Sicko

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.

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.