In the last post, Our Man discussed what he thought of the world and the factors that were a part of that decision. While opinion is important, it’s how it’s executed within a portfolio that determines success; so, as promised, let’s have a look at what this all means for Our Man’s portfolio.
Since early August the market had largely been pinned in a range between 1,120 and 1,220 and as we came into October, Our Man’s hope was that it might tumble in the low 1000’s before a combination of oversold stocks and some “positive” news flow would spark a rally. However, while the S&P did dip beneath 1,100 for a few days, it rallied far sooner than Our Man expected, and thus he only eased out some of the existing puts (IWM) early in this rally.
The rally has broken out of the top-end of the 1,120 to 1,220 range (reaching 1,280+ today) but Our Man remains of the belief that it’s a bear market rally, that’s being driven by a number of issues including:
- a European solution that’s full of leverage and hope but short on specifics;
- a solid but unspectacular Q3 Earnings (and the subsequent cries of “see, companies are fine”);
- a blind belief that China’s problems are behind it; and
- a focus on decent US macro coincident data (e.g. Q3 US GDP, +2.5%) but the ignorance of weak leading data.
Like all bear market rallies, Our Man expects it to end on good news (think TARP being approved back in 2008), and thus is predominantly looking for opportunities to roll some of the existing puts (i.e. sell the SPY puts that expire in Dec-11 with a strike at 100, and use the funds to help partially fund Dec-12 puts with a 100 strike) and add more puts/hedges as the market rallies to broaden out the Puts/Hedges portfolio and fully reflect his bearishness.
Thus, while the portfolio has a small bearish tilt to it at the moment, it’s likely to have a far more pronounced bearish tone in the coming months. So, what will OM be buying puts on to express his bearishness?
- Market indices
This is the broadest hedges that OM is looking at. They are predominantly broad US Indices, with strikes 20-25% out of the money (i.e. the market would need to fall this amount, before the puts would be profitable, if held till expiration). These would likely be on the IWM (Russell 2000) and SPY (S&P 500)
- Consumer Discretionary, especially high-end
The era of easy credit in the US, especially since the 1990’s, has managed to fuel a number of major bubbles. Most of the obvious ones, the Tech and the Housing bubbles, have burst but another remains; the US consumer. Like the Housing bubble (“House prices don’t fall nationally”) the US consumer has its own little tagline; “don’t bet against the US consumer”. What’s more the stocks in this space, especially at the high-end, have benefited from a boost from Emerging Markets consumers and investors’ extrapolation of how large this impact will be in coming years. This has resulted in the stocks comfortably out-performing the market (e.g. XLY – the S&P Consumer Discretionary ETF) and a number reaching all-time highs. With Our Man’s thoughts on deleveraging (if you’re saving, you’re not spending….and if you’re unemployed, you’re spending on staples not discretionary items) and skepticism on the China consumer story, it’s not a surprise that Consumer Discretionary is an area that falls into the nexus of things he’s looking at. Our Man’s focus is on the ETFs in the space (e.g. the aforementioned XLY) and especially some high-end retailers (e.g. TIF – Tiffany’s).
- China-Thesis
I’m sure you don’t want Our Man to repeat his thoughts on China, though if you do then I’d go here, then here and finally here. Things like recent (and largely ignored) Bank recapitalizations/bailouts and inflation at c6% (before any possible ECB/Fed/etc quantitative easing) help Our Man remain a skeptic. The ways he’s looking to play it haven’t changed much either and the focus remains on the commodity-related companies and countries (e.g. Brazil and Australia). Additionally, some of the above-mentioned plays on consumer spending (which will be in the Puts/Hedges book) will be strongly correlated to the China thesis.
So, now that we know where Our Man will be looking to build up his bearish exposure, all that remains is how large will this exposure be and when will he do it. Unfortunately, that’s not a simple answer as the price of the put options (once you know the strike price and expiry) depends on many things including the time to expiry, implied volatility and the current price of the underlying instrument. Thus the best explanation is to say that if everything goes as Our Man’s hoping (a small pull-back, followed by a rise to new highs during November) he’ll be looking to build up the positions over the next month until the portfolio has 250-400bps of risk. Should the market continue to rally into 2012 and Our Man retain his bearishness, he’ll likely add another 100bps or so of risk to the portfolio. In this way, Our Man will have defined risk (a maximum loss of 4-5% of his capital, by the end of 2012) should his expectations of significant declines prove mistaken, but retain significant short exposure to the market in the meantime. Given this likely significant negative exposure, Our Man may take the opportunity to partially offset this by adding to some the existing themes in the book including Energy Efficiency (through battery or LED companies), Value (if he can find compelling opportunities, or if the existing positions warrant being added to) and potentially finally starting investing his Water theme.
Thursday, October 27
Tuesday, October 18
After Half-Term Ponderings: Where Our Man stands
Our Man has raised a lot of cash in the portfolio over the last couple of months, largely as a result of the exiting most of his Treasury Bond positions as yields fell sharply (and prices rose). This, of course, leads to the question…what’s he going to do with it? To get to the bottom of this, it would help to know what Our Man’s baseline macro views and expectations are as well as where and when he’s looking to take some risk.
While there has been positive news in recent weeks, it has done little to diminish Our Man’s bearish mindset. Unfortunately, despite the talk and the plans, Our Man believes we’ve reached the point where the size of the problems we face is beyond the scope of the politicians and central bankers to solve. As regular readers will know, Our Man believes we’re in a balance sheet recession; there are no simple and easy solutions to a debt-driven crisis. Thus while the talk is about just how massive and impressive the latest European bailout plan is, to Our Man it is merely reminiscent of Paulson’s bazooka talk in the Summer of 2008. The mere idea of leveraging Germany, France et al’s commitments to the bailout fund fails to acknowledge the simple premise that this is not a liquidity issue but a solvency one, and that the problem of excess debt cannot be solved by the issuance of (and increase in) more debt. So, while more banks will be bailed out (without debt holders being haircut) and there’s the possibility of QE3 from the FED or some minor stimulus program in the US, once more the moves will only solve an imaginary counter-factual (if we’d not done this, then things would be worse) without encroaching on the real world issues.
For equity investors, the long-term impact of the steady increase in leverage (especially since the 1980’s at the household level) has helped smooth economic cycles and led to numerous distortions in the market. Furthermore, whenever the economy slows down, politicians & central bankers have become accustomed to using measures that foster an increase in debt (think lowering interest rates so you can refinance your home, or take out a loan, more easily) as their policy of choice. The problem now is that despite record low interest rates and ample liquidity (thanks to the Fed’s rate cuts, Quantitative Easing, Operation Twist, etc) loan growth continues to be stagnant; there is no demand! This lack of demand and the deleveraging, through both default and increased saving (i.e. reduced consumption), is something that equity investors should pay attention to.
In the longer-term, as Our Man has mentioned before, with interest rates losing their potency (now we’re stuck at 0% rates) and demand stagnant, it becomes less likely that policy makers will be able to smooth the economic cycle. As such, we should expect the choppier growth of recent years rather than the consistent economic cycles we’ve become accustomed to. Furthermore, the disinflationary tendencies of a balance sheet recession mean that pricing power is likely to be more curtailed (no demand means it’s harder to push price increases through). Combining these factors, means that over time Our Man is expecting stocks to exhibit greater cyclicality (as the magnitude of the cycles becomes more pronounced) and also to exhibit greater volatility (as the cycles become less smooth and more choppy). These are, of course, the enemies of the buy-and-hold and value-driven investor. The volatility affects the investor’s ability to hold his position from point A to point B, and means that the flight-path becomes as important as the destination. The increased cyclicality will lead to a derating of equities as a greater risk premium should be introduced by investors to account for the more cyclical nature of equities but also due to investors’ long-term expectations proving overly ambitious (due to the deflationary/disinflationary environment limiting pricing power).
In the short-run, none of this would matter if stocks were at low valuations and margins were at or near cyclical lows. Sadly, as the recent Chartology posts showed, neither is the case. Now, certainly the use CAPE (or Shiller P/E’s) isn’t flawless, but like other long-term measures of valuation (e.g. Tobin’s Q), it does have a strong historical track record of long-term success. So why does Our Man use the CAPE? Well, it’s cyclically-adjusted…the Earnings part of the equation has been smoothed for a cycle, meaning the margins are those that reflect a full cycle (not a point in time) and that the figure takes into account the write-offs that inevitably come from the irrational exuberance of the peak. Bear these factors in mind, when you next hear a Wall Street talking head say the market is cheap based on forward earnings (or even more egregiously forward operating earnings, which pretend we live in a fairytale world and ignore all the write-offs/etc). Not only is the analyst assuming that the margins (currently at a record high) will persist at their current level infinitely, they’re not even using the actual earnings but their projections of the future which they then compare to a historical norm (i.e. the market’s average Price-to-(trailing) Earnings, or PE, is 15)!
So, in short; the underlying major issues are not being tackled by the politicians/central bankers, equities are going to be more cyclical & volatile (and thus de-rated, or trade at lower multiples) in the future, and they’re also currently trading at high valuations at a time when they have close to record high margins. I think it is clear that Our Man’s bearishness remains undimmed. However, with the increased cash and limited exposure in the portfolio, this bearish is not currently being expressed in any major way. When will that change? How will he express it? Those, my friends, are questions for the next post.
While there has been positive news in recent weeks, it has done little to diminish Our Man’s bearish mindset. Unfortunately, despite the talk and the plans, Our Man believes we’ve reached the point where the size of the problems we face is beyond the scope of the politicians and central bankers to solve. As regular readers will know, Our Man believes we’re in a balance sheet recession; there are no simple and easy solutions to a debt-driven crisis. Thus while the talk is about just how massive and impressive the latest European bailout plan is, to Our Man it is merely reminiscent of Paulson’s bazooka talk in the Summer of 2008. The mere idea of leveraging Germany, France et al’s commitments to the bailout fund fails to acknowledge the simple premise that this is not a liquidity issue but a solvency one, and that the problem of excess debt cannot be solved by the issuance of (and increase in) more debt. So, while more banks will be bailed out (without debt holders being haircut) and there’s the possibility of QE3 from the FED or some minor stimulus program in the US, once more the moves will only solve an imaginary counter-factual (if we’d not done this, then things would be worse) without encroaching on the real world issues.
For equity investors, the long-term impact of the steady increase in leverage (especially since the 1980’s at the household level) has helped smooth economic cycles and led to numerous distortions in the market. Furthermore, whenever the economy slows down, politicians & central bankers have become accustomed to using measures that foster an increase in debt (think lowering interest rates so you can refinance your home, or take out a loan, more easily) as their policy of choice. The problem now is that despite record low interest rates and ample liquidity (thanks to the Fed’s rate cuts, Quantitative Easing, Operation Twist, etc) loan growth continues to be stagnant; there is no demand! This lack of demand and the deleveraging, through both default and increased saving (i.e. reduced consumption), is something that equity investors should pay attention to.
In the longer-term, as Our Man has mentioned before, with interest rates losing their potency (now we’re stuck at 0% rates) and demand stagnant, it becomes less likely that policy makers will be able to smooth the economic cycle. As such, we should expect the choppier growth of recent years rather than the consistent economic cycles we’ve become accustomed to. Furthermore, the disinflationary tendencies of a balance sheet recession mean that pricing power is likely to be more curtailed (no demand means it’s harder to push price increases through). Combining these factors, means that over time Our Man is expecting stocks to exhibit greater cyclicality (as the magnitude of the cycles becomes more pronounced) and also to exhibit greater volatility (as the cycles become less smooth and more choppy). These are, of course, the enemies of the buy-and-hold and value-driven investor. The volatility affects the investor’s ability to hold his position from point A to point B, and means that the flight-path becomes as important as the destination. The increased cyclicality will lead to a derating of equities as a greater risk premium should be introduced by investors to account for the more cyclical nature of equities but also due to investors’ long-term expectations proving overly ambitious (due to the deflationary/disinflationary environment limiting pricing power).
In the short-run, none of this would matter if stocks were at low valuations and margins were at or near cyclical lows. Sadly, as the recent Chartology posts showed, neither is the case. Now, certainly the use CAPE (or Shiller P/E’s) isn’t flawless, but like other long-term measures of valuation (e.g. Tobin’s Q), it does have a strong historical track record of long-term success. So why does Our Man use the CAPE? Well, it’s cyclically-adjusted…the Earnings part of the equation has been smoothed for a cycle, meaning the margins are those that reflect a full cycle (not a point in time) and that the figure takes into account the write-offs that inevitably come from the irrational exuberance of the peak. Bear these factors in mind, when you next hear a Wall Street talking head say the market is cheap based on forward earnings (or even more egregiously forward operating earnings, which pretend we live in a fairytale world and ignore all the write-offs/etc). Not only is the analyst assuming that the margins (currently at a record high) will persist at their current level infinitely, they’re not even using the actual earnings but their projections of the future which they then compare to a historical norm (i.e. the market’s average Price-to-(trailing) Earnings, or PE, is 15)!
So, in short; the underlying major issues are not being tackled by the politicians/central bankers, equities are going to be more cyclical & volatile (and thus de-rated, or trade at lower multiples) in the future, and they’re also currently trading at high valuations at a time when they have close to record high margins. I think it is clear that Our Man’s bearishness remains undimmed. However, with the increased cash and limited exposure in the portfolio, this bearish is not currently being expressed in any major way. When will that change? How will he express it? Those, my friends, are questions for the next post.
Monday, October 3
September Review
Portfolio Update
After Our Man’s comments a couple of months ago on the lack of portfolio activity, it goes without saying that September saw yet more activity! The following change was made during the course of the month:
- Treasury Bonds: With the volatility in the markets lasting into September, there continued to be a move towards “safe” assets during the month. Once more, US Treasury bonds proved to be a “safe asset” in the eyes of investors, and as a result of being and largely under-owned and speculation that the Fed may enact “Operation Twist” (and thus become a buyer of long-end Treasury bonds) we saw further falls in Treasury Yields (and rise Treasury bond prices!). This move was exaggerated when the Fed initiated “Operation Twist” (essentially buying longer-term Treasuries, and selling some of their shorter duration debt) at a larger size than the market expected. While Our Man still thinks yields at the long-end of the curve could fall further and find new lows, the risk-reward became substantially less attractive after the Fed’s intervention (and the subsequent sharp decline in yields) and Our Man exited the majority of the Treasury Bond positions (specifically, the TBT puts and ½ the TLT position).
Performance Review
As regular readers will know, Our Man hasn’t exactly been a buyer of the markets in recent times (and has almost zero faith in QE to improve the economy in any sustainable way), and thus the portfolio has very controlled exposure. Given this and the sharp decline in Treasury yields (described above), September proved to be another good month for the portfolio, +4.5% for the month (YTD: +8.7%).
Unsurprisingly, September’s performance was again predominantly driven by the Treasury Bond book (+372bps) which benefited from the continued “flight to quality” and resultant collapse in Treasury yields. The Bond Funds (-7ps), also benefited from this fall in US Treasury Bond yields but the gains were offset by their exposure to (non-Treasury) credit and precious metals.
The Equity books largely suffered throughout the month, as their small/micro-cap bias meant that these ‘riskier’ stocks were largely discarded by investors in the ‘flight to quality’. The NCAV (-40bps) book was the most severely impacted, falling almost 20%, as the stocks within it are largely micro-cap and barely profitable; thus amongst the most risky types of investment out there. While the Value Equities (-43bps) book fell in-line with the market, this disguises the weak performance of DRWI (which cost almost 60bps). While they key components DRWI’s fundamental story is unchanged, the stock fell heavily due to its small-size, lack of profitability and concern as to whether it would reach its break-even goals in early-2012. While last month’s addition to the position is longer-term in intent, it’s worth noting that the stock now trades noticeably below the price at which Our Man added! The Other Equities (-13bps) and Energy Efficiency (-1bp) book performed broadly in-line with the markets. Against this negative performance, the Puts/Hedges book (+71bps) performed well, with a number of the put positions now being at or close to the money. Once more the XIV investment was a negative contributor to the Puts/Hedges book; now that Our Man has held the position >30days, expect it to be sold in the coming months!
The Short China book (+48bps) was a strong contributor during the month, as uncertainty over a global slowdown and concerns over a potential China hard-landing saw copper prices (and related equities) fall during the month. This puts the book into positive territory for the year (and indeed means it is flat since its inception), the probability remains that Our Man will likely add to the book and position it more aggressively for 2012 on any significant rally.
The Currencies book (+62bps, also putting it in positive territory for 2011) was the other strong contributor during September, as the Euro fell following continued concerns over Greece’s debt and contagion both to other sovereigns (especially Spain and Italy) as well as the regions Banks. While there are a number of rumors of potential fixes to the sovereign debt issues, so far none seem to offer real solutions as they largely propose increasing debt (or adding leverage to the vehicle to buyout troubled countries debt).
The changes to the portfolio over August and September have resulted in the bearish tilt slowly being reduced, and a substantial increase in Our Man’s cash horde! It would only be fair to explain to you, what he’s anticipating in the markets and how he intends to spend it…but that’s the topic of a future blog post!
Portfolio (as at 9/30 - all delta and leverage adjusted, as appropriate)
14.4% - Bond Funds (DLTNX and HSTRX)
9.2% - Treasury Bonds (TLT)
4.7% - Value Idea Equities (THRX, and DRWI)
2.2% - Other Equities (NWS, CMTL and SOAP)
1.8% - NCAV Equities
0.3% - Energy Efficiency (AXPW)
-1.8% - China-Related Thesis (58bps premium in FCX put)
-6.2% - Hedges/Put Options (55bps premium in S&P Dec-11 puts, 70bps in IWM Jan-12 puts, and 62bps SLV Jan-12 puts, all offset by a position in XIV)
-9.6% - Currencies (EUO – Short Euro)
59.2% - Cash
Disclaimer: For added clarity, Our Man is invested in all of the securities mentioned (TLT, TBT puts, DLTNX, HSTRX, THRX, DRWI, NWS, CMTL, SOAP, AXPW, FCX puts, SPY puts, IWM puts, SLV puts, XIV and EUO). He also holds some cash.
After Our Man’s comments a couple of months ago on the lack of portfolio activity, it goes without saying that September saw yet more activity! The following change was made during the course of the month:
- Treasury Bonds: With the volatility in the markets lasting into September, there continued to be a move towards “safe” assets during the month. Once more, US Treasury bonds proved to be a “safe asset” in the eyes of investors, and as a result of being and largely under-owned and speculation that the Fed may enact “Operation Twist” (and thus become a buyer of long-end Treasury bonds) we saw further falls in Treasury Yields (and rise Treasury bond prices!). This move was exaggerated when the Fed initiated “Operation Twist” (essentially buying longer-term Treasuries, and selling some of their shorter duration debt) at a larger size than the market expected. While Our Man still thinks yields at the long-end of the curve could fall further and find new lows, the risk-reward became substantially less attractive after the Fed’s intervention (and the subsequent sharp decline in yields) and Our Man exited the majority of the Treasury Bond positions (specifically, the TBT puts and ½ the TLT position).
Performance Review
As regular readers will know, Our Man hasn’t exactly been a buyer of the markets in recent times (and has almost zero faith in QE to improve the economy in any sustainable way), and thus the portfolio has very controlled exposure. Given this and the sharp decline in Treasury yields (described above), September proved to be another good month for the portfolio, +4.5% for the month (YTD: +8.7%).
Unsurprisingly, September’s performance was again predominantly driven by the Treasury Bond book (+372bps) which benefited from the continued “flight to quality” and resultant collapse in Treasury yields. The Bond Funds (-7ps), also benefited from this fall in US Treasury Bond yields but the gains were offset by their exposure to (non-Treasury) credit and precious metals.
The Equity books largely suffered throughout the month, as their small/micro-cap bias meant that these ‘riskier’ stocks were largely discarded by investors in the ‘flight to quality’. The NCAV (-40bps) book was the most severely impacted, falling almost 20%, as the stocks within it are largely micro-cap and barely profitable; thus amongst the most risky types of investment out there. While the Value Equities (-43bps) book fell in-line with the market, this disguises the weak performance of DRWI (which cost almost 60bps). While they key components DRWI’s fundamental story is unchanged, the stock fell heavily due to its small-size, lack of profitability and concern as to whether it would reach its break-even goals in early-2012. While last month’s addition to the position is longer-term in intent, it’s worth noting that the stock now trades noticeably below the price at which Our Man added! The Other Equities (-13bps) and Energy Efficiency (-1bp) book performed broadly in-line with the markets. Against this negative performance, the Puts/Hedges book (+71bps) performed well, with a number of the put positions now being at or close to the money. Once more the XIV investment was a negative contributor to the Puts/Hedges book; now that Our Man has held the position >30days, expect it to be sold in the coming months!
The Short China book (+48bps) was a strong contributor during the month, as uncertainty over a global slowdown and concerns over a potential China hard-landing saw copper prices (and related equities) fall during the month. This puts the book into positive territory for the year (and indeed means it is flat since its inception), the probability remains that Our Man will likely add to the book and position it more aggressively for 2012 on any significant rally.
The Currencies book (+62bps, also putting it in positive territory for 2011) was the other strong contributor during September, as the Euro fell following continued concerns over Greece’s debt and contagion both to other sovereigns (especially Spain and Italy) as well as the regions Banks. While there are a number of rumors of potential fixes to the sovereign debt issues, so far none seem to offer real solutions as they largely propose increasing debt (or adding leverage to the vehicle to buyout troubled countries debt).
The changes to the portfolio over August and September have resulted in the bearish tilt slowly being reduced, and a substantial increase in Our Man’s cash horde! It would only be fair to explain to you, what he’s anticipating in the markets and how he intends to spend it…but that’s the topic of a future blog post!
Portfolio (as at 9/30 - all delta and leverage adjusted, as appropriate)
14.4% - Bond Funds (DLTNX and HSTRX)
9.2% - Treasury Bonds (TLT)
4.7% - Value Idea Equities (THRX, and DRWI)
2.2% - Other Equities (NWS, CMTL and SOAP)
1.8% - NCAV Equities
0.3% - Energy Efficiency (AXPW)
-1.8% - China-Related Thesis (58bps premium in FCX put)
-6.2% - Hedges/Put Options (55bps premium in S&P Dec-11 puts, 70bps in IWM Jan-12 puts, and 62bps SLV Jan-12 puts, all offset by a position in XIV)
-9.6% - Currencies (EUO – Short Euro)
59.2% - Cash
Disclaimer: For added clarity, Our Man is invested in all of the securities mentioned (TLT, TBT puts, DLTNX, HSTRX, THRX, DRWI, NWS, CMTL, SOAP, AXPW, FCX puts, SPY puts, IWM puts, SLV puts, XIV and EUO). He also holds some cash.
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