Portfolio Thoughts and Risks – 05/10

First, more generally, I try to stay away from regular missives on how the portfolio is doing; given my thematic bent, the pace of change is often excruciatingly slow and while writing about it may make it more exciting, it does little to help speed the passage of time.  That and as those who know would attest, I’ve never been known to be particularly loquacious on subjects that I have little to talk about.
As such, I’ll spare you all the “post hoc ergo propter hoc” analysis floating around to try and explain the market’s recent decline; bar to state the obvious and say that it’s the market that makes the news (not the other way around) and that fear (though I wouldn’t say panic or capitulation) is back. 

Given the general theses that I’ve been espousing and the portfolio’s construction, with its heavy leaning towards flight to quality assets and smattering of equity puts, it shouldn’t be a surprise that the portfolio is bearing up reasonably well and has eked out a small gain in May. 

Given that, what do I think and worry about?
The short-term:
I’m relatively sanguine at the moment, with the portfolio remaining set up to perform well on an absolute basis if markets fall and to “hang around” (though this likely entails giving up recent gains first) should the rally resume.  The latter situation would represent a disappointing year, though at least capital is unlikely to be noticeably impaired.

Any short-term views I hold tend to be applicable towards position sizing (rather than trading positions), and today clearly the biggest risk to the portfolio is a large shift back towards increased risk appetite.  A further bounce (e.g. following new European measures agreed over the weekend) within a continued downtrend isn’t overly concerning.  It will doubtless cost the portfolio, but if it was within a broader trend then it’s more likely short-term mark-to-market risk than anything that will have any longer-term impact.  Even an aggressive move, while painful for the Treasury position, would be acceptable given the increased size of the NCAV bucket (with its penchant towards micro-small cap names).

The most difficult situation would be a more orderly resumption of the rally coupled with investors putting an increased premium in liquidity (to give themselves flexibility); here, the small-micro cap nature of part of the book would see it suffer, while the puts and Treasuries would offer little protection and would probably suffer too in an unfortunate double whammy.   Separately, should the market progress from fear to panic the NCAV bucket would be heavily hit but this is less concerning given the probable performance of the puts and Treasuries.

Finally, you’ll notice that I haven’t talked about Treasuries much; I’ve been a little surprised by their sharp move over the last weeks -- TLT was +8.5% over the last month vs. +<4% Aug-Oct 2008.  Clearly, they’ve benefited from being under-owned and being seen as a flight-to-quality instrument, as well as the weak inflation data.  These are amongst the reasons that I’ve substantially discounted the probability of the European contagion in sovereign bonds spreading to US Treasuries.  Though I view the probability as small, this remains the scenario that would do the most damage to the portfolio.


Longer-term:
Strange at it seems, I’m already looking towards the late 3rd and 4th quarter and the turning of the calendar as being the period likely to be fraught with the most important decisions.  With my short exposure expressed through puts and the expirations around year-end, the nightmare scenario is a volatile S&P that falls back into somewhere that could broadly be described as acceptably fair value (850-1,000) and Treasuries finding a 2008-like end-of-year bid as investors seek to represent themselves as prudent.  Given the likelihood that I’ll have legged into some longs, and want to reduce the Treasury holdings, it leaves the possibility of going into 2011 in a no-man’s land, with increased but not substantial long exposure and a hoard of cash.

On the other side of the coin, there’s the fear of missing out on potential short names especially those related to the China theme (e.g. FCX, JOYG, etc) and Australia (EWA).  Both are down substantially from their peak, and with volatility having increased, they’re harder shorts (psychologically at least).  This matters because I worry most about the Euro and trade (and the restrictions on it).  I’ve stated before that the Kindleberger spiral of global trade during the Great Depression is one of my favourite graphs/pictures. 

I suspect any substantial fall in the Euro is setting the stage for our own modern-day version of the Kindleberger spiral.  However, far more troubling than that, in my (seemingly more frequent) darker more bearish moods I can’t help but wonder if the Greek crisis, and Europe’s reaction to it, may be our Franz Ferdinand or Credit Anstalt moments.  Seemingly innocuous events, far from the mainstream, that tipped an unstable world into a cascade of crises that spiraled far beyond our control.  Now there something that will keep one up at night…