It's Okay to Not Know...

“[T]here are known knowns; there are things we know that we know.

There are known unknowns; that is to say there are things that, we now know we don't know.

But there are also unknown unknowns – there are things we do not know, we don't know. ”

— US Secretary of Defense, Donald Rumsfeld

While I was never much of a fan of Secretary Rumsfeld, it always struck me as peculiar the people took such issue with this statement as it seems a fairly logical distillation of a rather complex thing.  Given that a number of Our Man's friends, acquaintances and contacts are in the financial world, it's even stranger that folks criticized the statement as it would seem to me that unknown unknowns could just as easily be called Black Swans.  Though, I suppose it was made in a pre-2008 world when black swans weren't as popular a topic.

So, why bring up Secretary Rumsfeld’s quote now?  Well, despite what you might hear if you have the misfortune to tune into CNBC, it’s okay to not know or have any conviction in a particular outcome.  It is however, important that you realize that you have limited conviction and behave accordingly.  We’re taught that if we do the “work” – if we research, think about and analyze a problem – we’ll find the answer (i.e. reach a conclusion in which we have conviction).  It’s those known unknowns and the pesky Black Swans (unknown unknowns) that mean this isn’t the case in reality.

I bring this up because Our Man’s portfolio continues to run relatively low exposure and the performance is where it has been all year, roughly flat.  The low exposure is a reflection of my lack of conviction; that I don’t know.  On the Equity-side, this is easy to explain – while the current positions have sufficient assets or earnings to make them ‘cheap’, most of the driver of future returns is based upon some form of change or future growth.  While I believe that you’re paying little to nothing for this growth and/or I’m more positive on the probability of its occurrence, potential size, and proximity, it’s also very likely given their uncertain nature that these factors will be influenced by the macro environment.  Thus, the positions are undersized to reflect my well-known macro skepticism.  What will cause the equity book to grow?  Well, a change in the macro conditions, a change in the risk/reward in existing names, or adding new names or a theme to the book; expect to hear more on these topics soon.

So, if I’m bearish, why are the Puts/Hedges and China thesis portfolios so small?  Well, for the following reasons: we’re not there yet and the Fed (and other Central Banks).  While my bearishness is unchanged and the economy remains relatively weak (and I think noticeably weaker than people realize) it isn’t yet absolutely weak.  As discussed before, my two favourite indicators for getting a sense of where the economy stands today are the Philly Fed’s Aruoba-Diebold-Scotti Business Conditions Index and the Chicago Fed National Activity Index. 

The second reason is the Fed who have shown a belief that throwing liquidity at problems will solve them, despite the lack of evidence that it does any more than provide a temporary sugar high while potentially creating greater distortions in the markets.  However, their willingness to do so seemingly every year (surely a sign of its outstanding success) means that there is a higher bar required (i.e. the economy must be weaker than historically) or signs of greater exogenous weakness (China and Europe) before I’m willing to increase the size.  

In short, my current level of conviction is relatively low ("I don't know") and thus the portfolio's level of exposure is low. So I'm spending my time doing two things (i) waiting for the data to change and help me build some short-medium term conviction in the existing theses, and (ii) looking into, researching, thinking about and analyzing some new ones.  When I've either built greater conviction in the existing theses or am close to putting new ones into the book, then this blog will become more lively and the portfolio's exposure and risk will start to increase.

Things from my Google Reader: Jun-12 Edition

Apparently, it has been almost 9 months since Our Man updated you with articles of interest that he’s been reading.  Thankfully, this isn’t a reflection of a drop in the quality of his reading material but instead solely represents at how poor he’s been posting it to this blog – apparently, putting the information together in a word document and expecting it to post itself, doesn’t work so well.  Thus, there is much catching up to do…so expect a plethora of “Things from my Google Reader” posts this summer.  This one will follow the typical format, with the most financial-orientated links at the bottom!

- A Nice Cup of Tea 

As you know, Our Man is a Brit and there’s nothing Brits like more than a cup of char (in fact, I’m having one now…as I write this).  I also have to say that American tea-making standards are pretty low (Mrs. OM is a fan of putting the milk in first, perish the thought!).  So, in this stressful world (and especially for my American friends) let George Orwell’s 1946 article school you on this important matter.  (George Orwell, Evening Standard)

- “Keep Calm and Carry On” (Video) 

I’m sure you’ve all seen the slogan on t-shirts and posters, but have you ever wondered where it came from?   This short film tells you the story behind the poster; from its origins at the start of the second World War, to how it was rediscovered in an English bookshop in 2000 and introduced into the public consciousness.

- Coaching a Surgeon:  What makes top performers better?

Given that top class athletes and singers have coaches, so why don’t you have one for whatever you do?  Irrespective of your training for your job, can you perform at your best on your own?  Clearly, some occupations lend themselves to this concept better than others but it’s a fascinating concept and well worth you reading about one surgeon’s experiences and research.  (Atul Gawande, New Yorker)

All things China

As y’all know, Our Man has been somewhat skeptical on China for a long-time.  While this was originally a contrarian view, the debate over China has progressed from whether China will (ever) slow-down to whether there will be a soft or hard landing and what’s a reasonable rate of growth to expect from China going forwards.  Here are some interesting articles that illustrate the change in tone over China, from the last few months:

- Professor Michael Pettis and the Economist’s Free Exchange blog have a two-legged wager on whether China will overtake the US within a decade and what Chinese GDP growth will be. (Michael Pettis’ blog & The Economist)

- Jonathan Weil finds that Chinese big banks look more like paper tigers, in large part to the remnants of the last time the government had to bail them out (something Our Man has discussed before). (Jonathan Weil, Bloomberg)

- Arthur Kroeber wonders if it will be social discontent and income inequality that will lead to China having issues (Arthur Kroeber, Foreign Policy)

- John Hempton is the most skeptical of all, suggesting China’s a “kleptocracy of a scale never seen before in human history” and tries to explain how it’s financed, and what might make it fail.  (John Hempton, Bronte Capital)

Financial Regulation – Some Andy Haldane love!

Financial regulators have done little good over recent decades, in large part because they’ve failed to understand Finance.   One of the few exceptions is Andy Haldane, the FSA’s Executive Director for Financial Stability, who Justin Fox (at HarvardBusiness Review) dubbed “the regulator who explained the world”. 

Personally, I was more impressed by the way the way he applied work from other fields and considered their impacts on finance.  Some of my favourite Haldane articles/speeches:

- “Patience & Finance”, where he looks at the role of patience in decision-making and the impact of patience, or rather succumbing to impatience has had, on finance.  (Oxford China Business Forum, in Beijing) 

- “The Short Long”, on whether the world (and stock market in particular) is becoming more short-sighted and myopic.

- “The Doom Loop”, where he talks about equity and the banking system. (Andy Haldane, London Review of Books)

May 2012 Review

Portfolio Update 

There were no changes to the portfolio during May. 

Performance Review

In similar fashion to both 2010 and 2011 the old stock market adage “Sell in May and go away”, proved to be useful advice as the S&P 500 tumbled by over 6%.  Unsurprisingly, it was as macro fears across the globe raised their heads once more.  In Europe, the slow-moving car crash continued as Greece’s elections brought matters to a head, with the possibility of Greece’s exit (which seems to have been term a “Grexit”) being openly discussed for the first time, while Spain seems to be doing its best to follow Ireland’s version of the bank & real estate debt problems!  The news outside of Europe wasn’t much better as speculation and debate continues as to whether China will have a hard landing or will instead avoid it through another large stimulus program in the full knowledge that the 2009-stimulus program only made their long-term economic rebalancing much harder.  Not to be left out, the US showed continued signs of softening in the economy, though it’s yet to reach levels where the talking heads are speculating about recession.  

Given the portfolio’s slightly negative/bearish tilt it fared reasonably well during May rising 1.13%, though it still remains underwater for the year (-9bps YTD).  The breakdown of performance was unsurprising.  The China book (+47bps) and Puts/Hedges (+42bps) both benefited as equity markets fell, with the Treasury book (+39bps) benefiting from the flight to quality.  The largest contributor was the Currencies book (+77bps) which benefited from the USD strengthening against the Euro following uncertainty in Europe, especially the fears that Greece would exit the Euro and speculation this could lead to contagion across Europe.

Equally unsurprising was that the equity-orientated books suffered heavily during the month, with both the Value Equities (-61bps) and Energy Efficiency (-46bps) books hampering performance.  As regular readers know, the names in these books tend to be smaller-capitalization companies where either a large part of their value is in (expected) future growth (i.e. the Energy Efficiency book) or where there is some uncertainty be it over legal issues, the value of an asset, the company’s normalized earnings, or corporate behavior/action.  Unfortunately, these traits mean that if there is no idiosyncratic even affecting the names in these books, they can be sold off heavily during bouts of uncertainty.  The Bond/Absolute Return Funds (+2bps) and NCAV (+12bps) books weren’t significant contributors to performance.

Portfolio (as at 5/31 - all delta and leverage adjusted, as appropriate)

17.6% - Bond/Absolute Return Funds (DLTNX and HSTRX)

5.5% - Value Idea Equities (THRX, and DRWI)

4.8% - Treasury Bonds (TLT)

1.9% - Energy Efficiency (AXPW, and XIDE)

0.5% - NCAV Equities

0.0% - Other Equities (none)

-2.4% - China-Related Thesis (92bps premium in EWZ Jan-13 puts)

-2.8% - Hedges/Put Options (37bps in IWM Jan-13 puts, 36bps in SPY Jan-13 puts and 25bps XLY Jan-13 puts)

-12.1% - Currencies (EUO – Short Euro)

61.8% - Cash

Disclaimer:  For added clarity, Our Man is invested in all of the securities mentioned (TLT, DLTNX, HSTRX, THRX, DRWI, AXPW, XIDE, , EWZ puts, IWM puts, SPY puts, XLY puts, and EUO).  He also holds some cash.  You should not buy any of these securities because Our Man has mentioned them, but should do your own work and decide what’s best for you.