Dirty

I didn’t kill myself worrying about the market over my holiday last week. What with rowing the kids over to the island, cooking barbecues, fishing for mackerel (good) and pollack (er…), and dog days on Howe strand.

Things had already got tricky the Friday we were leaving for Ireland. By that time I’d hit an 8% drawdown from my 38% high – the biggest drawdown of the year. And when I said I was going into the holiday with high conviction, I wasn’t ready to blow myself up. I halved my risk before we got on the plane. As a day trade that was just as well – at the close that day I was a fraction shy of 10% off my peak.

Now, as it happens, I was reading two books while I was there; ‘Amarillo Slim in a world full of fat people’ that I picked up in the gambling section of the Books etc at the airport, and ‘Mistakes were made, but not by me’ by Carol Tarvis and Elliot Aronson. Both were easy to read, and they got me thinking about how to deal with my trading.

So what I was thinking about in the downtime from the kids & family was how good a bet it is to bet on disinflation/deflation from here. Falling commodities, rising bonds, a rising dollar, and in the short term – a higher Dow.

Was I simply justifying my decision, because I’d made it already, and told everyone what I thought? Or did I still think, in the light of day, that the call had a great risk/reward payoff?

In short, I thought the bet was good. Early last week I put the risk I’d taken off the Friday before back on. The only other trade I made was to cut some of the long rate futures Thursday as oil fell apart (high oil, in my view, has been deflationary of late) and put it into long stocks.

Make no mistake, I’d have cut my losses in a New York second if I thought I was misreading the market; justifying a decision I’d already made, and misrepresenting the opposite view.

Now one of the best ways of analysing how good a trading view is, is to ask, dispassionately, how strong an alternative view is. And the strongest alternative view is that shortages in energy resources will continue to worsen. If that is right, then I will likely lose money. The dollar would struggle to rise, global recession would loom large, and high headline inflation numbers would help de-rate stocks further. Pretty much all my trades would fail.

The thing about the long energy trade is that it’s very convincing. The fundamentals in coal and oil are the tightest they have been in a generation. And my argument against them is, well, a little tentative.

My main consolation is that the best selling opportunities for commodities come when people think that they are running out (oil) – and the best buying opportunities come when people think the commodities will stay free forever (like, say, water).

I have been reading a bit of technical analysis on how long blow-off bull markets end. And this has been a long blow-off for oil– lasting 365 days to the high early last week. It’s rare for a major market to go asymptotic for longer.

The major macro reason for believing in deflation/disinflation is that the non-oil current account deficit has collapsed – from 5.5% of GDP in 2006, to 2.5% now. As I mentioned in a previous blog ‘Decision Three’ – that is the equivalent of reducing global base money supply. But that’s not the only deflationary effect. Global banks – especially those in Europe – will reduce their bank multipliers aggressively, as they seek to defend their balance sheets against further capital destruction. So the main source of inflation is the spending from the oil states (about 7% of world GDP) – the oil deficit rose from 2% of US GDP in 2006, to 3.5% now. My view is that this inflationary pressure is getting increasingly narrow.

The counter to this is that it is energy supply that has been the major factor behind the tightness. I struggle with that argument – as we have just seen the five strongest years both for global growth and for the intensity of commodity use in several generations. What I would agree with is that energy supply has been exceptionally unresponsive to that demand growth.

I don’t buy the idea that financial speculation has forced energy prices higher. I think financial speculation has simply followed the fundamentals. But I do think a couple of temporary factors have added the exceptional tightness this year. One was China’s aggressive moves against small/unsafe coal mines over the past two years. Moves that caused 11,000 mines to close, and which helped precipitate a major coal and energy shortage in the wake of China’s twin earthquake and big freeze disruptions earlier this year. I understand that 4,000 of the bigger mines are now reopening, and that China is now pursuing an active policy of reducing the energy intensity of exports, and growth in general. We’ll likely see a large reduction in diesel use for generators, and an easing of energy supply constraint in the months ahead. I then think slowing global growth will help to ease these constraints further over the next two years.

A few other things factored into the call;

1. The Fed and Paulson have said that they will seek to bail out Freddy & Fanny. The Fed has not said that it will let money rip – it isn’t, nor has it done over the last two years.

2. Aren’t folks bearish? On all sorts of sentiment measures, and across the mainstream media and the financial press. The VIX finally broke 30 early last week. And short positioning in financial stocks hit an all time high at the same time.

3. The European banking system is in a far worse state than the US banking system. Subprime exposure is similar, but the Europeans have an order of magnitude greater exposure to real estate in the UK, Ireland, Spain, Greece and Hungary, and to European convergence trades in general.

4. Two weeks ago I bought three stocks; BA, GM and Lloyds. And I have to admit – I felt a little bit dirty after buying them. After all, the fundamentals really are shocking. But these stocks were still up come Monday, after the Friday panic low.

And with a bit more disinflation (the commodity markets look to be breaking down) – and these things could really move. GM is now up 21% from when I bought it. BA is up 17%, and Lloyds is up 18%. Sometimes it’s good to be dirty.