Performance Review
Though February ended up as a negative month for the portfolio, ending down 96bips for the month (putting the portfolio down 51bips for the year), it was relatively quiet and not unexpected. Not unexpected in that the sources of losses were the closed GLD position (-23bips), the trimmed THRX position (-32bips) and the SPY/GS put options (-55bips) that fell as the market rose. The month was very quiet for the rest of the book, with the Long-term Treasuries (6bips), Bond Funds (2bips) and Restricted Equities (6bips) all providing minimal gains.
The book continues to hold significant catch and remains positioned to benefit principally from any flight to quality/safety scenario but with the likelihood of suffering small but steady losses should risky assets remain in favour and the market rally.
Portfolio
42.00% -- Long Long-term Treasuries (via L TLT and L Aug-29 Treasury Bond)
14.51% -- Long Bond Funds (via L VBIIX, 7.72%, and L HSTRX, 6.80%)
2.56% -- Long THRX
4.71% -- Long Restricted equity positions (via L NWS, L CMTL, L CRDN and L SOAP)
(4.68%) – Delta-Adjusted Short position in the SPY (via L Dec-10 puts, with strikes at 100 & 85; 0.73% premium at risk)
(2.50%) – Delta-Adjusted Short position in GS (via L Dec-10 puts, strike 120; 0.61% premium at risk)
34.90% -- Cash
Saturday, February 27
Saturday, February 20
S&P Valuation
For a back of the envelope look at valuation of equity markets, Our Man likes to check-in on the PE10 (also known as the Cyclically-Adjusted Price Earnings, or CAPE, ratio) which was made popular by Professor Robert Shiller (in his book “Irrational Exuberance). The reasons for using a longer-term measure like the PE10 are that it helps smooth out some of the cyclical and fudge factors that occur in year-to-year earnings and that there’s lots of data so things can be considered in a historical context.
With that in mind, here is a graph of the PE10 alongside the Long-Term (10-year) Interest Rates.
From the graph, a few things seem obvious top OM:
- That 1929 and 2000 stand out clearly as peaks in PE10-terms, at 31x and 43x respectively
- That 1921 and 1981 stand out clearly as troughs in PE10-terms, at 5.5x and 6.5x respectively
- That the market at an expected 20.45x is not ‘absolutely’ cheap in PE-10terms
- That, in fact, the market isn’t even cheap ‘relative’ to the historical average
- That even in March, the market was only slightly cheap vs. the historical average
- That the last time the market was cheap for any prolonged period was in the 1980’s
So what?
What OM certainly takes from this is that there’s nothing to suggest that (US) equities are a screaming buy at this point. However, it’s also clear that while they appear over-valued, they’ve been that way for the most of the last 20 years - talk about irrationality lasting longer than solvency, and that being S purely on valuation grounds is a fool’s errand.
Thus, with seemingly over-valued equities and a macro view that suggests a questionable outlook, Our Man remains reticent to add any equities to the book. Though expect us to check-in with the PE-10/CAPE for an update over the course of the year.
With that in mind, here is a graph of the PE10 alongside the Long-Term (10-year) Interest Rates.
From the graph, a few things seem obvious top OM:
- That 1929 and 2000 stand out clearly as peaks in PE10-terms, at 31x and 43x respectively
- That 1921 and 1981 stand out clearly as troughs in PE10-terms, at 5.5x and 6.5x respectively
- That the market at an expected 20.45x is not ‘absolutely’ cheap in PE-10terms
- That, in fact, the market isn’t even cheap ‘relative’ to the historical average
- That even in March, the market was only slightly cheap vs. the historical average
- That the last time the market was cheap for any prolonged period was in the 1980’s
So what?
What OM certainly takes from this is that there’s nothing to suggest that (US) equities are a screaming buy at this point. However, it’s also clear that while they appear over-valued, they’ve been that way for the most of the last 20 years - talk about irrationality lasting longer than solvency, and that being S purely on valuation grounds is a fool’s errand.
Thus, with seemingly over-valued equities and a macro view that suggests a questionable outlook, Our Man remains reticent to add any equities to the book. Though expect us to check-in with the PE-10/CAPE for an update over the course of the year.
Tuesday, February 16
China -- Part C: Timing and Instruments
So, finally, we come to the end of this brief China series ending with the things Our Man is watching to help with timing an investment, and the instruments he’s considering using.
Timing
- Inflation and Bank/Credit Tightening:
Inflation is the major factor that Our Man is following in China as its presence causes the Chinese government to have to choose between its competing realities; with the 23% differential between 09's monetary M2 growth and nominal GDP suggesting its arrival is more than likely. To allow inflation (and with it, wage inflation and other rising costs of production) risks both allowing Chinese goods to become less competitive (i.e. more expensive) globally and potentially encourages the use of credit for further speculation.
However, how does China prevent inflation? With its currency pegged to the US Dollar, monetary policy is somewhat constrained and limited by the FED's actions. Thus, China will most likely have to use its control of the banking system to restrict the flow of capital into the economy. Though it unquestionably exerts far more control over its banks than other countries, China is likely to find that encouraging banks to lend is somewhat easier than persuading them to reduce their lending. We are already seeing signs of this; while 2009's bumper 10trn Yuan of loans (up from 4trn in 2008) was supposed to be reduced to a 'mere' 7trn Yuan in 2010, the Banks apparently didn't get the message (issuing an alleged 1.1trn Yuan of loans in January alone) leading to the imposition of the first steps of credit tightening.
Why does credit tightening matter? Speculation, especially in property, requires new buyers to continue to cause prices to rise. While this is true in most bubbles, it is particularly the case in those that generate no/limited income (i.e. real estate); the income generated by the asset is not sufficient to cover the interest (let alone the principal) on the loans used to acquire the asset, thus the only way the bubble can continue is for asset value to rise (perpetually). A slowing of credit growth is likely to negatively impact the number of buyers (or at least the number of buyers that can get adequate financing); if executed and managed perfectly it helps deflate the bubbles slowly, if not the bubble unwinds all too rapidly as existing buyers are unable to meet their interest (or margin) calls and become distressed sellers.
- Loosening of Foreign Capital Controls/Floating the Yuan:
Our Man looks at the loosening of foreign capital controls and Yuan flotation as the likely final throw of the dice by the Chinese; this move to appreciate the currency (as Japan did after the Plaza accord in the mid-late 80's) and potentially transfer ownership (and thus risk) of inflated assets from domestic Chinese holders to (hot money?) foreign investors. However, beyond the possibility of transferring risk to foreign investors there is little long-term advantage for the Chinese in letting the Yuan float. Unlike the Japanese, whose businesses were already at the technological and productive cutting edge (and thus had some pricing power) China’s industry has no such comparative advantage and relies predominantly on low costs to compete. Couple this with the universal belief that (after flotation) the Yuan could only appreciate, leads Our Man to suspect that after the initial euphoria (which could last many months) of a Yuan flotation, we are more likely to see the Yuan depreciate (to help maintain China’s low cost production, and ensure that over-capacity may potentially be used) in the medium-term.
- Loosening of Foreign Capital Controls/Floating the Yuan:
Our Man looks at the loosening of foreign capital controls and Yuan flotation as the likely final throw of the dice by the Chinese; this move to appreciate the currency (as Japan did after the Plaza accord in the mid-late 80's) and potentially transfer ownership (and thus risk) of inflated assets from domestic Chinese holders to (hot money?) foreign investors. However, beyond the possibility of transferring risk to foreign investors there is little long-term advantage for the Chinese in letting the Yuan float. Unlike the Japanese, whose businesses were already at the technological and productive cutting edge (and thus had some pricing power) China’s industry has no such comparative advantage and relies predominantly on low costs to compete. Couple this with the universal belief that (after flotation) the Yuan could only appreciate, leads Our Man to suspect that after the initial euphoria (which could last many months) of a Yuan flotation, we are more likely to see the Yuan depreciate (to help maintain China’s low cost production, and ensure that over-capacity may potentially be used) in the medium-term.
How to Play a Slowing China?
Given that Our Man is constrained to US-listed equities/ETFs and bonds, it seems the best way to play a slowdown in China is through Commodities/Commodity-related instruments. The simple reason is that China, despite representing only c8.25% of Global GDP is the marginal buyer of commodities -- e.g. China is 50% of global demand for Steel, 45% of global demand for Aluminium and 40% of the demand for Copper. Since Our Man's account isn't allowed to trade commodities directly; the choices we're left with are Commodity Stocks and Commodity-related ETFs. Each has its own benefits, and problems...
Commodity Stocks -- FCX (Copper)
Sadly, Our Man is likely to be restricted in trading these as he has spent most of the last 3months+ (with only a modicum of success) trying to persuade his boss to go short & buy puts in this space. A simplified core of Our Man's arguments are as follows:
- Using LME data there has been a 30-year historical negative correlation between Copper prices and Copper Inventories (i.e. as copper prices go up, people hold less inventories). This broke down in Q3-Q4 (see here)
- There are no significant impingements on global supply, and supply exceeds production (as per the International Copper Study Group)
- China represents 40% of global copper demand (see link to ICSG report above)
- Technically, the copper spot price and the FCX chart have both broken down
- The cash cost of production for the copper majors is $1.00-$1.20
Given the excess supply, and speculative inventories out there, Our Man has been arguing to his boss that now that the charts are technically broken copper stocks (and longer-term way out of the month puts on them) are the single best instrument to express an equity view. To express this, Our Man would consider either a small amount of premium in long-dated (e.g. Jan-11) well out-of-the-money puts (e.g. 30-strike for FCX) or waiting for further confirmation of the technical breakdowns and then using the same premium to invest in a rolling hedge of closer to the money & short-dated puts.
Given that Our Man is constrained to US-listed equities/ETFs and bonds, it seems the best way to play a slowdown in China is through Commodities/Commodity-related instruments. The simple reason is that China, despite representing only c8.25% of Global GDP is the marginal buyer of commodities -- e.g. China is 50% of global demand for Steel, 45% of global demand for Aluminium and 40% of the demand for Copper. Since Our Man's account isn't allowed to trade commodities directly; the choices we're left with are Commodity Stocks and Commodity-related ETFs. Each has its own benefits, and problems...
Commodity Stocks -- FCX (Copper)
Sadly, Our Man is likely to be restricted in trading these as he has spent most of the last 3months+ (with only a modicum of success) trying to persuade his boss to go short & buy puts in this space. A simplified core of Our Man's arguments are as follows:
- Using LME data there has been a 30-year historical negative correlation between Copper prices and Copper Inventories (i.e. as copper prices go up, people hold less inventories). This broke down in Q3-Q4 (see here)
- There are no significant impingements on global supply, and supply exceeds production (as per the International Copper Study Group)
- China represents 40% of global copper demand (see link to ICSG report above)
- Technically, the copper spot price and the FCX chart have both broken down
- The cash cost of production for the copper majors is $1.00-$1.20
Given the excess supply, and speculative inventories out there, Our Man has been arguing to his boss that now that the charts are technically broken copper stocks (and longer-term way out of the month puts on them) are the single best instrument to express an equity view. To express this, Our Man would consider either a small amount of premium in long-dated (e.g. Jan-11) well out-of-the-money puts (e.g. 30-strike for FCX) or waiting for further confirmation of the technical breakdowns and then using the same premium to invest in a rolling hedge of closer to the money & short-dated puts.
Commodity-Related ETFs -- These fall into two buckets; Basic Materials/Mining-related ETFs and (Resource rich) Country ETFs.
- Basic Materials/Mining ETFs such as IYM, VAM or UYM are an inefficient way of playing commodity stocks. They're inefficient due to the diversification which means that they lack the explosive downside of an individual name (e.g. FCX). Furthermore, their size is also smaller than that of the major companies thus they don't offer any liquidity benefits. As such, for Our Man to be involved with these ETFs it would require Our Man to believe there's a sharp fall coming in a shorter (i.e. <3 mos) time horizon.
- Country ETFs, in particular China (FXI), Australia (EWA) and Brazil (EWZ).
- Basic Materials/Mining ETFs such as IYM, VAM or UYM are an inefficient way of playing commodity stocks. They're inefficient due to the diversification which means that they lack the explosive downside of an individual name (e.g. FCX). Furthermore, their size is also smaller than that of the major companies thus they don't offer any liquidity benefits. As such, for Our Man to be involved with these ETFs it would require Our Man to believe there's a sharp fall coming in a shorter (i.e. <3 mos) time horizon.
- Country ETFs, in particular China (FXI), Australia (EWA) and Brazil (EWZ).
Unlike the Basic Materials/Mining ETFs, from a directional standpoint EWA/EWZ have the advantage of having a currency play embedded within them. Given that Our Man would be looking for a substantial move in the underlying markets, such a move is potentially likely to cause substantial capital flows from the currency. Of the two, Our Man far prefers Australia (reasons outlined below) though again the paucity of longer-term options available means that Our Man will have to wait for further deterioration and use a rolling hedge of short-term close to the money puts (if he does indeed manage to get any trade on).
Our Man's favourite trade idea
Since Our Man can't put this on in his portfolio and his day-job is for a fund that will only trade equities, it would only be fair to let you all take advantage of his favourite idea centred on this idea of a Chinese slow-down! As you know, Our Man thinks far too much about these things, so here's a brief summary of the process that got Our Man to the idea:
- The idea stemmed from further pondering regarding the Australian ETF.
- The economist Steve Keen, one of Our Man's favourite, has been talking about the US-style credit bubble(private credit at 250%+ of GDP is more than comparable to the US) and the over-valuation of the Australian housing market for most of the last 3 years (see his blog). This was reiterated recently by data in the 6th Annual Demographia International Housing Affordability survey (here) where 3 Australian cities ranked in the top 4 globally (and 10 in the top 20) in terms of affordability.
- Given how Australia has benefited from both its own and the Chinese stimulus, Our Man believes a decline in China will have a negative impact on Australia. For example, looking at the impact of the global slowdown on Australia (using data from Australian FED) shows something very surprising -- during Q2-2009 Australia have negative nominal GDP (i.e. the volume of stuff they made declined) and saw deflation. Any more prolonged repeat of that would likely have a similar impact to what we saw in the US thus an obvious to play the derivative of this decline would be through construction cos, homebuilders or banks that have ADRs in the US. Sadly, those that do don't have listed options that make such a move worthwhile.
- Additionally, it's also clear that people are universally bullish on Australia; the Aussie dollar was one of 2009's best performers (partly on the entire China-related story) and the Aussie CB's decision not to raise rates last month was a surprise. Despite this, economists still expect future rate rises and the upward sloping yield curve in the bond market tallies with this.
- Given Australia's low government debt-to-GDP (c18%) credit risk is clearly low and Our Man became curious as to whether there were any US dollar-denominated (don’t want that AUD currency risk!) Australian Government bonds he might be able to purchase.
Why? Simple, any slow-down in China will hurt the Australian economy directly (reduced demand), but also have secondary impacts (bringing the credit issues and home-over valuation issues to the fore, in the same way that happened during the US slowdown). History shows us that Central Banks react to economic slow-downs (irrespective of the cause) by cutting interest rates. Thus, given the potential for both an economic slowdown and a housing market issue in Australia, instead of seeing the rate rises that investors currently expect we could see (if Our Man is correct) substantial interest rate cuts. This fall in interest rate (and yields) would be good for bond prices.
Why? Simple, any slow-down in China will hurt the Australian economy directly (reduced demand), but also have secondary impacts (bringing the credit issues and home-over valuation issues to the fore, in the same way that happened during the US slowdown). History shows us that Central Banks react to economic slow-downs (irrespective of the cause) by cutting interest rates. Thus, given the potential for both an economic slowdown and a housing market issue in Australia, instead of seeing the rate rises that investors currently expect we could see (if Our Man is correct) substantial interest rate cuts. This fall in interest rate (and yields) would be good for bond prices.
- However, as you no doubt guessed, there are no US Dollar Australian Government bonds out there. However, when further thinking about the reasoning why Our Man was interested in bonds, it also became clear that they were not the best instrument.
So what is the best instrument?
Our Man would say Australian interest rate options (on a specified US-Dollar amount – i.e. with a currency hedge).
Simply put, the market currently expects Australian interest rates to be in the region of 5% in 2-years time. If Our Man is right, then they will be substantially lower and thus by purchasing the right (but not the obligation) to receive, in 2-years time, interest at the rate of 4.5% on 1-year money will prove spectacularly attractive. Furthermore, since this is an out of the money option (and Australian interest rate volatility is expected to be low) it is a cheap trade (cost is the equivalent of c10bips per annum, i.e. an interest rate of 4.25-4.3% would break-even) with definable downside (the premium invested).
Tuesday, February 9
China -- Part B: Things Our Man ponders that make him skeptical
- Consumer Spending:
The most common argument Our Man hears is a version of “don’t worry about it, China’s domestic consumption is low, and due to the formation of a middle class it’s going to increase so there’ll be loads of domestic demand”. Part of that argument is certainly true, at not even 33% of GDP Chinese consumption is low…very low, and in dollar terms (c$1.25trn) we’re talking about all of those Chinese consumer spending as much as British consumers! However, blithely assuming it’s going to go up (because you want it to) isn’t much of an answer, and Our Man has two major issues:
1). Chinese consumption has declined steadily since the 1980’s when it was consistently in the 50-54% of GDP range. Why should it suddenly rise? I’ve not yet heard anyone say that the Chinese just enjoy saving, more than the rest of us, so we can safely rule that out…though the arguments that they save because of the lack of welfare/social safety net and because investment “crowds it out” have merit. However, the underlying reasons why are important. Of the arguments, I think it’s certainly fair to say that a major reason that investment crowds out consumption is because government policy favors investment; through low interest rates, distorting the way in which credit is allocated (the benefits of being able to tell the banks who to lend to, and how much) and having no great penalty for misallocated investment (the benefits of being State-Owned Enterprises, and not having to survive a capitalist system). It’s pretty clear to Our Man that to change these things, and thus really encourage consumption, we’re not talking about the Chinese making small changes to their financial system but also to the growth engine that’s served them so well recently (and got the bulls so excited). That kind of change doesn’t come quickly and perfectly smoothly!
2). It’s the maths, stupid! For all Wall Street’s preoccupation with modeling and spreadsheets, numbers are tossed around with too little thought. For example, Our Man was having this discussion with a sell-side friend “Consumption fell from 50% in 1990, all I’m saying is that it gets back to 50%. That’s the same as most Asian countries (e.g. Korea, Malaysia, etc) and well less than Europe (c65%) and the US (c70$)”. On the surface it sounds like he has a reasonable point, but does he? Not particularly. For consumer spending to return to 50% of GDP by 2030 (fully 20 years away) would require consumer spending growth to outpace total Chinese GDP growth by 2-2.5% per annum and GDP (ex-Cons Spen) growth by 4-5% each year. How likely is that? Well, bear in mind that the bulls won't consider the quickest option for an increase in consumer spending as % GDP, namely that China's GDP growth rate slows dramatically (or goes negative). Thus we're left with a situation that immediately calls for both China to grow quickly & consumer spending growth to surge, despite the issues mentioned above...and that's not even considering the impact that things to aid consumer spending (like wage increases, or people moving to the cities but then garnering their wage from production of tradable/exportable goods, etc) may have on the rest of the economy. Maybe the Chinese government are just better at managing an economy, and transitioning it from one driver to another, than the rest of the world but that's a lot of faith to base an investment case on.
- Banking Sector & Credit
As mentioned above, one of the advantages the Chinese government has is that they can dictate the amount of bank lending. Like much of the Chinese model, this also subtly implies that the primary driver for financial enterprises (including those private ones) is not entirely profit-focused. Thus Our Man doesn't think it is a massive leap to suggest that if banks are extending credit because they are ordered to there's a decent probability that they're more likely to have more bad loans than if they were driven by considering whether these loans would be profitable. Furthermore, looking historically, the biggest guide to potential bubbles has been the presence of easy credit and while China's lending target of 7trn yuan for 2010 is a decrease from the exceptionally lax 10trn yuan in 2009, it represents a significant increase over any prior year (e.g. 4.9trn yuan in 2008). Additionally, China's been through a non-performing loan crisis before (c10yrs ago)...and the government's response was a glorified version of extend & pretend (in short: govt sponsored AMC's bought the debt, and issued the banks bonds paying 100% and 50% of face value of the debt. The problem being the debt isn't worth 50-100% of face value. So far, as the debt has been liquidated the interest on the bonds has been paid, allowing the banks to treat them as whole, but when the first bond came due in December it was rolled, as the AMC can't pay the principal(!), with a letter of support from the Ministry of Finance.).
- Investment and Resource Allocation
The skepticism Our Man has here is a continuation of those listed above; a significant number of the recipients of the banks' (government ordered) credit are government sponsored/owned entities (again with no focus on profitability). Thus you have creditors (with no focus on profit) lending to borrowers (with no focus on profit) -- a recipe for misallocation of resources and non-performing loans.
Why does this matter? Historically, as noted in part A, China benefited from its investment in capacity by increasing its share of global exports. Now however, China already punches well above its weight in the export markets (it represents a greater percentage of global exports, c15%, than it does global GDP, c8%), but it continues to focus on building yet more capacity with the aim of increasing its exports (irrespective of the marginal returns on such investments in capacity). A recent public research piece from Pivot Capital (here) talks a lot about the fixed capital formation in China, both how it's broadly unprecedented and how it drove a significant portion of 2009's growth.
- Global Trade & Mercantilist Model
It's often said that pictures are worth a 1,000 words, hence Our Man will attempt to curtail his loquaciousness by showing you his favourite Financial picture (from Charles Kindleberger's book "World in Depression") showing what happened to Global Trade during the Great Depression.
Now, take into account the recent rumblings about protectionism and imposition of tariffs on Steel, Tires and Chicken (!), and consider what the impact on China would be if global trade did anything even mildly similar today. Our Man suspects that it's not going to be good for the world's largest exporter, who already has an oversized slice of the pie and is building (potentially rampant) over-capacity.
As an aside, it seems slightly bizarre to Our Man that China seems intent to proceed (at a vastly faster rate) down a similar mercantilist model to Korea & Japan before it, by seeking to become the supplier to the world and generate current account surpluses as a tool/proxy for national power. (In much the same way, as it seems odd to Our Man that the US Fed/Treasury seems keen to mimic Japan's policies of the 90's, in the hope that by doing so in greater size will bring about a different result).
- Reserves and Current Account Surpluses
A recent argument that Our Man encountered is that one should never bet against a country with substantial reserves. This argument is muppetry, at it's finest! Firstly, Our Man has no idea what reserves have to do with anything (with regards to the investment positions mentioned in part C), especially as reserves are a result of the imbalances (i.e. those big current account surpluses over time, from being an exporter) that have helped caused some of the issues. Secondly, even if reserves had anything do with anything, then Our Man would point out that China's reserves are 5-6% of global GDP and the only 2 other times that a single country has had anything similar as a % of Global GDP are.......late 1920's USA and late 1980's Japan! While this doesn't mean that China is guaranteed to face the same market crashes that Japan or the US did at that time, it certainly should debunk the counter-argument that one should never bet against a country with substantial reserves!
- Urbanisation
Another argument that Our Man has heard is that the migration of people from rural areas to the city's justifies the continued increase of real estate (both residential and commercial) in Chinese cities. Our Man has two observations on this; 1). It presumes that the migrant worker can afford the housing being built (which emprically seems somewhat questionable) and 2). building in anticipation of migration of people, by itself, is a weak argument as trends can quickly reverse (or stagnate) causing massive oversupply -- you'd think that the examples of Spain and Florida in the last 3 years would make this palpably obvious, but apparently not.
- Demographics
Look at the 2 pyramids below; China's population in 2010 and 2030 -- what should become immediately apparent is that China's going have a lot more older people (60+) in 20 years time and a lot less young adults (20-35yrs). In numeric form, in 2030: 31.8% of the adults will be 60+ (vs. 17.8% today), only 21.1% will be 20-35yrs old (vs. 32.3% today) AND the adult population will decline by c10%.
That's the result of China's 1-child policy! The impacts of those changes are significant, since it's the 20-35yo cohort that add the most to GDP (think buying first car/house/etc) and one of China's apparent advantages is endless supply of labour. Instead Our Man fears that China will get old before it gets rich.
- Stimulus & Data
The Chinese stimulus in 2009/10 at $1trillion was far larger than the US stimulus, especially when considered as a % of GDP (China's stimulus was 25% of GDP!). Given the impact this had on GDP, it should be no surprise that China showed great growth last year! However, just like the US, the impact of stimulus turns from a positive to a negative on GDP growth rates unless the stimulus is continued/renewed OR private demand steps up to replace it. Separately, there seems to be much teeth-gnashing over the quality of US data (e.g. the BLS revisions on Friday to the payrolls numbers for 2009) yet no such qualms exist over China (despite very strange data, like auto sales up 80% through October...yet gas sales up only 8%).
Next Up: The warning signs Our Man is watching, and trade ideas
The most common argument Our Man hears is a version of “don’t worry about it, China’s domestic consumption is low, and due to the formation of a middle class it’s going to increase so there’ll be loads of domestic demand”. Part of that argument is certainly true, at not even 33% of GDP Chinese consumption is low…very low, and in dollar terms (c$1.25trn) we’re talking about all of those Chinese consumer spending as much as British consumers! However, blithely assuming it’s going to go up (because you want it to) isn’t much of an answer, and Our Man has two major issues:
1). Chinese consumption has declined steadily since the 1980’s when it was consistently in the 50-54% of GDP range. Why should it suddenly rise? I’ve not yet heard anyone say that the Chinese just enjoy saving, more than the rest of us, so we can safely rule that out…though the arguments that they save because of the lack of welfare/social safety net and because investment “crowds it out” have merit. However, the underlying reasons why are important. Of the arguments, I think it’s certainly fair to say that a major reason that investment crowds out consumption is because government policy favors investment; through low interest rates, distorting the way in which credit is allocated (the benefits of being able to tell the banks who to lend to, and how much) and having no great penalty for misallocated investment (the benefits of being State-Owned Enterprises, and not having to survive a capitalist system). It’s pretty clear to Our Man that to change these things, and thus really encourage consumption, we’re not talking about the Chinese making small changes to their financial system but also to the growth engine that’s served them so well recently (and got the bulls so excited). That kind of change doesn’t come quickly and perfectly smoothly!
2). It’s the maths, stupid! For all Wall Street’s preoccupation with modeling and spreadsheets, numbers are tossed around with too little thought. For example, Our Man was having this discussion with a sell-side friend “Consumption fell from 50% in 1990, all I’m saying is that it gets back to 50%. That’s the same as most Asian countries (e.g. Korea, Malaysia, etc) and well less than Europe (c65%) and the US (c70$)”. On the surface it sounds like he has a reasonable point, but does he? Not particularly. For consumer spending to return to 50% of GDP by 2030 (fully 20 years away) would require consumer spending growth to outpace total Chinese GDP growth by 2-2.5% per annum and GDP (ex-Cons Spen) growth by 4-5% each year. How likely is that? Well, bear in mind that the bulls won't consider the quickest option for an increase in consumer spending as % GDP, namely that China's GDP growth rate slows dramatically (or goes negative). Thus we're left with a situation that immediately calls for both China to grow quickly & consumer spending growth to surge, despite the issues mentioned above...and that's not even considering the impact that things to aid consumer spending (like wage increases, or people moving to the cities but then garnering their wage from production of tradable/exportable goods, etc) may have on the rest of the economy. Maybe the Chinese government are just better at managing an economy, and transitioning it from one driver to another, than the rest of the world but that's a lot of faith to base an investment case on.
- Banking Sector & Credit
As mentioned above, one of the advantages the Chinese government has is that they can dictate the amount of bank lending. Like much of the Chinese model, this also subtly implies that the primary driver for financial enterprises (including those private ones) is not entirely profit-focused. Thus Our Man doesn't think it is a massive leap to suggest that if banks are extending credit because they are ordered to there's a decent probability that they're more likely to have more bad loans than if they were driven by considering whether these loans would be profitable. Furthermore, looking historically, the biggest guide to potential bubbles has been the presence of easy credit and while China's lending target of 7trn yuan for 2010 is a decrease from the exceptionally lax 10trn yuan in 2009, it represents a significant increase over any prior year (e.g. 4.9trn yuan in 2008). Additionally, China's been through a non-performing loan crisis before (c10yrs ago)...and the government's response was a glorified version of extend & pretend (in short: govt sponsored AMC's bought the debt, and issued the banks bonds paying 100% and 50% of face value of the debt. The problem being the debt isn't worth 50-100% of face value. So far, as the debt has been liquidated the interest on the bonds has been paid, allowing the banks to treat them as whole, but when the first bond came due in December it was rolled, as the AMC can't pay the principal(!), with a letter of support from the Ministry of Finance.).
- Investment and Resource Allocation
The skepticism Our Man has here is a continuation of those listed above; a significant number of the recipients of the banks' (government ordered) credit are government sponsored/owned entities (again with no focus on profitability). Thus you have creditors (with no focus on profit) lending to borrowers (with no focus on profit) -- a recipe for misallocation of resources and non-performing loans.
Why does this matter? Historically, as noted in part A, China benefited from its investment in capacity by increasing its share of global exports. Now however, China already punches well above its weight in the export markets (it represents a greater percentage of global exports, c15%, than it does global GDP, c8%), but it continues to focus on building yet more capacity with the aim of increasing its exports (irrespective of the marginal returns on such investments in capacity). A recent public research piece from Pivot Capital (here) talks a lot about the fixed capital formation in China, both how it's broadly unprecedented and how it drove a significant portion of 2009's growth.
- Global Trade & Mercantilist Model
It's often said that pictures are worth a 1,000 words, hence Our Man will attempt to curtail his loquaciousness by showing you his favourite Financial picture (from Charles Kindleberger's book "World in Depression") showing what happened to Global Trade during the Great Depression.
Now, take into account the recent rumblings about protectionism and imposition of tariffs on Steel, Tires and Chicken (!), and consider what the impact on China would be if global trade did anything even mildly similar today. Our Man suspects that it's not going to be good for the world's largest exporter, who already has an oversized slice of the pie and is building (potentially rampant) over-capacity.
As an aside, it seems slightly bizarre to Our Man that China seems intent to proceed (at a vastly faster rate) down a similar mercantilist model to Korea & Japan before it, by seeking to become the supplier to the world and generate current account surpluses as a tool/proxy for national power. (In much the same way, as it seems odd to Our Man that the US Fed/Treasury seems keen to mimic Japan's policies of the 90's, in the hope that by doing so in greater size will bring about a different result).
- Reserves and Current Account Surpluses
A recent argument that Our Man encountered is that one should never bet against a country with substantial reserves. This argument is muppetry, at it's finest! Firstly, Our Man has no idea what reserves have to do with anything (with regards to the investment positions mentioned in part C), especially as reserves are a result of the imbalances (i.e. those big current account surpluses over time, from being an exporter) that have helped caused some of the issues. Secondly, even if reserves had anything do with anything, then Our Man would point out that China's reserves are 5-6% of global GDP and the only 2 other times that a single country has had anything similar as a % of Global GDP are.......late 1920's USA and late 1980's Japan! While this doesn't mean that China is guaranteed to face the same market crashes that Japan or the US did at that time, it certainly should debunk the counter-argument that one should never bet against a country with substantial reserves!
- Urbanisation
Another argument that Our Man has heard is that the migration of people from rural areas to the city's justifies the continued increase of real estate (both residential and commercial) in Chinese cities. Our Man has two observations on this; 1). It presumes that the migrant worker can afford the housing being built (which emprically seems somewhat questionable) and 2). building in anticipation of migration of people, by itself, is a weak argument as trends can quickly reverse (or stagnate) causing massive oversupply -- you'd think that the examples of Spain and Florida in the last 3 years would make this palpably obvious, but apparently not.
- Demographics
Look at the 2 pyramids below; China's population in 2010 and 2030 -- what should become immediately apparent is that China's going have a lot more older people (60+) in 20 years time and a lot less young adults (20-35yrs). In numeric form, in 2030: 31.8% of the adults will be 60+ (vs. 17.8% today), only 21.1% will be 20-35yrs old (vs. 32.3% today) AND the adult population will decline by c10%.
That's the result of China's 1-child policy! The impacts of those changes are significant, since it's the 20-35yo cohort that add the most to GDP (think buying first car/house/etc) and one of China's apparent advantages is endless supply of labour. Instead Our Man fears that China will get old before it gets rich.
- Stimulus & Data
The Chinese stimulus in 2009/10 at $1trillion was far larger than the US stimulus, especially when considered as a % of GDP (China's stimulus was 25% of GDP!). Given the impact this had on GDP, it should be no surprise that China showed great growth last year! However, just like the US, the impact of stimulus turns from a positive to a negative on GDP growth rates unless the stimulus is continued/renewed OR private demand steps up to replace it. Separately, there seems to be much teeth-gnashing over the quality of US data (e.g. the BLS revisions on Friday to the payrolls numbers for 2009) yet no such qualms exist over China (despite very strange data, like auto sales up 80% through October...yet gas sales up only 8%).
Next Up: The warning signs Our Man is watching, and trade ideas
Saturday, February 6
Portfolio Update: Baling Out and Going (Almost) All In
Baling Out
THRX: The eagle-eyed amongst you will have noticed that it fell through Our Man's mental "stop loss" for the portion viewed as tactical. Despite some delays in getting the requisite approvals, Our Man sold just over 50% of the position. The owl-eyed amongst you, will notice that Our Man disposed of some of the strategic piece of the position too. This is a result of Our Man's increased bearishness, with the market (S&P) falling through a number of key technical levels in the recent week or so. The hope is that by under sizing the position now, Our Man will (at some point in the undetermined future) for taking the ‘opportunity cost’ risk and have both the available firepower and mental clarity to be able to top up his strategic position at a significantly more attractive price.
GLD: Our Man's Long position in Gold has long been the one that has been causing him the most intellectual discomfort. Today, the skeptic in him finally won out and the entire Gold position was closed. While Our Man is certainly sympathetic to the bullish arguments on Gold (in particular it's hedge against bad governance by the US Govt/Fed/Treasury, and as protection against a emerging-market type 'sudden stop' occurring in the US Dollar), the two primary bearish thoughts in his mind won out. Firstly, while the Fed/Treasury/US Govt have done little to show they can be trusted to not debase the dollar, currencies are a relative value instrument and the dollar is (in the short-medium term) the least worst of the major liquid currencies (the Euro, Yen and Sterling all have far more immediate risks in terms of budget deficits, bailouts, etc). Over the past 12months, based on Kitco's calculation, about 1/2 of Gold's return came as a result of weakening in the USD and about half from increased buying or 'fundamentals'. While this was important to Our Man's thinking, the second more philosophical point was of greater importance. Leaving aside those bulls that seem to believe that Gold will go up whatever the circumstance, over the last 6-12months there has been a general groundswell of opinion that Gold is a "flight to quality" safe haven. As this clamour has grown, Our Man has steadily become more skeptical of it -- can an instrument that's both viewed as a "flight to quality" (i.e. uber-low risk) safe haven AND bought by people as such PRIOR to the flight to quality, actually be a flight to quality instrument?? After much pondering, Our Man has decided the answer's probably not...that being out of favour, prior to the flight to quality, is probably a prerequisite for the instrument to actually behave like a safe haven during the flight to quality scenario.
Going (Almost) All In
HSTRX: Our Man added (or at least has tried to; he’s still waiting for the transaction to take place) a new position to the portfolio, in the Hussman Strategic Total Return Fund, though its theme is broadly consistent (a majority in Treasuries, though the ability to buy equities too) with Our Man's outlook. Given the constraints on Our Man (along with his lack of substantial fixed income experience and access to bonds), outsourcing the ability to choose between bonds seems sensible. Our Man has been fortunate enough to read Dr. Hussman's weekly market comments & thoughts over the last 5-years or so; while not always in total agreement with Dr. Hussman (such as currently on the probability of inflation), Our Man always finds him thought provoking and would heartily recommend his commentary.
With these changes to the portfolio, the tilt has become noticeably bearish with the majority of assets (combining the direct and indirect exposures) held in Treasuries, continuing to reflect Our Man's view both that they will be a flight to quality instrument and that (while lending remains constrained) the inflation prospects are much more limited than the market appreciates. Coupled with this the fund has a net Short position in equities (expressed through puts on the S&P and GS), which will only expand further should markets decline by 10-15%. While the use of puts constrains the capital loss in the equity positions (to c200bips), it should be expected that the portfolio will suffer from a return to risk-seeking behaviour in the markets.
Why Almost?
Our Man has a few other put positions he's pondering about, most notably in Mining & Australia (see upcoming China series) as well as potentially in REITS (especially Hotel REITs). However, he'd have to both find appropriate instruments and see a far more serious technical breakdown in the markets before considering putting these positions on.
Portfolio (as of cob 2/5)
56.98% Long Bonds
THRX: The eagle-eyed amongst you will have noticed that it fell through Our Man's mental "stop loss" for the portion viewed as tactical. Despite some delays in getting the requisite approvals, Our Man sold just over 50% of the position. The owl-eyed amongst you, will notice that Our Man disposed of some of the strategic piece of the position too. This is a result of Our Man's increased bearishness, with the market (S&P) falling through a number of key technical levels in the recent week or so. The hope is that by under sizing the position now, Our Man will (at some point in the undetermined future) for taking the ‘opportunity cost’ risk and have both the available firepower and mental clarity to be able to top up his strategic position at a significantly more attractive price.
GLD: Our Man's Long position in Gold has long been the one that has been causing him the most intellectual discomfort. Today, the skeptic in him finally won out and the entire Gold position was closed. While Our Man is certainly sympathetic to the bullish arguments on Gold (in particular it's hedge against bad governance by the US Govt/Fed/Treasury, and as protection against a emerging-market type 'sudden stop' occurring in the US Dollar), the two primary bearish thoughts in his mind won out. Firstly, while the Fed/Treasury/US Govt have done little to show they can be trusted to not debase the dollar, currencies are a relative value instrument and the dollar is (in the short-medium term) the least worst of the major liquid currencies (the Euro, Yen and Sterling all have far more immediate risks in terms of budget deficits, bailouts, etc). Over the past 12months, based on Kitco's calculation, about 1/2 of Gold's return came as a result of weakening in the USD and about half from increased buying or 'fundamentals'. While this was important to Our Man's thinking, the second more philosophical point was of greater importance. Leaving aside those bulls that seem to believe that Gold will go up whatever the circumstance, over the last 6-12months there has been a general groundswell of opinion that Gold is a "flight to quality" safe haven. As this clamour has grown, Our Man has steadily become more skeptical of it -- can an instrument that's both viewed as a "flight to quality" (i.e. uber-low risk) safe haven AND bought by people as such PRIOR to the flight to quality, actually be a flight to quality instrument?? After much pondering, Our Man has decided the answer's probably not...that being out of favour, prior to the flight to quality, is probably a prerequisite for the instrument to actually behave like a safe haven during the flight to quality scenario.
Going (Almost) All In
HSTRX: Our Man added (or at least has tried to; he’s still waiting for the transaction to take place) a new position to the portfolio, in the Hussman Strategic Total Return Fund, though its theme is broadly consistent (a majority in Treasuries, though the ability to buy equities too) with Our Man's outlook. Given the constraints on Our Man (along with his lack of substantial fixed income experience and access to bonds), outsourcing the ability to choose between bonds seems sensible. Our Man has been fortunate enough to read Dr. Hussman's weekly market comments & thoughts over the last 5-years or so; while not always in total agreement with Dr. Hussman (such as currently on the probability of inflation), Our Man always finds him thought provoking and would heartily recommend his commentary.
With these changes to the portfolio, the tilt has become noticeably bearish with the majority of assets (combining the direct and indirect exposures) held in Treasuries, continuing to reflect Our Man's view both that they will be a flight to quality instrument and that (while lending remains constrained) the inflation prospects are much more limited than the market appreciates. Coupled with this the fund has a net Short position in equities (expressed through puts on the S&P and GS), which will only expand further should markets decline by 10-15%. While the use of puts constrains the capital loss in the equity positions (to c200bips), it should be expected that the portfolio will suffer from a return to risk-seeking behaviour in the markets.
Why Almost?
Our Man has a few other put positions he's pondering about, most notably in Mining & Australia (see upcoming China series) as well as potentially in REITS (especially Hotel REITs). However, he'd have to both find appropriate instruments and see a far more serious technical breakdown in the markets before considering putting these positions on.
Portfolio (as of cob 2/5)
56.98% Long Bonds
42.46%: L Long-end Treasuries (22.3% in the Aug-29 Bond, and 20.2% in TLT)
14.52%: L Bond-orientated Funds (7.7% in VBIIX and c6.79% in HSTRX, when its completed)
14.52%: L Bond-orientated Funds (7.7% in VBIIX and c6.79% in HSTRX, when its completed)
2.03% Short Equities (on a delta-adjusted basis)
2.33%: L THRX
4.51%: L Restricted Equities
-5.89%: S S&P (via SPY puts, with a Dec-10 expiry and strike prices of 100 and 85; 76bips and 34bips of premium at risk, respectively)
-2.98%: S GS (via a put, with a Dec-10 expiration and a 120 strike; 81bips of premium at risk)
4.51%: L Restricted Equities
-5.89%: S S&P (via SPY puts, with a Dec-10 expiry and strike prices of 100 and 85; 76bips and 34bips of premium at risk, respectively)
-2.98%: S GS (via a put, with a Dec-10 expiration and a 120 strike; 81bips of premium at risk)
Wednesday, February 3
China Thoughts: Part A
Our Man has, over the last few months, alluded to his deep skepticism surrounding the broad positive conventional wisdom around China but has been spectacularly inept at providing further details as to why he feels this way. With other skeptical mutterings (most notably from Jim Chanos) becoming more common place, what better time to finally jot down some thoughts.
A Short Recap:
To start off with, it might help to recap some of the things that have helped China do so well?
- Joining the WTO: If Our Man had to point to the thing that had the largest impact, it's this; by doing so (in 2003) China essentially ensured that there was a market for it to take advantage of its low costs.
- Low cost: The big one that's focused a lot upon is labour; wage costs started from a low base and wage growth in China was pretty stagnant from the mid-90's to 2005, with the pool of labor swelled by those no longer needed in agriculture (due to greater efficiency). However, China also benefited from the other costs being low, with rent/land and raw materials being obvious examples.
- Low base: It helps to start at a low base, in both nominal dollar terms and on a GDP/capita basis (China's nominal GDP, in $-terms, doubled from $0.8trn to $1.6trnbetween 1995 and 2003. It has more than doubled since, to over $4trn)
- Reform: There is little doubt that China is today more ‘Westernized’ (both in terms of society and having some form of capitalist approach) and has greater freedoms than it was 5-10years ago.
- Good planning: There can be little argument that the Chinese government managed the economy well, building infrastructure ahead of growth and making good policy decisions (see joining WTO).
- Luck: The big customer for China was the US consumer, thus China was an indirect beneficiary of both the existence and the time of the credit bubble in the US.
The problem is that these factors aren’t ones necessarily present going forwards; China’s already the largest exporter in the world (its share of world exports is around twice its share of world GDP!) and with the recent rises (in wages, raw materials, etc) it’s no longer particularly low cost (compared to SE Asia). Furthermore, as the new US President is finding out, the first steps in “reform” are always the easiest as those with the power have more to lose the further reform goes (and if you happen to be a centrally-planned country, that’s doubly the case).
Thus the key drivers to China’s future growth are likely to be different from those that drove growth in the past; increased efficiency (to improve productivity, retain a cost advantage and move into producing higher value-added products/services) and creating new markets (especially a domestic one).
Next Up: Why Our Man is so skeptical.
A Short Recap:
To start off with, it might help to recap some of the things that have helped China do so well?
- Joining the WTO: If Our Man had to point to the thing that had the largest impact, it's this; by doing so (in 2003) China essentially ensured that there was a market for it to take advantage of its low costs.
- Low cost: The big one that's focused a lot upon is labour; wage costs started from a low base and wage growth in China was pretty stagnant from the mid-90's to 2005, with the pool of labor swelled by those no longer needed in agriculture (due to greater efficiency). However, China also benefited from the other costs being low, with rent/land and raw materials being obvious examples.
- Low base: It helps to start at a low base, in both nominal dollar terms and on a GDP/capita basis (China's nominal GDP, in $-terms, doubled from $0.8trn to $1.6trnbetween 1995 and 2003. It has more than doubled since, to over $4trn)
- Reform: There is little doubt that China is today more ‘Westernized’ (both in terms of society and having some form of capitalist approach) and has greater freedoms than it was 5-10years ago.
- Good planning: There can be little argument that the Chinese government managed the economy well, building infrastructure ahead of growth and making good policy decisions (see joining WTO).
- Luck: The big customer for China was the US consumer, thus China was an indirect beneficiary of both the existence and the time of the credit bubble in the US.
The problem is that these factors aren’t ones necessarily present going forwards; China’s already the largest exporter in the world (its share of world exports is around twice its share of world GDP!) and with the recent rises (in wages, raw materials, etc) it’s no longer particularly low cost (compared to SE Asia). Furthermore, as the new US President is finding out, the first steps in “reform” are always the easiest as those with the power have more to lose the further reform goes (and if you happen to be a centrally-planned country, that’s doubly the case).
Thus the key drivers to China’s future growth are likely to be different from those that drove growth in the past; increased efficiency (to improve productivity, retain a cost advantage and move into producing higher value-added products/services) and creating new markets (especially a domestic one).
Next Up: Why Our Man is so skeptical.
Monday, February 1
January Review
Performance Review
While December was Our Man’s most disappointing month as the investor (with Mrs. OM) in the portfolio, January was Our Man’s most disappointing month as a portfolio manager despite the portfolio producing a modest gain of +0.45%.
Why disappointing?
The reasoning is simple; as you’ll no doubt remember, Our Man has regularly expressed his negative sentiment towards equities and this is reflected in the portfolio’s setup. As such, we would expect the portfolio to have non-descript performance should the market’s rise but to be profitable should they stumble. So it proved, with the portfolio up over 1% going into the final day of the month, before seeing its month’s return largely wiped away by a 100bip+ loss from the THRX position.
THRX; What happened?
Let’s first talk (very briefly) about why THRX (a biotech company) fell; the company had applied (for the drug telavancin, to be used in nosocomial pneumonia) to the FDA to request that they be allowed to pool survival data from 2 studies. They unexpectedly received a response from the FDA, saying that even if the FDA accepted the pooled data, the existing studies would equate to only 1 appropriate trial. As such, THRX would need to conduct a second trial meaning a delay of at least 2-years (before the drug could be approved) and much additional cost. Obviously, for a drug development/biotech company, this is pretty bad news. The stock suffered heavily both from the fundamental impact (estimated at $1-1.50 per share by analysts) and especially from the change in sentiment (e.g. investors could reasonably conclude that THRX has higher execution risk than they had previously considered) that this type of news engenders. Fortunately, while Telavancin is a very important drug to THRX (and the only one in it has in Phase III Trials, currently) they have more important drugs coming through the pipeline (most notably Horizon, in Phase II Trials).
THRX; why this was bad portfolio management?
Let us go back to what Our Man wrote, when he was delighted to inherit the THRX position -- “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”. The sad truth is that the sizing was too large, with Our Man’s over-focus on the potential return meaning that he was reluctant to sell some immediately in order to bring the position down to an appropriate size (3.25-4.00%) given the risks involved. This over-sizing directly resulted in an extra 50-60bips of the negative impact to the portfolio in January.
As Our Man has been discussing portfolio management recently, it seems to be a good time to highlight the secondary (and potentially tertiary) impacts of the initial error. The side effect of it is that it leads to numerous different decision paths, which are all defensive in nature and fraught with various behavioural biases that can help compound the initial error. A small sample of possible questions Our Man now has to deal with; should the position be reduced immediately? Should the entire position be held, given the seeming over-reaction, and partially disposed of later? How much should be sold down? How much later – how much more pain should Our Man risk the position inflicting?
By contrast if Our Man had thought more thoroughly about the risk beforehand and right-sized the position, the decision-making process now would be far easier and likely more productive. In essence, it would boil down to is now the right time to add, and if so, to the initial level of risk (3.5-4.0%) or should the position now be oversized?
For what it’s worth, Our Man has decided to retain the full THRX position for the moment, given the severe reaction. However, it would be better to view the existing position as two; a long-term investment position (3.5-4.0%) and a short-term tactical position (1.5%-2%). The tactical position has a ‘stop loss’ at a strike price of $10 linked to it, with a rolling ‘take profit’ at $12.50.
Given all of the above, the breakdown of performance should be unsurprising; the stand-out contributors being the Long Treasuries positions (100bips+) and the long Put positions (25bips+), with their good work largely undone by the Long THRX position (-100bips+).
Portfolio
42.14% -- Long Long-term Treasuries (via L TLT and L Aug-29 Treasury Bond)
8.77% -- Long GLD
7.61% -- Long Intermediate Bond Fund (via L VBIIX)
5.39% -- Long THRX
4.61% -- Long Restricted equity positions (via L NWS, L CMTL, L CRDN, L SOAP)
(4.53%) – Delta-Adjusted Short position in the SPY (via L Dec-10 puts, with strikes at 100 & 85; 1.02% premium at risk)
(3.18%) – Delta-Adjusted Short position in GS (via L Dec-10 puts, strike 120; 0.85% premium at risk)
29.59% -- Cash
While December was Our Man’s most disappointing month as the investor (with Mrs. OM) in the portfolio, January was Our Man’s most disappointing month as a portfolio manager despite the portfolio producing a modest gain of +0.45%.
Why disappointing?
The reasoning is simple; as you’ll no doubt remember, Our Man has regularly expressed his negative sentiment towards equities and this is reflected in the portfolio’s setup. As such, we would expect the portfolio to have non-descript performance should the market’s rise but to be profitable should they stumble. So it proved, with the portfolio up over 1% going into the final day of the month, before seeing its month’s return largely wiped away by a 100bip+ loss from the THRX position.
THRX; What happened?
Let’s first talk (very briefly) about why THRX (a biotech company) fell; the company had applied (for the drug telavancin, to be used in nosocomial pneumonia) to the FDA to request that they be allowed to pool survival data from 2 studies. They unexpectedly received a response from the FDA, saying that even if the FDA accepted the pooled data, the existing studies would equate to only 1 appropriate trial. As such, THRX would need to conduct a second trial meaning a delay of at least 2-years (before the drug could be approved) and much additional cost. Obviously, for a drug development/biotech company, this is pretty bad news. The stock suffered heavily both from the fundamental impact (estimated at $1-1.50 per share by analysts) and especially from the change in sentiment (e.g. investors could reasonably conclude that THRX has higher execution risk than they had previously considered) that this type of news engenders. Fortunately, while Telavancin is a very important drug to THRX (and the only one in it has in Phase III Trials, currently) they have more important drugs coming through the pipeline (most notably Horizon, in Phase II Trials).
THRX; why this was bad portfolio management?
Let us go back to what Our Man wrote, when he was delighted to inherit the THRX position -- “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”. The sad truth is that the sizing was too large, with Our Man’s over-focus on the potential return meaning that he was reluctant to sell some immediately in order to bring the position down to an appropriate size (3.25-4.00%) given the risks involved. This over-sizing directly resulted in an extra 50-60bips of the negative impact to the portfolio in January.
As Our Man has been discussing portfolio management recently, it seems to be a good time to highlight the secondary (and potentially tertiary) impacts of the initial error. The side effect of it is that it leads to numerous different decision paths, which are all defensive in nature and fraught with various behavioural biases that can help compound the initial error. A small sample of possible questions Our Man now has to deal with; should the position be reduced immediately? Should the entire position be held, given the seeming over-reaction, and partially disposed of later? How much should be sold down? How much later – how much more pain should Our Man risk the position inflicting?
By contrast if Our Man had thought more thoroughly about the risk beforehand and right-sized the position, the decision-making process now would be far easier and likely more productive. In essence, it would boil down to is now the right time to add, and if so, to the initial level of risk (3.5-4.0%) or should the position now be oversized?
For what it’s worth, Our Man has decided to retain the full THRX position for the moment, given the severe reaction. However, it would be better to view the existing position as two; a long-term investment position (3.5-4.0%) and a short-term tactical position (1.5%-2%). The tactical position has a ‘stop loss’ at a strike price of $10 linked to it, with a rolling ‘take profit’ at $12.50.
Given all of the above, the breakdown of performance should be unsurprising; the stand-out contributors being the Long Treasuries positions (100bips+) and the long Put positions (25bips+), with their good work largely undone by the Long THRX position (-100bips+).
Portfolio
42.14% -- Long Long-term Treasuries (via L TLT and L Aug-29 Treasury Bond)
8.77% -- Long GLD
7.61% -- Long Intermediate Bond Fund (via L VBIIX)
5.39% -- Long THRX
4.61% -- Long Restricted equity positions (via L NWS, L CMTL, L CRDN, L SOAP)
(4.53%) – Delta-Adjusted Short position in the SPY (via L Dec-10 puts, with strikes at 100 & 85; 1.02% premium at risk)
(3.18%) – Delta-Adjusted Short position in GS (via L Dec-10 puts, strike 120; 0.85% premium at risk)
29.59% -- Cash
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