Fingers of Instability & Glimmers of Hope -- An Explanation

This is Our Man’s way of (exceptionally broadly) applying the concepts of Bak-Tang-Wisenfeld’s sandpile model to how he thinks about investing. While Our Man has no physics background, he’s stumbled across various descriptions of the game (most clearly in “Ubiquity” by Mark Buchanan, which he recently re-read), and found the idea fascinating and most helpful as a discipline in thinking about the world.

So what’s the idea and what does this have to do with investing?
Bak, Teng & Wisenfeld model stems from their investigations into the instability of complex systems, and their discovery was that these systems tended to naturally arrive at a “critical state”, after which any sand grain landing in the wrong spot can start an avalanche. Furthermore, the size of the avalanche is the result of a domino effect – how unstable was where the grain landed, and did the resulting slide cause grains to move over other unstable spots thereby creating more slippages, etc. Clearly the number and size of the “fingers of instability” that are impacted (primarily, and as an after-effect) by that falling grain of sand will play a key role in determining how large the eventual avalanche will be.

Fascinatingly, Bak-Teng-Wisenfeld discovered a mathematical property connecting the number of grains involved in an avalanche and the frequency of an avalanche of that size. Simply put, if you doubled the number of grains involved in an avalanche it becomes about 2.14x as rare. Moreover, the presence of a power law, critical state, and fingers of instability appears to be more widespread; for example, in Ubiquity, Buchanan talks about how similar properties are found in the size of earthquakes, forest fires, scientific paper citations (as a proxy for “new” scientific ideas), deaths in wars & last (but not leastly) stock price fluctuations (though Benoit Mandelbrot deserves a big nod for his works on that specific topic, but Our Man shall leave that for another time).

As such, in an attempt to impose some discipline over his thought process, Our Man hopes to jot down some of the Fingers of Instability (that could drag stock markets downwards) and Glimmers of Hope (that could drag it upwards) to: help him remind himself what he was worried about at the start of each year, to provide a guide of things to keep an eye on during the year, and to look back on in futures and see what he missed & why. It should be noted that these lists are absolutely 100% NOT predictions (it’s a mug’s game) but are things that Our Man is watching out for, worried about, or hoping for – if other people call something a “Black Swan” (something, along with 20-standard deviation events, that Our Man doesn’t believe in) and it’s not on Our Man’s list, he just missed it…

Portfolio Update

You may have noticed, over the last few of days that Gold fell back into Our Man's stop loss range. Now given that Our Man is a fairly simple kind of chap and is unable to short-term trade his positions (given the investing constraints imposed upon him, not to mention the commission involved!), he's a big fan of having a Stop Loss range rather than a specific Stop Loss point. After all, how do you pick that specific point, without it being somewhat arbitrary?

A range also makes more sense to Our Man as it can help balance the two conflicting emotions; a desire to be patient with positions and to give them an opportunity to work, and the ex-post need* to be disciplined in managing risk. Thus by having a range Our Man is able to encapsulate a number of things into his decision such as key support levels (be they moving average related or just psychological round numbers like $1,100) and normal intra-day volatility.

Anyways, in this instance…Gold fell through $1,100 (a psychological round number) and the moving averages (support levels, in the $1,080-$1,090 range), touching and intraday an intra-day low of $1,074. Thus discipline trumps patience and Our Man exited just over half the Gold position at the equivalent of $1,085. The Gold position now represents 8.8% NAV, with the Cash position increasing to 29.5% NAV.

*Note that by "ex-post..." Our Man means the need to be disciplined in managing risk, after the decision to invest has been made. The ex-ante discipline in managing risk should (obviously) be done before making the investment and Our Man's consideration of risk is an important factor in both making the investment AND how the investment is sized.

2010 - Year of the Relapse?

While Our Man has stated his central belief is that this is a credit crisis caused by an over-leveraging of the consumer, he hasn’t really explained why. As everybody knows, a major driver of the US economy is the consumer…and the US consumer (including Mrs. OM!) loves to shop, can’t get enough of it in fact! Some might even say that the US consumer over-consumes! And we’re not talking too many Happy Meals here; we’re talking the kind of consumption that bears little resemblance to future income (wages, etc) but instead comes from spending the kids’ college fund (or your retirement fund, or taking the equity out of your home to spend it now, or just not bothering to save) and then relying on ever-increasing amounts of debt to support it!

They say a picture’s worth a thousand words, so here’s a picture illustrating what I’m talking about:

Now there are a number of reasons why this debt problem has come around (hello ‘free-market’ neo-classical economic theory that doesn’t really consider the level of debt, bank lending policies & financial engineering, and irresponsible US consumers, to name a few) but that’s not our concern today. Our concern is what does it all mean! Well, Our Man’s firmly in the camp that it means we’re in a credit crisis…that the US consumer instead of over-consuming is going to have try and deleverage and do some of that 'saving', which was popular back in the old days! He also suspects that it also means that this recession (dare he mention the ‘d’ word) is going to end up in 1 of 2 ways; a Great Depression style collapse (quick deleveraging, increased savings but reduced consumption) or a Japanese (sorry Mrs OM!)-style stagnation and lots of w’s (where uneven growth, often driven by government, gives way to another recession as the government steps away…leading to the government throwing $$ at the problem, ad nauseum while delivering takes a longer slower trajectory).

The government’s response has been simple; keep asset prices up (TARP, liquidity to banks, get rid of mark-to-market, etc), try to get the consumer to spend (and taken on more debt, cash-for-clunkers, first-time high buyers credit, etc) and throw money at the problem (Stimulus). Though you’ll notice very little on debt forgiveness and credit write-downs (though, Our Man supposes HAMP was an attempt at this!), it’s also fair to say that they’ve been very successful so far in producing GDP growth. The questions will come when the support is removed and the baton is passed to the private sector.

For the baton to be passed over smoothly it will almost certainly require the consumer to be willing to take on debt (or at least not reduce debt, and take advantage of lower interest rates to refinance/roll-over debt) and resume over-consuming. However, Our Man’s wager is that the hand-off will not go smoothly, and the Japanese W’s will raise their ugly heads. We may see the first signs of this in asset prices, after February when the FED’s move to single-handedly support the toxic assets is scheduled to be withdrawn.

So either way, Our Man looks at 2010 as the year of the relapse…it’s just a question of whether it’s the economy or the consumer who’s relapsing!

What does this mean for the portfolio; well this core view helps create a starting point and from there Our Man tries to consider the “Glimmers of Hope” and the “Slivers of Instability” that could impact the markets and his book. More on that, next time…

Mid-Month Update: Waiting for Godot…

Our Man, being of a more laconic nature, has never been accused of being “communicative” but he had hoped to stumble upon such a talent upon starting this blog. Sadly old habits die hard, especially when aided by distractions of birthday and holiday season. Nonetheless, after an impressively dismal run of performance to start December there is surely no better time for update!

So far, December has proved to be a microcosm of the scenario that Our Man fears most; a drifting market. It means, that in the absence of good news, the portfolio quietly bleeds a small amount as Our Man’ negative bets (through puts) quietly burn their theta (time decay), which his equity holdings barely offset this as they drift sideways. As such, the book’s performance is buffeted by the sparring forces of his (overly?) popular position in GLD (Gold) and his (overly?) unpopular position at the long-end of the Treasury curve (TLT). The two positions have combined fairly evenly for almost the entirety of the month-to-date losses and as the numbers below show, death by a thousand cuts never looks pretty…

Our Man’s Current Thoughts:

- TLT: Despite being the largest position in the book, the Treasuries position remains a comfortable one that Our Man would consider adding to in the future. The position reflects the underlying belief that we’re in a deleveraging cycle, as evidenced by the FED’s Commercial/Industrial and Consumer lending data, which will likely prove deflationary despite the FED’s attempts. Additionally, the position would also benefit from any flight to safety away from risky assets (in particular equities).

- GLD: As mentioned when the Gold position was cut-back, it is now a far more popular position than when it was originally put on. As such, Gold has also generated an array of articles from market commentators which run the gamut from “bubble” to “fair value of $6,000+”. Our Man’s thought process remains unchanged; Gold continues to be held firstly as a hedge against bad governance (by the Fed/Treasury), and secondly as a shorter-term momentum/trend play. In November, Our Man noted that he intended to place the equivalent of a rolling stop under 50-67% of the position once gold reached $1,250. While Gold never quite got there, it has retreated to the level where Our Man exited his first slug of his position and currently sits just above its 50-day & 65-day moving averages. Should it break these levels (c$1,080) then Our Man will be exiting at least 50% of the existing position.

On a more general basis, December has shown many of the potential risks that this portfolio could suffer from in 2010:

- How sideways markets will likely lead to small and steady theta burn that goes uncompensated by the equity positions
- How uncertainty over US government debt levels, increased supply of long-term bonds, and a lack of short-medium term clarity on inflation/deflationary trend, and no catalyst for a flight to safety will likely cause bond prices to drift.
- That whether or not Gold is in a bubble, its ride from here is likely to be more volatile…especially as the US-Dollar shows signs of strengthening.

November Review

Performance Review
November proved to be the strongest month in the portfolio’s short history, with the portfolio rising 6.43%. The portfolio was profitable throughout the month making money in every 5-day rolling period, and during both the strong 1st half of the month for the markets, and the more uncertain 2nd half.

The performance was again driven by the position in GLD (Gold ETF) which contributed over 500bips to the month’s profit following the barbarous metal’s almost 20% rise during the month. The position in L-end Treasuries (through L TLT, and an individual bond) contributed over 150bips as yields continued to tighten. As noted during the mid-month updates, the portfolio’s positioning changed significantly during the month and the new positions proved a small drag on performance.

Portfolio
The portfolio’s positioning is unchanged from the update a couple of days ago.

During December, Our Man hopes to discuss the following issues:
- 2010 Outlook and Positioning
- 2010 Alternative Scenarios
- China, and Our Man’s skepticism of its economic miracle
- Potential Investments that Our Man hopes to build during 2010

Portfolio Update

When Our Man mentioned on Monday that he was expecting inflows in the coming days, he did not have Tuesday morning in mind. Nonetheless, in they came and with trade approvals garnered from the requisite people, the portfolio was reshaped. A less charitable fellow would complain about the negative impact to performance (given it was a good day for both Gold and Treasuries) on the day, but not Our Man. The reshaped portfolio, as of close of business on 11/24 is below:

42.31% -- L 20Yr+ Treasuries (split almost evenly between TLT, and the 6.125% coupon Aug-29 Treasury Bond)
20.89% -- L GLD
7.43% -- L VBIIX (Vanguard Interm-Term Bond Index)
6.40% -- L THRX
4.02% -- L Restricted Equities (CMTL 1.59%, NWS 1.42%, CRDN 0.81%, SOAP 0.21%)

-4.45% (delta-adjusted) – L SPY Puts (Dec-10, 100 and 85 strikes, 113bips of premium at risk)
-1.74% (delta-adjusted) – L GS Put (Jan-11, 120 strike, 81bips of premium)

Portfolio Update

This is an unexpected update and due to a sore neck that Our Man claims is from looking at the soaring markets, it shall be a brief one. Somewhat to OM’s surprise, Mrs. OM has decided that he should be in charge of a more substantial part of their LNW and as such has suggested he take over the rest of their assets in the market. Thankfully, such generosity of spirit does not come with a ban on the words such as Japan, bubble, Minsky, credit contraction, deflation and Treasuries that Our Man has a tendency to throw around, and so unfortunately you will not be spared his ludicrous ideas.

As with all things in life, while the move almost doubles the size of the portfolio it also comes with some downside; in this case, it’s that these assets while predominantly in cash also contain a number of securities, some of which cannot be sold at the current time (due to the constraints that Our Man operates under). However, this is but a minor detail and the assets are expected to be co-mingled and the portfolio reshaped to reflect Our Man’s views immediately.

The timing also allows Our Man to use the moment to introduce some of the new ideas that he’s been considering. The most notable of these is by adding some medium-term high quality bond exposure to the portfolio, by adding some risk exposure to the book but by limiting the directionality of the portfolio by adding a substantial exposure to medium-term downside equity protection (through puts).

It goes without saying that the performance and exposures will include these assets, the moment they are co-mingled within the portfolio. As noted, the incoming assets are primarily in cash but also include the following:

- 1 TIPS Bond

As someone who prattles on about deflation, it’s unsurprising that OM will sell it immediately.

- 2 Intermediate Term Bond funds

Our Man expects to sell one (which holds 40% in pass through mortgage securities!), and substantially increase the size of the other Fund (VBIIX), which holds both Treasuries and Corporate bonds and (ironically) was amongst the list of potential bond funds that OM had been looking at.

- 4 Equity positions

These are positions that OM expects to be restricted from adding/removing from the portfolio (or in 1 case the commission would make it pointless to do so). While none of these names fall into the ideas that OM was considering investing, and add directionality to the book, they also make up a relatively small part of the book (OM estimates <4% style="">

- L THRX (OM doesn’t believe that it will be restricted)

However, it is a position that Our Man knows reasonably well, having done a stock pitch on the name just under a year ago while he was a loafing student, and having encouraged Mrs. OM to purchase it when she was considering adding exposure. Ironically, the stock trades today at almost the exact price that Mrs. OM entered the name (read what you will into that, about OM’s stock-picking ability!) and Our Man is secretly quite pleased to be inheriting this name. The sizing is a little large (6.5% of total assets, estimated), but OM is comfortable with the downside given the heavy equity put-hedge that he intends to apply.

Other portfolio moves that will be made, concurrently:

- TLT

So far Our Man’s exposure to long-end Treasuries has been through a specific bond; with the need to add to the Treasuries position in order to take long-end Treasuries back up towards 40% of the book, TLT will be added to the portfolio.

- Put Options (SPY and Financial Firm/ETF)

Our Man is largely constrained in expressing his negative views on things except via options (especially since he has no understanding why people with time horizon >1week would invest in Short/Ultrashort ETFs, and have the magic of simple mathematics working against them)

During December, we’ll look a little more closely at what Our Man suspects and fears could happen in 2010. Suffice to say, that it’s not likely the most bullish of views and this is reflected by a heavy put hedge on the portfolio. Our Man intends to buy Dec-10 options on the SPY, with a couple of different strikes (one close to at the money, one out of the money) and to do so now (rather than later/in the New Year) as he’s somewhat more skeptical of a strong run into year-end (potentially in the face of weakening data) than most.

In addition, there will also be a longer-dated option on a Financial Institution/ETF reflecting the belief that the “Credit Crisis” is in hibernation rather than over, and spread to prime mortgages, Option-ARM recasts (rather than resets) and CRE weakness will raise further issues for financial firms in 2010.

The premium is likely to be 2-3% of the total assets.

- GLD

The Gold position has proved the hardest to decide what to do with; while Our Man would like to add to it (to retain its % of NAV in the book), it seems like it will be somewhat impractical to do so. This a function of the gold price (now $1,170-ish), OM’s desire to run a ‘mental’ stop under the 50%+ of the existing position once it goes through the $1,200-$1,250 barrier, and given the constraints imposed (OM would not be able to trade in it again for at least 1-month). If the last issue wasn’t applicable, Our Man would double the position and continue with his original plan, but given its presence (and the pace at which Gold is moving!) OM is currently leaning (very frustratedly) to forsaking on adding to the GLD position and instead running that mental stop underneath a far smaller part of the resultant position.