Coke is still it

If you’re more of a contrarian than a momentum guy, as I used to be, the thing that would kill you, time and time again was getting in early. You’d lose some, you’d make some more, and then you’d give it all back, betting that the momo guys were late and wrong.

Now, when I went into my ‘end of inflation’ call six weeks ago – with the post ‘Decision three’ – I had the right to go in large – I was up 35% at the time. And I had the reason. Positioning was extreme (long resource stocks and commodities, short financials). The inflation theme was at an extreme. And I had an angle – the combination of a shrinking US current account deficit, and falling bank multipliers meant that disinflation/deflation had already begun.

So I bet half my gains for the year – my stop was just shy of an 18% drawdown. What I was looking to do was to double my gains – to get to 70% up.

To make that kind of money, I couldn’t just be a contrarian. I’d have to be a contrarian first, and a momentum man second. Now my ‘perfect’ roadmap involved making 35% over the rest of the year, holding my nerve during 10% drawdowns. It worked out very differently. I made 9% in a week. I gave back 8% in a 24 hour period. Then I saw three or four big daily swings. I reduced my risk some after a gain. And now, in the six weeks after ‘Decision three’ – I’ve made 27% and I now stand 62% up.

The calls I made six weeks ago were deeply contrarian. Now they’re mid-term momentum. Which is nice.

I kind of deliberately got out of broadband range when it looked like I was on the right track. When it’s noisy it’s often good to turn down the volume. But now I want to start listening more carefully.

And what I want to listen to is reflationary tendencies. The fall in oil opens up a lot of doors. So does the YoY fall in Chinese construction activity. And the falling house prices across the Anglo and Scandinavian economies.

So the question I have is this. How do the professions respond? In my last piece I wrote that global macro is mainly inhabited by men in the professions, but fewer professionals (Of course, that doesn’t make it easy to make money – the professionals can build some very big positions).

What do people in the professions do here? They stop ordering or lending anything. July this year felt eerily similar to September 2000. In March 2000 we’d seen the dotcoms go while the economy was fine. July this year was another ‘six months after’ – this time, six months after Soc Gen.

In September 2000, one piece of data alerted me to the problem – the collapse in US aluminium orders. The world at large got wary when in October of that year John Chambers of Cisco said all was well, but in November said that he’d never seen such a sudden and extreme collapse in orders. Turns out Cisco had been financing its customers.

So suddenly, in July 2008, the macro fell to pieces. A little later, Vodaphone appeared to do a Cisco.

But the world is a mirror image of what it was then. Then the US was full of wage growth and the dollar was dominant. Now, the opposite. And the way out will be very different.

So now we’ve had a proper resource correction, getting on for a third.

And I’ve put on my first directional trade for six weeks (rather than adjusting my risk exposure across the board to control my volatility). I’ve cut back a third of my commodity shorts (in gold, copper and oil), and like for like I’ve raised my US equity exposure (I’ve bought the Dow). I’ve left all my long dollar positions intact.

It’s a small step towards a reflation call. So far all I can hear is the air flowing through open doors. My view right now is that, from here, we’ll see a lot more easing outside the US rather than within it. I am also expecting a rapid decline in the US current account deficit, and increased credit stress in Eastern Europe. So I’m still very bullish on the dollar, and I still think the winners will be companies that do well in a disinflation. Stocks like Coke, GM, British Airways, Walgreen and Majestic Wine (See my post – ‘Coke break’). But I think the risk/reward of being outright short commodities has diminished somewhat at the margin, while the risk/reward of being long stocks has improved.

Now I only have two resource stocks out of the 22 resource and infrastructure companies I owned on May 1st. Petrobras, 5% of NAV, is down 16% from when I bought it. Pico holdings, 6% of NAV, is up 32%.

In one post, before I turned bearish commodities, I said I’d bought Petrobras for the kids. My daughter won’t be thanking me now. Nor will the daughters of all the Barron's readers who later caught the infamous ‘Barron's Curse’. I haven’t yet hit my stop on Petrobras – although I’m close – but until I do I’ll hold it – it’s my proxy for the potential for reflationary pressure to build as the Fed faces lower growth and lower inflation in the months ahead – and I’ll use it as a signal to tell me when it’s time to move the entire portfolio onto the reflation trade.

2058

Why do you have to work so late? I’m not working. Well, the screen is on and you’re reading a book that’s clearly not a novel. Er….

That’s not an unusual conversation chez Garran.

Here’s a new one; you just said that you didn’t trade last month, but you’ve been watching the screen the whole time. Er yes, er, sorry.

So a month ago I found that one of my trading sites offered online poker. I mentioned it to my wife. Her faced dropped. She had a bit of an inkling about my character.

The next three weeks I played a couple of hours a day. Outside trading hours. Mainly around when the pubs closed – I’d heard that was a good time to take advantage. In the first week, I found I was making about £15 an hour with one losing session to four wins on average. Second week I was making £30 an hour with four winning sessions in six. Third week I was making about £60 an hour, before I found out there’s a good reason other people lose money when they play after the pubs have closed. And I dumped two weeks of effort in a petulant frenzy.

Here’s how I did it. I moved two levels up from $100 to $500. I then quadrupled my buy-in playing the first hour. What I was looking for was weakness, and when I found it – I went all in. So, the third time I went in heavy I blew it. I went from $2000 to $1100. And from there, I was road kill. I busted. $500 more, busted, $500 more, I busted, & I cut. Discipline, schmiscipline. I was all over, Grover. So I thought about it. Like you do. And I realised this – I love poker – I’ve played since I was nine. But I love trading macro more.

And the problem with poker is – I reckon I could get pretty good at it, but I’d have to put my soul into it, and that would crowd out time at home and trading macro.

There’s one thing about poker; everyone’s trying to win. At the low tables, that’s great, because most folks don’t have the knowledge, or the temperament, to win. Trying screws them up. But at the higher tables, more have the temperament. And higher still, more again. There’s always Muppets with money. Some pros will fly around the world to play them. But mainly, there are pros.

In macro, there are many people in the professions, but fewer professionals. My own attitude is the same as the pro poker player – I’ll fly anywhere in macro to play against the weak.

Now, this wouldn’t be a blog by me if I didn’t mention a book. And the book I spent my remaining poker profits on was Brett Steenbarger’s ‘Enhancing trader performance’. My view on these sorts of books is that the odds of any one being any good is like drawing a card to an inside straight. It’s just less than a one in 13 call. But the difference is that the payoff when you draw a good book is worth 50 busted flushes. To mix a metaphor.

So already this is a quality book. Steenbarger realises that his previous idea – don’t get frustrated – ain’t quite right. Cool dudes and three-day weekers, well, they didn’t seem to last. The frustrated guys did. So why?

Well, if you trade when you’re frustrated, you trade badly. That’s what happened to me when I lost out playing poker. Dennis Gartman’s rule – if you lose, get smaller - is largely a psychological call. And it is a good call at that. But if frustration gets you thinking – it’s useful. If it gets you more stuck-in, and working out a better way to do things. So I’m no Zen trader.

Benjamin Bloom, a University of Chicago researcher, sought out successful people in a range of fields – and he tried to analyse systematically the source of their success. It seemed they had something in common. They started out doing it for fun. Then they were in a place where they got supported big time, and started turning fun into profit. Then they just kept working to get better. So they ended up working on it more, getting better, and having more fun. It was never really work in the first place.

Now I’ve tried out fifty ways to make money. From fieldwork to working a field. But out of all of them, the thing I’ve really enjoyed – that I really got stuck into, and just kept working on it to get better – is trading macro.

It started when I was broking commodities. I was a one man band, and I knew I’d not beat Macquarie – with three detail pros – if I concentrated on building the most comprehensive supply/demand balances. And I wouldn’t beat UBS, with their 24 strong resources team, with my breadth of coverage or my access to sources. And it would be hard to be faster to a story than the producers, who have 1000s on the ground, and who can trade their own book with impunity. I knew I’d only beat these guys with a macro call, so that’s what I set out to do.

And I enjoyed it from day one. From commodities and resource stocks, through European equity strategy, to broking and trading global macro. Now I said to someone not very long ago, that I wanted to run macro for another 50 years. And for one reason – it’s great fun making money that way. I don’t notice I’m working.

So rule one; never blow up. I always run preset risk, and I always cut. And rule two; always bet hard on a big call – when I see extreme positioning, sentiment, and a fundamental angle.
And one thing I’ll bet on; I’ll still be trading macro in 2058. But I’ve no idea if I’ll still be playing poker.

The Thin Blue Line

‘It’s a fine line between clever and stupid’ – Nigel Tuffnel, Spinal Tap.

Past few days we’ve been deep in country. No mobile signal, no wifi connection. The family manned the whisky tombola at the local fair. One thing I noticed – some people would look at the stand, and if you said nothing, they’d walk on by. But engage them, and they’d buy a ticket every time. Even if, after you explained that the prize was a bottle of whisky and they said they didn’t like whisky, they’d still want to buy a ticket.

It suggests that people susceptible are incredibly suggestible, and that once their mind is made up, they find it very hard to change course. Even if it becomes obvious that the pay-off from what they’re doing has disappeared.

So I picked up a book from the bookstall. Someone had donated a box of business and market books. I’d read a lot of them already. But I hadn’t read ‘The Downwave – surviving the second great depression’ by Robert Beckman. On the cover blurb we have ‘The Downwave is likely to change all aspects of society as we know it. From fashion and entertainment, to the political and spiritual, staggering changes lie ahead’. ‘Everything indicates that the second great depression is starting. Property prices are already falling in real terms, unemployment continues to grow. Businesses are collapsing. Today, few people are not feeling the effects.’ ‘Beckman foresees further banking crises, financial panic, and calamities of desperate proportions’.

What is great about this book is that Beckman didn’t just publish it this week (like the series started on Monday in the FT) – a full year into the credit crunch. No, Beckman was early. He published the book in 1983.

Now it’s worth comparing Beckman’s work with another book that came out around the same time; ‘Is inflation over, are you ready’ by Kiril Sokoloff – who currently runs 13d – far and away the best market letter of the past five years.

Beckman’s book starts with an exposition of the long wave – the 50-60 year Kondratieff cycles of prices, unemployment, wars and political change. Most of the book is about these cycles. Now, I find these sorts of things engaging. Even if Kondratieff offered little in the way of explanation for these cycles. Kondratieff was a quant – he mainly nailed the data. But what struck me about Beckman’s book was that there was nothing scientific in it at all. In 1983, we’d seen three 50-60 year Kondratieff cycles. Predicting a fourth wasn’t like forecasting the sun to rise in the East. There was little about when to follow, and when to fade, the prevailing mood – or what the prevailing mood really was. There was nothing about the evils of inflation, its impact on valuation, on profitability, economic volatility, or underlying business profitability. We were headed for a great deflation, said Beckman – so sell your house, sell your stocks, buy bonds – and do nothing until 1990 (when it would be time to buy stocks again).

Now it’s easy to criticise something with hindsight that was proved wrong. But that’s no reason not to do it.

I think the main problem with the Beckman book was that he stated that the Kondratieff wave had turned, but he didn’t explain why he thought it had turned, or how reliable these turns were in predicting stock prices. Like so much pseudoscience – it’s unprovable, and undeniable, until it’s too late. For you, and for your capital.

The same sort of pseudoscience stalks the debate on climate change. Remember – most of the climate change debate is about the forecasts. But the models the climate change gurus use are neither reproducible (the basic tenet of science) – nor are they starting point consistent (ie they can’t explain the current situation, let alone the recent past). Nigel Lawson’s ‘An Appeal to Reason – a cool look at global warming’ is an excellent account of the current debate.

The Sokoloff book is a different kettle of fish altogether. It started off as a contrary conversation, between Sokoloff and his co-author, one day as they were walking through Central Park in 1982. They discussed, against a backdrop of 12% inflation and 15% rates, what would be the contrary thing to do. Kiril said – mortgage your house to buy stocks. They both packed up laughing. It was ludicrous. But it was right.

There are two things that Sokoloff identified. First – the inflation theme was long in the tooth. It was deeply consensus. But politicians were beginning to turn against inflation. Second, inflation is pernicious for businesses. Businesses can’t measure their cost of capital, they have no earnings certainty. They see their ratings crushed. So, if it was right, and the world was turning away from inflation, the reduction in inflation would paper over a lot of cracks. The payoff from stocks and from zeros (zero coupon bonds) would be enormous.

Now, it may be a fine line between clever and stupid, but the title of this post refers to a documentary about a miscarriage of justice. It’s a great film, and the line itself comes from a police officer – referring to the police as the thin blue line, between a society in order and one in anarchy. That apparently justified the shocking actions of the police in this case. A similar line is taken by the environmental lobby. It doesn’t matter if we misrepresent facts, fabricate data, or downright lie. Climate change is the greatest ever threat to our planet, so all action is justified to achieve our goal.

My own position is very different. I believe that the greatest threat to our existence comes from political solutions to society’s problems – solutions that show diminishing returns. Returns far lower than the cost of capital. Solutions that, in other words, destroy value. In ‘The collapse of complex societies’, Joseph Tainter creates a matrix of explanations for collapse – and finds that diminishing political returns is the most convincing. And there’s no doubt that the returns of something like the Kyoto agreement – a trillion dollars for half a degree in 20 years time (according to the models, that is)– are well below the cost of capital. In what may be the greatest irony of modern times, those self-ordained protectors of our planet, the environmentalists, may be the ones most at risk of destroying it.

Which brings me neatly back to the market. There is plenty of scope for an ironic outcome from here. With the papers screeching of the credit crunch, the housing bust that will last 30 years, telling us ‘not to bank on cheap oil’ (all from Monday’s FT), we know that sentiment is still extreme.

What I look for at times like these is dissonance. There was a cracker in the weekend paper. ‘BA, down 30% this year, announces 90% fall in profits, reduction in routes.’ That’s all well and good. But BA is also 35% up from when I bought it last month.

When sentiment has gone this far, and when positioning has followed it, the payoff from a reversal can be very large.

But in my view, this is not just an issue of opportunity. I think there is gathering evidence that the tide has turned. I think an end to inflation – however temporary – is the most likely outcome here.

We have seen the non-oil current account deficit in the US collapse. And now oil is off the top, the oil deficit will shrink as well. We are seeing a profound reduction in the banking multiplier. China and India have entered cyclical downturns. We have seen the CRB Rind index of non-traded commodities – the index least susceptible to financial speculation – and an excellent long lead on inflation - fall a third from its peak. We have seen cement prices in the US crack lower. And the markets are certainly beginning to sniff it out. My fund has hit a new high as I write; up 52% from the Mid-February start.

Inflation is ending. Are you ready?