While Our Man has been involved in finance since leaving University, he took a non-normal route (i.e. has never spent a day inside an investment bank) to his role at a hedge fund. While there’s undoubtedly a cost to this, there are also advantages especially when it comes to thinking about investing, considering risk and portfolio.
As such, over the years, Our Man has jotted down some risk tenets to help himself consider exposure and risk.
1. There are no 20 standard deviation events
They don’t exist. Full stop! The mere fact they seem to happen so frequently (the 87’crash, 94’ LTCM, 98 Asian Crisis, 00-02 Tech bubble bursting & 08-09 Great Recession to name the major ones in the last 25years) means they can’t be 20-standard deviation events! It’s funny how they only impact people negatively -- Our Man never heard anyone explain their profits as not coming from their skill, talent, or general awesomeness but from a 20-standard deviation event. The people who believe they are fall into one of the following categories: i). Have not thought about risk, ii). Didn’t understand the risk in their book, or iii). Believe that people are rational and market returns are normally distributed. Our Man reserves most of his scorn and sarcastic eye-rolling for the last group; neither of the beliefs is true, have ever been true or will ever be true (while humans make decisions!)
2. Cut your losses
It’s an underappreciated fact, that making money over the long-run is primarily a function of avoiding huge losses rather than finding great winners. That’s the magic of compounding. Our Man thinks about this rule a lot when sizing positions – specifically, how much pain is he willing to suffer in any position and what positions are related/correlated to it -- to try and right-size the position so that the behavioural biases (especially in dealing with losing positions) that come naturally are more limited.
3. Don’t try to turn a bad trade into an investment
Speaking of behavioural biases, here’s a prime example of anchoring (to cost-price) at play – if only I hold X for a little longer, it’ll be profitable. Sadly, Our Man has learned from experience, it probably won’t…cut your loss.
4. If you buy a stock for a reason that’s no longer valid; sell it
Our Man has struggled with this in the past, after all who likes admitting they were wrong! Writing down why you’re investing in something, BEFORE you invest makes it an easier mistake to avoid. Hence this blog!
5. No matter how much you know about a stock, it owes you nothing
Take emotion out of the decision making process.
6. The best hedge is to sell
It really is; at best when hedging/pairing you’re not removing risk but just swapping directional risk for basis risk.
7. Never attempt to use leverage to turn a mediocre return into an attractive one
The dirty truth is that leverage introduces far more risk, than the return it helps to generate. The most basic is that while returns increase linearly, risk increases at a rate that is closer to exponential. Furthermore, new risks such as additional risks (e.g. counterparty risk – you know that your leverage provider will pull the leverage at the worst possible time) are introduced.
8. Avoid incremental thinking; be decisive
The more performance hurts, the easier it is to say “things will bounce back” or to nibble around the edges and not make a change.
9. Don’t be afraid to have no positions
Sometimes (like now in Our Man’s perspective) things just aren’t that attractive on an absolute basis; better have no positions and suffer the opportunity cost of that (i.e. risk under performance) than to have positions you don’t particularly want and suffer the (possible) negative returns impact of that!
10. Don’t fight the tape; respect the markets
Our Man’s view is that the simple act of taking a position is an intellectually arrogant thing to do (see below, re. Our Man’s position in Treasuries), and that Keynes is right (“markets can remain irrational far longer than I can remain solvent”), thus this rule tries to help with timing. In essence don’t become insolvent before you have a chance to be right!
Our Man’s Long-end Treasury position implies that he thinks not only are the many smart people who’re talking about shorting Treasuries wrong, but so is the entire market for pricing them so attractively! I think we’d all agree that it’s a pretty intellectually arrogant stand point!
11. Watch for “Salzmans”; sophisticated ways to lose money
The most important skill in Wall Street isn’t being able to think, it’s being able to sell! As such, investors have to be watchful for products that fill a need in the market and thus seem interesting and useful, but instead are just sophisticated ways of losing money. Simple examples are Commodity ETFs (e.g. UNG & USO; where the contango/backwardation impacts in those markets mean that price performance bears no resemblance to that of the underlying commodity) and Short ETFs (where the compounding impact kills the performance, such that over longer time periods it bears on reflection to the underlying).
12. Are you Short a put? Are you really being paid enough to be Short that put?
A Short put position has the classic large left-tail that (inevitably) eventually results in a blow-up; while the return stream looks steady and predictable (i.e. collecting premium) an sharp market move (which the seller of the put often calls “a 20-standard deviation” event) results in a substantial loss of capital. Short-put positions often offer a mediocre return, and are thus leveraged up, resulting in impressive blow-ups.
13. The object of these tenets is not to be conservative; it’s to make the right decision
Our Man likes this little tenet. It serves as a good reminder that while he (like most) has a tendency to chase trends and hopes for very profitable years, that these tenets aren’t designed to encourage him to reduce to be more conservative. Instead, the serve to help him make the right decisions which hopefully means that he sacrifices opportunity cost in order to avoid the big down years that can ruin performance.
14. See number 1; there are no 20-standard deviation events
Since, it’s so much easier to blame bad fortune for our own failures.
Tuesday, January 26
Saturday, January 23
Thoughts on Portfolio Management – Part A
One of the things that Our Man has noticed from his years in and around the hedge fund industry is that ability to manage a portfolio and think about the risks embedded within it is one of the most undervalued skill sets in the industry.
Thus, in a bid to help himself become a better portfolio manager, Our Man’s going to be jotting down some of his thoughts and observations over the coming months (perhaps years, who knows!). The categorizations aren’t mutually exclusive, and given his Swiss Cheese of a brain it’s likely Our Man will forget things so don’t be surprised to find addendum’s to them as we wander down this path.
The Analyst-Portfolio Manager Gap
Given his non-traditional background, coupled with being an analyst in his day-job, and a PM in this night-job, Our Man ponders a lot on this subject. In fairness, a primary portion of this divide stems from Our Man’s puritanical belief as to what a PM’s role; namely that it’s predominantly focused on understand and managing the risk in the portfolio, with the intent of generating an absolute return. Clearly there are other definitions of the role (e.g. maximizing annual returns, beat a bench-mark, etc), which may lead others to not see such a gap.
Furthermore, portfolio management is also something on which there’s very little formal training; after all the path is generally start as an analyst, become a very good analyst, then eventually get portfolios to manage – but are the skills to be an analyst and to be a portfolio manager the same? Our Man believes that while there’s certainly overlap, there are substantial differences; most notably, that an analyst can generally start by considering each position of his/hers in the portfolio as unique, whereas as a PM must consider all positions are being inter-related. These are two very different starting points, which require very different mindsets and skills.
Yeah, but what does that all mean?
At an exceptionally simplified level good analyst’s job is to identify the key drivers (1-3, normally) behind a company’s performance, to do a lot of (often very dull) follow-up research to identify various potential paths of these drivers and the probabilities of these paths, and then model out the expected returns of these potential paths. In reality of course, neither the potential paths nor the expected returns from them are simple discrete numbers but ever-changing.
However, for the point of a simple illustration, let’s assume our analyst is infallible (i.e. the probabilities and expected returns are certain) and take a very simplified 1 driver with only 2 possible paths (A & B) scenarios that will play out definitively in 1 year. Path A is very likely (let’s go with 75%, implying Path B has a 25% chance of occurring) and will lead to a good return (say 50%). Path B is far less likely but the result would be a major decline in the stock (say -70%).
Exp. Annual Return (Position) = Prob (A) * Exp. Annual Return (A) + Prob (B) * Exp. Annual Return (B)
In our case; Exp Return = 20% = (0.75 * 50%) + (0.25 * -70%)
Overall, as the calculation above shows, the expected return from this position would be 20%. While Path B is potentially terrible, its relatively small probability only resulted in the idea becoming less attractive. However, even considering this, the position has a potentially an attractive return and thus the analyst may well go to his PM to pitch the idea. Given the infallibility of the analyst (sadly, in this instance only) and the attractive return, the PM should put the position into the portfolio, right?
Well no, not necessarily. Why?
Well, here is where Our Man sees the PM and Analyst paths diverge.
In all likelihood Exp. Return (B) figure more heavily into the PM’s decision than the analyst’s. The reason is simple, rather than look at each position on a stand-alone basis, the PM should consider the portfolio (and all its underlying biases) as a whole. The skill-set to do this is clearly different as it requires an understanding of the portfolio’s biases, both intended and unintended, as well as an understanding of how others might see the biases of the portfolio.
- The intended biases are easily understood; at the simplest level, imagine the driver was Real Estate prices and prob (B) was the probability of falling real estate prices. If the PM knew that there were numerous positions in the book that would suffer from falling real estate prices it may not be sensible to add the position to the book with that same risk. i.e. we have enough of that risk, and are getting better bang for our buck elsewhere.
- The unintended biases are more complicated, even in our simple world. Imagine a 2 company portfolio. Company A is a US Copper Company and its major risk is a fall in global demand for copper. Company B is a French Telecoms Equipment Company, and its major risk is that the 3G networks that it has contracts to supply base stations for may get built out more slowly. These two companies don’t share any obvious intentional risks; they’re in different countries, industries, sectors, and copper/base stations are massively correlated. Yes, but…the unintended bias may be that they’re both plays on the same underlying thing – e.g. the base station company’s major contract is to build out a network in China, who’re also the marginal buyer of copper. Hence, the addition of the new position may well increase an existing bet on China’s growth.
- The importance of the view of others: While the analyst may be 100% right on all of their analysis, if the market views the drivers as something different (e.g. are using the Copper company as a proxy for investing in China, rather than caring about copper’s supply/demand characteristics) then it stands to reason that the behavior of the stock price may bear no resemblance to the analyst’s expectations (i.e. people become less bullish on China, so sell the stock, even though demand for copper is increasing).
That’s genesis Our Man’s view that the starting points of the analyst and portfolio manager should be different and the need to think about and build portfolio management skills to complement analytic ones. Some more thoughts on portfolio management, in the coming week…
Thus, in a bid to help himself become a better portfolio manager, Our Man’s going to be jotting down some of his thoughts and observations over the coming months (perhaps years, who knows!). The categorizations aren’t mutually exclusive, and given his Swiss Cheese of a brain it’s likely Our Man will forget things so don’t be surprised to find addendum’s to them as we wander down this path.
The Analyst-Portfolio Manager Gap
Given his non-traditional background, coupled with being an analyst in his day-job, and a PM in this night-job, Our Man ponders a lot on this subject. In fairness, a primary portion of this divide stems from Our Man’s puritanical belief as to what a PM’s role; namely that it’s predominantly focused on understand and managing the risk in the portfolio, with the intent of generating an absolute return. Clearly there are other definitions of the role (e.g. maximizing annual returns, beat a bench-mark, etc), which may lead others to not see such a gap.
Furthermore, portfolio management is also something on which there’s very little formal training; after all the path is generally start as an analyst, become a very good analyst, then eventually get portfolios to manage – but are the skills to be an analyst and to be a portfolio manager the same? Our Man believes that while there’s certainly overlap, there are substantial differences; most notably, that an analyst can generally start by considering each position of his/hers in the portfolio as unique, whereas as a PM must consider all positions are being inter-related. These are two very different starting points, which require very different mindsets and skills.
Yeah, but what does that all mean?
At an exceptionally simplified level good analyst’s job is to identify the key drivers (1-3, normally) behind a company’s performance, to do a lot of (often very dull) follow-up research to identify various potential paths of these drivers and the probabilities of these paths, and then model out the expected returns of these potential paths. In reality of course, neither the potential paths nor the expected returns from them are simple discrete numbers but ever-changing.
However, for the point of a simple illustration, let’s assume our analyst is infallible (i.e. the probabilities and expected returns are certain) and take a very simplified 1 driver with only 2 possible paths (A & B) scenarios that will play out definitively in 1 year. Path A is very likely (let’s go with 75%, implying Path B has a 25% chance of occurring) and will lead to a good return (say 50%). Path B is far less likely but the result would be a major decline in the stock (say -70%).
Exp. Annual Return (Position) = Prob (A) * Exp. Annual Return (A) + Prob (B) * Exp. Annual Return (B)
In our case; Exp Return = 20% = (0.75 * 50%) + (0.25 * -70%)
Overall, as the calculation above shows, the expected return from this position would be 20%. While Path B is potentially terrible, its relatively small probability only resulted in the idea becoming less attractive. However, even considering this, the position has a potentially an attractive return and thus the analyst may well go to his PM to pitch the idea. Given the infallibility of the analyst (sadly, in this instance only) and the attractive return, the PM should put the position into the portfolio, right?
Well no, not necessarily. Why?
Well, here is where Our Man sees the PM and Analyst paths diverge.
In all likelihood Exp. Return (B) figure more heavily into the PM’s decision than the analyst’s. The reason is simple, rather than look at each position on a stand-alone basis, the PM should consider the portfolio (and all its underlying biases) as a whole. The skill-set to do this is clearly different as it requires an understanding of the portfolio’s biases, both intended and unintended, as well as an understanding of how others might see the biases of the portfolio.
- The intended biases are easily understood; at the simplest level, imagine the driver was Real Estate prices and prob (B) was the probability of falling real estate prices. If the PM knew that there were numerous positions in the book that would suffer from falling real estate prices it may not be sensible to add the position to the book with that same risk. i.e. we have enough of that risk, and are getting better bang for our buck elsewhere.
- The unintended biases are more complicated, even in our simple world. Imagine a 2 company portfolio. Company A is a US Copper Company and its major risk is a fall in global demand for copper. Company B is a French Telecoms Equipment Company, and its major risk is that the 3G networks that it has contracts to supply base stations for may get built out more slowly. These two companies don’t share any obvious intentional risks; they’re in different countries, industries, sectors, and copper/base stations are massively correlated. Yes, but…the unintended bias may be that they’re both plays on the same underlying thing – e.g. the base station company’s major contract is to build out a network in China, who’re also the marginal buyer of copper. Hence, the addition of the new position may well increase an existing bet on China’s growth.
- The importance of the view of others: While the analyst may be 100% right on all of their analysis, if the market views the drivers as something different (e.g. are using the Copper company as a proxy for investing in China, rather than caring about copper’s supply/demand characteristics) then it stands to reason that the behavior of the stock price may bear no resemblance to the analyst’s expectations (i.e. people become less bullish on China, so sell the stock, even though demand for copper is increasing).
That’s genesis Our Man’s view that the starting points of the analyst and portfolio manager should be different and the need to think about and build portfolio management skills to complement analytic ones. Some more thoughts on portfolio management, in the coming week…
Saturday, January 9
2010: Glimmers of Hope
- Private Sector takes up the slack
While it’s been clear that a lot of demand in Q3 and Q4 has been government driven, the idea is that the government stimulus is only to keep the economy chugging along until private demand is ready to takeover. I think it’s clear to most that over the last 12month fear of the recession has receded, wealth has increased (in at least that people’s investments/retirement funds have risen, and house prices have stabilized for the moment), and the rate of redundancies/firings have decreased. This has led to improvements in confidence, and shouldn’t this confidence show itself up in better business conditions, leading to the virtuous circle of production, profit, increased employment and increased demand. That’s the hope.
- Consumer Spending
During 2002, Our Man’s first boss used to constantly tell him “Never doubt the US consumers’ ability to spend”! At first, Our Man put this down to his boss’ French background and seeming disdain for spending money on anything other than cabs, style and French food. However, he quickly learnt it was useful advice – yes, the US consumer could spend their way down to a 1.4% annual savings rate (May-08). While this annual rate has risen to over 4.5% as of November, that level is so 1990’s and habits are hard to break!
- The V-shaped recovery
The above are key premises behind the V-shaped recovery; it’s the way business cycles work, people get too excited at the top, produce too much, then have to make adjustments when demand comes in lower, so cut costs (and the biggest cost is staff), right the ship and boom…off we go again. It’s happened in every recession since the War…and if you look at the numbers, the bigger the fall the bigger the comeback. So stop whining about how this time’s a credit/solvency crisis, and look at history (excluding the Depression, and those crazy Japanese, since they were one-offs that can’t happen here)…the V’s the way it is!
- Stimulus II: The Return of the Thing-That-Shall-Not-Be-Named
But just in case there’s any sign that the private sector isn’t quite ready to take up the slack, Our Man fully expects the government to do the only thing it knows – throw money at the problem, and hope it disappears. However, “Stimulus” is bad politics, 2010 is an election year, so don’t expect the word Stimulus to be anywhere near anyone’s lips. Instead it’ll be subtler, nicer and happier version of Thing-That-Shall-Not-Be-Named where it’s all about the government helping citizens make good choices for the benefit of America – you know what I mean; “You really should buy that energy efficient washer/dryer, and here’s a pretty little government rebate to help you do that”, “Weatherize your home; Yes, We Can give you a rebate check for that”, “CHANGE your light bulbs to these new energy efficient LED ones, and we’ll give you some change to help with the cost!”, etc
- The FED
Hey, it was never a solvency problem, just a liquidity one…and the one thing the FED has mastered over the years is providing liquidity. Buying $1.25trillion of mortgage securities for crazy prices using cold hard cash is no problem for the FED, which plans to complete that by March 2010. While the FED claims most of its liquidity provision will be completed in March, Our Man expects they’ll find some exceptional circumstance or need to temporarily keep doing it either directly or indirectly (hello Fannie and Freddie).
- China
Our Man can hear your collective “Huh”, given his often snide remarks about China and its prominence in the Fingers of Instability list. But hey, you know what, maybe Our Man is just plain ole wrong – perhaps the Chinese have built a better mousetrap in terms of this whole running an economy thing! And if they haven’t, well their ability to throw money at problems makes the rest of the world look impotent. A c$575bn direct stimulus program and a 2009 quota set for bank lending (driven by the state-controlled big 4 – how nice it must be to have banks do as you tell them) of $1,300bn, equates to a 40% of direct and indirect GDP stimulus in 2009. Now that should get your economy moving…and while 2010 won’t be as big, it’ll still be might impressive!
- Valuation
Another round of “Huhs”, as Our Man has been muttering about an expensive market. Well, yes…the Case-Shiller PE-10 and Our Man’s forward-looking model screams expensive, with a P-E of c23x compared to the average (of c16.5x). But the model also suggests the market’s positively cheap compared to the last 10-years (average 26.67x). The reality is most people don’t look back beyond 5-years let alone 10-years…
While it’s been clear that a lot of demand in Q3 and Q4 has been government driven, the idea is that the government stimulus is only to keep the economy chugging along until private demand is ready to takeover. I think it’s clear to most that over the last 12month fear of the recession has receded, wealth has increased (in at least that people’s investments/retirement funds have risen, and house prices have stabilized for the moment), and the rate of redundancies/firings have decreased. This has led to improvements in confidence, and shouldn’t this confidence show itself up in better business conditions, leading to the virtuous circle of production, profit, increased employment and increased demand. That’s the hope.
- Consumer Spending
During 2002, Our Man’s first boss used to constantly tell him “Never doubt the US consumers’ ability to spend”! At first, Our Man put this down to his boss’ French background and seeming disdain for spending money on anything other than cabs, style and French food. However, he quickly learnt it was useful advice – yes, the US consumer could spend their way down to a 1.4% annual savings rate (May-08). While this annual rate has risen to over 4.5% as of November, that level is so 1990’s and habits are hard to break!
- The V-shaped recovery
The above are key premises behind the V-shaped recovery; it’s the way business cycles work, people get too excited at the top, produce too much, then have to make adjustments when demand comes in lower, so cut costs (and the biggest cost is staff), right the ship and boom…off we go again. It’s happened in every recession since the War…and if you look at the numbers, the bigger the fall the bigger the comeback. So stop whining about how this time’s a credit/solvency crisis, and look at history (excluding the Depression, and those crazy Japanese, since they were one-offs that can’t happen here)…the V’s the way it is!
- Stimulus II: The Return of the Thing-That-Shall-Not-Be-Named
But just in case there’s any sign that the private sector isn’t quite ready to take up the slack, Our Man fully expects the government to do the only thing it knows – throw money at the problem, and hope it disappears. However, “Stimulus” is bad politics, 2010 is an election year, so don’t expect the word Stimulus to be anywhere near anyone’s lips. Instead it’ll be subtler, nicer and happier version of Thing-That-Shall-Not-Be-Named where it’s all about the government helping citizens make good choices for the benefit of America – you know what I mean; “You really should buy that energy efficient washer/dryer, and here’s a pretty little government rebate to help you do that”, “Weatherize your home; Yes, We Can give you a rebate check for that”, “CHANGE your light bulbs to these new energy efficient LED ones, and we’ll give you some change to help with the cost!”, etc
- The FED
Hey, it was never a solvency problem, just a liquidity one…and the one thing the FED has mastered over the years is providing liquidity. Buying $1.25trillion of mortgage securities for crazy prices using cold hard cash is no problem for the FED, which plans to complete that by March 2010. While the FED claims most of its liquidity provision will be completed in March, Our Man expects they’ll find some exceptional circumstance or need to temporarily keep doing it either directly or indirectly (hello Fannie and Freddie).
- China
Our Man can hear your collective “Huh”, given his often snide remarks about China and its prominence in the Fingers of Instability list. But hey, you know what, maybe Our Man is just plain ole wrong – perhaps the Chinese have built a better mousetrap in terms of this whole running an economy thing! And if they haven’t, well their ability to throw money at problems makes the rest of the world look impotent. A c$575bn direct stimulus program and a 2009 quota set for bank lending (driven by the state-controlled big 4 – how nice it must be to have banks do as you tell them) of $1,300bn, equates to a 40% of direct and indirect GDP stimulus in 2009. Now that should get your economy moving…and while 2010 won’t be as big, it’ll still be might impressive!
- Valuation
Another round of “Huhs”, as Our Man has been muttering about an expensive market. Well, yes…the Case-Shiller PE-10 and Our Man’s forward-looking model screams expensive, with a P-E of c23x compared to the average (of c16.5x). But the model also suggests the market’s positively cheap compared to the last 10-years (average 26.67x). The reality is most people don’t look back beyond 5-years let alone 10-years…
Monday, January 4
December Review
Performance Review
December provided Our Man’s first dose of reality, with the portfolio bleeding steadily during the month resulting in a loss of 4.24% for the month. As indicated during the mid-month update (Waiting for Godot), substantially all of the loss came from the Long positions in Gold and in Long-term Treasuries. The L GLD position cost 160bips and risk management triumphed over patience, with the position substantially cut-back. The Long positions in Long-term Treasuries (L TLT and L Aug-29 Treasury Bond) cost 258bips, however no action was taken and this remains the portfolio’s largest positions.
Why the difference in reaction?
Well, without going into substantial depth, the underlying reasons are based on Our Man’s conviction (the underlying thesis being debt deflation and the key information being the lending data to consumers/commercial industries), maximum loss of capital (which Our Man believes to be substantially lower for Treasuries than for Gold), expected return (similar over a 12-month period) and time horizon (Our Man’s thesis behind his Treasury position is strategic and secular, and thus long-term in nature, whereas as discussed previously part of his Gold position was tactical). As such, Our Man has far more patience with his Treasury position (note the short-term volatility is also substantially smaller, which in conjunction to the above is why Our Man is comfortable with its size in the book).
Portfolio
40.08% -- Long Long-term Treasuries (via L TLT and L Aug-29 Treasury Bond)
9.11% -- Long GLD
7.49% -- Long Intermediate Bond Fund (via L VBIIX)
6.57% -- Long THRX equity
4.79% -- Long Restricted equity positions (via L NWS, L CMTL, L CRDN, L SOAP)
(4.01%) – Delta-Adjusted Short position in the SPY (via L Dec-10 puts, with strikes at 100 & 85; 0.88% premium at risk)
(2.04%) – Delta-Adjusted Short position in GS (via L Dec-10 puts, strike 120; 0.49% premium at risk)
29.58% -- Cash
Performance
December provided Our Man’s first dose of reality, with the portfolio bleeding steadily during the month resulting in a loss of 4.24% for the month. As indicated during the mid-month update (Waiting for Godot), substantially all of the loss came from the Long positions in Gold and in Long-term Treasuries. The L GLD position cost 160bips and risk management triumphed over patience, with the position substantially cut-back. The Long positions in Long-term Treasuries (L TLT and L Aug-29 Treasury Bond) cost 258bips, however no action was taken and this remains the portfolio’s largest positions.
Why the difference in reaction?
Well, without going into substantial depth, the underlying reasons are based on Our Man’s conviction (the underlying thesis being debt deflation and the key information being the lending data to consumers/commercial industries), maximum loss of capital (which Our Man believes to be substantially lower for Treasuries than for Gold), expected return (similar over a 12-month period) and time horizon (Our Man’s thesis behind his Treasury position is strategic and secular, and thus long-term in nature, whereas as discussed previously part of his Gold position was tactical). As such, Our Man has far more patience with his Treasury position (note the short-term volatility is also substantially smaller, which in conjunction to the above is why Our Man is comfortable with its size in the book).
Portfolio
40.08% -- Long Long-term Treasuries (via L TLT and L Aug-29 Treasury Bond)
9.11% -- Long GLD
7.49% -- Long Intermediate Bond Fund (via L VBIIX)
6.57% -- Long THRX equity
4.79% -- Long Restricted equity positions (via L NWS, L CMTL, L CRDN, L SOAP)
(4.01%) – Delta-Adjusted Short position in the SPY (via L Dec-10 puts, with strikes at 100 & 85; 0.88% premium at risk)
(2.04%) – Delta-Adjusted Short position in GS (via L Dec-10 puts, strike 120; 0.49% premium at risk)
29.58% -- Cash
Performance
Sunday, January 3
2010: Fingers of Instability
The first few fingers relate to the possibility of Banks suffering from “rolling waves of defaults” (Our Man thinks Mike Mayo, of Calyon Securities and formerly Deutsche Bank coined the term a couple of years ago). Our Man suspects that most of the cases below bear conceptual similarities to sub-prime in that the risks are well understood by the market but that the consequences (especially the secondary and tertiary impacts; as a result of parceling out of risk from the banks to other investors) are not fully appreciated.
- Commercial Real Estate
The weakness of CRE is well-known, with the Moods/REAL Commercial Property Price Index down 44% from its October 2007 peak and reaching levels last seen in August 2002. Given how well-known the decline is, the general assumption is that defaults will have limited impact on the markets. With only a limited number of defaults so far, an estimated $1.4trn of CRE debt scheduled to mature over the next 5-years and 50%+ of it underwater (per Foresight Analytics), Our Man thinks we’ve yet to see how this one plays out.
- Residential Real Estate:
While Our Man thinks it is fair to say that most believe that the residential estate issues are behind us, his opinion is that we’re sitting in the midst of a lull period between the first wave of issues and a second wave. Unfortunately, while the FED/Treasury has done a fine job in delaying (or ‘extending and pretending’, if you’re feeling less generously inclined) defaults and trying to maintain home prices (think HAMP, first-time tax buyer’s credit and it’s extension and expansion, FED buying mortgages, Treasury backstopping Fannie & Freddie, etc), Our Man is of the opinion that this is all it is…delaying. Things he worries about in Residential Real Estate world are:
a). The recast schedule for Option ARMs (which is when the payment changes, to reflect full amortization as well as interest payments).
Given the predominance of homeowners (analysis from S&P, Moodys, etc suggests they are in the 80%+ range) who’ve been paying only the minimum payment (i.e. interest-only), the jump in payment (to include amortization over the remaining term of the mortgage) is far more important than the impact of a change in rates (known as a “reset”). The difficulty is knowing when the recast will happen, as it will happen at either at the time of the reset (generally 5-years after the mortgage was taken out) or when the negative amortization cap (normally 125% of the original principal balance) is reached. Given the level of minimum payments being made, it is likely that recasts will happen before the reset schedule.
b) Prime Mortgages default rates well above historic norms.
Our Man can hear you snickering in the background at this one, after all Prime Mortgages are the good stuff and have been around long-before all this financial shenanigans began so we can data-mine and know how they’ve defaulted historically. However, Our Man notes that the standard (pre-2003) DTI (Debt-To-Income) ratios were 28% (for housing, 33% for Jumbo loans) and 36% (for total debt) and were based (largely) on documented income. Post-2003, they could be anything up to 50% and in many cases (data varies from 35-50%+of Prime/Jumbo Prime loans) were based upon limited documentation (which Our Man is willing to bet is because the borrowers didn’t have their stated income). Given these 2 changes; Our Man isn’t certain that the historical data will be an accurate guide to future problems.
- Bank Lending (general) and Consumer Deleveraging
Our Man has already mentioned that he thinks Bank Lending & Consumer Deleveraging will prove to be the key factors in the coming months (perhaps years). The reason is simply that they stand at the hub of the primary debate, will the FED's 'quantitative easing' cause inflation or will we see continued deleveraging from an over-levered consumer causing deflation.
- Sovereign Risk
Dubai & Greece have hit the headlines recently, there have been additional worries over Spain and Ireland during the year, Short Japanese Government Bond trades are being put back on (again!) as their Debt/GDP goes through 200% and there’s been a lot of muttering over the last couple of months about how US rates will have to rise substantially (though Our Man's L Treasury position is clearly a wager that this will not be the case), will there be more tumult (especially across Eastern Europe, Italy and Our Man's homeland) to follow.
- Monetary Tightening
While Our Man would be surprised if the FED Funds rate went up any time soon (in part since many blame the FED for raising too early during the Great Depression causing the relapse; though Our Man's view this is that it's a tad hopeful to try and solve a major solvency crisis by injecting liquidity, and then being shocked that the underlying solvency issues remain when the liquidity is removed).
- China
“The Chinese government…are executing their eleventh ‘five year plan.’ They do exactly what they say they will do. They will likely be the biggest economy in the world someday. Man, these guys are good.” - Jeffrey Immelt, CEO of GE, following a speech at WestPoint earlier this month.
The point of the quote isn't mean to disparage Jeff Immelt (who in OM’s opinion has done a fine job, given the abysmal quality of the hand dealt to him by Jack Welch) but more to display what's the prevailing conventional wisdom China be it from business folk or finance experts (like Nomura's Richard Koo, an expert on Japan) -- China can do no wrong & will grow at 10%+ forever (ok, maybe that’s a touch of hyperbole). Sadly, Our Man fears reality is never like that...and notes that in addition to mass certainty in an outcome (house prices never go down & Tech is the new paradigm (and so deserves a new valuation model where profitability doesn't matter) the other 'best' indicator of an asset bubbles is loose credit conditions (and he'd certainly call China's loose).
- Terrorism
Enough said.
- 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. That threat is clearly present today (see this week's decision by the US ITC) and will only become more tempting for US firms/ politicians/ people to demand should the recovery prove sluggish. With so many Asian economies relying on export driven demand (to Japan, Western Europe, and the US), and gearing their industrial production to a pick-up in this demand, the rise (or not) of protectionism home & abroad could be a vital factor.
- Valuation
From Our Man’s perspective, the market is not cheap; currently, based on the Shiller 10yr P/E ratio, the S&P trades around 20x, which is above the historical average (c16.5x). Furthermore, Our Man notes the persistent overvaluation of the S&P over the last 20years and despite expectation of a V-shaped recovery, his simple model (using the very generous assumption of $75+ Earnings for the S&P 500 in 2010) the S&P’s multiple looks set to climb next year (towards 22x) even without an increase from the present S&P level.
- Commercial Real Estate
The weakness of CRE is well-known, with the Moods/REAL Commercial Property Price Index down 44% from its October 2007 peak and reaching levels last seen in August 2002. Given how well-known the decline is, the general assumption is that defaults will have limited impact on the markets. With only a limited number of defaults so far, an estimated $1.4trn of CRE debt scheduled to mature over the next 5-years and 50%+ of it underwater (per Foresight Analytics), Our Man thinks we’ve yet to see how this one plays out.
- Residential Real Estate:
While Our Man thinks it is fair to say that most believe that the residential estate issues are behind us, his opinion is that we’re sitting in the midst of a lull period between the first wave of issues and a second wave. Unfortunately, while the FED/Treasury has done a fine job in delaying (or ‘extending and pretending’, if you’re feeling less generously inclined) defaults and trying to maintain home prices (think HAMP, first-time tax buyer’s credit and it’s extension and expansion, FED buying mortgages, Treasury backstopping Fannie & Freddie, etc), Our Man is of the opinion that this is all it is…delaying. Things he worries about in Residential Real Estate world are:
a). The recast schedule for Option ARMs (which is when the payment changes, to reflect full amortization as well as interest payments).
Given the predominance of homeowners (analysis from S&P, Moodys, etc suggests they are in the 80%+ range) who’ve been paying only the minimum payment (i.e. interest-only), the jump in payment (to include amortization over the remaining term of the mortgage) is far more important than the impact of a change in rates (known as a “reset”). The difficulty is knowing when the recast will happen, as it will happen at either at the time of the reset (generally 5-years after the mortgage was taken out) or when the negative amortization cap (normally 125% of the original principal balance) is reached. Given the level of minimum payments being made, it is likely that recasts will happen before the reset schedule.
b) Prime Mortgages default rates well above historic norms.
Our Man can hear you snickering in the background at this one, after all Prime Mortgages are the good stuff and have been around long-before all this financial shenanigans began so we can data-mine and know how they’ve defaulted historically. However, Our Man notes that the standard (pre-2003) DTI (Debt-To-Income) ratios were 28% (for housing, 33% for Jumbo loans) and 36% (for total debt) and were based (largely) on documented income. Post-2003, they could be anything up to 50% and in many cases (data varies from 35-50%+of Prime/Jumbo Prime loans) were based upon limited documentation (which Our Man is willing to bet is because the borrowers didn’t have their stated income). Given these 2 changes; Our Man isn’t certain that the historical data will be an accurate guide to future problems.
- Bank Lending (general) and Consumer Deleveraging
Our Man has already mentioned that he thinks Bank Lending & Consumer Deleveraging will prove to be the key factors in the coming months (perhaps years). The reason is simply that they stand at the hub of the primary debate, will the FED's 'quantitative easing' cause inflation or will we see continued deleveraging from an over-levered consumer causing deflation.
- Sovereign Risk
Dubai & Greece have hit the headlines recently, there have been additional worries over Spain and Ireland during the year, Short Japanese Government Bond trades are being put back on (again!) as their Debt/GDP goes through 200% and there’s been a lot of muttering over the last couple of months about how US rates will have to rise substantially (though Our Man's L Treasury position is clearly a wager that this will not be the case), will there be more tumult (especially across Eastern Europe, Italy and Our Man's homeland) to follow.
- Monetary Tightening
While Our Man would be surprised if the FED Funds rate went up any time soon (in part since many blame the FED for raising too early during the Great Depression causing the relapse; though Our Man's view this is that it's a tad hopeful to try and solve a major solvency crisis by injecting liquidity, and then being shocked that the underlying solvency issues remain when the liquidity is removed).
- China
“The Chinese government…are executing their eleventh ‘five year plan.’ They do exactly what they say they will do. They will likely be the biggest economy in the world someday. Man, these guys are good.” - Jeffrey Immelt, CEO of GE, following a speech at WestPoint earlier this month.
The point of the quote isn't mean to disparage Jeff Immelt (who in OM’s opinion has done a fine job, given the abysmal quality of the hand dealt to him by Jack Welch) but more to display what's the prevailing conventional wisdom China be it from business folk or finance experts (like Nomura's Richard Koo, an expert on Japan) -- China can do no wrong & will grow at 10%+ forever (ok, maybe that’s a touch of hyperbole). Sadly, Our Man fears reality is never like that...and notes that in addition to mass certainty in an outcome (house prices never go down & Tech is the new paradigm (and so deserves a new valuation model where profitability doesn't matter) the other 'best' indicator of an asset bubbles is loose credit conditions (and he'd certainly call China's loose).
- Terrorism
Enough said.
- 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. That threat is clearly present today (see this week's decision by the US ITC) and will only become more tempting for US firms/ politicians/ people to demand should the recovery prove sluggish. With so many Asian economies relying on export driven demand (to Japan, Western Europe, and the US), and gearing their industrial production to a pick-up in this demand, the rise (or not) of protectionism home & abroad could be a vital factor.
- Valuation
From Our Man’s perspective, the market is not cheap; currently, based on the Shiller 10yr P/E ratio, the S&P trades around 20x, which is above the historical average (c16.5x). Furthermore, Our Man notes the persistent overvaluation of the S&P over the last 20years and despite expectation of a V-shaped recovery, his simple model (using the very generous assumption of $75+ Earnings for the S&P 500 in 2010) the S&P’s multiple looks set to climb next year (towards 22x) even without an increase from the present S&P level.