with today's data and I wish and hope that the folks at Research Affiliates where messrs Arnott et al work will do updates.


2) Financials have bounced back from 11.6% of US total market cap at the end of February 2009 to 16% in 2010, according to the proportions of holdings in Vanguard's Total Stock Market ETF VTI.

3) In Canada, one could almost say that the equity market consists of Financials and a few other bits and pieces - by market cap, Financials occupy 31% of the iShares TSX Composite ETF (XIC), while the Canadian RAFI Fundamental Index ETF of Claymore (CRQ), which contains 65 of the largest companies measured by a combination of sales, cash flow, dividends and book equity, has no less than a 47.4% weight in Financials. The folks who make the RAFI indices describe them as representing the companies' economic footprint. Is that really what the Canadian economy now consists of, and is it normal or healthy such that a change may happen sooner or later? The comparable market cap ETF to CRQ is iShares TSX 60 (XIU). Interestingly, it shows the market under-weighting Financials, especially insurance companies like Manulife and Sunlife, by some 13.4% (i.e. Financials are 34% of XIU) compared to CRQ.

4) The UK's FTSE All Share Index still has about 21% of its market cap weight in Financials as of the end of February 2010, judging by the db x-trackers ETF that tracks this index. Again, it is the single largest sector, though just barely ahead of oil and gas.

Tax Filing and Foreign Income Form T1135 - Save Some Trees and Your Time

Tax filing tip of the day ...
The Canada Revenue Agency is keen to track down potential tax cheats who hide their millions and billions away in foreign tax havens. So they oblige everyone to declare their foreign holdings over $100,000 by filling in form T1135 "Foreign Income Verification Statement" to submit with their tax return. Unfortunately, in the course of testing online tax prep packages I have noticed that the packages are not always clear about a couple of common situations where taxpayers do NOT need to fill in T1135:
1) if those holdings happen to be within a registered account, such as an RRSP, RESP, RRIF, TFSA, LIRA, LRIF, RPP etc; or
2) foreign investments held in Canadian ETFs (e.g. iShares XSP, which holds the S&P 500, but is registered in Canada by iShares Canada and traded on the TSX) or Canadian mutual funds

The instructions and examples on page 2 of the T1135 (available here from the CRA with an FAQ here) make this clear. It makes sense that it would be so as the CRA already is able to collect and control taxes on such accounts.

If you do have over $100k in foreign assets, such as US shares or ETFs in a taxable account, then you must mail in the signed paper copy, even though the rest of the tax info has been NetFile'd online.

QuickTax Winner

Congratulations to Jon, the winner of the QuickTax web tax preparation contest. If you are reading this Jon, please contact me via email to claim the prize. There is a link in the right-hand column of the blog to email me.

Tax Saving Idea for Couples: the Superficial Loss Shuffle

"Superficial loss shuffle" is such an appealing name and the concept itself has the amusingly ironic quality of turning the CRA's superficial loss rules, which normally disallow tax advantages to an investor, on their head and give an advantage instead to the couple with investments in separate taxable accounts, one of which has capital gains and the other losses.

The idea is that the spouse with the losses be able to transfer them to the spouse with the gain and eliminate any tax owing. The idea and the description of how it works is here on the CCH website in Tax Planning in a Downturn in the February 2009 issue of the Financial Planning eMonthly newsletter under the pen of lawyer and accountant David Louis.

Note that the CRA prescribed rate of 3% mentioned in the article is now down to the can-never-go-lower rate (since it must be a positive whole number) of 1%.

QuickTax Online Tax Return Giveaway

Tax preparation season is in full swing with just over a month to go till the April 30th filing deadline. To help us get through with a minimum of fuss and bother and maybe to promote their product, tax software heavyweight QuickTax has provided me with an access code to give away to readers for use of any of its online versions (cannot be used for the download version to install on your own PC). That's a value of up to $39.99.

Enter by leaving a comment on this post by midnight eastern time Friday March 26th. Use a unique name (not as anonymous) so I can do a random draw from the entries. I will post the winner's name for him/her to contact me via email so I can send the code. The winner's email will not be used for any other purpose.

Disclosure: QuickTax has given me another access code for my own use. I am busily using it to test all the NetFile certified online tax prep software out there to find out which is the best as I did last year for the 2008 tax year. Look for the results soon.

Understanding Wall Street Book Draw Winner - AC!

Congratulations to blog reader AC, winner of the draw for the book Understanding Wall Street, which I reviewed last week.

AC, please contact me via the email link in the right margin column with your postal address so I can send you the book.

Inflation at 4% to be the New Normal?

Cynics might say it is a conspiracy to prepare the ground for higher inflation to be accepted by central banks. Realists will observe and weigh the probability that it will happen and think how to protect themselves or profit from the eventuality. Whatever one's attitude it is worth noting recent comments and facts on the subject.

Chief economist at the International Monetary Fund Olivier Blanchard published a paper in February advocating a higher inflation target of 4%, which idea influential US economist Paul Krugman praised in the NY Times, citing other economists who have proposed the same. A UK news article in the Independent then discusses the idea, saying the old targets of 2% may have been fine in the past but not for the future.

Meanwhile, the most recent actual UK inflation rate was 3.5% and the National Posts reports that the World Bank forecasts that inflation worldwide will be 3.7% this year and that a rate of 4-5% in emerging markets is not a problem. Canada's inflation rate was only 1.9% in the latest January figures. That's nice and right in the middle of the official target range of 1 to 3%. However, it might be good to keep in mind one of Wayne Gretzky's secrets of success, the advice from his dad Walter to "skate where the puck's going, not where it's been".

Of course, not everyone agrees that 4% would be a good thing, but who listens to blogger Mike Moffatt when a Nobel Laureate like Krugman speaks? The fact that higher inflation would reduce the real value of the huge amounts of public debt taken on to recapitalize banks and to stimulate the economy conveniently enhances the acceptability of the idea to governments.

So, what are some of the investments to counter or profit from higher inflation?

• Real return bonds - the best and surest: best, because it offers an automatically-adjusted positive return over and above CPI and; surest, because it has the guarantee of the government (which admittedly is not an absolute but it is better than anyone else's). Note that in Canada, if RRBs are held in a taxable account, the government taxes all of the return, including the nominal increase to adjust for inflation. The higher the inflation and the higher the tax bracket, the more taxes to pay. That can result in a net after-tax loss relative to inflation (e.g. 4% inflation + 1.5% real return less 40% tax = 3.3% net after-tax). RRBs are most effective in a registered, tax-protected account.
  
• Equities - when inflation is higher but steady - businesses can and do adjust their prices; not so good to deal with unexpected inflation and big erratic jumps, like the 1970s. This scenario seems to be more the case now with the talk of new inflation-targeting of 4%.
  
• Gold - probably best for unexpected hyperinflation or crisis scenarios and not for steady, expected high(er) inflation like a 4% target that is maintained and adhered to

Update April 1: the Globe and Mail reports that a Bank of Canada deputy governor doesn't like the IMF idea. Good on him! If most people were to be asked, if there was any change made to the inflation target it should be downwards to 0%, in other words price stability.