Thursday 29 May 2008

Happy Campers

Ever had the experience? You start talking on a topic – something that you know is the bomb – it’s got eclectic details, it puts together facts that everybody knows, or feels that they know – but it puts them together in a different order. It makes you look at the world backwards.

Only problem, when you bring the subject up, everyone, even your best friend, looks at you like you’re, er, off your game – so you take the signal that, if you keep pressing, you’ll diminish yourself. That you won’t be taken seriously no more.

I get that feeling a lot these days – whenever I talk about social moods.

About a year ago I saw a programme – it was a documentary – all about New Labour focus groups. This guy from the States – Mark Penn – was asking groups of people in the UK what they thought about all sorts of issues. And Mark Penn is a pro – he wrote ‘Microtrends’ – which is a cracker of a book, and which gives you a better understanding of issue politics than anything I’ve ever read. It convinced me that Bush won his second term because he knew, or because Karl Rove knew, that to say a certain thing to Hispanic Protestants at a certain time would gain sufficient votes to win the presidency. Go figure that. You have to know, for a start, that there’s such a thing as Hispanic Protestants, how many there are, where they are, and what they think. In the sordid world these politicos occupy, that was $1bn information.

So, a year or so ago, Mark Penn asked some Brits in a room what they thought. And I was stunned. There was an incredibly negative response. They thought politicians to be deeply untrustworthy, and that the environment was on the brink of collapse. And this was at the very point that the UK was booming, house prices were flying, and the Morgan Stanley index of global stocks was within a hair’s breadth of an all-time high. This was deeply dissonant. Most often, politicos are feted at this point. Clearly, this is no Camelot. And remember, the sins of Camelot were a bunch worse than the sins of today. It’s just that they were forgiven (See Seymour Hersh’s ‘The Dark Side of Camelot’).

One example – data just released through the Freedom of Information Act shows that Gordon Brown claimed £100 too much on a cleaning bill. He has the lowest rating of any prime minister in two generations. But it’s not exactly the Bay of Pigs.

And what that documentary got at early a year ago – soon nobody would like Gordon Brown. Apparently, he only communicates by e-mail. Something of a bunker mentality appears to be setting in.

So, the topic is this – mood – the mood that folks are in - determines everything.
The system is – mood first, then market, political and cultural scene (papers, then TV, then movies), then economic scene, then market again. It all feeds back.

But this is where the trouble lies. Because, we always want a direct, causal link. But moods are, er, moody. They are often hard to predict. The trick is to spot them early, especially when they run against recent market moves.

So here are a few comments on social mood as gathered by your intrepid South London reporter;

1. We’re seeing a return to the ‘survival’ themes of the ‘70s but with a twist – now, rather than spend £30 on cans of baked beans, you spend £220 on a Ray Mears survival course in Sussex. Ray’s view; ‘Society will need these skills again’.

2. Yesterday’s Evening Standard had two articles on growing your own food, and four on saving money.

3. Kath Kitson issued a ‘trendy tent’ four years ago, sales are now rocketing. Our mates are going camping.

4. Incumbent politicians are in the doldrums. Even Sarkozy, on the face of it the most charismatic European politician in a generation, is up against the wall.

5. There is a sudden influx of anti-heroes. Vic Mackey from ‘The Shield’, MacNulty from ‘The Wire’, Daniel Day Lewis in ‘There Will be Blood’. The bloke with the funny haircut from ‘No Country for Old Men’.

6. Posh Spice is selling her new range of jeans – featuring £300 couture denim flares.

7. Breakfast TV runs regular segments with a guy telling you how to save money, and some other bloke explaining how to forage for borage.

8. Most of the pros in cricket defended sledging in a documentary out last week. Cricket has turned from the gentleman’s game to a ‘badboy’ sport.

9. Ok – this is a bit subjective – I reckon about 20% of drivers round the Elephant & Castle run the lights.

10. Clint Eastwood, the 70s icon, has directed a movie about a child abduction in 1928 – coming to your screens soon.

11. That’s enough social comments, Ed.

Probably the best dissection of the feedback loops between social mood and the markets is Robert Prechter’s ‘Pioneering Studies in Socionomics’. He’s got a great table showing everything from trends in sports attendance to themes in pop music – and what types of markets they coincide with. Robert Prechter is the Dean of Elliot Wave Theory. One of his problems is that his disciples often let him down.

A lot of technical analysis is too short term, is constantly ‘reviewing the wave count’ and says things like ‘if the market goes down below 1400, then it will go down to 1360, unless it’s a false breakout’. Prechter himself has something much deeper to say. His argument is that the market does not, as most believe, discount the future. If it did, how would the extreme overvaluation of tech occur in 1999? Or for that matter, the strong rally from March to June last year – as evidence of deteriorating credit conditions was mounting?

His view, simply, is that the market is an index of the current social mood. And it is the social mood now that drives the fundamentals in the future. His believes that markets and social moods move in waves. Certain types of markets correspond to certain types of social mood – and so, by observing the mood, and characterising the market, you can raise your odds of calling the next major trade.

A third wave up corresponds with fantastic macro fundamentals and an improving social mood. A fifth and final wave up with credit growth, less robust fundamentals than wave three and greed. 1948-1965 was a third wave up, as was August 2004-April 2006. 1982-2000 was a fifth wave up, as was July 2006-June 2007. As you can tell, these patterns work over any timescale – from years to decades.

After a peak, there is a jagged decline – a fall, a new rise, and a further fall to new lows. How do you know that the bounce isn’t the start of something bigger? You check the social mood. It tends to be dissonant. That’s exactly what we have now.

So if you follow this view, and I have to say I’m getting partial to it, you’d say it was a good risk/reward bet that we now break the March lows. Prechter’s view is much more aggressive – he believes that social mood became so extreme by 2000, after a 130 year climb, that we are now going to retrace the entire gains, in real terms, from 1982.

Happy camping!

Wednesday 28 May 2008

Plan B

It might be the weather – it’s muggy as hell down here in South London - but I started getting this ominous feeling over lunch. Like something big was going to happen, and I wasn’t ready for it. And the ominous feeling I was getting was this – it feels like we’re going to have an inflationary bust this summer.

Now, to give you a bit of colour on this – there are four major phases of global macro. Deflationary boom, inflationary boom, inflationary bust and deflationary bust. As a macro trader my main job is to work out where we’re at, and where we’re going to. And one reason that I like running global macro money is because you’re moving away from just buying or selling stocks – to playing markets on three or four dimensions. When you catch it right, you can make a bundle with limited risk. Why limited risk? Because some of your trades will likely work, even if your call is off.

Now, to get a disinflationary boom – you need accelerating growth and underutilised resources. 1991-3, and 2003-5 were classic examples. They were the best of years for emerging market stocks, the dollar fell, and credit, real estate and financials tended to outperform. The yield curve was steep.

This decade’s deflationary boom morphed into an inflationary boom on the way into 2006. Growth continued strong, but utilisation got stretched. The Fed raised rates, and gave the markets pause in May and June of that year. After oil fell in August, it set off another brief bout of reflationary boom, that turned into inflationary boom through to mid-2007.

Now what I think we get going into autumn 2008 is an inflationary bust; slowing growth, with high resource utilisation. What happens in an inflationary bust? Stocks go down – in part due to slowing earnings, in part due to derating. Commodities get ragged – with a narrower and narrower leadership. Emerging market stocks get shot. The dollar consolidates after a big fall. Oh, and banks get stuffed. But probably the defining point about an inflationary bust is the yield curve – it flattens hard.

So a few things are playing to this call. Yield curves have indeed been flattening of late, as central banks have got more worried about current inflation, and markets have started to worry about future growth. The rise in commodities has narrowed, with softs and various base metals rolling over while oil has hit new highs. The dollar has been whipping around – basing against the Euro, and rising fast against the Rupee and the Won. And over the past week or so, stocks have stuttered.

So the market is certainly setting up for the move. But what about the macro?

My bet here – we’re about to run into an unpleasant lurch down in developed world macro going into the end of the year. And there are a few reasons to suspect that markets might not be ready for this.

The first is the fact that two shocks are more than double the trouble of one. I owe this insight to James Carrick from Legal & General. Back when oil was rising, but the world economy kept booming – a lot of people would ask us why oil wasn’t causing more trouble. Our answer – because the credit boom was accommodating higher oil prices. US consumers didn’t have to worry about oil doubling over two years. They could extract more than enough capital from their houses to make up for the dent in real income. And what’s more, their nominal incomes were rising fast as well. No need for concern.

But when oil prices double in a year when house prices are down 14% (on the CaseShiller index), and nominal income growth is fading fast – well, then there’s no place to hide.

Likewise, you can live through a credit crunch if you have a proactive central bank and collapsing resources prices – as you did after the Asian crisis in 1998 and after the gulf war going into 1991. But you can’t live through a credit crunch if oil doubles to a real all time high. You’ve got no plan-B.

The next issue is lags. And I’m grateful to Gerard Minack of Morgan Stanley for this one. The lag from a credit crunch can be long. Gerard noted that bank lending standards typically lead investment spending by nine months. And banks only started their tightening in July of last year. So, you’d only expect to see the impact on investment starting around the April data – due out this month. A lot of economists have been surprised by the resilience of the US economy this year – and now expectations of recession have receded sharply. But it seems to me quite likely that the recession call will be right back on the table once the deterioration in US business investment finally shows up in the data this summer.

Third, the tax break. Yes, it’s a monster. Yes – it’s adding large to US growth on an annualised basis right now. But for every percentage point of growth it adds to what would have been below trend growth right now, it will subtract from below trend growth in the autumn. My view – the US enters recession in September.

Fourth – the leading indicators on the UK and Europe have collapsed. And both central banks are determined to quell inflation – which lags growth – before reflating again. They are so far behind the curve, I’m not sure they know where the curve is.

And finally, we are seeing increasing numbers of emerging markets getting shredded – another hallmark of an inflationary bust. It’s the diametric opposite of a deflationary boom. First we saw Iceland, now we have Vietnam. India is looking more and more precarious. And, as I’ve highlighted before, I think the economies of Eastern Europe are in Wil-E-Coyote mode – they have run off the edge of the cliff – but they haven’t looked down yet.

My sense – there will be nowhere to hide this summer. So either close up and go watch Wimbledon. Or – my preferred choice - go very short, and watch Wimbledon on the other screen. I’ve taken my net short to 100%.

Tuesday 27 May 2008

When Growth Ain't Good

Most of the time, growth is good. It’s not hard to see why. Utilisation rates rise, economies of scale kick-in, and operational leverage pushes up profits.

But, from time to time, growth ain’t so good. And it most definitely ain’t good in a time of infrastructural bottlenecks and resource shortages. In fact, it’s so bad to have strong growth at a time of shortage, that markets tend to perform better when there’s a major global slowdown.

Right now, shortages are exactly what we’ve got. Unfortunately, I think that global growth still has legs. That puts us into a position not unlike 1967 – when we still had the prospect of six more years of decent global growth – but markets embarked on a 16 year bear market just the same. After staying bullish from mid-Jan to late April this year, I’ve been getting cautious equities for the last month or so. Last Tuesday I went short – and I now stand around 70% net short of equities.

So why can growth be bad? Well, it’s because various commodities display a distinctly asymmetric response to tightening markets. The chart below shows the relationship between price and inventory for copper. A small reduction in inventory between May 2005 and May 2006 led the price to more than double. We’ve just seen something similar with oil over the past year.


And the problem is that these extreme moves in resources crowd out returns on capital and labour in the rest of the economy. Consumers’ real incomes come under pressure, and corporate earnings growth falls back. And it gets worse - at the same time, these kinds of resource moves keep headline inflation elevated. And headline inflation has a little understood property – it drives stock ratings. The higher the headline inflation – the lower the PE rating. Falling earnings and a de-rating is a toxic cocktail indeed.

That’s led me to a pretty simple strategy; stay short equities until oil breaks down.

Now, my view on oil is pretty straightforward. I don’t think it’s speculation that’s got us here, I think it’s fundamentals. I think the bidding up of oil prices in a shortage is entirely rational. And up to now, pretty predictable. But now that the oil chart looks not unlike the chart of Gouda tulip prices in the Netherlands from 1634 to early 1636 – during which time tulip prices rose tenfold – the oil price outlook is far from predictable from here. An imperceptible change in fundamentals, or in market mood, could send us either crashing or soaring.

And just because someone tells you that everyone is bullish of oil, that there are stocks held in tankers off the coast of Iran, or that marginal cost is below price – none of it means that the price is going down. From 1980-1982 oil supply rose, and demand weakened. But the price kept going up. In the 12 months from February 1636 to February 1637, Gouda tulip bulbs rose six fold more –for a total 6,000% appreciation in three years (vs. 1400% for oil in the past decade). And the tulips, they weren’t even useful.

Of course, oil would struggle to do anything like the final six fold tulip blow off – because by that time, around half the returns on capital and labour globally would have been crowded out. We’d be in the mother of all recessions. There would be extreme demand destruction. All I’m saying that any sense of oil ‘fundamentals’ and ‘valuation’ should be taken with a pinch of salt. They may not have much bearing on price.

So why do I think global growth still has legs?

It starts with a contradiction.

The chart below rings a warning bell. It shows the change in the US trade deficit. When the deficit shrinks it means less imports from the rest of the world and less dollars for the rest of the world. That on its own is not a major problem. The problem comes when you consider credit. Because the dollar finds its way into an overseas bank – and it gets multiplied 5-10 times by the banking multiplier. That’s why a shrinking US deficit often precipitates financial crises. It worked again in 2007.


But it’s not good enough to look at the deficit alone – the equivalent to global base money growth – it’s also worth looking at the global equivalent of broad money – you need to take account of money velocity – how much the money base is multiplied.

Now global financial statistics are never perfect. But the best we have on global money is shown in the chart below. It shows US base money, plus global central bank reserves held with the fed, plus an adjustment I have made for Gulf surplus cash (which isn’t reported in global reserves).



What’s interesting is that it is reaccelerating. This is similar to what happened in the 70s, as petrodollars were distributed around the world. This should be bullish for growth. And as it is petrodollars that is causing the majority of the growth – it is the direction of that marginal dollar that will determine investment returns over the coming years. In my view, those petrodollars are moving increasingly towards infrastructure spending.

But there is another hurdle to jump. And that is returns. If the cash goes into money losing enterprises, it will soon dissipate. The next chart shows the difference between nominal growth (a proxy for economy wide returns) and the cost of credit (a proxy for the cost of capital) in Brazil, Russia, India and China. Back in the 90s the cost of capital was above the return. So investments lost money on average, and the environment was deflationary.

Now, they are making a lot. That generates a self reinforcing growth process. This is not an end of cycle and global recession story – it is a mid-cycle story.


But, the process is inflationary. Utilisation across the BRICs (Charts courtesy of James Carrick who substituted Taiwan for China, as the data isn’t good enough in China) is at multi-year highs across the board. That’s inflationary. And inflation is just what we’re seeing.


In an environment where the West is being crowded out, and when the banks are doing everything they can to survive (which means hoarding capital) – it is worth looking for trouble at the weakest credit. That weakest credit is Eastern Europe.


These economies are seeing demographic decline, large fiscal and current account deficits, with debt often denominated in foreign currency. They are an accident waiting to happen.

So my basic position is this – the crowding out thesis I’ve been trading is now coming to the fore. I own infrastructure and resources stocks (although a reduced position from this time last week), I am 70% net short – including shorts on Banks with Eastern European exposure. And I’ll cut my short when oil breaks down.

Friday 23 May 2008

In with the out crowd

On Wednesday I presented the global macro overview to the Citigroup commodities conference. I thought I'd set out the highlights in the next couple of posts. I made two strong statements; first, global commodities demand will be above trend again this year, despite a US recession. And second, global commodities supply will be below trend again this year, despite record prices. Why?

When I was a full time commodities analyst I found you could make a living if you could call a demand cycle. But if you could call a change in intensity of use, you could make a fortune. Intensity of use has changed, and it's staying changed.

Why will intensity stay changed? The key point is set out in the next chart. This chart takes some explaining. If you imagine every worker in the world in a line – in order of their income. From someone earning $100 a year – to Gates and Buffet on the other end. The chart answers the question – who gets the last dollar - the marginal dollar – of growth?



The answer in the 90s was someone with a high income – averaging $18,000-20,000 a year. But from 1999 – when it was someone earning $22,000 to 2008 it halved. Now, the marginal dollar goes to someone earning $11,000.

Why is this important? Because it completely changes intensity of use.

The left hand chart on the following slide shows why. Down at the low incomes – growth leads to a much steeper increase in energy use, than does a dollar of growth in high income countries (where the curve is flatter). The same is true for aluminium on the right hand side.


But take a look at two more charts. On the left hand side is mobile phones. Here the scale is different – it’s penetration not units sold. A 30% increase in income from around $6,000 trebles demand. There are only minor gains beyond $10,000. But it’s a high value added good – so a combination of increased productivity and low unit labour costs has pushed down prices. It’s a classic deflationary boom.

On the right side is advertising spend. And that’s a completely different picture. Down at the low incomes – there’s only a very gradual incremental spend on ads. But it goes vertical at the higher incomes.



Why’s this important – because it causes a massive change in intensity of use.

The next chart shows what happens to the trend demand growth for a basic good, and a value added service if you change the mix of global growth (no change to total global growth, just the mix). The results are extraordinary.

If two thirds of global growth comes from the developed world, as it did in the 1990s, then the trend demand for a basic good is just over 2%. The trend for a value added service is nearer 6%. But switch that growth two two thirds emerging markets, as we see now, then things change completely. Trend growth in basic resources jumps to 6%.

So even if global growth fades back to trend, or a little below this year, the fact that the growth is coming from the emerging markets mean that we’ll have an above trend 5-6% growth year again for basic goods and for commodities. Value added services are due a much weaker year.


The following stat brings the story home…..

Now I said earlier that global commodities supply would be below trend again this year, despite some record prices across the complex. Why?

Well, here are some key points for oil;


And not only had strong relative growth in emerging markets, we’ve had, as Larry Summers said ‘not just the strongest five years of global growth in a generation, but the strongest in all of economic history’.

When you get that….

And when you get shortages – prices can rise with a very small change in fundamentals. And when you start seeing shortages, combined with infrastructure deficits – thy have habit of concatenating – feeding off each other to create more shortages.



Perhaps the best example of concatenation is food for oil. Back in 2000 only 3% of US farmland went to biofuels. Last year it was 17%. Food prices duly followed.

The basic point is that when there is a shortage – returns rise on the shortage, and they fall on labour and capital. The chart below shows April retail sales in the US. Quite clearly, US consumers are being forced to spend more on gas and food, and they’re choosing to spend less on cars, furniture, and in regular retail stores.



That’s the centre of my very big picture call. I'll talk about more immediate issues in my next post.

Wednesday 21 May 2008

The Russian Metal

I presented my global macro overview at the Citigroup commodities conference here in London today. I’ll lay down the highlights from my presentation over the next couple of posts. But today I thought I’d cover my strongest carry-out from the conference.

And that was the contrast between the massively bearish consensus on palladium, and the massively bullish fundamentals.

You might not want to invest in Russian equities. George Soros won’t. But you should invest in Russian metal. And the most Russian of metals is palladium.

The central problem with the palladium market is that the Russians have been selling. They’ve been selling from stockpiles. And they’ve been selling a lot. These stockpile sales added close to 30% to global supply last year.

Johnson Matthey – the platinum group metals specialist – has a part to play in the general negative sentiment on palladium. It has an idiosyncratic way of describing palladium supply; it includes these Russian inventory drawdowns in the supply number. And then it says that the results of its calculations are ‘fundamentals’.

That’s a dangerous way to do it. Because it lulls you into a sense of security – that the market’s easy – and that it will be for years. But if Russian stock sales slow, or even stop, the market fundamentals change overnight. They become very bullish.

Why? Because demand growth is massively outstripping the growth in mine supply.

On the demand side we are seeing substitution of palladium into diesel cars for the first time. In 2005, palladium accounted for less than of 1% of PGMs (platinum group metals) used in diesel catalysts. In 2007, this had risen to 10%. The current leading formulation is 30% palladium, and this will likely rise. This means that palladium demand in diesel auto cats could treble over the next three years or so – after rising tenfold in the last three years – from a tiny base. By that time, it will be significant.

The next issue is jewellery. Palladium is stealing a march over platinum, due to the fact that its qualities are similar, but it trades at a quarter to a fifth of the price. We’re seeing that substitution locally – down in Hatton Gardens – the London jewellery centre. And we’re seeing it in China. But the interesting thing is that the rise in intensity has been completely hidden by some major destocking at the Chinese jewellers over the last two years. That destocking is winding down – and we will likely see a big pop in demand over the next year.

Last year demand rose 3.5% - including the destocking. This year – I’m betting on 5-6%.

Then there’s supply. On the supply side, there is no growth. The ongoing disruptions in South Africa, the trickiness of the Stillwater ore body, and flat Russian production are all contributing to the moribund production picture.

And there is investment. The new palladium ETFs have had a powerful effect – adding a quarter of a million ounces to demand last year. There’s no reason I can see for this to stop. Especially as further platinum ETFs are likely to be delayed due to the dearth of physical material.

So the big issue is the Russian stockpile. The size of the stockpile is a state secret. For decades the Siberian mines, now under Norilsk’s control, produced palladium as a bi-product of their nickel and platinum supply. The problem was – they didn’t have any use for it. So it went into inventory, waiting for a purpose.

Since the wall came down, the Russian’s have promoted palladium use heavily. First for gasoline auto catalysts. Then for jewellery. And now for diesel cats. They’ve done this by ensuring an ample and easy supply (in the mid-late ‘90s, and again over the last few years)– through selling stockpiles and maintaining production and sales out of Norilsk. They’ve also subsidised technological research in auto-catalysts, and for industrial uses. And they have provided cash to promote palladium jewellery use.

But the Russian sales out of inventory are by no means assured. The work I did when I was a full time analyst suggested that there was not an infinite supply of inventory – and that Russian inventory would run thin towards the end of this decade.

And then there is the issue of foreign financial reserves. Clearly, Russian reserves are rising sharply, as oil prices power higher. The Russian state does not need to sell any more palladium.

And I’ve heard on the grapevine that Russian sales out of inventory have fallen off sharply of late – that they wouldn’t sell a chunk to some modern day Hunt brothers due to a lack of availability – and Swiss and US trade data suggest that information may be true. Those slower sales came before oil hit $100bl.

All in all, palladium looks like a nice risk/reward trade on a 1-2 year view. I’ve bought some for the fund, and I’ll look at buying some physical for the family. And I’m not George Soros; I am invested in Norilsk.

A quick bit of housekeeping. Over the past month I’ve got cautious on the market – but every time I’ve put in a short – on banks with Eastern European exposure, or on an index – I’ve been stopped out.

Yesterday that changed, and the shorts I’d put on in previous days started earning fast. I’ve been looking for a break for a little while, and as soon as I saw the Asian price action yesterday I moved aggressively – I put on large FTSE, CAC-40 and Dow shorts during the morning, to take me significantly short overall. I also put on some dollar shorts. That partially protected the portfolio from the vicious sell off in resources and engineering names yesterday. It’s making money outright today.

Monday 19 May 2008

The Balham Review of Books

A publisher friend of mine told me that there is only one rule of book reviewing; you’ve got to be rude. Every review should be a vicious exposition of the vituperative arts.

So the book I thought I’d review today – George Soros’ ‘The Credit Crisis of 2008 and What it Means’ – started out in promising fashion. The title was none too snappy, to say the least, and then he got into philosophy. And the problem with philosophy is that most of it is complete gibberish. There’s a great book called ‘The Art of Plain Writing’ – by Rudolf Flesch – that sets out the gold standard for clear prose. I reckon that just one in forty philosophers is capable of constructing a clear sentence. I don’t know the profession got there – after all these boys are there to make sense of the world. But somehow they’ve got themselves so tied up in abstruse isms – they’ve turned into a bunch of Foucaults.

Three chapters in, the Soros book was suitably prolix. It was heading for a good book review.

But, unfortunately, it all went downhill from there – the book started making sense. Because Soros basically has macro down pat. The big point is that nobody knows for sure everything that’s going on. But we act on our imperfect view of the world. And that changes the world, and it changes our view of the world. The problem with this is it means that there’s no such thing as demand and supply curves. Because every purchase and every sale influences how all the players in a market think about demand and supply. And that means that the central tenet of modern macro – that prices today don’t influence prices tomorrow – well, that’s not true. That means there’s no such thing as an economic equilibrium. The future is indeterminate.

It makes you wonder about why people pay so much for economic forecasts.

Now Soros complains that people haven’t taken his ideas on this theme – which he calls reflexivity – seriously enough. But I think there’s loads of serious analysis on this. But it’s by polymaths, not economists. And Benoit Mandelbrot is probably at the forefront of it – with his view that markets are driven by power laws. A power law basically means that prices today influence prices tomorrow. And lots of results come from it. The most fundamental is that the bigger the power law, (or the more ‘reflexive’ the system to use Soros’ term), the bigger the fat tail; the more likely you are to see extreme events. Another is the volatility moves in phases. It puts the lie to VAR. And it means that risk shouldn’t be left in the hands of risk managers. For me, the only way to manage risk is to bet on self-reinforcing processes and extreme events. And that suits me – those are often the best risk/reward trades.

Soros then goes on to run through how he made money backing self-reinforcing booms, and busts, in conglomerates in the 60s, in REITs, in growth banks etc. It’s all good stuff.

He tells how he got back into the action last August, and he sets out his own macro trading diary – something he strangely calls a ‘real time experiment’ – all the way up to mid-March. This kind of thing is fantastic – I love reading how the greats break it down – and this almost in real time.

Soros’ broad brush view is similar to mine – he thinks China and the oil states have enough ‘stuff’ to weather the credit storm. But the developed world will suffer. Because – after a 27 year ‘super bubble’ – there’s hardly a soul who understands how easily housing, credit and consumers in the developed world could form a whirlpool of self-reinforcing capital destruction. When do the problems really start? When the fed cuts rates but the 10-yr yield rises. It hasn’t happened yet. But it’s getting closer.

The basic point; the US dollar is going to pass on the mantle of global reserve currency. And that will be disruptive, to put it, er, mildly.

What was Soros doing to play this from the start of the year? He was long Chinese and Indian stocks, short US and European indices. He was short the dollar and short US treasuries. He was looking for a short term ‘tradeable bottom’ in stocks around mid-March.

Now my overall view is not a million miles from this. But, by virtue of a smaller size, I have been playing it a little differently. I think this market is not one to trade with the big indices – but instead with individual stocks. The slight difference in my view is that, while I believe that Chinese and Middle East growth is self sustaining, the big long opportunities are in resources and infrastructure – and many of those stocks are listed in Europe and the US. So I’ve no problem holding those stocks, as well as the big resource stocks in Brazil.

The second difference is I think the next blow-up comes not from the banks in general, but from the recipients of credit. The banks will do everything in their power to survive – and that means yanking liquidity from the weakest credit. And I think the weakest credit is Eastern Europe. When the credit crisis rears it head again, and I’m betting that it will do exactly that later this year, I think the economies of the Ukraine, Hungary, Slovenia and Lithuania are going to be right at the heart of it.

I’ve been busy losing money at various times over the last month shorting Erste bank, Swedbank and the Greeks as a play on the Eastern European theme – as they are the biggest lenders in the region. I don’t mind losing money on these – I’ve kept the positions very small as the stocks have rebounded, and I’ve been making out like a bandit on my long book anyway. But by keeping these shorts on board, I’ll see it as soon as they start misbehaving – and I’ll get the positions to serious size in rapid fashion.

I’ll be doing the opening presentation at the Citigroup global commodities and currencies conference on Wednesday. Hope to see you there.

Friday 16 May 2008

Vierd

I was watching this documentary of Miles Davis jamming around in the studio. He started playing something, stopped. And he said ‘Vierd, where did that come from?’

You kind of wonder the same thing about the market from time to time. This is the ultimate whiplash market for the MoMo men. All the big momentum trades; short banks, long wheat, long gold, curve steepeners etc – all have been mullered of late. And if you tried to go the other way, you were pretty sure to get caught up in the chop.

When gold reversed badly a month or so ago, I knew it was time to pull in my momentum horns. I have been running maybe a third of my normal leveraged positions since. Which is just as well, as I’ve lost money on almost every trade. It’s a swing trader’s market, no doubt. And for good reason. Since January 2007, momentum has been king. It’s pulled in the big money, and it’s got to be a massively crowded trading style.

And, as it does, I think the macro is contributing to it. The US will be accelerating over the next three to six months, while Europe slows down. That’s not exactly conducive to big dollar short positions. And then there’s inflation in Asia and Eastern Europe, rate hikes etc.

That’s a major reason that I don’t run ‘one trick’ money; value / growth / momentum / swing etc. Quite simply, when everyone is in, the risk/reward goes sour. There’s nothing odd in Bill Miller losing his winning streak over the past two years. Value was the best performing style, by a country mile, from 2000-2006. As a big value investor, you’ve got to expect some payback. For a great account of value investing through the late 1990s and early 2000s – check out ‘Capital Account’ by Edward Chancellor for the fund managers Marathon. It was almost enough to turn me into a value investor myself.

Now, my big call for the past few years has been energy efficiency. In 2004 I put out a very bullish paper on the engineers. I was a big buyer of ABB, Alstom and GEA. I own all three today.

A year or so ago, I refined the argument. The basic question I wanted to answer; how far could this thing go?

Now, forgive me for a minute – this is going to get a bit academic. Economists have always had loads of models to explain equilibrium. For a long time, they struggled to explain growth. Then Robert Solow took the Cobb-Douglas equation, which uses capital and labour factor inputs to explain growth at firm level, and he applied it to the whole economy. His model explained 54% of US growth from 1900-2000. And for that, Solow won the Nobel Prize. It shows they’ve always held the bar pretty low for economists.

And to explain the rest? The economists wave their arms around a lot and say productivity.

Unhappy with this state of affairs, Dr. Richard Ayres thought about a third scarce resource; energy. And he thought about the increasing efficiency with which energy was used (back in 1900, power stations ran at 20% efficiency or so. Now, the best local closed loop systems can run 70-80%). Factor that into an improved Cobb-Douglas equation (the Linux model in the chart below), and you explain 95% of US growth in the 20th century.





This is where it gets interesting. Energy and ‘energy efficiency’ account for 45% of the growth in US value added over the past 100 years. But they only account for around 7% of the total returns in the US economy (labour is at around 67%, the rest of the capital stock gets around 26%).

Now, the issue here is that, if energy gets scarce – and my view is that this is exactly what will happen, then it will start taking returns from capital and labour. How much? Well, up to its contribution to growth; another 40%, or around six times what it’s currently receiving.

Of course, that’s too aggressive. The process of redistributing those returns would be highly unpleasant – likely involving a deeper recession, consumers economising, and some loosening of energy markets. So it won’t go in a straight line. But the theory is there. We could go a distance towards that number.

So, in my book, the biggest risk out there is not a high VAR, it is that energy gets ever more scarce. And that is a central call in my thematic portfolio, which I’m playing through the following energy, engineering and resource stocks;

ABB, AP Moller-Maersk, Cosan, ENRC, Ocean Rig, Petrobras, Stanelco, SSAB, Alstom, Patterson, Schneider, Technip and Vallourec. If you follow a few of these names – you’ll know that some of them have started to move pretty aggressively of late. That’s made up for the chopping around in my leveraged fund, and leaves me up 19% from my mid-February start.

Thursday 15 May 2008

Mulch

I read too much. But lately I read a really cool justification for reading too much. From someone who also reads, er, too much. It’s Tom Hodgkinson’s ‘How to be Free’. His view; the brain needs mulch. Fertilizer. Compost. There are whole books on compost – do it right and the mulch turns active in a couple of weeks. A less expert effort takes a year.

Why does the brain need mulch? Well, it’s stuff for the brain to work on. To process. And the beauty of it is you’re not the best person to judge its value. Your brain is. Later.

So the thing I’m mulching is this; the parallels between now and the late 1960s and ‘70s. The other thing I’m mulching is the differences.

The first parallel is the self-reinforcing shortages. Here’s a quote from Adam Smith’s ‘Paper Money’, the difficult third book (Both ‘The Money Game’ and ‘Supermoney’ were best sellers. ‘Paper Money’, er…). The thing about Smith, he was such a writer – I still hang on his every word. So here’s his intro to ‘Paper Money’;

‘Every once in a while, almost a decade ago, I would get a skidding feeling. You know the feeling. You are in your car, listening to the radio or just thinking, and very momentarily, the wheels are not solidly on the road, which is wet from rain or snow. Subliminally, you sense that slide, you snap back to awareness, you react. I was getting this feeling, not in a car, but sitting at a desk, reading about prices and money rates.’

So what happened? Something to do with La Nina. It caused a dearth of anchovies off the coast of Peru. Problem was, no anchovies, no cattle feed. Peru starts importing soy to feed the cows. Food gets tight. Russia bans wheat exports. Sound familiar?

But there are deep differences. We are still seeing real productive change. We’re seeing massive deflationary growth in all things media – from the price of calls, to broadband and publishing.

A couple of posts ago I added to the internet’s general ability to pass on rubbish. I said TV prices were down 28% YoY. They’re not. Official numbers show TV prices down 18%. Until you ask for the shops ‘best price’. Try it, it works. At least it does on Totenham Court Road.

There’s little doubt that tech and the net are a source for deflationary growth. And tech culture reinforces this trend. The memes – the fashionistas of tech are all about working to save costs. Pay £500 for office works. Forgeddaboudit. They’ll use freeware, or Google etc.

So what’s more important. My bet – the inflation. A key issue is that China has turned. Back in 2003, unit labour costs in China were falling 2-3%. Even with decent wage growth. Now, unit labour costs are rising 2-3%. And if we look around the world, there are several places where the rise in labour costs looks like more than just the passing down of growth – it looks like rising inflationary expectations. India, Russia, the Ukraine and Hungary all spring to mind.

There’s a good word 13d – the consultants – use to describe the current situation; concatenation. It’s when disparate factors start to reinforce themselves.

The anchovies and Russia’s banning wheat exports in the 70s is an example of concatenation.

There are maybe 20 concatenating series developments I can see right now. Here’s just one example.

South Africa invests too little in power infrastructure. Power prices rise and mines see power rationing. Oil demand rises sharply as firms use oil fired generators to service power needs. Chrome prices rise due to higher costs and lower production. Specialist steels rise in cost and face shortages as a result of reduced availability of chrome and other additives. Costs of oil drilling rise due to rising costs of specialist pipe and other equipment. Projects are delayed. Oil prices rise.

And so it goes.

So what breaks these self reinforcing cycles? In my view one thing, and one thing only; higher rates in the States.

Right now the currency and resource markets are trading around because the US is picking up while Europe is slowing fast. Over the next couple of months we could easily see sentiment on European rates turn more negative than in the US. And that makes the ground ripe for an upward correction in the dollar.

But the big issue for me is how the US economy behaves after the tax boost. My view, it rolls straight over. The April retail sales data, which the market got excited about on Tuesday, showed a very dangerous development. Most of the rise in sales was to cover higher oil and food costs. Everything else suffered. That is not a positive development. In my view, US consumers are getting crowded out. The fact that mortgage costs have not really fallen back, despite the fall in Fed funds, and that house prices are now suffering serious downside momentum – all suggest that the US is going to head back down again come the autumn.
And that suggests to me that we’ll get another bout of reflation, another bout of dollar weakness, and another bout of commodity strength before the year is done. Come winter, we’ll be concatenating again.

Tuesday 13 May 2008

The Shape of Things to Come pt II

Yesterday I talked about how I manage the base equity of my fund. Today I’m going to talk about the leveraged portion.

The first thing I do is to work out if I want to hedge anything. And I hedge for one particular reason. The stock positions in my base equity are designed to be there for two or three years. But with the best will in the world, they ain’t going to be going up in a straight line. And when they do go down, the market has an almost spooky knack of getting them to the point at which I doubt myself, and get tempted to bail out.

I keep the hedges separate from anything else I’m doing in this part of the fund. They’re not absolute bets; they’re not there to make money directly. The hedges are a rod for my back – that I put on when the short term risk/reward for my thematic bets has deteriorated – to give me the stamina to ride out the inevitable corrections.

That’s exactly what I’m doing right now. I have a 60% short position purely as a hedge against my market exposure elsewhere. It’s comprised of shorts on the Dow Jones, the FTSE 100 and Erstebank.

The rest of the fund uses the leverage inherent in futures, CFDs or borrowed money to add anything from 0-400% of exposure onto the base equity. And it’s there for one purpose only – to make absolute returns.

And for that reason, I’m perfectly happy to run zero exposure. That’s what I’m running now. I wrote a while ago about how to lose money. One way – always be fully geared. I only put a position on when I like the risk/reward. And I only like the risk/reward when I think that the market is paying me to take the bet.

I have up to 40 units of risk exposure, each one with an average of 10% of the value of the fund (NAV). I adjust the exact position size according to the volatility of the instrument. I can put from one to four units of risk on any one position. And I hold a maximum of 10 separate positions. If I go four units of risk, say, long gold, then I limit myself to just two units long of something highly correlated – like silver or platinum.

And I build into positions. One risk unit on to start with, and then pre-set double-up points up to get the position up to four risk units.

If this all sounds a little familiar then you’ve probably read one of the books that I’ve read – ‘The way of the turtle’ by Curtis Faith. An excellent book on rule based trading.

Now I’m no black box or technical trader. I make my own judgements on when to get in. But once I’m in, I’ve found that rules pay dividends.

So what’s the advantage of doing it this way?

First, it reduces my mistakes. So I tend to win much bigger than I lose. If I’m in with one risk unit on a trade and I’m wrong, I’m stopped out once I lose a quarter percent of NAV. If I’m right, and a trend forms, I am making money four times as fast, and I can run the position five or ten times as far.

That means I can comfortably lose much more often than I win. It means I can look for a big payoff from an unlikely event. That’s something that most people don’t like to do – so I reckon it gives me an advantage.

And I think this structure diminishes my weaknesses – overtrading, or betting too big when the market’s churning and I’m frustrated. And it likely augments my strengths – betting on good risk/reward trades, and keeping discipline in both cutting and holding.

This approach tends to take a chunk of the emotion out of trading. I’m not stressed because I know exactly how much I’ve got to lose on a trade before I cut. It helps me focus on the fact that it’s not important whether any individual position loses money – as long as I took a good risk/reward bet when I got in. Over time, good risk/reward bets make good money. And I’ve found that the less stressed I am, the easier it is to follow the rules, and the better I am at judging good bets in the first place.

I also think that this risk/reward business is a matter of psychology. There is a massive pressure on funds not to miss out on any significant market moves – with Fund of Funds regularly pruning their worst performers over ever shorter periods – even if that worst performance is just flat in a rising market. So many fund managers internalise that pressure to get involved in a moving market. The problem of course is that this leads to crowded momentum trades - and ultimately vicious reversals.

I’ve found that by keeping a clear eye on risk/reward, I’ve tended to be uncorrelated with other funds, particularly during the big countertrend moves. This makes my fund quite unusual. It doesn’t behave like the average fund, which often ends up looking just like a leveraged long equity bet, with a trailing stop.

Monday 12 May 2008

The Shape of Things to Come pt I

Churchill was responsible for some cracking quotes. ‘We shape our houses and then they shape us’ is, er, quite incredibly good. I read another while buying my mum a present online. ‘Gentlemen buy their cheese from Paxton & Whitfield’. It shows that even the greats can have an off day.

Charlie Munger is one for more plain spoken remarks. His view is that the key to investment is not having a high IQ, it is making your IQ count double. He breaks down four key attributes; constant learning, running multiple mental models, patience or discipline, and the willingness to make big decisive investments when the time is right.

I’ve spent quite some time over the past few years thinking on how I could best construct a fund – to shape my trading to fit these qualities.

I knew from the start that it would never be a long only relative performance fund. I know some real pros that do this. But for me, if I think that the market is going down, I want to be short, not just defensive.

And I knew it had to be global and it had to be multi-asset. There is little point sitting in Japan in 1992 if you think the opportunities are in the States. Or buying gold stocks, when you would rather buy gold.

But the big issue is how I structure the fund; the house that shapes my performance. And that comes down to where I’ve got an edge. There are four or five things I reckon I can do that help me make money;

- Wait patiently for a high returning business to generate strong shareholder returns. I’ve held tobacco stocks and GEA for four years through thick and thin.
- Identify big themes early. I was long gold and resources from 2003. I was short Irish banks from November 2006 (yes, sometimes I’m too early).
- Cut when I’m losing. I run specific cash losses for any position; a loss of one percent of capital for long term stocks. A quarter to one percent for leveraged positions.
- Identify self reinforcing macro themes across several asset classes.
- Spot when a market is turning from a good to a bad risk/reward bet.

And that’s about it. So what I’ve done to try to ‘outperform my IQ’ (yes, perhaps not a difficult task), is to run two funds in parallel.

The first is the base equity of the fund – and that’s what I’ll talk about today.

The idea here is to use the 100% of base equity in the fund to distribute between cash, equities, bonds, credit and commodities. And by optimum, I don’t mean putting it on some bizarre, volatility adjusted, efficient frontier straight out of modern portfolio theory. I mean the blend of assets that will make me the most money over the next several months. The assets with the best risk/reward. The plan is to move the asset allocation around no more than, say, four times a year. Right now I’m 85% equities (more on that later), 5% cash, 5% Gilts and 5% gold. Last time I moved was mid-late March, when I sold a 20% position in Gilts for equities.

The next issue is what I hold within each asset class, and particularly equities. Now it’s common knowledge that, on average, equities are the best asset class to hold – on account of their risk premium. If you’re prepared to take the risk – the volatility and the potential loss. Equities tend to pay 4% or so more than bonds, and say 5% more than cash. That four or five percent is the risk premium. And when you compound those high returns, on average, you double your nominal money every seven years, compared to every 14 years for cash. And you go from 2x to maybe 3x faster than cash if you’re thinking in real terms which, of course, you should. Buffet’s quote; ‘I’d rather make a volatile 15% than a steady 12%’. Compounding is why.

And you can go a lot faster than the 8-10% average for stocks in two ways. First, if you walk away from stocks when the risk premium is low – say below one or two percent – and go heavy when the premium is high – say six or seven percent or above – then you compound at a much higher rate. That’s harder than it seems – you might have to wait out three or four years (you did in 1999). But it’s worth it. Compounding at 12% rather than 8% doubles you in six years rather than nine.

And then there are the themes. Oftentimes individual sectors and stocks will offer a poor risk/reward. Others like infrastructure, energy and mining now price in declines in prices and margins, and a slowdown in growth. If my theme suggests the opposite, which it does, then the notional risk premium – what you’re being paid to take the bet – is much higher than most people believe. You may find yourself compounding at 20-30%. This isn’t what Buffet and Munger do – the look for the moat – the long term sustainable competitive advantage – of an individual business. I’m looking more for thematic medium term calls – say three or four years. If I’m right and resources and infrastructure in general have got a large moat over the next few years – then the high returns that these companies are making will compound over that time.

So I manage my equity calls based on what I think are three year themes. I generally want to hold a stock that long – provided I don’t lose 20% from entry, or the risk reward gets too far out of whack.

And I make sure that the equity bets are big enough. Each position starts at 5% of fund value (NAV), and I double up if the fundamentals and the chart look right. Right now I have three stocks in which I invested a full 10%; Patterson (The US natural gas driller), SSAB (The steelmaker), and GEA (The German Mittelstand conglomerate). And then I have a bunch of others that started at 5% including ENRC (Kazakhstan Ferrochrome), ABB (Swedish power infrastructure), Ocean Rig (Norwegian deep sea drilling), Cosan (Brazilian sugar and ethanol), CVRD (Brazilian iron ore) and Petrobras (Brazilian oil). And among my smaller positions, I bought some Crox two weeks ago at $11. I know, that’s a bit leftfield, I’ll explain it later.

As you can tell – I’m not big on diversification. I’d rather hold cash than a stock I don’t believe in. Nor am I big on VAR. There are three reasons. First, it’s based on the assumption that the world is ‘Gaussian’ – that all risk is distributed on a normal curve. But Benoit Mandelbrot – in his book ‘Market (Mis) Behaviour’ – showed that risk is distributed on a power law. So you get fat tails – a much greater likelihood of extreme events.

Second, it usually takes volatility from the recent past (Most hedge funds use six months) as a guide to future volatility. But that’s misleading. Hyman Minsky showed that ‘stability breeds instability’. Something that the recent credit crunch demonstrated rather clearly.

And third, VAR induces you to do exactly the wrong thing. When markets have fallen, investors become more fearful. Implied volatility (The VIX) rises. Which means that the risk premium – the prospective returns over cash or treasuries – must be higher. Your VAR goes up so your friendly risk manager tells you to cut your positions. But as I talked about earlier, in the discussion about compounding returns, it’s precisely when risk premia are high that prospective returns are high, and that you should be investing most. It also works in reverse. When the VIX and VAR is low, risk managers induce you to bet more, just when you should be taking risk off the table. VAR is for the birds.

So the aim is to hold stocks long enough for an oversized risk premium to compound. It’s where the patience and discipline comes in. I try to check the stocks only once a day. I review them only if they’ve fallen 10%, or risen 25%. And I think that gives me an edge. Tomorrow – the shape of things to come, Pt II – the leveraged portfolio….

Thursday 8 May 2008

Bear market rules

I take no credit for the title – it comes from Mark Stevenson, an ex-colleague of mine and a charting guru – who now runs CLSA’s technical analysis in Asia. I met him last in mid-January, when I’d just turned bullish stocks after seven months on the bear side.

And Mark’s comment then was that it was right to trade for a rally. Bear market rallies can be fast and furious. We’ve seen 50% rallies in bear markets – the most notable being the 50% jump in the Dow Jones during the 1929-1932 bear market. We also saw one in the Nasdaq during the 2000-2003 bear market.

My favourite example of the power of a bear market rally was January 3rd, 2001. After a strong summer for stocks in 2000, the markets lurched badly in the last four months of that year, as it became apparent that tech orders had fallen off a cliff. You’d have been feeling pretty pleased with yourself if you were short the Nasdaq in the final three months of 2000. That was until you showed up in the office on the first trading day of 2001. Because the Fed had carried out an intermeeting rate cut the night before, and the Nasdaq jumped 14% in one session. There are times, even in a horrific bear market, when it ain’t no fun to be short.

So I felt happy to go long in mid-January this year, with the VIX above 30, and some of the worst sentiment readings I’d ever seen. I felt just as happy adding to positions in Mid-march.

But, while Mark was keen to trade a bear market rally, he was very clear – you had to follow ‘Bear market rules’. There are three parts to these rules. First off, take the money and run when the VIX falls back down from 30+ to the low 20s. The same when the relative strength of the market gets back up to 60. And watch out for big fibonnacci numbers – like 50% retracements of the previous falls.

Well, we’d pretty much had all of these as of a couple of weeks ago, when I got more cautious in my post; R&R.

And now the signals are getting more worrisome. The VIX fell back into the 17-19 range this week, a range that was poisonous for stocks in the high volatility 1998-2003 period. We’re still hanging around the 50% retracement of falls in the S&P, the China H-share and a range of other markets. The RSI is elevated, but in a downtrend that started last July. And worst of all, Barrons last week had a cover showing a bull dipping its toe into the water. That was after a 10% gain in stocks.

When I wrote R&R I put on a bunch of hedges – short S&P etc, to cover my long exposure in global resources and infrastructure stocks. I also got rid of some financials. I was too early – I lost money on the hedges and had to stop several out. But thankfully I made enough on my long positions to hold the overall portfolio pretty flat over the period, at around 14% up from the mid-Feb start. I’ve no problem with missing out on the upside from the move higher in the last week or two – I didn’t think the risk/reward was very good – so I saw no point in expending financial or psychological capital trying to ride the wave higher.

But I’m now coming to the view that the risk/reward of being long is getting toxic. So now I have three positions on in the leveraged part of the fund; two risk units short the Dow Jones, two units long Dec-08 Euribor, and one unit long the yen. At the moment these are hedging out about half my long portfolio – I’ll wait to see how the market behaves before building them up, or cutting them back.

And apart from technicals alone, I also think there are some decent macro reasons not to be too cheerful. Back in January, I thought that a combination of Fed ease, tax breaks, an end to destocking and strong exports could push the ISM back from sub-50 towards the mid-50s by Q308. Combine that with a steep yield curve, and you had perfect macro backdrop for a cyclical bounce in stocks. And that worked well – the market was able to look through the rotten data released over the past five months, to the prospect of better stats in Q3.

I now think that most of that is priced in. And now the macro backdrop doesn’t look so helpful. The yield curve has flattened after the vicious sell off in the twos. The sharp move higher in oil will eat into consumers’ real spending power. And there is mounting evidence that mortgage rates are remaining elevated, and lenders becoming more cautious, despite the low rate of Fed funds.

If the market could bottom out in mid-Jan to look through six months of recessionary data to a recovery beyond, what will it do now? My view is that it will look through four or five months of improving US data, to a slowdown beyond. Because, once the tax break is spent (if it is spent), we’ll be left with the same mess we started with; an overstretched US consumer facing the headwinds of falling housing wealth, rising unemployment, slowing nominal wage growth, and a big mismatch between income growth and the rising price of food and fuel. The US economy will likely be rolling back down the hill this autumn.

So I see little to gain, and a lot to lose, from swinging the bat at a big gain in stocks right now.

Wednesday 7 May 2008

Pub Landlord

Q; If we had no rules, where would we be?
A; France

Q; If we had too many rules, where would we be?
A; Germany.

And that is the start of just about every skit by Al Marray, aka the Pub Landlord, that I have ever seen. I think he should add to the repertoire;

Q; If we had too many rules, but we never obeyed them, where would we be?
A; Italy.

So, before I offend everyone in Europe, what kind of rules should I set up for my fund? And how often should I obey them?

The first rule is the big one; always survive. I plan to be running money until I retire, and I don’t plan to retire. So I have a primary rule; always cut. I always set a cut point in advance. And I never deviate from it, however often I’ve felt like an idiot cutting previous trades at the lows. I’m positively Germanic in my discipline.

Now it’s easiest to explain this rule by looking at its opposite; always double down (doubling up a losing trade). It’s a method that often works wonders. The problem is, on those rare occasions when it doesn’t work, when there is a genuine trend against you, you blow yourself up. Always cutting means that you never add to your losses, and while it may be deeply vexing at times, it at least guarantees that you stay in the game.

During my last gardening leave, unlike this one, I did no gardening. Instead I watched the cricket and read all of Warren Buffet’s letters. I then had a look at how the shares traded after he bought them. His best ever trade in a listed stock was to buy the Washington Post. When I looked, it was a 1000 bagger. What’s less well known is that the shares dropped 20% in the months after he bought them. That happens to be my limit for any thematic stock holding, and it shows that, if you follow any set of rules, you will miss some big opportunities.

My view, though, is that cutting pays out more. Dennis Gartman, the long time trader and florid letter writer, talks about financial and psychological capital. Cutting preserves your financial capital, no doubt. It also preserves your psychological capital. Cutting before a position rips a big hole in your portfolio stops your brain from exploding. I’ve been there on trades in the past and there is no way that it was a good thing. Either for me, or for my subsequent performance.

Now the next rules are much more Continental in outlook; they’re not so rigid, and they are designed to magnify, rather than constrain, talent. They help you to answer the ultimate b***stard money management interview question; what’s your edge?

Now, before I attempt to answer that for myself, likely later this week, I thought I’d bring in the big gun on this one; Puggy Wilson. He was the blue collar Texan who won the World Poker Championships in the early ‘70s, documented brilliantly in David Spanier’s ‘Total Poker’. Puggy looked like Budha, if you caught him in a certain light, and he put his trading rules down like a haiku;

Know yourself
Know how to manage your money
Know the right end of a 60:40 proposition.

So in much less elegant and economical a fashion, here’s my spin on each one.

Know yourself is about knowing how you’ll feel, and how you’ll behave, if your trading goes badly wrong, or, for that matter, fantastically right. A whole heap of literature identifies how people take more risk to win back what they’ve lost. And ‘The Psychology of Trading’ shows how people overtrade when they are frustrated – typically putting on big bets to trade small moves; making them much more vulnerable to random noise and to frittering away performance in trading costs. Brett Steenbarger wires himself up to a biofeedback machine and stops trading when it tells him he’s frustrated. Hard to see that catching-on on a city trading floor, which means it probably gives Steenbarger an edge.

The same thing happens to me. So I took Steenbarger’s advice when I was getting frustrated two or three weeks ago, and cut back my trading on my leveraged account, in order to focus on my long term thematic positions. That turned out to be exactly the right call.

The rule also applies to how you behave when you’re making big money. Nicholas Taleb describes the action of serotonin on the brain in his book ‘Fooled by Randomness’. When you’re up, you’re more open, more spontaneous, more attractive to women – more likely to ride your own luck. That works for me also, well, except maybe for the bit about being more attractive to women.

So what I do to guard against overconfidence is to run risk/reward models. That helps me identify when trends are mature, and when macro forces are acting to undermine them. It helps me get hedges up and running and look for major reversals.

Rule two is; know how to manage your money. For me that means the Germanic discipline of cutting that I outlined above. But it also means making sure that your bets are big enough to count – both ways.

In my thematic portfolio, my standard starting bet on a particular stock is 5% of the whole portfolio, sometimes doubling to 10% if all is going well. That sets up the opportunity for proper performance

I also apply the ‘big enough to hurt’ rule to the leveraged portfolio. If I am at full stretch I will have 10 positions on that could all hurt. Right now, I’m trading one.

And finally, rule three; know the right end of a 60:40 proposition. Now that, of course, is easier said than done. My own way is to do one or more of four things;
- Looking to see where I can compound high corporate returns by holding patiently.
- Looking for self-reinforcing macro cycles.
- Looking for what might trigger a regime change in those same cycles.
- Watching the other punters.

I’ll talk about these later this week, when I’ll write on how I’ve structured my portfolio to accentuate the positive, and edit out the average, in my trading life.

Tuesday 6 May 2008

Ain't that the truth?

We just had a cracker of a bank holiday weekend. In-between tennis, dinner out and digging our new allotment, I had time to do some serious reading. And there’s nothing like getting stuck into a good book on a sunny day.

Now some of the reading was around a new project I’m working on. Someone called Dr Chris Patterson, of the University of Leeds, used a program to spot plagiarism on news websites (where 60% of Americans get their news). In the case he was looking for verbatim reproductions of Reuters and Associated Press reports. In 2001, 34% of all web news reports were verbatim transcripts from two or three wire services. By 2006, 50% was verbatim. That 50% doesn’t even include the stories that have been taken direct off the wires and rewritten with no new information.

Now it strikes me as funny that plagiarism is an expellable offence at schools or in colleges. Surely, if these places of higher learning were teaching people how to get by in the real world – they’d be teaching them how to plagiarise.

But the direct copying from the wires isn’t the whole problem. In a fantastic book called Flat Earth News, Nick Davies highlights the real fault of the ‘churnalists’. They are under so much time pressure, he says, that they end up copying PR announcements. Davies got some original empirical work funded – carried out by academics at the University of Cardiff. They trawled through every domestic UK story for two weeks in the UK broadsheets and in the Mail. They found 30% were copied directly from PR statements, 54% of stories were taken from PR statements with no facts changed. And 70% were either wholly or partly taken from PR or a wire service. They found only 12% were original work, with 8% undecided (it could have been PR, but on ‘background’). They found that these papers checked the facts on less than a quarter of wire/PR stories before reprinting.

Davies goes on to say that certain newswires seek to promote ‘accuracy’ – by which they mean accurately writing down what PR people tell them, as opposed to finding out whether what these people said has any validity.

It’s all quite eye opening. And this all plays to one of my prejudices. I can’t bear to watch the TV news. Ever since the press went wild reporting that Norman Lamont had seen the ‘Green shoots of recovery’ I’ve struggled to see the point – couldn’t the journalists identify this stuff for themselves? According to Nick Davies, with all the commercial demands on them – filing ten stories a day, on four different media etc, there just isn’t enough time in the day.

So I suspect that for all the blather about information overload, there is, in fact, a real dearth of information out there. Repetition certainly, but maybe less information, checked, and thought through, than there used to be.

Now in my last job I used to work with a dead sharp economist. His basic premise was that he didn’t believe a word anyone said – he went back to first principles on everything – and worked out his own story. Sometimes, sure, he’d wasted his time, and the consensus call was pretty near the mark as he saw it. But from time to time he would nail a completely out of consensus call – that would be worth a small trading fortune.

And I think that’s the right approach. The only way to get an edge – an analytical edge at least – is to develop your own information. That’s one of the things I liked about the Alchemy of Finance – Soros would write out capital flow diagrams that showed how an overvalued dollar could coincide with twin deficits – and how the two could reinforce each other. Something no textbooks, and very few economists, ever tried to explain.

I also like how Richard Heuer – in Psychology of Intelligence Analysis – argues that analysts should take projections of future events very different from their own calls, and work them backwards. Oftentimes, it does not take an outrageous chain of events to get there.

And that brings me to inflation. A lot of serious analysts I read tell me that the US housing bust and the broader credit crunch is a deeply deflationary event. And that, in due course it will infect commodities, stocks et al. The world, after all, can’t help but slow.

But it’s worth looking at it backwards. Say we’re in 2011 or 2012, and we’ve got a major global inflation problem on our hands. And by that I don’t mean rising oil prices. Because rising oil could simply crowd out consumption in other areas – leading to falling prices for TVs. Right now that is what we have – TV prices are 28% down YoY in the US.

What I mean is proper inflation – when all prices go up. What would have to happen to get that?

I think the wrong answer is a strong US housing market and a healthy financial system. If we had that, the Fed would crank up rates – the dollar would boom - emerging markets would crack– and we’d replay the late 1990s. A disinflationary world.

What I think you need to get real inflation three or four years down the track is a US housing bust and a fragile banking system. You need a moribund US – one that struggles again after the tax boost. That way money stays very easy. The dollar holds a weakening bias. And global reserves keep on growing, as they are now, by 20%+. Not unreasonable.

And that is why I still have my resources, my infrastructure and my gold.

Thursday 1 May 2008

Resistance is futile

Bloggers are wont to refer to other bloggers. So much so that some of the most popular sites are just reference lists, and the sites they refer to themselves refer back to the previous sites, until they disappear into a tornado of self referential gibber. It’s enough to make your brain spin.

So I’m going to try to avoid too much referential stuff – I’d rather think for myself.

Now I went from full on bullish to more cautious last week – clearly a bit early.

So the big fundamental questions right here are;
a) Is the US recession over?
b) Has the dollar made a major low?
c) Did food prices spike because of hoarding, and will prices unwind once hoarding slows down?
d) Did oil spike for the same reason, and will it fall off as well?

Now, the reason these are important questions is that the coincident spikes in food and oil, against a recessionary background in the US, and of course the credit crunch – all went directly to the 20% fall in the S&P from October through January. If we dial back food prices and if we’ve got through the worst of the recession, equity markets could move up sharply. Back in 73/4 it was precisely the fall off in resources prices after an inflationary scare, coincident with a recovery, which led to the jump in stocks. Not many stocks. Just the Nifty 50.

The reason for this is pretty clear. It’s because inflation drives stock ratings. The chart below shows headline inflation vs S&P ratings. A lot of strategists called for stock reratings during the 2003-7 bullmarket. It never happened. The US market actually rose more slowly than earnings per share. Why? Because headline inflation just kept rising.


Now, if the answers to a, b, c and d above are all positive, then I was wrong to turn cautious. Because a rerating will send the markets straight through the well defined resistance on the S&P. Even if earnings are lacklustre.

And it won’t matter that the VIX has gone back to 19, that complacency has jumped, and the front cover of Barron’s has a bull dipping its toes into the water.

Now the market clearly thinks today that the above answers are all yes; gold and oil are taking a bath, and the market has the horn. A few of my hedges got stopped out today, and my base portfolio is underperforming the rising market, badly. My fund has moved back from 14% ahead at its peak from the mid-Feb start, to 10.5% up now. It’s just as well I decided to reduce my gross, and cut down my trading a couple of weeks ago. It’s been tough enough even with lower risk on the table.

So the thing is this; should we answer yes to all the questions above? No, I don’t think we should.
There are three reasons for arguing that we are neither returning to the halcyon days of the late 1990s, nor even the mad nifty 50 explosion of 1973/4.

The first thing is this; there ain’t no slack. The US hasn’t been under trend long enough to allow for non-inflationary, let alone disinflationary growth. And if you cast around the BRICs – every single one has utilisation rates at multi-year highs.

The second thing is that global rates never got high enough to stop growth directly – through raising the cost of capital above the return on capital in the BRICs. It was the implosion of asset backed securities, of leverage, at relatively low rates that caused the carnage. I still think all engines are firing in the BRICs. And I can’t see the prospect of rates getting dialled back anywhere apart from Europe.

The third thing is global reserves. Global reserves are probably the best measure of how many dollars are finding their way overseas. They are, in short, the prime leading indicator of global reflation. They’re exploding right now – up 25% YoY. And that’s despite the shrinking US current account deficit. It’s global macro's greatest anomaly. This kind of reflation, added to high utilisation, well, it’s the perfect recipe for inflation.

So it looks to me that this brief disinflationary boom we’re in is a countertrend move. A bit like late 2006. Back then I made a nice turn long the French banks. I’m not going to trade French banks now – my job is to try not to lose too much money before we get back on the inflation train.