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.