Our Man in NYC

2012: Fingers of Instability

2012-01-21T16:38:00.000-05:00

Our Man recently looked at some of the things that could help the economy and markets in the upcoming year, now for some of the things that offer more concerning thoughts.

- European debt problems (and recession?)

In the absence of major Quantitative Easing from the ECB (see Glimmers), which would reflect a transfer of risk from the individual sovereigns to the Euro-collective, Europe’s debt problems are likely to continue apace in 2012. However, unlike 2012, the uncertainty may spill over more into the real economy and if European banks retrench (which the ECB’s LTRO’s seem designed to prevent) and we could easily see a Europe-wide recession. The knock-on effects of this both within Europe and globally, are likely substantially under-appreciated!

- Political (and Social) Instability

History suggests that political instability increases during economic downturns, and Europe is likely to see its fair share be it through more elected governments being replaced by unelected technocrats (see Italy and Greece), or some of these technocratic governments falling from power when it becomes clear their policies are (intentionally?) better for “the European project” than the people they’re supposed to represent. For Europe, an economic recession (especially one that hits Germany and France) may make QE by the ECB more palatable, but it also increases the prospect of French/German citizens becoming less willing to support further bailouts for the PIIGS. This of course, doesn’t even consider the further issues we’re likely to see in the Middle East (especially Iran) and Asia (North Korea).

- China (and the rest of the BRICs)

As I’m sure you’re all well aware, Our Mani skeptical of the Chinese growth miracle and believes that while they’ve mastered the art of creating GDP-growth but are failing to create wealth due to the credit-fueled malinvestment that’s driving the GDP-growth creation. Rather than bore you with more of the same, I’ll point you in the direction of a previous post and leave you with one additional thought; in global recessions (and especially debt-driven depressions), it’s the trade surplus countries that suffer the most, as they’re more reliant on foreign demand and at risk as foreign countries try to support and protect their domestic industrial base (e.g. the UK suffered an 8-10% fall in GDP during the 1930’s depression, whereas the trade-surplus US suffered a GDP fall of 3x this!).

- Global Trade & Protectionism

On a related noted, and especially for those who are historically minded, the steady decline of Global Trade and the rise of protectionism, was one of the noticeable features of the 1930's depression in the US. With so many countries facing growth headwinds, and attempting to encourage exports, the temptation for domestic politicians will continue to be to blame foreigners and the rhetoric about punishing “cheating” (i.e. trade surplus) countries will remain. Let’s hope we don’t see an equivalent of the Kindleberger spiral for 2010’s!

- Japan

Japan fascinates Our Man, in part because they were the first country into a debt-deflationary spiral and there’s a reasonable chance that they may be the first country out of it. What’s intrigues Our Man is that two of the pillars of Japan’s strength, its savings rate and trade surplus, are both fast waning. The savings rate has been steadily declining from over 15% in the early 1990’s to c2% today, and 2011 saw Japan’s first trade deficit in almost 50yrs. Though all eyes are focused on Europe at the moment, Our Man’s guess is that it’s Asia (China or Japan) that will prove to be the interesting story of 2012.

- Corporate Margins & Valuation

While all the other ‘fingers of instability’ suggest risks to the global economies, it’s corporate margins and valuations that make the market particularly vulnerable. While short-term measures (such as trailing P/E or the awful forward Operating P/E) suggest that the market is cheap/fairly valued they require the belief that the current level of margins (near all-time highs) are sustainable ad infinitum. Perhaps they are, and we’re in a new paradigm but Our Man suspects that reality is that the elevated levels of margins offers more potential for downside surprise than upside opportunity. While long-term measures of valuation are a terrible guide to any given year’s market performance, they do offer a valuable guide or map for real cheapness or value and they don’t suggest that the broad equity markets offer much in the way of absolute value.

2012: Glimmers of Hope

2012-01-07T19:52:00.000-05:00

Traditionally, at the start of each year, Our Man looks at some of the major things that could help or hinder the economy and markets during the upcoming year. As such, here are this years Glimmers of Hope (see here for an explanation of the thinking behind Fingers of Instability and Glimmers of Hope), which looks at some of the things that could go right in the economy and drive markets higher.

- Monetary Policy and (lack of) Inflation

The largest stimulant to the market in 2012 is once more likely to be the action of central banks and their policies. Perhaps, I’m just cynical, but it seems to me that the Federal Reserve (since the Greenspan days) is late to every issue and believes that they can all be solved through injecting liquidity. As such, we’ve seen rates cut (to 0%), promises to keep them there for years, Large Scale Asset Purchases (aka Quantitative Easing 1, 2, Lite, etc) and even recent coordinated central bank actions to help provide liquidity. With the make-up of the Federal Reserve’s Open Market Committee changing in 2012 to likely become yet more dovish, I’m fully expecting more of the same in 2012; promises to hold rates lower for longer, more asset purchases (QE3…) and probably some new fangled way to try and force longer-term interest rates to stay low (maybe they’re even reckless enough to sell options). The ‘good’ news is we can probably expect monetary easing from everywhere else of note in the world! The ECB is already lending to European banks at generous rates (1% p.a. for 3yrs), the Japanese were the first big users of QE, and the Chinese are likely to loosen policy in an attempt to stave off a hard-landing for their economy. In short; the Central Bankers of the world agree – sell your bonds, and buy risky assets…please! This plea and its impact on market participants psychology is what most worries Our Man, given his bearishness.

- ‘Constructive’ Government behavior (i.e. can-kicking)

In the US, while the two parties have shown no ability to solve any major problems by working together and with both parties having more incentive to disagree (it’s an election year, after all), it would seem like the possibility for constructive government behaviour is limited. However, the government behaviour I’m expecting is not the “solving of problems” kind but the “let’s give things a bit of a sugar-high, so the economy is still weak (and thus Obama can lose) but not so bad that we don’t all get kicked out of office (so incumbent Republican congressman can keep their seats)” kind. This is the type of compromise that leads to terrible long-term decisions, with faux compromises on a small short-term stimulus which will be paid for by some future (probably unspecified) cost cuts. While these types of deals are not good for the long-term health of the economy, they can help stabilize things in the short-term and also support the equity markets.

In Europe, Our Man expects much more talk of Grand Plans, bazookas, and anything else that can keep sentiment up while only a limited amount of new money is provided (via the EMU countries, or IMF) to deal with budget issues and stave off defaults, Central Banks attempt to provide liquidity, and elected governments are replaced by IMF/EU-approved “technocratic” ones.

In China, with the economy slowing the government will no doubt do its best to try and reignite the credit-fueled boom, be it through encouraging banks to lend (directly or indirectly, through reducing reserve requirements) or other measures.

- Housing Market

It may have taken a while, but the moribund state of the housing market is acknowledged as a major issue problem by both the Administration and the Federal Reserve. The importance of the issue can be seen in the constant rumors of an Administration plan on housing, as well as a recent speech by William Dudley (President of the NY Fed), which even offered his thoughts on potential solutions. While there merit and effectiveness of the proposals can certainly be debated, it’s a step in the right direction. Efforts to help reduce the problems in the housing market, if effective and well-thought out, would unquestionably help both socially and economically.

- Falling Unemployment (and rising incomes)

While there’s many flaws in the data (and its computation), it’s also clear that jobs data in the US is consistently improving, albeit at a slower pace than everyone (I think) would like. Now perhaps this improvement slows or reverses later in the year and there are seasonal biases benefiting the data currently, but the declining trend in unemployment, positive revisions and increase in hours worked (which will, hopefully, feed through into incomes) is unquestionably good for the economy! With companies being in a relatively strong position, if demand continues to hold up well, there is potential for this favourable trend to continue.

- China & an Asian soft landing

What if Our Man is wrong? Just because nobody else has succeeded in controlling their economy, or transitioned from an investment-driven one to a consumer-driven one without going through major pains, it doesn’t mean that the Chinese won’t. Perhaps they’ve just built a better mouse-trap for managing the economy than the rest of us…

- Valuation
This is a repeat from prior years’ lists.. Our Man continues to mutter that it’s an expensive market (and using longer-term measures it is) but if one only looks at short-term horizons (or uses current year P/E, or mutations of it…such as P/E based on Operating Earnings, or projected forward P/E, etc) then an argument can be made that the market is cheap.

December Review

2012-01-02T21:19:00.000-05:00

Portfolio Update
There were only a couple of changes to the portfolio this month, which had no real impact on the portfolio.
- NCAV: The BXG position was sold during the month, following a bid from the majority shareholder (in November) and there were no counter-bids.
- Hedges/Put Options: The SPY puts expired in December, worthless as they were out of the money.

Performance Review

Unsurprisingly, given the portfolio’s large cash hoard, the portfolio did not show much volatility throughout December ending the month -0.4% (+7.7% YTD).

While markets were broadly up over the course of the month, it was the portfolio’s defensive buckets that helped returns while the equity buckets were largely negative contributors. The Currencies bucket (+36bps) benefited from the continued uncertainty in Europe (which saw the Euro weaken against the US Dollar), while the uncertainty also helped Treasury Bonds (+15bps) as their remained a strong bid for safety. The Puts/Hedges book did well (+17bps) despite the rising equity markets and worthless expiration of the SPY Dec-11 puts, as Silver’s weakness during the month offset these losses. The only broadly defensive books that were negative were China Thesis book (-9bps), largely as a result of burning through premium for the options that expire in Jan-12, and the Bond Funds (-17bps) as a result of their underlying exposures to natural resources stocks and some more esoteric bonds that suffered with the reduced liquidity in December. The main negative impacts to performance came from the equity books; NCAV (-8bps), Value Equities (-56bps) and Energy Efficiency books (-14bps). The NCAV and Energy Efficiency books drifted during the month with a number of names suffering from their lack of liquidity. In the Value Equities book, which was by far the largest detractor over the course of the year, the majority of the loss came as the DRWI position gave up its November gains (which came after the company reached an attractive agreement to buy a business segment from Nokia-Siemens, which will substantially impact revenues) as investors further considered the company’s position and the likely time horizon to sustained profitability.

Portfolio (as at 12/31 - all delta and leverage adjusted, as appropriate)
14.6% - Bond Funds (DLTNX and HSTRX)
5.2% - Value Idea Equities (THRX, and DRWI)
4.9% - Treasury Bonds (TLT)
1.9% - NCAV Equities
1.7% - Energy Efficiency (AXPW, and XIDE)
0.0% - Other Equities (none)

-1.2% - China-Related Thesis (6bps premium in FCX Jan-12 put, and 45bps premium in EWZ Jan-13 puts)
-5.7% - Hedges/Put Options (76bps in IWM Jan-13 puts and 47bps SLV Jan-12 puts)

-10.2% - Currencies (EUO – Short Euro)

65.0% - Cash

Disclaimer: For added clarity, Our Man is invested in all of the securities mentioned (TLT, DLTNX, HSTRX, THRX, DRWI, AXPW, XIDE, FCX puts, EWZ puts, IWM puts, SLV 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.

November Review

2011-12-03T13:19:00.000-05:00

Portfolio Update
There were only a couple of changes to the portfolio this month, which slightly reduced the bearish tilt of Our Man’s portfolio.
- Treasury Bonds: The TLT position was halved as month-end approached after 20-30yrs Treasuries tightened back towards their low yields on fears around Europe and the possibility of QE3 in the US.
- Energy Efficiency: The XIDE position was added to near month-end after the company’s stock had started to recover following a sharp fall earlier in the month.

Performance Review
Unsurprisingly, given the portfolio’s large cash hoard, the portfolio did not show much volatility throughout November and ended the month up +0.4% (+8.1% YTD). Unlike recent months, which have been characterized by sharp movements in stocks and bonds, November was a far tamer month and this was reflected in the performance across the portfolio’s buckets.

The main impact to performance came from the NCAV (+20bps), Value Equities (+37) and Energy Efficiency books (-74bps). The NCAV book benefited from a takeover bid for one of the holdings, which will likely be exited in December (assuming no counter-bid is forthcoming). In the Value Equities book, the DRWI position was solid contributor, after the company came to an attractive agreement to buy a business segment from Nokia-Siemens that will have a substantial impact on DRWI’s revenues. However, while Our Man may have been patient waiting for XIDE, in the Energy Efficiency book, to come back to an attractive entry price, he would have been better off waiting a month. The company announced disappointing numbers in November, and was particularly hurt as it also revealed that one of its recycling plants in Portugal had intentionally misstated inventory & production numbers. While the company’s investigation suggests that only this one planted was affected, the stock lost over 1/3 of its value within a couple of days. Our Man added to the position towards the end of the month, as the selling seemed to subside, bringing it up to c1.6%.

Elsewhere, the Treasuries (+17bps) and Bond Funds (+15bps) benefited from a mild tightening in yields and reduced stress in the credit markets, while the uncertainty in Europe and resulting weakness in the Euro helped the Currencies book (+24bps). The China-related thesis (+4bps) benefited from continued concern about weakness in China, while the Other Equities (+1bp) book benefited from a dividend. The Puts/Hedges book (-8bps) suffered as the Dec-11 options burnt through their premium and are now largely worthless.

Portfolio (as at 11/30 - all delta and leverage adjusted, as appropriate)
14.7% - Bond Funds (DLTNX and HSTRX)
5.7% - Value Idea Equities (THRX, and DRWI)
4.8% - Treasury Bonds (TLT)
2.1% - NCAV Equities
1.8% - Energy Efficiency (AXPW, and XIDE)
0.0% - Other Equities (none)

-1.6% - China-Related Thesis (6bps premium in FCX Jan-12 put, and 45bps premium in EWZ Jan-13 puts)
-4.1% - Hedges/Put Options (1bps premium in S&P Dec-11 puts, 86bps in IWM Jan-13 puts, and 18bps SLV Jan-12 puts)

-8.9% - Currencies (EUO – Short Euro)

64.7% - Cash

Disclaimer: For added clarity, Our Man is invested in all of the securities mentioned (TLT, DLTNX, HSTRX, THRX, DRWI, AXPW, XIDE, FCX puts, EWZ puts, SPY puts, IWM puts, SLV 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.

NCAV 2011-3

2011-11-10T20:43:00.000-05:00

The third NCAV update of the year has been much delayed, as the screen failed to show up any new names that could be added to the Absolute Value/NCAV bucket portfolio (for information on this bucket, and how it works, read here). However, on new name came up in recent days, passed the qualitative overlay, and was added to the portfolio. It was:

- OPXT (Opnext Inc) which had a market cap of $98mn (vs. a 65% NCAV of $101.5mn at the end of Q3)

While the screen is a valuable tool, a number of names were removed during the simple qualitative overlay;
- As Our Man has discussed previously, Chinese companies (listed in the US) that come up on the screen are currently being excluded due to the number of frauds within their ranks (see DGW, JGBO, Sino-Forest, Longtop Financial, etc for just 4 examples) . Like all screens, Our Man’s NCAV screen is reliant upon the quality of the data going into it and the number of recent Chinese-based frauds listed in the US argues for their exclusion.
- A number of Financial companies were excluded, due to their different definition of Current Assets or the screen mistakenly using Total Assets (instead of Current Assets) to pass them.
- A number of companies were excluded as the data used in the screen was sufficiently dated to be of no great value (i.e. 2010 year-end).

One existing name (TWMC) reappeared on the screen. As such, the final date that this name must be sold by has been extended (here are the rules when NCAV names are sold). Finally, as noted in the recent monthly update, AVTR & IESC, had now spent 366+ days in the portfolio since last appearing in the NCAV screen so were removed from the portfolio.

October Review

2011-11-05T19:00:00.000-04:00

Portfolio Update
As the recent Portfolio Thoughts piece hinted, there were a number of changes to the portfolio in the last few days of October which gave the portfolio a more bearish tone.

- Puts/Hedges: The Jan-12 puts on the Russell 2000 Index (IWM) was sold early in the month, after the Russell (and S&P) bounced off their year-to-date lows. Later in the month, as the market rebounded, Jan-13 puts on the Russell 2000 (IWM) were added to the portfolio and the position in XIV was also sold. The XIV position was a disappointment and negative contributor. It’s clearly not an instrument to be bought early, when things can remain very volatile, and Our Man would have been better off sacrificing some potential upside and selling some of his puts.

- Other Equities: Sold NWS and CMTL, and wrote SOAP down to zero. Our Man was finally able to see the positions in NWS and CMTL at the end of the October. The SOAP position would have been sold too, but it’s value ($1.50) is less than the commission cost of selling it (SOAP essentially liquidated itself back in 2009 and returned all of its cash back to shareholders, leaving just a shell) and thus it was written down to 0, so Our Man doesn’t have to track it any more.

- Energy Efficiency: A c2% position in Exide (XIDE), a lead-acid battery maker, was added to the portfolio. Our Man’s interest in Lead-Acid battery makers is largely due to the need (and regulations) for increased fuel efficiency and the unsuitably of the newer technologies for that purpose. The more alert of you may remember that Our Man discussed missing out on buying XIDE last year; well, the best things come to those who wait and after a wild ride (from $4 to $12 and down again), XIDE is at the same level as it was back then!

- Short China Thesis: A Jan-13put position in the MSCI Brazil Index (EWZ) was added. The index is largely made up of Brazilian raw materials and financials companies. In essence, Our Man views it a ricochet play on a Chinese slowdown, with a helping of local Brazilian financial/credit issues thrown in.

- NCAV: Two stocks were removed from the portfolio (AVTR & IESC) after both had been in the portfolio for >1year since they last passed the screen. There are likely to be a couple of additions to this portfolio in November, so look out for an NCAV update soon!

Performance Review
While the S&P posted its best month in decades, rising by over 10%, the portfolio posted a small loss of -0.9% (YTD: +7.7%). Given the portfolio’s bearish positioning this should not be surprising, and there was very little that drove performance apart from the strong shift away from “safer” assets towards more risky ones during October.

The losses were primarily centred on the 3 books where this bearish tilt is most obvious; Treasury Bonds, China, and Puts/Hedges. The Treasury Book (-38bps) suffered as risk appetite increased during the month, though its substantially reduced size meant the impact on performance was minor when compared to the contributions from the book over the summer. Both the China-related thesis (-48bps) and the Puts/Hedges book (-80bps) are short-biased, and gave up substantially all of their September gains as the market rallied. The Currencies (-33bps) was another negative contributor, as hopes of that Europe’s continued solvency and liquidity issues were being solved rose during the month.

These losses were partially offset from the performance in the various books that are long equities. The Value Equities (+57bps), Other Equities (+37bps) and NCAV (+15bps) posted decent performance despite the lack of major news flow on their underlying names. The Energy Efficiency book (-12bps) posted a small loss, again on no great news.

Finally, the Bond Funds (+9bps) contributed, largely benefiting from the non-Treasury or non-Bond holdings within the underlying funds' portfolios.

Portfolio (as at 10/31 - all delta and leverage adjusted, as appropriate)
14.6% - Bond Funds (DLTNX and HSTRX)
8.9% - Treasury Bonds (TLT)
5.4% - Value Idea Equities (THRX, and DRWI)
2.1% - Energy Efficiency (AXPW, and XIDE)
1.4% - NCAV Equities
0.0% - Other Equities (none)

-1.9% - China-Related Thesis (11bps premium in FCX Jan-12 put, and 37bps premium in EWZ Jan-13 puts)
-4.6% - Hedges/Put Options (8bps premium in S&P Dec-11 puts, 82bps in IWM Jan-13 puts, and 23bps SLV Jan-12 puts)

-9.0% - Currencies (EUO – Short Euro)

61.5% - Cash

Disclaimer: For added clarity, Our Man is invested in all of the securities mentioned (TLT, DLTNX, HSTRX, THRX, DRWI, AXPW, XIDE, FCX puts, EWZ puts, SPY puts, IWM puts, SLV 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.

After Half-Term Ponderings: Portfolio Thoughts

2011-10-27T21:36:00.001-04:00

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.

After Half-Term Ponderings: Where Our Man stands

2011-10-18T21:58:00.000-04:00

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.

September Review

2011-10-03T19:04:00.001-04:00

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.

Things from my Google Reader: Sep-11 Edition

2011-09-20T23:35:00.002-04:00

With Europe deciding what to do with Greece, and with the Fed about to try their latest unconventional policy to get the economy going (or at least the markets up), what better time to (largely) look away from finance and see what’s been in Our Man’s google reader recently! As usual, I’ve put the finance ones at the top and the non-finance (more interesting?) ones at the bottom.

- Short-termism and the risk of another financial crisis
An article penned by Sheila Bair as she left the chairmanship of the FDIC, where she appears to have been one of the few people, in power, who possessed any common sense and didn’t want to bail out the banks. Her “exit” interview is well worth a read too. (Sheila Bair, Washington Post)

- Is the SEC covering up Wall Street crimes?
It would be funny, if there hadn’t been a major economic meltdown and market crash that took place while (amongst many other things) the regulators were asleep at the wheel. While it’s not apparent to all, capitalism requires good strong regulation to avoid merely turning into cronyism. (Matt Taibbi, Rolling Stone)

- The Future of Light is LED
As you know, Our Man has a small exposure to Energy Efficiency which is currently focused on battery technology. However, one of the other areas that is interesting is LED technology; while LEDs have taken over in phones, computers and now TVs, the ultimate hope is that LED technology will be used in lightbulbs. Here’s a good primer on LEDs. (Dan Koeppel, Wired)

- Why Software is Eating the World
The initial leaps forward in technology were as the result of hardware (e.g. a PC you could use at home, a mobile phone, etc) but the real transformation has come from the impact of software. If you want think further on the subject, John Hempton’s (Bronte Capital) post is a great place to start. (Marc Andreesen, Wall Street Journal)

- Enter the Cyber-dragon
With software and computer technology becoming so important, it shouldn’t be a surprise that both corporate and national espionage (and warfare) is shifting to take place online. (Michael Joseph Gross, Vanity Fair)

- Getting Bin-Laden
A look behind Seal Team Six’s mission. (Nicholas Schmidle, New Yorker)

Apple Section:
- How Apple Works: Inside the world’s biggest startup
Apple has been one of the success stories of the 2000’s, with its entrepreneurial enterprise and innovation being rewarded on both Main Street and Wall Street. Here’s Fortune’s view of how the company works. (Adam Lashinsky, Fortune magazine)

- Creation Myth
It might never have been, but for the kindness (and foolishness) of others. How Xerox unwittingly (and perhaps incompetently) failed to realize what it had already created/invented, and gave Apple a glimpse of the future. “If Xerox had known what it had and had taken advantage of its real opportunities,” Jobs said, years later, “it could have been as big as I.B.M. plus Microsoft plus Xerox combined—and the largest high-technology company in the world.” (Malcolm Gladwell, New Yorker)

- Steve Jobs’ Commencement Address at Stanford (2005)
Wherein he touches on a number of stories that helped mould him as a person. (Steve Jobs, YouTube)

August Review

2011-09-05T18:30:00.000-04:00

Portfolio Update
After Our Man’s recent comments on the lack of portfolio activity, it goes without saying that August proved to be one of the portfolio’s busiest months! The following changes were made during the course of the month, and are listed in chronological order:

- NCAV: The position in LAB (now under ticker COWN) was sold during the month, as a result of COWN’s takeover of LAB, which completed while Our Man was on vacation. Due to incompetence, Our Man didn’t sell the position before the takeover closed, and as the ticker symbol changed (as LAB became part of COWN), he was forced to wait before selling it.

- Currency: Our Man increased the Short position in the Euro (i.e. a bet on the US dollar strengthening versus the Euro) by around 1/3 in the early part of the month. While the Euro has remained resilient despite the sovereign debt concerns (centred on the PIIGS countries) and has been bolstered by countries (especially China) buying French and German bonds, Our Man is wagering that this resilience will not last. The price of this transaction was slightly above the August-end price, and as such this additional exposure cost a small amount of money in August.

- Value Equity: Our Man doubled the DRWI position during August, as the stock suffered heavily. This move was only possible due to the undersized nature of the position (it was c1% before being doubled) and the attractive entry price, especially given the company’s fundamentals were unchanged. While the entry price for this additional exposure was well above DRWI’s lows for the month, it was also below the month-end price and hence contributed positively.

- Bond Funds: When Our Man added DLTNX to the portfolio, back in January, he said it was a medium-term replacement for VBIIX. The sharp fall in US Treasury Bond yields, provided an opportunity to exit the VBIIX position at an attractive price (though well-below the highs of the month).

- Put/Hedges: The start of August was exceptionally volatile, and as a result Our Man’s index puts (on SPY and IWM) saw both their implied volatility increase and their delta. Given the speed of the move, in the middle of the month, Our Man despite suspecting the market was headed much lower was worried about the possibility of a short-term (1-3month) sharp rally in the markets and so sought to hedge this (and the likely resultant fall in medium-term volatility) out. He did so through taking a position in XIV, which is a complicated instrument that seeks to perform the opposite of short-term futures on the CBOE Options Volatility Index, or VIX. In essence, it is profitable when markets start calming down (i.e. being less volatile) AND people expect them to remain at these calmer (less volatile) levels. As you know, August did not calm down (and we certainly seem to have no expectations of reduced volatility) and thus the position suffered heavily (20-25%) in the second half of the month. The only good news was that its size was limited (to an initial 2% NAV), and it remains to be seen/is up for debate whether Our Man was merely early or foolishly crossed one of his own risk tenets (see number 6).

- Treasury Bonds: The volatility in the market resulted in a large move towards “safe” assets during August. Despite all the naysayers, and an S&P downgrade, US Treasury bonds proved to be both a safe asset and largely under-owned, resulting in a large fall in Treasury Yields (and rise in price of Treasury bonds!). With Treasury Bonds representing the largest part of the portfolio, Our Man took advantage of this to sell his Aug-29 US Treasury bond (at a 2.87% yield to maturity). While Our Man still thinks yields, especially at the long-end of the curve (i.e. the furthest into the future, such as bonds maturing in 20-30yrs time) may continue to fall, the risk-reward is less attractive at this point.

Performance Review
As regular readers will know, Our Man has not been a buyer of the recent market rally and isn’t much of a fan of QE2, and thus his portfolio has had a slight bearish tilt to it. This tilt was fully visible during August, with the portfolio up +4.2% for the month (YTD: +4.1%). Despite the positive performance, the portfolio was not immune from the market’s volatility and saw its 2 best days (+1.5% on 8/4 and 8/8) and its worst day (-1.4% on 8/11) since inception.

Unsurprisingly, August’s performance was driven entirely by the Treasury Bond book (+436bps) and the Bond Funds (+45bps), which both benefited from the large decline in US Treasury Bond yields.

The Equity books, on the other hand proved to be a mixed bag. Other Equities (+12bps) performed admirably, despite the market, while the NCAV book (-24bps) underperformed, hampered by its micro-cap makeup and falling over 8%. The Puts/Hedges book (-6bps) was disappointingly down for the month, though this was entirely the result of a c40bp negative contribution of the XIV investment. The Value Equities book (-42bps) was also negative for the month; DRWI’s performance (+1bp) was helped by the additional investment in mid-month while THRX (-42bps) was not so fortunate.

The Short China book (+6bps) benefited slightly during the month, though with uncertainty over a global slowdown yet to fully spread to copper prices it struggled to contribute significantly. The Energy Thesis book (-5bps) and Currencies book (-5bps) were small negative contributors.

With the adjustments to the portfolio, the make-up is somewhat changed compared to recent months. While the most noticeable difference is the increase in cash, the portfolio retains a smaller bearish tilt and should not suffer heavily in a market rally. This reflects Our Man’s concern that the FED, much like the drunken gambler who keeps losing, will not view the economic uncertainty/weakness as reflection of their abject failure with QE2 but as a sign that they did not bet big enough in QE2. If circumstances (in Europe) do not overwhelm them first, Our Man expects to hear more and more about QE3 (most likely under another guise, Operation Twist, or the like) as the coming weeks progress, and the market to rally on expectations of its announcement. Expect Our Man to further add to the puts/hedge book should this come to pass…

Portfolio (as at 8/31 - all delta and leverage adjusted, as appropriate)
25.4% - Treasury Bonds (TLT, and 158bps premium in TBT Jan-13 puts)
15.2% - Bond Funds (DLTNX and HSTRX)
5.2% - Value Idea Equities (THRX, and DRWI)
2.4% - Other Equities (NWS, CMTL and SOAP)
2.2% - NCAV Equities
0.3% - Energy Efficiency (AXPW)

-0.6% - China-Related Thesis (15bps premium in FCX put)
-4.2% - Hedges/Put Options (34bps premium in S&P Dec-11 puts, 37bps in IWM Jan-12 puts, and 15bps SLV Jan-12 puts, all offset by a position in XIV)

-8.5% - Currencies (EUO – Short Euro)

49.2% - 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.

Chartology: U-G-L-Y, You ain’t got no alibi!

2011-08-11T21:48:00.002-04:00

As some of you may have noticed, despite the attempted rallies, the markets have not been a pretty sight this month! No doubt, if you’ve had the misfortune of watching the terrible talking heads you’ve no doubt heard it’s all the politicians fault (debt-ceiling muppetry), or S&P’s (how dare they downgrade the US from AAA), or the Europeans (call that a plan for dealing with Greece, Ireland and Portugal and Spain and err Italy), or companies (how dare they say things aren’t as rosy as the talking heads would like) or just the whole world (damn the whole globe for a global slow-down!). As you know, Our Man believes that markets are far more of a Bak-Tang-Wisenfeld sandpile and when they’re in a “critical state” it only takes one stray grain of sand landing in the wrong spot to bring it all down; thus, there’s little point blaming the particular grain of sand whether it’s European, Global, political, economic or company fundamentals!

Given that, here’s some graphs showing you why (or perhaps, that) we’re in a critical state!

1) Valuation

Look, the CAPE (or Shiller PE10) isn’t perfect and certainly isn’t useful as a timing device but it does provide the single best (and historically tested) look at valuation on a long-term basis. Forget what you hear about markets being cheap (especially when it’s drivel like based on analyst-projected operating earnings) and suck it up…equity markets have been expensive by historical standards for well over a decade! If CAPE isn’t your long-term valuation measure of choice, how about Tobin’s Q or Market Cap-to-GDP (Buffet's favourite, apparently).

2) Corporate Fundamentals

(Graph courtesy of Bill Hester, Hussman Funds)

If you want to buy stocks that are not only expensive but whose profit margins are close to their all time highs, then that’s your prerogative. It’s certainly possible that margins improve and we see record highs, but is that really something you want to bet on.

3) Signs of Economic Slowdown

Sure, this is just a PMI graph for China and it’s barely crossed into the recessionary (<50) readings but pick a major economy, and this and the leading indicators all look the same. So far that’s over-valued stocks, with near peak margins and signs of global economies cooling…doesn’t exactly sound like a recipe for success.

4) US Economic Data is pretty either

There’s no great way of telling how the economy is doing in real-time, but the Chicago Fed’s National Activity Index is a good start (I’d also point you in the direction of the Philly Fed’s ADS Index . You’ll notice that they’re not telling a happy tale at the moment with both so far above, but flirting with, recession-like levels (and noticeably worse than 2010’s dalliances).

5) Italian yields have seen better days

The ECB's buying of Italian and Spanish bonds this week has clearly helped lower their yields from the danger levels seen last week, but the risk is that it's coming at the cost of putting France into the firing line. With the Italian’s having 120% Debt-to-GDP, will France and Germany risk their AAA status (which is vital to the EFSF) to buy Italy time for reform and austerity? Perhaps, will it work out as well(!) as buying Greece time by bailing it out last year has? Probably, and that's what should worry you!

6) The Charts

(Courtesy of OEW/Elliott Wave lives on)

Look, Our Man will never profess to be a technical analyst, or to fully appreciate its wares, but he does have a small crush on Objective Elliot Wave analysis, what with its relation to behavioural theory and market psychology and all. It’s not perfect but given OEW's track record, when it flips from a bull market to bear market (and vice versa) then Our Man thinks you should at least listen (especially since they’ve been suggesting the bull market might be ending since May, with increasing conviction through July).

In conclusion, these are the little things that make a market interesting. They have been on the brink of a “critical state” for a while now so blaming any one thing is foolish. Our Man didn’t own much equity before and he sure as hell won’t be using this correction to load-up, and instead will only be nibbling at the odd thing that becomes exceptionally cheap under the security blanket that his puts offer. What'd it take for OM to load-up? Well, a good starting point to thinking about having a reasonable equity position would be when valuations were cheap (i.e. CAPE under historical mean) and margins were small; and Our Man would "fill his boots" should he ever see a CAPE near its historical lows and margins near theirs (but we're talking an S&P of c400 for that to happen, so don't hold your breath). As for everyone else (in the whole wide world), they make their own decisions and that’s what makes a market!

Special Bonus Chart: That downgrade…

It didn’t seem to cause any immediate spike in Japanese yields! Interestingly, US yields have also collapsed post-downgrade…not exactly what the talking heads had in mind! Apparently, inflation (and inflation expectations) & GDP growth (and growth expectations) have more impact on what bond investors do and where yields trade than an S&P rating. Colour me shocked!

July Review

2011-08-03T20:22:00.002-04:00

Portfolio Update

There were no changes to the portfolio during July.

Performance Review
After positive performance on each of the first 8 trading days of July had safely ensconced the book well into positive territory, the portfolio bounced around to ultimately end near the mid-point between its intra-month high and low. The result was a strong July, with the portfolio finishing +1.4% for the month bringing the year-to-date performance (-0.1%) to the brink of flat.

With all the words spent discussing US default as the debt-ceiling debate intensified into month-end, it would be reasonable to think that the L Treasury Bonds book would have suffered. This thought would have been mistaken, as the book drove performance (+159bps) largely on the back of a seemingly continual stream of disappointing economic data. The Bond Funds book (+42bps) also contributed strongly.

The Equity books were somewhat disappointing. The NCAV book (+2bps), which has underperformed so far this year, largely weathered the storm while the limited size of the Short China (-1bp) and Energy Efficiency (-1bp) books meaning that they had no real impact on the portfolio. Disappointingly, both the Other Equities (-17bps) and the Put/Hedges (-13bps) books suffered more than might have been expected, with the Silver puts largely responsible for the latter’s performance. The Value Equity book (-37bps) was again the worst performing book, with both positions suffering from their longer-term thesis as risk aversion increased. While we remain in a risk-off period both THRX and DRWI are likely to continue their struggles in the coming months, with neither likely to have a major catalyst till late-2011/early-2012. Given their limited size in the portfolio, while the volatility makes for uncomfortable month-to-month performance, it is a risk that the portfolio can comfortably underwrite and there are likely to be opportunities to add to both names at attractive prices in the days and weeks ahead.

The portfolio’s Currency exposure (+4bps) was positive, despite the latest European bailout. My opinion is largely unchanged; today’s situation bears a certain analogue to the failure of Credit-Anstalt (in 1931) and the dominoes that subsequently toppled due to the poor handling of the issues of the day. I believe that we are continuing to witness the slow-motion toppling of dominoes, resulting from too much debt (i.e. debt beyond a level that can realistically expect to be repaid). It was started by the US subprime crisis but has now spread its epicenter to European sovereigns fanned by a global unwillingness to accept failure (especially of banks), to force bondholders to accept their investment risk (i.e. default), and a refusal to treat the source of the crisis (too much debt which means more debt is not the solution) rather than the symptoms (liquidity issues). Europe’s single currency experiment (removing the option of devaluation, for the weak) and its bureaucratic structure are amongst the reasons that the ricochet has bounced there first.

Portfolio (as at 6/30 - all delta and leverage adjusted, as appropriate)
36.9% - Treasury Bonds (Aug-29 Bond & TLT, and 76bps premium in TBT Jan-13 puts)
22.1% - Bond Funds (VBIIX, DLTNX and HSTRX)
5.0% - Value Idea Equities (THRX, and DRWI)
3.0% - NCAV Equities
2.4% - Other Equities (NWS, CMTL and SOAP)

0.3% - Energy Efficiency (AXPW)

<-0.1% - China-Related Thesis (6bps premium in FCX put)
-1.1% - Hedges/Put Options (14bps premium in S&P Dec-11 puts, 17bps in IWM Jan-12 puts, and 17bps SLV Jan-12 puts)

-6.7% - Currencies (EUO – Short Euro)

28.0% - Cash

Disclaimer: For added clarity, Our Man is invested in all of the securities mentioned (Aug-29 Treasury Bond, TLT, TBT puts, VBIIX, DLTNX, HSTRX, THRX, DRWI, NWS, CMTL, SOAP, AXPW, FCX puts, SPY puts, IWM puts, SLV puts and EUO). He also holds some cash.

The Lion Sleeps Tonight

2011-07-29T19:19:00.003-04:00

“Hush my darling, don’t fear my darling

The lion sleeps tonight”

- "Mbube", by Solomon Linda and the Evening Birds (the original)

As you may have noticed, there’s a bit of bother over the US debt ceiling, which if not increased is likely to lead to all kinds of uncertainty and seemingly anything ranging from a complete government shut-down, to downgrades of US debt, to default, and perhaps even to intergalactic warfare (okay, I might have made that last one up). Not only that but the same people who’re in-charge of coming up with the budget also set the debt ceiling (at a completely different time), which makes one wonder how they’re all “shocked” that the results of the budget they set 6months ago broke through the arbitrary debt limit they set 18months ago. Pretty much moronic all around, and the spectacle of recent weeks only adds to that.

Our Man was chatting with Mrs. OM this week, and the fact that not much has changed in the portfolio over recent weeks (a figurative lion sleeping?), despite the book’s largest position being in US Treasury bonds, came up. What better time (or possibly more foolish, depending on how things pan out) to share his thoughts with you. The short-answer is things are very uncertain and it depends on what happens, when and how: will the US actually full-on default, or prioritise payments/shut-down parts of the government (which I suspect is most likely), or will it merely miss/delay some interest payments and then see a compromise reached, etc). Clearly though, this isn’t much help in understanding how (or indeed, if) Our Man is thinking, so let’s break it down a little.

Equity books: Doing nothing here is relatively easy as the total Long Equity exposure across the equity-orientated books (NCAV, Value Equities, Other Equities & Energy Efficiency) is a mere 11.1% NAV. Thus even a substantial decline fails to produce a sizeable impact (>500bps) on performance. This is before we even consider the positive impact that fall in markets would have on the put/hedge book (51bps of premium at risk), and the manner in which this exposure (currently a mere 1.3% short) would increase as the markets fell. As such, it’s pretty clear that the equity book wouldn’t drive any major losses and that the worst possible result for it would be a market fall of ‘only’ 10-30%.

Fixed Income books (L Treasury Bonds and L Bond Funds, c58.5% NAV): In the short-run, I’d expect these to suffer should the US miss interest payments (remember new debt can be issued to meet principal payments, as the total level of debt doesn’t change) but am comfortable underwriting these short-term losses in the portfolio in all but the most extreme of scenarios (the US government saying we’ll never payback any bonds ever) and thus am comfortable with the existing position sizes. The longer-term is harder to predict, and while some expect that it’s just a continuation in the US’ path to hyperinflation, I (unsurprisingly) suspect that it won’t. More likely, any prolonged cut-back in government services will help threaten to push the US into negative GDP growth territory (after <2% GDP in Q1, and I dare say something similar or worse in Q2) and make deflation the more likely scenario. If there is eventually a debt-ceiling deal (involving cutting government spending) that sees creditors made whole (for the delayed interest payments), I believe this would be good for Treasuries! In the case of no default but a downgrade of US debt (from AAA to AA) then I’d be a buyer of US 10-Yr Treasuries on any noticeably widening of yields (i.e. the 10-Yr moving from c2.90% to 3.25-3.50%), since the headline rating is irrelevant (as seen in Japan) when compared to factors like inflation.

As an aside, when thinking about defaulting/etc there’s a subtle difference between Japan/US and Greece/Italy/Spain that’s frequently overlooked. Both Japan and the US issue debt in their own currency and are the monopolist supplier of their currency; thus, they ALWAYS have the ability to pay back the debt (through printing money) and thus should they default it’s because of their willingness to do so (see US Debt-Ceiling muppetry!). In the case of Greece/Italy/Spain they’re not the monopolist supplier of their currency and as such default is solely a question of their ability (or perceived ability) to pay off this debt. The same is true for countries that issue their debt in foreign currencies (e.g. Germany’s reparations post-WWI, or large tracts of Iceland’s debt before the Financial Crisis) as they are (by definition) not the monopolist supplier of these currencies.

Currencies: This discussion leads us nicely onto Greece, and the most recent bailout mechanism. Much like the (2 or is it 3 or 4) previous bailouts of Greece, the current one doesn’t offer any solution merely another effort to buy more time. In the end, basic arithmetic is working against Greece as even with generous assumptions it is likely that 23%+ of Greek government revenues** are needed to pay interest on their debt (no principal) before they even get around to providing any services. Clearly, that’s not a sustainable! So what does it require for Greece to go bankrupt and default? I actually think that’s simple; you need the French/Germans to not want to give/transfer their taxpayer money to Greece, and that requires France/Germany to be suffering enough economic pain, such that the political will to bail out Greece ranks behind the desire to help out French/German voters. Thus, it’s most likely Greece goes bankrupt when there’s the next bear market/recession (and Greece going late in that). Why’s Our Man still happy to be S the Euro…well, currencies are a relative value game and the for all the US’ faults, Europe is still uglier.

* Yes, the title was a gratuitous lead-in to bask in some of Mrs. OM’s photography from our recent holiday!

** How did Our Man come up with this number:

By generously assuming things haven’t got worse since 2010 (i.e. Debt/GDP stays constant) and using 144% Public Debt to GDP, a 6% interest rate on debt (vs. 16% 5-Year yield, currently ), and Government Revenue of $114.5bn on a $305.4bn economy (thus revenue = 37.5% of GDP). Which gives us 144% * 6% = 8.64% of GDP spent on interest payments, or 23.05% of government revenue used solely for interest payments.

June Review

2011-07-16T20:26:00.001-04:00

Portfolio Update

Our Man is back from his vacation, so a brief but late update on June, which saw changes to the portfolio.

Performance Review

June was a thoroughly disappointing month, with the portfolio falling into negative territory on the 2^nd and never managing to clamber back into the black. For the vast majority of the month, until the final few days, the book was down in the 25-75bps range but the book suffered as the market rallied strongly in the final days and ended up -2.1% (-1.5% YTD). However, this sharp negative performance late in the month should not disguise the portfolio’s weakness, with pretty much every book contributing to the poor performance.

The Treasury Bond book (-63bps) and the Bond Funds (-16bps) were the main contributors to the end of the month swoon, giving up their gains, as the fears over the ongoing problems in Greece after the country’s parliament approved another austerity program.

The Value Equities book (-87bps), as both THRX and DRWI fell heavily during the month and was the largest negative contributor. DRWI suffered from continued uncertainty over its short-term outlook after management reduced their guidance for their fiscal Q1 (May-end). While this hurt the stock, the long-termstory is largely unchanged and the position is well-sized to cope with the interim volatility. Theravance (THRX) had a larger impact on the portfolio, despite announcing reasonable Phase II trials together with Glaxo; the company is still developmental and has limited current revenues and thus suffered as market risk aversion rose and investors moved towards less risky companies. The NCAV equities (-22bps), which consists of 9 micro-cap companies, also suffered from the increased risk aversion. The Other Equities (-5bps), Energy Efficiency (-5bps) and China (-2bps) all hampered performance, with the Puts/Hedges book (+2bps) offering the only (and minimal) respite.

The Currencies book (-7bps) was up for most of the month as concerns surrounding Greece’s fiscal problems affected the Euro, but ending up costing money after the Euro rallied once the Greek Parliament approved further austerity measures.

Portfolio (as at 5/31 - all delta and leverage adjusted, as appropriate)
36.0% - Treasury Bonds (Aug-29 Bond & TLT, and 60bps premium in TBT Jan-13 puts)
22.0% - Bond Funds (VBIIX, DLTNX and HSTRX)
5.5% - Value Idea Equities (THRX, and DRWI)
3.0% - NCAV Equities
2.6% - Other Equities (NWS, CMTL and SOAP)

0.4% - Energy Efficiency (AXPW)

-0.1% - China-Related Thesis (7bps premium in FCX put)
-1.3% - Hedges/Put Options (13bps premium in S&P Dec-11 puts, 16bps in IWM Jan-12 puts, and 33bps SLV Jan-12 puts)

-6.7% - Currencies (EUO – Short Euro)

27.7% - Cash

How long does it take to create a financial religion?

2011-06-28T23:03:00.000-04:00

Since Our Man is heading off (with Mrs OM) on his holidays tomorrow, he thought he’d leave with you with something to ponder in his absence. Sadly, it’s not some bright new revelation that he’s going to ask you to ponder…but one strongly related to something he discussed in this blog’s early days.

How long does it take for the financial patterns to become so culturally ingrained, that investors can’t help but slavishly adhere to them?

Well, if Our Man had to guess (and he does, else this post wouldn’t be much use otherwise), he would wager a maximum of 30-40years. Why? Well, that seems to be the length of time it takes for a full financial cycle to run its course. The graph below shows the most recent full cycle for bond and equity yields.

Bond and equity yields moved largely in lock-step between the mid-60’s and the end of the tech bubble (in 2000). This lead to the traditional bond yields fall and equity prices rise (i.e. equity yields fall) argument that has become a mantra, and underpins the “given where the 10yr is equities are cheap” argument. However, over recent years they’ve started to diverge.

What if this religious belief in the lock-step move of bond & equity yield has ill-prepared the equities are cheap crowd? After all, their rationale makes logical sense (equities and bonds compete for a share of the investment portfolio) and the historical data, especially since the bull market of 1981-200, seems to back up their case.

And what if the sharp bond yield rises of the 70’s have ill-prepared the bond vigilantes for what comes next? They know what happens when inflation gets out of control – and it must do with the FED printing like crazy, right?

Why would they both be getting misled – as with everything, perhaps we should look at the whole picture…

Now, the correlation between equity and fixed income yields suddenly doesn’t look as strong. Are they just a side-effect of the Federal Reserve’s belief in monetarism & attempts to control those fixed income yields over the last 30-40years?

Will the relationship exist should using interest rates loses its primary role (due to a zero-interest rate policy) and effectiveness as monetary tool. What if bond and equity yields decouple like we’ve seen in Japan? (Our Man does have certain expectations…)

What if Albert Edwards (SocGen’sbrilliant strategist, and one of Our Man's inspirations) was right all those years ago, and we really are following Japan into the Ice Age?

What of the carefully nurtured “bond yields down, stock prices up” financial religion then?

What to do about China?

2011-06-26T13:17:00.000-04:00

In the past, Our Man has opined a lot on the difference between opinion and execution, and how it is vital to consider this difference whenever you hear someone stating an opinion (especially when it’s on a disreputable source, like CNBC) on financial markets.

To this point, just last week, Our Man shared his strongly-held skepticism about China’s economic miracle. This skepticism hasn’t done much for the portfolio, with the China thesis being a consistent negative contributor since it was added to the book in mid-10. Fortunately, the execution has been somewhat better; despite the persistent losses, the thesis has cost a mere 50bps since its inception. This is a result of the small amount of capital that’s been allocated to the trade due to Our Man’s acceptance that the timing factors haven’t fully aligned, yet…

However, there are some signs that the timing signals are finally coming around. As you will no doubt recall, a couple of the key timing signals that Our Man was waiting for were the arrival of inflation and some signs of Bank/Credit tightening (see he said it, right here). Well, as the pretty little graph (from The Economist) down below shows these elements certainly seem to showing up, with both inflation and the banks’ reserve ratio steadily climbing!

Given this, you won’t be surprised that Our Man is starting to look to increase his exposure to the China thesis and here’s a recap of the ways he’d consider doing so. As a brief reminder, Our Man can only go Short through longer-term put options (12mths+ for companies, 3-6mths+ for various ETFs) and is limited to solely investing in US-listed ETFs and companies. This eliminates a number of the more esoteric positions, which have far better risk-reward, out there in fixed income world (I’m talking Australian interest rate swaptions, CDS on Japanese industrials, etc). This inability to execute as efficiently as Our Man would like is also why the China thesis, despite Our Man’s strong opinion, will never be as large a position as it could be (given that strong opinion).

- Commodity (and Commodity-related) Companies

The argument for betting against these names is simple; China is both the major and the marginal buyer of their products. For example, China represents over 40% of the global demand for copper, or over ½ of global demand for Steel (and thus directly and indirectly Iron ore). Furthermore, much of the shenanigans to circumvent the credit tightening at the banks is through the use of commodities (originally copper, now it has allegedly progressed to other commodities following a government crackdown on using copper) as collateral, meaning the behavior of real demand is less clear than it appears. As such, should a slow-down happen in China… the likely impact will be larger on commodities and related companies than people expect.

- Australia

Not much has changed in Australia, since Our Man talked about it at length a year ago. The economy continues to benefit from its large supply of raw materials and households continue to pile on more (largely mortgage) debt. Much like the rest of the China thesis the timing factors have improved, most notably home prices have started to slide, which has resulted in an increase in the number of homes for sale. This has a certain similarity to the 2006-7 period in the US, and we’ll see if the Australian Banks’ claims that they have been better at underwriting mortgage risk than their US peers holds true. Unfortunately, the only real way Our Man can play Australia remains EWA (an ETF) and some Australian-listed commodity companies that have US ADRs.

- Brazil

The one region that has become vastly more interesting as a potential short over the last year is Brazil. Brazil has a similar underlying story to Australia; it’s a vast producer of raw materials (especially iron ore and soy products) and thus exports a great deal of this to China (though it lacks Australia’s proximity). However, despite these large exports to China the country remains a net importer overall. What’s more (and spot the trend here) there are signs of potential credit issues looming, after a strong period of credit growth (credit doubled between 2002 and 2010) and an infrastructure that’s not yet developed for such credit growth (i.e. Banks can’t see a customer’s total credit outstanding, just their credit outstanding with the bank). What’s yet more interesting, is that the timing factors are also lining up well, with the Brazilian yield curve becoming inverted (see here) – while this is no guarantor of recession, it’s typically a sign that the market expects one in the coming year or so (e.g. the US yield curve became inverted in mid-07). The final benefit of a potential Brazilian position is the ETF, which is large and liquid and largely consists of commodity-related and financial firms.

Some More Observations on China...

2011-06-19T17:15:00.000-04:00

Our Man has long been skeptical of the “China story” and the seemingly commonly held view that China is the panacea, since GDP growth there will never slow down. So in this glance at China, rather than give you a regurgitation of his earlier posts (in case you wanted to know, here’s why Our Man is skeptical), Our Man thought he’d just blithely refer you to various bits in them as he meanders through some observations of the last few months.

A few months ago, Our Man motioned in the direction of the weakening Chinese PMI’s which suggested that the pace of Chinese growth was slowing and this trend continues with the PMI’s preliminary reading for May falling to 51.1 (from 51.8 in April). Our Man also mentioned the various shenanigans that were going on in the copper market (where copper was being used as collateral to help obtain financing, i.e. as a way around credit constraints).

The last few months have seen a whole new spate of shenanigans featuring Chinese companies that are listed in the US. No fewer than a dozen Chinese-based companies currently have seen their shares suspended or halted from trading in US, predominantly as a result of accusations of fraud. There are a lot of companies listed in the US, yet the vast majority of those whose shares are suspended are Chinese. What is more surprising is that many of these companies were ‘supposedly’ blue-chip names like China Media Express, which reached c$1bn market cap, before allegations of fraud led to its CFO and auditor to resign. Or Longtop Financial, a multi-billion dollar darling of the hedge fund crowd, whose auditors resigned saying their previous audits weren’t to be trusted as management and the local banks were complicit in the fraud after the firm was exposed in the impressive Citron Research blog. The most recent example is Sino-Forrest, a $4bn+ market cap company that has lost 80% of its value since a report by research firm Muddy Waters alleging fraud came out. Muddy Waters aren’t the only ones who have been skeptical and now even the mainstream media are cottoning on to the various issues surrounding Sino-Forest. Now, Our Man’s not saying that everything you hear from China and every company there is a lying crock of ****, but hopefully if you’re a believer in the China story you have got your eyes wide-open.

Now, Our Man was pointing this out to a Sinophile friend of his, when the friend very politely suggested that these were private companies and hence while there were shenanigans, the private Chinese companies were merely suckering naive or lazy American investors who bought into their story. Lest that you fall for such clap-trap, Our Man thought it only fair to point you in the direction of some public-sector shenanigans. Remember when everyone was so impressed by China’s high-speed rail? Well, unfortunately, the man-in-charge Liu Zhijun was arrested for embezzlement and that his ministry managed to rack up $271mn of debt (or 5% of Chinese GDP!) and that numerous others are being investigated after safety concerns cropped up (the result of using low quality concrete and other materials). That said, needing to bail out high-speed rail links isn’t unique to China (see Japan’s bullet train, Taiwan’s high speed trains and the lack of profitability of France’s various high-speed lines as examples) though it’s normally takes longer before you need to quietly shutter high-speed lines because no one wants, or perhaps it's can afford, to travel on them.

However, this wasn’t the public issue that caught Our Man’s eye over the last few months. Imagine there were a bail-out of local state debt that represented >10% of GDP (i.e. we’re talking bigger than California or Greece)…that would make major news, right? Well, apparently if it’s a US state or a European country it’s good for 24/7 coverage…but not if it’s China bailing out its local governments. Interestingly, most people thing that the Chinese government tackling this problem head-on is a good thing and certainly acknowledging and quantifying the problem is. However, what matters is who eventually has to pay the bill not who carries the liability. The Chinese have some form with determining who pays from their banking crisis in the 90’s which was a glorified version of extend and pretend. Back then government-backed Asset Management companies bought the impaired bonds from the Banks, issued the Banks new ones and made the interest payments by liquidating the impaired bonds over time. Obviously, when the principal came due the Asset Management cos didn’t have the capital and so rolled the bonds into a new bond backed solely by…a Ministry of Finance letter! Hence the eventual cost was borne by the household sector which through taxation and negative real interest rates helped provide this subsidies to the banks. Don’t be shocked to see a similar thing happen this time. There are of course other ways for the State to pay for this debt that it's taken on; perhaps the state will sell-off some assets to meet these debts, or they will confiscate wealth from the wealthy/SME’s/etc but Our Man suspects that they will continue to rely on the household sector to bear the burden as they’ve done for the last 20years+. The identity of the ultimate payer matters, especially if it's to be the household sector, since one of the primary aims of China’s much lauded latest 5-year plan is the aim of increasing consumption by 2-3% of GDP…and thus starting to reverse the trend of the last 20years.

All very interesting, I’m sure you’ll agree, but the real question is what is Our Man doing with all this information and data that he’s seeing. For that, you shall have to wait till next time.

Things from my Google Reader: Jun-11 Edition

2011-06-04T19:45:00.002-04:00

- Ireland’s Future Depends on Breaking Free From Bailout

In 2006, Professor Morgan Kelly wrote a paper entitled “On the Likely Extent of Falls in Irish House Prices” and was largely mocked for this and his various other articles in 2007 calling the rise in Irish house prices a bubble. Here’s his op-ed in the Irish Times, about what Ireland should do to get itself back on somewhat firmer footing. (Irish Times)

- The Brain Behind Teledyne, A Great American Capitalist

Our Man is heading on vacation at the end of the month, and top of the list of his vacation reading is a book/biography on Henry Singleton. Singleton was one of the great modern capitalists, who build Teledyne Corporation from a firm with <$2mn revenues into a multi-billion dollar conglomerate in the 1960’s. And all this while never taking an option grant! It’s a sign of the decline in American corporate management that a mere12years after his death nobody knows his name! (New York Observer)

- Somali Pirates’ Rich Returns

In these missives from his google reader, Our Man has mentioned the Somali pirates before. As more information about their structure comes out the more it seems to look like a business rather than some rag-tag bunch of fisherman. As the tagline to the article says; “Imagine if you could invest $100,000 to control a $200 million asset for three months and sell it back to the owners for $10 million—tax-free. That's the Somali pirate way.” (Business Week)

- Cracking the Autism Code

As you know, Our Man is an investor in one of John Hussman’s funds (HSTRX) and has long been a reader of his weekly market commentary. However, what you may not know is that after Dr. Hussman’s son was diagnosed with autism, he started researching it…and this year, together with others, published a paper (in Molecular Autism) that experts say has helped advance the field. (Fortune Magazine)

- How Carrots Became the New Junk Food

Imagine you had a very healthy food product that had a long-life and was tasty; pretty good, right? Sadly not! Instead, in phase one, you want make your product accessible by cutting it up into smaller pieces, with a shorter shelf-life, and giving it a cool name…like “baby carrots”. Then, in phase two, to guarantee them life in the snack drawer you want to start thinking about cutting them into cool shapes, put them in fancy packaging, and maybe even try infusing some different flavours! Just remember when you buy your first packet of potato-chip packaged cheese-infused carrots that you heard it here first! (Fast Company Magazines)

- AFC Wimbledon celebrate phenomenal rise

We’re back, baby! And even Britain’s best investigative sports journalist thinks you should care!

Nine years ago, Our Man’s hometown football club were stolen in the only (to date failed) attempt at franchising in English football. Thankfully, football in England is at least a true meritocracy and the Wimbledon fans (including Our Man) were able to form their own club and start at the very bottom of the English amateur football structure. Fast forward nine years and AFC Wimbledon have fought their way up through the amateur ranks, and with last week’s penalty-shoot out victory over Luton return to the professional leagues (the equivalent of moving up to single A, for you baseball fans). Just 3 more promotions and we’re back in the EPL with the big boys, and who knows maybe there will be another 1988 Cup Final (when Wimbledon beat Liverpool 1-0 to win the English FA Cup) victory - a win so famous, the BBC made a documentary about it - to celebrate (The Guardian)

May Review

2011-06-02T21:09:00.001-04:00

Portfolio Update

May saw very limited changes to the portfolio; largely reflecting Our Man’s belief that over the coming months markets are likely to offer more interesting entry points for some equity names and that the more defensive positions are appropriately sized.

- The NCAV/Absolute value book saw the only change with the position in CNTF exited during the month, after it had been in the portfolio for 1-year after dropping off the NCAV screen. Given the expected nature of this book (a small number of large winners, and a larger number of stocks that contribute flat to negatively) nothing should be read into the contribution of individual stocks within the book. That said, CNTF’s contribution was much appreciated as it fell into the winners category (+133% profit).

Performance Review
May continued the trend of quiet but strange month-to-date performance over the last 6months; February, April and May saw the portfolio’s performance reside almost entirely in the black for the duration of those months, while the fund posted a solitary day when it registered positive month-to-date number during December, January and March. What one should read into that, I don’t know!

Like April, the month was quiet but steadily positive registering a final gain of +0.95% that was enough to move the YTD performance (YTD: +0.57%) out of the red.

Again, the biggest driver of performance was the Long-end Treasury Book (+119bps) though this should come as little surprise, given it continues to represent the largest capital and risk exposure within the book. A plethora of weaker than expected (but not yet outright negative) data in the US and overseas saw increased risk aversion, from which Treasuries benefited. In particular, the weakness of this data and the related GDP-growth concerns resulted in a decrease in people’s inflation expectations (especially more than a couple of years into future) which helped these long-end bonds. The Bond Funds (+32bps) book again contributed steadily throughout the month.

The Currencies book (+17bps) recouped some of its year-to-date losses during the month. The luster of the ECB’s April rate rise faded during May, as the troubled fiscal state of Greece hit the news once more and debates began over whether there should be another bail-out. These discussions, and the increased uncertainty they brought to the forefront both about the strength of the European economy (and thus the need for future rate rises) and the impact of the bail-out helped weaken the Euro.

The equity-side saw continued mediocre performance. The NCAV book (-3bps) and the Other Equities book (-1bp) were both down in line with the market during the month, while the Short China thesis (-1bp) and Energy Efficiency (-5bps) also produced small negative returns. While the Puts/Hedges book (+4bps) posted a small positive return, almost the entirety of this came from the Silver puts which doubled during the month.

This leaves the Value Equity book (-66bps) which was the main negative contributor during the month though again it's no surprise as it represents the majority of the exposure and risk within the Equity-orientated books. The position in Theravance (THRX), a biotech development company, fell around 6% (or c4% more than the market), largely reflecting the increased risk aversion in the market; it remains a 4.5%+ position and will likely continue to be volatile (to both upside and downside) until it becomes clearer that their products are viable (or not). The position in DragonWave Inc (DRWI) fell almost 19% during the month, though there was nothing to change the thesis during the month. Given that the company disappointed with its quarterly earnings, it’s certainly fair to ask why Our Man is unbothered. The reasoning is simple, the thesis (see here) is largely unchanged – in essence, more wireless 4G build-outs will happen (only Clearwire, DRWI’s largest customer, has started theirs in earnest) and DRWI, as the cheapest and more efficient option, will be involved (90%+ penetration at Clearwire). Thus rather than worry that the company’s quarterly numbers were disappointing, Our Man takes solace in the fact they continue to add more customers (and do more trials) and build the groundwork to position themselves for when the 4G roll-outs occur in earnest, while winning most of the currently available business. Given the increase in risk aversion, it should not be a surprise that a small company that is break-even/makes a small loss (but is very well capitalized) and whose success depends on future events (i.e. the timing is uncertain) suffers disproportionately during the month. These risks are reflected in the position’s sizing (c1.6%) and in truth, Our Man rather hopes it falls further over the next few months so that he can add to the position at a more attractive price (and with the thesis closer to coming to fruition).

Portfolio (as at 5/31 - all delta and leverage adjusted, as appropriate)
36.2% - Long Treasury Bonds (Aug-29 Bond & TLT, and 50bps premium in TBT Jan-13 puts)
21.7% - Bond Funds (VBIIX, DLTNX and HSTRX)
6.2% - Value Idea Equities (THRX, and DRWI)
3.2% - NCAV Equities
2.6% - Other Equities (NWS, CMTL and SOAP)

0.4% - Energy Efficiency (AXPW)

-0.1% - China-Related Thesis (7bps premium in FCX put)
-1.4% - Hedges/Put Options (13bps premium in S&P Dec-11 puts, 17bps in IWM Jan-12 puts, and 29bps SLV Jan-12 puts)

-6.7% (leverage-adjusted) – Currencies (EUO – Short Euro)

27.7% - Cash

Disclaimer: One of Our Man's lawyery friends felt he should put a disclaimer here noting if he was Long (or Short) a stock/ETF/etc that he talked about during each post...so Our Man has.

Our Man is Long all the stocks/ETFs/puts mentioned in the portfolio section above (in case you didn't realize that)!

Only Fools and Horses...

2011-05-15T19:27:00.000-04:00

When Our Man was growing up in the leafy yet mean suburbs of London during the late 80’s and early 90’s, the most popular idiom floating around was “only fools and horses”. The idiom was a shortened form of an old saying ("only fools and horses work") and represented the philosophy of life that those people who do not look for an easy way of earning a living are fools. The idiom was enshrined within popular culture through the eponymous TV, which was (of course) one of Our Man’s favourites!

“Only Fools and Horses” followed the capers of Derek “Del Boy” Trotter, a fast-talking cockney trader who lived in a council flat in a high-rise tower block (‘Nelson Mandela House’, no less) in Peckham (South London), and his (nice but slightly clueless younger brother) Rodney as they try to get rich…quickly. It goes without saying that their futile schemes, mainly involving trading in various low-quality and/or black market goods (think Russian camcorders, luminous yellow paint, and the like), regularly backfire but this doesn’t dim their hopes with Del Boy often proclaiming that by “this time next year we’ll be millionaires”. Only Fools and Horses succeeded by capturing the ethos of Thatcherite Britain where the ideals of capitalism and deregulation meant that there was hope that anyone with the right product, skills or luck could be a millionaire by this time next year.

Fittingly, Only Fools and Horses saw its viewership peak (c24mn people in the UK, a viewership that in US-terms would be similar to that seen for final episode of M*A*S*H) for a Christmas Special in 1996, as Thatcherism was on the brink of being rejected at the ballot box. So why’s Our Man talking about a long-since defunct TV sitcom? Well, other than to introduce you, my long-suffering readers, to some fine British Comedy (I mean, how can you not love this), Only Fools and Horses has been strangely newsworthy in recent weeks. Firstly, with the sad passing of John Sullivan (the creator and writer) and then with the news that the Royal Wedding, after 15years, has finally knocked that Christmas-96 episode out of the Top 10 largest UK audiences ever.

However, thinking about Only Fools and Horses also led Our Man to cast his mind back to the other idiom of Thatcherite Britain; “as safe as houses”. While the phrase had been around a long-time (representing the strength of UK housing as an investment since at least the 1950’s, if not well before), it gained broad appeal during the 1980's spurred by the Thatcherism-defining Housing Act of 1980. The Act brought the opportunity of home-ownership to millions as it gave council house tenants (such as those living in ‘Nelson Mandela House’) the right to buy their dwelling, and is credited with helping drive the home ownership rate in the UK from 55% in 1980 to 64% just 7 years later.

Unfortunately, in the last few years, we’ve seen that “as safe as houses” has proved to be an inadequate motif for the risks of home-ownership both in the UK and the US. Furthermore in recent weeks, after ill-conceived government efforts to prop up real estate have largely faded, prices have largely started to fall through their 2009 lows; let’s hope it is just a temporary phenomenon and that the impact on the economy (and by extension) is more “contained” this time.

Silver has a Cloudy Future

2011-05-03T22:45:00.001-04:00

It seems like just a few days ago that Our Man was pointing in the direction of Silver’s chart and suggesting a bubble might be brewing (see here). As if to confirm that it was a parabolic move, Silver moved from c$37 back in late March to brush with the $50-level last week, a move of 35%+ in around 5-weeks! To put these moves into some context here are some charts on Silver and the various instruments one can play it through. Firstly, the same long-term weekly close graph that Our Man showed last time – note the nominal all-time high back in 1979** when the Hunt Brothers tried to corner the market.

Now, here’s a Bloomberg screen showing what Silver has done over the last 12months. Notice how it started to rise following the rumours of QE2 in August, and how also rampant the move has been.

Finally, here’s a chart showing the premium to NAV of the Sprott Physical Silver Trust (PSLV) for the month of April.

This trust holds all of its assets in physical silver, thus the chart shows how much people were willing to pay ABOVE the price of silver for a guarantee (or as close to one as possible) that it was held in physical form. As you can see, even though silver had moved 179%+ since August…investors were willing to pay 15-25% above the spot price (or the ETF) in order to buy into Sprott Physical Silver Trust. Think about that for a moment – not only are people willing to buy silver after it has risen 150%+ in well under a year, but they’re also prepared to pay an addition 15-25% premium on top of its price to do so. Not only does it suggest they’re keen to buy silver, it also suggests that they don’t believe that SLV (the Silver ETF run by Blackrock), or other similar instruments, that claims to hold their Silver in physical form (since SLV, as an ETF, trades almost exactly at its NAV). To be proven right, these investors either need a continued rally in silver or SLV (or other instruments) to be fraudulent (or at least people to fear that they may be) in their claims of holding physical silver.

This kind of sentiment, coupled with the final surge towards $50 over the Easter weekend, proved too tempting for Our Man; while he definitely missed the perfect entry point, a small put position (25bps of risk initially) on the SLV ETF was added to the portfolio on Easter Monday. Since then, Silver (and SLV) has been all over the place – falling then bouncing following Bernanke’s press conference, before falling heavily over the last few days.

Interestingly, the fall is being attributed to Comex increasing its margin requirements for Silver with some (various silver bugs) claiming such a move is a conspiracy to crush the metal price! Frankly, Our Man finds that idea somewhat amusing and another possible sign of the bubblemania that surrounds silver. Thankfully, the excellent Kid Dynamite explained the situation far more eruditely than Our Man’s clumsy drafts. Simply put (i) the CME acts as the central clearing-house and so takes the risk of investors not meeting margin calls and (ii) it sets it margin requirements in dollar (not % of contract value) terms. What this means is that as a futures contract value increases (i.e. as Silver goes up by 150%+ in 8 months) the exchange should require greater $ margin in order to cover the same percentage of an in investor’s potential losses. This is further exacerbated when the volatility of the price increases, as this means bigger swings in price, and thus a sensible exchange should increase its margin in order to cover these larger swings (and reduce its risk of an investor not meeting margin calls). Apparently, however, this is lost on some…and it’s just an evil conspiracy.

(** Keep this in mind, when you read the next Chartology)

April Review

2011-05-01T20:09:00.003-04:00

Portfolio Update

As indicated last month, following the addition of some capital, there was a little movement within the portfolio but the books were not uniformly adjusted. In fact, the majority of the cash went unspent, and thus portfolio’s exposures declined slightly during the month. The various books that saw changes were:

- Option/Hedge book: This was increased slightly and saw its exposure broadened during the month with Jan-12 60 strike puts on the Russell 2000 ETF (IWM) added. Additionally, following Silver’s brief mention in March and its continued rapid ascent to touch $50 in late April, a small position was taken in some Jan-12 30-strike puts on the Silver ETF (SLV).

- The Long Treasury book was increased. Rather than buy direct exposure (through either TLT, the existing bond, or other ETFs that offered direct Long Treasury exposure), the exposure has been gained indirectly through a Jan-13 25-strike put option on TBT. TBT is an instrument that seeks “daily investment results that correspond to twice (200%) the inverse (opposite) of the daily performance of a 20+ Year U.S. Treasury Bond Index”. These indices are generally not terribly attractive (and to be avoided), but Our Man is hoping to benefit from the large negative carry (-9.5%+ per annum) and (hopefully) a trend towards lower yields in long-end Treasury bonds.

- The Energy Efficiency book and the Bond Funds were increased to levels broadly similar to those held throughout the first-quarter through adding to existing positions. The Currencies book was increased slightly (as discussed in last month’s wrap-up).

- The NCAV/Absolute value book was updated (the moves and rationale can be seen in this post). However, the existing positions were not resized to reflect new capital due to the prohibitive cost (given each position’s small size, it required a >15% return per position just to cover the brokerage commission)

Performance Review
April proved to be a quiet but steadily positive month for the portfolio, which eked out gains of +0.86% (YTD: -0.37%) over the course of the month. While the number of positive and negative days was evenly split, the positive days consistently had a larger impact on the portfolio.

Despite all the fears surrounding the debt ceiling, the US fiscal deficit, and the stance of the Federal Reserve, the Long-end Treasury Book (+68bps) was a large driver of performance. It was ably supported by the Bond Funds (25bps) book which contributed steadily throughout the month.

Unfortunately, the Currencies book (-29bps) was a major negative contributor. The reasons were two-fold; firstly while the US Treasury Secretary and the Chairman of the Federal Reserve offered some support to the US Dollar, the market believes their support is nothing more than token and they would be comfortable with a weaker dollar. Secondly, and more importantly, the hike in the ECB’s interest rates was well telegraphed (and discussed last month) investors believe that this is the start of an interest raising cycle by the ECB with a further 50bps expected by year-end. It is on this second point that Our Man differs in his views from the market…

The equity-side mixed performance amongst the various books. The Value Equity book (+69bps) was the main positive contributor driven by the continued positive news and strong price action in THRX. These gains were supplemented by a small positive contribution from the Other Equities book (+8bps). The weak performance of some micro-cap names hindered the NCAV book (-23bps), which unlike the broader market has seen no real bounce since the days following the Japanese earthquake. The Energy Efficiency book (-16bps) was a negative contributor; though the position in AXPW is small in size it is, and will likely continue to be, exceptionally volatile which befits its status as a development-orientated company. The Put/Hedges book (-23bps) and the China-thesis (-3bps) both suffered as the market rose during the month.

Portfolio (as at 4/30 - all delta and leverage adjusted, as appropriate)

34.0% - Long Treasury Bonds (Aug-29 Bond & TLT, and 50bps premium in TBT Jan-13 puts)
21.6% - Bond Funds (VBIIX, DLTNX and HSTRX)
7.0% - Value Idea Equities (THRX, and DRWI)
3.8% - NCAV Equities
2.7% - Other Equities (NWS, CMTL and SOAP)

0.5% - Energy Efficiency (AXPW)

-0.1% - China-Related Thesis (10bps premium in FCX put)
-1.2% - Hedges/Put Options (18bps premium in S&P Dec-11 puts, 20bps in IWM Jan-12 puts, and 17bps SLV Jan-12 puts)

-6.6% (leverage-adjusted) – Currencies (EUO – Short Euro)

27.3% - Cash

NCAV 2011-2

2011-04-14T21:17:00.001-04:00

The second NCAV update of the year was a little more successful than the first, providing one new name to be added to the Absolute Value/NCAV bucket portfolio (for information on this bucket, and how it works, read here).

- SUTR (Sutor Technology Group) which had a market cap of $62mn (vs. a 65% NCAV of $72mn)

While the screen is a valuable tool, I think that some of the names removed from this month’s list highlight the importance of a simple qualitative overlay to it;

- As usual, there were the names that were removed because the screen mistakenly used total assets rather than current assets (PCC and SVLF) or stale (>6mths old) financial data (NINE).

- As Our Man has discussed previously, given the prevalence of Chinese companies (which are listed on NASDAQ) the qualitative overlay has become more important to ensure that the data the screen uses is both timely and appropriate. Unfortunately, given this month’s developments we shall have to add accurate to that list. In TWO cases this month NASDAQ-listed Chinese companies were removed from the list after passing the quantitative screen for being potential frauds.

- DGW: Saw its CFO resign after the stock was accused of being a fraud by a research firm (interestingly, DGW’s sister company DYP, which has the same chairman, is being investigated by the SEC for being a fraud!)

- JGBO: Also saw its CFO resign and replaced its auditor!

A couple of existing names (LTON and XIN) reappeared on the screen. As such, the final date that these names must be sold by has been extended (here are the rules when NCAV names are sold). Finally, QXM has now spent 366 days in the portfolio since last appearing in the NCAV screen so is coming out of the portfolio.

March Review

2011-04-03T19:41:00.002-04:00

Portfolio Update
There were some small changes to the portfolio during March, which are outlined (chronologically) below:

i). The Option/Hedge book was increased slightly during the month, with additional Dec-11 100-strike puts on the S&P added.

ii). The Energy Efficiency thesis was finally introduced to the portfolio (see here and here) through a small position in Axion Power (AXPW), a maker of lead-carbon (as well as regular lead-acid) batteries.

iii). On the penultimate day of the month, Mrs. OM and I added a little bit to our savings (i.e. this portfolio). This is the first of 2 additions (the second will be in early April) and as such the portfolio has (even) more cash than normal.

Performance Review

While March was a dramatic month both for the market and in-terms of global news (with Japan and Libya at the forefront), it was a fairly dull month for the portfolio. After dropping 80bips in the first week of the month, the portfolio steadily eased its way back towards flat over the balance of the month, eventually ending down 20bps for March (-1.22% YTD).

This lack of drama was most visible in the two bond-related books, with both the Long-end Treasury Bond book (-1bp) and the Bond Funds (-0bps) having no real impact on the portfolio. The Currencies book (-17bps) saw the most inconsistent performance over the month, ending as a noticeable negative contributor as the Euro rallied following ECB President Trichet signaling thatan interest rate hike is likely at the ECB’s April meeting. Our Man is likely to use such an event to increase his position.

The equity-side saw far more disparate performance amongst the various books. The Value Equity book (+52bps) was the main positive contributor following some decent news for both positions; THRX benefited on the back of some mixed news for a competitor and DRWI won several new contracts for business that helped further solidify the thesis and will help reduce its dependence on Clearwire (its largest customer). These gains were offset by losses in the NCAV book (-32bps) as these (generally) microcap companies were sold-off heavily (the book fell 10%, on invested capital, from peak to trough) after the earthquake in Japan and never really recouped any of the losses as the market recovered. The other two equity books, Other Equities (+3bps) and Energy Efficiency (+1bp), were marginally positive contributors. Against this decent performance from the equity books, the Put/Hedge book (-20bps) was a negative contributor as was the Short China (-7bps) book.

Portfolio (as at 3/31)

37.0% - Long Treasury Bonds (Aug-29 Bond & TLT)
19.9% - Bond Funds (VBIIX, DLTNX and HSTRX)
7.2% - Value Idea Equities (THRX, and DRWI)
4.2% - NCAV Equities
3.0% - Other Equities (NWS, CMTL and SOAP)

0.5% - Energy Efficiency (AXPW)

-0.2% (delta-adjusted) - China-Related Thesis (14bps premium in FCX put)
-1.72% (delta-adjusted) - Hedges/Put Options (34bps premium in S&P Dec-11 puts)

-4.9% (leverage-adjusted) – Currencies (EUO – Short Euro)

25.3% - Cash

Things from my Google Reader: March/April Edition

2011-03-31T22:44:00.003-04:00

This post is a little earlier than anticipated for 3 very good reasons; (i) it includes my most education link to date (Compounding: Why don't people get it?), (ii) it includes my favourite link to date (Solitude and Leadership) and lastly (iii) because the Final Four is imminent and I wanted to get in an NCAA basketball-orientated link (Princeton vs. UCLA). As usual, the links go from the most financially-orientated to the least.

- Compounding: Why don't people get it?
If you must ignore everything else in this post, just look at the first rule and table in the link. Especially if you're young -- I can say with some certainty it will be the only undeniably important thing that you ever read on this blog! Over the last few weeks, Our Man has been decrying the foolishness of youth after talking with some young colleagues/acquaintances about saving (they don't want to). Now Our Man isn't here to give you a lecture (or even to show you some basic maths!) so instead he's going to give you a link to an article written by Richard Russell that will do it for him. Suffice to say, if there's only one financial lesson Our Man could pass on to his & Mrs OM's (hypothetical) kids it'd be this one. (Dow Theory Letters)

- What Barofsky said!
Neil Barofsky is one of the few civil servants or politicians to have been an unmitigated (and I'd say unarguable, but there's always someone who'll disagree) success in actually doing his job over the last few years. Thus, it goes without saying that on the day he was leaving his job as the special investigator general of the government's bailout program, he does what he did throughout his tenure; call-out the Treasury/government (and the Banks) for the failure that is TARP. (New York Times)

- The Blind Man who Taught himself to see
Daniel Kish has been blind since he was a year-old, yet navigates the wilderness alone, can recognize a building from 1,000 feet away and knows to mock his interviewer's bad parallel parking. Here's how he learned to see by using sound, and the non-profit he's set-up to help others do the same. (Men's Journal)

- Solitude and Leadership
Of all the articles that I’ve linked to, this speech to the plebe class at West Point, by William Deresiewicz, is my favourite. Why? Because it touches on a number of things that I believe and find interesting; how we conflate leadership with aptitude, achievement and/or excellence, how the educational system (especially the higher educational system) claims to train leaders but instead produces masterful technocrats, and how our bureaucracies (be they government, corporate, educational or other) reward conventional wisdom and a talent for maneuvering over almost anything else. However, most of all, because it’s a speech that talks about the importance of thinking for yourself, and coming to your own decisions independent of crowd. (The American Scholar)

- A Declaration of Cyber-War

Remember Stuxnext - the virus that apparently crippled Iran's nuclear program last year. Here's an in-depth article about what went on in the software-security world as they tried to work out who sent it and what it was targeted on, and more broadly how the face of warfare is changing once more (Vanity Fair)

- Princeton vs. UCLA; how an Ivy League team beat the defending NCAA Champs!
Here's Sean Gregory (at the time he was bench-player for Princeton) writing his reflections on Princeton vs UCLA at the big dance, in what became legendary coach Pete Carril's legacy-defining penultimate game. It's also a great excuse to include my favourite NCAA moment; Our Man was in the upper reaches of the arena, sandwiched between (the future) Mrs OM and the good friend who introduced us, when this happened! Hoya Saxa! (Time Magazine)

- When you let artists play with household objects and wire you get...stories?
Photographer Terry Border was let loose with some every-day household objects and some wire...and came up with some photos telling their own interesting stories. They were so good he has a book out and a blog that he updates with new ones. (Big Picture and Bent Objects blog)

Chartology – March 2011

2011-03-26T19:07:00.003-04:00

Here are some charts that have caught Our Man’s beady eye over the recent few weeks:

1) Double Dip in Housing?

The above graph (courtesy of Calculated Risk) shows the Case-Shiller home prices indices starting to turn negative again. Given that one of the aims (and successes) of QE2 was to influence the economy through the “wealth” effect this should be concerning. For all the incremental help that a higher equity market offers to some, it’s far overshadowed by the impact of house prices. Finally free of government stimulus and support, house prices have started to fall once more and if it continues this will have far more serious implications for the economy.

2) “We wants it, we needs it. Must have the precious.”

The story of the last few months has been the rise of various commodities, and few have moved as obviously as Silver. For reference, the peak on the left of the graph is when the Hunt Brothers tried to corner the silver market. While silver is still short of that peak, and there are valid reasons for holding silver, the speed of the ascent and the psychology that has gone with it makes Our Man think that the time is coming when it’ll be opportune to have some puts on Silver.

3) The Fed “doth protest too much, methinks.”

In its latest FedViewspiece, the San Francisco Fed argues that “Global commodity prices have followed economic activity as measured by industrial production”. That’s a fair enough argument and to back it up they produce this pretty compelling chart:

Case closed!

Well, except for one minor thing – those with more skeptical minds might notice that there’s a bit of a scaling issue (i.e. the scales on the 2 y-axes are somewhat different). What would the chart look like if they axes were scaled similarly? Furthermore, given industrial production and commodity price data have been around a while, why such a limited historical chart to back up their view?

Thankfully, John Kemp of Reuters had similar questions and saved me an hour in front of Bloomberg this morning by plotting them for us.

For some reason, these graphs show the linkage is somewhat less clear! Perhaps the Fed needs to brush-up on its Wall Street-esque marketing techniques

Revisiting China

2011-03-23T21:34:00.003-04:00

As Our Man suggested last week, now’s a good time to check-in on China and that’s because there have been subtle signs of a slow-down there. This is most clearly seen by looking at the PMI’s; both the manufacturing and services sectors have shown signs of slowing growth.

However, the January-February data is generally given short-shrift by investors as it contains the Chinese New Year and can thus be confusing/distorted depending on when the New Year falls. Thus, it will be interesting to observe February & March’s data to check whether these signs remain -- expect people to be “shocked” if they do.

As Our Man noted some time ago, inflation is the one of the key data points that he’s watching in China. The last 3-4months have shown signs that it has started to pick-up.

At some point, it becomes the variable that forces the government to make the choices that they’ve avoided so far; how much polarization (and potential social unrest) do the Chinese want for their GDP growth, do they really want a consumer-driven economy (i.e. do they really want to pay workers more) rather than an investment-driven one (that they can control), etc.

So far, the signs are that they’re willing to tackle inflation at the cost of growth; we’ve seen yet more reserve ratio hikes (the most recent pushing it to 20%, up from 15.5% in mid-2010) but also mandated wage rises.

China’s new five-year plan: well the headline news that the country will eschew its pursuit of investment-driven growth and encourage consumer spending has certainly excited some. However, colour Our Man a little more skeptical – while targeting a 2-3-percentage point increase in Consumer Spending (as a % of GDP) over 5-years sounds most impressive, it reveals the problems China faces. Why? Consumer spending was a mere 35.1% (in 09) of China’s GDP, the lowest by some distance globally. Should they achieve their aim, and Consumer Spending would still be below the 40% of GDP that it was 5-years ago! And this is before we consider whether China can do this while seeing no drop off in exports but an increase in imports, a rise in wages but no inflation and all this while being better to the environment.

Finally, a couple of random China-related things that I’ve seen over the last couple months that are worth bearing in mind. Firstly, we’ve all seen videos of deserted cities and malls in China (and here’s an in-depth Australian news report that's well worth the 5-10mins) – it’s just another reminder that GDP can be manipulated (build a house, knock it down and rebuild it…2 houses to GDP, but only 1 to wealth/productive stock) and that the quality of GDP matters over time. Secondly, my google crawlers have shown a pick-up of articles like this (“Economic slowdown in China Likely in 2^nd Half of 2011”) in the mainstream media. On its own it means nothing, but cumulatively articles like these are worth noticing. Lastly, in the absence of being able to use more complicated instruments (CDS and receiver swaptions), Our Man has focused expressing his Short China thesis through puts on Commodity & Industrial names (see here for explanation). When rumours persist that firms are allowing copper to be used as collateral in financing, well it’s safe to say Our Man feels a little more comfortable about how the dynamics of this would all play out when the worm turns.

Thus, while the exposure to the China theme remains very small, it's also one of the places that's likely to see increased capital over the coming months.

Things Our Man’s pondering

2011-03-13T22:41:00.000-04:00

In the words of President Eisenhower; “plans are nothing, planning is everything” - here are some of the things that Our Man’s been looking at. They’re a mixture of some of the existing ideas in book and some new things that Our Man’s been reading up on and thinking about.

- "Lower for Longer” trades
As readers will know, Our Man believes that the Fed (and ECB and BoE, in Europe and the UK) will ed up having to keep interest rates lower, for a far longer period, than most people expect. This is because I believe the ongoing impact of debt-deflation mean that the economy remains weak without the support of the government (either directly through Stimulus, or indirectly through Quantitative Easing). While it is hard to execute this idea very efficiently (i.e. by using interest rate receiver swaptions) given the instruments that Our Man can use, the idea is reflected in the portfolio. At the moment, this is predominantly through being Long 20Yr+ Treasury Bond position, though over time this exposure may be expressed through Long 20Yr+ Treasury Bonds, Zero-Coupon Bonds and options on either of these. In the short-term however, Our Man would like to see the idea of inflation and the need for rate rises further embedded within investors’ expectations before increasing or re-adjusting the position. As such, while it will hurt the NAV in the short-term, don’t be surprised to hear Our Man cheer some of the following: month-on-month CPI numbers of 0.3-0.4% in the next few months, a European rate rise (with firming expectations of more to come - something that could potentially encourage Our Man to increase the S Euro position too), and a strong Non-Farm Payroll number or two.

- Tobacco & Other Deflation-proof Staples
These businesses tend to be somewhat…well, boring! As such, their stocks are the kind of ones that investors ignore in these fabulous (bear-market) rallies. However, that also leaves opportunity for those less excitable. For example, Altria is up a mere 67% from its lows up a (paling in comparison to the market’s c100% rise), but people seem to forget it is also trading above its 2008 highs and pays a healthy 6% annual dividend yield. Furthermore, as we all know, while smoking isn’t pleasant, it’s certainly a habit that’s difficult to kick. Now all Our Man needs is to persuade Mrs. OM to drop her valid moral objections, and these names will finally make it into the portfolio.

- China
This is a topic that Our Man has written about before and in the next week or so, we’ll be checking in to see whether the time is right to increase the small exposure to the Short China thesis.

- Japan
Before Friday’s earthquake, Japan was at the very top of Our Man’s list of things that he was cogitating, reading about and working on. However events have changed that and it goes without saying that the human impact is far more important than the uncertain economic toll of the earthquake and tsunami. As for Our Man’s thoughts, prior to Friday the outline was that a continued appreciation of the yen (vs. the USD) would eventually set the stage for the Nikkei to have an inflation-fueled run at its all-time high. We shall have to see what happens in the coming days (and/or weeks) with the impact on Yen repatriations and Central Bank policy, let alone a whole host of other issues, all unknown at this point before making any major decisions.

- Previously discussed Themes: Energy Efficiency and Storage Theme and Water Theme
Both remaining attractive secular themes, though it has been hard to find ETFs or stocks that are not over-valued at this point. Our Man has some names on his radar screen and continues to look for interesting opportunities in the respective spaces.

- Value Ideas
Our Man continues to scour for interesting value ideas, with a couple of names like Capstone Therapeutics (CAPS) and REalNetworks Inc (RNWK) almost at attractive levels.

Why so quiet…

2011-03-06T15:00:00.002-05:00

Given the dearth of posts over the last few weeks, it would certainly be fair for you to wonder where Our Man has been! Sadly, there are no tales of excitement (or woe) to break to you but nonetheless a simple explanation shall be offered.

Partially it is because Our Man returned to the world of the gainfully employed at the start of the year. While earning a wage and having some job-security are a long-term boon to this portfolio’s continued existence, some of the time that was devoted to writing has been lost. Separately, for those of you hoping that gainful employment would result in Our Man being more “in the know” - you will, I’m afraid, be sadly disappointed. However, with Our Man’s now allocating his time better (goodbye sleep, we enjoyed the best of times together!) work will be but a minor factor going forwards, and I will be here to offer you my unsolicited and unvarnished thoughts.

However, the primary reason for my silence is that not all that much has changed over recent months. It’s tempting for those of us involved in the markets to talk breathlessly of all the data releases, changes and market movements as though each one will be THE driver of the economy or market (or even our returns) over the coming periods. The truth is, that is rarely the case. However, we help justify our own existences by substituting real-time with its far flashier cousin, dramatic-time, where everything is vital and which only an expert could navigate through. While CNBC is the most extreme (or should that be comical) example of this in finance, it’s prevalent in some way in the dealings of almost every financial professional (and I suspect, an equivalent is prevalent outside finance too!). This is interesting but why does it matter, I hear you clamour. Well the reason is two-fold:

1. A large part of Our Man’s approach is to generate medium to long-term thematic premises. By their nature, these premises will take time to play out and require some element of patience and long-term resolve. In real-time things change slowly, and it is people’s perceptions of reality that change rapidly leading to 'dramatic-time'. As the legendary Bob Farrell used to say, “Fear and greed are stronger than long-term resolve”.

2. The biggest risks to Our Man’s premises are being early and wrong; and being too early is often the same as being wrong. This is where the portfolio management comes; it is important to balance having some exposure to the thesis with containing the losses when one is too early. As such, Our Man’s portfolio management relies on having exposure to the key theses that is akin to being Fabian** in nature. In essence, it is about finding a way to hang around without suffering major losses until a thesis starts to play out (or people’s perceptions to the underlying thesis change), and then looking to capitalize as the thesis plays out.

So why has Our Man been quiet? Well, not much has changed to either validate or invalidate the underlying theses, and a larger part of the portfolio is in its Fabian setup, and thus the returns are also not fluctuating wildly. While patience and long-term resolve may be investing virtues, they don’t always make for frequent updates or a permanently entertaining blog. However, the good news is that there are some posts on tap for the coming week or two; some things I’ve been pondering, checking in on the China thesis, and some further early thoughts on Japan.

** Now, those who’ve had the benefits of a classical education will know that the Fabian strategy was named after Quintus Fabius Maximus Verrucosus Cunctator (or Fabius Maximus, to you and me) and refers to his (unpopular but ultimately successful) military strategy to defeat Hannibal of Carthage (not to be confused with this Hannibal). On a random but unrelated note, Hannibal is one of Our Man’s favourite historical figures. Equally unrelated, another of Our Man’s favourite historical characters is Air Marshal Hugh “Stuffy” Dowding, who gets somewhat overlooked when people come to discuss the Second World War (much like Alan Turing, one of the fathers of the computer!) because his most vital role (the Battle of Britain) occurred far too early in the War (1938-1940) to get appropriate notice. While Our Man is tempted to take advantage of your unsuspecting state and fulfill his childhood ambition of offering some history lectures, Mrs. OM has wisely pointed out that this would likely be exceptionally long and only bore people further. So instead a mere run-down of Dowding’s major decisions in 1936-1940; approving the building of both the Hurricane (allegedly based on seeing the first one fly) and the Spitfire fighter planes, seeing the importance of radar in the late 30’s and integrating it centrally into the British defence system (which came to be known as the “Dowding System”), and refusing Prime Minister Churchill’s requests to send fighter planes to France and also to offer greater air support for the evacuation at Dunkirk (both rejected on the basis that they would reduce Fighter Command's strength for defending Britain). The point of all of this? Dowding in the summer of 1940 implemented a classic Fabian strategy to defeat the significantly larger and more experienced German Luftwaffe. Finally, for those of you who appreciate irony, both Dowding and Fabius were fired from their jobs as a result of their successful strategy. Let us hope Our Man suffers no similar fate...

February Review

2011-03-02T22:36:00.000-05:00

Portfolio Update
There were no changes to the portfolio during February though we did receive the semi-annual interest payment on the Aug-2029 Treasury bond, which added to the level of cash.

Performance Review
February saw a slight bounce back in the portfolio’s performance, with a 1.5% gain helping offset part of January’s losses (-1.0% YTD).

The tension in the Middle East resulted in increased risk aversion in the markets during the middle part of February. As a result, the Long Treasury Bonds book (+55bps) was a strong contributor, despite the continued relatively positive tenor of the economic data. The majority of the portfolio’s risk remains concentrated in this book, and it’s likely to be volatile given the numerous economic (ranging from potential US Govt shut-downs, to potential short-term inflation, to the end of QE2, to name just three) and political (further Middle-East protests, German regional elections, new Irish government trying to renegotiate their bail-out, etc) factors that may affect markets over the coming months. The Bond Funds bucket (+10bps) was a small contributor during the month.

The Value Equities book (+60bps) recovered part of its January losses, largely as a result of THRX bouncing back from its January swoon on the back of decent results and the progression of a drug into phase III trials. The Other Equity (+14bps) and NCAV (+25bps) were helpful contributors to performance, both outperforming the equity markets. Against their gains, the Puts/Hedges book (-7bps) and the small Short China book (-<1bp) both hampered performance. Finally, with Europe showing some signs of calm the Currency book (-6bps) was also a negative performer.

Portfolio
40.7% - Long Treasury Bonds (Aug-29 Bond & TLT)
21.8% - Long Bond Funds (VBIIX, DLTNX and HSTRX)
7.5% - Value Idea Equities (THRX, and DRWI)
4.9% - NCAV Equities
3.3% - Other Equities (NWS, CMTL and SOAP)

-0.8% (delta-adjusted) - China-Related Thesis (22bps premium in FCX put)
-0.74% (delta-adjusted) - Hedges/Put Options (21bps premium in S&P Dec-11 puts)

-5.7% (leverage-adjusted) – Currencies (EUO – Short Euro)

18.7% - Cash

Things from my Google Reader: Feb-11 Edition

2011-02-24T20:09:00.000-05:00

Hopefully, Our Man will have more productive things to say in the upcoming weeks but until then…here’s some things from my google reader! As usual, I’ve put the finance ones at the top and the non-finance (more interesting?) ones at the bottom.

- What Hoenig said…
I don’t always agree with KC Fed President Thomas Hoenig (who deserves great credit as the only one to actually dissent on Fed policy votes over the last year) but he's always interesting to listen to. Now that he can longer vote, he’s not been shy about criticizing the Fed and the Administration (with truisms such as “it is ironic that in the name of preserving free market capitalism in this country, we have undermined it so deeply.”) The entire speech is worth a read, but for those after just the interesting bits, the Pragmatic Capitalist has culled them for you.

- When Irish Eyes are Crying
Michael Lewis continues his worldwide tour of collapsing sovereigns with a visit to Ireland. If you’ve seen this movie before, it's because the tale is not dissimilar to that of Greece or Iceland but with its own unique twists. I suppose Portugal and Spain are up next...

- It’s the Income Inequality, Stupid….
In Our Man’s brief divergence into politics during the tail-end of last year, we touched on income inequality. Here are 11 charts that explain it a little further (and also why Our Man sniggers whenever anyone says that the solution to our problems is cutting Corporate Taxes)

- The History of the Honey-trap
Over the last 12-15months, there have been various accusations leveled at China most notably currency manipulation. However, according to the Times of London leaked documents from MI5 purport that China “bugs and burgles Britain” using some of the oldest methods!

- Some thoughts on Cities
Our Man is a city person having spent the vast majority of his life in London and New York, and as such he’s quite prone to reading articles about cities. After all, some think that their core elements just be reduced to equations by physicists. Elsewhere, others thing they need saving…and that skyscrapers can do it!

- The Adventures of Egglant
While Jersey Shore provides entertainment for us in the US, there’s no doubt that the Japanese are the kings of the reality game show!

January 2011 Review

2011-02-02T00:18:00.000-05:00

Portfolio Update
A slight change to the format this year; rather than post every time there’s a change to the portfolio, I’m going to update you at the end of the month (unless there’s a large flurry of activity during a month). The second half of this month saw some small additions to the portfolio.

i). The short China thesis (see this post, for an explanation of Our Man's skepticism) was reintroduced to the book. Again, it was expressed through a put position in FCX (see here, for discussion on timing and instruments), though the position is once again pretty small (25bips max loss in 2011).

ii). A Long position was added to the Bond Funds book. Buying individual bonds is exceptionally hard for a small investor (ironically, the excellent David Merkel wrote an article about it recently) and as such Our Man looks to get his bond exposure entirely through Treasuries, ETFs or Bond Funds. The position is in DoubleLine Total Return Bond Fund (DLTNX) run by Jeff Gundlach & Phil Barach. In the medium-term the fund will be an actively managed replacement for the existing holding in VBIIX (a passively managed fund).

Performance Review
January saw a continuation of the weak performance of recent months, with the portfolio beginning the year by falling 2.5%. What differentiated January from the tail-end of 2010 was the correlation amongst the various buckets/books, with almost every one providing negative performance.

The Long Treasury Bonds book (-91bps) suffered as the tenor of the economic data released during January remained relatively positive. Though the position was the strongest contributor to performance in 2010, it has been a negative contributor over each of the last 5-months, as QE2 has helped buoy investors’ animal spirits and strengthened the belief that 2011 GDP will prove self-sustaining. This increased optimism coupled with concerns over the US government deficit has made Treasury Bonds (especially long-term ones) one of the few assets on which the market is uniformly bearish. As regular readers know, Our Man isn’t put off by the controversy of being long Treasury Bonds (some might even say he embraces it a little too much) and despite the efforts of QE2, he still leans towards both deleveraging and deflation as the probable outcomes. The Bond Funds book (-4bps) was also a small negative contributor.

The Value Equities book (-129bps) was the largest negative contributor during the month. The majority of the negative contribution came from THRX, which is (and will continue to be) volatile and largely gave up its November and December gains. DRWI suffered after weak guidance due to the lack of clarity regarding Clearwire’s (it largest customer) demand in the upcoming quarters. This uncertainty is nothing particularly new and has been touched on before and while it adds volatility the position, it doesn’t at this point change the thesis. The Other Equity (+3bps) and NCAV (+5bps) were minor contributors to performance, though both underperformed the equity markets. Against their small gains, the Puts/Hedges book (-16bps) and the reintroduced China (-4bps) book both hampered performance. Finally, with Europe showing some signs of calm the Currency book (-15bps) was also a negative performer.

Portfolio
41.3% - Long Treasury Bonds (Aug-29 Bond & TLT)
22.1% - Long Bond Funds (VBIIX, DLTNX and HSTRX)
7.0% - Value Idea Equities (THRX, and DRWI)
4.7% - NCAV Equities
3.2% - Other Equities (NWS, CMTL and SOAP)

-0.8% (delta-adjusted) - China-Related Thesis (c25bps premium in FCX put)
-2.0% (delta-adjusted) - Hedges/Put Options (29bps premium in S&P Dec-11 puts)

5.9% (leverage-adjusted) – Currencies (EUO)

18.3% - Cash

2011: Glimmers of Hope

2011-01-31T21:15:00.000-05:00

The counterpoint to Fingers of Instability is Glimmers of Hope (see here for an explanation of the thinking behinds Fingers of Instability and Glimmers of Hope), which looks at some of the things that could go right in the economy and drive markets higher.

- Private Sector to drive GDP growth
While Our Man believes that the underlying problem in the US (and other places) is primarily a solvency issue, the Government and the Fed believes that through increased fiscal spending and liquidity (i.e. QE1, QE-lite and QE2) they can help provide an escape valve. In essence, QE and fiscal stimulus have supplied liquidity to the market to help boost GDP and asset prices. This has provided support for the private sector, allowing it time to repair its balance sheet and rebuild confidence in the economy. The underlying hope is that with confidence rebounding and balance sheets in better shape, the private sector will be able to take over the leadership in driving GDP growth and balance sheets can be further repaired as a function of this growth. The Q4 survey data showed the first hints of truly positive data points, and this was supplemented by the Q4-10 GDP data which saw Real Final Sales leaping to 7%+ annualized from the 1-2% run-rate since the recession ended. (Tim Duy has other morcels of good news from the recent Q4-10 GDP data)

- QE2 & the Wealth Effect
The other aim of Quantitative Easing has been to help US households rebuild their balance sheets & net worth, primarily through rising equity prices and the attempt to curtail the fall in house prices. The additional hope is that a rising market will further help build confidence in the economy by boosting investors’ “animal spirits”. Should this prove successful, there’s the possibility of the strong market performance (since QE2 rumours abounded during late-Q3) turning into a melt up.

- Falling Unemployment (and Rising Incomes)
It should go without saying that the best way for US households to repair the balance sheets and increase consumption is for them to be employed in jobs whose salaries are increasing! With regards to the first part, Weekly Unemployment Claims still remain elevated by historical levels, but they have certainly declined from their peak. This, coupled with hiring starting to edge up as the private sector gains confidence in the economy’s stability, has seen the economy start to produce net hiring over the last 6months. While the numbers have been small, they have helped chip slowly chip away at the unemployment numbers. While the second part of the equation has been quieter, Our Man think it’s fair to surmise real incomes are more likely to rise in a falling unemployment market than a rising one!

- China & an Asian soft landing
In much of a similar vein to last year’s Glimmers, perhaps Our Man remains just plain ole wrong on China. Maybe they genuinely have built a better mousetrap in terms of this whole running an economy thing! And if they haven’t, well they’ve shown a willingness and ability to throw money at problems whenever they arise. While this may lead to longer-term imbalances and further misallocation of resources, it could certainly help 2011’s markets.

- Valuation
Like the prior note, it’s another repeat from 2010’s list. Our Man continues to mutter that it’s an expensive market (and using longer-term measures it is) but if one only looks at short-term horizons (or uses current year P/E, or mutations of it….such as P/E based on Operating Earnings, or projected forward P/E, etc) then the market can look cheap.

- Constructive Government behaviour (in the US and Europe)
Stranger things have happened! In the US, with a Democratic President looking to run for re-election in 2012 and the Republican’s having taken over Congress there is incentive for both parties to ensure the economy doesn’t suffer a reversal in the next year or two. Who knows, perhaps they might even find their way to co-operating to do something constructive on Medicare/Medicaid and Social Security over the coming year or so. In Europe, with Greece and Ireland having to be bailed out by their European partners, and Portugal seemingly next on the list, perhaps recent reports of a move towards investors having to take haircuts on their troubled bonds (i.e. reducing the debt burden, for those countries in trouble by making investors take a loss on their bonds) is the first step towards sorting out their sovereign debt problems.

NCAV 2011-1

2011-01-17T16:03:00.003-05:00

The first NCAV update of the year, proved to have no major impact on the Absolute Value bucket portfolio (for information on this bucket, and how it works, read here).

Three new names (NINE and PCC) were found by the screen but were removed by my qualitative overlay;
- PCC and SVLF: the screen used total assets (rather than current assets) thereby invalidating its calculation of NCAV.
- NINE: the financial statements used were stale (over 6months old) and hence NINE was qualitatively removed.

A number of existing names (BXG, LAB, LTON, NED, TWMC, and XIN) reappeared on the screen. As such, the final date that these names must be sold by has been extended (here are the rules when NCAV names are sold).

Finally, a short update on QXM who were subject to a take-over offer from their majority shareholder, Qiao Xing Universal Resources (XING), back in September. The offer was of $0.80 in cash and 1.9 shares in XING for each of share in QXM, which is potentially worth $5.95 (XING closed at $2.71 on Friday) or about 20% higher than QXM’s closing price. In early January, a special committee of QXM’s directors has authorized that the offer be put to minority shareholders. As such with QXM trading at a discount to the bid-value, and since Our Man doesn’t want to hold any XING shares, the position will be sold either on/around 1st April 2011 (when it will have spent 366 days since last appearing in the NCAV screen) or earlier, should the deal with QXM be approved and close (so that Our Man does not receive any XING shares).

2011: Fingers of Instability

2011-01-09T21:32:00.000-05:00

This is Our Man’s way of (exceptionally broadly, see here for an explanation of the thinking behind Fingers of Instability & Glimmers of Hope) applying the concepts of Bak-Tang-Wisenfeld’s sandpile model to how he thinks about investing

- Fraudclosure & the Housing Market
Residential construction has been an important driver in post-WW2 recoveries. Unfortunately, there have been recent signs of a double dip in house prices and the underlying problem of too much supply/too many homes on the market has not been solved. One of the ancillary factors that has been in the background is the “fraudclosure” scandal. While the long-term impacts are unclear, what is clear is that there is greater doubt surrounding the ownership of homes (both foreclosed and not) in the US, which adds yet more uncertainty to the housing market. In all probability there’s unlikely to be any Federal moratorium on foreclosures, though a State-level moratorium (like we saw in the 30’s) is eminently possible. An interesting, but less talked about issue, remains that most of the Mortgage-Backed Securities vehicles (to whom the mortgages were sold) were enacted under NYS Law, where the dealer has to deliver to the mortgage notes to the trustee. If the trustee doesn’t have notes, then the contract isn’t alive and is potentially uncollateralized which I’m certain will lead to all manner of legal arguments.

- Property Taxes, and State & Local Government Finances
The unwritten story of foreclosures is the impact on property taxes, which will hamper state and local governments. This is just another problem for cash-strapped states and local governments with a number of analysts predicting potential defaults in 2011 and the municipal bond market reacting negatively. What does seem likely is that we’ll see some belt-tightening at the state level.

- European debt problems
During 2010 we saw bailouts for Greece and Ireland, what does 2011 hold for Portugal, Spain and Italy? The Europeans have largely been resistant to burden-sharing (i.e. making bondholders take a haircut), instead preferring bailouts of troubled members, as this would force European banks to take losses and potentially raise fears concerning their stability. It will be worth watching to see if there's any impact from the Irish election in March, where the opposition currently lead by double digits and are threatening to press for debt reduction.

-The make-up of the Fed and Politics
Ron Paul, author of “End the Fed”, is now the chairman of the sub-committee charged with overseeing the Fed which should prove for closer Congressional scrutiny and livelier hearings. However, a more important change is in the voting make-up of the Federal Reserve; 2 of the new voting Federal Reserve Bank presidents (Charles Plosser, Philly Fed, and Richard Fisher, Dallas Fed) oppose QE and a third (Narayana Kocherlakota, Minneapolis Fed), is skeptical that it will work. They replace three of the “doves” (Rosengren (Boston Fed), Pianalto (Cleveland Fed) and Bullard (St. Louis Fed), which may not make QE3 as inevitable as it currently seems.

-Inflation (in China)
Our Man has talked about inflation in China before, in large part because it presents great difficulties for the economic planners there. The two biggest ways that the Chinese have been trying to control it is through raising rates and controlling credit expansion (directly, or indirectly via the banks’ reserve ratios). However, both of these have the potential impact of slowing down their economy growth which has been a driver of Global growth (and especially commodity prices) and is expected to grow at 10% (ad infinitum!). Furthermore, given the possibility of a credit-driven bubble in Chinese property are the Chinese about to discover (like their Western peers) that it’s not easy to engineer a soft-landing from a credit boom?

- Global Trade, Protectionism & Emerging Asian Economies
For those who are historically minded, the steady decline of Global Trade and the rise of Protectionism, was one of the noticeable features of the 1930's depression in the US. With many seeing Quantitative Easing (QE) as an attempt to weaken the dollar, others accusing China of currency manipulation and most countries still hoping to drive GDP gains through increases in exports, it is little surprise that rhetoric surrounding trade wars continues to increase. Let’s hope we don’t see an equivalent of the Kindleberger spiral for 2010’s!

- Valuation
Though market participants always seem to manage to call the market ‘cheap’, from Our Man’s perspective the market does not appear cheap based on long-term measures. Both the Shiller CAPE ratio (currently 22x vs. a historical average of 16.5x), and the Tobin’s Q (Q3-end 1.05x vs. a historical average of 0.70x) suggest that markets are over-valued. While these long-term measures have not helped investors time the markets, they have served as good long-term guides to valuation and are worth noting.

December Review

2011-01-03T15:23:00.001-05:00

Performance Review
The portfolio’s behaviour and performance in December tended to be broadly reminiscent of recent months, especially October. The result, a fall of 180bips in December left the 2010 performance at a disappointing +5.04%.

The theme of recent months, weak Treasury bond performance as hopes for economic growth increased, continued throughout December. The Long Treasury Bonds (-166bps) and Long Bond Funds (-26bps) contributed substantially all of the portfolio’s losses during December. While their combined sizable negative contribution over the last 4 months of the year hampered the portfolio, it should not be forgotten that they were the largest contributors to performance (c500bps combined) throughout the year.

With December proving to be another strong month for equities, it is little surprise that the main positive contribution came from the various Equity buckets. Value Idea Equities (+28bps), NCAV Equities (+35bps) and Other Equities (+2bps) all largely moved with the markets. Against this, the Hedges/Put Options bucket (-34bps) suffered from both the rise of the equity markets and the continued fall in volatility. For the year, the NCAV bucket (+45bps) contributed well and largely outperformed the market from its inception during the latter half of the first quarter. The other main equity buckets (Value Idea Equities, Other Equities and Hedge/Put Options) were largely a wash during the year, with the negative performance of the Hedges/Put Options cancelling out positive performance from the other buckets. I was early in exploiting my China thesis and that bucket (-35-40bps) was a negative contributor. The position in Gold, which was sold far too early, also proved to be a small negative contributor.

Finally, the recently introduced Currencies bucket (-19bps) gave back part of its gains during the month as the Euro strengthened following approval of a bailout package for Ireland.

Portfolio
41.3% - Long Treasury Bonds (TLT and the Aug-29 Bond)
14.6% - Long Bond Funds (HSTRX, and VBIIX)
8.1% - Value Idea Equities (THRX, and DRWI)
4.6% - NCAV Equities
3.1% - Other Equities (NWS, CMTL and SOAP)

-0.0% (delta-adjusted) - China-Related Thesis (<1bp premium in FCX put)
-1.3% (delta-adjusted) - Hedges/Put Options (43bps premium in S&P Dec-11 puts and 1bps premium in a GS Jan-11 put)

6.0% (leverage-adjusted) – Currencies (EUO)

25.0% - Cash

Occam’s Razor, the Gordian Knot and the Von Mises Prophecy

2010-12-21T20:18:00.001-05:00

The rise in Treasury yields has hurt Our Man’s portfolio in recent months, but there seems to be no consensus as to why they’ve risen with numerous opposing points of view. Arguments range from the Bond bubble is bursting (and hyperinflation is imminent) to this just being evidence that the Fed’s QE2 is working.

How to untangle such a mess? Well, 14th century English logician William de Ockham created a helpful ‘rule’ that’s come to be known as Occam’s Razor. It recommends that when choosing between hypotheses which are equal in other respects, one should choose the hypothesis that makes the fewest new assumptions.

What does that mean in this situation?
Simply that Treasury yields have risen as a result of people’s perception of the economy improving, something that’s been evident by the broadly better data and by various economists (and Wall Street Banks) upping their GDP growth targets during November/December. Now, perhaps, time will also suggest that the alternative arguments are true…that QE2 was successful (though for $600bn, or 4% of GDP, you’d hope that the Fed’s aim was to increase actual growth not just people’s perceptions about it), that the bond bubble has burst (though the graph below would suggest “not yet”) or that hyperinflation is imminent (again the CPI, and other inflation measures don’t yet show it). For now, however, I’m sticking with the guy who lived over 600years ago.

Now, with all these worries about hyper-inflation and QE2’s impact on prices, a reasonable fellow might ask why is Our Man comfortable holding Treasuries and betting on deflation. Well, regular readers will know that Our Man doesn’t view this as your run-of-the-mill business cycle recession but instead one caused by the level of debt (see graph here) reaching unsustainable levels. As such, the typical monetarist solutions that are the foundation of central banking have little impact on the economy when contrasted against the size of the deleveraging that occurs as households rebuild their balance sheets. (While this is, of course, a simplistic overview...for those wanting to know a little more, I’d recommend this piece by Professor Steve Keen, and for the very geeky his entire blog).

This idea of debt-deflation was developed by Irving Fischer during the 1930’s. What makes it interesting is that it is the Gordian Knot of the economics profession; the traditional and preferred solutions (many of which are being attempted now) have no real impact on solving the underlying problem. Reductions in interest rates fail to spur businesses or households to relever. Supplying money to the system, either through fiscal policy (“stimulus”) or monetary policy (“quantitative easing”) produces an initial response which fades and then collapses each time the policy is stopped, and the longer it continues the greater the risk of the economy becoming dependent upon it. Austerity, while it may help reset the generation of future debts, merely increases the pain by future reducing demand and enhancing the deflationary forces. The “Alexandrian solution” to the challenge is of course default (in the private/household sector, preferably) but the resultant probable insolvency of financial institutions* is not something the powers that be are currently willing to accept. Thus for the foreseeable future, unless the household sectors starts to relever itself, Our Man will continue to bet on deflation and disinflation.

As for the long-term; here, Our Man will once again defer to some chap to lived a long time ago. Ludwig von Mises, the Austrian economist, wrote the following:
“There is no means of avoiding the final collapse of a boom expansion brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”

* The side benefits of bankruptcy on the system are under-rated. As a simple example, Bank of America is getting sued by a number of investors who are seeking to have BoA repurchase soured mortgages that were packaged into bonds by Countrywide Financial (Bank of America bought them in 2008). Do you know why we’re not hearing anything about J.P. Morgan getting sued for the deals that Washington Mutual (or why nobody’s suing Lehman Brothers)? Because when WaMu (and Lehman) went through bankruptcy, the unliquidated claims are trapped there and thus have no impact on JP Morgan. Therein lies the beauty of bankruptcy for the system -- clean assets with which to regenerate things!

Things from my Google Reader: Dec-10 Edition

2010-12-09T17:30:00.000-05:00

As Our Man has been running around interviewing, doing projects and lining up references in his quest for a day job, posting has continued to be light. To fill the void, here are some of the things that Our Man has read recently, and found rather interesting.

As usual, I’ve put the finance ones at the top and the non-finance (more interesting?) ones at the bottom.

- Is QE printing money or not? (Video)
Who knows, not Fed Chair Ben Bernanke who thought it was 2-years ago but doesn’t think it is now. It’s a little sad, that John Stewart not the “real” media was the one to call him out on it.

- Buy the Dip (Video)
Some fine ‘advice’ proffered to Our Man, by a good friend (and reader) after a recent post.

- What 311 Reveals about New York
If you’re a New Yorker then you’ve probably used 311. Not only is it surprisingly helpful and efficient, they are actually trying to capture all of the data and find ways to use it productively! (Wired Magazine)

- Some Thoughts on Harry Potter
To Mrs. OM’s chagrin, Our Man decided not to venture to the cinema to see the latest in the Harry Potter films. Instead he read this fine article by Joe Posnanski about his Harry Potter reading experience (both alone, and reading it with his young daughter). Mr. Posnanski’s a sports writer, hence there’s also a nod towards the debatable scoring system in Qudditch. (Joe Posnanski Blog)

- Roads Gone Wild
Making driving seem more dangerous could make it safer. So argues Hans Monderman, one of the leading traffic engineers in the world, and you do that you start by getting rid of traffic signs and then let human behavior (and the survival instinct) take over! (Wired Magazine)

- Later
What does procrastination tell us about ourselves? Even those who know about behavioural biases, and the downside to them, find themselves unable to escape their trap. (New Yorker)

- You Get What You Pay For?
Healthcare has been prominently debated over the last few years, but Dr. Rob nails it when he says "your system is perfectly designed to yield the outcome you are currently getting"! (Musings of a Distractible Mind)

And finally,
- An Irrational Guide to Gifts
In a nod to the impending arrival of Christmas, here are a Behavioural Economics Professor’s suggestions on the best type of gifts. (Dan Ariely's Blog)

November Review

2010-12-02T23:56:00.002-05:00

Performance Review
November was a strange month for the portfolio, which spent the majority of the month mired in negative territory before benefiting from a mixture of the troubles surrounding Ireland and a company specific events (THRX, in the Value Equity bucket) to end up 7bips (putting the YTD at +6.97%)

The Treasury Bonds bucket was the big negative performer during the month (-69bps) as we saw continued appetite for risk for the majority of the month, before concerns about Ireland’s fiscal stability led to a late rally in yields. The Bond Funds (-10bps) also posted a small loss, which was constrained largely due to their exposure to shorter duration instruments. The concern surrounding Ireland’s fiscal debt situation resulted in some weakness for the Euro, something that benefited the Currency bucket (+39bps).

With the equity markets largely flat to down slightly, a number of the equity buckets failed to contribute. The NCAV (-24bps) and Other Equity (-13bps) buckets both posted small losses, which were broadly spread amongst the underlying positions, and the neither the Puts/Hedges (-1bp) nor the China bucket (-<1bp) had much impact on the portfolio.

The portfolio was however, pushed into positive territory by the Value Equity bucket (+83bps) but even here performance was mixed with DRWI being a slight negative contributor. The same could not be said of THRX, which was the key to this month’s performance, adding almost 100bps after the stock rallied over 20% during the month. The key driver came late in the month when GlaxoSmithKline (GSK) announced it would increase its stake in THRX to 19% through a private placement.

Portfolio
42.2% - Long Treasury Bonds (20.1% TLT and 22.2% in the Aug-29 Bond)
14.6% - Long Bond Funds (6.8% HSTRX, and 7.9% VBIIX)
7.7% - Value Idea Equities (5.5% THRX, and 2.2% DRWI)
4.1% - NCAV Equities
3.0% - Other Equities (1.5% NWS, 1.5% CMTL, and 0.0% SOAP)

-0.0% (delta-adjusted) - China-Related Thesis (<1bp premium in FCX put)
-2.3% (delta-adjusted) - Hedges/Put Options (1bps premium in S&P 2010 puts, 68bps premium in S&P 2011 puts and 7bps premium in a GS put)

6.3% (leverage-adjusted) – Currencies (3.2% EUO)

24.5% - Cash

The storyline matters too…

2010-11-24T23:00:00.002-05:00

It’s been a while since I have posted, something that reflects the fact that while the market has moved around recently I feel it’s been of the “full of sound and fury, signifying nothing” variety as market participants prepared for and are now digesting the Fed’s QE announcement. However, just because the market's movement over the last couple of months may determine little over the medium-term, it doesn’t mean they should be ignored or that one shouldn’t seek to profit from them. Unfortunately, that’s not something that Our Man has succeeded in during recent months.

When we think about investing we spend a lot of time thinking about the end or the final scenario; for example, will we see deflation or massive inflation? Is China a bubble? What’s the target price for Stock X? However, much like reading a book, while the end is important…the story-line matters too. It’s the twists in the plot that make markets (and books) interesting. For an investor, this means that one should think about the twists in the plot that one might encounter on the way to reaching end; there’s little point having a portfolio today that’s perfectly set up for the end, if you can’t continue to hold it through all the twists in the plot to get there! This is far from easy since it means thinking and weighting information (and your beliefs) about different time horizons and then using this information to help structure a position and the portfolio in general.

Why mention this? Well, it’s not something that Our Man has done well, especially recently. As you know Our Man doesn’t trade (i.e. do anything in the 30-day time horizon window) but that should not stop me from taking advantage of short-term factors to exit investments (with the opportunity to reinvest later) or change the composition of the portfolio.

The biggest example of this has come in the last few months, with regards to the Treasury holdings. While they have been strong contributors for the year, they have hurt in recent months and Our Man missed an opportunity to take advantage of some short-term factors to exit the position even though the long-term view is unchanged.

The graph above (courtesy of Mish Global Economic Trend Analysis) shows the movement in Treasury yields. As we can see, leading into Bernanke’s Jackson Hole speech there was a tightening of Treasury yields (including at the long-end, where Our Man is invested) as investors began to fear a double dip in the economy. These yields remained largely steady, though off their lows, following the speech in which Bernanke hinted at the possibility of QE2 as investors “bought the rumour”. However, following the Fed announcement of QE2 these spreads have widened as investors “sold the news”. For Our Man this has meant that much of the Treasury gains from the summer have been given up but it need not have been this way. While my long-term view hasn’t changed, I should have taken both my short-term understanding of the “buy the rumour, sell the news” phenomenon and the fact that the returns had become more front-end loaded (as a result of the tightening around/before the Jackson Hole speech) as a sign to at least reduce the position.

Hopefully, this is something that Our Man will learn in the coming months and years. While it's great to have conviction, especially in long-term ideas, Our Man's got to a better job of taking into account some of the short-term factors. Remember, it's not just the ending...the storyline matters too!

Late for Halloween: The Horror.....a post on a pointless topic!

2010-11-02T23:41:00.000-04:00

There are many things that Our Man tries to avoid talking about in this blog, mainly because they’re terribly dull. However, some of these he does his best to avoid talking about at all (even with friends, down the pub). These include topics as tedious as why don’t Arsenal have a good ‘keeper and why are the Mets terrible, but there’s one topic that Our Man avoids more than any other; politics!! It’s not that Our Man doesn’t like politics (he does), it’s just that talking about it isn’t all that interesting; it’s largely ideological (on both sides), and who cares about the facts!

So why force you to read a post on politics? Well, as a politician would say, “It’s their fault” (cue: Our Man pointing in the direction of various friends who’ve attempted to get him to discuss politics over the last 2 weeks. You know who you are). I can’t blame you for turning away now, but if you can stomach it, here are Our Man’s thoughts on some political topics:

Does a Republican House suit President Obama?
Firstly, I’d note that the biggest impact on Obama’s presidency (2011-2012 edition) probably won’t be the election results tonight! It was likely Peter Rouse replacing Rahm, on at least an interim basis, as Chief of Staff.

While most, especially the market, are assuming that a Republican House means gridlock and that’s a good thing, I’d instead ask if a Republican House suits the President? Doesn’t it allow him to do what he does well – sit above the fray, and broker consensus building agreements between the Senate and the House? And given Republicans control the House, doesn’t it make it harder to characterize the President as a Socialist when you’re writing the bills and sending them to him? And if you’re in power, and control the House (which writes the legislation) it’s probably somewhat harder to be the party of “No”…without taking a hit from the public for it.

The most important post-election story for the markets
Won’t be an extension of the Bush Tax Cuts (more on that below), but will be the chairmanship of a sub-committee of the US House of Representatives Financial Services Committee. Yes, you read that right. Why? As among the roles of the Domestic Monetary Policy & Technology sub-committee are the Oversight of Emergency Authority and the Audit of the Federal Reserve. Oh, and the ranking minority member (and thus presumably favourite to become Chairman of the sub-committee) is a certain Ron Paul. Yes, the Ron Paul who published a book in the last 18months called “End the Fed”.

Bush Tax Cuts and Wealth
While there is much debate as to whether the Bush Tax Cuts will be extended, and for whom, the debate is likely moot. In all reality, the current Congress will let them expire and the new Congress will pass something with even the President willing to extend them for those making up to $500K/$1million. Given that, according to the IRS, less than 2% of US households make even $250/year the debate about whether the tax cuts should be extended for those over $500K or $1mn will have little impact on the majority of society. Thus Our Man's view of how far up the tax-cuts are extended is, in Snoopy-style, to go Bleah!

Before I venture off further into contentious ground, let me end this blog post with a Rawls-ian thought experiment. Imagine splitting the US into wealth quintiles (or fifths, as I personally like to call them) from the wealthiest (top 20%) to the least wealthy (bottom 20%), and ask yourself: i). To estimate how much wealth do each of these quintiles currently represent as a % of the total? (i.e. Top 20% currently represent A%, Second 20% represent B%, etc) and ii). To construct a distribution of wealth, that in an ideal world, you think would be fair (i.e. Top 20% should have X% of the wealth, Second 20% should have Y%, etc)

Thankfully, I’m not crowdsourcing, but a recent paper by Michael Norton (Harvard Business School) and Dan Ariely (Duke University) actually asked these kind of questions in a nationally representative sample and their results are below. You’ll note the irony that people’s estimates were almost (identical irrespective of sub-group) and their ideals were also broadly similar, but neither was a good reflection of reality.

October Review

2010-10-30T15:25:00.001-04:00

Performance Review
October proved another strong month for equities as the economic data continued to point towards lackluster (but positive) growth and there were further signs that the FED will launch a second quantitative easing program (QE2) in early November. Unlike September, the portfolio was unable to perform positively spending the majority of the month fighting to stay around flat before succumbing in the final week, ending the month down 1.65% (putting the YTD at +6.9%).

The Treasury Bonds bucket drove the negative performance during the month (-156bps) as the long-end of the curve suffered throughout the month as a result of the various discussions on both the size of QE2 (ranging from $100bn/month for a number of months, to a shock-and-awe $1trn+ in the short-term) and where it would be focused (with consensus being that it would likely not be heavily in long-end Treasuries). Furthermore bonds all suffered from proclamations of an end to “bull market in bonds” but various market participants, most notably by Bill Gross (though it should be noted that he also proclaimed a bear market in bonds in mid-2007). Unlike the Treasury bucket, the Bond Funds (+8bps) managed a small positive gain, in part due to their exposure to shorter duration instruments.

In contrast the fund’s equity positions again benefited from the rise in the markets. The Value Equity bucket (+37bps) was the primary contributor, on the basis of a strong performance from DRWI following decent guidance from management. The Other Equities bucket (+28bps) and the NCAV bucket (+1bp) also helped performance during the month. Against these profitable Long positions, the Hedges/Put options (-75bps) and the China-Related thesis (-<1bp) were negative contributors. The newly-started Currency bucket also posted a small loss during the month (-7bps)

Portfolio
43.0% - Long Treasury Bonds (20.5% TLT and 22.5% in the Aug-29 Bond)
14.7% - Long Bond Funds (6.8% HSTRX, and 7.9% VBIIX)
6.8% - Value Idea Equities (4.5% THRX, and 2.4% DRWI)
4.4% - NCAV Equities
3.1% - Other Equities (1.6% NWS, 1.6% CMTL, and 0.0% SOAP)

-0.0% (delta-adjusted) - China-Related Thesis (<1bp premium in FCX put)
-3.9% (delta-adjusted) - Hedges/Put Options (6bps premium in S&P 2010 puts, 68bps premium in S&P 2011 puts and 5bps premium in a GS put)

5.5% (leverage-adjusted) – Currencies (EUO, Ultrashort Euro, 2.76%)

24.4% - Cash

Portfolio Update

2010-10-28T17:07:00.001-04:00

Not much has changed with the portfolio over the last few months, so this represents the first update in a while following a couple of trades in the last day or so.

In the NCAV bucket, while there has been no further news on the QXM situation since the last update, the last little bump in the stock put it up over 65%+ since inception. As such, in accordance with the NCAV bucket's selling rules I have cut half the position. The same is true of CNTF, which was up around 75% since inception.

Finally, in a follow-up to the recent post on currencies, a new theme or bucket was started (which I’m titling “Currencies”, catchy isn’t it!) with the addition of EUO (A 2x Short Euro vs. USD position). The recent hints of more Greek accounting issues and the Euro meeting continued resistance once more at $1.40/Euro was the tipping point for me to put on the trade, which is initially sized at c3% NAV (though remember, it’s a double leverage position so it will have the impact of a 6% position size).

The next week promises to be a bonanza of macro-related news; with Q2 GDP out on Friday, US mid-term elections next week and then (not to be left out) the FED telling us how much money they intend to throw at the problems (and how frequently) through QE2. It will be interesting to see how markets respond to all this news, and whether the response in the coming weeks matches the initial response.

Some Initial Thoughts on Currencies

2010-10-20T22:02:00.003-04:00

While not much has happened in recent months to warrant changes to the portfolio, the single most interesting thing has been the march of the Yen. As this graph shows, the yen has continued to strengthen (a drop in the graph = yen strength, and dollar weakness) fairly steadily throughout the period and this has also been broadly true since mid-2007.

As you can see the big spike in mid-September was when the Bank of Japan announced it would intervene to slow the yen’s rise (during September it bought sold 2.12trn yen and bought $25.4bn). The alert amongst you will have noticed that September’s intervention wasn’t sterilized (i.e. the Japanese just printed the money and then bought dollars with it) as Japan again tries to create inflation.

With the yen having started rising again, we have unsurprisingly seen the Bank of Japan moving to employ new ways of trying to prevent the yen’s rise, including asset purchases of corporate bonds, real estate trusts and even stock funds!

But, why’s this interesting?
Well, because Japan’s government bonds have (again) become a popular theme on the short side with Kyle Bass, amongst others, eloquently stating the case (here on CNBC). A corollary to this is the generally held view that the yen should be far weaker, with various Japanese politicians (not to mention various financial folk) others suggesting a 120 Yen/Dollar rate as being ‘fair’. Over time, I have great faith that both those who are short the yen and JGBs will be proven correct. I can’t help but wonder, however, if in order to see the yen move to the 120-140 range that people predict, we won’t have to see it reach the other extreme (i.e. the Yen at 50-60) first!

Perhaps, the move that’s currently underway is the start of a spring uncoiling, after all Japan’s consistent trade surpluses (and the foreign reserves that they’ve build up) mean that the Japanese (like everyone else) are short the yen. If people start to unwind those positions and the stronger Yen causes Japanese exporters to struggle (and potentially need to take on more debt…thus increasing the demand for yen) then things could get really interesting. The irony is, of course, that if the Japanese government is successful with the asset purchases and even manages to create inflation, the victory will be pyrrhic (as the higher inflation will necessitate higher nominal interest rates on JGBs, hastening the default that the JGB shorts see coming).

So that’s my ponderings on the yen, interesting but given the scope of the move the risk-reward probabilities suggest that there’s nothing to do here, However, as mentioned back in the mid-year review, one of the things I have my eyes on is a short position in the Euro (vs. the Dollar)…something that’s not a popular sentiment these days.

The dollar has been unquestionably weak against the Euro over recent months (see this chart). It’s also expected to remain weak for the foreseeable future, with Europe countries having seemingly resolved their sovereign debt problems and the Fed poised to undertake another Quantitative Easing program (QE2). However, with a 10% move over the last month and sentiment so anti-dollar, is all the news priced in?

Certainly, it seems pretty certain that QE is coming after the Fed’s Nov 2-3 meeting with people now mainly arguing over the size (will it be $1trn at once in a shock and awe move, or $100bn a month for 6-12months?) and the instruments that will be purchased (predominantly Treasuries, but potentially also some munis). For those who’re wondering why the QE is seen as such a sure thing; through Bernanke’s statements (and those of his cohorts, like Charles Evans), it’s become clear that there seems to be consensus for it. The only thing that the Fed fears more than inflation is deflation; and if a picture’s worth a 1,000 words, then the Fed’s fears can be summed up in this one chart (source: SF Fed):

As for Europe, are the sovereign problems are resolved (with Portugal, Ireland, Italy Greece and Spain now model sovereigns with no real probability of default) or has the ECB’s program to back-stop the debt provided suitable liquidity to push the questions of solvency further down the road. I would suggest that a real solution to the problem of excess debt is unlikely to be found in taking on more debt, and programs that facilitate this rather than looking for a better long-term solution are likely to eventually fail. While the ECB’s moves have succeeded in pushing the spectre of European sovereign failures from the front pages, they haven’t addressed the underlying problem (too much debt!). Furthermore, I would expect that any recurrence of the fears that we saw earlier in the year will be reflected in the Euro’s performance.

Longer-term, as readers know, I believe that the problem of excess credit/debt will be solved either by paying back the debt or by defaulting on it (and the creditor having to write-off that debt). When you payback debt (and don’t replace it with new debt) or write it off then dollars are removed from the system…and the dollar, like all things that become scarcer, will go up! While the scale of the Fed’s QE is expected to be large ($1trn), it pales in comparison when we consider that about 50% of the world’s debt issued is denominated in dollars. As such, there’s likely to be a meaningful opportunity to go Long the Dollar (vs. the Euro) in the near future.

Things from my Google Reader...

2010-10-07T18:16:00.000-04:00

You may have noticed posting has been rather light recently, and there are of course some fine excuses for this. In part it’s because Our Man has been scouring the market for a job, and hence spending a chunk of his time preparing for and being in interviews. However, it’s also large because there’s not much to do at the moment – I’m relatively comfortable with the portfolio and while there’s a little bit to do on some of the other themes that are on deck, you know what they are (Energy Storage and Water). Finally, I’ve also been doing a little bit of pondering on currencies, which I’ve mentioned before but is a new area for me. In some ways, they (or rather the ETFs related to them, since I can’t actually hold foreign currencies) seem like the best way to play some of the animal spirits and trends that I’m seeing in the market so expect some preliminary thoughts on that.

However, here are some of the things that I’ve been reading recently and have found thought provoking. Like the “Chartology” series, expect to see “Things from my Google Reader” series to appear irregularly but hopefully serve as something interesting (if nothing else they’ll at least be a good way for me to find links back to these articles in the future).

(Spoiler Alert: I’ve put the finance ones at the top and non-finance ones at the bottom)

- A Gold Valuation Model: Talk about gold is everywhere at the moment, with lots of people saying it’s going up but…how should you value gold? It has no earnings, and its value comes from people’s belief in its value (kind of like those much derided fiat currencies…). Here’s a model worth thinking about from Eddy Elfenbein, at Crossing Wall Street.

- The politics of Chinese Adjustment: As you know, I’m not a China bull (see here and here), in part because of the economic imbalances that I see in their economy. In this post on his blog Peking University Professor Michael Pettis looks through the sequence of steps on rebalancing those imbalances.

- Beware of Greeks Bearing Gifts: In case you thought that Greek crisis thing was all over, here’s a really good (and easy to read and understand) article on it by Michael Lewis, at Vanity Fair. It’s right on the Money(ball)!

- Fractals and the Art of Roughness: Our Man often makes references to trading time being slow or fast, to fingers of instability and glimmers of hope, etc when talking about the portfolio and markets. All are related to do with the fractals and roughness, and if you’ve ever wanted to know what the hell that means…here’s a video of a talk by the father of fractal geometry, Benoit Mandelbrot (at TED 2010) that introduces the subject gently. (For those who're tired of the finance-related links, here's JJ Abrams talking about Lost and other mysteries at TED 2007).

- Scared of Mathematics (and other educational things): Learn everything you fail to remember from school at the Khan Academy. Apparently even Bill Gates likes this former hedge fund guy’s easy to understand bite-size videos on a variety of subjects. (Fortune)

- Nolan and Ichiro: Is Nolan Ryan the Greatest Pitcher Ever? Here’s a finely constructed argument saying that though Nolan is great, he’s not the greatest (ditto for Ichiro). (Joe Posnanski).

- The Fan Experience at Sports Events: Never Look Down: Mark Cuban’s thoughts on what it should be like to go to a game. As a football (aka soccer) loving Brit, it doesn’t quite resonate with me (soccer doesn’t have the non-playing time during the game that US sports have, and by the virtue of being relatively rare goals feel special vs. baskets/runs) but I can certainly see why it makes sense.

September Review

2010-10-02T14:23:00.002-04:00

Performance Review
September proved the strongest month for equities in some time as a result of both economic data steadying and market participants becoming more confident that the FED will launch a second quantitative easing program (QE2) in early November. Despite this move towards a risk-on sentiment in September the portfolio was able to eke out a small gain of 0.72% (putting the YTD at 8.7%), though this pales in comparison to the strong performance of most markets.

Unsurprisingly, the Treasury Bonds bucket was a large negative contributor (-87bps) as it suffered heavily in the first half of the month from both the reduction in risk aversion and fears about QE2’s impact on long-term government finances. The Bond Funds (+7bps) also suffered during the first half of the month, but were able to benefit more from the recovery in the 2nd half of the month.

In contrast the fund’s equity positions benefited from the rise in the markets, with Other Equities (+44bps) and NCAV Equities (+33bps) both contributing well. However, the main driver of performance in September was the Value Equities bucket (+209bps), which was driven by the position in THRX (+174bps) following some Phase II trial results (if circumstances allow, the position in THRX will be trimmed a little). Against these profitable Long positions, the Hedges/Put options and the China-Related thesis were negative contributors (130bps).

Portfolio
44.0% - Long Treasury Bonds (21.2% TLT and 22.8% in the Aug-29 Bond)
14.4% - Long Bond Funds (6.6% HSTRX, and 7.8% VBIIX)
6.4% - Value Idea Equities (4.3% THRX, and 2.0% DRWI)
5.0% - NCAV Equities
2.8% - Other Equities (1.4% NWS, 1.0% CMTL, and 0.0% SOAP)

-0.0% (delta-adjusted) - China-Related Thesis (1bp premium in FCX put, <1bps premium in EWA put)
-7.0% (delta-adjusted) - Hedges/Put Options (27bps premium in S&P 2010 puts, 101bps premium in S&P 2011 puts and 24bps premium in a GS put)

25.9% - Cash

NCAV Q2.5-10

2010-09-27T19:19:00.000-04:00

As promised, a September update on the NCAV screen was run at the end of last week. It resulted in 3 new names finding their way into the Absolute Value bucket portfolio (for information on the this bucket, and how it works, read here), they are:

- LAB (LaBranche) which had a market cap $165mn (vs. a 65% NCAV of $173mn)
- NED (Noah Education Holdings) which had a market cap of $88mn (vs. a 65% NCAV of $91mn)
- IESC (Integrated Electrical Services Co) with a market cap of $50mn (vs 65% NCAV of $55.5mn)

Additionally, a number of the existing holdings (AVTR, BXG, LTON, TWMC and XIN) reappeared on the screen. As such, the final date when these names have to be sold has been extended (here are the rules on when NCAV names must be sold).

Finally, there was one bit of news on a name within the bucket; in early September, QXM was subject to a take-over offer from its majority shareholder Qiao Xing Universal Resources (XING) of $0.80 in cash and 1.9 shares in XING for each of share in QXM. This is potentially worth $3.65 (XING closed at $1.50 today plus the value of the $0.80 in cash) or about 10% above QXM’s closing price ($3.35). However, a special committee of QXM’s directors has asked for more time to analyze the offer; a number of the minority shareholders have said that the offer is too low (it is below the NAV/share and Cash/share of QXM as of their 6/30/10 financials). I am waiting to see what the Special Committee recommends (and whether the bid is raised) before taking any final action

One Year In......

2010-09-13T23:22:00.007-04:00

(Apologies to all the people who're seeing this post again. I was trying to spruce up the blog while watching Monday Night Football, and somehow managed to delete the original post from the weekend. As such, here it is again with some bonus statistics thrown in!)

It’s strange to believe it, but this week saw the one year anniversary for the portfolio, which started on 7th September 2009, with this blog following with its first posts in October. As such, what better time for a small array of tit-bits related to the portfolio’s first year.

As you know the portfolio exactly reflects Our Man & Mrs OM's investments, and here's what the NAV (base = 100) looks like:

And for those who’re a little more mathematically orientated, here’s the key statistics (based on Yahoo’s S&P daily data):
Ptf’s Annualized Return: 11.1%
Ptf’s Standard Deviation (based on daily data): 7.4%

(a bonus statistic, for those reading this again; 54.1% of days have been positive. A second bonus statistic is that on those positive days the portfolio has an average return of +0.36%, which is a little better than the corresponding loss of -0.34% it's suffered on the average negative day).

Alpha (vs. S&P 500): 11.7%
Beta (vs. S&P 500): -0.10
Correlation (vs. S&P 500): -0.27

None of the S&P-related statistics above should be entirely surprising, given that the Long position in Treasury Bonds has been both the largest and the only one held since inception. The original thoughts behind it are still largely valid today, though Our Man was unquestionably early (and too large!).

August Review

2010-09-01T12:52:00.001-04:00

Performance Review
August proved a successful month, with the portfolio returning +3.36% (putting the YTD at +7.9%) after rebounding in the final couple of days of the month to recoup almost the entirety of the Friday 27th’s loss (at 135bips, this was the portfolio’s single worst day since inception). After last month, it was good to see the portfolio behave far more in line with expectations during August.

The Treasury positions, which I’ve expected to be the driver of returns until the equity markets are noticeably lower (or higher) was dominant contributor (+331bps), with the Bond Funds also making a healthy contribution (+37bps).

The Equity positions were not as successful, and combined to be a small detractor from performance. The Value Equity book (-68bps) almost entirely due to the position in THRX, which as a developmental drug company particularly suffered from the risk aversion during August to trade back down to the bottom of its recent range. The NCAV book (-26bps), which is populated with micro-cap names, also suffered heavily from the increased risk aversion. The Other Equity Book (-13bps) was a small negative contributor. Against these negative contributions from the Equity positions, the Hedges/Put Options (+77bps) managed to offset a decent proportion of these losses. The Short China thesis (-1bp) has fallen to such a small part of the portfolio, that it had no meaningful impact on returns. While I believe the thesis (Part A, Part B, Part C) holds the timing has so far been far too early, and the question is whether and when to add additional positions (with longer duration) to increase the exposure to the theme.

Portfolio
45.2% - Long Treasury Bonds (21.97% TLT and 23.23% in the Aug-29 Bond)
14.4% - Long Bond Funds (6.6% HSTRX, and 7.8% VBIIX)
4.3% - Value Idea Equities (2.6% THRX, and 1.7% DRWI)
2.9% - NCAV Equities
2.4% - Other Equities (1.4% NWS, 1.0% CMTL, and 0.0% SOAP)

-0.1% (delta-adjusted) - China-Related Thesis (5bps premium in FCX put, <1bps premium in EWA put)
-10.6% (delta-adjusted) - Hedges/Put Options (82bps premium in S&P 2010 puts, 120bps premium in S&P 2011 puts and 56bps premium in a GS put)

27.9% - Cash

And now for something completely different; Mrs. OM has kinds informed me that the link to the Magic of Procrastination, in yesterday’s suggestion of things to read, didn’t work. That’s been amended now, and here it is for those wanting to click straight through.

Back from Vacation

2010-08-31T20:44:00.001-04:00

After a rather delightful sojourn to see friends and family in London, and then on to a couple of Greek Islands (including the one of Chios, where we got to enjoy a friend’s traditional Greek wedding), OM and Mrs. OM are back from their summer vacation.

It goes without saying that we arrived back (on Friday 27th August) just in time to see the portfolio’s worst daily performance since inception (-1.35%) as a combination of a good GDP downgrade (!) and a Bernanke speech helped buoy the markets and setback the grinding lower of Treasury yields. While not a vast amount happened in terms of price action while we were away (equities were mildly lower and even with Friday’s widening, Treasury yields had compressed marginally) it does seem that the incremental macro data points that have been coming out are slightly more negative. With the month having just ended, I’ll save more information on performance until the monthly review.

However, since I’ve spent much of the last few days catching up on reading (via my Google Reader) here are some of the interesting stories that caught my attention:

- Japan and the Ancient Art of Shrugging: Some thoughts on Japan’s lost decade(s) impact on the younger generations (Norihiro Kato, NY Times)

- Bernanke’s Blind Spot: My favourite economist’s critique of the Fed Chairman’s Friday statement (Steve Keen, Business Spectator)

- Friedrich Hayek’s Nobel Prize Lecture in 1974: it shows a prescient understanding of his profession’s failings. (Friedrich August von Hayek, Nobel Prize Website)

- The Magic of Procrastination: A Behavioural Finance Professor’s way of solving the behavioural biases/issues regarding when students’ do the work they have to turn in. (Dan Ariely, his blog!)

- Roads Gone Wild: About Hans Monderman, who’s leading the charge to turning 80-years of traffic engineering on its head and taking advantage of behavioural biases in doing so (Tom McNnichol, Wired)

- On the Shoulders of Giants: Could Spain, if it embraces structural reform, be the next Germany? (Edward Hugh, Credit Writedowns)

NCAV Q2.0-10

2010-08-13T11:48:00.000-04:00

While second quarter 10-Q’s haven’t all been filed with the SEC yet, I am disappearing off on holiday tonight with Mrs OM, so it made sense to run a NCAV screen before I departed. Another will be run in September, to make sure we catch anything that might have slipped through the net.

The disappointing news is that there were no new stocks to add to the portfolio, though existing holding BXG passed the screen (with updated Jun-10 data) and hence it’s sell-by date is extended. Five other existing holdings passed the screen (AVTR, LTON, QXM, TWMC and XING) but in all cases the Financial Statements were stale and as such their sell-by dates are unchanged. As a reminder, the sell-by dates represent 12-months from when a company last passed the screen (with up-to-date data) and is when the holding will be sold should none of the other “sell rules” come into effect before then. The current sell-by dates for the existing holdings are:
1st April 2011: AVTR
7th May 2011: CNTF, LTON, TWMC, XING
12th August 2011: BXG

The following stocks also passed the screen but were rejected for qualitative reasons; FMD, MYRX, NINE, NUHC and NCTY were all rejected due to stale Financial Statements (largely as they were using December 2009 Financials) and PCC & STU was rejected as 'Financial Companies' (i.e. the screen used total assets, not current assets, to calculate the Net Current Asset Value).

Given that I’m away for the next couple of weeks, expecting posting to be non-existent barring a major move in the markets.

Energy Storage – Lead Acid Batteries: Part B

2010-08-13T00:58:00.002-04:00

Following on from our introduction to Lead Acid & Lithium-Ion batteries and the overview of how batteries fit into the Energy Storage theme, now is a good time to go into greater depth.

When we’re talking about batteries, for vehicles or energy grid storage, we’re really talking about “battery packs”. In lead-acid world this is typically six cells in the same hard plastic box (think your car battery). For Li-Ion (or NiMH, as used in the Prius) the basic building block is the battery cell that you have in your cellphone or camera. These cells are strung together depending on what you’re powering; 12 or so for a laptop battery pack, 75 for an electric bicycle, 1,000 for a hybrid electric vehicle (HEV) and somewhere around 5,000 for an Electric car. It’s useful to know this as it helps us put into context two things that matter when considering batteries; volume/weight and price.

Volume/Weight
I’ll touch on volume/weight first, since it’s the smaller of the two issues; while lead-acid batteries have been prevalent in our vehicles for a long-time, their volume and weight were the reason they never made it to our handheld devices. In essence, they couldn’t provide the power that was needed in a small and light enough form to be useful in hand held devices. The best estimates suggest that for a full hybrid car, a Li-Ion battery pack would weigh around 75-100lbs and take up about 1 cubic foot less than the necessary Lead-Acid battery pack. While this is a clear advantage, it shouldn’t be a determining factor when deciding which technology to use as a car weighs around 3,000lbs and the boot space (as we Brits call it) is 10-12 cubic feet.

Price
Unlike in existing applications (from cars to cellphones), the price of the battery actually has a material impact on the price of a hybrid car. The proposed fully Electric Vehicles, such as the Nissan Leaf and Chevy Volt are both priced at well over $30K (before any government rebates), in part because their battery packs cost somewhere between $12.5-$18K. More generally, there is a lot of argument over the costs of production given that none of batteries are produced on mass scale. As such, I’ve gone with Sandia National Laboratories who in a July-2008 report for the Department of Energy estimated the current cost of battery packs at $500/KWh for Advanced Lead Acid Batteries and $1,333/KWh for Li-Ion batteries. This would imply the following cost structure:

In the context of the typical $15,000 to $20,000 cost of a regular car these numbers should have some impact, even given the likely dominance of mild/micro hybrids in the coming years.

However, things are not so simple and a major point of contention is that the Li-Ion manufacturers claim that they can reduce the price per KwH “substantially” or “once the batteries are in mass production.”

Unsurprisingly, it’s a fairly big argument over in battery-world and given it’s entirely about forecasts there isn’t yet a right answer. My thoughts are as follows:

- The don’t currently: No US listed public company has managed to get to even get to the mass production stage, and the $1,333 number is a reasonable estimate of their current price (e.g. using A123’s latest 10-K shows its cost of production (excluding all R&D, let alone any profit) was around $1,250/KWh).

- Raw materials: If you speak to the companies (or listen to the calls, read their presentations, etc) there is a clear belief that raw materials won’t be a problem for them on the cost side. Logically, this seems strange. Let’s make some really generous assumptions; over the next 5 years, Li-Ion use in hybrids (like the Prius and assuming no sales of any plug-in vehicles) captures a mere 15% of the US market (and nothing abroad!) and the US car sales stay at c10mn (i.e. no increase from 09-10 numbers). That would be 1.5mn battery packs that would be sold per year; the equivalent of 1.5bn cellphones/year (currently c1.25bn/year sold) or 125mn computers/year (currently 300mn/year sold). Given Lithium mines don’t start overnight, and the growing demand for Lithium in other battery-operated products (like Mrs OM’s shiny new iPad), I would think there would be some price impact from a new industry suddenly stepping in with big demand.

- Physics Envy: This is the most interesting but the least considered problem, largely because it’s behavioural (some might say obtuse) in nature. A core of the argument for Li-Ion’s ability to reduce future manufacturing costs as production increases is because we’ve seen it before. More specifically, our recent experience with technology and computers has shown us that it’s possible to increase production, innovate and reduce price…all at that same time. For example, our computers are far better than they were 1, 3, 5 and 10years ago yet they cost less. This has been Physics’ gift (more specifically Moore’s Law) to the world over the recent decades. Given that most analysts who cover Li-Ion battery companies come from the Technology world, it’s not surprising that there’s acceptance that progress in batteries can be similar to that seen in computing. There is one major flaw in this belief; batteries produce energy through chemical reactions, thus the ability to get more energy from them is likely to follow the laws of chemistry, not physics! These laws most assuredly operate differently, they won’t prevent existing technologies from being improved, or new one’s found, but they likely will prevent small tweaks to existing technologies from creating huge and continuous leaps forward.

- Safety & Lifespan: While these two issues are largely ignored in the discussion over Li-Ion batteries, they are the great unknown. Safety questions over Li-Ion batteries flared up again last year (after causing a fire on a plane) and as anyone who’s ever used an electronic device knows, lifespan is always an issue (think how your cellphone battery loses its ability to charge fully and then imagine that happening to your car battery). Simply put, we just don’t know if a Li-Ion battery pack can attain a 15-year life (and the 1000’s of cycles that entails) that is currently standard for a car battery or whether they will function effectively in various conditions (inclement weather, etc) as required.

As such, you can see some of the reasons for my skepticism that we will see Li-Ion battery packs in our mild/micro hybrids in the immediate future (though I’m sure we’ll see them in expensive ego-cars or gimmicks, which the car companies have more interest in talking about than mass producing).

Advanced Lead-Acid Batteries
The observant amongst you will notice that I didn’t compare the Li-Ion batteries with the traditional Valve-Regulated Lead Acid (VRLA) batteries, but instead with Advanced Lead-Acid (largely Carbon-enhanced Lead-Acid) batteries. While they’re not sexy or cool, like their Li-Ion counterparts, they are a technological jump from existing VRLA batteries that look like they can fulfill our vehicular needs (potentially all the way up the hybrid chain). There are a number of companies working on Advanced Lead Acid Batteries, including Firefly (spun-off from Caterpillar), C&D Technologies, Furukawa/CSIRO and Axion Power. I’m going to focus on the last 2, since I know them the best and their efforts appear the most promising.

Australia’s national science agency, CSIRO, developed the Ultrabattery and has licensed it out to their partner Furakawa (a Japanese Company, who sub-licensed it to East Penn. Manufacturing for the NAFTA area). Interestingly, Furukawa successfully tested prototypes of the Ultrabattery in a Honda Insight hybrid back in 2007/8, confirming the viability of the project. They also submitted the UItrabattery to Sandia, where it was tested alongside other batteries in a DOE Storage Systems Research Program. The key graph is this one:

As you can see the Ultrabattery’s performance was a significant improvement on the VRLA battery and comparable to a Lithium-Ion battery, again suggesting that the technology is viable.

Axion Power began making and testing a Carbon-Enhanced battery (called a PbC battery) back in 2003. One of their early aims was to try and create a technology that could easily be implemented in the existing Lead-Acid battery plants around the globe, with minimal capex required. It’s a project they’ve been working on, at their own lead-acid battery plant in New Castle. They also began testing, initially with a large battery pack (called a Power Cube) at a NYSERDA-funded program to store energy from a solar power system at CUNY College. However, in the last year or so things have progressed quickly and they have also moved to test their battery in vehicles, signed a worldwide supply agreement with Exide (the 2nd largest Lead-Acid battery maker for vehicles) and received a joint DOE-grant with Exide for the production of PbC car batteries.

Next time: While we have 2 interesting new technologies (Li-Ion and Advanced Lead-Acid), and an incumbent technology (VRLA), it all means nothing for an investor without looking at valuation. As such, in what’s probably the final part of this series, we’ll take a peek at how the companies are valued.

I hope you've had your Wheaties...

2010-08-06T14:45:00.001-04:00

As a brief addendum to the recent portfolio update, one thing I failed to mention as part of my willingness to carry the extra put exposure is Wheat. It’s not normally something I look at, but the recent news and moves on wheat are certainly worth considering...

The long-term bull story for Agricultural products is very well known, and relatively simple – world population is growing rapidly (see graph below) and hence both demand and expected future demand for grains/food are rising. Historically, technological advancements such as dwarf wheat (for which the late Norman Burlaugh won a Nobel Prize) along with other genetic modifications to crops (e.g. to be able to resist pesticides, etc) have helped supply keep pace, but there are signs that this is meeting headwinds and slowing.

In the short-term, a drought in Russia that has led to reduced production there and a Russian ban on wheat exports has caused a big spike in Wheat prices (n.b. remember this when we see future headline inflation numbers). What’s interesting, in the longer-term, is this spike has caused prices to break out from the large base that has formed since late-2008.

If this current drought’s impact on prices proves to be a temporary (which it should) then wheat’s likely to fall back to that base. For the technicians amongst you, that could form a bullish flag or a rising wedge, which would be the time to buy for the long-term. If this was accompanied by a change in the global wheat stocks to usage ratio (i.e. there were signs of a shortage of wheat) in addition to the long-term bull story then things might getting really interesting!

However, as the graph above shows, we’re clearly not there yet. Nonetheless, while it’s something that’s hard to execute efficiently (GRU - appears the best bet, and even it is <50% direct exposure wheat) for those (like me) who don’t have a commodities account, it’s definitely something to keep in the back of your mind as with the charts as well and long-term/short-term fundamentals threatening to line up it could prove spectacular!

Portfolio Update

2010-08-03T16:33:00.000-04:00

This is the first portfolio update since May, a reflection of how quiet trading time has been for the book over the summer. A couple of trades today; increasing the size of the SPY 100 strike with Dec-10 expiry put and adding two more market hedge (SPY 100 Dec-11, SPY 65 Dec-11).

The moves reflect a couple of things which have different time horizons. They reflect a rolling over the market hedges (from Dec-10 expiry to Dec-11) as was discussed in the recent Portfolio Thoughts. However, the roll isn’t complete as not only have I retained the pre-existing SPY put (strike 100, Dec-10 expiry) rather than sell (and thus complete the move) but I’ve also added to it today. Whereas the rolling of the hedges can be thought of a strategic move (essentially paying a cost for lengthening maturities), the retention and addition to the existing hedges is tactical. There reasons are manifold but it reflects my belief that there are a number of technical resistance points near here (1,140-1,150 range), that the expectation of a double dip is underpriced (e.g. JPM amongst others, expect the first revision to Q2 GDP to come in at 1.7% vs. 2.4% originally reported), and that stocks remain overvalued (on long-term measures, like CAPE or Tobin’s Q).

Energy Storage Theme: How Lead-Acid Batteries Fit in…

2010-08-01T14:53:00.001-04:00

On reflection, Energy Storage as a broader title for this theme is appropriate as it is a better indication of where I see the opportunity in the long-term, with Lead-Acid Batteries likely to be the most effective way to express the theme in the short-to-medium-term.
Energy Storage broadly encompasses all of the ways that we can store energy for future use, for example through batteries, supercapacitors, and flywheels. There are 2 main areas that I think about as the primary uses for Energy Storage;
- Vehicles, where people are looking for a move from an internal combustion engine to a battery as the primary driver of propulsion. This is something I expect to happen using baby steps (i.e. lots of mild/micro-hybrid cars soon) as opposed to a giant leap (Plug-in Electric Vehicles tomorrow). This is one of the reasons that I think the incumbent technology (Lead Acid Batteries) is being under-rated.
- Power Storage (meaning Electricity grid-related storage, and Industrial-related storage). Unlike in vehicles, there are far more storage options in play here and most will find some role in what will be a massive market. As I’ve not talked much about this before, I’m going to spend the rest of this post talking about Energy storage and the power markets.

Why Energy Storage is becoming more important in the power markets
The easiest way to describe is to think through it aloud. First-off, our demand for electricity is pretty variable. Yes, it follows patterns both daily and seasonal, but it is variable around these broad patterns meaning that while an electricity company has a good estimate for the power they’re going to need to deliver in 30mins/60mins/4hrs/etc they don’t know exactly how much. Electricity’s also pretty binary; your TV can’t show half the picture, it’s either on and working or it isn’t! Hence when the electricity company can’t supply enough power, you get black-outs or brown-outs…which are no fun, and pretty unpopular. Thus, in the energy company tries to supply a tiny bit more power than is actually required at any given minute, and needs some easily accessible reserves if there’s a spike in demand.

On the supply side let’s consider that the vast majority of electricity is still being generated from fossil fuel power plants. Again, while the capacity that these plants are running is controllable, either the plants are running (at the desired capacity) or they’re idle. Now compare this to the alternative sources that have started to become more prevalent over the last couple of years, like wind and solar. The power these plants produce is far more variable and less controllable by man; after all is it suitably windy/sunny, how windy or sunny is it, what happens if there’s a cloud or a gust of wind, etc. Given the variability of these production methods, and how poorly electricity travels via the grid, it is clear that there’s a need to be able to store energy efficiently and to be able to supply it quickly and efficiently from this storage. Furthermore, in the case of solar, the electricity is being generated (during the day when it’s sunny) at a time when it’s not generally being consumed (the evening) thus there is additional need for storage.

As such, you can see how Energy Storage is considered by some as being an important part of the broader Clean Technology “revolution” that is underway.

Different Types of Storage/Needs in Power
An important thing to consider when talking about the power grid and energy storage is the need for different types of storage and delivery. This is due to the different time horizons for the power to be stored, and the differing speeds at which it might need to be delivered from the storage to the grid. For example, the storage and delivery periods for something attached to solar power plants might be hours (i.e. the storage device would be required to store the power for hours, the deliver it over a period of hours), whereas for other things the delivery period may be seconds (e.g. to smooth out the power sent to the grid), with everything else in between. This is important as those electricity providers only want to provide a tiny amount more energy than people need in order to maximize their profits. Furthermore, those technologies that are great at storing lots of energy are not so good at delivering it quickly (i.e. batteries can store a lot but don’t providing it quickly, hence there’s an opportunity for multiple technologies to play a role.

Given this there are other types of Energy Storage systems that we might look at in more-depth in the future, such as Flywheels (likely compete with Li-Ion/Lead-Acid batteries), Supercapicitors (likely will dominate the segment that requires power delivery in seconds), Other-type of battery (e.g. molten sulphur batteries, which can store/deliver power over a longer time period that Li-Ion/Lead Acid batteries) and Compressed-Air Energy Storage (which can deliver power over many hours, much longer than Li-Ion/Lead Acid batteries). However, I expect that Li-Ion and/or Lead-Acid Batteries in addition to being the only real players in the Vehicle space and will be amongst the major players here in the Power space. As such, that’s why they’re the logical first step for us to consider an investment.

July Review

2010-07-31T12:14:00.001-04:00

Performance Review
After my recent ponderings that the portfolio’s performance in the short-term was likely to be dictated the movement of Long-end Treasuries, it goes without saying that July’s performance was entirely driven by other factors. In truth, it was a messy month that was flattered by the final performance of -0.83% (putting the YTD at +4.4%).

The bond-orientated components of the portfolio were boosted by the strong rally in Treasuries during the final day of the month, after the initial Q2 GDP estimate came out. The results was that the Long Treasury Bond bucket (-9bps) and the Long Bond Funds (+14bps) ended up having negligible impact on the portfolio.

The NCAV bucket was the strongest performing part of the portfolio, contributing 32bps with almost every position helped, as it benefited from the rising markets and increased risk appetite throughout the month. The rest of the equity-orientated buckets were not so productive. The Value Equity bucket (+52bps) was a positive contributor, though DRWI was largely flat (though that could be considered a positive development, given its travails during the month. The Other Equity bucket (-34bips) hampered performance due to a large negative contribution from CMTL, after failing to win an army contract – unfortunately, there remains little one can do about the names in the Other-equity bucket.

The Short China thesis (-21bps) suffered as raw materials names rebounded following recent signs of growth in China steadying and as investors saw increased signs that the Chinese government would take steps to aid growth should it slow any further. The Hedge bucket broadly suffered from the broad market rally and corresponding drop in volatility, but also directly suffered as Goldman Sachs settled the recent case brought by the SEC, helping remove some of the uncertainty surrounding the stock.

Portfolio
44.0% - Long Treasury Bonds (21.0% TLT and 23.0% in the Aug-29 Bond)
14.5% - Long Bond Funds (6.7% HSTRX, and 7.9% VBIIX)
5.1% - Value Idea Equities (3.3% THRX, and 1.8% DRWI)
3.3% - NCAV Equities
2.6% - Other Equities (1.5% NWS, 1.2% CMTL, and 0.0% SOAP)

-0.5% (delta-adjusted) - China-Related Thesis (7bps premium in FCX put, <1bps premium in EWA put)
-5.2% (delta-adjusted) - Hedges/Put Options (34bps premium in S&P put, and 35bps premium in a GS put)

29.7% - Cash