Two days watching sport in the sun Tuesday and Wednesday finally coddled my brains – my body temperature started yo-yoing – I had chills and fever. And not in a good way. Then yesterday I slept for 16 hours, and I was in such bad shape when I woke up I couldn’t even eat a curry. That got my wife properly worried.
So I only looked at the market two or three times over the last couple of days, and then only briefly. But from everything I’ve seen the first rule of global macro still holds;
If the Fed does not control global liquidity, then global liquidity will control the Fed.
Now when I saw the market reaction to the Fed on Wednesday I was a bit, er, confused. After all, if it was ‘dovish’ then shouldn’t stocks go up while the dollar falls? But when I thought on it, it made sense. Three speeches & comments from Lacker, Poole and Bernanke himself in recent weeks had indicated a strong desire to ‘take back some of the stimulus’ this year. The statement, while not reversing that possibility (inflation was still the bigger threat), also allowed for flexibility if the ‘downside risks to growth’ came through.
That’s genuinely dangerous, in my book. It’s the Fed saying that it will loosen liquidity again if growth falls off. This in a world where 40% of the world’s population is facing double digit inflation, where oil has hit $140/bbl. And right now rates are lower across emerging markets than in 2000, despite the fact that inflation and resource utilisation are higher.
It’s like the 90’s through the looking glass. Back then US growth was strong, and inflation kept undershooting. When the risk of inflation rose, the Fed would hike (’94 is the standout) – which would undermine the emerging economies, and put major downward pressure on resource prices. Now growth is undershooting and inflation overshooting, the Fed is struggling to hike because of weaker growth. And that’s causing oil prices to run higher, weakening growth and ramping up inflation. It’s no use complaining that they can’t control the oil price. Of course they can, they can hike rates sharply. It’s just that the costs – in the face of a weak domestic economy and a banking crisis, would be high. So a dual mandate of growth and inflation is all very well, but at times like these it is staying the Fed’s hand, and setting us up a more insidious end-game.
It’s no wonder that Paul Volker came out of retirement to warn on inflation a couple of months back. If the Fed lets liquidity loose – when most everyone else is loose – most likely, oil keeps going up – boosting inflation and sapping US consumer spending. And the Fed does it again – vicious circle.
So, structurally, I’m still very bearish. The Fed needs to induce a global recession to set up a better outlook. When the dollar gets strong, and oil weak, then I get bullish. Without that, the structural pressure will likely ensure a sustained bear market.
If that’s my big picture call, what do I think is going on right now?
I think we’re seeing forced selling. I think the insurance companies are now bailing out of stocks. I wrote about the problems at the insurers in my piece ‘shrink wrapped’ a few weeks back. They received another deep blow last week as Moody’s delivered a doubled downgrade to MBIA and AMBAC. So the insurers – faced with a sudden jump in the risk value of their portfolios, and a sudden drop in value – are now cutting their risk.
But it’s not easy. Because all the insurance companies want to sell the high yield instruments they own to reduce the discount on their future liabilities. Only problem, everyone wants to sell them. They’re very hard to sell.
That goes double for property. And there’s an interesting dynamic in property. While the boss might have wanted to sell for a while, it is not in the interest of the property fund manager to do it. Because the fund manager is paid on performance relative to benchmark. The chances are they’ll be close to benchmark – maybe ahead - if they do nothing. But if they sell, they have to accept an ugly discount to listed price. Selling creates underperformance. So they’ve dragged their heels selling, leaving the insurance companies even more exposed.
Facing a rapidly rising risk profile, and an unpleasant hike in the present value of their liabilities, my guess is that the insurance companies are now selling what they can. And that means equities, indiscriminately. It was no coincidence that yesterday Xstrata finally broke down below its rising trend.
And once you have big trends broken – the CTAs – the futures trading funds – get stuck in.
Now, my own view is that, when you’re in a trade that’s getting increasingly crowded, you’re risk/reward in that trade deteriorates. And if there are big irrational players in the market acting under duress – like the insurance companies today – then the risk reward gets worse again.
So I’ve quietened down my short positions – and I now stand 50% short, down from 180% short at their max a fortnight or so ago. I’ve taken a chunk of profit on shorts in a number of individual names like Swedbank, Erstebank and Allied Capital. And I’ve taken some profit on my short Indian Nifty and FTSE trades.
On the currency side, my yen long finally moved into the money, so I doubled it. The yen tends to come into its own in the final stages off a sell-off, and so it tends to offer better risk/reward than a vanilla short stocks as an equity sell-off matures.
I stepped out of the way of the speeding train on cable and the euro immediately post fed – which saved a few bob, but I’m looking to build again. And I kept my short kiwi trade intact. Clearly I’ve been too early on the euro trade – but I stand ready to ramp back up at the right time. Overall my stock shorts and my yen long outweighed the loss on my euro and cable positions over the past few days, leaving me 37% up from the mid-February start.
Friday 27 June 2008
Wednesday 25 June 2008
Singularities
‘I have always known that one day I would travel this road, but yesterday I did not know it would be today’
Confucius, at least I think it was him.
I’m not a huge one for quoting quotes. I don’t collect them or anything. But I quite like remembering ideas.
Then I heard about Art Garfunkel. He was the tall odd looking one with the totally weird high-pitched voice out of Simon & Garfunkel.
Anyway, Art may look like a freak. Turns out he is. He’s read two or three books a week for the past 20 years. Every one of them he’s written up in his blog.
He’s also gone walking for mile upon endless mile, across the United States. Of all the things you could do with the money from singing in a high pitched voice in a popular folk combo – that’s quite a cool bunch of things to do.
So I’ve taken a leaf out Art’s book. I’ve started collecting ideas. Learning from others’ successes. And in particular, learning from others' mistakes. The latter is harder. People don’t like to dwell too much on their mistakes. It’s not often you read a book ‘Why I was a bit lazy, not particularly inquisitive, and why I followed the people who knew better’. But yet, this is what we have to learn not to do.
I thought that finding books about big failures would tell me something I needed to know. There’s good stuff in these books. They are mostly catastrophic self-reinforcing flame-outs. Written mainly by people with the wit and detachment to write them after the fact. Often caused by an unwillingness to accept a mistake, to cut and move on.
But I’m also very interested in the loss of will. I have two ambitions for my trading; One, I’ll still be trading for a living in 40 years time. Two, I’ll wake up every day between now and then knowing that’s what I want to do.
I’ve written before – to achieve that end and for it to be worthwhile to achieve, I must never blow up. Hence the stops. Stops may sound like weakness to some. For me they represent humility in the face of a complex world. And humility, I think, is strength.
But there’s another thing that might derail my plan. And this I’m more afraid of. Losing will.
There are only about 50 books I’ve read ‘in-one-go’ in my life. And when I found one, I treasure it. It get’s into the library. One of them is ‘Goodbye to all that’ by Robert Graves. At one point in it he talked about suicide on the front. For him it was not a deliberate act. Just a certain carelessness. Down the trench slightly upright, helmet askew, fag upfront. He could see it immediately when a man took on the attitude. In a subtler form, nowadays, it is drift, allowing events to take their course. Going with the flow. This loss of will, it is potentially the most pernicious thing.
What I’ve tried to in my reading and writing is to find the next thing before I’d need it. So I’d always have the chops to be able to deal, fast and decisively, before a major change in market direction.
That’s why something a mate said recently got me thinking. He asked what do we buy when this thing blows through? I couldn’t think of anything is stocks. All I could see was the singularity - the point at which all my trades come through. And then nothing at all. I couldn’t see past that.
I’m not normally like that. And before, whenever I’ve been ‘one-way-only’ I’ve lost money. That was a warning bell – that I needed to do some work to sure up my conviction for the months ahead.
Now, to deal with it I started talking to people, and of course, I bought a book. ‘Investing the Templeton Way’ – written by his grand niece, or something. It’s all about what ‘Uncle John’ done. Hard to get through the introduction I admit. But once you tune out the cant, you get good stuff. And what is fascinating about John Templeton was the strength of his will in the face of outstanding social or consensus pressure the other way. But he wasn’t just a deep contrarian. He always seemed to look for an angle.
When he went long the US airline stocks at the end of the first trading day post 9/11 he did it because he felt it inconceivable that the government would allow the airlines to fail in this circumstance – a bailout would come. That took incredible nerve. When he went long Japan in the early 1960s he saw a fast growing economy, with fast growing cheap stocks which, critically, did not report consolidated earnings. They were, at the time, much cheaper than most people thought.
But before we start trumpeting value above all else – it’s worth being scientific. There are no books by optimistic US investors who were investing pre 1929. Only after. And the most optimistic – Benjamin Graham – we know blew it all in 1929-32.
And, as Templeton and Buffet proved – value worked in the ‘70s. You stayed alive. The volatility offered you great opportunities. As long as you kept discipline.
But the problem comes if you hit a deflation. Then value suffers. Here’s one example; in an inflation price to book hides the value of a stock – because the replacement cost of the capital stock will have increased substantially. So the engineers like ABB right now are probably cheaper than they look (although they look so expensive I wouldn’t say they were cheap). But in a deflation, capital replacement gets cheaper – so price to book gives a false signal. And so of course does PE, and especially a PEG (Price to earnings divided by growth). And so the main problem I have with value investing is that it doesn’t tell you when to get in during a 1929 type crash. It would have been easy to get in after the market fell 80%, all the ratios were attractive, and the mood deeply pessimistic, only to see it fall a further 50%. Not particularly good for compounded returns.
And that’s the thing about singularities – nothing gets through them, even the best value techniques – without being denatured.
Now, my concern is that I think we’re in the fourth major singularity in financial markets in 100 years. The first was stocks in 1929-32. The second was large caps in 1973/4 (after the Nifty 50 bubble). The third was the Nasdaq bubble from 2000-2002. The fourth is credit 2007-9.
One thing worth noting is that these singularities blow up very big and very fast. And what you buy on the way out is not necessarily what went down the most.
So, by way of groundwork, to try to see through the singularity – I collected a few thoughts from the Templeton book;
Buy at the point of maximum pessimism.
Look where other people aren’t looking.
Look four years ahead, when others are reacting to today’s news.
Get in before sentiment changes. That’s the bit that differentiates you from the crowd. But diversify – so you don’t get killed for being too early.
The time to reflect on your investing is when you are most successful, not when you are under pressure.
Look for an angle, one that people are generally unaware of, that gives you an edge on the trade.
The short stocks and short Eastern European exposed financials trade that I’ve been running has now worked out well. It has also become somewhat more consensus. So late last week and early this, I’ve taken profit on around half my positions, leaving me 75% short. And this week I’m on a double header of sport – I went to Wimbledon yesterday with my wife, and I’m off to the cricket today with my dad.
But I think there is a big trade out there that could make a lot of money over the next few years. And that is long the dollar. Sentiment, valuation and pricing are all at an extreme. But the US current account deficit will likely shrink by 6% over the next four years. And it is the direction, not the size of the deficit that drives the currency. I am now standing 150% long the dollar.
Now as a postscript, I enjoyed meeting up with the boys at Templeton three years back. The day started with a two mile swim, then I walked down a three mile crescent beach, coconuts washing in with the tide. One thing I noticed in funky Nassau; so many half built houses just across from the beach. My take on this; liquidity going out before they were fully built. One thing value investors don’t tell you about is neap tides. That’s what we have in the banks right now, so I’ll be waiting some while longer before I go hunting for value there. Heck, the US consumer hasn’t even capitulated yet.
Confucius, at least I think it was him.
I’m not a huge one for quoting quotes. I don’t collect them or anything. But I quite like remembering ideas.
Then I heard about Art Garfunkel. He was the tall odd looking one with the totally weird high-pitched voice out of Simon & Garfunkel.
Anyway, Art may look like a freak. Turns out he is. He’s read two or three books a week for the past 20 years. Every one of them he’s written up in his blog.
He’s also gone walking for mile upon endless mile, across the United States. Of all the things you could do with the money from singing in a high pitched voice in a popular folk combo – that’s quite a cool bunch of things to do.
So I’ve taken a leaf out Art’s book. I’ve started collecting ideas. Learning from others’ successes. And in particular, learning from others' mistakes. The latter is harder. People don’t like to dwell too much on their mistakes. It’s not often you read a book ‘Why I was a bit lazy, not particularly inquisitive, and why I followed the people who knew better’. But yet, this is what we have to learn not to do.
I thought that finding books about big failures would tell me something I needed to know. There’s good stuff in these books. They are mostly catastrophic self-reinforcing flame-outs. Written mainly by people with the wit and detachment to write them after the fact. Often caused by an unwillingness to accept a mistake, to cut and move on.
But I’m also very interested in the loss of will. I have two ambitions for my trading; One, I’ll still be trading for a living in 40 years time. Two, I’ll wake up every day between now and then knowing that’s what I want to do.
I’ve written before – to achieve that end and for it to be worthwhile to achieve, I must never blow up. Hence the stops. Stops may sound like weakness to some. For me they represent humility in the face of a complex world. And humility, I think, is strength.
But there’s another thing that might derail my plan. And this I’m more afraid of. Losing will.
There are only about 50 books I’ve read ‘in-one-go’ in my life. And when I found one, I treasure it. It get’s into the library. One of them is ‘Goodbye to all that’ by Robert Graves. At one point in it he talked about suicide on the front. For him it was not a deliberate act. Just a certain carelessness. Down the trench slightly upright, helmet askew, fag upfront. He could see it immediately when a man took on the attitude. In a subtler form, nowadays, it is drift, allowing events to take their course. Going with the flow. This loss of will, it is potentially the most pernicious thing.
What I’ve tried to in my reading and writing is to find the next thing before I’d need it. So I’d always have the chops to be able to deal, fast and decisively, before a major change in market direction.
That’s why something a mate said recently got me thinking. He asked what do we buy when this thing blows through? I couldn’t think of anything is stocks. All I could see was the singularity - the point at which all my trades come through. And then nothing at all. I couldn’t see past that.
I’m not normally like that. And before, whenever I’ve been ‘one-way-only’ I’ve lost money. That was a warning bell – that I needed to do some work to sure up my conviction for the months ahead.
Now, to deal with it I started talking to people, and of course, I bought a book. ‘Investing the Templeton Way’ – written by his grand niece, or something. It’s all about what ‘Uncle John’ done. Hard to get through the introduction I admit. But once you tune out the cant, you get good stuff. And what is fascinating about John Templeton was the strength of his will in the face of outstanding social or consensus pressure the other way. But he wasn’t just a deep contrarian. He always seemed to look for an angle.
When he went long the US airline stocks at the end of the first trading day post 9/11 he did it because he felt it inconceivable that the government would allow the airlines to fail in this circumstance – a bailout would come. That took incredible nerve. When he went long Japan in the early 1960s he saw a fast growing economy, with fast growing cheap stocks which, critically, did not report consolidated earnings. They were, at the time, much cheaper than most people thought.
But before we start trumpeting value above all else – it’s worth being scientific. There are no books by optimistic US investors who were investing pre 1929. Only after. And the most optimistic – Benjamin Graham – we know blew it all in 1929-32.
And, as Templeton and Buffet proved – value worked in the ‘70s. You stayed alive. The volatility offered you great opportunities. As long as you kept discipline.
But the problem comes if you hit a deflation. Then value suffers. Here’s one example; in an inflation price to book hides the value of a stock – because the replacement cost of the capital stock will have increased substantially. So the engineers like ABB right now are probably cheaper than they look (although they look so expensive I wouldn’t say they were cheap). But in a deflation, capital replacement gets cheaper – so price to book gives a false signal. And so of course does PE, and especially a PEG (Price to earnings divided by growth). And so the main problem I have with value investing is that it doesn’t tell you when to get in during a 1929 type crash. It would have been easy to get in after the market fell 80%, all the ratios were attractive, and the mood deeply pessimistic, only to see it fall a further 50%. Not particularly good for compounded returns.
And that’s the thing about singularities – nothing gets through them, even the best value techniques – without being denatured.
Now, my concern is that I think we’re in the fourth major singularity in financial markets in 100 years. The first was stocks in 1929-32. The second was large caps in 1973/4 (after the Nifty 50 bubble). The third was the Nasdaq bubble from 2000-2002. The fourth is credit 2007-9.
One thing worth noting is that these singularities blow up very big and very fast. And what you buy on the way out is not necessarily what went down the most.
So, by way of groundwork, to try to see through the singularity – I collected a few thoughts from the Templeton book;
Buy at the point of maximum pessimism.
Look where other people aren’t looking.
Look four years ahead, when others are reacting to today’s news.
Get in before sentiment changes. That’s the bit that differentiates you from the crowd. But diversify – so you don’t get killed for being too early.
The time to reflect on your investing is when you are most successful, not when you are under pressure.
Look for an angle, one that people are generally unaware of, that gives you an edge on the trade.
The short stocks and short Eastern European exposed financials trade that I’ve been running has now worked out well. It has also become somewhat more consensus. So late last week and early this, I’ve taken profit on around half my positions, leaving me 75% short. And this week I’m on a double header of sport – I went to Wimbledon yesterday with my wife, and I’m off to the cricket today with my dad.
But I think there is a big trade out there that could make a lot of money over the next few years. And that is long the dollar. Sentiment, valuation and pricing are all at an extreme. But the US current account deficit will likely shrink by 6% over the next four years. And it is the direction, not the size of the deficit that drives the currency. I am now standing 150% long the dollar.
Now as a postscript, I enjoyed meeting up with the boys at Templeton three years back. The day started with a two mile swim, then I walked down a three mile crescent beach, coconuts washing in with the tide. One thing I noticed in funky Nassau; so many half built houses just across from the beach. My take on this; liquidity going out before they were fully built. One thing value investors don’t tell you about is neap tides. That’s what we have in the banks right now, so I’ll be waiting some while longer before I go hunting for value there. Heck, the US consumer hasn’t even capitulated yet.
Friday 20 June 2008
A Catalogue of Errors
Every two or three months I go back through my trades – to see where I’ve made mistakes. This isn’t as easy at it as it seems. Because I don’t view losses as mistakes. If you think about it, they’re not. If you’re playing poker, you reckon you’ll win with a straight, you have a one in six chance of drawing to fill a straight, and the pot is offering you 10 to one. Well, that is a good bet, irrespective of whether you win or lose. The same with trading, as long as you’re making good risk/reward bets, it’s no mistake to lose on a trade.
The first mistake I noticed was in my blog from a couple of months ago. I said that there just weren’t enough books about how to lose money. Well, now I’ve found several. One I read last week was ‘Wiped out – how I lost a fortune in the stock market while the averages were making new highs’ by an anonymous investor. It’s clearly written and utterly cringemaking. The guy gets into a trading death spiral. He makes lots of mistakes – and six whoppers.
He’s way too ambitious. He wants 100% a year. So each position he takes is much too large (often risking 10-20% of NAV). That’s mistake one. He operates entirely on tips, with no sense of how they deliver a competitive advantage. Mistake two. He adds to losers, and runs no stops. Mistake three. He takes quick profits. Mistake four. He never takes any profits out to spend on his family – mistake five. And he borrows his wife’s money to put on a trade. Mistake six.
One of the best bits of advice I ever got was from the book Zurich Axioms, by Max Gunther. He said – set trading targets. And when you hit them, take some money out and treat yourself and the family. My rule is to do this every 5%. We’ve had a cracker since I started in Mid-February. Today we hit a new target for the seventh time, and the posh dinners are backing up. The coolest place we’ve been so far is downstairs at L’Atellier de Joel Rubichon. I never regret taking profits when it’s in a good cause.
Now, if it’s not necessarily an error to make a loss – what constitutes a mistake? I’m looking for any one of four things;
a) Did I do enough work to identify the self reinforcing trend, and the good risk/reward before the trade?
b) Did I bet in the right size?
c) Did I cut when I hit my stops?
d) Did I run my winners?
So what mistakes have I made? I’ve made three stand-out mistakes over the last couple of months.
I built up too big a short position in gold too quickly, and I quickly hit my stops. This was an error because I didn’t adjust the position size for volatility as I normally do. This was basically because I put the position on fast, without the normal testing. Going too large cost me 0.5%.
Second, I built up my Euro/Yen short and straight long yen positions too quickly. I’d done sufficient work to justify the positions, but I was too aggressive too quick – assuming that the severe pressure on financials over the past couple of weeks would break the currency trend. So I got up to four risk units in the time it would normally take me to two. That was costly, as I was forced to cut them as soon as I hit stops. That mistake also cost an extra 0.5%.
Third – I got too aggressive on a short sterling trade. Now, I’d tried a couple of small short sterling trades in previous weeks and lost on them. Then, when I looked into it further, I felt that it was not the greatest risk/reward trade to go long (expect fewer rate hikes) – given the pound’s move lower, and the escalation in inflation expectations. Anyway, I kept watching it, and then a mate told me that there was a trading opportunity. At 9.30 on Wednesday RPI was due out, and he reckoned it could print high. But then at 10am Merv’s letter would get released and there was no evidence it would talk hikes. The inflation report had inflation back on track with no hikes. Given the moves we’d seen of late, and the size of the short position, I thought I could rip out a decent trade. So, in five minutes from 9.35 to 9.40am on Wednesday I put on six risk units long – which wasn’t against the larger trading limits that I’d set four weeks before. But it was large given that I’d previously identified it as an uncompelling trade.
In this case I got away with it. I made 1% for the fund in about two hours. I then took profits on almost the whole position on a 35bps move – 25 was my target. That was lucky. Had it moved 10bps I might have left it on. The next morning, the freak retail sales caused a 35bps move the other way. That would have been exceptionally painful. The basic lesson I learnt from that – don’t get too large unless the risk/reward is great and you believe it enough to stick with it. Second – avoid markets where the elephants are stampeding around. There are too many stressed banks with haemorrhaging fixed income and structured product positions. It’s causing horrific trading volatility.
Life’s too short to play these sorts of moves. Better, simply, to be short the banks themselves.
The three things I’m proud of are doubling my risk exposure in May to play the short side. Then I was up 22% and I was prepared to risk half my gains to play what I thought was an exceptional risk/reward opportunity. And then sticking with it over the past week or two – when the market bounced, only to fall to new lows. Earlier today I hit 35% up.
Second, not allowing a single trade to run through its stop.
Third, spending much more time reading and writing – and much less time watching the screen. I’ve found reading during the trading day makes me much more patient on the big risk/reward trades – and that’s definitely helping my trading.
The first mistake I noticed was in my blog from a couple of months ago. I said that there just weren’t enough books about how to lose money. Well, now I’ve found several. One I read last week was ‘Wiped out – how I lost a fortune in the stock market while the averages were making new highs’ by an anonymous investor. It’s clearly written and utterly cringemaking. The guy gets into a trading death spiral. He makes lots of mistakes – and six whoppers.
He’s way too ambitious. He wants 100% a year. So each position he takes is much too large (often risking 10-20% of NAV). That’s mistake one. He operates entirely on tips, with no sense of how they deliver a competitive advantage. Mistake two. He adds to losers, and runs no stops. Mistake three. He takes quick profits. Mistake four. He never takes any profits out to spend on his family – mistake five. And he borrows his wife’s money to put on a trade. Mistake six.
One of the best bits of advice I ever got was from the book Zurich Axioms, by Max Gunther. He said – set trading targets. And when you hit them, take some money out and treat yourself and the family. My rule is to do this every 5%. We’ve had a cracker since I started in Mid-February. Today we hit a new target for the seventh time, and the posh dinners are backing up. The coolest place we’ve been so far is downstairs at L’Atellier de Joel Rubichon. I never regret taking profits when it’s in a good cause.
Now, if it’s not necessarily an error to make a loss – what constitutes a mistake? I’m looking for any one of four things;
a) Did I do enough work to identify the self reinforcing trend, and the good risk/reward before the trade?
b) Did I bet in the right size?
c) Did I cut when I hit my stops?
d) Did I run my winners?
So what mistakes have I made? I’ve made three stand-out mistakes over the last couple of months.
I built up too big a short position in gold too quickly, and I quickly hit my stops. This was an error because I didn’t adjust the position size for volatility as I normally do. This was basically because I put the position on fast, without the normal testing. Going too large cost me 0.5%.
Second, I built up my Euro/Yen short and straight long yen positions too quickly. I’d done sufficient work to justify the positions, but I was too aggressive too quick – assuming that the severe pressure on financials over the past couple of weeks would break the currency trend. So I got up to four risk units in the time it would normally take me to two. That was costly, as I was forced to cut them as soon as I hit stops. That mistake also cost an extra 0.5%.
Third – I got too aggressive on a short sterling trade. Now, I’d tried a couple of small short sterling trades in previous weeks and lost on them. Then, when I looked into it further, I felt that it was not the greatest risk/reward trade to go long (expect fewer rate hikes) – given the pound’s move lower, and the escalation in inflation expectations. Anyway, I kept watching it, and then a mate told me that there was a trading opportunity. At 9.30 on Wednesday RPI was due out, and he reckoned it could print high. But then at 10am Merv’s letter would get released and there was no evidence it would talk hikes. The inflation report had inflation back on track with no hikes. Given the moves we’d seen of late, and the size of the short position, I thought I could rip out a decent trade. So, in five minutes from 9.35 to 9.40am on Wednesday I put on six risk units long – which wasn’t against the larger trading limits that I’d set four weeks before. But it was large given that I’d previously identified it as an uncompelling trade.
In this case I got away with it. I made 1% for the fund in about two hours. I then took profits on almost the whole position on a 35bps move – 25 was my target. That was lucky. Had it moved 10bps I might have left it on. The next morning, the freak retail sales caused a 35bps move the other way. That would have been exceptionally painful. The basic lesson I learnt from that – don’t get too large unless the risk/reward is great and you believe it enough to stick with it. Second – avoid markets where the elephants are stampeding around. There are too many stressed banks with haemorrhaging fixed income and structured product positions. It’s causing horrific trading volatility.
Life’s too short to play these sorts of moves. Better, simply, to be short the banks themselves.
The three things I’m proud of are doubling my risk exposure in May to play the short side. Then I was up 22% and I was prepared to risk half my gains to play what I thought was an exceptional risk/reward opportunity. And then sticking with it over the past week or two – when the market bounced, only to fall to new lows. Earlier today I hit 35% up.
Second, not allowing a single trade to run through its stop.
Third, spending much more time reading and writing – and much less time watching the screen. I’ve found reading during the trading day makes me much more patient on the big risk/reward trades – and that’s definitely helping my trading.
Thursday 19 June 2008
Trust
‘Trust’ is Francis Fukayama’s difficult second book. It’s hard to write a second book, if your first book is called ‘The End of History and the Last Man’. The end of history meant that, once the East turned West, there was no more international ideological conflict, just individuals competing with each other. It was history’s own grey goo. Fukayama has since recanted ‘The End of History’. He admits he should have called it ‘The End of an Era’. But hey, you gotta eat, it was a great title and, er, it looked right at the time.
‘Trust’ is a different kettle of fish. It’s more of a slow burner. It’s not so much of a time, more something that keeps coming up, all of the time.
Now Fukayama’s big idea here is that trust is good. You can measure economic development by trust. You can measure richer nations against poorer by the level of trust. It’s all good. A high correlation exists.
There’s a bizarre police procedural on the telly called ‘Numbers’. The lead detectives brother, dad, sister-in-law and uncle are all maths geeks. And as he discusses the case, the foppish haired but slightly too intense brother will suggest using a Bayesian filter to analyse the likely early action of the killer.
Now, you can take this at face value – and it’s pretty funny at face value. Or you can ask a Robert Prechter type of question – how does a populist maths geek program get made? The last time I saw a mathematician on telly, he was in black & white, and he had crumbs in his beard. Well, yes, it’s because of trust. And when ‘Numbers’ got commissioned, in 2006, geeks were great.
The last episode of Numbers I watched, the floppy haired maths guy suggested a tit-for-tat strategy with an assassin who promised to give up his scores. Tit-for-tat, as you know, is the way to solve the ‘failure of the commons’ problem. You trust first, and if the other person behaves well, you keep trusting. If they misbehave, you ‘tat’ – or punish them. All’s well if you make clear that’s what you’re doing – the opposition fall in line and behaves. Self preservation prevails. If you don’t pass on the information, well, it’s Dr Strangelove all over again.
Tit-for-tat, in the case of the assassin, did not work. The killer lied. The chisel faced, but tortured, mathematics genius then suggested tit-for-tit-for-tat. The idea behind this strategy is that. Once you’ve punished, yet the opposition has not responded by cooperating, well, be stern, think about it, but, well, give them another go. In repeated computer simulations, as in life, this works well. It certainly did in Numbers. It generally does in a successful society. On account of the general high level of trust.
But in the computer simulations tit-for-tit-for-tit-for-tat, that is one more level of trust, well, that is suboptimal. Forgive once, forgive twice, but three times, well, you’re hurting yourself. It strikes me that the financials are asking us to forgive them thrice. They want us to forgive them for their over-exuberance, er, ok. They want us to forgive them for their failure, well, er, maybe yes, ok. And they want us to forgive them for ‘maintaining confidence’ – the banking sector’s new economics of truth. Fine, most of the time. But when conditions are deteriorating materially again, well, personally I’m not into self harm.
The night before last, I stayed up ‘til 3am. And I’m ashamed to admit that there was no alcohol or drugs involved. I was reading David Einhorn’s ‘Fooling some of the people all of the time’. What turns this book from the good – something well written and financially wordly-wise, like the Zurich Axioms, to the great – is the moral truth of the thing. If most players in the world, in the face of abuse, are a bunch of ‘tits’, this guy is the ‘tat’. And he tells you why. In rather a lot of detail.
The question here, is how many people, faced with the third round of abuse from the financials, will turn from ‘tit’ to ‘tat’. My guess is that self preservation will rule. Most people, most of the time, don’t actually want to hurt themselves.
‘Trust’ is a different kettle of fish. It’s more of a slow burner. It’s not so much of a time, more something that keeps coming up, all of the time.
Now Fukayama’s big idea here is that trust is good. You can measure economic development by trust. You can measure richer nations against poorer by the level of trust. It’s all good. A high correlation exists.
There’s a bizarre police procedural on the telly called ‘Numbers’. The lead detectives brother, dad, sister-in-law and uncle are all maths geeks. And as he discusses the case, the foppish haired but slightly too intense brother will suggest using a Bayesian filter to analyse the likely early action of the killer.
Now, you can take this at face value – and it’s pretty funny at face value. Or you can ask a Robert Prechter type of question – how does a populist maths geek program get made? The last time I saw a mathematician on telly, he was in black & white, and he had crumbs in his beard. Well, yes, it’s because of trust. And when ‘Numbers’ got commissioned, in 2006, geeks were great.
The last episode of Numbers I watched, the floppy haired maths guy suggested a tit-for-tat strategy with an assassin who promised to give up his scores. Tit-for-tat, as you know, is the way to solve the ‘failure of the commons’ problem. You trust first, and if the other person behaves well, you keep trusting. If they misbehave, you ‘tat’ – or punish them. All’s well if you make clear that’s what you’re doing – the opposition fall in line and behaves. Self preservation prevails. If you don’t pass on the information, well, it’s Dr Strangelove all over again.
Tit-for-tat, in the case of the assassin, did not work. The killer lied. The chisel faced, but tortured, mathematics genius then suggested tit-for-tit-for-tat. The idea behind this strategy is that. Once you’ve punished, yet the opposition has not responded by cooperating, well, be stern, think about it, but, well, give them another go. In repeated computer simulations, as in life, this works well. It certainly did in Numbers. It generally does in a successful society. On account of the general high level of trust.
But in the computer simulations tit-for-tit-for-tit-for-tat, that is one more level of trust, well, that is suboptimal. Forgive once, forgive twice, but three times, well, you’re hurting yourself. It strikes me that the financials are asking us to forgive them thrice. They want us to forgive them for their over-exuberance, er, ok. They want us to forgive them for their failure, well, er, maybe yes, ok. And they want us to forgive them for ‘maintaining confidence’ – the banking sector’s new economics of truth. Fine, most of the time. But when conditions are deteriorating materially again, well, personally I’m not into self harm.
The night before last, I stayed up ‘til 3am. And I’m ashamed to admit that there was no alcohol or drugs involved. I was reading David Einhorn’s ‘Fooling some of the people all of the time’. What turns this book from the good – something well written and financially wordly-wise, like the Zurich Axioms, to the great – is the moral truth of the thing. If most players in the world, in the face of abuse, are a bunch of ‘tits’, this guy is the ‘tat’. And he tells you why. In rather a lot of detail.
The question here, is how many people, faced with the third round of abuse from the financials, will turn from ‘tit’ to ‘tat’. My guess is that self preservation will rule. Most people, most of the time, don’t actually want to hurt themselves.
Tuesday 17 June 2008
The Ambassadors
One of the best paintings, I think, that’s ever been made is Hans Holbein’s ‘The Ambassadors’.
It shows two men of similar age and stature. They seem to be connected somehow. They are surrounded by books, maps, instruments. But something is wrong. A silver crucifix hangs half obscured by a velvet curtain. The lute has lost a string. There is detritus scattered and books torn. And there is the apparition. The distorted skull set between them. Somehow the two men, the Ambassadors, so similar in outlook, are riven by forces greater than they can control. This picture is so good, I think it is almost up there with Velasquez’s painting ‘Las Meninas’ - the Maids of Honour. Both were painted by great artists in disquieting times. And somehow that disquiet makes its way into the very form of their work, causing them to push the boundaries of painting in their, or to be honest any, time.
A good mate asked me today what we should buy when this sell-off is done. I struggled to answer. And, if you know me, you’ll know that’s a rare occurrence. The problem is that whenever I try to conceive a good way out – and with it the opportunity to accumulate stocks that can get into virtuous cycles of growth and good returns – well, I just keep seeing detritus. Signs foretelling dangerous times.
Now of course, you might say that it is the preponderance of bad news that often marks a major low in stocks. Or, more subtly, that it is a peak in negative sentiment that marks a bottom, as by that time people have priced in more bad news than is ever likely to occur. My problem, I see forces at work that will make news that is not priced in. Investors are still anchored to a benign outcome.
It’s not that I lack imagination. I can see a benign outcome. I’ve constructed a roadmap to get us there. The only problem is that it takes a collapse in the US current account deficit, a primary dollar bull market, and an implosion in the ‘reflator’ states from Romania to Spain before we get there. In short, I need a panic to get positive. Now this is unfortunate, as I’m a big believer in a positive mental attitude. What I’m positive about now is that I’ll make lots of money before I turn positive.
Now, I thought of a new way to frame the debate. Well, not exactly new – I wrote it up in an essay called ‘pancake’ a couple of years back. The idea was simple. It concerned the new world order – the ‘Bretton Woods II’ system that redistributed cash from savings and investment rich China, to the savings and investment poor US. This depressed yields, boosted earnings, and led to all round financial good times. But it had an invisible symptom. One that, like a dodgy ticker, would only show up when the central banks exerted themselves, and then, potentially, with catastrophic consequences.
The symptom was a flat Phillips curve – as flat as a pancake.
Now the Phillips curve, as I’m sure you know, is the trade off between unemployment and inflation. Back in the 1990s, in the US at least, it was incredibly steep. It only took a small rise in unemployment to give inflation a real bashing. Donald Kohn at the Fed described it as a low sacrifice ratio. The Fed wouldn’t have to sacrifice many jobs to get inflation expectations anchored. And with a low sacrifice ratio, Greenspan saw to it that inflationary expectations got anchored a little bit lower each cycle, with all the fantastic benefits that brought. It was the golden age of central banking.
But the advent of ‘Bretton Woods II’ (BW2) in 2002 changed the dynamic. And since then the Phillips curve has collapsed. Now somewhere like the UK might need to see unemployment back at 4m to get inflation and inflation expectations back in check.
What’s changed? Well BW2 was incredibly effective at reflating consumption in the US, UK, Western and Eastern Europe. With utilisation rates low around the world we saw an unprecedented boom, with little or no wage pressure. Resources fared a lot better than wages – due to the high intensity of demand and the relatively scarce supply.
So far BW2 looks like BW1 – that lasted from 1944 to 1971, with the first 20 years of that period ‘good’ years. So what’s the problem?
The problem is that they are not exactly alike. Barry Eichengreen - - the ‘Daddy’ of global financial analysis - highlighted in his book ‘Global Imbalances and the Lessons of Bretton Woods’ – that Germany and Japan redirected capital flows towards infrastructure and capital investment over the period. The infrastructure investment helped promote massive, initially disinflationary growth, and a continuous productive redeployment of underutilised workforces.
This time round, lower yields caused a massive increase in asset prices – particularly real estate – around the world. Barry’s view; that’s highly unstable. BW2 will break down much faster than BW1. In my view, the primary cause of the breakdown will be the same – inflationary pressure stemming from the guns and butter policies of the US. Policies that saw – both from 2002-7, and from 1962-1971 – rapid deteriorations in the US current account. The second inflationary pressure came from the full utilisation of the workforces of Europe and Japan by the end of the 1960s. It could be argued, though I’ll admit it’s controversial, that China is now seeing a similar tightness as migration slows and wages rise.
But there’s also no doubt that the monetary authorities in the West are a different breed nowadays. All have an inflation mandate. And I think to a person, the members of the Fed, the ECB and the MPC believe that the effects of a ‘de-anchoring’ of inflationary expectations would be dire indeed.
But there’s the rub. Because BW2 keeps grinding. Only now what we’re seeing is robust domestic demand growth of the BRICs (where, mostly, the growth is self-sustaining) and relentless demand growth out of the oil exporters. All this when utilisation rates in these areas are at generational highs. The result; bottlenecks and resource price spikes. Spikes that are fraying inflationary expectations in the West.
That leaves us in trouble deep. If the West lets inflation expectations go unchecked, then we’re headed for a massive inflation ridden bear market, not dissimilar to the 16 years of pain from 1966-1982. But to check them it must induce more unemployment than would be politically, or socially, acceptable. On account of the flat Phillips curve – the fact that rising unemployment in the West will struggle to affect the dynamics in the oil market, the oil rich states, or the BRICs.
Is there no way out? I have to admit that I’m with DR Pangloss. I think a disciplined Fed, a dollar bull market, a collapse in Eastern and Southern Europe, and falling resource prices, while painful, would be by far the least painful outcome. You see I’m no Ambassador – I’m an optimistic guy – from here it would be the best of all possible worlds – and that’s what I’m betting on.
Now of course, you might say that it is the preponderance of bad news that often marks a major low in stocks. Or, more subtly, that it is a peak in negative sentiment that marks a bottom, as by that time people have priced in more bad news than is ever likely to occur. My problem, I see forces at work that will make news that is not priced in. Investors are still anchored to a benign outcome.
It’s not that I lack imagination. I can see a benign outcome. I’ve constructed a roadmap to get us there. The only problem is that it takes a collapse in the US current account deficit, a primary dollar bull market, and an implosion in the ‘reflator’ states from Romania to Spain before we get there. In short, I need a panic to get positive. Now this is unfortunate, as I’m a big believer in a positive mental attitude. What I’m positive about now is that I’ll make lots of money before I turn positive.
Now, I thought of a new way to frame the debate. Well, not exactly new – I wrote it up in an essay called ‘pancake’ a couple of years back. The idea was simple. It concerned the new world order – the ‘Bretton Woods II’ system that redistributed cash from savings and investment rich China, to the savings and investment poor US. This depressed yields, boosted earnings, and led to all round financial good times. But it had an invisible symptom. One that, like a dodgy ticker, would only show up when the central banks exerted themselves, and then, potentially, with catastrophic consequences.
The symptom was a flat Phillips curve – as flat as a pancake.
Now the Phillips curve, as I’m sure you know, is the trade off between unemployment and inflation. Back in the 1990s, in the US at least, it was incredibly steep. It only took a small rise in unemployment to give inflation a real bashing. Donald Kohn at the Fed described it as a low sacrifice ratio. The Fed wouldn’t have to sacrifice many jobs to get inflation expectations anchored. And with a low sacrifice ratio, Greenspan saw to it that inflationary expectations got anchored a little bit lower each cycle, with all the fantastic benefits that brought. It was the golden age of central banking.
But the advent of ‘Bretton Woods II’ (BW2) in 2002 changed the dynamic. And since then the Phillips curve has collapsed. Now somewhere like the UK might need to see unemployment back at 4m to get inflation and inflation expectations back in check.
What’s changed? Well BW2 was incredibly effective at reflating consumption in the US, UK, Western and Eastern Europe. With utilisation rates low around the world we saw an unprecedented boom, with little or no wage pressure. Resources fared a lot better than wages – due to the high intensity of demand and the relatively scarce supply.
So far BW2 looks like BW1 – that lasted from 1944 to 1971, with the first 20 years of that period ‘good’ years. So what’s the problem?
The problem is that they are not exactly alike. Barry Eichengreen - - the ‘Daddy’ of global financial analysis - highlighted in his book ‘Global Imbalances and the Lessons of Bretton Woods’ – that Germany and Japan redirected capital flows towards infrastructure and capital investment over the period. The infrastructure investment helped promote massive, initially disinflationary growth, and a continuous productive redeployment of underutilised workforces.
This time round, lower yields caused a massive increase in asset prices – particularly real estate – around the world. Barry’s view; that’s highly unstable. BW2 will break down much faster than BW1. In my view, the primary cause of the breakdown will be the same – inflationary pressure stemming from the guns and butter policies of the US. Policies that saw – both from 2002-7, and from 1962-1971 – rapid deteriorations in the US current account. The second inflationary pressure came from the full utilisation of the workforces of Europe and Japan by the end of the 1960s. It could be argued, though I’ll admit it’s controversial, that China is now seeing a similar tightness as migration slows and wages rise.
But there’s also no doubt that the monetary authorities in the West are a different breed nowadays. All have an inflation mandate. And I think to a person, the members of the Fed, the ECB and the MPC believe that the effects of a ‘de-anchoring’ of inflationary expectations would be dire indeed.
But there’s the rub. Because BW2 keeps grinding. Only now what we’re seeing is robust domestic demand growth of the BRICs (where, mostly, the growth is self-sustaining) and relentless demand growth out of the oil exporters. All this when utilisation rates in these areas are at generational highs. The result; bottlenecks and resource price spikes. Spikes that are fraying inflationary expectations in the West.
That leaves us in trouble deep. If the West lets inflation expectations go unchecked, then we’re headed for a massive inflation ridden bear market, not dissimilar to the 16 years of pain from 1966-1982. But to check them it must induce more unemployment than would be politically, or socially, acceptable. On account of the flat Phillips curve – the fact that rising unemployment in the West will struggle to affect the dynamics in the oil market, the oil rich states, or the BRICs.
Is there no way out? I have to admit that I’m with DR Pangloss. I think a disciplined Fed, a dollar bull market, a collapse in Eastern and Southern Europe, and falling resource prices, while painful, would be by far the least painful outcome. You see I’m no Ambassador – I’m an optimistic guy – from here it would be the best of all possible worlds – and that’s what I’m betting on.
Monday 16 June 2008
Triple D
‘Well, what do you know?’ says one trader to the other.
‘Just covered my Steel’ is the reply. ‘Too much company. Everybody seems to be short’
‘Everybody I’ve seen thinks just as you do. Each one has covered because he thinks everybody else is short – still the market doesn’t rally much. I don’t believe there’s much short interest left, and if that’s the case, we shall get another break’
‘Yes, that’s what they all say – and they’ve all sold short again because they think everybody else has covered. I believe there’s just as much short interest now as there was before’
From ‘The Psychology of the Stock Market’
By G.C. Seldon, 1912
Seldon went on to say that these mental gymnastics could go on & on – and that it highlighted a fundamentally different mindset among those that are short, and those that are long. Often jittery, technical – they speculate. But few ever ‘invest’ in a short position.
So it is worth asking – now we’ve seen a decent break in the markets, do I believe what we just saw was a technical correction lower? A reaction that gets weak players out, so the strong holders can build again for the new bull market? Or, are we in a more serious type of trouble? The type of trouble that will lead to a break of the March lowers to new, deeper, lows beyond.
That brings me to Jesse Livermore’s epiphany. He started out making a small fortune in the bucket shops – the equivalent of spread betting accounts today. Then he moved to a full retail brokerage, where he proceeded to lose money fast. One day he saw this old guy in the office, who went by the moniker Mr Partridge. Something to do with how his head was stuck halfway down his chest. The young guys would come up to him, saying he should cover his Steel, on account a rally was coming. Partridge said – yes, yes, thank you young man, you’re most likely right. When, asked after a decent pop, whether he’d covered, he said ‘No, I didn’t want to lose my position’.
And as he went on, Livermore came to see the wisdom in Mr Partridge’s ways – you could only make big money on the major moves. Working out whether people were short and covering might be good for a turn. But likely harmful to making the big dollars.
That is where I stand right now. I bought my net short down some on Tuesday and Wednesday last week. Mainly for technical reasons; panic selling of the UK banks, people no longer bullish etc. But fundamentally, I’m still bearish, and I’m still over 100% short.
And that’s because I think we are a small way through a big movement lower. In short – I think we’re headed for a triple derating. The events of the last fortnight, I suspect, have made this even more likely. So, how will this come about?
The first derating will come from the expectation, and then the realisation, of slower growth. The leading indicators in Europe and the UK have fallen off a cliff. And I think the US economy will ‘double-dip’ in the autumn when the tax break fades and the ‘end-of-destocking’ ends. But this isn’t the trouble. I think the big problem is that the slowdown may start reinforcing itself. I think that credit will play the central role.
In Bernanke’s ‘Essays on the Great Depression’, he did not think that a lack of credit available to small firms caused the depression. After all, big, cash rich firms could have used to invest and replace the smaller firms. Funny, you hear the same arguments today. But back then, the big cash rich firms just stopped investing. Why?
Because aggregate demand fell. Why did aggregate demand fall? Bernanke found that bank crises were a significant cause (he modelled it in some detail – but I’ll spare you that). Why? Because bank crises disrupted financial intermediation between consumers. Consumers could save at the ‘safe’ rate – which was, as it is now in the US, pretty low. And that’s if they trusted the bank. But consumers could only borrow at a much higher rate – if at all – due to banks’ unwillingness to lend. That kind of behaviour leads to asset price deflation and a reduction in the ability and willingness to lend, again. It was when the money stopped circulating, after the credit boom of the ‘20s, that the trouble really started.
There’s little doubt that this has started to happen in the US. My suspicion is that it’s going to get even worse than that in Europe and the UK.
Second, equity markets will derate as two year rates rise. This hasn’t been obvious, and that’s why so many people have lost their shirts buying short sterling, Euribor etc in recent weeks. What’s happened is that the rules have changed. In the 1990s, slower growth meant lower yields, and once slower growth was halfway done, stock rerating – as the discount on future earnings shrunk, and expectations of future growth improved.
But now we have shortages in oil. Shortages in food. And now consumers’ inflation expectations are fraying as a result – so the inflation targeting central banks are stuck. And, as I’ve discussed before, the unwinding of the European Banks’ structured product positions is also a big factor. So now we have slowing growth and rising two year yields. It’s a double derating; we’re discounting future earnings by more, just as we’re starting to suspect that future growth will worsen.
And if that’s not bad enough, I now think we get de-rating, part III.
What’s stage III? Well, I think we’re headed right into the jaws of a good old fashioned currency crisis. I think the ‘Bretton Woods II’ construct now unravels. And with it will come the kind of fear and volatility that will get stocks genuinely cheap. Cheap enough to buy.
I think three main forces are in place. The most important – the US current account deficit is now shrinking, after blowing out by 7.5% in five years. There’s a spooky similarity – in timing and magnitude - between that and the collapse in the US current account surplus in the years prior to the collapse of Bretton Woods I. A shrinking surplus or a rising deficit allows for both guns and butter. If the Fed holds to it's line that inflation expectations must remain anchored, and i believe that it will, the deficit will shrink further. A shrinking deficit means the butter, and then the guns, have to go.
‘Just covered my Steel’ is the reply. ‘Too much company. Everybody seems to be short’
‘Everybody I’ve seen thinks just as you do. Each one has covered because he thinks everybody else is short – still the market doesn’t rally much. I don’t believe there’s much short interest left, and if that’s the case, we shall get another break’
‘Yes, that’s what they all say – and they’ve all sold short again because they think everybody else has covered. I believe there’s just as much short interest now as there was before’
From ‘The Psychology of the Stock Market’
By G.C. Seldon, 1912
Seldon went on to say that these mental gymnastics could go on & on – and that it highlighted a fundamentally different mindset among those that are short, and those that are long. Often jittery, technical – they speculate. But few ever ‘invest’ in a short position.
So it is worth asking – now we’ve seen a decent break in the markets, do I believe what we just saw was a technical correction lower? A reaction that gets weak players out, so the strong holders can build again for the new bull market? Or, are we in a more serious type of trouble? The type of trouble that will lead to a break of the March lowers to new, deeper, lows beyond.
That brings me to Jesse Livermore’s epiphany. He started out making a small fortune in the bucket shops – the equivalent of spread betting accounts today. Then he moved to a full retail brokerage, where he proceeded to lose money fast. One day he saw this old guy in the office, who went by the moniker Mr Partridge. Something to do with how his head was stuck halfway down his chest. The young guys would come up to him, saying he should cover his Steel, on account a rally was coming. Partridge said – yes, yes, thank you young man, you’re most likely right. When, asked after a decent pop, whether he’d covered, he said ‘No, I didn’t want to lose my position’.
And as he went on, Livermore came to see the wisdom in Mr Partridge’s ways – you could only make big money on the major moves. Working out whether people were short and covering might be good for a turn. But likely harmful to making the big dollars.
That is where I stand right now. I bought my net short down some on Tuesday and Wednesday last week. Mainly for technical reasons; panic selling of the UK banks, people no longer bullish etc. But fundamentally, I’m still bearish, and I’m still over 100% short.
And that’s because I think we are a small way through a big movement lower. In short – I think we’re headed for a triple derating. The events of the last fortnight, I suspect, have made this even more likely. So, how will this come about?
The first derating will come from the expectation, and then the realisation, of slower growth. The leading indicators in Europe and the UK have fallen off a cliff. And I think the US economy will ‘double-dip’ in the autumn when the tax break fades and the ‘end-of-destocking’ ends. But this isn’t the trouble. I think the big problem is that the slowdown may start reinforcing itself. I think that credit will play the central role.
In Bernanke’s ‘Essays on the Great Depression’, he did not think that a lack of credit available to small firms caused the depression. After all, big, cash rich firms could have used to invest and replace the smaller firms. Funny, you hear the same arguments today. But back then, the big cash rich firms just stopped investing. Why?
Because aggregate demand fell. Why did aggregate demand fall? Bernanke found that bank crises were a significant cause (he modelled it in some detail – but I’ll spare you that). Why? Because bank crises disrupted financial intermediation between consumers. Consumers could save at the ‘safe’ rate – which was, as it is now in the US, pretty low. And that’s if they trusted the bank. But consumers could only borrow at a much higher rate – if at all – due to banks’ unwillingness to lend. That kind of behaviour leads to asset price deflation and a reduction in the ability and willingness to lend, again. It was when the money stopped circulating, after the credit boom of the ‘20s, that the trouble really started.
There’s little doubt that this has started to happen in the US. My suspicion is that it’s going to get even worse than that in Europe and the UK.
Second, equity markets will derate as two year rates rise. This hasn’t been obvious, and that’s why so many people have lost their shirts buying short sterling, Euribor etc in recent weeks. What’s happened is that the rules have changed. In the 1990s, slower growth meant lower yields, and once slower growth was halfway done, stock rerating – as the discount on future earnings shrunk, and expectations of future growth improved.
But now we have shortages in oil. Shortages in food. And now consumers’ inflation expectations are fraying as a result – so the inflation targeting central banks are stuck. And, as I’ve discussed before, the unwinding of the European Banks’ structured product positions is also a big factor. So now we have slowing growth and rising two year yields. It’s a double derating; we’re discounting future earnings by more, just as we’re starting to suspect that future growth will worsen.
And if that’s not bad enough, I now think we get de-rating, part III.
What’s stage III? Well, I think we’re headed right into the jaws of a good old fashioned currency crisis. I think the ‘Bretton Woods II’ construct now unravels. And with it will come the kind of fear and volatility that will get stocks genuinely cheap. Cheap enough to buy.
I think three main forces are in place. The most important – the US current account deficit is now shrinking, after blowing out by 7.5% in five years. There’s a spooky similarity – in timing and magnitude - between that and the collapse in the US current account surplus in the years prior to the collapse of Bretton Woods I. A shrinking surplus or a rising deficit allows for both guns and butter. If the Fed holds to it's line that inflation expectations must remain anchored, and i believe that it will, the deficit will shrink further. A shrinking deficit means the butter, and then the guns, have to go.
What else blows up Bretton Woods II?
We have the structural weakness in the reflator states - the Stans, the Baltics, Southern Europe, Ireland and the UK; the inflated property, the consumer debt, the foreign borrowing, the current account deficits.
And we have the infrastructure and spending boom in the resource rich inflator countries like Mexico, the Gulf States, Russia, Kazakhstan and several African states. They are subsidising domestic oil consumption, they are ramping up spending on infrastructure and the domestic industrial base, they are tolerating escalating inflation. And they are crowding out everyone else to boot. These guys are on an inexorable road from consuming less than their small oil earnings back in 2002/3 to consuming more than their much larger earnings in the coming years.
The symptoms of this lot so far….yields are rising in Europe because consumption in the oil exporters is out of control. The global monetary system is no longer making good things happen, as it did from 2003-6. It has started to make bad things happen.
That is the stuff of which confusion and panics are made.
It is also the stuff of regime change. Regime change is what I’m working on right now. I thought I’d get the thoughts of the master - so I’ve started reading Barry Eichengreen’s ‘Global Imbalances & the Lessons of Bretton Woods’. I’ll report back later in the week.
We have the structural weakness in the reflator states - the Stans, the Baltics, Southern Europe, Ireland and the UK; the inflated property, the consumer debt, the foreign borrowing, the current account deficits.
And we have the infrastructure and spending boom in the resource rich inflator countries like Mexico, the Gulf States, Russia, Kazakhstan and several African states. They are subsidising domestic oil consumption, they are ramping up spending on infrastructure and the domestic industrial base, they are tolerating escalating inflation. And they are crowding out everyone else to boot. These guys are on an inexorable road from consuming less than their small oil earnings back in 2002/3 to consuming more than their much larger earnings in the coming years.
The symptoms of this lot so far….yields are rising in Europe because consumption in the oil exporters is out of control. The global monetary system is no longer making good things happen, as it did from 2003-6. It has started to make bad things happen.
That is the stuff of which confusion and panics are made.
It is also the stuff of regime change. Regime change is what I’m working on right now. I thought I’d get the thoughts of the master - so I’ve started reading Barry Eichengreen’s ‘Global Imbalances & the Lessons of Bretton Woods’. I’ll report back later in the week.
Friday 13 June 2008
Diworsification
When it comes to diversifying trades – my heart, it’s in the Warren Buffet camp; put all your eggs in one basket, then watch the basket. Well, obviously not just one basket. Buffet doesn’t own just one company. But everything he bought had one characteristic – it was big enough to hurt. As Max Gunther said in the Zurich Axioms – if you’re not worried, you haven’t bet big enough.
Around three weeks ago I felt that the risk/reward on an inflationary bust was so strong that it was time to double my risk limits. This I duly did. I took out shorts on the FTSE, the Eurostoxx, the Nifty, Erstebank & Swedbank. I was prepared to give up 11% on the trade. I also cut half my long positions in individual name plays on resources and infrastructure. At the heights, I took the trade up to 160% net short. Nosebleed territory. I took some profit yesterday and the day before on the extreme move in financials, to take me to around 105% short.
Over the past couple of weeks, I’ve added a second major trade; long the dollar. I am now standing 120% long the dollar against the Euro, 60% long the dollar against the pound, and 30% short gold. These are aggressive positions, no doubt. And to take them on, I set up strict risk controls in advance. Wide controls, in percentage terms, to be fair, but strict controls, to be sure. I’m basically allowing myself double the standard risk limits that I set out in my posts ‘The Shape of Things to Come, Pt I & II’.
A month ago I said that I was going to risk half my gains – then standing at 22% - on the ‘inflationary bust’ trade. Now that the fund is up 30% from mid-feb, I’m in the same position; I’m risking half my gains, or 15%, on the same trade – it’s just that I’m moving my weight around, from foot to foot, between the components of that trade.
As of yesterday, with HBOS down 11%, the risk/reward on the short equities call had deteriorated somewhat – which is why I banked about a third of my short position.
But the risk/reward of the long dollar call has improved over the last week as the dollar fell, the European curve flattened massively, and the stress at Europe’s banks mounted.
And I think that the inversion of the European and UK curves, combined with the flattening in the US, is, in a way, the index of macro today. I’m focussed on three main mechanisms at work right now;
First; the European and UK central banks are sacrificing growth as insurance against inflation. So the outlook for six to nine months time is for lower growth, a little less domestic inflation and falling rates. It makes sense to sell the currencies in advance. I reckon they might go before headline inflation falls. Remember that the Bank of England is responsible for ‘financial stability’. Last week, we were re-informed that the ECB is not.
My view, if you want to make money, rather than live by logic alone, you want to go long the Euro when the Euro area inflates – short when it deflates. Don’t let hawkish rate rhetoric fool you – it’s good for the currency for a day, but terrible as a trade.
Second, the US curve is steeper than that in Europe, but it’s flattening hard. It’s what happens when you get what I call a ‘front loaded recovery’. That’s when stimulus and an end to destocking cause a bump in growth. Oftentimes it causes a hawkish policy response. And especially hawkish when inflation expectations are getting a little, er, frayed. Hawkish is what the Fed is now doing. Frayed is what consumers are doing, all over.
And when the US curve flattens, well, look out emerging markets. Early 2004 saw a 25% pullback in India while the US markets fell, at most, 8%. And guess what? India is under the cosh again. The key point – flatten the US curve, buy the dollar. Flatten the Euro curve, sell the Euro. Do both together, aggressively, sell emerging markets, sell European markets. Heck, take the money and run.
Third, the inverted curves in Europe are terrible for the banks. Not only does the standard borrow short, lend long business of the old core commercial banking business go wrong, but the collateral that backs their loans deteriorates, and, yes, defaults rise.
But above all this, all the banks’ embedded risk capital in structured products and convergence trades go south. Now, these trades had worked so well, for so long, that I expect that the Banks stopped thinking about them as risk positions at all. Instead they started thinking of them, at best, as new sustainable business units. At worst, they thought of them as a ‘new banking paradigm’.
Of course, they were nothing of the sort. And now these ‘units’ are to be disbanded, and that this ‘new paradigm’ is to be discredited – the banks will unwind the dollar debt upon which the entire pyramid of bureaucratic ambition and leverage is built.
Bernanke’s analysis of 1931-3 provides a bit of colour. The countries that fell off the gold standard early held up. The ones that stuck to the standard, that refused to reflate, er, France, well, she & they walked under the cross of gold – they were the ones that saw the deepest asset deflation, and the most serious macro damage.
It looks like Bernake has learnt, vicariously, from the damage in France in the 1930s. It looks like Trichet has learnt nothing from that episode in history.
What’s the next stage? Well, the weakest credit goes bust. My bet has been that it will be the Baltic States, and the Banks that lend to them. But it turns out that the UK’s banks and insurers are giving the Baltics a run for their money.
And, as a rule, bust banks break currencies.
It’s not a direct link, of course. It’s just that politicians tend to get involved.
I started off this piece talking about diversification. Now, the problem with diversification is that you end up with so many positions that you can’t watch them. They’re too small to matter anyway. And ultimately, you’re not sure, cumulatively, which way you’re facing. When your view of the world changes, it is not obvious what you’re meant to do with your portfolio.
But when you’ve got all your eggs in one basket, and that basket is to sell stocks, well, once it is really working, a bit of diversification is useful. Especially in an ongoing inflationary bust.
And that’s because, right now, a rise in the dollar tends to coincide with a fall in oil. And the knee jerk response tends to be a rise in stocks. That’s intraday that is.
And that’s nonsense, of course. A fall in oil will not generate a rise in stocks. Because a 13 fold rise in oil from $9/bbl from 1998 did not lead to a similar contraction in stocks. As Robert Prechter noticed, the Dow Jones Transports index hit an all time high last month – with oil up over 1000%? Now it’s going to go up when oil falls 10%. Go figure. And if you can figure, call me, please.
If that’s what the people want to believe, well, ok. While this lasts, I’m hedged. Long dollar/short stocks. With a few resource infrastructure names in my long book. I’ll sit here, worrying hard, until we see the real break.
Around three weeks ago I felt that the risk/reward on an inflationary bust was so strong that it was time to double my risk limits. This I duly did. I took out shorts on the FTSE, the Eurostoxx, the Nifty, Erstebank & Swedbank. I was prepared to give up 11% on the trade. I also cut half my long positions in individual name plays on resources and infrastructure. At the heights, I took the trade up to 160% net short. Nosebleed territory. I took some profit yesterday and the day before on the extreme move in financials, to take me to around 105% short.
Over the past couple of weeks, I’ve added a second major trade; long the dollar. I am now standing 120% long the dollar against the Euro, 60% long the dollar against the pound, and 30% short gold. These are aggressive positions, no doubt. And to take them on, I set up strict risk controls in advance. Wide controls, in percentage terms, to be fair, but strict controls, to be sure. I’m basically allowing myself double the standard risk limits that I set out in my posts ‘The Shape of Things to Come, Pt I & II’.
A month ago I said that I was going to risk half my gains – then standing at 22% - on the ‘inflationary bust’ trade. Now that the fund is up 30% from mid-feb, I’m in the same position; I’m risking half my gains, or 15%, on the same trade – it’s just that I’m moving my weight around, from foot to foot, between the components of that trade.
As of yesterday, with HBOS down 11%, the risk/reward on the short equities call had deteriorated somewhat – which is why I banked about a third of my short position.
But the risk/reward of the long dollar call has improved over the last week as the dollar fell, the European curve flattened massively, and the stress at Europe’s banks mounted.
And I think that the inversion of the European and UK curves, combined with the flattening in the US, is, in a way, the index of macro today. I’m focussed on three main mechanisms at work right now;
First; the European and UK central banks are sacrificing growth as insurance against inflation. So the outlook for six to nine months time is for lower growth, a little less domestic inflation and falling rates. It makes sense to sell the currencies in advance. I reckon they might go before headline inflation falls. Remember that the Bank of England is responsible for ‘financial stability’. Last week, we were re-informed that the ECB is not.
My view, if you want to make money, rather than live by logic alone, you want to go long the Euro when the Euro area inflates – short when it deflates. Don’t let hawkish rate rhetoric fool you – it’s good for the currency for a day, but terrible as a trade.
Second, the US curve is steeper than that in Europe, but it’s flattening hard. It’s what happens when you get what I call a ‘front loaded recovery’. That’s when stimulus and an end to destocking cause a bump in growth. Oftentimes it causes a hawkish policy response. And especially hawkish when inflation expectations are getting a little, er, frayed. Hawkish is what the Fed is now doing. Frayed is what consumers are doing, all over.
And when the US curve flattens, well, look out emerging markets. Early 2004 saw a 25% pullback in India while the US markets fell, at most, 8%. And guess what? India is under the cosh again. The key point – flatten the US curve, buy the dollar. Flatten the Euro curve, sell the Euro. Do both together, aggressively, sell emerging markets, sell European markets. Heck, take the money and run.
Third, the inverted curves in Europe are terrible for the banks. Not only does the standard borrow short, lend long business of the old core commercial banking business go wrong, but the collateral that backs their loans deteriorates, and, yes, defaults rise.
But above all this, all the banks’ embedded risk capital in structured products and convergence trades go south. Now, these trades had worked so well, for so long, that I expect that the Banks stopped thinking about them as risk positions at all. Instead they started thinking of them, at best, as new sustainable business units. At worst, they thought of them as a ‘new banking paradigm’.
Of course, they were nothing of the sort. And now these ‘units’ are to be disbanded, and that this ‘new paradigm’ is to be discredited – the banks will unwind the dollar debt upon which the entire pyramid of bureaucratic ambition and leverage is built.
Bernanke’s analysis of 1931-3 provides a bit of colour. The countries that fell off the gold standard early held up. The ones that stuck to the standard, that refused to reflate, er, France, well, she & they walked under the cross of gold – they were the ones that saw the deepest asset deflation, and the most serious macro damage.
It looks like Bernake has learnt, vicariously, from the damage in France in the 1930s. It looks like Trichet has learnt nothing from that episode in history.
What’s the next stage? Well, the weakest credit goes bust. My bet has been that it will be the Baltic States, and the Banks that lend to them. But it turns out that the UK’s banks and insurers are giving the Baltics a run for their money.
And, as a rule, bust banks break currencies.
It’s not a direct link, of course. It’s just that politicians tend to get involved.
I started off this piece talking about diversification. Now, the problem with diversification is that you end up with so many positions that you can’t watch them. They’re too small to matter anyway. And ultimately, you’re not sure, cumulatively, which way you’re facing. When your view of the world changes, it is not obvious what you’re meant to do with your portfolio.
But when you’ve got all your eggs in one basket, and that basket is to sell stocks, well, once it is really working, a bit of diversification is useful. Especially in an ongoing inflationary bust.
And that’s because, right now, a rise in the dollar tends to coincide with a fall in oil. And the knee jerk response tends to be a rise in stocks. That’s intraday that is.
And that’s nonsense, of course. A fall in oil will not generate a rise in stocks. Because a 13 fold rise in oil from $9/bbl from 1998 did not lead to a similar contraction in stocks. As Robert Prechter noticed, the Dow Jones Transports index hit an all time high last month – with oil up over 1000%? Now it’s going to go up when oil falls 10%. Go figure. And if you can figure, call me, please.
If that’s what the people want to believe, well, ok. While this lasts, I’m hedged. Long dollar/short stocks. With a few resource infrastructure names in my long book. I’ll sit here, worrying hard, until we see the real break.
Wednesday 11 June 2008
Bringing it all Back Home
The cover of Bob Dylan’s album of the same name features a Plato’s cave of treasures, all his influences, from mundane to downright strange. And as I write this I’m listening to Bob Dylan’s Theme Time Radio Hour on BBC Radio I-player. It’s brilliantly odd – this week the theme is walking. Nietsche apparently said – great thoughts can only be achieved by walking.
It’s hard to walk and type at the same time – so you’ll have to accept some less than great thoughts as I switch seamlessly to talking about investment.
One of the reasons I don’t hang my hat on one particular style of investment or any particular asset class is that it disobeys a fundamental tenet of investing – kind of obvious really – always maximise performance. And to do that, Buffet and Munger will tell you – you have to maximise your risk/reward on every trade.
Now the best performing investment style over the last forty years has been to buy stocks with a top quartile earnings yield, and a top quartile spread between the return on invested capital, and the cost of capital. In the UK, BHP Billiton, Rios and Xstrata all fitted the bill at the start of 2007. They were the year’s big winners.
And it makes a huge amount of sense. If the stock is relatively cheap, but it can compound good returns, well, someday the share price will come to reflect those underlying fundamentals. You can make money just by being patient. But that’s not enough for me. Because, forty years of outperformance is no guarantee of future returns, however sensible the underlying philosophy.
And that’s because the trade got way too crowded. Credit Suisse’s cash flow return on capital almost became dogma among fund managers from 2002. And this and other similar gauges of value saw the biggest outperformance from 2000-mid-2007 than at any time over those 40 years. And then, from mid-2007 to mid-January 2008, it all came crashing down. Value got punked so badly in the first two weeks of 2008 that many value managers may struggle to get their heads above benchmark for the year as a whole. Q108 was, I understand, Bill Miller’s worst ever quarter.
So, the advantage of running global multi-asset money is that you can walk away from trades that everyone else is on. And, if you are like me, you can go actively short.
And right now, I think the big opportunities to play against crowded trades lie in the currencies.
Last week I wrote – in Dollar Bill – why I have turned fundamentally bullish on the dollar.
But the more I’ve been thinking about the role of currencies in the current system, the more I’ve come to think that the monster trade is to short the Euroyen cross.
When I wrote about why I was fundamentally bullish the dollar, I highlighted that the shrinking US current account deficit was step one – as it reduced the flow of dollars into the rest of the world. Step two was a sharp reduction in the banking multiplier applied to those dollars. And step three was slowing growth and falling rates outside the US.
The FT earlier this week reported on a study into why the Libor/base rate spread has remained so elevated, despite the best efforts of the central banks. The answer was the positioning of the European commercial banks. They had raised US dollar borrowing by $500bn from 2003-2007. And you can bet your bottom dollar that this borrowing funded all manner of convergence trades and purchases of other exotic structured products. The spread will remain elevated throughout the great unwind.
My view is that these positions will be the European Banks’ undoing.
Yet another example showed up last week. When Trichet hinted at a rate hike, we saw an extraordinary 80 basis point flattening in the curve between the 2s and 30s. That, to use the technical term, is totally mental. Why did it happen? The obvious answer is that too many punters were sitting on steepeners. But that’s not enough - there’s another answer. It turns out that the European banks had bought a particular structured product. What this thing did was pay out an income whenever the yield curve was steeper than, say, 10 basis points. It would pay out nothing between, say -10bps and +10bps. And then it would cost you if the curve inverted more than 10bps. Now, this trade was a no-brainer. The curve hadn’t been inverted since the advent of the Euro. And at certain times; 2001-4 for instance, it was massively lucrative.
Only problem – it caused a fantastic increase the Banks’ risk in extremis – as their regular businesses also deteriorate when curves flatten and invert. So when the curve inverted last week, they all started unwinding their positions at once. Welcome to the house of pain.
What’s in store now? Well, my view is that The European Banks will sell-off, over the next two to three years, the vast array of structured products and convergence trades that they built up over the past decade. Losses will be enormous. And as they do that, they will be buying dollars to repay the $500bn of loans that they took out to make these trades. A Euro won’t buy $1.55 when they’re done.
And what of the other side of the trade; the yen? The yen has recently weakened from around 95 to the dollar in mid-March, to 107.50 this morning. I am now betting on a return trip, at the very least. Now, there is no question that there has been a relentless pressure on the yen to weaken from 2003. It came from the massive portfolio diversification of the Japanese housewife, and to an extent, the banks and corporates too. They bought bonds in Australia and New Zealand – all yielding attractively relative to Japanese bonds– and then adding a currency kicker to boot (as everyone got on the trade). But perhaps the notable event is the Indian equity madness. Japanese private investors own more Indian stocks than they own European stocks, a market many times larger.
Now, emerging market inflation throws a spanner in the works of this particular trade. Inflation disrupts the real returns from holding bonds outside of Japan, it also disrupts the currencies – the rupee is now falling. And, yes, it also causes trouble for the stocks – the Indian market is getting whacked. At the same time, we’re seeing some reflation in Japanese property – so the prospects for domestic investment are maybe improving. My bet is that the emerging market inflation, and the general pressure on risk assets, will bring those yen back home.
It’s hard to walk and type at the same time – so you’ll have to accept some less than great thoughts as I switch seamlessly to talking about investment.
One of the reasons I don’t hang my hat on one particular style of investment or any particular asset class is that it disobeys a fundamental tenet of investing – kind of obvious really – always maximise performance. And to do that, Buffet and Munger will tell you – you have to maximise your risk/reward on every trade.
Now the best performing investment style over the last forty years has been to buy stocks with a top quartile earnings yield, and a top quartile spread between the return on invested capital, and the cost of capital. In the UK, BHP Billiton, Rios and Xstrata all fitted the bill at the start of 2007. They were the year’s big winners.
And it makes a huge amount of sense. If the stock is relatively cheap, but it can compound good returns, well, someday the share price will come to reflect those underlying fundamentals. You can make money just by being patient. But that’s not enough for me. Because, forty years of outperformance is no guarantee of future returns, however sensible the underlying philosophy.
And that’s because the trade got way too crowded. Credit Suisse’s cash flow return on capital almost became dogma among fund managers from 2002. And this and other similar gauges of value saw the biggest outperformance from 2000-mid-2007 than at any time over those 40 years. And then, from mid-2007 to mid-January 2008, it all came crashing down. Value got punked so badly in the first two weeks of 2008 that many value managers may struggle to get their heads above benchmark for the year as a whole. Q108 was, I understand, Bill Miller’s worst ever quarter.
So, the advantage of running global multi-asset money is that you can walk away from trades that everyone else is on. And, if you are like me, you can go actively short.
And right now, I think the big opportunities to play against crowded trades lie in the currencies.
Last week I wrote – in Dollar Bill – why I have turned fundamentally bullish on the dollar.
But the more I’ve been thinking about the role of currencies in the current system, the more I’ve come to think that the monster trade is to short the Euroyen cross.
When I wrote about why I was fundamentally bullish the dollar, I highlighted that the shrinking US current account deficit was step one – as it reduced the flow of dollars into the rest of the world. Step two was a sharp reduction in the banking multiplier applied to those dollars. And step three was slowing growth and falling rates outside the US.
The FT earlier this week reported on a study into why the Libor/base rate spread has remained so elevated, despite the best efforts of the central banks. The answer was the positioning of the European commercial banks. They had raised US dollar borrowing by $500bn from 2003-2007. And you can bet your bottom dollar that this borrowing funded all manner of convergence trades and purchases of other exotic structured products. The spread will remain elevated throughout the great unwind.
My view is that these positions will be the European Banks’ undoing.
Yet another example showed up last week. When Trichet hinted at a rate hike, we saw an extraordinary 80 basis point flattening in the curve between the 2s and 30s. That, to use the technical term, is totally mental. Why did it happen? The obvious answer is that too many punters were sitting on steepeners. But that’s not enough - there’s another answer. It turns out that the European banks had bought a particular structured product. What this thing did was pay out an income whenever the yield curve was steeper than, say, 10 basis points. It would pay out nothing between, say -10bps and +10bps. And then it would cost you if the curve inverted more than 10bps. Now, this trade was a no-brainer. The curve hadn’t been inverted since the advent of the Euro. And at certain times; 2001-4 for instance, it was massively lucrative.
Only problem – it caused a fantastic increase the Banks’ risk in extremis – as their regular businesses also deteriorate when curves flatten and invert. So when the curve inverted last week, they all started unwinding their positions at once. Welcome to the house of pain.
What’s in store now? Well, my view is that The European Banks will sell-off, over the next two to three years, the vast array of structured products and convergence trades that they built up over the past decade. Losses will be enormous. And as they do that, they will be buying dollars to repay the $500bn of loans that they took out to make these trades. A Euro won’t buy $1.55 when they’re done.
And what of the other side of the trade; the yen? The yen has recently weakened from around 95 to the dollar in mid-March, to 107.50 this morning. I am now betting on a return trip, at the very least. Now, there is no question that there has been a relentless pressure on the yen to weaken from 2003. It came from the massive portfolio diversification of the Japanese housewife, and to an extent, the banks and corporates too. They bought bonds in Australia and New Zealand – all yielding attractively relative to Japanese bonds– and then adding a currency kicker to boot (as everyone got on the trade). But perhaps the notable event is the Indian equity madness. Japanese private investors own more Indian stocks than they own European stocks, a market many times larger.
Now, emerging market inflation throws a spanner in the works of this particular trade. Inflation disrupts the real returns from holding bonds outside of Japan, it also disrupts the currencies – the rupee is now falling. And, yes, it also causes trouble for the stocks – the Indian market is getting whacked. At the same time, we’re seeing some reflation in Japanese property – so the prospects for domestic investment are maybe improving. My bet is that the emerging market inflation, and the general pressure on risk assets, will bring those yen back home.
Monday 9 June 2008
Shrink wrapped
‘The industrial production series reveals that a recession began in the United States during 1929. By late 1930, the downturn, although serious, was still comparable in magnitude to the recession of 1920-1922. As the decline slowed, it would have been reasonable to expect a brisk recovery, just as in 1922.
With the first banking crisis, however, there came what Friedman and Schwartz called a ‘change in the character of the contraction’. The economy first flattened out, then went into a new tailspin, just as the banks began to fail again in June 1931’.
Ben Bernanke – Essays on the Great Depression
It’s probably history’s greatest example of the fact that two shocks are more than twice as bad as one.
A couple of posts ago, I highlighted my view that we are now faced with five major shocks (see A Bout de Soufflé). I now think we have a sixth shock coming. It’s something Gerard Minack of Morgan Stanley has been talking about – counterparty risk.
A lot of people have exaggerated the monetary impact of the explosion in the global derivatives business. Much of the supposed increase in liquidity is in fact double counting. But what is critical is that it has led to a fantastic increase in counterparty risk. A bit like when you get in longer and longer chains when you’re selling your house; the chance of disruption increases exponentially.
And the biggest counterparty risk right now is the credit, or monoline, insurers.
Now, following the law of unintended consequences, when the regulators tried to reduce risk taking at insurers after the 2001/2 debacle, they effectively forced a reduction in equity exposure, and a rise in credit holdings. But this has likely set up a much greater risk than had the regulators left well alone.
What the regulators did was to insist that insurers discounted future liabilities by the risk adjusted yield on their ‘float’ (The assets they held to back future insurance and pension liabilities). If you put a big discount on your liabilities, your deficit quickly turned to surplus. It was all good.
But the regulators fiddled the risk, putting too high a premium on equities and too low a premium on credit. All in a good cause, of course.
This induced the bean counters at the insurers to hunt for stuff with a high yield and a high credit rating. That kind of product shouldn’t show up too much in an efficient market.
But where there is a will, on Wall Street, oftentimes there is a way.
Enter the monolines. These boys would offer to insure, or wrap-up, a basket of low quality credit in an insurance default wrapper. And immediately, that basket of credits takes on the monolines’ credit rating; AAA.
As if by magic, the insurers got what they wanted; a basket of high yielding credit, with an AAA rating.
This created a relentless institutional dynamic. Once one insurer did it, it gained a major competitive advantage. It reduced its reserve requirements, it cut its cost of capital, it raised its earnings, and it boosted its ratings. Its competitors felt massive pressure to follow suit, and they succumbed to that pressure. And once they were all doing it, there was an escalating motive to do it some more.
This, in turn, created a self-reinforcing bid for credit – especially low quality credit. As the bid rose, yields fell, creating the need among insurers to delve further down the quality spectrum in search of more yield.
Now, this also had a fundamental effect. As companies with poor credit ratings saw their debt being bid (and their yields falling) it reduced their cost of capital. It raised their ratings, and created an inducement to invest to build their own businesses.
Aggregated, this supported benign macro conditions, reduced default risk, it improved balance sheets and the quality of collateral and it raised earnings at financial institutions. It all helped to raise the bid, and reduce the yield on credit once again. Globally, exploding demand for credit insurance and collapsing defaults meant that earnings at the monolines went through the roof, further reinforcing their AAA ratings, and the confidence in their business models.
It is perhaps telling that Bernanke, in his essays on the Great Depression, focuses on the role of assets as collateral for loans. In a boom, it makes lending cheaper and easier, as rising asset prices mean that banks can lend with limited information on the borrower. This is because the rising collateral value is a big incentive not to default, and ample payment to the banks in the case of default. Falling asset prices can freeze the credit markets, because the banks would rather not lend than root out genuinely strong businesses to lend to. In a sense, the ‘information asymmetry’ between borrowers and lenders makes it real hard to lend when assets are depreciating.
So then came the subprime crisis, the disruption in the wholesale banking model and the lurch away from a zero default world.
Last week saw S&P downgrade the monolines from AAA to AA. It followed Fitch, the smaller of the three major ratings agencies. Moody’s will likely follow soon.
And so we will see further significant credit unwinding. In my view, it will end with a bust at the monoline insurers, and major capital raisings at the world’s insurers.
Because, as monolines go to AA, the wrapper round the insurance companies’ credit shrinks to AA. Their deficits rise, their cost of capital jumps, their earnings and ratings drop. There is a lot of pressure to move back up the quality scale. But every step they take, they diminish their own strength – as they raise their deficits and weaken their balance sheets.
So credit spreads widen, the cost of capital at low grade corporates rises, and they tend to invest less in their own businesses. And in aggregate, this weakness turns the macro environment sour – raising defaults. That causes a fundamental deterioration in the balance sheet and earnings prospects of the monolines.
My view; the cut to AA is the first of many. And AA is way too high for businesses with bust business models. Now the ratings agencies have taken the first, most difficult, step, they will find it easier to keep cutting the ratings on the monolines. Ambac and MBIA lost 24% and 21% respectively on the S&P news.
The insurers now have to work out what to do with multi-billions of credit that will lose its insurance wrapper. Just when all credit faces a major increase in defaults from the credit crunch, the global downturn and the widespread resource shortages.
And, as we have now come to expect, the insurers’ risk models are simply not equipped for this. Because, between them, they own the market, they are all way too long, and they will be selling all at the same time.
This is likely to blow a hole in a bunch of insurers’ balance sheets. My bet is that we see capital raising by Christmas.
With the first banking crisis, however, there came what Friedman and Schwartz called a ‘change in the character of the contraction’. The economy first flattened out, then went into a new tailspin, just as the banks began to fail again in June 1931’.
Ben Bernanke – Essays on the Great Depression
It’s probably history’s greatest example of the fact that two shocks are more than twice as bad as one.
A couple of posts ago, I highlighted my view that we are now faced with five major shocks (see A Bout de Soufflé). I now think we have a sixth shock coming. It’s something Gerard Minack of Morgan Stanley has been talking about – counterparty risk.
A lot of people have exaggerated the monetary impact of the explosion in the global derivatives business. Much of the supposed increase in liquidity is in fact double counting. But what is critical is that it has led to a fantastic increase in counterparty risk. A bit like when you get in longer and longer chains when you’re selling your house; the chance of disruption increases exponentially.
And the biggest counterparty risk right now is the credit, or monoline, insurers.
Now, following the law of unintended consequences, when the regulators tried to reduce risk taking at insurers after the 2001/2 debacle, they effectively forced a reduction in equity exposure, and a rise in credit holdings. But this has likely set up a much greater risk than had the regulators left well alone.
What the regulators did was to insist that insurers discounted future liabilities by the risk adjusted yield on their ‘float’ (The assets they held to back future insurance and pension liabilities). If you put a big discount on your liabilities, your deficit quickly turned to surplus. It was all good.
But the regulators fiddled the risk, putting too high a premium on equities and too low a premium on credit. All in a good cause, of course.
This induced the bean counters at the insurers to hunt for stuff with a high yield and a high credit rating. That kind of product shouldn’t show up too much in an efficient market.
But where there is a will, on Wall Street, oftentimes there is a way.
Enter the monolines. These boys would offer to insure, or wrap-up, a basket of low quality credit in an insurance default wrapper. And immediately, that basket of credits takes on the monolines’ credit rating; AAA.
As if by magic, the insurers got what they wanted; a basket of high yielding credit, with an AAA rating.
This created a relentless institutional dynamic. Once one insurer did it, it gained a major competitive advantage. It reduced its reserve requirements, it cut its cost of capital, it raised its earnings, and it boosted its ratings. Its competitors felt massive pressure to follow suit, and they succumbed to that pressure. And once they were all doing it, there was an escalating motive to do it some more.
This, in turn, created a self-reinforcing bid for credit – especially low quality credit. As the bid rose, yields fell, creating the need among insurers to delve further down the quality spectrum in search of more yield.
Now, this also had a fundamental effect. As companies with poor credit ratings saw their debt being bid (and their yields falling) it reduced their cost of capital. It raised their ratings, and created an inducement to invest to build their own businesses.
Aggregated, this supported benign macro conditions, reduced default risk, it improved balance sheets and the quality of collateral and it raised earnings at financial institutions. It all helped to raise the bid, and reduce the yield on credit once again. Globally, exploding demand for credit insurance and collapsing defaults meant that earnings at the monolines went through the roof, further reinforcing their AAA ratings, and the confidence in their business models.
It is perhaps telling that Bernanke, in his essays on the Great Depression, focuses on the role of assets as collateral for loans. In a boom, it makes lending cheaper and easier, as rising asset prices mean that banks can lend with limited information on the borrower. This is because the rising collateral value is a big incentive not to default, and ample payment to the banks in the case of default. Falling asset prices can freeze the credit markets, because the banks would rather not lend than root out genuinely strong businesses to lend to. In a sense, the ‘information asymmetry’ between borrowers and lenders makes it real hard to lend when assets are depreciating.
So then came the subprime crisis, the disruption in the wholesale banking model and the lurch away from a zero default world.
Last week saw S&P downgrade the monolines from AAA to AA. It followed Fitch, the smaller of the three major ratings agencies. Moody’s will likely follow soon.
And so we will see further significant credit unwinding. In my view, it will end with a bust at the monoline insurers, and major capital raisings at the world’s insurers.
Because, as monolines go to AA, the wrapper round the insurance companies’ credit shrinks to AA. Their deficits rise, their cost of capital jumps, their earnings and ratings drop. There is a lot of pressure to move back up the quality scale. But every step they take, they diminish their own strength – as they raise their deficits and weaken their balance sheets.
So credit spreads widen, the cost of capital at low grade corporates rises, and they tend to invest less in their own businesses. And in aggregate, this weakness turns the macro environment sour – raising defaults. That causes a fundamental deterioration in the balance sheet and earnings prospects of the monolines.
My view; the cut to AA is the first of many. And AA is way too high for businesses with bust business models. Now the ratings agencies have taken the first, most difficult, step, they will find it easier to keep cutting the ratings on the monolines. Ambac and MBIA lost 24% and 21% respectively on the S&P news.
The insurers now have to work out what to do with multi-billions of credit that will lose its insurance wrapper. Just when all credit faces a major increase in defaults from the credit crunch, the global downturn and the widespread resource shortages.
And, as we have now come to expect, the insurers’ risk models are simply not equipped for this. Because, between them, they own the market, they are all way too long, and they will be selling all at the same time.
This is likely to blow a hole in a bunch of insurers’ balance sheets. My bet is that we see capital raising by Christmas.
Friday 6 June 2008
Sand
Yesterday I got chatting to an emerging market fund manager. And she told me that she’d tried to be bearish emerging markets, but it just wasn’t happening. So she was bullish. And anyway, she said, whatever the doubters believed, there was plenty of liquidity.
Now that caught my attention. Charlie Munger would have been horrified. His view – if you want to maximise your investing IQ – the first thing you need is patience. A bear market rally, after the extreme moves into mid-January, shouldn’t be enough to shake your view of the world. Munger said he’d often spent years in treasuries before he found enough value to buy stocks. A couple of months doesn’t really count.
And then there’s the issue about hanging your hat on liquidity. You’ve got to be dead sure you know what it is and how it works.
What is it? It is dollars passed abroad and multiplied through the global commercial banking system.
How does it work? It is very slow, but utterly relentless.
So, to trade on the basis of liquidity, you need to be very patient, and you need to think in terms of probabilities – the liquidity regime changes the odds of the investment game. A liquidity downturn is a time to be more cautious equities. It can last for years.
This is how I build it up. First off, I look at the US current account deficit. This is like global base money. It’s the number of extra dollars flowing out to the world.
Now the obvious thing about the US deficit is that it shrinks in a US recession. It’s not completely obvious before hand. After all export could slow as fast as imports. But imports are much larger. They also have a much higher macro beta – as they comprise an outsize proportion of basic cyclical inputs at one end, and luxury items at the other. But few basic services. The bottom line is that if you are the US in recession, the world – to use Bill Clinton’s phrase – feels your pain.
But this being global capital flows, it’s not that simple. Because the Gulf States don’t report their reserves. So what I’ve done is to try to approximate them – using oil prices, Gulf production and an assumption on costs. And once you do that you get a chart that shows a bit of extra juice coming through over the past year.
That was one of several data series that kept me bullish resources through the first five months of this year.
This week, I went back to look at the assumptions behind the chart. That Middle East oil cost $35/bbl to get out of the ground. And that the surplus flows directly into reserves.
First off, the likelihood is that costs are escalating fast. The start-up operations in Saudi are substantially more expensive than Ghawar, and Ghawar itself is getting more expensive as the water cut rises, and the pressure falls. Burgan in Kuwait is looking increasingly expensive as production fades from peak. And that’s before we get into the runaway inflation across the region, the specific rise in material costs, the shortage of engineers, and the increased security costs. Perhaps a more realistic view of production costs is that they are rising through the forties.
The second issue is where the cash is going. A lot has been written about sovereign wealth funds. But the bigger story is the Gulf infrastructure boom. And this is no flash in the pan – it is a deliberate policy, based on a far reaching vision that the Gulf will be the hub of the new ‘spice route’ of global trade. The vision is massive, and it will consume the surplus. My suspicion is that, with the major rise in infrastructure costs over the last two years, combined with the fantastic increase in the Gulf States’ ambitions over the same period, those surpluses are likely fading – even in the face of the vertical move in oil. If oil stops going up, heaven forbid.
That reminds me of a passage in Adam Smith’s ‘Paper Money’. In the 70’s the financial markets had got used to petrodollar reflows. They were a major source of liquidity. But then, in the late 70s, they stopped. Noone knew why.
Until some bright spark found that Saudi Arabia was importing sand. Now of course, as there is more sand per capita in Saudi Arabia than in any other country in the world, this made no sense. It turned out that someone had persuaded the Saudis that they had the wrong kind of sand for construction cement. They imported it, and it was the lasting symbol of their disappearing financial surplus.
The Gulf States may not be importing sand today, but they are importing just about everything else, as they build out one of the greatest infrastructure programmes in all history. My bet, some month soon, those petrodollars will stop flowing round the world, and instead they will slip back into the desert sands.
Now that caught my attention. Charlie Munger would have been horrified. His view – if you want to maximise your investing IQ – the first thing you need is patience. A bear market rally, after the extreme moves into mid-January, shouldn’t be enough to shake your view of the world. Munger said he’d often spent years in treasuries before he found enough value to buy stocks. A couple of months doesn’t really count.
And then there’s the issue about hanging your hat on liquidity. You’ve got to be dead sure you know what it is and how it works.
What is it? It is dollars passed abroad and multiplied through the global commercial banking system.
How does it work? It is very slow, but utterly relentless.
So, to trade on the basis of liquidity, you need to be very patient, and you need to think in terms of probabilities – the liquidity regime changes the odds of the investment game. A liquidity downturn is a time to be more cautious equities. It can last for years.
This is how I build it up. First off, I look at the US current account deficit. This is like global base money. It’s the number of extra dollars flowing out to the world.
Now the obvious thing about the US deficit is that it shrinks in a US recession. It’s not completely obvious before hand. After all export could slow as fast as imports. But imports are much larger. They also have a much higher macro beta – as they comprise an outsize proportion of basic cyclical inputs at one end, and luxury items at the other. But few basic services. The bottom line is that if you are the US in recession, the world – to use Bill Clinton’s phrase – feels your pain.
Now the most intelligent question in global macro is one I’ve heard asked only once of late; where is the US current account deficit going?
Back in the 1990 recession, and again in the 2001 recession, the US current account deficit shrank by 1.5 percentage points of GDP. In both cases, the result was global financial carnage.
Since Q107, the deficit has again shrunk by 1.5 percentage points. But this time the deficit has not shrunk from 1.5% or 2.5% to near zero. It has shrunk from 6% to 4.5%. Already we’ve seen a good dose of financial destruction. But, the question is – is this it? Or are we headed for 3%, or 1.5%, or zero again?
I see no conceptual reason, in the face of the mother of all self reinforcing housing and credit downturns in the US, that the deficit can’t get back towards zero over the next two or three years. The chart shows that every time the deficit swings down, we get a financial crisis. If we do go to zero, then, on past form, we are due three more financial crises from here.
Now, there’s no way that a reduction in imports from the rest of the world would be sufficient to cause a major financial problem on its own. The issue is not so much the direct slowdown in growth – it is the contraction in ‘free’ dollars travelling round the world. And each of those dollars finds itself in a commercial bank – where it is loaned, returned and loaned again. So much so that the effect is to turn the initial flow of dollars into a five to tenfold greater increase in the supply of global credit.
Now, there are no perfect series for global financial flows. But the best series is FRODOR – developed by Ed Yardeni. It is base money in the US added to global central banks reserves held with the Fed. This works as a kind of global broad money – how much cash is sloshing around once it’s been through the commercial banking system. If it runs faster than 6% (average nominal global growth) then it’s expansionary, below and it starves the world of credit.
In a world short of credit, the weakest credit usually goes bust.
Now FRODOR hasn’t collapsed yet, but with a shrinking US deficit, and the clear signal from banks across the developed world that they are pulling back from lending – my bet is FRODOR heads towards zero – genuine danger territory – over the coming year or so.
Back in the 1990 recession, and again in the 2001 recession, the US current account deficit shrank by 1.5 percentage points of GDP. In both cases, the result was global financial carnage.
Since Q107, the deficit has again shrunk by 1.5 percentage points. But this time the deficit has not shrunk from 1.5% or 2.5% to near zero. It has shrunk from 6% to 4.5%. Already we’ve seen a good dose of financial destruction. But, the question is – is this it? Or are we headed for 3%, or 1.5%, or zero again?
I see no conceptual reason, in the face of the mother of all self reinforcing housing and credit downturns in the US, that the deficit can’t get back towards zero over the next two or three years. The chart shows that every time the deficit swings down, we get a financial crisis. If we do go to zero, then, on past form, we are due three more financial crises from here.
Now, there’s no way that a reduction in imports from the rest of the world would be sufficient to cause a major financial problem on its own. The issue is not so much the direct slowdown in growth – it is the contraction in ‘free’ dollars travelling round the world. And each of those dollars finds itself in a commercial bank – where it is loaned, returned and loaned again. So much so that the effect is to turn the initial flow of dollars into a five to tenfold greater increase in the supply of global credit.
Now, there are no perfect series for global financial flows. But the best series is FRODOR – developed by Ed Yardeni. It is base money in the US added to global central banks reserves held with the Fed. This works as a kind of global broad money – how much cash is sloshing around once it’s been through the commercial banking system. If it runs faster than 6% (average nominal global growth) then it’s expansionary, below and it starves the world of credit.
In a world short of credit, the weakest credit usually goes bust.
Now FRODOR hasn’t collapsed yet, but with a shrinking US deficit, and the clear signal from banks across the developed world that they are pulling back from lending – my bet is FRODOR heads towards zero – genuine danger territory – over the coming year or so.
But this being global capital flows, it’s not that simple. Because the Gulf States don’t report their reserves. So what I’ve done is to try to approximate them – using oil prices, Gulf production and an assumption on costs. And once you do that you get a chart that shows a bit of extra juice coming through over the past year.
That was one of several data series that kept me bullish resources through the first five months of this year.This week, I went back to look at the assumptions behind the chart. That Middle East oil cost $35/bbl to get out of the ground. And that the surplus flows directly into reserves.
First off, the likelihood is that costs are escalating fast. The start-up operations in Saudi are substantially more expensive than Ghawar, and Ghawar itself is getting more expensive as the water cut rises, and the pressure falls. Burgan in Kuwait is looking increasingly expensive as production fades from peak. And that’s before we get into the runaway inflation across the region, the specific rise in material costs, the shortage of engineers, and the increased security costs. Perhaps a more realistic view of production costs is that they are rising through the forties.
The second issue is where the cash is going. A lot has been written about sovereign wealth funds. But the bigger story is the Gulf infrastructure boom. And this is no flash in the pan – it is a deliberate policy, based on a far reaching vision that the Gulf will be the hub of the new ‘spice route’ of global trade. The vision is massive, and it will consume the surplus. My suspicion is that, with the major rise in infrastructure costs over the last two years, combined with the fantastic increase in the Gulf States’ ambitions over the same period, those surpluses are likely fading – even in the face of the vertical move in oil. If oil stops going up, heaven forbid.
That reminds me of a passage in Adam Smith’s ‘Paper Money’. In the 70’s the financial markets had got used to petrodollar reflows. They were a major source of liquidity. But then, in the late 70s, they stopped. Noone knew why.
Until some bright spark found that Saudi Arabia was importing sand. Now of course, as there is more sand per capita in Saudi Arabia than in any other country in the world, this made no sense. It turned out that someone had persuaded the Saudis that they had the wrong kind of sand for construction cement. They imported it, and it was the lasting symbol of their disappearing financial surplus.
The Gulf States may not be importing sand today, but they are importing just about everything else, as they build out one of the greatest infrastructure programmes in all history. My bet, some month soon, those petrodollars will stop flowing round the world, and instead they will slip back into the desert sands.
Thursday 5 June 2008
The Boys are Back in Town
When I think about Swedbank I can’t help thinking that, er, there’s something rotten in the state of Denmark.
Swedbank has one ugly chart. It’s broken down and it looks like there’s nothing below it but empty space.
And the noises off are none too good either. The Riksbank has been displaying some unusual behaviour of late. Two weeks ago it got together with the central banks of Denmark and Norway to bail out the Icelandic Central bank. Now, why would they do that? Unless they felt that a collapse in the Icelandic banks (whose balance sheets are over three times Iceland’s GDP) could set off a systemic crisis through the Scandinavian banking system. Perhaps there are some vulnerabilities among the Scandy banks that we are not, er, fully party to.
Then the Riksbank this week warned that Sweden’s banks may be affected by deteriorating global conditions. Severely affected. That is unusual talk for a central bank.
Charlie Munger likes to anticipate self-reinforcing trends. He’s got a name for the time when several good things kick-in all at once; the Lolapalooza effect. He’s also got a knack for getting at how bad management, bad culture and bad thinking can mess up a good business.
Bureaucrats in banks run relative risk. They follow the Maynard Keynes’ dictat that for them ‘it is better to fail conventionally than to succeed unconventionally’. They don’t do it deliberately. They just feel the pressure from their managers. And their managers feel pressure from their shareholders. To outperform their competitors, each quarter. To stay on the dance floor. To be like Chuck.
Now today has been a rough day for my book. I gave up in three hours all the returns of the past week. And those were good returns.
Two things happened. As I’m sure you know, Trichet said that the ECB would likely raise rates. And then Wal-mart’s sales beat expectations. So stocks rose, the dollar fell, and I got whacked.
My own reaction on the ECB was to get an uneasy October 1987 feeling. One day Bernanke goes out on a limb to suggest that the Fed needs to protect the dollar – in part to prevent excessive commodity price gains, and a potential escalation of inflationary expectations. Two days later Trichet ignores the rapid deterioration in Eurozone growth, and the weakened condition of the banks, threatens a rate hike, and precipitates a mini dollar rout.
Shades of Baker’s tête-à-tête with the Bundesbank prior to Black Monday.
What did the market do today in response to Trichet? It bid oil up by $5/bbl. Trichet’s remarks had the effect of raising inflationary pressure, and further risking Euro-area growth.
So, if you ask me, it’s Wal-Mart Schmal-mart. This is the most dangerous time to own stocks since the Bundesbank boys gave Baker a good kicking, one sunny Frankfurt morning in October.
Swedbank has one ugly chart. It’s broken down and it looks like there’s nothing below it but empty space.
And the noises off are none too good either. The Riksbank has been displaying some unusual behaviour of late. Two weeks ago it got together with the central banks of Denmark and Norway to bail out the Icelandic Central bank. Now, why would they do that? Unless they felt that a collapse in the Icelandic banks (whose balance sheets are over three times Iceland’s GDP) could set off a systemic crisis through the Scandinavian banking system. Perhaps there are some vulnerabilities among the Scandy banks that we are not, er, fully party to.
Then the Riksbank this week warned that Sweden’s banks may be affected by deteriorating global conditions. Severely affected. That is unusual talk for a central bank.
Charlie Munger likes to anticipate self-reinforcing trends. He’s got a name for the time when several good things kick-in all at once; the Lolapalooza effect. He’s also got a knack for getting at how bad management, bad culture and bad thinking can mess up a good business.
Bureaucrats in banks run relative risk. They follow the Maynard Keynes’ dictat that for them ‘it is better to fail conventionally than to succeed unconventionally’. They don’t do it deliberately. They just feel the pressure from their managers. And their managers feel pressure from their shareholders. To outperform their competitors, each quarter. To stay on the dance floor. To be like Chuck.
Now today has been a rough day for my book. I gave up in three hours all the returns of the past week. And those were good returns.
Two things happened. As I’m sure you know, Trichet said that the ECB would likely raise rates. And then Wal-mart’s sales beat expectations. So stocks rose, the dollar fell, and I got whacked.
My own reaction on the ECB was to get an uneasy October 1987 feeling. One day Bernanke goes out on a limb to suggest that the Fed needs to protect the dollar – in part to prevent excessive commodity price gains, and a potential escalation of inflationary expectations. Two days later Trichet ignores the rapid deterioration in Eurozone growth, and the weakened condition of the banks, threatens a rate hike, and precipitates a mini dollar rout.
Shades of Baker’s tête-à-tête with the Bundesbank prior to Black Monday.
What did the market do today in response to Trichet? It bid oil up by $5/bbl. Trichet’s remarks had the effect of raising inflationary pressure, and further risking Euro-area growth.
So, if you ask me, it’s Wal-Mart Schmal-mart. This is the most dangerous time to own stocks since the Bundesbank boys gave Baker a good kicking, one sunny Frankfurt morning in October.
Wednesday 4 June 2008
Dollar Bill
One of the things I do to test my conviction on my views is to reverse engineer outcomes on trades. My last big success on this was asking, back in mid-January, if we’re in May, and the S&P is 15% higher, what would have to have happened? The conditions actually seemed more likely than not – so I made the bet. Reverse engineering outcomes is something Charlie Munger and Richard Heur – whose books are listed next to this post – argue is essential before committing to any view.
In late March, I tried the same thing on the US dollar. If the US dollar was up 15% by the end of the year – what would have made it happen? Problem was I couldn’t answer the question well enough. So I didn’t trade.
Most likely, we were due a correction. Sentiment against the dollar was extreme. There was a raft of business magazine covers depicting the dollar crash – notably the Economist’s George Washington going down in a fighter plane late last year. And this kind of sentiment usually coincides with a low.
And then there was a macro kicker. The US tax-break was going to be a monster – pretty much guaranteeing above trend US growth through the middle of the year. But Europe was on its uppers – leading indicators were deteriorating rapidly, and the hard numbers were likely to follow suite.
That, I thought, was good for 5%. But, by the Autumn the US would be slowing again and the Fed likely considering cutting rates - so I couldn’t think of anything too likely to get me to 15%. But I’ve had another go – and now I can.
First off, the valuation on the Euro isn’t exactly compelling. At my previous house, we recreated a bunch of Morgan Stanley currency strategist Stephen Jen’s models – which are showing the dollar at a two standard deviation extreme in cheapness against Sterling and the Euro. That the dollar is cheap, and the Euro expensive, I think, everybody knows.
But what I hadn’t realised – and thanks to Chad Slater for this one – is that it now costs the same to buy a Big Mac in Shanghai as it does in New York. Now I’ve been listening to folks banging on for so long about why the Renminbi needs to be revalued, that I’d stopped testing the assumption that it is cheap. It isn’t.
So what’s happened in China? In one word; inflation. China has seen its inflation pick up sharply. But the degree of increase is masked in the official CPI, due to statistical manipulation, and due to price controls. Go to something that isn’t controlled – like a Big Mac – and you get a better picture. And China’s inflation is not just food. Chinese wages are booming – with 15% pay rises a regular occurrence in the Pearl River Delta and other Industrial hubs. And employer costs are rising even faster than this – as they have to compete with other employers by providing bed and board for increasingly scarce migrant workers. The result is that productivity can’t keep up, so unit labour costs are rising at 2-3% annually, compared to an average 2-3% fall just five years ago. China has revalued by another means – by letting inflation build, it has reduced the value of it’s currency while allowing it’s currency to appreciate gradually against the dollar.
But I don’t see China as the problem. Yesterday I put the emerging markets into boxes. China was a ‘conservative reflator’ – pretty stable in my book. What’s interesting to look at is the wild ones. I described a wild inflator as a country with big dollar earnings from dollar exports, plus booming credit growth (of more than 3x GDP growth). Russia and many of the Gulf States fall into this category. Now the Gulf States are dollar peggers. But they’ve got inflation running in the teens. So they’re already appreciating by 10+% against the dollar – just by keeping the peg. I don’t think the revaluation of the gulf currencies is the slam dunk that many believe it is. The currencies are getting less valuable by the day.
But it’s when you look at the wild reflators – the countries that have seen large capital inflows into their bond and property markets, combined with blow-out current account deficits and booming credit expansion – well, then things really heat up. Because their fair value against the dollar is collapsing. The Ukraine, Latvia, Vietnam etc – it’s a long list. Soon, they’ll be the wild deflators.
And what I think we’ve got here is the start of a story. The potential for a self-reinforcing trend to emerge – involving capital flight, bank write offs, reduced willingness and ability to lend, weakening currency, falling asset prices (especially in foreign currency terms)and more capital flight. And what’s interesting about this is the potential for the infection to spread from the wild reflators like Eastern Europe and the Baltic States – to a mild reflator like Europe. Why?
The first reason is the Euro area contains within it some wild reflators. Spain, Ireland and Greece are the obvious contenders. But Italy – while it hasn’t seen that degree of credit expansion – is getting there on the deficit front. Spain and Ireland are already seeing reflation twist into asset price deflation. Soon this will spread.
The second reason is that the European banks were best in class when it came to funding the wild reflators. Yesterday I talked about hedge funds running a leveraged long equities trade with a trailing stop for 61 of the last 62 months. Well, that’s chicken feed compared to what the European banks have been up to. For a decade they built up assets in the wild reflator states. It is the essence of the convergence trade – betting that bonds, currencies and property values in the periphery will converge with those in Germany and France.
Now that trade is beginning to unravel, the European banks have started to realise that there is no one to sell their positions to. They are all sellers. And they are all very large in the trade.
A risk study I read on the Amaranth hedge fund blow up said that a priori, based on a VAR analysis, it was a 12 sigma event. It should have only taken place once in around 100 lifetimes of the universe. Unlucky, then.
The study was a bit better than that though. It highlighted that Amaranth got too large in the forward natural gas market, and that there was no natural buyer. So Amaranth changed the blow-up odds against itself. From around 12 sigma to around zero sigma.
In my view, that is exactly what the European banks have done. Their risk models say one thing about their convergence trades. But the fact that they have all got on the trade, and all got on it large, has completely changed the odds.
As with housing in the US. When people said, at the start of 2007, that US housing had never fallen in nominal terms, and that was a reason for not being bearish, it was, well, a poor reason. Because the banks, the subprime borrowers and the buy-to-letters had changed the odds of the game.
And so that brings me back to the currency call. From a point of extreme valuation against the dollar, I can now see a process whereby the Euro, Sterling, the Swedish kroner, and the Eastern European and Baltic currencies now fall into a self perpetuating spiral of devaluation and debt deflation.
Yesterday, I put on some dollar longs.
In late March, I tried the same thing on the US dollar. If the US dollar was up 15% by the end of the year – what would have made it happen? Problem was I couldn’t answer the question well enough. So I didn’t trade.
Most likely, we were due a correction. Sentiment against the dollar was extreme. There was a raft of business magazine covers depicting the dollar crash – notably the Economist’s George Washington going down in a fighter plane late last year. And this kind of sentiment usually coincides with a low.
And then there was a macro kicker. The US tax-break was going to be a monster – pretty much guaranteeing above trend US growth through the middle of the year. But Europe was on its uppers – leading indicators were deteriorating rapidly, and the hard numbers were likely to follow suite.That, I thought, was good for 5%. But, by the Autumn the US would be slowing again and the Fed likely considering cutting rates - so I couldn’t think of anything too likely to get me to 15%. But I’ve had another go – and now I can.
First off, the valuation on the Euro isn’t exactly compelling. At my previous house, we recreated a bunch of Morgan Stanley currency strategist Stephen Jen’s models – which are showing the dollar at a two standard deviation extreme in cheapness against Sterling and the Euro. That the dollar is cheap, and the Euro expensive, I think, everybody knows.
But what I hadn’t realised – and thanks to Chad Slater for this one – is that it now costs the same to buy a Big Mac in Shanghai as it does in New York. Now I’ve been listening to folks banging on for so long about why the Renminbi needs to be revalued, that I’d stopped testing the assumption that it is cheap. It isn’t.
So what’s happened in China? In one word; inflation. China has seen its inflation pick up sharply. But the degree of increase is masked in the official CPI, due to statistical manipulation, and due to price controls. Go to something that isn’t controlled – like a Big Mac – and you get a better picture. And China’s inflation is not just food. Chinese wages are booming – with 15% pay rises a regular occurrence in the Pearl River Delta and other Industrial hubs. And employer costs are rising even faster than this – as they have to compete with other employers by providing bed and board for increasingly scarce migrant workers. The result is that productivity can’t keep up, so unit labour costs are rising at 2-3% annually, compared to an average 2-3% fall just five years ago. China has revalued by another means – by letting inflation build, it has reduced the value of it’s currency while allowing it’s currency to appreciate gradually against the dollar.
But I don’t see China as the problem. Yesterday I put the emerging markets into boxes. China was a ‘conservative reflator’ – pretty stable in my book. What’s interesting to look at is the wild ones. I described a wild inflator as a country with big dollar earnings from dollar exports, plus booming credit growth (of more than 3x GDP growth). Russia and many of the Gulf States fall into this category. Now the Gulf States are dollar peggers. But they’ve got inflation running in the teens. So they’re already appreciating by 10+% against the dollar – just by keeping the peg. I don’t think the revaluation of the gulf currencies is the slam dunk that many believe it is. The currencies are getting less valuable by the day.
But it’s when you look at the wild reflators – the countries that have seen large capital inflows into their bond and property markets, combined with blow-out current account deficits and booming credit expansion – well, then things really heat up. Because their fair value against the dollar is collapsing. The Ukraine, Latvia, Vietnam etc – it’s a long list. Soon, they’ll be the wild deflators.
And what I think we’ve got here is the start of a story. The potential for a self-reinforcing trend to emerge – involving capital flight, bank write offs, reduced willingness and ability to lend, weakening currency, falling asset prices (especially in foreign currency terms)and more capital flight. And what’s interesting about this is the potential for the infection to spread from the wild reflators like Eastern Europe and the Baltic States – to a mild reflator like Europe. Why?
The first reason is the Euro area contains within it some wild reflators. Spain, Ireland and Greece are the obvious contenders. But Italy – while it hasn’t seen that degree of credit expansion – is getting there on the deficit front. Spain and Ireland are already seeing reflation twist into asset price deflation. Soon this will spread.
The second reason is that the European banks were best in class when it came to funding the wild reflators. Yesterday I talked about hedge funds running a leveraged long equities trade with a trailing stop for 61 of the last 62 months. Well, that’s chicken feed compared to what the European banks have been up to. For a decade they built up assets in the wild reflator states. It is the essence of the convergence trade – betting that bonds, currencies and property values in the periphery will converge with those in Germany and France.
Now that trade is beginning to unravel, the European banks have started to realise that there is no one to sell their positions to. They are all sellers. And they are all very large in the trade.
A risk study I read on the Amaranth hedge fund blow up said that a priori, based on a VAR analysis, it was a 12 sigma event. It should have only taken place once in around 100 lifetimes of the universe. Unlucky, then.
The study was a bit better than that though. It highlighted that Amaranth got too large in the forward natural gas market, and that there was no natural buyer. So Amaranth changed the blow-up odds against itself. From around 12 sigma to around zero sigma.
In my view, that is exactly what the European banks have done. Their risk models say one thing about their convergence trades. But the fact that they have all got on the trade, and all got on it large, has completely changed the odds.
As with housing in the US. When people said, at the start of 2007, that US housing had never fallen in nominal terms, and that was a reason for not being bearish, it was, well, a poor reason. Because the banks, the subprime borrowers and the buy-to-letters had changed the odds of the game.
And so that brings me back to the currency call. From a point of extreme valuation against the dollar, I can now see a process whereby the Euro, Sterling, the Swedish kroner, and the Eastern European and Baltic currencies now fall into a self perpetuating spiral of devaluation and debt deflation.
Yesterday, I put on some dollar longs.
Tuesday 3 June 2008
A bout de soufflé
I don’t know if using French in a blog title has the same effect as using an equation in a book – that of guaranteeing to halve your readership. But I guess I’ll find out later today. It’s the title of the classic new wave Jean-Luc Godard movie from 1960 – starring Belmondo and Jean Seberg. And it translates as ‘breathless’.
That strikes me as just the right phrase to describe a bunch of emerging markets nowadays, and probably a bunch of hedge funds too. They’ve got so big, they are struggling to breathe under their own weight.
I like to watch how the average hedge fund manager behaves. It doesn’t matter how eclectic they all are, whether they’re trying to shoot out the lights, or to hug low volatility to gain assets under management. From 2003 to October 2007, the aggregate hedge fund performance indices all behaved in a certain way. They behaved as if they were a mechanical leveraged long position on the S&P 500, with a trailing stop.
Now, when I discovered this in early 2006, I thought it was ridiculous. Why pay 2&20 for something you could run with a two line spreadsheet model? But lately I’ve thought about it some more, and I’ve changed my mind.
There’s a good book by New Yorker columnist James Surowieki called the ‘Wisdom of Crowds’ – that I’m sure many of you have read. In it he describes how that, if you average out the responses from a group of random people at a fair guessing the weight of a cow, well, you get a more accurate result than if you ask a individual expert; a farmer or a butcher.
And so with hedge funds over the period. The most efficient way of trading the market from 2003-October 2007 was leveraged long stocks with a trailing stop. Amazing really, that all the thought, all the emotion and all the complexity in markets over that period could be reduced to such a simple formula.
That changed in November 2007, when hedge funds held up, despite a fall in the market. That was very interesting – it was the first sign of a change in behaviour in over four years.
Then we had Q108. And the funds got toasted. It was the worst performance quarter on record – as equities collapsed, rebounded, collapsed and started to rebound again – all in three months. But, according to Hedge Fund Research, Hedge funds have now made up, in April and May, all their losses from Q1.
So on average this year, the funds are back to leveraged long with a trailing stop. The way they’ve been for around 61 of the last 62 months.
Now what all that tells me is that funds are struggling to adapt. They’ve got a tendency, on average, to revert to the lucrative behaviour of the 2003-7 years. And that’s probably why, when I got cautious a little over a month ago, the market kept running for a few weeks, even as the risk/reward of going long had deteriorated. Funds were reverting to the leveraged long trade, stops on short positions were getting hit, and there was a tendency to get on the momentum, to make up the losses of Q1.
But like any organism that has taken such massive advantage of its environment – the funds have grown to the point that the environment can no longer support them in their present form. Returns have been falling. Hedge funds, on average, will now have to adapt or die.
My own view is that, with the weight of money – and the likelihood that the overall pool of funds will shrink – it is very unlikely that leveraged long with a trailing stop will prove the most efficient way to run money over the year ahead. The adaptation I expect is this; funds will end up doing the opposite. Leveraged short with a trailing stop. And the earlier they do it, the larger they’ll get. Indeed, I suspect some of the funds that have blown the lights out – and gained assets over the last twelve months - are predisposed to behaving this way.
And that got me to thinking about what to look for in this environment.
That comes back to my title at the head of this post. When the global economy was recovering from a point in 2003 at which resources, globally, were grossly underutilised (we were back at 1982 lows) - everything could reflate. Housing, property, resources. Everything. And capital flows from East to West and the convergence of Eastern Europe helped to prolong and exaggerate the process.
But that dynamic – which generated an incredible uniformity of performance across risk markets - hid some profound differences.
Don’t laugh, but I like to keep things simple. I think a good way of categorising countries (and sectors if you like) – is to split them into inflators and reflators. An inflator is a country that’s pulling in large resource dollars for fundamental reasons (described in my presentation – crowded house). A reflator is a country that has pulled in large amounts of capital for investment in local bonds, credit, commercial and residential real estate.
Obviously, there are shades of grey. If an inflator country allows its credit to expand rapidly – say above 3x GDP – then it’s a wild inflator. Russia, Dubai and the UAE fall into this category. If a reflator still has good returns on capital, a current account surplus, and credit growth of less than 2x GDP – then it is a conservative reflator. China is a clear example. If a reflator has blowout current account deficits and rip-roaring credit growth – like the Ukraine, Vietnam, Latvia and co – then they are wild reflators.
And the reason these distinctions are useful, is that all these countries are going to have to adapt to the current environment in very different ways. The first to run out of breath will be the wild reflators. My view is that the oxygen is already scarce.
Not just financial oxygen either. The inflator nations aren’t just selling high priced oil. They are using the funds to subsidise a massive expansion of domestic oil consumption and growth (oil exporting countries, that make up less than 15% of world GDP, account for more than 50% of oil demand growth). Smells like a self-reinforcing process to me – one that starves consumers and corporates of air in reflator nations.
On the principle that two shocks are more than twice as bad as one – we now have to deal with – I’d say – five major shocks;
1) The original structural problems with the winding down of bank disintermediation and deteriorating asset backed securities in reflator nations.
2) The breakdown of the wholesale banking model as libor/base rate spreads widened.
3) The self-reinforcing crowding out of consumers in reflator nations by inflator nations – and a subsequent slowdown.
4) The deterioration in credit generally and property loans in particular in reflator nations as a result of 1, 2 & 3.
5) A reversal of speculative funding in assets in reflator nations due to 1,2,3,4 and due to a change in fund behaviour.
In my experience, markets can and do price in bad news. But markets are very bad at pricing in self-reinforcing negative processes like the ones described above. There’s still a long way to go on the short side.
That strikes me as just the right phrase to describe a bunch of emerging markets nowadays, and probably a bunch of hedge funds too. They’ve got so big, they are struggling to breathe under their own weight.
I like to watch how the average hedge fund manager behaves. It doesn’t matter how eclectic they all are, whether they’re trying to shoot out the lights, or to hug low volatility to gain assets under management. From 2003 to October 2007, the aggregate hedge fund performance indices all behaved in a certain way. They behaved as if they were a mechanical leveraged long position on the S&P 500, with a trailing stop.
Now, when I discovered this in early 2006, I thought it was ridiculous. Why pay 2&20 for something you could run with a two line spreadsheet model? But lately I’ve thought about it some more, and I’ve changed my mind.
There’s a good book by New Yorker columnist James Surowieki called the ‘Wisdom of Crowds’ – that I’m sure many of you have read. In it he describes how that, if you average out the responses from a group of random people at a fair guessing the weight of a cow, well, you get a more accurate result than if you ask a individual expert; a farmer or a butcher.
And so with hedge funds over the period. The most efficient way of trading the market from 2003-October 2007 was leveraged long stocks with a trailing stop. Amazing really, that all the thought, all the emotion and all the complexity in markets over that period could be reduced to such a simple formula.
That changed in November 2007, when hedge funds held up, despite a fall in the market. That was very interesting – it was the first sign of a change in behaviour in over four years.
Then we had Q108. And the funds got toasted. It was the worst performance quarter on record – as equities collapsed, rebounded, collapsed and started to rebound again – all in three months. But, according to Hedge Fund Research, Hedge funds have now made up, in April and May, all their losses from Q1.
So on average this year, the funds are back to leveraged long with a trailing stop. The way they’ve been for around 61 of the last 62 months.
Now what all that tells me is that funds are struggling to adapt. They’ve got a tendency, on average, to revert to the lucrative behaviour of the 2003-7 years. And that’s probably why, when I got cautious a little over a month ago, the market kept running for a few weeks, even as the risk/reward of going long had deteriorated. Funds were reverting to the leveraged long trade, stops on short positions were getting hit, and there was a tendency to get on the momentum, to make up the losses of Q1.
But like any organism that has taken such massive advantage of its environment – the funds have grown to the point that the environment can no longer support them in their present form. Returns have been falling. Hedge funds, on average, will now have to adapt or die.
My own view is that, with the weight of money – and the likelihood that the overall pool of funds will shrink – it is very unlikely that leveraged long with a trailing stop will prove the most efficient way to run money over the year ahead. The adaptation I expect is this; funds will end up doing the opposite. Leveraged short with a trailing stop. And the earlier they do it, the larger they’ll get. Indeed, I suspect some of the funds that have blown the lights out – and gained assets over the last twelve months - are predisposed to behaving this way.
And that got me to thinking about what to look for in this environment.
That comes back to my title at the head of this post. When the global economy was recovering from a point in 2003 at which resources, globally, were grossly underutilised (we were back at 1982 lows) - everything could reflate. Housing, property, resources. Everything. And capital flows from East to West and the convergence of Eastern Europe helped to prolong and exaggerate the process.
But that dynamic – which generated an incredible uniformity of performance across risk markets - hid some profound differences.
Don’t laugh, but I like to keep things simple. I think a good way of categorising countries (and sectors if you like) – is to split them into inflators and reflators. An inflator is a country that’s pulling in large resource dollars for fundamental reasons (described in my presentation – crowded house). A reflator is a country that has pulled in large amounts of capital for investment in local bonds, credit, commercial and residential real estate.
Obviously, there are shades of grey. If an inflator country allows its credit to expand rapidly – say above 3x GDP – then it’s a wild inflator. Russia, Dubai and the UAE fall into this category. If a reflator still has good returns on capital, a current account surplus, and credit growth of less than 2x GDP – then it is a conservative reflator. China is a clear example. If a reflator has blowout current account deficits and rip-roaring credit growth – like the Ukraine, Vietnam, Latvia and co – then they are wild reflators.
And the reason these distinctions are useful, is that all these countries are going to have to adapt to the current environment in very different ways. The first to run out of breath will be the wild reflators. My view is that the oxygen is already scarce.
Not just financial oxygen either. The inflator nations aren’t just selling high priced oil. They are using the funds to subsidise a massive expansion of domestic oil consumption and growth (oil exporting countries, that make up less than 15% of world GDP, account for more than 50% of oil demand growth). Smells like a self-reinforcing process to me – one that starves consumers and corporates of air in reflator nations.
On the principle that two shocks are more than twice as bad as one – we now have to deal with – I’d say – five major shocks;
1) The original structural problems with the winding down of bank disintermediation and deteriorating asset backed securities in reflator nations.
2) The breakdown of the wholesale banking model as libor/base rate spreads widened.
3) The self-reinforcing crowding out of consumers in reflator nations by inflator nations – and a subsequent slowdown.
4) The deterioration in credit generally and property loans in particular in reflator nations as a result of 1, 2 & 3.
5) A reversal of speculative funding in assets in reflator nations due to 1,2,3,4 and due to a change in fund behaviour.
In my experience, markets can and do price in bad news. But markets are very bad at pricing in self-reinforcing negative processes like the ones described above. There’s still a long way to go on the short side.
Monday 2 June 2008
Short Shrift
I’ve been talking for over a month now on why I was getting cautious. And for the past week, I’ve been explaining why I’ve gone net short. As of Friday I was 150% net short. About a third of that is against the FTSE, and the rest is distributed between shorts on the Dow, the CAC 40, the Indian Nifty, Swedbank and Erstebank. I also bought some US treasuries along the way.
Now this is a decent sized position – and larger than I would normally go. Deliberately so. I’m up 22% from my start in mid-Feb and I’m ready to bet half my gains on the short trade.
I have a rule about changing the rules by which I trade. First, I’ve got to change the rules in advance – rather than altering my game plan after a loss. So – in advance of any losses - I’ve doubled my normal risk tolerance. Let me make myself clear. If I was down 5% to date, I’d be running half normal risk, not double. But this is no hubris driven momentum trade. I made money this year long resources and infrastructure – and from here I plan to make money short.
And I’m fully aware – at 150% net short, I have a lot of risk on board. But the risk I’m taking is not the risk most people suppose.
It’s not the risk that the market will go up, and I’ll blow up. I know, if the market rises, exactly how much I will lose. That’s deliberate – I made the commitment to lose that money when I put the bet on. If I lose, will I regret it? No. I think, a priori, this is one of the best risk/reward bets I’ve made.
The risk I fear is that I’ll chicken on my call. That I’ll make a few percent, then walk away.
So I’m steeling myself for that commitment. And the only way I know how to do that is to get intellectually involved. So I’ve switched from focussing on opportunities for compounding returns – which has made me a bundle over the past four years – to looking for stocks that will fall over 50%.
I’ve halved all my long equity positions bar Petrobras and Pico holdings. And I’m prepared to take everything, bar Petrobras, down to zero. Petrobras is the only stock I’m holding for the kids. It’s the only stock I’m prepared to watch halve, and stay invested.
So what’s going to go down more than 50%? That’s no idle question. It takes some serious changes to fundamentals and to sentiment to take a stock down that far.
As I write this – Heidi Couch of Bloomberg TV is telling me that small cap ozzie resources are up a lot. Fortescue has gone mental. So it would be tempting to suggest that these stocks will tumble.
Of course, that’s not impossible. And the risk/reward of a short here is pretty good. But I’m always a bit worried betting against self-reinforcing fundamentals in China – and the potential for self-reinforcing resource shortages. I’d still rather go hunting among the banks with Eastern and Southern European exposure.
Starting in November 2006 I was short Irish banks and domestic Spanish banks (I wanted to avoid being short the Brazilian businesses of the major Spanish players) – a painful 10-15% too early. I was short them through 2007, and I added shorts on the investment banks, US real estate and Eastern European property during the year. I’ve been in and out of shorts on Erstebank, Swedbank, and the Greek banks since I restarted in mid- Feb. Erste hasn’t made me any money of late. Swedbank looks set to break below its January lows – and from there….
So what are the key themes here?
The first one is the morphing of the credit crunch. Round one was a combination of unwinding bank disintermediation, the deterioration of asset backed securities (ABS) and the pressure on the wholesale banking model in the developed world. But remember – that all happened in 2007, before there was any real macro stress. Round two - macro stress - is a whole different ballgame.
And my guess is that it’s a much bigger problem than what we saw in the early 1990s and early 2000s. There are two reasons for this. First, it’s because the commercial banks have got themselves deeply unbalanced. In the UK, I understand that 80% of bank lending by the majors is property related.
The second reason is that inflation is staying the hand of the MPC, the ECB, the Fed and many Asian central banks. That means yield curves will be flatter than normal – for longer than normal – in the downturn. It’s going to be very tough for the banks to recapitalise – especially here in Europe.
Now this makes for a classic vicious circle. A friend of mine has a pat line; bankers always lie. So when the banks started to realise the trouble that they were in last Autumn, they did what they do best. They were economical with the truth about the deterioration in their asset quality, and they shut up shop. They stopped lending to other banks as their own balance sheets exploded, and as they realised that those other banks could be in a bunch of trouble too.
So first the demand for ABS collapses, and so therefore does the issuance. That means fewer and tougher loans on property in Spain, Ireland, the UK and the US. Then the breakdown in the wholesale banking model (as Libor base rate spreads blew out globally) meant these banks had to collapse lending too. That’s why we saw the sudden fall in commercial property valuations in the UK late last year, and that’s why we’re seeing the lagged crunch in residential property here as well. And clearly, as these assets deteriorate, the banks’ willingness and ability to lend will weaken further.
But so far, much of the trouble is with the lenders. We are only now seeing the weakening of labour market conditions – which will reduce demand for commercial property, and raise residential defaults in the US and across Europe. And that will get the vicious circle started again.
So much, so obvious. I think a key point to hold onto is that the central banks have much less room to operate than in previous recessions – due to inflation and due to the fact that it will be rock hard to reflate commercial and residential property now, in 2008, that the property is so overvalued.
I think a second key point is that the commercial banks are now much less able to recapitalise and grow loans given the potential for flat curves, and the fact that their assets have deteriorated so aggressively before the usual macro hit in a downturn. Betsy Grassek, the Morgan Stanley financials analyst, estimates that bad loan provisioning in the US is due to have a bigger negative impact on earnings than the subprime write-offs.
But, if you’re looking for trouble, it’s worth going the whole hog. And that’s why it’s worth looking for macro trouble. If you add a macro breakdown to a vicious cycle in bank lending and property prices, well – it gets real exciting. And the past several weeks, we have seen that macro trouble emerging. We’ve got stagflation – proper stagflation – in India, Pakistan, Vietnam, the Ukraine, Latvia, Hungary, Bulgaria, South Africa and Iceland. We’ve seen pressure on the rupee, the rand and the Icelandic krona.
I’ve taken the chance to go short the Nifty. Not only is inflation and slowing growth ugly in its own right, it’s downright hideous when you realise the amount of Japanese money in the Indian market. Japan currently invests more in Indian stocks than those in Europe. It’s been a huge trade for the Japanese housewife over the past five years. My view is that it could unravel fast – and that it will be exacerbated if, as I expect, the yen starts to move up hard against the rupee.
Then there are the Eastern European economies. Now I’ve already said I thought these guys were in trouble. They have inflation and their economies are rolling over. So far, so bad. But they also have massive current account and budget deficits. Then they have almost all seen credit growth above 20% for the past four or five years – and all have seen massive property booms. That’s a pretty good benchmark for trouble in a slowdown.
And yes, it gets worse. They have borrowed from abroad – in many cases loans, even domestic mortgage loans, are denominated in Swissies and Euros. If you look down the list of big lenders in Eastern Europe, you find Erstebank, Swedbank and the Greeks. These guys are facing the same pressure as the rest of the European Banks – they are pulling in their lending horns as they try to protect their assets, and stabilise their reserves. The problem is this leads to a vicious cycle in emerging Europe similar to the one I described for the UK above.
But in Eastern Europe, falling currencies will likely reinforce this vicious cycle (as less capital comes in, and more flows out). And that’s when the going gets genuinely tough. Because inflation worsens, spending power falls, defaults rise and the banks’ assets in the region collapse in local currency terms – forcing another round of loan reduction. I think we now have a higher than 50% chance of a full on financial crisis in Eastern Europe. The bankers involved may not be saying much in public, but I’ll wager that, behind closed doors, they’re panicking.
Now this is a decent sized position – and larger than I would normally go. Deliberately so. I’m up 22% from my start in mid-Feb and I’m ready to bet half my gains on the short trade.
I have a rule about changing the rules by which I trade. First, I’ve got to change the rules in advance – rather than altering my game plan after a loss. So – in advance of any losses - I’ve doubled my normal risk tolerance. Let me make myself clear. If I was down 5% to date, I’d be running half normal risk, not double. But this is no hubris driven momentum trade. I made money this year long resources and infrastructure – and from here I plan to make money short.
And I’m fully aware – at 150% net short, I have a lot of risk on board. But the risk I’m taking is not the risk most people suppose.
It’s not the risk that the market will go up, and I’ll blow up. I know, if the market rises, exactly how much I will lose. That’s deliberate – I made the commitment to lose that money when I put the bet on. If I lose, will I regret it? No. I think, a priori, this is one of the best risk/reward bets I’ve made.
The risk I fear is that I’ll chicken on my call. That I’ll make a few percent, then walk away.
So I’m steeling myself for that commitment. And the only way I know how to do that is to get intellectually involved. So I’ve switched from focussing on opportunities for compounding returns – which has made me a bundle over the past four years – to looking for stocks that will fall over 50%.
I’ve halved all my long equity positions bar Petrobras and Pico holdings. And I’m prepared to take everything, bar Petrobras, down to zero. Petrobras is the only stock I’m holding for the kids. It’s the only stock I’m prepared to watch halve, and stay invested.
So what’s going to go down more than 50%? That’s no idle question. It takes some serious changes to fundamentals and to sentiment to take a stock down that far.
As I write this – Heidi Couch of Bloomberg TV is telling me that small cap ozzie resources are up a lot. Fortescue has gone mental. So it would be tempting to suggest that these stocks will tumble.
Of course, that’s not impossible. And the risk/reward of a short here is pretty good. But I’m always a bit worried betting against self-reinforcing fundamentals in China – and the potential for self-reinforcing resource shortages. I’d still rather go hunting among the banks with Eastern and Southern European exposure.
Starting in November 2006 I was short Irish banks and domestic Spanish banks (I wanted to avoid being short the Brazilian businesses of the major Spanish players) – a painful 10-15% too early. I was short them through 2007, and I added shorts on the investment banks, US real estate and Eastern European property during the year. I’ve been in and out of shorts on Erstebank, Swedbank, and the Greek banks since I restarted in mid- Feb. Erste hasn’t made me any money of late. Swedbank looks set to break below its January lows – and from there….
So what are the key themes here?
The first one is the morphing of the credit crunch. Round one was a combination of unwinding bank disintermediation, the deterioration of asset backed securities (ABS) and the pressure on the wholesale banking model in the developed world. But remember – that all happened in 2007, before there was any real macro stress. Round two - macro stress - is a whole different ballgame.
And my guess is that it’s a much bigger problem than what we saw in the early 1990s and early 2000s. There are two reasons for this. First, it’s because the commercial banks have got themselves deeply unbalanced. In the UK, I understand that 80% of bank lending by the majors is property related.
The second reason is that inflation is staying the hand of the MPC, the ECB, the Fed and many Asian central banks. That means yield curves will be flatter than normal – for longer than normal – in the downturn. It’s going to be very tough for the banks to recapitalise – especially here in Europe.
Now this makes for a classic vicious circle. A friend of mine has a pat line; bankers always lie. So when the banks started to realise the trouble that they were in last Autumn, they did what they do best. They were economical with the truth about the deterioration in their asset quality, and they shut up shop. They stopped lending to other banks as their own balance sheets exploded, and as they realised that those other banks could be in a bunch of trouble too.
So first the demand for ABS collapses, and so therefore does the issuance. That means fewer and tougher loans on property in Spain, Ireland, the UK and the US. Then the breakdown in the wholesale banking model (as Libor base rate spreads blew out globally) meant these banks had to collapse lending too. That’s why we saw the sudden fall in commercial property valuations in the UK late last year, and that’s why we’re seeing the lagged crunch in residential property here as well. And clearly, as these assets deteriorate, the banks’ willingness and ability to lend will weaken further.
But so far, much of the trouble is with the lenders. We are only now seeing the weakening of labour market conditions – which will reduce demand for commercial property, and raise residential defaults in the US and across Europe. And that will get the vicious circle started again.
So much, so obvious. I think a key point to hold onto is that the central banks have much less room to operate than in previous recessions – due to inflation and due to the fact that it will be rock hard to reflate commercial and residential property now, in 2008, that the property is so overvalued.
I think a second key point is that the commercial banks are now much less able to recapitalise and grow loans given the potential for flat curves, and the fact that their assets have deteriorated so aggressively before the usual macro hit in a downturn. Betsy Grassek, the Morgan Stanley financials analyst, estimates that bad loan provisioning in the US is due to have a bigger negative impact on earnings than the subprime write-offs.
But, if you’re looking for trouble, it’s worth going the whole hog. And that’s why it’s worth looking for macro trouble. If you add a macro breakdown to a vicious cycle in bank lending and property prices, well – it gets real exciting. And the past several weeks, we have seen that macro trouble emerging. We’ve got stagflation – proper stagflation – in India, Pakistan, Vietnam, the Ukraine, Latvia, Hungary, Bulgaria, South Africa and Iceland. We’ve seen pressure on the rupee, the rand and the Icelandic krona.
I’ve taken the chance to go short the Nifty. Not only is inflation and slowing growth ugly in its own right, it’s downright hideous when you realise the amount of Japanese money in the Indian market. Japan currently invests more in Indian stocks than those in Europe. It’s been a huge trade for the Japanese housewife over the past five years. My view is that it could unravel fast – and that it will be exacerbated if, as I expect, the yen starts to move up hard against the rupee.
Then there are the Eastern European economies. Now I’ve already said I thought these guys were in trouble. They have inflation and their economies are rolling over. So far, so bad. But they also have massive current account and budget deficits. Then they have almost all seen credit growth above 20% for the past four or five years – and all have seen massive property booms. That’s a pretty good benchmark for trouble in a slowdown.
And yes, it gets worse. They have borrowed from abroad – in many cases loans, even domestic mortgage loans, are denominated in Swissies and Euros. If you look down the list of big lenders in Eastern Europe, you find Erstebank, Swedbank and the Greeks. These guys are facing the same pressure as the rest of the European Banks – they are pulling in their lending horns as they try to protect their assets, and stabilise their reserves. The problem is this leads to a vicious cycle in emerging Europe similar to the one I described for the UK above.
But in Eastern Europe, falling currencies will likely reinforce this vicious cycle (as less capital comes in, and more flows out). And that’s when the going gets genuinely tough. Because inflation worsens, spending power falls, defaults rise and the banks’ assets in the region collapse in local currency terms – forcing another round of loan reduction. I think we now have a higher than 50% chance of a full on financial crisis in Eastern Europe. The bankers involved may not be saying much in public, but I’ll wager that, behind closed doors, they’re panicking.
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