Running your own money from home is great. Set up in the garden, a glass of rosé on a sunny day, reading and writing about markets, - it’s a good way to be spending time.
And even better, I don’t have to listen to the ravings of lunatic risk managers – who are worried about whether commodities will get delivered, and who want you to cut your equity exposure at the point of maximum volatility. The point, in other words, when you should be raising your stake. Risk managers are happy, almost try to persuade you to add risk at points like this, when the risk reward has deteriorated. But I didn’t intend to pen a rant about VAR and its disciples – I wanted to talk about running money at home.
The problem of course, is that there aren’t so many people around. So it’s hard to sniff out when there’s real fear in the air – something that was clear in mid-January – when I moved back to the long side. Hard to know when folks are getting complacent. Something I suspect is happening right now.
And it’s harder to keep in touch with contacts. That was something I did all the time when I was a commodities strategist. And on occasion it paid off big time. I heard about the collapse in aluminium orders from the horse’s mouth in October 2000 - around three weeks before the data came out. That set up some very profitable trades.
Now what I heard over the weekend reminded me of that time. I was chatting to a guy who runs a major global ad business. And what is interesting is not that things are slowing – but just how diverse everything is. Russia and India are going gangbusters – with Western companies, even banks, buying ads aggressively. The US of course, is weak. No surprises there. But Western Europe is doing a swallow dive.
Now that is intriguing. It’s certainly not consensus. And it’s the kind of scuttlebutt that shows up later in the data. It also supports some of the leading indicators – such as business confidence – that have been coming out much weaker than the activity data itself.
Now I like the negative call on Europe. It was Europe, much more than the US, that benefitted from easy money and the credit boom. It was Europe that saw the most aggressive house price inflation. And it was the European banks that went furthest down the rabbit hole of structured credit derivatives, convergence trades and other esoterica. They will be the ones most hamstrung in the great unravelling of the shadow banking system that is still to come.
Now, of course, the German Mittelstand and the French engineers are, and will, continue to be beacons of strength. But it is precisely because they are strong that rates have stayed too high for too long for the rest of the economy. And it is now, according to the scuttlebutt I’ve heard, that the chickens are coming home to roost.
Now I’ve thought a bit about how to trade this. And it looks to me like Dec 08 Euribor is ripe for a bid – after a vicious 120 point sell off from early February. I’m long Dec08 Euribor with one risk unit, looking to build up to a maximum of four units long if the trade is successful – in line with my standard practise for my leveraged fund.
Wednesday, 30 April 2008
Tuesday, 29 April 2008
Compounded
Many of the investment greats – Charlie Munger among them – claim to have no sense of market timing.
Now that is anathema to many active money managers. After all, if you call the timing on the two or three big turning points in a year, and you put your money where your mouth is, you can likely clear 20% – more than enough to stay in business.
So what are the big guys doing, if they’re not market timing.
The one thing they’re not doing is buying stuff that Graham & Dodd would buy. Two relatively little known facts reveal a lot about the Graham & Dodd legacy. The first is that Ben Graham destroyed most of his funds under management after the 1929 crash. Second, a large chunk of his strong performance thereafter is attributable to GEICO, which didn’t comply with his own stringent valuation requirements.
Warren Buffet himself had a lot of trouble in the textile business, even though he bought in at what looked to be staggeringly cheap valuations. Berkshire Hathaway might not exist if Buffet had no more ‘game’ than a Graham & Dodd valuation screen.
The turning point at Berkshire Hathaway may well come down to a single insight – and it was Charlie Munger’s insight; A great business at a fair price is superior to a fair business at a great price.
That doesn’t sound like the talk of a partner in the most successful value investing team in history. But as soon as Munger explains the power of compounding returns, that simple statement turns out to be one of the great investment insights.
Here’s a simplified example, and to make it really simple, let’s assume no depreciation, and an expectation that all free cash is reinvested in the business at the same rate of return. So here are two companies – one that makes 20% a year free cash, and is trading at two times par (two times price to book), the other that is making 10% a year free cash, and is trading at par. The first company is a great company at a fair price, the second a fair company at a great price.
The question Munger asks; if I buy both, and I’m sitting here in ten years’ time, what will each be worth? The fair business we assume rises from par to 2x par and reinvests its spare cash. What’s that worth in a decade? 2x1.1^10 = 5.2 times your initial stake.
With the great business – we assume it still trades at 2x par in ten years – and reinvests its 20% free cash – that’s 1.2^10 – or 6.2 times your money.
So even with something as extreme as a par price on the fair business, and even assuming that the fair business rerates, but the great business does not, even then, it’s still better to buy the great business. And if you reduce the discount of the fair business to say 1.5x par, or alternatively let the great business get re-rated some– the great business is worth about double the fair business in ten years time.
Most of Buffet & Munger’s time is spent working out whether a company can sustain high returns, and whether it can grow sufficiently to be able to reinvest at those same high rates of return. In other words, they spend their time working out whether businesses are great.
And you have to admit that the maths is pretty startling. No wonder Einstein called compound interest; ‘The eighth wonder of the world’. No wonder, also, that there are no trillion dollar commodity funds, but there is a Capital in equities. A friend told me about one of Capital’s greatest investors. He started in the 1960s. By the time he retired, the annual dividends on several of his stocks were greater than his total investments in those companies.
Now, I tend to invest thematically – I tend to believe that long running global themes can lead to a sustained change in returns in specific sectors or companies.
I think that the global infrastructure theme, and possibly the global resources theme, has several years to run. And when I say several years to run, all I mean is this; the fundamental forces in play will tend to keep returns high in infrastructure and resource businesses. As I described yesterday, it will take a long time to get capital and labour back into line.
Now, of course, I’m going to try like heck to get my timing right. But when I’m thinking about value, rather than just price, well, I bought the stocks I now own because I think the value will compound at 20% over the next five years. And if that is right, I’m happy to take a chance on their price.
I can’t say the same for banks. Can you?
Now that is anathema to many active money managers. After all, if you call the timing on the two or three big turning points in a year, and you put your money where your mouth is, you can likely clear 20% – more than enough to stay in business.
So what are the big guys doing, if they’re not market timing.
The one thing they’re not doing is buying stuff that Graham & Dodd would buy. Two relatively little known facts reveal a lot about the Graham & Dodd legacy. The first is that Ben Graham destroyed most of his funds under management after the 1929 crash. Second, a large chunk of his strong performance thereafter is attributable to GEICO, which didn’t comply with his own stringent valuation requirements.
Warren Buffet himself had a lot of trouble in the textile business, even though he bought in at what looked to be staggeringly cheap valuations. Berkshire Hathaway might not exist if Buffet had no more ‘game’ than a Graham & Dodd valuation screen.
The turning point at Berkshire Hathaway may well come down to a single insight – and it was Charlie Munger’s insight; A great business at a fair price is superior to a fair business at a great price.
That doesn’t sound like the talk of a partner in the most successful value investing team in history. But as soon as Munger explains the power of compounding returns, that simple statement turns out to be one of the great investment insights.
Here’s a simplified example, and to make it really simple, let’s assume no depreciation, and an expectation that all free cash is reinvested in the business at the same rate of return. So here are two companies – one that makes 20% a year free cash, and is trading at two times par (two times price to book), the other that is making 10% a year free cash, and is trading at par. The first company is a great company at a fair price, the second a fair company at a great price.
The question Munger asks; if I buy both, and I’m sitting here in ten years’ time, what will each be worth? The fair business we assume rises from par to 2x par and reinvests its spare cash. What’s that worth in a decade? 2x1.1^10 = 5.2 times your initial stake.
With the great business – we assume it still trades at 2x par in ten years – and reinvests its 20% free cash – that’s 1.2^10 – or 6.2 times your money.
So even with something as extreme as a par price on the fair business, and even assuming that the fair business rerates, but the great business does not, even then, it’s still better to buy the great business. And if you reduce the discount of the fair business to say 1.5x par, or alternatively let the great business get re-rated some– the great business is worth about double the fair business in ten years time.
Most of Buffet & Munger’s time is spent working out whether a company can sustain high returns, and whether it can grow sufficiently to be able to reinvest at those same high rates of return. In other words, they spend their time working out whether businesses are great.
And you have to admit that the maths is pretty startling. No wonder Einstein called compound interest; ‘The eighth wonder of the world’. No wonder, also, that there are no trillion dollar commodity funds, but there is a Capital in equities. A friend told me about one of Capital’s greatest investors. He started in the 1960s. By the time he retired, the annual dividends on several of his stocks were greater than his total investments in those companies.
Now, I tend to invest thematically – I tend to believe that long running global themes can lead to a sustained change in returns in specific sectors or companies.
I think that the global infrastructure theme, and possibly the global resources theme, has several years to run. And when I say several years to run, all I mean is this; the fundamental forces in play will tend to keep returns high in infrastructure and resource businesses. As I described yesterday, it will take a long time to get capital and labour back into line.
Now, of course, I’m going to try like heck to get my timing right. But when I’m thinking about value, rather than just price, well, I bought the stocks I now own because I think the value will compound at 20% over the next five years. And if that is right, I’m happy to take a chance on their price.
I can’t say the same for banks. Can you?
Monday, 28 April 2008
Pop Quiz
OK here’s a test of your economic knowledge; check out the chart below and don’t peek at the text beneath. The chart has a familiar ring. Fuel prices are up 177%, Wheat’s up 66%, real wages are down a fraction, and value added goods are down 9%. So the question is…..when did this happen?
That’s not what we’re seeing today. TV prices are down 18% YoY in the US, computers and broadband access are similarly falling in price. This is no money induced frenzy of escalating inflation expectations like 1967-1976. Something else is happening entirely.
I got the two historical charts out of a storming book by David Hackett Fischer called ‘The Great Wave’. And he offers an interesting explanation for the events of 1260-1320. It was all caused by a massive population boom (itself caused by rising real wages in the previous couple of generations), and only amplified by easy money. The rising population pressed against resource constraints. The fuel in chart one is firewood, and the rising population helped exacerbate deforestation. At the same time, more workers meant downward pressure on real wages, and on ‘value added’ goods with a large labour component.
I think population is the missing element in much global macro analysis today. Probably the paramount economic event in the modern era was the tearing down of the Berlin Wall in 1989. It was that event, combined with Tiananmen Square, itself fallout from an inflationary spiral, that induced the Chinese authorities to embrace profit seeking, and a greater interaction with the capitalist world. It also pushed India into substantial reforms.
In one fell swoop, that should have doubled the world’s capitalist workforce. The problem was, to start with, they couldn’t compete. And if you can’t compete in a capitalist world, you don’t exist.
The dearth of Western standard capital stock, and the high cost of capital available at the time, meant that however cheap the workforces, they could neither produce goods economically enough, nor good enough, to sell abroad. My Dad reckoned that there was only one factory in all of East Germany, a glass optics business, which could sell anything overseas at all once the wall came down. Everything else was expensive rubbish.
Russia and the Baltic states fell immediately into a deflationary spiral, followed by Latin America and to an extent China in 1994/5, then by the rest of Asia in 1997/8. All the while, the US boomed.
Only in 2003 did the BRICs see their returns rise above the cost of capital (Chart 2). At which point, you could say, the workforce in the world – the competitive workforce - doubled.
It is difficult to explain the enormity of that point. But it is critical in understanding what will happen next.
Because, if the competitive labour force doubles overnight, as it did in 2003, it likewise halves the capital to labour ratio. And that should double the returns on capital until…..there is enough capital around to bring the ratio back into line. But that is a static analysis – because if labour keep rising – due to population growth, while returns on labour rise due to productivity gains – then the returns on capital will keep rising further – until investment accelerates sufficiently to drive them down again. And that capital is not just private capital, invested in plant and machinery, it is infrastructure capital in particular, and intellectual capital as well.
Now of course, the credit crunch is a big issue, and it stemmed from a period in the 90s and early 2000s when rates stayed low, because the global factors of production; labour as well as capital, were underutilised. Now that utilisation rates are high, and the bloom is off the structured credit rose, we’ll have a sustained underperfomance of all things leveraged.
But is this as big an issue as the doubling of the world’s workforce, and the need to more than double the world’s stock of private and infrastructural capital. This is the Billion dollar judgement call. And my call is simple – the doubling of the world’s capitalist population and the massive increase in the returns on capital employed, that is the bigger issue.
That’s why I think the BRIC’s demand for infrastructure and resources will generate continued strong returns for investors, and why I think it will simultaneously crowd out consumers and financials in the West.
To that end, I’ve raised my exposure to global infrastructure stocks with purchases of Alstom (Alo FP), Parker Drilling (PKD US), Technip (TEC FP) and Veolia (Veo FP).
The answer is 1260 to 1320. Now this may seem like some snippet of arcane knowledge, of little relevance to the current world. But I think that there’s more to it than meets the eye.
Over the weekend I continued reading ‘Psychology of intelligence analysis’ by Richard Heuer. And the more I read of it, the more I think that it might be the best book on analysis ever written. So much so that if I ever take on a head of research post in the future, it’s the one book I’d buy for all my analysts to read. As it is I’ve got a research department of one, and I made myself read it before coming up with any more theories.
Heuer’s central idea is that we do analysis all wrong. We’re inclined to build a mental model, a hypothesis, about current events. But we’re very slow to recognise if another hypothesis is better. And things we look at to confirm our view, well, they might support a very different view of the world as well.
Heuer’s prescription is to do something very unnatural – to hold all competing hypotheses in your head, keep an open mind, and then use your observation, analysis and argument to render some less likely, and others, one if you’re lucky, dominant.
Heuer also distinguishes between good analysts – who have a detailed knowledge of similar circumstances – globally and historically – to draw from, and policy makers, who have much less, but who perhaps benefit from a less tenacious hold of their recent best theory.
Heur’s bête noir seems to be historical comparison. It’s poor analysis, he reckons, because it fails to point out the difference between periods – just the similarities. And a major problem with policymakers, he feels, is that they draw upon too little knowledge – they use the last incident to inform their judgements. They keep fighting the last war.
And this is where a lot of analysis of the current situation falls down, in my book. We’re not going through a repeat of the deflationary bust of the late 1920s or the late 1990s. Why? Because returns on capital are miles ahead of the cost of capital in the BRICs, and in several, but not all, of the Western world non-financial sectors. That means that growth is self reinforcing – as it creates profit, investment, and more profit. Back in 2000 the story was totally different. Just about every major region in the world was facing a cost of capital above its returns – so growth became self-defeating, feeding in, as it did, to lower profits and lower investment.
Over the weekend I continued reading ‘Psychology of intelligence analysis’ by Richard Heuer. And the more I read of it, the more I think that it might be the best book on analysis ever written. So much so that if I ever take on a head of research post in the future, it’s the one book I’d buy for all my analysts to read. As it is I’ve got a research department of one, and I made myself read it before coming up with any more theories.
Heuer’s central idea is that we do analysis all wrong. We’re inclined to build a mental model, a hypothesis, about current events. But we’re very slow to recognise if another hypothesis is better. And things we look at to confirm our view, well, they might support a very different view of the world as well.
Heuer’s prescription is to do something very unnatural – to hold all competing hypotheses in your head, keep an open mind, and then use your observation, analysis and argument to render some less likely, and others, one if you’re lucky, dominant.
Heuer also distinguishes between good analysts – who have a detailed knowledge of similar circumstances – globally and historically – to draw from, and policy makers, who have much less, but who perhaps benefit from a less tenacious hold of their recent best theory.
Heur’s bête noir seems to be historical comparison. It’s poor analysis, he reckons, because it fails to point out the difference between periods – just the similarities. And a major problem with policymakers, he feels, is that they draw upon too little knowledge – they use the last incident to inform their judgements. They keep fighting the last war.
And this is where a lot of analysis of the current situation falls down, in my book. We’re not going through a repeat of the deflationary bust of the late 1920s or the late 1990s. Why? Because returns on capital are miles ahead of the cost of capital in the BRICs, and in several, but not all, of the Western world non-financial sectors. That means that growth is self reinforcing – as it creates profit, investment, and more profit. Back in 2000 the story was totally different. Just about every major region in the world was facing a cost of capital above its returns – so growth became self-defeating, feeding in, as it did, to lower profits and lower investment.
And it’s not the 1970s either. The chart below shows what happened from 1967-1976. Everything, including wages, went up.
That’s not what we’re seeing today. TV prices are down 18% YoY in the US, computers and broadband access are similarly falling in price. This is no money induced frenzy of escalating inflation expectations like 1967-1976. Something else is happening entirely.I got the two historical charts out of a storming book by David Hackett Fischer called ‘The Great Wave’. And he offers an interesting explanation for the events of 1260-1320. It was all caused by a massive population boom (itself caused by rising real wages in the previous couple of generations), and only amplified by easy money. The rising population pressed against resource constraints. The fuel in chart one is firewood, and the rising population helped exacerbate deforestation. At the same time, more workers meant downward pressure on real wages, and on ‘value added’ goods with a large labour component.
I think population is the missing element in much global macro analysis today. Probably the paramount economic event in the modern era was the tearing down of the Berlin Wall in 1989. It was that event, combined with Tiananmen Square, itself fallout from an inflationary spiral, that induced the Chinese authorities to embrace profit seeking, and a greater interaction with the capitalist world. It also pushed India into substantial reforms.
In one fell swoop, that should have doubled the world’s capitalist workforce. The problem was, to start with, they couldn’t compete. And if you can’t compete in a capitalist world, you don’t exist.
The dearth of Western standard capital stock, and the high cost of capital available at the time, meant that however cheap the workforces, they could neither produce goods economically enough, nor good enough, to sell abroad. My Dad reckoned that there was only one factory in all of East Germany, a glass optics business, which could sell anything overseas at all once the wall came down. Everything else was expensive rubbish.
Russia and the Baltic states fell immediately into a deflationary spiral, followed by Latin America and to an extent China in 1994/5, then by the rest of Asia in 1997/8. All the while, the US boomed.
Only in 2003 did the BRICs see their returns rise above the cost of capital (Chart 2). At which point, you could say, the workforce in the world – the competitive workforce - doubled.
It is difficult to explain the enormity of that point. But it is critical in understanding what will happen next.
Because, if the competitive labour force doubles overnight, as it did in 2003, it likewise halves the capital to labour ratio. And that should double the returns on capital until…..there is enough capital around to bring the ratio back into line. But that is a static analysis – because if labour keep rising – due to population growth, while returns on labour rise due to productivity gains – then the returns on capital will keep rising further – until investment accelerates sufficiently to drive them down again. And that capital is not just private capital, invested in plant and machinery, it is infrastructure capital in particular, and intellectual capital as well.
Now of course, the credit crunch is a big issue, and it stemmed from a period in the 90s and early 2000s when rates stayed low, because the global factors of production; labour as well as capital, were underutilised. Now that utilisation rates are high, and the bloom is off the structured credit rose, we’ll have a sustained underperfomance of all things leveraged.
But is this as big an issue as the doubling of the world’s workforce, and the need to more than double the world’s stock of private and infrastructural capital. This is the Billion dollar judgement call. And my call is simple – the doubling of the world’s capitalist population and the massive increase in the returns on capital employed, that is the bigger issue.
That’s why I think the BRIC’s demand for infrastructure and resources will generate continued strong returns for investors, and why I think it will simultaneously crowd out consumers and financials in the West.
To that end, I’ve raised my exposure to global infrastructure stocks with purchases of Alstom (Alo FP), Parker Drilling (PKD US), Technip (TEC FP) and Veolia (Veo FP).
Saturday, 26 April 2008
Game Theory
I’m big on games. So much so that people get a bit freaked out about it. I told a friend I’d read a book about Mastermind – the strange logic game from the 70s, with the picture of the Swedish bloke on the box, accompanied by the first example of an Asian Babe as a status symbol. Probably the main reason it was so successful. You use logic to work out the sequence of coloured pegs that your opponent has hidden. With good play you should work it out in four of five tries. I told her the book explained how to do it in one.
It took a while before she called my bluff. Ok, there is no book.
But there is a way you can do it in one. If you’re playing against your seven year old daughter, who is wont to believe that four reds is tricky to guess – you can win by counting the remaining pegs in the box. Too few reds – bingo.
My wife wasn’t too impressed when I told her how I’d won in one. She thought I was cheating. No Asian Babes for me, then.
No doubt I’m biased. But I think games are good for you. Even video games. There's a great book – ‘Everything Bad is Good for You’ by Steven Johnson. He explains how video games give kids stimulus, teach them patience, problem solving.
Charlie Munger is no sleeping partner. He may be the straight man in the Berkeshire Hathaway double act. But he has an incredibly active mind. His view; to invest you need to bat above your ability. It’s no good having the highest IQ in the room. You’ve got to make each point count double.
To do that, he says, you need three things. Fantastic patience, iron discipline, and the willingness and ability to run 100 mental models. Models that you can throw at any business – to understand its dynamics, the sustainability of its profits, what it is worth. In ‘Poor Charlie’s Almanac’, Munger uses his mental models to reverse engineer the idea of world dominance for Coke, and it works.
So I thought I’d apply some mental models to Nintendo – my latest purchase.
First off, on video games. Video games are one of the very few opportunities kids have for being in control – every decision and strategy is their own. And that control, that stimulus, is massively positive. There was an experiment on rats in the 60s – described in Adam Smith’s ‘Powers of the Mind’. One group of rats was pampered & stroked, one group was given electric shocks, and a third group was ignored. After a time the rats in the third group started losing their immune systems and died. But the group that was being pampered – and the group that was being shocked – they were both fine, you couldn’t tell them apart. Kids are a lot like rats in that regard.
And Nintendo has nailed the older market as well. With games like brain training and sight training – the games offer older people the chance for feedback and self-improvement. Something that may otherwise be lacking.
Second; keeping it simple. When Nintendo developed the Wii it knew it would be up against the Playstation 3 and the X-box 360 – both of which are powerfully engineered, with fast and sophisticated graphics. The computer within an X-box 360 is at least as good as an entry level laptop.
But this is where you get the innovator's dilemma. In the book of the same name, Clayton Christenson describes the old floppy disk drive industry. The successful incumbents would ask their clients if they wanted smaller drives. The smaller drives were always slower and held less data. The clients never wanted them. The marketing team told the engineers not to bother. Then a new entrant would come in with a smaller drive, pick up new growth applications, then raise the storage and speed, then take over the clients for the larger drives. The incumbents were always late going smaller, and always ended up losing their business.
So Microsoft and Sony went bigger and better and hit higher price points – because the hardcore gamers said that’s what they wanted. But Nintendo went cheaper and more intuitive – and developed a whole new audience. When we got our Wii my 91 year old grandmother played a needle match of tennis against my seven year old daughter.
Third – hacking. Microsoft and Sony have spent millions making it very difficult to hack into their machines and rip off the games. Seems sensible. Nintendo’s machines you can ‘chip’ or hack quite easily – if you’re that way inclined - to get games for free. Surely Nintendo is worse off? No. Because advertising for products like this is viral. Malcolm Gladwell talks about memes in ‘The Tipping Point’. Individuals who proselytise – who infect others into buying a product. And the tech geeks who hack games are just the right group of people to spread the word. So Nintendo might lose some sales to the geeks, but it gains ten fold in sales to the rest of us.
Fourth – the edge. Once a console – the DS or the Wii – has a numerical advantage, it tends to self-reinforce its own dominance. Software houses are more likely to write for it. There are big economies of scale in advertising. And Nintendo has made sure it is best placed to do this. My daughter loves making the Miis – the self created characters you can use on the screen – for her friends when they come round - you can move them to other machines, and you can bring your controllers over to your friends’ houses so four kids can play tennis at once. The whole collaboration, software availability and advertising buzz make it hard to go for another console.
Now that Nintendo has pulled back, and now it appears to be breaking out, I’ve bought it again for the portfolio.
It took a while before she called my bluff. Ok, there is no book.
But there is a way you can do it in one. If you’re playing against your seven year old daughter, who is wont to believe that four reds is tricky to guess – you can win by counting the remaining pegs in the box. Too few reds – bingo.
My wife wasn’t too impressed when I told her how I’d won in one. She thought I was cheating. No Asian Babes for me, then.
No doubt I’m biased. But I think games are good for you. Even video games. There's a great book – ‘Everything Bad is Good for You’ by Steven Johnson. He explains how video games give kids stimulus, teach them patience, problem solving.
Charlie Munger is no sleeping partner. He may be the straight man in the Berkeshire Hathaway double act. But he has an incredibly active mind. His view; to invest you need to bat above your ability. It’s no good having the highest IQ in the room. You’ve got to make each point count double.
To do that, he says, you need three things. Fantastic patience, iron discipline, and the willingness and ability to run 100 mental models. Models that you can throw at any business – to understand its dynamics, the sustainability of its profits, what it is worth. In ‘Poor Charlie’s Almanac’, Munger uses his mental models to reverse engineer the idea of world dominance for Coke, and it works.
So I thought I’d apply some mental models to Nintendo – my latest purchase.
First off, on video games. Video games are one of the very few opportunities kids have for being in control – every decision and strategy is their own. And that control, that stimulus, is massively positive. There was an experiment on rats in the 60s – described in Adam Smith’s ‘Powers of the Mind’. One group of rats was pampered & stroked, one group was given electric shocks, and a third group was ignored. After a time the rats in the third group started losing their immune systems and died. But the group that was being pampered – and the group that was being shocked – they were both fine, you couldn’t tell them apart. Kids are a lot like rats in that regard.
And Nintendo has nailed the older market as well. With games like brain training and sight training – the games offer older people the chance for feedback and self-improvement. Something that may otherwise be lacking.
Second; keeping it simple. When Nintendo developed the Wii it knew it would be up against the Playstation 3 and the X-box 360 – both of which are powerfully engineered, with fast and sophisticated graphics. The computer within an X-box 360 is at least as good as an entry level laptop.
But this is where you get the innovator's dilemma. In the book of the same name, Clayton Christenson describes the old floppy disk drive industry. The successful incumbents would ask their clients if they wanted smaller drives. The smaller drives were always slower and held less data. The clients never wanted them. The marketing team told the engineers not to bother. Then a new entrant would come in with a smaller drive, pick up new growth applications, then raise the storage and speed, then take over the clients for the larger drives. The incumbents were always late going smaller, and always ended up losing their business.
So Microsoft and Sony went bigger and better and hit higher price points – because the hardcore gamers said that’s what they wanted. But Nintendo went cheaper and more intuitive – and developed a whole new audience. When we got our Wii my 91 year old grandmother played a needle match of tennis against my seven year old daughter.
Third – hacking. Microsoft and Sony have spent millions making it very difficult to hack into their machines and rip off the games. Seems sensible. Nintendo’s machines you can ‘chip’ or hack quite easily – if you’re that way inclined - to get games for free. Surely Nintendo is worse off? No. Because advertising for products like this is viral. Malcolm Gladwell talks about memes in ‘The Tipping Point’. Individuals who proselytise – who infect others into buying a product. And the tech geeks who hack games are just the right group of people to spread the word. So Nintendo might lose some sales to the geeks, but it gains ten fold in sales to the rest of us.
Fourth – the edge. Once a console – the DS or the Wii – has a numerical advantage, it tends to self-reinforce its own dominance. Software houses are more likely to write for it. There are big economies of scale in advertising. And Nintendo has made sure it is best placed to do this. My daughter loves making the Miis – the self created characters you can use on the screen – for her friends when they come round - you can move them to other machines, and you can bring your controllers over to your friends’ houses so four kids can play tennis at once. The whole collaboration, software availability and advertising buzz make it hard to go for another console.
Now that Nintendo has pulled back, and now it appears to be breaking out, I’ve bought it again for the portfolio.
Thursday, 24 April 2008
Alternative investment
Just as I was starting to get comfortable with my lower risk positions and my fundamental call; long resources and short banks with Eastern European exposure, well, volatility has kicked in on the resources. ENRC – the Kazakhstani chrome conglomerate was up around 18% over the last two days, and it’s down 7% today. And the price action on a number of metals has deteriorated – gold is an obvious example.
At the same time, a stock I’ve had my eye on for some time – after owning it for most of last year – is Nintendo. It was a monster for the first ten months of last year – it’s been a dog most of the time since. But the last few weeks it’s improved. And now it’s threatening to break out.
This kind of price action doesn’t quite fit my crowding out theme – when resources outperform to the exclusion of most other sectors – especially consumer stocks. So it’s time to look at how I could be wrong.
I’ve enlisted the help of a cracking book called ‘The Psychology of Intelligence Analysis’ by Richard Heur. In it he describes the cognitive biases analysts have looking at data. Heur says that our brains just ain’t wired right to look through the natural fog of uncertain and incomplete data, and the man made fog of deception and bias.
So Heur developed a number of techniques for raising the bar in intelligence analysis – and one of his key recommendations; spend as much time thinking about how you think as about the analysis at hand. Now that may sound a bit self-indulgent, after all who’s got the time? The problem is that it’s probably right.
Most people, me included, tend to go with the first analysis that they come up with that fits the facts, and then stick with it as if their lives, or at least their reputations, depended on it. And then all sorts of biases creep in – the big ones being to search out data that confirms the thesis, while downplaying data that contradicts it.
Heur says we should use aah – analyse alternative hypotheses. Constantly.
Now, there are two main hypotheses that compete with the crowding out call.
The first is the deflationary boom call. This is what Gavekal (http://www.gavekal.com/) call ‘the natural state of capitalism’ – falling commodities, rising corporate value added. Gavekal has been hoping for a spontaneous fall in commodities for over a year. They may get their wish for a while – some commodities and resource stocks are overextended, some have large speculative length. But I still see above trend demand and below trend resources supply this year. I don’t see a strong case for anything but a temporary ‘disinflationary boom’.
Second, the deflationary bust. There are lots of people who believe that the credit crunch will lead to an inexorable fall into deflation. There are some strong arguments for this call. Not least from Edward Chancellor and other disciples of Minsky. But the one I most enjoy reading is from http://www.elliotwave.com/ - they put us in a final 5th wave of the commodities boom, and already over the top of wave II ‘up’ of a supercycle 5 waves down in equities.
Now this might sound like Greek to some, but what the Elliot wave theorists argue is that we see major feedback loops between markets and society. When this kind of market action has happened before – from 1979-82, it was marked by certain traits in society; fear of terror, fear of environmental collapse, food hoarding and fear of resource scarcity. And the rise of the anti-hero in the big movies and TV series of the day.
You have to admit, the similarities are spooky. In terms of anti-heroes I’m currently torn between Daniel Day-Lewis in ‘There Will be Blood’, the guy with the weird haircut in ‘No Country for Old Men’, McNulty in ‘The Wire’, and Vic Mackey in ‘The Shield’. Check out http://museumofthe70s.blogspot.com/ for more ‘70s references. Maybe the Elliot Wave boys are onto something.
Now in terms of covering against the risk that we are approaching a serious deflation, I think my short Eastern Europe trades will work – and they would also be the canaries if things were starting to deteriorate. I will likely double them up at the expense of my resource holdings if the trade gains momentum.
If we move to sustained disinflationary boom – something I think is a very low probability event – then my fund will get into difficulty. I’ll get stopped out of my Eastern European shorts at the very least.
Right now, I still think the crowding out call is the one that best fits the facts. But I’m aware that things could get volatile in the current consolidation. So I’ve hedged some resources exposure – to protect myself from wanting to cut what are meant to be long term holdings at the lows. I’ve shorted some gold, cable and the Euro. Right now, the hedges are doing their job; they’re making money and I’ve not felt the need to cut any stocks.
I’ve enlisted the help of a cracking book called ‘The Psychology of Intelligence Analysis’ by Richard Heur. In it he describes the cognitive biases analysts have looking at data. Heur says that our brains just ain’t wired right to look through the natural fog of uncertain and incomplete data, and the man made fog of deception and bias.
So Heur developed a number of techniques for raising the bar in intelligence analysis – and one of his key recommendations; spend as much time thinking about how you think as about the analysis at hand. Now that may sound a bit self-indulgent, after all who’s got the time? The problem is that it’s probably right.
Most people, me included, tend to go with the first analysis that they come up with that fits the facts, and then stick with it as if their lives, or at least their reputations, depended on it. And then all sorts of biases creep in – the big ones being to search out data that confirms the thesis, while downplaying data that contradicts it.
Heur says we should use aah – analyse alternative hypotheses. Constantly.
Now, there are two main hypotheses that compete with the crowding out call.
The first is the deflationary boom call. This is what Gavekal (http://www.gavekal.com/) call ‘the natural state of capitalism’ – falling commodities, rising corporate value added. Gavekal has been hoping for a spontaneous fall in commodities for over a year. They may get their wish for a while – some commodities and resource stocks are overextended, some have large speculative length. But I still see above trend demand and below trend resources supply this year. I don’t see a strong case for anything but a temporary ‘disinflationary boom’.
Second, the deflationary bust. There are lots of people who believe that the credit crunch will lead to an inexorable fall into deflation. There are some strong arguments for this call. Not least from Edward Chancellor and other disciples of Minsky. But the one I most enjoy reading is from http://www.elliotwave.com/ - they put us in a final 5th wave of the commodities boom, and already over the top of wave II ‘up’ of a supercycle 5 waves down in equities.
Now this might sound like Greek to some, but what the Elliot wave theorists argue is that we see major feedback loops between markets and society. When this kind of market action has happened before – from 1979-82, it was marked by certain traits in society; fear of terror, fear of environmental collapse, food hoarding and fear of resource scarcity. And the rise of the anti-hero in the big movies and TV series of the day.
You have to admit, the similarities are spooky. In terms of anti-heroes I’m currently torn between Daniel Day-Lewis in ‘There Will be Blood’, the guy with the weird haircut in ‘No Country for Old Men’, McNulty in ‘The Wire’, and Vic Mackey in ‘The Shield’. Check out http://museumofthe70s.blogspot.com/ for more ‘70s references. Maybe the Elliot Wave boys are onto something.
Now in terms of covering against the risk that we are approaching a serious deflation, I think my short Eastern Europe trades will work – and they would also be the canaries if things were starting to deteriorate. I will likely double them up at the expense of my resource holdings if the trade gains momentum.
If we move to sustained disinflationary boom – something I think is a very low probability event – then my fund will get into difficulty. I’ll get stopped out of my Eastern European shorts at the very least.
Right now, I still think the crowding out call is the one that best fits the facts. But I’m aware that things could get volatile in the current consolidation. So I’ve hedged some resources exposure – to protect myself from wanting to cut what are meant to be long term holdings at the lows. I’ve shorted some gold, cable and the Euro. Right now, the hedges are doing their job; they’re making money and I’ve not felt the need to cut any stocks.
Wednesday, 23 April 2008
How not to do it
There aren’t many bestsellers dealing with how to lose money. I looked up ‘lose’ and ‘million’ on Amazon and got just one hit – ‘how to make millions in real estate and lose it’ by TW Weston. Published in 2002 – it looks like the American public followed the book to the letter.
Prior to that, the best commentary on how to lose money came from Humphrey B. Neill in ‘The art of contrary thinking’ – first published in 1954. In it he lists ’10 ways to lose money in Wall St.’ And they all ring true today;
1. Put your trust in board-room gossip
2. Believe everything you hear, especially tips.
3. If you don’t know, guess.
4. Follow the public.
5. Be impatient.
6. Greedily hang on for the top eighth.
7. Trade on thin margins.
8. Hold to your opinion, right or wrong.
9. Never stay out of the market.
10. Accept small profits and large losses.
Now, my own best efforts at losing money have come from either
a) getting in too early and not obeying the stop (accepting large losses), or
b) trading around too much on low conviction ideas (a combination of 3, 5, 7 and 9 above).
One of the nuggets I got out of ‘The psychology of trading’ by Brett Steenbarger was that the key to successful trading was eliminating behaviour that caused losses. For me that is the mindset that leads me to go too large on low conviction trades. That’s the behaviour I’m trying to edit out right now.
Now my high conviction view is that we’re in a world of crowding out. Larry Summers laid the groundwork in a comment a year or so back – ‘we are witnessing the strongest five year span of global growth, not just in our lifetimes, but in all of recorded economic history’ .
Clearly growth has been great. And naturally, that is putting pressure on resources. Even abundant resources, like Chinese labour, are tightening up. So much so that Chinese unit labour costs are now rising 2% per annum, rather than falling 2% as they were in 2003. That’s natural, and while not as benign as five years ago, it’s not a cause for panic.
What’s much more troubling is where this extreme global demand is running into the failings of the current system of resource allocation.
Anywhere that has an inadequate property rights and rule of law - the African and Chinese 'agricultural commons' are a clear case in point - is seeing a very weak productive performance. Any non-price determined system - power infrastructure in South Africa, global government controlled oil infrastructure, even global water provision - all have suffered gross underinvestment.
This is the heart of my 'crowding out' theme. These resource constraints raise prices and costs, and reduce real wages and aggregate profits. That's the deep reason I went cautious on Monday. This is no 1999; we're not in a free money, disinflationary rerating out of the credit debacle. We're in crowding out. Which tells me to be long the 'crowding', and short the 'out'. And to try not to get carried away with directional equity bets unless we move to extremes.
To that end I’m long resources and infrastructure stocks – all the better if, like the Brazilians, they have above average cost control. And I’m short the banks with Eastern European exposure.
So, over the past few days, I pared down my long commodity and short bond futures, and I cut out the stocks I bought to play the bounce from mid-March; Lloyds, Credit Suisse, Wal-Mart and Richemont. And I went short Erstebank, Swedbank and Alpha bank. Along with a FTSE short, that has lowered my gross and brought my net back to neutral. I’ll see if I can break the bad habit of trading around in a choppy market – and stick with lower risk and my clearly stated fundamental calls.
Prior to that, the best commentary on how to lose money came from Humphrey B. Neill in ‘The art of contrary thinking’ – first published in 1954. In it he lists ’10 ways to lose money in Wall St.’ And they all ring true today;
1. Put your trust in board-room gossip
2. Believe everything you hear, especially tips.
3. If you don’t know, guess.
4. Follow the public.
5. Be impatient.
6. Greedily hang on for the top eighth.
7. Trade on thin margins.
8. Hold to your opinion, right or wrong.
9. Never stay out of the market.
10. Accept small profits and large losses.
Now, my own best efforts at losing money have come from either
a) getting in too early and not obeying the stop (accepting large losses), or
b) trading around too much on low conviction ideas (a combination of 3, 5, 7 and 9 above).
One of the nuggets I got out of ‘The psychology of trading’ by Brett Steenbarger was that the key to successful trading was eliminating behaviour that caused losses. For me that is the mindset that leads me to go too large on low conviction trades. That’s the behaviour I’m trying to edit out right now.
Now my high conviction view is that we’re in a world of crowding out. Larry Summers laid the groundwork in a comment a year or so back – ‘we are witnessing the strongest five year span of global growth, not just in our lifetimes, but in all of recorded economic history’ .
Clearly growth has been great. And naturally, that is putting pressure on resources. Even abundant resources, like Chinese labour, are tightening up. So much so that Chinese unit labour costs are now rising 2% per annum, rather than falling 2% as they were in 2003. That’s natural, and while not as benign as five years ago, it’s not a cause for panic.
What’s much more troubling is where this extreme global demand is running into the failings of the current system of resource allocation.
Anywhere that has an inadequate property rights and rule of law - the African and Chinese 'agricultural commons' are a clear case in point - is seeing a very weak productive performance. Any non-price determined system - power infrastructure in South Africa, global government controlled oil infrastructure, even global water provision - all have suffered gross underinvestment.
This is the heart of my 'crowding out' theme. These resource constraints raise prices and costs, and reduce real wages and aggregate profits. That's the deep reason I went cautious on Monday. This is no 1999; we're not in a free money, disinflationary rerating out of the credit debacle. We're in crowding out. Which tells me to be long the 'crowding', and short the 'out'. And to try not to get carried away with directional equity bets unless we move to extremes.
To that end I’m long resources and infrastructure stocks – all the better if, like the Brazilians, they have above average cost control. And I’m short the banks with Eastern European exposure.
So, over the past few days, I pared down my long commodity and short bond futures, and I cut out the stocks I bought to play the bounce from mid-March; Lloyds, Credit Suisse, Wal-Mart and Richemont. And I went short Erstebank, Swedbank and Alpha bank. Along with a FTSE short, that has lowered my gross and brought my net back to neutral. I’ll see if I can break the bad habit of trading around in a choppy market – and stick with lower risk and my clearly stated fundamental calls.
Tuesday, 22 April 2008
Stress Bunnies
It’s a strange thing. Most people I meet are risk averse. They don’t bet much. They don’t talk about large speculations in stocks and commodities that they have on the go. And the same for the majority of market pro’s I’ve worked with. Only a select few have made large wagers with their own money.
The Zurich Axioms, by Max Gunther, is one of the best reads on speculation you can buy. His view; because most don’t have the nerve to speculate, the payoff for those that do is considerable. From some angles, the risks of active speculation are lower than sitting on a pension. And it may raise you into the realms of genuine financial freedom. His best advice; always take profit on a big score, and buy you and your wife something nice. That’s a principle I stick to religiously.
But the Zurich Axioms don’t go into what happens when the bureaucrats get their hands on the cash money. Then you have to throw away the old rules of the risk game. The quote from Keynes sums it up – for them it is better to fail conventionally than to succeed unconventionally. So the risk for these bank apparatchiks is that they are not doing what everyone else is doing. They might get left behind. They gotta keep dancing.
And it will likely be one of the last great bank lending themes that will be the source of the next set of troubles to hit global markets; the European convergence trade.
Now I don’t intend to steal the thunder from Gavekal, who have done Sterling work on the theme, and who have recently set up a fund to trade it.
But what interests me most is how relentless the pressure is going to be – from two angles. The first is the macro divergence. Germany is going from strength to strength. The German Mittelstand – the industrial hinterland – is like a chunk of China transported into the heart of Europe. It is perfectly placed to sell into the relentless infrastructure booms in the Middle East and Asia. It’s one reason I’ve held onto GEA, the Mittelstand conglomerate, through thick and thin over the last four years, and why it’s my second biggest holding now. Contrast that to the well covered troubles in Ireland and Spain, and now increasingly Italy and Greece. Then add in a central bank determined to target inflation over growth, and a series of increasingly populist and spendthrift governments and – well – you have the makings of an investment theme. It’s a theme I’ve been playing since November 2006, when I went short the Irish Banks a painful three months too early.
But what really takes the biscuit is not the diverging macro story in Europe, which was obvious a while ago. It is the mess the banks have got themselves in. Because the banks have built up a gargantuan, decade long, convergence trade. Betting on the convergence of Italian bond yields with German, Greek property yields with French, or Hungarian property prices with those to the West. And the deeper that they got in, and the more money they made, the more conventional, the more acceptable, the trade became. You had to be on it, and the banks that were full on – like Erste Bank, Swedbank and Alphabank – they scored big wins.
And they all had the most risk on – in mid-2007- just as the risk/reward was at its worst.
I have now reinstated my shorts in all three banks. Last December, when I started getting interested in shorting the Greeks, I read a great broker report on why I should buy them on account of their defensive qualities. They had no subprime, see. What they do have is massive exposure to property lending in Eastern Europe, not to mention their own shores. If you look up the biggest lenders across Eastern Europe, you’ll find a Greek bank on the hit parade for each country.
I think the mechanism for the trade is this; as the banks pull in their Eastern European property lending on account of their own capital constraints, we’ll see fewer loans made, combined with a reduced willingness and ability of borrow to buy (on account of high European rates, the slowdown, and falling property prices in Ireland, Spain and the UK). That will threaten the funding for the currencies, which, on average, have the worst current account and budget deficits, and the worst mixture of growth and inflation, of any region in the world. When the currencies weaken, particularly against the Euro and the Swiss, mortgage costs will rise, as anything from 40-70% of mortgage loans across the region are denominated in foreign currency. That will hit consumers and investors, reducing demand, reducing the ability and willingness to borrow, and impairing the willingness and ability to lend.
And you’ve got to ask who’s there to step in to bail the banks out. Will the Hungarian central bank bail out Erste’s Hungarian operations, or should it be the Austrians who step up to the plate?
To quote the Carpenters; ‘It’s only just begun’.
The Zurich Axioms, by Max Gunther, is one of the best reads on speculation you can buy. His view; because most don’t have the nerve to speculate, the payoff for those that do is considerable. From some angles, the risks of active speculation are lower than sitting on a pension. And it may raise you into the realms of genuine financial freedom. His best advice; always take profit on a big score, and buy you and your wife something nice. That’s a principle I stick to religiously.
But the Zurich Axioms don’t go into what happens when the bureaucrats get their hands on the cash money. Then you have to throw away the old rules of the risk game. The quote from Keynes sums it up – for them it is better to fail conventionally than to succeed unconventionally. So the risk for these bank apparatchiks is that they are not doing what everyone else is doing. They might get left behind. They gotta keep dancing.
And it will likely be one of the last great bank lending themes that will be the source of the next set of troubles to hit global markets; the European convergence trade.
Now I don’t intend to steal the thunder from Gavekal, who have done Sterling work on the theme, and who have recently set up a fund to trade it.
But what interests me most is how relentless the pressure is going to be – from two angles. The first is the macro divergence. Germany is going from strength to strength. The German Mittelstand – the industrial hinterland – is like a chunk of China transported into the heart of Europe. It is perfectly placed to sell into the relentless infrastructure booms in the Middle East and Asia. It’s one reason I’ve held onto GEA, the Mittelstand conglomerate, through thick and thin over the last four years, and why it’s my second biggest holding now. Contrast that to the well covered troubles in Ireland and Spain, and now increasingly Italy and Greece. Then add in a central bank determined to target inflation over growth, and a series of increasingly populist and spendthrift governments and – well – you have the makings of an investment theme. It’s a theme I’ve been playing since November 2006, when I went short the Irish Banks a painful three months too early.
But what really takes the biscuit is not the diverging macro story in Europe, which was obvious a while ago. It is the mess the banks have got themselves in. Because the banks have built up a gargantuan, decade long, convergence trade. Betting on the convergence of Italian bond yields with German, Greek property yields with French, or Hungarian property prices with those to the West. And the deeper that they got in, and the more money they made, the more conventional, the more acceptable, the trade became. You had to be on it, and the banks that were full on – like Erste Bank, Swedbank and Alphabank – they scored big wins.
And they all had the most risk on – in mid-2007- just as the risk/reward was at its worst.
I have now reinstated my shorts in all three banks. Last December, when I started getting interested in shorting the Greeks, I read a great broker report on why I should buy them on account of their defensive qualities. They had no subprime, see. What they do have is massive exposure to property lending in Eastern Europe, not to mention their own shores. If you look up the biggest lenders across Eastern Europe, you’ll find a Greek bank on the hit parade for each country.
I think the mechanism for the trade is this; as the banks pull in their Eastern European property lending on account of their own capital constraints, we’ll see fewer loans made, combined with a reduced willingness and ability of borrow to buy (on account of high European rates, the slowdown, and falling property prices in Ireland, Spain and the UK). That will threaten the funding for the currencies, which, on average, have the worst current account and budget deficits, and the worst mixture of growth and inflation, of any region in the world. When the currencies weaken, particularly against the Euro and the Swiss, mortgage costs will rise, as anything from 40-70% of mortgage loans across the region are denominated in foreign currency. That will hit consumers and investors, reducing demand, reducing the ability and willingness to borrow, and impairing the willingness and ability to lend.
And you’ve got to ask who’s there to step in to bail the banks out. Will the Hungarian central bank bail out Erste’s Hungarian operations, or should it be the Austrians who step up to the plate?
To quote the Carpenters; ‘It’s only just begun’.
Monday, 21 April 2008
R&R
I’ve been bullish the market since the mid-January capitulation lows. Back then I highlighted the depths of market sentiment and the explosion of volatility – both of which have a good track-record of reaching extremes just as the market troughs. Albeit, they can’t distinguish between lows that are temporary – say three months – and lows that are durable. I took the chance to load up again in mid-March. And I took the view that commodities, and resources/infrastructure stocks with good cost control, would lead the way.
On a more fundamental basis I’ve also highlighted the reacceleration of global reserves, the end of destocking in basic goods, and the US tax break. All were reasons to expect a decent cyclical recovery through the third quarter. Finally a piece from Morgan Stanley caught my eye – the market was pricing less growth into stocks than at any time in the last 14 years. I thought that meant that resources stocks, at the very least, could get re-rated.
So now we’ve seen 1000 points on the Dow, and some resources stocks, like Eramet, have doubled, it’s worth looking back at the indicators.
And, in short, the risk/reward has deteriorated. And as I’m a risk/reward rather than a pure momentum trader, I’m going to pull in my horns. I’m moving from around 110% net long equity back to 60% net long. And looking to shrink further if any downward move picks up steam.
So why the change? First off, the technicals. Investor sentiment has moved back to neutral. Insider buying is fading away. Volatility has fallen back to the lows of the upward channel established from July last year. And the RSI (relative strength) on the Eurostoxx has jumped to 60 – typically the high for a bear market rally – and likely decent resistance if we’re still in the bull.
Fundamentally, the global reserves issue remains unchanged – reserves have accelerated to grow at a 25% yoy lick – and that suggests I want to remain structurally positive on growth. On my trading rules, following Gartman, I don’t want to go net short equities at any point, even for a trade. And FDI into China has also reaccelerated – usually a good leading indicator of a growth boom to come. Structurally, then, commodities are going to remain the best asset – so I’m happy with the large positions I have in resources and infrastructure stocks, and in the commodities themselves.
But something fundamental has changed – and that’s my crowding out indicator. This indicator works on a simple idea – that moves in oil and bond yields trigger cycles in consumer spending and domestic profitability in the US. It’s the crowding in/crowding out principle. If oil and bond yields fall sharply, as they did in August of 2006, then that opens up space for more consumer spending and rising corporate profitability. That got me bullish stocks back then, which was a trade that worked, despite the Feb 2007 hiccup, all the way through to June the following year.
But lately, that indicator has started to flash amber. Now oil is in the hundred and teens – and particularly because it’s got there fast in recent weeks – there is good cause to think that US consumers are going to feel a sharp shock. If we combine that with the recent back-up in bond yields, as well as the well documented drought in credit availability, it suggests that the cyclical rebound story is going to suffer some headwinds. And finally, the main driver of stock ratings – inflation – remains elevated, that acts further against the chance of a sustained re-rating from here.
I thought the market was paying me to be long stocks in mid-January and mid-March, and it was paying me double to be long resources. That risk premium has now shrunken substantially. I’ve made 12.5% on the portfolio from the point I went active in mid-February, and it’s now time to hunker down and wait for some better opportunities. I’ve cut my risk by half on Friday and this morning, and I will likely cut my Walmart, and my financial shares shortly. Tomorrow I’ll talk about some short positions I am planning.
On a more fundamental basis I’ve also highlighted the reacceleration of global reserves, the end of destocking in basic goods, and the US tax break. All were reasons to expect a decent cyclical recovery through the third quarter. Finally a piece from Morgan Stanley caught my eye – the market was pricing less growth into stocks than at any time in the last 14 years. I thought that meant that resources stocks, at the very least, could get re-rated.
So now we’ve seen 1000 points on the Dow, and some resources stocks, like Eramet, have doubled, it’s worth looking back at the indicators.
And, in short, the risk/reward has deteriorated. And as I’m a risk/reward rather than a pure momentum trader, I’m going to pull in my horns. I’m moving from around 110% net long equity back to 60% net long. And looking to shrink further if any downward move picks up steam.
So why the change? First off, the technicals. Investor sentiment has moved back to neutral. Insider buying is fading away. Volatility has fallen back to the lows of the upward channel established from July last year. And the RSI (relative strength) on the Eurostoxx has jumped to 60 – typically the high for a bear market rally – and likely decent resistance if we’re still in the bull.
Fundamentally, the global reserves issue remains unchanged – reserves have accelerated to grow at a 25% yoy lick – and that suggests I want to remain structurally positive on growth. On my trading rules, following Gartman, I don’t want to go net short equities at any point, even for a trade. And FDI into China has also reaccelerated – usually a good leading indicator of a growth boom to come. Structurally, then, commodities are going to remain the best asset – so I’m happy with the large positions I have in resources and infrastructure stocks, and in the commodities themselves.
But something fundamental has changed – and that’s my crowding out indicator. This indicator works on a simple idea – that moves in oil and bond yields trigger cycles in consumer spending and domestic profitability in the US. It’s the crowding in/crowding out principle. If oil and bond yields fall sharply, as they did in August of 2006, then that opens up space for more consumer spending and rising corporate profitability. That got me bullish stocks back then, which was a trade that worked, despite the Feb 2007 hiccup, all the way through to June the following year.
But lately, that indicator has started to flash amber. Now oil is in the hundred and teens – and particularly because it’s got there fast in recent weeks – there is good cause to think that US consumers are going to feel a sharp shock. If we combine that with the recent back-up in bond yields, as well as the well documented drought in credit availability, it suggests that the cyclical rebound story is going to suffer some headwinds. And finally, the main driver of stock ratings – inflation – remains elevated, that acts further against the chance of a sustained re-rating from here.
I thought the market was paying me to be long stocks in mid-January and mid-March, and it was paying me double to be long resources. That risk premium has now shrunken substantially. I’ve made 12.5% on the portfolio from the point I went active in mid-February, and it’s now time to hunker down and wait for some better opportunities. I’ve cut my risk by half on Friday and this morning, and I will likely cut my Walmart, and my financial shares shortly. Tomorrow I’ll talk about some short positions I am planning.
Friday, 18 April 2008
The whipping post
Last night I went out with an old friend, who also happens to be one of the world’s leading authorities on stainless steel and nickel.
And what she was saying confirmed something I suspected was true across the whole commodity complex; the destocking has already happened – it happened last year.
Back in the day when I was a commodity analyst with CRU, the consultancy, I developed weighted industrial production indices for the metals – Alwip, Cuwip, Steelwip, and so on. They weighted an index according to how much of the demand for each metal came for each industrial subsector.
The advantage of these indices was that you could see immediately what was happening to stockbuilding. If aluminium demand was running ahead of the Alwip – it was a clear sign that industrialists were building inventories of aluminium and its products. What was also clear was that stockbuilding tended to run fastest in the first six months of an upturn in weighted industrial production.
What happened last year was the opposite – as industrial production slowed from mid year, and as the ISM fell from over 60 to under 50, we saw a major destocking phase. For stainless steel this meant that demand growth for the year came in at a paltry 1%, compared to the normal trend of 5% or so. No wonder nickel got whacked in H207.
Now most people out there are assuming that 2008 will be a poor year for the metals demand - as the assumed US recession has knock-on effects around the world. Most professional forecasters have another sub-trend year pencilled in for stainless and nickel. But my friend doesn’t – she reckons stainless demand is going to grow by an above trend 8% this year, as restocking kicks in. And I think she’s dead right – with the ISM due a strong rebound going through the third quarter, as the US tax breaks kick-in, I think we see a surge in demand across the metals complex.
A second key issue in nickel is the Chinese blast furnace production – a relatively new technique using low grade nickel/iron ores. This added a meaningful chunk to nickel supply from left field last year.
But this supply might get disrupted this year – due to the electricity shortages, and an environmental crackdown by the authorities ahead of the Olympics.
I’ve bought some nickel for the fund.
And what she was saying confirmed something I suspected was true across the whole commodity complex; the destocking has already happened – it happened last year.
Back in the day when I was a commodity analyst with CRU, the consultancy, I developed weighted industrial production indices for the metals – Alwip, Cuwip, Steelwip, and so on. They weighted an index according to how much of the demand for each metal came for each industrial subsector.
The advantage of these indices was that you could see immediately what was happening to stockbuilding. If aluminium demand was running ahead of the Alwip – it was a clear sign that industrialists were building inventories of aluminium and its products. What was also clear was that stockbuilding tended to run fastest in the first six months of an upturn in weighted industrial production.
What happened last year was the opposite – as industrial production slowed from mid year, and as the ISM fell from over 60 to under 50, we saw a major destocking phase. For stainless steel this meant that demand growth for the year came in at a paltry 1%, compared to the normal trend of 5% or so. No wonder nickel got whacked in H207.
Now most people out there are assuming that 2008 will be a poor year for the metals demand - as the assumed US recession has knock-on effects around the world. Most professional forecasters have another sub-trend year pencilled in for stainless and nickel. But my friend doesn’t – she reckons stainless demand is going to grow by an above trend 8% this year, as restocking kicks in. And I think she’s dead right – with the ISM due a strong rebound going through the third quarter, as the US tax breaks kick-in, I think we see a surge in demand across the metals complex.
A second key issue in nickel is the Chinese blast furnace production – a relatively new technique using low grade nickel/iron ores. This added a meaningful chunk to nickel supply from left field last year.
But this supply might get disrupted this year – due to the electricity shortages, and an environmental crackdown by the authorities ahead of the Olympics.
I’ve bought some nickel for the fund.
Thursday, 17 April 2008
Complementary
I’m always at my weakest when I’m doing well. I play this guy at tennis down on tooting common. We’re dead equal. He complemented my shots, said I’d just won seven games in a row. I proceeded to lose the next six. Or he won them.
Nicholas Taleb said that you didn’t need to ask a trader how he was doing. You just needed to look at him.
Cerratonin in the brain – it kicks in when you win. Makes you more aggressive, more attractive to women, it makes your brain more plastic. Better able to think new thoughts and come up with more trades. More likely to tell people about your trades.
That’s what I did in yesterday’s post. In Neiderhoffer’s ‘Practical Speculation’ he said he’d never had a perfect day of speculation.
I won’t claim yesterday was the exception that proved the rule. But it felt like it – after two weeks blowing my brains out long gold, euro, copper, S&P and short bonds – constantly doubling, then getting stopped out. Bad for the soul, no doubt.
I mentioned in yesterday’s post I’d had a monster day –up 3.8% at the time of writing. Once I signed off I raise my euro, gold and treasury trades – and the monster day turned into Godzilla. By the close I was 6.5% up – around 3x my best day when I was pro.
This blog is as much about process as it is about my calls.
One of my favourite books is Cat’s cradle by Kurt Vonnegut. It talks about the process a chemist followed – creating a more efficient water molecule; ice-9. So efficient it froze at 30 degrees, not zero.
One seed molecule of this, and the world froze. Men standing like pillars of salt on the side of the road.
I think sulphur is ice-9. Sulphur’s frozen. It’s made sulphuric acid freeze. It’s made fertilizer freeze. And fertilizer’s made food freeze. As an aside, it’s also stuffing the copper market – which is sitting on three days of inventory, and a strike at Codelco.
Now processes are fascinating things. I love the logic, how a process works its way out. Whenever I make a big macro play, I’m betting on a self sustaining process to work out.
But the process always destroys itself, eventually. The trick is to look for the signs. To understand how it could self destruct. That is the Soros insight I like the best. He would only go in large when he knew how the trade would go wrong.
By about half way through yesterday, I was all in. I was at the full limit of my trading risk. In the cold light, it was not a perfect trading day – I bought one unit of palladium, when I should have bought a unit of silver. And I didn’t sell my remaining gilts out of my unleveraged portfolio, even though I knew I should.
The other trades were pretty cool though. I added another unit of risk to my treasury short – taking it to 150% of the portfolio. I added a unit of gold, moving to 80% long. I doubled my copper – going to 45%. I added to my long euro, going to 60%. And I put on a 30% position long EUR/JPY. I bought some German mid-cap, taking the equity indices position to 35%, to add to the 80% long in my unlevered portfolio.
When you add that to my base equity, that takes my overall leverage to 490%, which is nosebleed territory. It’s safe to say that if my old risk manager saw this he’d either have a nosebleed, or he’d try to give me one.
But I have a very different view of risk that what he does. He didn’t want me to buy commodities for the macro fund back then, because he was worried that they would get delivered. He had no problems with buying bonds at those levels though.
I think the big risk is that we’re going into 1999, but for commodities rather than tech. Valuations on the resources stocks, and prices for the commodities themselves might go so far, with so much momentum, that no-one will be able to bring themselves to buy them. Until they have to, to stop the bleeding. And my view is that the commodity action will crowd out all other trades. Ultimately including equities. My pilot fish on that trade is Wal-Mart – when that breaks lower I’m taking off the long equity bet.
So how could my call self destruct. It comes from the process. There is an interesting connotation in the word – it is also the name of a Beelzebub cult started out of my old school in the 60’s. The process, like ice-9, only leads to trouble. The trouble for me comes when inflation expectations accelerate. Not now, but sometime.
As long as Asian currencies rise, and Middle Eastern and Asian infrastructure spending builds, I’ll try to stick with the big picture call.
My current favourite trading book is Steinberger’s ‘The psychology of trading’. What I took out of that book is that trading is a bit like learning skiing – something I did for the first time this Easter. You have to do the opposite of what comes natural – leaning down hill gives you more control. But all you want to do is to lean backwards. In trading you have to gear into your winning positions and then let them run. It doesn’t feel natural at all. But the sun’s out on the mountain, I’m fully loaded, and I’m going out to lunch. Try to quell the butterflies in my stomach.
Nicholas Taleb said that you didn’t need to ask a trader how he was doing. You just needed to look at him.
Cerratonin in the brain – it kicks in when you win. Makes you more aggressive, more attractive to women, it makes your brain more plastic. Better able to think new thoughts and come up with more trades. More likely to tell people about your trades.
That’s what I did in yesterday’s post. In Neiderhoffer’s ‘Practical Speculation’ he said he’d never had a perfect day of speculation.
I won’t claim yesterday was the exception that proved the rule. But it felt like it – after two weeks blowing my brains out long gold, euro, copper, S&P and short bonds – constantly doubling, then getting stopped out. Bad for the soul, no doubt.
I mentioned in yesterday’s post I’d had a monster day –up 3.8% at the time of writing. Once I signed off I raise my euro, gold and treasury trades – and the monster day turned into Godzilla. By the close I was 6.5% up – around 3x my best day when I was pro.
This blog is as much about process as it is about my calls.
One of my favourite books is Cat’s cradle by Kurt Vonnegut. It talks about the process a chemist followed – creating a more efficient water molecule; ice-9. So efficient it froze at 30 degrees, not zero.
One seed molecule of this, and the world froze. Men standing like pillars of salt on the side of the road.
I think sulphur is ice-9. Sulphur’s frozen. It’s made sulphuric acid freeze. It’s made fertilizer freeze. And fertilizer’s made food freeze. As an aside, it’s also stuffing the copper market – which is sitting on three days of inventory, and a strike at Codelco.
Now processes are fascinating things. I love the logic, how a process works its way out. Whenever I make a big macro play, I’m betting on a self sustaining process to work out.
But the process always destroys itself, eventually. The trick is to look for the signs. To understand how it could self destruct. That is the Soros insight I like the best. He would only go in large when he knew how the trade would go wrong.
By about half way through yesterday, I was all in. I was at the full limit of my trading risk. In the cold light, it was not a perfect trading day – I bought one unit of palladium, when I should have bought a unit of silver. And I didn’t sell my remaining gilts out of my unleveraged portfolio, even though I knew I should.
The other trades were pretty cool though. I added another unit of risk to my treasury short – taking it to 150% of the portfolio. I added a unit of gold, moving to 80% long. I doubled my copper – going to 45%. I added to my long euro, going to 60%. And I put on a 30% position long EUR/JPY. I bought some German mid-cap, taking the equity indices position to 35%, to add to the 80% long in my unlevered portfolio.
When you add that to my base equity, that takes my overall leverage to 490%, which is nosebleed territory. It’s safe to say that if my old risk manager saw this he’d either have a nosebleed, or he’d try to give me one.
But I have a very different view of risk that what he does. He didn’t want me to buy commodities for the macro fund back then, because he was worried that they would get delivered. He had no problems with buying bonds at those levels though.
I think the big risk is that we’re going into 1999, but for commodities rather than tech. Valuations on the resources stocks, and prices for the commodities themselves might go so far, with so much momentum, that no-one will be able to bring themselves to buy them. Until they have to, to stop the bleeding. And my view is that the commodity action will crowd out all other trades. Ultimately including equities. My pilot fish on that trade is Wal-Mart – when that breaks lower I’m taking off the long equity bet.
So how could my call self destruct. It comes from the process. There is an interesting connotation in the word – it is also the name of a Beelzebub cult started out of my old school in the 60’s. The process, like ice-9, only leads to trouble. The trouble for me comes when inflation expectations accelerate. Not now, but sometime.
As long as Asian currencies rise, and Middle Eastern and Asian infrastructure spending builds, I’ll try to stick with the big picture call.
My current favourite trading book is Steinberger’s ‘The psychology of trading’. What I took out of that book is that trading is a bit like learning skiing – something I did for the first time this Easter. You have to do the opposite of what comes natural – leaning down hill gives you more control. But all you want to do is to lean backwards. In trading you have to gear into your winning positions and then let them run. It doesn’t feel natural at all. But the sun’s out on the mountain, I’m fully loaded, and I’m going out to lunch. Try to quell the butterflies in my stomach.
Wednesday, 16 April 2008
Celeritas
Celeritas is the greek word for the speed of light. It is the c in e=mc². It’s also the only absolute constant. Now there’s no good reason why anyone should know this, but it’s what I’ve called my fund. The idea being I try to make absolute returns. Although perhaps not at the speed of light.
I have a basic view – there is no way anyone can know everything. Predicting the past is hard enough as it is. So running relative money – which is a series of pairs trades – strikes me as asking too much. I try to keep it simple – I try to make money, whatever happens.
So I thought I’d give a quick guided tour of my portfolio over the next couple of posts, and take a few detours to explain why I follow the rules that I do.
I’ll make no bones about it, I nicked the structure of my fund from George Soros. He set out his basic philosophy of running money in his book – The Alchemy of Finance. His real time experiment – a trading diary of his thoughts and positions around the time of the Plaza Accord - is a tour de force of macro thinking.
So I run the equity part of my fund as an unleveraged multi-asset fund – split between equities, bonds, property, credit, cash and commodities. I try not to change the asset allocation on this money more than, say, four or five times a year. But I might move money between individual equities within the portfolio a little more often.
And here I take a big picture view, and I back it. In mid Feb, when I started trading the fund actively, I moved from 60% bonds, 20% cash, 5% gold and 15% equity to 10% bonds, 5% cash, 5% gold and 80% equity.
The next asset allocation move I have planned is to sell some more bonds – for cash and equity. I’ll likely do that over the next week.
The next point is the equities. I buy individual stocks, not sectors or markets, in this part of the fund. I try to buy them on a six month plus view, to reduce trading costs. But I have a basic rule – I revisit anything that’s down 10% to decide if I want to keep it, and I cut anything down 20% from purchase.
Now the stock investments are mainly thematic. I wrote in my last post – crowded house - that the global economy was not only not in recession, but was actually inflating.
That makes me very bullish resources stocks. But you have to be careful, and buy companies with the least cost pressure. At a time when every mining input, from electricity to engineers, is inflating at 20% plus pa, finding a producer with limited cost inflation is critical.
So I’ve bought CVRD (5%) the Brazilian iron ore producer, Petrobras (5%) the Brazilian oil and biofuels company, and Cosan (5%) the Brazilian sugar and biofuels stock. Why Brazilian stocks? Because Brazil has had the highest cost of capital relative to growth of any BRIC – and that has contained inflation. It has let the real rise almost unhindered, and the companies themselves have strong cost control, and an ethic of early infrastructure investment.
Elsewhere in resources I own ENRC (5%), the Khazakstani chrome conglomerate – which has its own power and rail, and will benefit from the escalating problems in South Africa, the chrome capital of the world. I own Norilsk (5%) – the Russian palladium, platinum and nickel producer as a play on further deterioration in South African mining.
I also own Patterson, which, at 10% of the fund, is my biggest position. Patterson is the US natural gas driller, and while I can’t argue that it has amazing cost control, I can argue that natural gas is deeply undervalued, and the most obvious choice for industrialists and power companies seeking to reduce their own costs.
I have one small holding in Watermark (2%) – a smallcap industrial water recycling company that is currently underwater, and 5% in United Utilities, the UK water stock that looked to me to be better value than owning bonds a couple of months back.
One move up the value chain, I own SSAB (5%), the Norweigan steelmaker, ABB (5%) – the Swedish power plant manufacturer, GEA (5%) – the German mittelstaad conglomerate, and Ocean Rig (3%) – the Norweigan deep drilling specialist. All are trades on ongoing Middle Eastern and global infrastructure spending.
Finally I have non-thematic trades - none of which I’m married to, but all of which seemed quite attractive at the time. I bought Credit Suisse (2%), and Lloyds (3%) around the worst of the sell-off in mid-March. I bought Walmart (5%) at around the same time. I bought it as a hedge in case we saw a big oil liquidation. That’s clearly not the case now but the stock is still going up, so I’m holding. I bought Richemont (5%) as a special sit. Its holding of BAT is deeply undervalued. And I own Imperial Tobacco (5%) – a legacy position from when I got very bullish Tobacco in Q1 2004. It’s doubled since then, and I see no need to sell it. That all adds up to the 80% equity holding in this part of the fund.
The 5% gold holding is a legacy position. Back in 2003, when I first became full-on bullish on gold, I would bicycle down to Hatton Garden every payday, and use a quarter of my salary to buy Krugerands. I bought a tolya bar when I was passing through Dubai, and a couple of gold nuggets when I was in Perth. I stopped buying the physical when gold went through $400/oz. The gold fits in with my macro theme, so it stays in the portfolio.
Finally, the bonds I own are 2010 Gilts. They seemed like the best value bonds around, but that doesn’t mean that they are good value.
I’ll talk about the leveraged part of the fund tomorrow – what’s in it and how I trade it. But a sneak preview of my biggest positions (the total leveraged part can get as high as 400% of equity) – I’m 40% long copper, 40% long gold, 35% long S&P and 75% short treasuries. The overall fund is having a bit of a monster today – up 3.8%, and up 12.7% from the mid-feb start.
I have a basic view – there is no way anyone can know everything. Predicting the past is hard enough as it is. So running relative money – which is a series of pairs trades – strikes me as asking too much. I try to keep it simple – I try to make money, whatever happens.
So I thought I’d give a quick guided tour of my portfolio over the next couple of posts, and take a few detours to explain why I follow the rules that I do.
I’ll make no bones about it, I nicked the structure of my fund from George Soros. He set out his basic philosophy of running money in his book – The Alchemy of Finance. His real time experiment – a trading diary of his thoughts and positions around the time of the Plaza Accord - is a tour de force of macro thinking.
So I run the equity part of my fund as an unleveraged multi-asset fund – split between equities, bonds, property, credit, cash and commodities. I try not to change the asset allocation on this money more than, say, four or five times a year. But I might move money between individual equities within the portfolio a little more often.
And here I take a big picture view, and I back it. In mid Feb, when I started trading the fund actively, I moved from 60% bonds, 20% cash, 5% gold and 15% equity to 10% bonds, 5% cash, 5% gold and 80% equity.
The next asset allocation move I have planned is to sell some more bonds – for cash and equity. I’ll likely do that over the next week.
The next point is the equities. I buy individual stocks, not sectors or markets, in this part of the fund. I try to buy them on a six month plus view, to reduce trading costs. But I have a basic rule – I revisit anything that’s down 10% to decide if I want to keep it, and I cut anything down 20% from purchase.
Now the stock investments are mainly thematic. I wrote in my last post – crowded house - that the global economy was not only not in recession, but was actually inflating.
That makes me very bullish resources stocks. But you have to be careful, and buy companies with the least cost pressure. At a time when every mining input, from electricity to engineers, is inflating at 20% plus pa, finding a producer with limited cost inflation is critical.
So I’ve bought CVRD (5%) the Brazilian iron ore producer, Petrobras (5%) the Brazilian oil and biofuels company, and Cosan (5%) the Brazilian sugar and biofuels stock. Why Brazilian stocks? Because Brazil has had the highest cost of capital relative to growth of any BRIC – and that has contained inflation. It has let the real rise almost unhindered, and the companies themselves have strong cost control, and an ethic of early infrastructure investment.
Elsewhere in resources I own ENRC (5%), the Khazakstani chrome conglomerate – which has its own power and rail, and will benefit from the escalating problems in South Africa, the chrome capital of the world. I own Norilsk (5%) – the Russian palladium, platinum and nickel producer as a play on further deterioration in South African mining.
I also own Patterson, which, at 10% of the fund, is my biggest position. Patterson is the US natural gas driller, and while I can’t argue that it has amazing cost control, I can argue that natural gas is deeply undervalued, and the most obvious choice for industrialists and power companies seeking to reduce their own costs.
I have one small holding in Watermark (2%) – a smallcap industrial water recycling company that is currently underwater, and 5% in United Utilities, the UK water stock that looked to me to be better value than owning bonds a couple of months back.
One move up the value chain, I own SSAB (5%), the Norweigan steelmaker, ABB (5%) – the Swedish power plant manufacturer, GEA (5%) – the German mittelstaad conglomerate, and Ocean Rig (3%) – the Norweigan deep drilling specialist. All are trades on ongoing Middle Eastern and global infrastructure spending.
Finally I have non-thematic trades - none of which I’m married to, but all of which seemed quite attractive at the time. I bought Credit Suisse (2%), and Lloyds (3%) around the worst of the sell-off in mid-March. I bought Walmart (5%) at around the same time. I bought it as a hedge in case we saw a big oil liquidation. That’s clearly not the case now but the stock is still going up, so I’m holding. I bought Richemont (5%) as a special sit. Its holding of BAT is deeply undervalued. And I own Imperial Tobacco (5%) – a legacy position from when I got very bullish Tobacco in Q1 2004. It’s doubled since then, and I see no need to sell it. That all adds up to the 80% equity holding in this part of the fund.
The 5% gold holding is a legacy position. Back in 2003, when I first became full-on bullish on gold, I would bicycle down to Hatton Garden every payday, and use a quarter of my salary to buy Krugerands. I bought a tolya bar when I was passing through Dubai, and a couple of gold nuggets when I was in Perth. I stopped buying the physical when gold went through $400/oz. The gold fits in with my macro theme, so it stays in the portfolio.
Finally, the bonds I own are 2010 Gilts. They seemed like the best value bonds around, but that doesn’t mean that they are good value.
I’ll talk about the leveraged part of the fund tomorrow – what’s in it and how I trade it. But a sneak preview of my biggest positions (the total leveraged part can get as high as 400% of equity) – I’m 40% long copper, 40% long gold, 35% long S&P and 75% short treasuries. The overall fund is having a bit of a monster today – up 3.8%, and up 12.7% from the mid-feb start.
Tuesday, 15 April 2008
Crowded House
Something, quite clearly, does not add up. The consensus has it that the US is in recession, and that the US recession will cause the rest of the world to catch cold.
But if that analysis is right, why are copper and oil hitting all time highs? And why is the CRB Rind – an index comprising many basic non-exchange traded commodities – like hemp, steel scrap and butter – why is that up near an all time high as well?
In short, it’s because there is no global recession. Not only is there no global recession, but global commodities demand growth will likely be above trend again this year. And global commodities supply growth will likely be below trend again this year, despite record prices.
And my view is simple – commodity fundamentals will continue to ratchet tighter, and commodity prices will continue to ratchet higher over the next couple of years.
When I was a commodity strategist at ABN I reckoned that if I could call commodity demand cycles I could make a living. But if I could call changes in intensity of use, I could make a fortune.
We’re right in the middle of a major change in intensity of use. Broadly speaking, the commodity use in a dollar of growth in the BRICs (Brazil, Russia, India and China) is around four or five times greater than the use in a dollar of growth in the US.
One factoid tells the story quite nicely – the US economy is now around twice the size it was in 1982. But a year of growth now weighs no more than it did back then. China’s economy is around twice the size it was in 1999. But a year of growth now weighs around three times as much.
The key issue is where the world’s growth is coming from. If two thirds is coming from the US and the developed world, as it was in the late 1990s, then commodities demand will struggle. But my calculations show that, if two thirds comes from developing countries, as it is now, it will double the trend commodities demand. The kind of slowdown I’m expecting in the US won’t be enough to pull commodities demand back below trend.
Now the next issue is whether the US slowdown will undermine growth elsewhere. Normally it does – whenever the US falls into recession, it’s current account deficit shrinks. And that means fewer dollars for the rest of the world. It is the loss of liquidity that undermines profitability, and then growth, outside the US. But something very strange is happening – because while the US current account deficit is duly contracting, global liquidity – as measured by global reserves – is actually expanding. And not only is it expanding, it is accelerating. That’s pointing to a reacceleration of growth, not a global recession.
And profitability in the BRICs is pointing to a longer cycle. When the cost of capital rises above nominal growth – like it did globally in 1999 – it is a sure fire harbinger of macro doom. But that is very far from being true in the BRICs now – the cost of capital is close to 5%, but nominal growth in the BRICs is over 10%.
That’s quite a combination; accelerating global liquidity, strong emerging market profitability, above trend commodity demand, and below trend supply.
Things are going to get a lot hotter before the commodities complex tops out.
But if that analysis is right, why are copper and oil hitting all time highs? And why is the CRB Rind – an index comprising many basic non-exchange traded commodities – like hemp, steel scrap and butter – why is that up near an all time high as well?
In short, it’s because there is no global recession. Not only is there no global recession, but global commodities demand growth will likely be above trend again this year. And global commodities supply growth will likely be below trend again this year, despite record prices.
And my view is simple – commodity fundamentals will continue to ratchet tighter, and commodity prices will continue to ratchet higher over the next couple of years.
When I was a commodity strategist at ABN I reckoned that if I could call commodity demand cycles I could make a living. But if I could call changes in intensity of use, I could make a fortune.
We’re right in the middle of a major change in intensity of use. Broadly speaking, the commodity use in a dollar of growth in the BRICs (Brazil, Russia, India and China) is around four or five times greater than the use in a dollar of growth in the US.
One factoid tells the story quite nicely – the US economy is now around twice the size it was in 1982. But a year of growth now weighs no more than it did back then. China’s economy is around twice the size it was in 1999. But a year of growth now weighs around three times as much.
The key issue is where the world’s growth is coming from. If two thirds is coming from the US and the developed world, as it was in the late 1990s, then commodities demand will struggle. But my calculations show that, if two thirds comes from developing countries, as it is now, it will double the trend commodities demand. The kind of slowdown I’m expecting in the US won’t be enough to pull commodities demand back below trend.
Now the next issue is whether the US slowdown will undermine growth elsewhere. Normally it does – whenever the US falls into recession, it’s current account deficit shrinks. And that means fewer dollars for the rest of the world. It is the loss of liquidity that undermines profitability, and then growth, outside the US. But something very strange is happening – because while the US current account deficit is duly contracting, global liquidity – as measured by global reserves – is actually expanding. And not only is it expanding, it is accelerating. That’s pointing to a reacceleration of growth, not a global recession.
And profitability in the BRICs is pointing to a longer cycle. When the cost of capital rises above nominal growth – like it did globally in 1999 – it is a sure fire harbinger of macro doom. But that is very far from being true in the BRICs now – the cost of capital is close to 5%, but nominal growth in the BRICs is over 10%.
That’s quite a combination; accelerating global liquidity, strong emerging market profitability, above trend commodity demand, and below trend supply.
Things are going to get a lot hotter before the commodities complex tops out.
Phone a friend
Most people look on investment as a way to deliver something that they want. 10%. A comfortable retirement. Money for nothing.
But that's wishful thinking. And wishful thinking, well, it's not thinking at all.
My view is very different. Investment is money for something. Money for taking risk - capital risk.
So the rules of investment have to come from one simple truth. You have to put your capital at risk. You stand to lose your money. That is not money for nothing.
Now, before I talk about China, food, cobalt and copper, i want to talk about risk.
I don't know if it's me, but i'm not sure i've met anyone outside the business who understands risk. And i'm not sure i've met anyone inside the business who understands risk either.
The big issue is this; most people, they're chickens. Noone wants to risk anything. Unless the papers say it's ok. By which time, obviously, it isn't.
Investment is a bit like skiing. You only do it if you're rich. And, well, leaning downhill doesn't feel natural at all. But if you don't lean forward then you'll break you're leg. It's funny how my daughter is a better skier than me.
Sometimes taking risk reduces your risk.
Strike that. If you don't take risk, then you are taking too much risk.
But stories about amateurs don't cut it. Anthony Sampson lived down the road from my parents' house. He wrote some big time books; the seven sisters - about the oil majors, the Anatomy of Britain.
I never knew him. But if I could iI'd love to pick his brains right now.
Because it feels like there are new books to be written. About the return of the Spice Road. About infrastructure. About risks our governments didn't take - refusing to invest in infrastructure until it's too late. Until money has halved, and costs have doubled.
Governments never make money, unless by accident.
I'll talk about the big macro call - is it inflation or deflation - later. In the meantime - the money call is how to make cash in an industry - infrastructure - that is full of piss (politicians) and vinegar (rising capital costs).
When i buy an infrastructure stock i look at both. That's why i'm long Brazil.
JRTG
But that's wishful thinking. And wishful thinking, well, it's not thinking at all.
My view is very different. Investment is money for something. Money for taking risk - capital risk.
So the rules of investment have to come from one simple truth. You have to put your capital at risk. You stand to lose your money. That is not money for nothing.
Now, before I talk about China, food, cobalt and copper, i want to talk about risk.
I don't know if it's me, but i'm not sure i've met anyone outside the business who understands risk. And i'm not sure i've met anyone inside the business who understands risk either.
The big issue is this; most people, they're chickens. Noone wants to risk anything. Unless the papers say it's ok. By which time, obviously, it isn't.
Investment is a bit like skiing. You only do it if you're rich. And, well, leaning downhill doesn't feel natural at all. But if you don't lean forward then you'll break you're leg. It's funny how my daughter is a better skier than me.
Sometimes taking risk reduces your risk.
Strike that. If you don't take risk, then you are taking too much risk.
But stories about amateurs don't cut it. Anthony Sampson lived down the road from my parents' house. He wrote some big time books; the seven sisters - about the oil majors, the Anatomy of Britain.
I never knew him. But if I could iI'd love to pick his brains right now.
Because it feels like there are new books to be written. About the return of the Spice Road. About infrastructure. About risks our governments didn't take - refusing to invest in infrastructure until it's too late. Until money has halved, and costs have doubled.
Governments never make money, unless by accident.
I'll talk about the big macro call - is it inflation or deflation - later. In the meantime - the money call is how to make cash in an industry - infrastructure - that is full of piss (politicians) and vinegar (rising capital costs).
When i buy an infrastructure stock i look at both. That's why i'm long Brazil.
JRTG
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by Anthony Sampson 
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