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.

Portfolio Update

Just before the close today, after some pondering Our Man decided closed out 1/3 of the GLD position in the portfolio account, though GLD remains a sizable portion of the portfolio (see below).

But why so?
OM continues to lean towards a deflationary view of the world, and thinks that GLD offers a decent hedge against any and all of bad Fed governance, a weak currency and an EM-style ’sudden-stop’ and as such GLD remains a valuable part of the portfolio (especially given it is anchored around Long-end Treasuries).

However, there are a number of other things to consider, which reflect Our Man’s way of thinking. Conceptually-speaking Our Man doesn’t view his GLD position as 1 position, but rather mentally splits the holding to reflect 3 time horizons (though even this is a simplification, as he tries to view it in 2 dimensions, based on both time horizon and price). Thus he broadly viewed the GLD position as 25-33% short-term (c1-4mos), 33-67% medium-term (c4-12mos) and 10-15% long-term (12mos+). As such, today’s reduction represents the elimination of the original short-term position. When we began this portfolio in early September, gold was trading beneath its March-high but was threatening to break through these highs; hence Our Man thought it was a reasonable opportunity to take a short-term position.

Why sell now?
Firstly, price…gold did indeed breakthrough its March highs, and has continued to climb leading to a tidy profit on the short-term piece. Secondly, it’s a far more popular trade now (Our Man remembers when “activism” started to get viewed as a strategy, rather than as a tool for achieving an objective) and that brings inherent risks with it. Furthermore, Our Man wonders…if everyone believes that Gold is a good hedge against (inflation/bad FED governance/etc) does that mean it’s more likely to fail to behave as one? (He’s certain there’s a smart name for that type of thing, but can’t remember it) or more simply put, is Gold more likely to behave as a good hedge when it’s not widely held and subject to the investment whims, decisions and liabilities of the many holders? Finally, and relatedly, Our Man doesn’t believe in religion (never has, and despite Mrs. OM’s best efforts probably never will) and when he hears many rail with such certainty against fiat currencies and their weaknesses, even though Gold itself’s value is largely dependent on people’s belief in its value rather than its economic value, he cannot help but smile a little skeptically.

What about the rest of the GLD position?
Well, Our Man still believes that Gold has further to run…and would be looking to put in the equivalent of a rolling stop behind the 50-75% of the remaining position, should Gold run through $1,250. Should it fall back, through the March highs, he’s also likely to close out that portion of the holding.

However, things are never so simple and one-dimensional and Our Man also considers the portfolio context. Currently, with just a L TLT/20yr+ Treasury position that is simple, but Our Man has also been investigating adding some new positions to the portfolio both on the Long-side and the short-side (through puts). Should he do so that would impact the amount of market-related risk he would be willing to accept (either negatively, or positively, depending on the other positions)

Portfolio Positioning (cob 11/18/09):
L GLD 37.44%
L 20yr+ Treasuries 39.93%
Cash 22.64%

Disclosure: Long Gold and TLT/Individual 20yr+ Treasuries

The Plight of the Consumer

While we’re suffering through it, every recession is “special” with unique characteristics; however, as mentioned before the type of recession that Our Man fears is a ‘balance sheet’ recession as he’s not convinced that the power that be (let alone simpleton’s like himself) have figured out a way to get out of such a recession (see Japan). Thus, as we’ve also discussed before, he makes it a point to mosey on over to the FED’s website and take advantage of the voluminous information that they provide. Last week, we saw on how Commercial Bank’s lending to real companies (as defined by their Commercial and Industrial loans) provided unpleasant viewing and the pain has yet to show signs of abating. Today, Our Man thought he’d stop in and see how consumers are doing…

As you know, Our Man is a Brit and as such has great respect for the American consumer. In fact, when he was knee-high to a grasshopper his first ever money making scheme was an arbitrage involving American consumers; where he would purchase cans of Coke from his subsidized school shop, before strolling down Church Road to sell them at a hefty premium to the tourists (mainly American) queuing to get into the Wimbledon tennis tournament! As such, he learned at an early age never to underestimate the buying power of the American consumer!

So Our Man fully expected to see credit growth over the last few years but what he hadn’t expected was to see how consistently positive it was. Some random things he discovered by looking at the statistics:

- From 2002 to July 2008 (peak of consumer credit) consumer credit grew at an amazingly steady rate of c5% per annum (with each calendar year falling in between 4.0% to 5.6%). This was positively tepid compared to the previous few years (where it threatened double digit annual growth)
- In the 10-years leading up to July 2008, credit never contracted in any single month. Not one….in 10 years!
- In the 15-years leading up to July 2008 credit contracted in 1 (yes, one) month. October 1998, in case you were curious.
- The longest contraction in consumer credit lasted 20months (Nov-90 to Jun-92) and consumer credit contracted a whopping 2.01% in that time. (It recovered the loss in 9months)
- That 2.01% contraction was the largest contraction since the end of World War 2 (until the 2008 peak).
- The current contract has lasted 14months, and credit has contracted by 4.87% in that time and hasn’t showed much sign of slowing (3.92% annualized over the last quarter, including August’s C4C impact, and almost 7% annualized last month).

And here are some self-explanatory charts and graphs:


Consumer Credit



So how does this fit in with Our Man’s thinking?
Well, he assumes that the last few years have seen a negative wealth effect for Mr. & Mrs. Consumer given the likely impact on their home price and investments. Now, as well as the increased prospect of unemployment, they are also seeing their access to credit financing is being diminished not to mention higher credit card rates (per Rasmussen, 50% have seen increased rates in the last 6months). What are Mr. & Mrs. Consumer to do? Well, Our Man’s thinking is if…and it’s a big if...they are rational, we should see Mr. & Mrs. Consumer choose to pay down their credit balances (and its 20% interest rate) and start to save a little for their impending retirement, rather than splurge it on a (final?) Christmas shopping binge. This broad thesis is, amongst a number of other reasons, why Our Man is quite comfortable with his large Long TLT/Long-end Treasuries position. That slowly, despite the government’s best efforts and bribes, saving will become the new consumption and (given Mr. & Mrs. Consumer’s age) income will become the new capital gain. However, Our Man is wary of the American consumer…and as such, you will find him each month checking in with the FED to see that Mr. & Mrs. Consumer’s credit is declining (and quarterly to check-in on their savings).

Bubbles, Bubbles, Everywhere...

Our Man mentioned his proclivity to check-in with the FED so that he can get updates on Commercial Lending, but why does he do it?

Well, while not a professional economist, Our Man does have the benefit of having spent his undergraduate years studying that dark art and one of the few things he still remembers is the importance of multipliers. While this may seem a like tangential path that we are wandering, all will become clear…

The Technology Bubble and the Real-Estate bubbles of the last decade were transported to the real economy where they were able to percolate and spread due to multipliers; through Technology’s impact on corporate productivity, costs and profitability and through Real Estate’s impact on consumers perceived wealth (Home Equity = ATM). But how does this tie in with OM’s view of deflation and Commercial Lending?

Well OM’s belief in deflation is two-fold: that we are in a secular debt reduction phase and that these multiplier effects which extended the previous bubbles don’t exist in the current one. Or more accurately, that the most likely transition mechanism…that of Banks lending to real businesses is broken (and likely, if we’re in a secular deleveraging cycle as OM purports, to remain that way). And how better to see if this viewpoint has merit, than to check-in with the FED…and so that is what we shall do.




A cursory inspection of the data, in the graph and table above, leads to a couple of interesting things…
- Credit seemed to grow steadily from the mid-1970’s to 2001 at about 9% per year, before increasing its rate of growth to 15%+ in the 4-5 years leading to the 2008.
- It appears, with the caveat of limited data, that credit expansion cycles appear to have shortened though contractions haven’t.
- This contraction is noticeably more violent than any preceding contractions.

Our Man thinks these points can be instructive in the debate.
Firstly, it is clear that the FED’s quantitative easing hasn’t resulted in a smoothing of the credit contraction (i.e. banks didn’t take the FEDs money and go out and lend it) though given the weakness of the banking system, this should come as no surprise. That said, if the FED’s quantitative easing results in a quicker and prolonged up-turn in Commercial & Industrial Lending there is the potential to reinflate the economy, and we shall all live happily ever after with only the fear of inflation (which we have an existing toolset to control) before us.

However, what if the FED’s easy money policy solely succeeds in encouraging speculation in the markets but fails to transition to the real economy? What if that multiplier isn’t there? A stock-market bubble perhaps, but one with a shorter life…

And that’s without even considering the consequences of a structural, as opposed to cyclical, decline in debt, the weakness of the consumer & unemployment, and OM’s skepticism on China (bubbles, bubbles, everywhere).

Broad things that Our Man is pondering

Our Man is by nature a cynic, and hence considers himself more the Risk Officer of this PA portfolio than the Investment Officer, and has a primary focus on protection of capital rather than stellar returns. Below are the things he’s been pondering in his free-time; some of which he hopes to jot his thoughts (and analysis) down on in greater detail at some point…

- Commercial Lending & Consumer Lending

Our Man is a believer that inflation is not the primary threat, and that this is a balance sheet recession leading to deflation. Thus he makes sure to check in with the FED and purview the Consumer Credit (G.19) numbers and the Commercial Banks’ Commercial & Industrial Lending (H.8) numbers. Expect to see something in greater detail on those figures this week, but **Spoiler alert** a pretty picture they do not paint.

- Is everyone Long, despite their protestations, but with stops underneath their positions?

With Mutual Fund world getting to (or at) their year-ends, is there any incentive for managers to take risk? Our Man speaks to a bunch of people in the hedge fund world; some believe in the sustainability of the recovery, some believe that China will pull everyone along, and some are just skeptical. However, the significant majority seem to be Long risk assets in some way, be they domestic or international equities or just commodity-related (and a decent number are S the Dollar). Does that mean that there's the mother of all correlated trades on at the moment and that with the incentive for seemingly everyone to protect their performance numbers this year, that if we pull-back enough to start triggering all those stops (be they mental or actual), will we find a vacuum of buyers underneath…

- Does the make-up of GDP matter?
In the wake of the over-analysis of the US GDP’s figures and the celebration surrounding China’s GDP numbers, there’s been a spate of commentary on how Chinese stimulus is focused on investment and isn’t that clever. Is it or is this just looking at China through American eyes? Are they just doing the Chinese equivalent of the US; reinforcing their existing problems…

- Bankruptcies – does anyone care?

Given the role that Archstone-Smith, and MBS, had in Lehman collapsing will bankruptcies have broader implications? Does Capmark filing 2 weekend matters, or CIT? Will Stuyvesant Town, if it runs out of cash around year-end? If so, how long do their effects take to percolate?

- Commercial RE death spirals?

OM spent some of his early career looking at folks who traded convertible bonds and while they both never appreciated his nosiness and couldn’t help him learn more than 4 words of Greek, they did acquaint him with death spiral convertible bonds. Now as a reluctant apartment owner (damn you and your conventionality, Mrs. OM!) he was recently reminded about the undesirable impact of foreclosed homes in ones neighborhood (or an apartment in one’s building, as it were). While most of Our Man’s short-medium term value from his abode is derived it being a roof over his head this isn’t the case in Commercial Real Estate. And so OM has been thinking about what happens when that almost identical but nearly vacant building next door is foreclosed and sold to someone who will have smaller mortgage payments? Does it create a death spiral for the almost homogeneous buildings nearby?

- Population pyramids

They are pretty cool, and Our Man has used them very broadly to help think about investing. Now he intends to find out if they can help as a (very) long-term investment screen.

October Review

Performance Review
October saw good performance, with the PA positing a +1.36% month. The performance during the month was driven by the Long Gold position (+c200bips), which was partially offset by the decline in the Long 20-yr+ Treasury position (-c60bips). However, the positives really came later in the month, after the S&P peaked on the 19th October. Firstly after breaking through its high (c$98) early in the month, the L GLD position was able to hold the level despite weakness towards the end of the month. Secondly, the Long Treasury position performed as hoped for, adding 90bips to performance when risk aversion returned more noticeably to the market in the final week of the month.

(The Kaching mirror portfolio was down 19bips from its inception on 10/19, benefitting from its larger position in Treasuries which contributed positively during the period).

Positioning Thoughts
The positioning of the portfolio remained unchanged going into November; Long GLD (54.01%) and Long 20Yr+ Treasuries (41.81%) with the balance held in cash.
- The Long GLD position continues to be viewed as 1/3 a long-term position and 2/3 a medium-term position. The medium-term portion was purchased in anticipation of the break-out through the March-highs, and with the intent of selling this portion should the breakout-fail (it didn’t), March-highs be broken to the downside or at $120-ish (though it may be run beyond there, but with a rolling stop…or as close to one as I can given the constraints). Furthermore, should a breakdown in GLD accompany a broader risk reversal, a portion of the long-term position will probably be exited at the same time. While the long-term broader arguments for Long GLD (see below) may still hold, the breakdown of GLD would signal Gold’s inability to retain its value in a time of increased stress and hence part of the attractiveness would be diminished.
- Our Man is comfortable with the Long 20yr+ Treasury position, though some of the risk capital may potentially be rolled into equity options should the S&P break-down through 1,020.