Occam’s Razor, the Gordian Knot and the Von Mises Prophecy

The rise in Treasury yields has hurt Our Man’s portfolio in recent months, but there seems to be no consensus as to why they’ve risen with numerous opposing points of view.  Arguments range from the Bond bubble is bursting (and hyperinflation is imminent) to this just being evidence that the Fed’s QE2 is working.

How to untangle such a mess?  Well, 14th century English logician William de Ockham created a helpful ‘rule’ that’s come to be known as Occam’s Razor.  It recommends that when choosing between hypotheses which are equal in other respects, one should choose the hypothesis that makes the fewest new assumptions.

What does that mean in this situation? 
Simply that Treasury yields have risen as a result of people’s perception of the economy improving, something that’s been evident by the broadly better data and by various economists (and Wall Street Banks) upping their GDP growth targets during November/December.  Now, perhaps, time will also suggest that the alternative arguments are true…that QE2 was successful (though for $600bn, or 4% of GDP, you’d hope that the Fed’s aim was to increase actual growth not just people’s perceptions about it), that the bond bubble has burst (though the graph below would suggest “not yet”) or that hyperinflation is imminent (again the CPI, and other inflation measures don’t yet show it).  For now, however, I’m sticking with the guy who lived over 600years ago.

Now, with all these worries about hyper-inflation and QE2’s impact on prices, a reasonable fellow might ask why is Our Man comfortable holding Treasuries and betting on deflation.  Well, regular readers will know that Our Man doesn’t view this as your run-of-the-mill business cycle recession but instead one caused by the level of debt (see graph here) reaching unsustainable levels.  As such, the typical monetarist solutions that are the foundation of central banking have little impact on the economy when contrasted against the size of the deleveraging that occurs as households rebuild their balance sheets.  (While this is, of course, a simplistic overview...for those wanting to know a little more, I’d recommend this piece by Professor Steve Keen, and for the very geeky his entire blog). 

This idea of debt-deflation was developed by Irving Fischer during the 1930’s.  What makes it interesting is that it is the Gordian Knot of the economics profession; the traditional and preferred solutions (many of which are being attempted now) have no real impact on solving the underlying problem.  Reductions in interest rates fail to spur businesses or households to relever.  Supplying money to the system, either through fiscal policy (“stimulus”) or monetary policy (“quantitative easing”) produces an initial response which fades and then collapses each time the policy is stopped, and the longer it continues the greater the risk of the economy becoming dependent upon it.  Austerity, while it may help reset the generation of future debts, merely increases the pain by future reducing demand and enhancing the deflationary forces.  The “Alexandrian solution” to the challenge is of course default (in the private/household sector, preferably) but the resultant probable insolvency of financial institutions* is not something the powers that be are currently willing to accept.  Thus for the foreseeable future, unless the household sectors starts to relever itself, Our Man will continue to bet on deflation and disinflation.

As for the long-term; here, Our Man will once again defer to some chap to lived a long time ago.  Ludwig von Mises, the Austrian economist, wrote the following:
“There is no means of avoiding the final collapse of a boom expansion brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”



* The side benefits of bankruptcy on the system are under-rated.  As a simple example, Bank of America is getting sued by a number of investors who are seeking to have BoA repurchase soured mortgages that were packaged into bonds by Countrywide Financial (Bank of America bought them in 2008).  Do you know why we’re not hearing anything about J.P. Morgan getting sued for the deals that Washington Mutual (or why nobody’s suing Lehman Brothers)?  Because when WaMu (and Lehman) went through bankruptcy, the unliquidated claims are trapped there and thus have no impact on JP Morgan.  Therein lies the beauty of bankruptcy for the system -- clean assets with which to regenerate things!

Things from my Google Reader: Dec-10 Edition

As Our Man has been running around interviewing, doing projects and lining up references in his quest for a day job, posting has continued to be light.  To fill the void, here are some of the things that Our Man has read recently, and found rather interesting.

As usual, I’ve put the finance ones at the top and the non-finance (more interesting?) ones at the bottom.

- Is QE printing money or not? (Video)
Who knows, not Fed Chair Ben Bernanke who thought it was 2-years ago but doesn’t think it is now.  It’s a little sad, that John Stewart not the “real” media was the one to call him out on it.

- Buy the Dip (Video)
Some fine ‘advice’ proffered to Our Man, by a good friend (and reader) after a recent post.

- What 311 Reveals about New York
If you’re a New Yorker then you’ve probably used 311.  Not only is it surprisingly helpful and efficient, they are actually trying to capture all of the data and find ways to use it productively! (Wired Magazine)

- Some Thoughts on Harry Potter
To Mrs. OM’s chagrin, Our Man decided not to venture to the cinema to see the latest in the Harry Potter films.  Instead he read this fine article by Joe Posnanski about his Harry Potter reading experience (both alone, and reading it with his young daughter).  Mr. Posnanski’s a sports writer, hence there’s also a nod towards the debatable scoring system in Qudditch. (Joe Posnanski Blog)

- Roads Gone Wild
Making driving seem more dangerous could make it safer.  So argues Hans Monderman, one of the leading traffic engineers in the world, and you do that you start by getting rid of traffic signs and then let human behavior (and the survival instinct) take over!  (Wired Magazine)

- Later
What does procrastination tell us about ourselves?  Even those who know about behavioural biases, and the downside to them, find themselves unable to escape their trap.  (New Yorker)

- You Get What You Pay For?
Healthcare has been prominently debated over the last few years, but Dr. Rob nails it when he says "your system is perfectly designed to yield the outcome you are currently getting"! (Musings of a Distractible Mind)

And finally,
- An Irrational Guide to Gifts
In a nod to the impending arrival of Christmas, here are a Behavioural Economics Professor’s suggestions on the best type of gifts. (Dan Ariely's Blog)

November Review

Performance Review
November was a strange month for the portfolio, which spent the majority of the month mired in negative territory before benefiting from a mixture of the troubles surrounding Ireland and a company specific events (THRX, in the Value Equity bucket) to end up 7bips (putting the YTD at +6.97%)

The Treasury Bonds bucket was the big negative performer during the month (-69bps) as we saw continued appetite for risk for the majority of the month, before concerns about Ireland’s fiscal stability led to a late rally in yields.  The Bond Funds (-10bps) also posted a small loss, which was constrained largely due to their exposure to shorter duration instruments.  The concern surrounding Ireland’s fiscal debt situation resulted in some weakness for the Euro, something that benefited the Currency bucket (+39bps).

With the equity markets largely flat to down slightly, a number of the equity buckets failed to contribute.  The NCAV (-24bps) and Other Equity (-13bps) buckets both posted small losses, which were broadly spread amongst the underlying positions, and the neither the Puts/Hedges (-1bp) nor the China bucket (-<1bp) had much impact on the portfolio.

 The portfolio was however, pushed into positive territory by the Value Equity bucket (+83bps) but even here performance was mixed with DRWI being a slight negative contributor.  The same could not be said of THRX, which was the key to this month’s performance, adding almost 100bps after the stock rallied over 20% during the month.  The key driver came late in the month when GlaxoSmithKline (GSK) announced it would increase its stake in THRX to 19% through a private placement.

Portfolio
42.2% - Long Treasury Bonds (20.1% TLT and 22.2% in the Aug-29 Bond)
14.6% - Long Bond Funds (6.8% HSTRX, and 7.9% VBIIX)
7.7% - Value Idea Equities (5.5% THRX, and 2.2% DRWI)
4.1% - NCAV Equities
3.0% - Other Equities (1.5% NWS, 1.5% CMTL, and 0.0% SOAP)

-0.0% (delta-adjusted) - China-Related Thesis (<1bp premium in FCX put)
-2.3% (delta-adjusted) - Hedges/Put Options (1bps premium in S&P 2010 puts, 68bps premium in S&P 2011 puts and 7bps premium in a GS put)

6.3% (leverage-adjusted) – Currencies (3.2% EUO)

24.5% - Cash

The storyline matters too…

It’s been a while since I have posted, something that reflects the fact that while the market has moved around recently I feel it’s been of the “full of sound and fury, signifying nothing” variety as market participants prepared for and are now digesting the Fed’s QE announcement.  However, just because the market's movement over the last couple of months may determine little over the medium-term, it doesn’t mean they should be ignored or that one shouldn’t seek to profit from them.  Unfortunately, that’s not something that Our Man has succeeded in during recent months.

When we think about investing we spend a lot of time thinking about the end or the final scenario; for example, will we see deflation or massive inflation?  Is China a bubble?  What’s the target price for Stock X?  However, much like reading a book, while the end is important…the story-line matters too.  It’s the twists in the plot that make markets (and books) interesting.  For an investor, this means that one should think about the twists in the plot that one might encounter on the way to reaching end; there’s little point having a portfolio today that’s perfectly set up for the end, if you can’t continue to hold it through all the twists in the plot to get there!  This is far from easy since it means thinking and weighting information (and your beliefs) about different time horizons and then using this information to help structure a position and the portfolio in general.

Why mention this?  Well, it’s not something that Our Man has done well, especially recently.  As you know Our Man doesn’t trade (i.e. do anything in the 30-day time horizon window) but that should not stop me from taking advantage of short-term factors to exit investments (with the opportunity to reinvest later) or change the composition of the portfolio.

The biggest example of this has come in the last few months, with regards to the Treasury holdings.  While they have been strong contributors for the year, they have hurt in recent months and Our Man missed an opportunity to take advantage of some short-term factors to exit the position even though the long-term view is unchanged.

The graph above (courtesy of Mish Global Economic Trend Analysis) shows the movement in Treasury yields.  As we can see, leading into Bernanke’s Jackson Hole speech there was a tightening of Treasury yields (including at the long-end, where Our Man is invested) as investors began to fear a double dip in the economy.  These yields remained largely steady, though off their lows, following the speech in which Bernanke hinted at the possibility of QE2 as investors “bought the rumour”.  However, following the Fed announcement of QE2 these spreads have widened as investors “sold the news”.  For Our Man this has meant that much of the Treasury gains from the summer have been given up but it need not have been this way.  While my long-term view hasn’t changed, I should have taken both my short-term understanding of the “buy the rumour, sell the news” phenomenon and the fact that the returns had become more front-end loaded (as a result of the tightening around/before the Jackson Hole speech) as a sign to at least reduce the position.

Hopefully, this is something that Our Man will learn in the coming months and years.  While it's great to have conviction, especially in long-term ideas, Our Man's got to a better job of taking into account some of the short-term factors.  Remember, it's not just the ending...the storyline matters too!

Late for Halloween: The Horror.....a post on a pointless topic!

There are many things that Our Man tries to avoid talking about in this blog, mainly because they’re terribly dull.  However, some of these he does his best to avoid talking about at all (even with friends, down the pub).  These include topics as tedious as why don’t Arsenal have a good ‘keeper and why are the Mets terrible, but there’s one topic that Our Man avoids more than any other; politics!!  It’s not that Our Man doesn’t like politics (he does), it’s just that talking about it isn’t all that interesting; it’s largely ideological (on both sides), and who cares about the facts!

So why force you to read a post on politics?  Well, as a politician would say, “It’s their fault” (cue: Our Man pointing in the direction of various friends who’ve attempted to get him to discuss politics over the last 2 weeks.  You know who you are).  I can’t blame you for turning away now, but if you can stomach it, here are Our Man’s thoughts on some political topics:

Does a Republican House suit President Obama?
Firstly, I’d note that the biggest impact on Obama’s presidency (2011-2012 edition) probably won’t be the election results tonight!  It was likely Peter Rouse replacing Rahm, on at least an interim basis, as Chief of Staff.

While most, especially the market, are assuming that a Republican House means gridlock and that’s a good thing, I’d instead ask if a Republican House suits the President?  Doesn’t it allow him to do what he does well – sit above the fray, and broker consensus building agreements between the Senate and the House?  And given Republicans control the House, doesn’t it make it harder to characterize the President as a Socialist when you’re writing the bills and sending them to him?  And if you’re in power, and control the House (which writes the legislation) it’s probably somewhat harder to be the party of “No”…without taking a hit from the public for it.

The most important post-election story for the markets
Won’t be an extension of the Bush Tax Cuts (more on that below), but will be the chairmanship of a sub-committee of the US House of Representatives Financial Services Committee.   Yes, you read that right.  Why?  As among the roles of the Domestic Monetary Policy & Technology sub-committee are the Oversight of Emergency Authority and the Audit of the Federal Reserve.   Oh, and the ranking minority member (and thus presumably favourite to become Chairman of the sub-committee) is a certain Ron Paul.  Yes, the Ron Paul who published a book in the last 18months called “End the Fed”.

Bush Tax Cuts and Wealth
While there is much debate as to whether the Bush Tax Cuts will be extended, and for whom, the debate is likely moot.  In all reality, the current Congress will let them expire and the new Congress will pass something with even the President willing to extend them for those making up to $500K/$1million.  Given that, according to the IRS, less than 2% of US households make even $250/year the debate about whether the tax cuts should be extended for those over $500K or $1mn will have little impact on the majority of society.  Thus Our Man's view of how far up the tax-cuts are extended is, in Snoopy-style, to go Bleah!

Before I venture off further into contentious ground, let me end this blog post with a Rawls-ian thought experiment.  Imagine splitting the US into wealth quintiles (or fifths, as I personally like to call them) from the wealthiest (top 20%) to the least wealthy (bottom 20%), and ask yourself: i). To estimate how much wealth do each of these quintiles currently represent as a % of the total? (i.e. Top 20% currently represent A%, Second 20% represent B%, etc) and ii). To construct a distribution of wealth, that in an ideal world, you think would be fair (i.e. Top 20% should have X% of the wealth, Second 20% should have Y%, etc)

Thankfully, I’m not crowdsourcing, but a recent paper by Michael Norton (Harvard Business School) and Dan Ariely (Duke University) actually asked these kind of questions in a nationally representative sample and their results are below.  You’ll note the irony that people’s estimates were almost (identical irrespective of sub-group) and their ideals were also broadly similar, but neither was a good reflection of reality.

October Review

Performance Review
October proved another strong month for equities as the economic data continued to point towards lackluster (but positive) growth and there were further signs that the FED will launch a second quantitative easing program (QE2) in early November.  Unlike September, the portfolio was unable to perform positively spending the majority of the month fighting to stay around flat before succumbing in the final week, ending the month down 1.65% (putting the YTD at +6.9%).

The Treasury Bonds bucket drove the negative performance during the month (-156bps) as the long-end of the curve suffered throughout the month as a result of the various discussions on both the size of QE2 (ranging from $100bn/month for a number of months, to a shock-and-awe $1trn+ in the short-term) and where it would be focused (with consensus being that it would likely not be heavily in long-end Treasuries).  Furthermore bonds all suffered from proclamations of an end to “bull market in bonds” but various market participants, most notably by Bill Gross (though it should be noted that he also proclaimed a bear market in bonds in mid-2007).  Unlike the Treasury bucket, the Bond Funds (+8bps) managed a small positive gain, in part due to their exposure to shorter duration instruments.

In contrast the fund’s equity positions again benefited from the rise in the markets.  The Value Equity bucket (+37bps) was the primary contributor, on the basis of a strong performance from DRWI following decent guidance from management.  The Other Equities bucket (+28bps) and the NCAV bucket (+1bp) also helped performance during the month.  Against these profitable Long positions, the Hedges/Put options (-75bps) and the China-Related thesis (-<1bp) were negative contributors.  The newly-started Currency bucket also posted a small loss during the month (-7bps) 

Portfolio
43.0% - Long Treasury Bonds (20.5% TLT and 22.5% in the Aug-29 Bond)
14.7% - Long Bond Funds (6.8% HSTRX, and 7.9% VBIIX)
6.8% - Value Idea Equities (4.5% THRX, and 2.4% DRWI)
4.4% - NCAV Equities
3.1% - Other Equities (1.6% NWS, 1.6% CMTL, and 0.0% SOAP)

-0.0% (delta-adjusted) - China-Related Thesis (<1bp premium in FCX put)
-3.9% (delta-adjusted) - Hedges/Put Options (6bps premium in S&P 2010 puts, 68bps premium in S&P 2011 puts and 5bps premium in a GS put)

5.5% (leverage-adjusted) – Currencies (EUO, Ultrashort Euro, 2.76%)

24.4% - Cash

Portfolio Update

Not much has changed with the portfolio over the last few months, so this represents the first update in a while following a couple of trades in the last day or so.

In the NCAV bucket, while there has been no further news on the QXM situation since the last update, the last little bump in the stock put it up over 65%+ since inception.  As such, in accordance with the NCAV bucket's selling rules I have cut half the position.  The same is true of CNTF, which was up around 75% since inception.

Finally, in a follow-up to the recent post on currencies, a new theme or bucket was started (which I’m titling “Currencies”, catchy isn’t it!) with the addition of EUO (A 2x Short Euro vs. USD position).  The recent hints of more Greek accounting issues and the Euro meeting continued resistance once more at $1.40/Euro was the tipping point for me to put on the trade, which is initially sized at c3% NAV (though remember, it’s a double leverage position so it will have the impact of a 6% position size).

The next week promises to be a bonanza of macro-related news; with Q2 GDP out on Friday, US mid-term elections next week and then (not to be left out) the FED telling us how much money they intend to throw at the problems (and how frequently) through QE2.  It will be interesting to see how markets respond to all this news, and whether the response in the coming weeks matches the initial response.

Some Initial Thoughts on Currencies

While not much has happened in recent months to warrant changes to the portfolio, the single most interesting thing has been the march of the Yen.  As this graph shows, the yen has continued to strengthen (a drop in the graph = yen strength, and dollar weakness) fairly steadily throughout the period and this has also been broadly true since mid-2007. 

As you can see the big spike in mid-September was when the Bank of Japan announced it would intervene to slow the yen’s rise (during September it bought sold 2.12trn yen and bought $25.4bn).  The alert amongst you will have noticed that September’s intervention wasn’t sterilized (i.e. the Japanese just printed the money and then bought dollars with it) as Japan again tries to create inflation.

With the yen having started rising again, we have unsurprisingly seen the Bank of Japan moving to employ new ways of trying to prevent the yen’s rise, including asset purchases of corporate bonds, real estate trusts and even stock funds!

But, why’s this interesting?
Well, because Japan’s government bonds have (again) become a popular theme on the short side with Kyle Bass, amongst others, eloquently stating the case (here on CNBC).  A corollary to this is the generally held view that the yen should be far weaker, with various Japanese politicians (not to mention various financial folk) others suggesting a 120 Yen/Dollar rate as being ‘fair’.  Over time, I have great faith that both those who are short the yen and JGBs will be proven correct.  I can’t help but wonder, however, if in order to see the yen move to the 120-140 range that people predict, we won’t have to see it reach the other extreme (i.e. the Yen at 50-60) first! 

Perhaps, the move that’s currently underway is the start of a spring uncoiling, after all Japan’s consistent trade surpluses (and the foreign reserves that they’ve build up) mean that the Japanese (like everyone else) are short the yen.  If people start to unwind those positions and the stronger Yen causes Japanese exporters to struggle (and potentially need to take on more debt…thus increasing the demand for yen) then things could get really interesting.  The irony is, of course, that if the Japanese government is successful with the asset purchases and even manages to create inflation, the victory will be pyrrhic (as the higher inflation will necessitate higher nominal interest rates on JGBs, hastening the default that the JGB shorts see coming).

So that’s my ponderings on the yen, interesting but given the scope of the move the risk-reward probabilities suggest that there’s nothing to do here,  However, as mentioned back in the mid-year review, one of the things I have my eyes on is a short position in the Euro (vs. the Dollar)…something that’s not a popular sentiment these days.

The dollar has been unquestionably weak against the Euro over recent months (see this chart).  It’s also expected to remain weak for the foreseeable future, with Europe countries having seemingly resolved their sovereign debt problems and the Fed poised to undertake another Quantitative Easing program (QE2).  However, with a 10% move over the last month and sentiment so anti-dollar, is all the news priced in?

Certainly, it seems pretty certain that QE is coming after the Fed’s Nov 2-3 meeting with people now mainly arguing over the size (will it be $1trn at once in a shock and awe move, or $100bn a month for 6-12months?) and the instruments that will be purchased (predominantly Treasuries, but potentially also some munis).  For those who’re wondering why the QE is seen as such a sure thing; through Bernanke’s statements (and those of his cohorts, like Charles Evans), it’s become clear that there seems to be consensus for it.  The only thing that the Fed fears more than inflation is deflation; and if a picture’s worth a 1,000 words, then the Fed’s fears can be summed up in this one chart (source: SF Fed):

As for Europe, are the sovereign problems are resolved (with Portugal, Ireland, Italy Greece and Spain now model sovereigns with no real probability of default) or has the ECB’s program to back-stop the debt provided suitable liquidity to push the questions of solvency further down the road.  I would suggest that a real solution to the problem of excess debt is unlikely to be found in taking on more debt, and programs that facilitate this rather than looking for a better long-term solution are likely to eventually fail.  While the ECB’s moves have succeeded in pushing the spectre of European sovereign failures from the front pages, they haven’t addressed the underlying problem (too much debt!).  Furthermore, I would expect that any recurrence of the fears that we saw earlier in the year will be reflected in the Euro’s performance.

Longer-term, as readers know, I believe that the problem of excess credit/debt will be solved either by paying back the debt or by defaulting on it (and the creditor having to write-off that debt).  When you payback debt (and don’t replace it with new debt) or write it off then dollars are removed from the system…and the dollar, like all things that become scarcer, will go up!  While the scale of the Fed’s QE is expected to be large ($1trn), it pales in comparison when we consider that about 50% of the world’s debt issued is denominated in dollars.  As such, there’s likely to be a meaningful opportunity to go Long the Dollar (vs. the Euro) in the near future.

Things from my Google Reader...

You may have noticed posting has been rather light recently, and there are of course some fine excuses for this.  In part it’s because Our Man has been scouring the market for a job, and hence spending a chunk of his time preparing for and being in interviews.  However, it’s also large because there’s not much to do at the moment – I’m relatively comfortable with the portfolio and while there’s a little bit to do on some of the other themes that are on deck, you know what they are (Energy Storage and Water).  Finally, I’ve also been doing a little bit of pondering on currencies, which I’ve mentioned before but is a new area for me.  In some ways, they (or rather the ETFs related to them, since I can’t actually hold foreign currencies) seem like the best way to play some of the animal spirits and trends that I’m seeing in the market so expect some preliminary thoughts on that.

However, here are some of the things that I’ve been reading recently and have found thought provoking.  Like the “Chartology” series, expect to see “Things from my Google Reader” series to appear irregularly but hopefully serve as something interesting (if nothing else they’ll at least be a good way for me to find links back to these articles in the future).

(Spoiler Alert: I’ve put the finance ones at the top and non-finance ones at the bottom) 

 - A Gold Valuation Model:  Talk about gold is everywhere at the moment, with lots of people saying it’s going up but…how should you value gold?   It has no earnings, and its value comes from people’s belief in its value (kind of like those much derided fiat currencies…).  Here’s a model worth thinking about from Eddy Elfenbein, at Crossing Wall Street. 

- The politics of Chinese Adjustment: As you know, I’m not a China bull (see here and here), in part because of the economic imbalances that I see in their economy.  In this post on his blog Peking University Professor Michael Pettis looks through the sequence of steps on rebalancing those imbalances. 

- Beware of Greeks Bearing Gifts: In case you thought that Greek crisis thing was all over, here’s a really good (and easy to read and understand) article on it by Michael Lewis, at Vanity Fair.  It’s right on the Money(ball)! 

- Fractals and the Art of Roughness:  Our Man often makes references to trading time being slow or fast, to fingers of instability and glimmers of hope, etc when talking about the portfolio and markets.  All are related to do with the fractals and roughness, and if you’ve ever wanted to know what the hell that means…here’s a video of a talk by the father of fractal geometry, Benoit Mandelbrot (at TED 2010) that introduces the subject gently.  (For those who're tired of the finance-related links, here's JJ Abrams talking about Lost and other mysteries at TED 2007). 

- Scared of Mathematics (and other educational things):  Learn everything you fail to remember from school at the Khan Academy.  Apparently even Bill Gates likes this former hedge fund guy’s easy to understand bite-size videos on a variety of subjects.  (Fortune) 

 - Nolan and Ichiro:  Is Nolan Ryan the Greatest Pitcher Ever?  Here’s a finely constructed argument saying that though Nolan is great, he’s not the greatest (ditto for Ichiro).  (Joe Posnanski). 

- The Fan Experience at Sports Events: Never Look Down:  Mark Cuban’s thoughts on what it should be like to go to a game.  As a football (aka soccer) loving Brit, it doesn’t quite resonate with me (soccer doesn’t have the non-playing time during the game that US sports have, and by the virtue of being relatively rare goals feel special vs. baskets/runs) but I can certainly see why it makes sense. 

September Review

Performance Review
 September proved the strongest month for equities in some time as a result of both economic data steadying and market participants becoming more confident that the FED will launch a second quantitative easing program (QE2) in early November.  Despite this move towards a risk-on sentiment in September the portfolio was able to eke out a small gain of 0.72% (putting the YTD at 8.7%), though this pales in comparison to the strong performance of most markets.

Unsurprisingly, the Treasury Bonds bucket was a large negative contributor (-87bps) as it suffered heavily in the first half of the month from both the reduction in risk aversion and fears about QE2’s impact on long-term government finances.   The Bond Funds (+7bps) also suffered during the first half of the month, but were able to benefit more from the recovery in the 2nd half of the month.

In contrast the fund’s equity positions benefited from the rise in the markets, with Other Equities (+44bps) and NCAV Equities (+33bps) both contributing well.  However, the main driver of performance in September was the Value Equities bucket (+209bps), which was driven by the position in THRX (+174bps) following some Phase II trial results (if circumstances allow, the position in THRX will be trimmed a little).  Against these profitable Long positions, the Hedges/Put options and the China-Related thesis were negative contributors (130bps).

Portfolio
44.0% - Long Treasury Bonds (21.2% TLT and 22.8% in the Aug-29 Bond)
14.4% - Long Bond Funds (6.6% HSTRX, and 7.8% VBIIX)
6.4% - Value Idea Equities (4.3% THRX, and 2.0% DRWI)
5.0% - NCAV Equities
2.8% - Other Equities (1.4% NWS, 1.0% CMTL, and 0.0% SOAP)

-0.0% (delta-adjusted) - China-Related Thesis (1bp premium in FCX put, <1bps premium in EWA put)
-7.0% (delta-adjusted) - Hedges/Put Options (27bps premium in S&P 2010 puts, 101bps premium in S&P 2011 puts and 24bps premium in a GS put)

25.9% - Cash

NCAV Q2.5-10

As promised, a September update on the NCAV screen was run at the end of last week.  It resulted in 3 new names finding their way into the Absolute Value bucket portfolio (for information on the this bucket, and how it works, read here), they are:

- LAB (LaBranche) which had a market cap $165mn (vs. a 65% NCAV of $173mn)
- NED (Noah Education Holdings) which had a market cap of $88mn (vs. a 65% NCAV of $91mn)
- IESC (Integrated Electrical Services Co) with a market cap of $50mn (vs 65% NCAV of $55.5mn)

Additionally, a number of the existing holdings (AVTR, BXG, LTON, TWMC and XIN) reappeared on the screen.  As such, the final date when these names have to be sold has been extended (here are the rules on when NCAV names must be sold).

Finally, there was one bit of news on a name within the bucket; in early September, QXM was subject to a take-over offer from its majority shareholder Qiao Xing Universal Resources (XING) of $0.80 in cash and 1.9 shares in XING for each of share in QXM.  This is potentially worth $3.65 (XING closed at $1.50 today plus the value of the $0.80 in cash) or about 10% above QXM’s closing price ($3.35).  However, a special committee of QXM’s directors has asked for more time to analyze the offer; a number of the minority shareholders have said that the offer is too low (it is below the NAV/share and Cash/share of QXM as of their 6/30/10 financials).  I am waiting to see what the Special Committee recommends (and whether the bid is raised) before taking any final action

One Year In......

(Apologies to all the people who're seeing this post again.  I was trying to spruce up the blog while watching Monday Night Football, and somehow managed to delete the original post from the weekend.  As such, here it is again with some bonus statistics thrown in!)

It’s strange to believe it, but this week saw the one year anniversary for the portfolio, which started on 7th September 2009, with this blog following with its first posts in October.  As such, what better time for a small array of tit-bits related to the portfolio’s first year.

As you know the portfolio exactly reflects Our Man & Mrs OM's investments, and here's what the NAV (base = 100) looks like:

 

And for those who’re a little more mathematically orientated, here’s the key statistics (based on Yahoo’s S&P daily data):
Ptf’s Annualized Return: 11.1%
Ptf’s Standard Deviation (based on daily data): 7.4%

(a bonus statistic, for those reading this again; 54.1% of days have been positive.   A second bonus statistic is that on those positive days the portfolio has an average return of +0.36%, which is a little better than the corresponding loss of -0.34% it's suffered on the average negative day).

Alpha (vs. S&P 500): 11.7%
Beta (vs. S&P 500):  -0.10
Correlation (vs. S&P 500):  -0.27

None of the S&P-related statistics above should be entirely surprising, given that the Long position in Treasury Bonds has been both the largest and the only one held since inception. The original thoughts behind it are still largely valid today, though Our Man was unquestionably early (and too large!).

August Review

Performance Review
August proved a successful month, with the portfolio returning +3.36% (putting the YTD at +7.9%) after rebounding in the final couple of days of the month to recoup almost the entirety of the Friday 27th’s loss (at 135bips, this was the portfolio’s single worst day since inception).  After last month, it was good to see the portfolio behave far more in line with expectations during August. 

The Treasury positions, which I’ve expected to be the driver of returns until the equity markets are noticeably lower (or higher) was dominant contributor (+331bps), with the Bond Funds also making a healthy contribution (+37bps).

The Equity positions were not as successful, and combined to be a small detractor from performance.  The Value Equity book (-68bps) almost entirely due to the position in THRX, which as a developmental drug company particularly suffered from the risk aversion during August to trade back down to the bottom of its recent range.  The NCAV book (-26bps), which is populated with micro-cap names, also suffered heavily from the increased risk aversion.  The Other Equity Book (-13bps) was a small negative contributor.  Against these negative contributions from the Equity positions, the Hedges/Put Options (+77bps) managed to offset a decent proportion of these losses.  The Short China thesis (-1bp) has fallen to such a small part of the portfolio, that it had no meaningful impact on returns.  While I believe the thesis (Part A, Part B, Part C) holds the timing has so far been far too early, and the question is whether and when to add additional positions (with longer duration) to increase the exposure to the theme.

Portfolio
45.2% - Long Treasury Bonds (21.97% TLT and 23.23% in the Aug-29 Bond)
14.4% - Long Bond Funds (6.6% HSTRX, and 7.8% VBIIX)
4.3% - Value Idea Equities (2.6% THRX, and 1.7% DRWI)
2.9% - NCAV Equities
2.4% - Other Equities (1.4% NWS, 1.0% CMTL, and 0.0% SOAP)

-0.1% (delta-adjusted) - China-Related Thesis (5bps premium in FCX put, <1bps premium in EWA put)
-10.6% (delta-adjusted) - Hedges/Put Options (82bps premium in S&P 2010 puts, 120bps premium in S&P 2011 puts and 56bps premium in a GS put)

27.9% - Cash

And now for something completely different; Mrs. OM has kinds informed me that the link to the Magic of Procrastination, in yesterday’s suggestion of things to read, didn’t work.  That’s been amended now, and here it is for those wanting to click straight through.

Back from Vacation

After a rather delightful sojourn to see friends and family in London, and then on to a couple of Greek Islands (including the one of Chios, where we got to enjoy a friend’s traditional Greek wedding), OM and Mrs. OM are back from their summer vacation. 

It goes without saying that we arrived back (on Friday 27th August) just in time to see the portfolio’s worst daily performance since inception (-1.35%) as a combination of a good GDP downgrade (!) and a Bernanke speech helped buoy the markets and setback the grinding lower of Treasury yields.  While not a vast amount happened in terms of price action while we were away (equities were mildly lower and even with Friday’s widening, Treasury yields had compressed marginally) it does seem that the incremental macro data points that have been coming out are slightly more negative.  With the month having just ended, I’ll save more information on performance until the monthly review.

However, since I’ve spent much of the last few days catching up on reading (via my Google Reader) here are some of the interesting stories that caught my attention:

- Japan and the Ancient Art of Shrugging: Some thoughts on Japan’s lost decade(s) impact on the younger generations (Norihiro Kato, NY Times)

- Bernanke’s Blind Spot: My favourite economist’s critique of the Fed Chairman’s Friday statement (Steve Keen, Business Spectator)

- Friedrich Hayek’s Nobel Prize Lecture in 1974: it shows a prescient understanding of his profession’s failings. (Friedrich August von Hayek, Nobel Prize Website)

- The Magic of Procrastination: A Behavioural Finance Professor’s way of solving the behavioural biases/issues regarding when students’ do the work they have to turn in.  (Dan Ariely, his blog!)

- Roads Gone Wild: About Hans Monderman, who’s leading the charge to turning 80-years of traffic engineering on its head and taking advantage of behavioural biases in doing so (Tom McNnichol, Wired)

- On the Shoulders of Giants: Could Spain, if it embraces structural reform, be the next Germany? (Edward Hugh, Credit Writedowns)

NCAV Q2.0-10

While second quarter 10-Q’s haven’t all been filed with the SEC yet, I am disappearing off on holiday tonight with Mrs OM, so it made sense to run a NCAV screen before I departed.  Another will be run in September, to make sure we catch anything that might have slipped through the net.

The disappointing news is that there were no new stocks to add to the portfolio, though existing holding BXG passed the screen (with updated Jun-10 data) and hence it’s sell-by date is extended.  Five other existing holdings passed the screen (AVTR, LTON, QXM, TWMC and XING) but in all cases the Financial Statements were stale and as such their sell-by dates are unchanged.  As a reminder, the sell-by dates represent 12-months from when a company last passed the screen (with up-to-date data) and is when the holding will be sold should none of the other “sell rules” come into effect before then.  The current sell-by dates for the existing holdings are:
1st April 2011: AVTR
7th May 2011: CNTF, LTON, TWMC, XING
12th August 2011: BXG

The following stocks also passed the screen but were rejected for qualitative reasons; FMD, MYRX, NINE, NUHC and NCTY were all rejected due to stale Financial Statements (largely as they were using December 2009 Financials) and PCC & STU was rejected as 'Financial Companies' (i.e. the screen used total assets, not current assets, to calculate the Net Current Asset Value).

Given that I’m away for the next couple of weeks, expecting posting to be non-existent barring a major move in the markets.

Energy Storage – Lead Acid Batteries: Part B

Following on from our introduction to Lead Acid & Lithium-Ion batteries and the overview of how batteries fit into the Energy Storage theme, now is a good time to go into greater depth.

When we’re talking about batteries, for vehicles or energy grid storage, we’re really talking about “battery packs”.  In lead-acid world this is typically six cells in the same hard plastic box (think your car battery).  For Li-Ion (or NiMH, as used in the Prius) the basic building block is the battery cell that you have in your cellphone or camera.  These cells are strung together depending on what you’re powering; 12 or so for a laptop battery pack, 75 for an electric bicycle, 1,000 for a hybrid electric vehicle (HEV) and somewhere around 5,000 for an Electric car.  It’s useful to know this as it helps us put into context two things that matter when considering batteries; volume/weight and price.

Volume/Weight
I’ll touch on volume/weight first, since it’s the smaller of the two issues; while lead-acid batteries have been prevalent in our vehicles for a long-time, their volume and weight were the reason they never made it to our handheld devices.  In essence, they couldn’t provide the power that was needed in a small and light enough form to be useful in hand held devices.  The best estimates suggest that for a full hybrid car, a Li-Ion battery pack would weigh around 75-100lbs and take up about 1 cubic foot less than the necessary Lead-Acid battery pack.  While this is a clear advantage, it shouldn’t be a determining factor when deciding which technology to use as a car weighs around 3,000lbs and the boot space (as we Brits call it) is 10-12 cubic feet.

Price
Unlike in existing applications (from cars to cellphones), the price of the battery actually has a material impact on the price of a hybrid car.  The proposed fully Electric Vehicles, such as the Nissan Leaf and Chevy Volt are both priced at well over $30K (before any government rebates), in part because their battery packs cost somewhere between $12.5-$18K.  More generally, there is a lot of argument over the costs of production given that none of batteries are produced on mass scale.  As such, I’ve gone with Sandia National Laboratories who in a July-2008 report for the Department of Energy estimated the current cost of battery packs at $500/KWh for Advanced Lead Acid Batteries and $1,333/KWh for Li-Ion batteries.   This would imply the following cost structure:

In the context of the typical $15,000 to $20,000 cost of a regular car these numbers should have some impact, even given the likely dominance of mild/micro hybrids in the coming years.

However, things are not so simple and a major point of contention is that the Li-Ion manufacturers claim that they can reduce the price per KwH “substantially” or “once the batteries are in mass production.”

Unsurprisingly, it’s a fairly big argument over in battery-world and given it’s entirely about forecasts there isn’t yet a right answer.  My thoughts are as follows:

- The don’t currently: No US listed public company has managed to get to even get to the mass production stage, and the $1,333 number is a reasonable estimate of their current price (e.g. using A123’s latest 10-K shows its cost of production (excluding all R&D, let alone any profit) was around $1,250/KWh).

- Raw materials:  If you speak to the companies (or listen to the calls, read their presentations, etc) there is a clear belief that raw materials won’t be a problem for them on the cost side.   Logically, this seems strange.  Let’s make some really generous assumptions; over the next 5 years, Li-Ion use in hybrids (like the Prius and assuming no sales of any plug-in vehicles) captures a mere 15% of the US market (and nothing abroad!) and the US car sales stay at c10mn (i.e. no increase from 09-10 numbers).  That would be 1.5mn battery packs that would be sold per year; the equivalent of 1.5bn cellphones/year (currently c1.25bn/year sold) or 125mn computers/year (currently 300mn/year sold).  Given Lithium mines don’t start overnight, and the growing demand for Lithium in other battery-operated products (like Mrs OM’s shiny new iPad), I would think there would be some price impact from a new industry suddenly stepping in with big demand.

- Physics Envy:  This is the most interesting but the least considered problem, largely because it’s behavioural (some might say obtuse) in nature.  A core of the argument for Li-Ion’s ability to reduce future manufacturing costs as production increases is because we’ve seen it before.   More specifically, our recent experience with technology and computers has shown us that it’s possible to increase production, innovate and reduce price…all at that same time.  For example, our computers are far better than they were 1, 3, 5 and 10years ago yet they cost less.  This has been Physics’ gift (more specifically Moore’s Law) to the world over the recent decades.  Given that most analysts who cover Li-Ion battery companies come from the Technology world, it’s not surprising that there’s acceptance that progress in batteries can be similar to that seen in computing.  There is one major flaw in this belief; batteries produce energy through chemical reactions, thus the ability to get more energy from them is likely to follow the laws of chemistry, not physics!  These laws most assuredly operate differently, they won’t prevent existing technologies from being improved, or new one’s found, but they likely will prevent small tweaks to existing technologies from creating huge and continuous leaps forward.

- Safety & Lifespan:  While these two issues are largely ignored in the discussion over Li-Ion batteries, they are the great unknown.  Safety questions over Li-Ion batteries flared up again last year (after causing a fire on a plane) and as anyone who’s ever used an electronic device knows, lifespan is always an issue (think how your cellphone battery loses its ability to charge fully and then imagine that happening to your car battery).  Simply put, we just don’t know if a Li-Ion battery pack can attain a 15-year life (and the 1000’s of cycles that entails) that is currently standard for a car battery or whether they will function effectively in various conditions (inclement weather, etc) as required.

As such, you can see some of the reasons for my skepticism that we will see Li-Ion battery packs in our mild/micro hybrids in the immediate future (though I’m sure we’ll see them in expensive ego-cars or gimmicks, which the car companies have more interest in talking about than mass producing). 

Advanced Lead-Acid Batteries
The observant amongst you will notice that I didn’t compare the Li-Ion batteries with the traditional Valve-Regulated Lead Acid (VRLA) batteries, but instead with Advanced Lead-Acid (largely Carbon-enhanced Lead-Acid) batteries.  While they’re not sexy or cool, like their Li-Ion counterparts, they are a technological jump from existing VRLA batteries that look like they can fulfill our vehicular needs (potentially all the way up the hybrid chain).   There are a number of companies working on Advanced Lead Acid Batteries, including Firefly (spun-off from Caterpillar), C&D Technologies, Furukawa/CSIRO and Axion Power.  I’m going to focus on the last 2, since I know them the best and their efforts appear the most promising.

Australia’s national science agency, CSIRO, developed the Ultrabattery and has licensed it out to their partner Furakawa (a Japanese Company, who sub-licensed it to East Penn. Manufacturing for the NAFTA area).  Interestingly, Furukawa successfully tested prototypes of the Ultrabattery in a Honda Insight hybrid back in 2007/8, confirming the viability of the project.  They also submitted the UItrabattery to Sandia, where it was tested alongside other batteries in a DOE Storage Systems Research Program.  The key graph is this one:

 As you can see the Ultrabattery’s performance was a significant improvement on the VRLA battery and comparable to a Lithium-Ion battery, again suggesting that the technology is viable.

Axion Power began making and testing a Carbon-Enhanced battery (called a PbC battery) back in 2003.  One of their early aims was to try and create a technology that could easily be implemented in the existing Lead-Acid battery plants around the globe, with minimal capex required.  It’s a project they’ve been working on, at their own lead-acid battery plant in New Castle.  They also began testing, initially with a large battery pack (called a Power Cube) at a NYSERDA-funded program to store energy from a solar power system at CUNY College.  However, in the last year or so things have progressed quickly and they have also moved to test their battery in vehicles, signed a worldwide supply agreement with Exide (the 2nd largest Lead-Acid battery maker for vehicles) and received a joint DOE-grant with Exide for the production of PbC car batteries.

Next time:  While we have 2 interesting new technologies (Li-Ion and Advanced Lead-Acid), and an incumbent technology (VRLA), it all means nothing for an investor without looking at valuation.  As such, in what’s probably the final part of this series, we’ll take a peek at how the companies are valued.

I hope you've had your Wheaties...

As a brief addendum to the recent portfolio update, one thing I failed to mention as part of my willingness to carry the extra put exposure is Wheat.  It’s not normally something I look at, but the recent news and moves on wheat are certainly worth considering...

The long-term bull story for Agricultural products is very well known, and relatively simple – world population is growing rapidly (see graph below) and hence both demand and expected future demand for grains/food are rising.  Historically, technological advancements such as dwarf wheat (for which the late Norman Burlaugh won a Nobel Prize) along with other genetic modifications to crops (e.g. to be able to resist pesticides, etc) have helped supply keep pace, but there are signs that this is meeting headwinds and slowing.

In the short-term, a drought in Russia that has led to reduced production there and a Russian ban on wheat exports has caused a big spike in Wheat prices (n.b. remember this when we see future headline inflation numbers).  What’s interesting, in the longer-term, is this spike has caused prices to break out from the large base that has formed since late-2008.

If this current drought’s impact on prices proves to be a temporary (which it should) then wheat’s likely to fall back to that base.  For the technicians amongst you, that could form a bullish flag or a rising wedge, which would be the time to buy for the long-term.  If this was accompanied by a change in the global wheat stocks to usage ratio (i.e. there were signs of a shortage of wheat) in addition to the long-term bull story then things might getting really interesting!

However, as the graph above shows, we’re clearly not there yet.  Nonetheless, while it’s something that’s hard to execute efficiently (GRU - appears the best bet, and even it is <50% direct exposure wheat) for those (like me) who don’t have a commodities account, it’s definitely something to keep in the back of your mind as with the charts as well and long-term/short-term fundamentals threatening to line up it could prove spectacular!

Portfolio Update

This is the first portfolio update since May, a reflection of how quiet trading time has been for the book over the summer.  A couple of trades today; increasing the size of the SPY 100 strike with Dec-10 expiry put and adding two more market hedge (SPY 100 Dec-11, SPY 65 Dec-11). 

The moves reflect a couple of things which have different time horizons.   They reflect a rolling over the market hedges (from Dec-10 expiry to Dec-11) as was discussed in the recent Portfolio Thoughts.  However, the roll isn’t complete as not only have I retained the pre-existing SPY put (strike 100, Dec-10 expiry) rather than sell (and thus complete the move) but I’ve also added to it today.  Whereas the rolling of the hedges can be thought of a strategic move (essentially paying a cost for lengthening maturities), the retention and addition to the existing hedges is tactical.  There reasons are manifold but it reflects my belief that there are a number of technical resistance points near here (1,140-1,150 range), that the expectation of a double dip is underpriced (e.g. JPM amongst others, expect the first revision to Q2 GDP to come in at 1.7% vs. 2.4% originally reported), and that stocks remain overvalued (on long-term measures, like CAPE or Tobin’s Q).

Energy Storage Theme: How Lead-Acid Batteries Fit in…

On reflection, Energy Storage as a broader title for this theme is appropriate as it is a better indication of where I see the opportunity in the long-term, with Lead-Acid Batteries likely to be the most effective way to express the theme in the short-to-medium-term. 
Energy Storage broadly encompasses all of the ways that we can store energy for future use, for example through batteries, supercapacitors, and flywheels.  There are 2 main areas that I think about as the primary uses for Energy Storage;
- Vehicles, where people are looking for a move from an internal combustion engine to a battery as the primary driver of propulsion.  This is something I expect to happen using baby steps (i.e. lots of mild/micro-hybrid cars soon) as opposed to a giant leap (Plug-in Electric Vehicles tomorrow).  This is one of the reasons that I think the incumbent technology (Lead Acid Batteries) is being under-rated.
- Power Storage (meaning Electricity grid-related storage, and Industrial-related storage).  Unlike in vehicles, there are far more storage options in play here and most will find some role in what will be a massive market.  As I’ve not talked much about this before, I’m going to spend the rest of this post talking about Energy storage and the power markets.

Why Energy Storage is becoming more important in the power markets
The easiest way to describe is to think through it aloud.  First-off, our demand for electricity is pretty variable.  Yes, it follows patterns both daily and seasonal, but it is variable around these broad patterns meaning that while an electricity company has a good estimate for the power they’re going to need to deliver in 30mins/60mins/4hrs/etc they don’t know exactly how much.  Electricity’s also pretty binary; your TV can’t show half the picture, it’s either on and working or it isn’t!  Hence when the electricity company can’t supply enough power, you get black-outs or brown-outs…which are no fun, and pretty unpopular.  Thus, in the energy company tries to supply a tiny bit more power than is actually required at any given minute, and needs some easily accessible reserves if there’s a spike in demand.

On the supply side let’s consider that the vast majority of electricity is still being generated from fossil fuel power plants.  Again, while the capacity that these plants are running is controllable, either the plants are running (at the desired capacity) or they’re idle.  Now compare this to the alternative sources that have started to become more prevalent over the last couple of years, like wind and solar.  The power these plants produce is far more variable and less controllable by man; after all is it suitably windy/sunny, how windy or sunny is it, what happens if there’s a cloud or a gust of wind, etc.  Given the variability of these production methods, and how poorly electricity travels via the grid, it is clear that there’s a need to be able to store energy efficiently and to be able to supply it quickly and efficiently from this storage.  Furthermore, in the case of solar, the electricity is being generated (during the day when it’s sunny) at a time when it’s not generally being consumed (the evening) thus there is additional need for storage.

As such, you can see how Energy Storage is considered by some as being an important part of the broader Clean Technology “revolution” that is underway.

Different Types of Storage/Needs in Power
An important thing to consider when talking about the power grid and energy storage is the need for different types of storage and delivery.  This is due to the different time horizons for the power to be stored, and the differing speeds at which it might need to be delivered from the storage to the grid.   For example, the storage and delivery periods for something attached to solar power plants might be hours (i.e. the storage device would be required to store the power for hours, the deliver it over a period of hours), whereas for other things the delivery period may be seconds (e.g. to smooth out the power sent to the grid), with everything else in between.  This is important as those electricity providers only want to provide a tiny amount more energy than people need in order to maximize their profits.  Furthermore, those technologies that are great at storing lots of energy are not so good at delivering it quickly (i.e. batteries can store a lot but don’t providing it quickly, hence there’s an opportunity for multiple technologies to play a role.

Given this there are other types of Energy Storage systems that we might look at in more-depth in the future, such as Flywheels (likely compete with Li-Ion/Lead-Acid batteries), Supercapicitors (likely will dominate the segment that requires power delivery in seconds), Other-type of battery (e.g. molten sulphur batteries, which can store/deliver power over a longer time period that Li-Ion/Lead Acid batteries)  and Compressed-Air Energy Storage (which can deliver power over many hours, much longer than Li-Ion/Lead Acid batteries).  However, I expect that Li-Ion and/or Lead-Acid Batteries in addition to being the only real players in the Vehicle space and will be amongst the major players here in the Power space.  As such, that’s why they’re the logical first step for us to consider an investment.

July Review

Performance Review
After my recent ponderings that the portfolio’s performance in the short-term was likely to be dictated the movement of Long-end Treasuries, it goes without saying that July’s performance was entirely driven by other factors.  In truth, it was a messy month that was flattered by the final performance of -0.83% (putting the YTD at +4.4%). 

The bond-orientated components of the portfolio were boosted by the strong rally in Treasuries during the final day of the month, after the initial Q2 GDP estimate came out.  The results was that the Long Treasury Bond bucket (-9bps) and the Long Bond Funds (+14bps) ended up having negligible impact on the portfolio.

The NCAV bucket was the strongest performing part of the portfolio, contributing 32bps with almost every position helped, as it benefited from the rising markets and increased risk appetite throughout the month.  The rest of the equity-orientated buckets were not so productive.  The Value Equity bucket (+52bps) was a positive contributor, though DRWI was largely flat (though that could be considered a positive development, given its travails during the month.  The Other Equity bucket (-34bips) hampered performance due to a large negative contribution from CMTL, after failing to win an army contract – unfortunately, there remains little one can do about the names in the Other-equity bucket.

The Short China thesis (-21bps) suffered as raw materials names rebounded following recent signs of growth in China steadying and as investors saw increased signs that the Chinese government would take steps to aid growth should it slow any further.  The Hedge bucket broadly suffered from the broad market rally and corresponding drop in volatility, but also directly suffered as Goldman Sachs settled the recent case brought by the SEC, helping remove some of the uncertainty surrounding the stock.

Portfolio
44.0% - Long Treasury Bonds (21.0% TLT and 23.0% in the Aug-29 Bond)
14.5% - Long Bond Funds (6.7% HSTRX, and 7.9% VBIIX)
5.1% - Value Idea Equities (3.3% THRX, and 1.8% DRWI)
3.3% - NCAV Equities
2.6% - Other Equities (1.5% NWS, 1.2% CMTL, and 0.0% SOAP)

-0.5% (delta-adjusted) - China-Related Thesis (7bps premium in FCX put, <1bps premium in EWA put)
-5.2% (delta-adjusted) - Hedges/Put Options (34bps premium in S&P put, and 35bps premium in a GS put)

29.7% - Cash

Half-term Ponderings – Portfolio Thoughts

First-half disappointments
While the book’s strategic positioning has broadly been a positive during the first half, there has been little contribution from any tactical trades or elements of the book.  To look into this disappointment a little more closely, let’s touch on a couple of trades that we have clearly missed in the first half:

- Short Spanish Banks (e.g. Banco Santander)
If we go back to late 2009, when the sovereign problems came to attention in Dubai and then in Greece, one of the prevalent strains of commentary was the fear of contagion from Greece into other European countries.  Of these countries, Spain was the one that people were most concerned about due to its size making it difficult to bail out.  A consequence of sovereign and financial stress (or its perceived likelihood) is often funding difficulties for the nation’s financial institutions.  Thus Spanish banks presented an opportunity where the potential stress (or its perception, at least) was predictable but not particularly priced in.  It’s always frustrating to miss a trade that you could and should have seen, especially one that had a strong probability of happening within H1-2010.

- Long Exide (XIDE, Lead-Acid Battery Theme)
Sadly, this one’s entirely down to my failure to get organized and write up the Lead-Acid battery theme, which I had spent a lot of time working on at my previous job.  The point of writing up the underlying ideas behind a theme is so that I can move quickly to investigate, document and act should unexpected opportunities appear.  Well, an unexpected opportunity did crop up in Exide, my favourite of the lead acid battery companies, during May 2010 just prior to their results.  Unfortunately, despite having talked about writing up the theme back in March, I never got around to collating my mass of notes and data and actually doing it and as such, wasn’t in shape to take advantage of the opportunity.  Doh!  Exide is now up >30% from its lows, double doh!  While Part A has now set the scene, expect further posts on Lead-Acid Batteries in the next week or two, so I don’t miss the boat again!

Positioning and Thoughts
The positioning is largely unchanged since I wrote about it in May and so I’m going to try and touch on some different things in this piece rather than repeating myself.

My current expectation is that the day-to-day and week-to-week summer market movements will be “a tale told by an idiot, full of sound and fury, (but) signifying nothing”.  The data points will likely be variable enough that the market will continue to be driven by sentiment, though likely trapped broadly in its current range (S&P: 1,000-1,150).  Given the limited equity exposure in the book (due to the market hedges, and the Short China thesis), the portfolio’s NAV will continue to be dominated by the movement of long-end Treasuries.  I’m prepared for this to prove frustrating on a daily/weekly basis, but it is probable that the bond market direction will lead the equity markets.  As such, I’ll be focusing on whether yields continue to crunch lower or whether the (seemingly unlimited number of) bond bears will finally have something to cheer about.

Given this short-term outlook, ‘trading time’ is likely to be slow and there are unlikely to be significant changes to the portfolio until the data helps provide some clarity on the economic situation.  That said, looking at the rosy current expectations (the below is from a couple of weeks ago), I’d be surprised not to see GDP forecasts continue to be lowered.

As an aside, it is noticeable how many now simply equate the market with the economy (i.e. market is up 60%+ from last year/5%+ this month, thus the economy has rebounded strongly/is not going to double dip) but the level of confidence in the economy remains the key for the market.  Thus, I worry that the economic data over the next 3-4 months could risk setting off either a virtuous or vicious cycle, as the information flows through the feedback loop between the market and the (real) economy that results in stocks moving in a binary fashion to price in either Armageddon or Utopia.  When that starts to happen, is when the trading time will speed up and the real opportunities will arise.  Until then our job is to continue to eke out a small profit and protect capital so that the portfolio is positioned (and our reserves of mental strength and confidence are intact) so that we can take advantage of the quicker ‘trading time’.

Things I’m looking at for the Second Half
I’ve broadly split the ideas into two camps those that would increase or reduce the book’s existing biases (profiting from tightening long-term Treasury spreads and a noticeable fall in the equity markets).  Those that would increase the existing biases are first:

- Zero-Coupon 20Yr+ Treasury Bonds (ZROZ)
A clear increase in the long-end Treasury exposure, through a higher beta instrument.  It’s just the kind of tactical trade one would look to put on, if fear had passed through panic and was looking at capitulation (i.e. bad GDP numbers, equities tumbling and people realizing that the expiration of the Bush tax-cuts means 2010’s a great time to book your capital gains).

- 2x Short Euro (EUO)
Generally, I’m not a fan of levered short ETFs as the combination of leverage and the inverse compounding kills you.  However, there are signs of complacency amid the belief that Europe’s problems are done/priced-in/etc and the technical signs in the recent bounce in the Euro (this video neatly captures most of them) I am tempted by this one.  My skepticism goes back to its launch and my days as wide-eyed Econ undergraduate who irked his professors by failing to comprehend how it could possibly work in the long-term.  In short, the Euros flaws (to name the first 2 that come to mind; there’s no stick to punish countries that cheat, in reality there was no requirement for any meaningful convergence) are in its politically-driven construction and unless the sovereign countries join to form a federal Europe there’s little prospect of these flaws being corrected.  A weak foundation becomes apparent when it’s stressed and, while the ECB can try and reduce the stress in the short-term without major changes (starting with debt and budget restructuring) and pain (likely significant deflation and entitlement reductions in periphery countries) the stress will only increase over time.

- Rolling the maturities of the market hedge puts
In the absence of a market collapse the market hedges will need to be rolled.  The timing of this is flexible, though likely to be end of Q3/start of Q4 (before the theta decay really impacts them too much).  There’s the potential for both sets of puts to be on the book at the same time, if economic data shows noticeable weakness, and the market show some weakness but manage to hold up.

- NCAV Portfolio updates
With Q2 reporting season upon us, it’s likely there may be some new names for the NCAV bucket in the coming weeks after companies file their results with the SEC.

- Water Thesis
As this is a long-term strategic theme, it’s something one should be very comfortable starting a small position in and scaling into should it fall with the market.  The first step is likely to be through some of the utility-orientated ETFs, before considering adding risk (through more Industrials-focused ETFs, and potentially individual names) only when the timing is more favorable.

- Lead Acid Battery Cos
As mentioned above, we missed out on Exide once and I don’t intend to a second time.  As such, expect more on the Lead Acid Battery Co write-up (Part A) to be completed sooner rather than later, so that we’re in a position to put Exide (and other names) into the book should the chance arise.

Half-term ponderings – Random Macro Thoughts

It is a mark of how quickly uncertainty has returned to one’s thoughts that in looking through my notes I was convinced that claims of the economy reaching its fabled ‘escape velocity’ were made last year.  They were, of course, not.  Instead Larry Summers’ April confidence marked the peak of the positive economic data, which has become increasingly questionable over recent months.  The question that thus stands before us today is whether recent weakening data simply illustrates a mere soft patch as the economy (and its participants) digests the sharp changes of recent years before self-sustainable growth is resumed, or if now that the sugar-high of government support is waning we are merely seeing the underlying weakness that was ever present beneath it.

As we are currently in the eye of the storm the data is not conclusive in either direction.  As such, much of the debate raging amongst those in the financial world is more ideological and belief-orientated in nature.  On the one-hand, those who believe that this is a run-of-the mill recession, and can be modeled as such, can point to numerous historical examples of soft patches that have proven non-fatal.  Their point is well-founded; most of us (especially in the US, and Western Europe) have never experienced anything bar a run-of-the mill recession, so why should this time be different?  On the other-hand, for those who see this as a credit crisis, whose primary underlying cause (too much debt) hasn’t been attacked and fear the debt-driven deflation as it is reduced, largely see the current weakness as a come-down from the sugar-high of QE and Stimulus-driven GDP.  Their argument is that no, this time is not different and implementing Japan-esque policies, albeit in much larger size, will not produce a different end result.  Some might even say it is insanity.

However, only data and time will provide the answer to this debate, though as a tangent it seems quite possible that we will fail to draw the right conclusions; when one is only left with bad choices, the temptation is to blame the last of those ill-fated choices rather than appreciating the underlying problem that led us down the path.  This is apparent from the rhymes of history; after all, no lesser lights than Fed Chair Ben Bernanke and Milton Friedman have noted that the Fed’s raising of rates in 1932 was cause for the economy falling back into recession.  Or that the leading expert on Japan’s lost decade(s), Richard Koo, blames Japan’s relapses on the various moments when the government tried fiscal reforms (and reduced Quantitative Easing).  Sadly, I fear both are arguing over the footnotes of history; is the real sin the normalization of policy or the implementation of the “extraordinary” policy in the first place? 
Perhaps the prevalence of economic weakness across many countries means that the modern-day Austerians will have greater luck than those in the past as those countries that stick with the program emerge solvent and in better shape.

The underlying problem is, of course, the level of debt, which is a cultural phenomenon of Anglo-Saxon capitalism (in particular) with debt being something we’ve quite mastered creating and disbursing be it through securitization, collateralization or just your plain old leveraged financing.  For those who balk at the word cultural, consider the following true tale. Mrs OM’s insistence on fulfilling the American dream of homeownership means that we have a nice little mortgage, for which we receive a tax break on the interest payments.  However, our small savings (bar this portfolio) sit in the bank accruing interest but we’re not rewarded by the government for this and instead watch some of the interest generated head over to the taxman.  Given these simple government incentives, is it thus any kind of surprise that Americans (and Brits, amongst others) have a proclivity to take out too much debt and buy shiny new things with it, along with an aversion to saving?  The same incentive structure holds true for corporations, except that their executives have even greater personal incentives to use debt rather than the equity they’re paid in.  What’s more, if it all goes wrong…that’s ok, because you get a bail out (if you have the right friends) or a mortgage modification (meaning you pay less that your neighbor who didn’t show such poor judgment of their finances) or some other juicy offering from the powers that be.  In the absence of a firm willingness to subject debtors to the creative destruction of the bankruptcy process, especially when it’s felt that it may be a systemic issue, shouldn’t the incentive structures be set such that the level of debt is never a structural issue and one is encouraged to save.  But I digress…

Those that venture here often know that my opinion has long-been that this is credit crisis (see Plight of the Consumer and Commercial Lending) and so I fear now for the economy as the sugar-high subsides, with the Fed’s efforts having failed to spur any revival in bank lending.  If one could only pick one graph, to suggest why this is your normal recovery…the weakness of real final sales, as shown compared to the 80’s recovery below, would be it.

Last month’s Chartology showed the signs of the leading indicators (including two of my favourites in ECRI and Consumer Metics) declining along with both M2 and M3 (which is declining at the fastest pace since the Great Depression), and these trends have continued with a number of coincident indicators (including my favourite, the ADS) threatening to roll-over.  The data in the remainder of the year will be important and likely unpredictable on a short-term basis.  While I will touch on the portfolio’s positioning and my thoughts on it in the coming days, it’s fair to say that from a macro perspective I worry about a second pre-emptive QE from the Fed.  Should it happen, it’s likely to be a rough time for the book though perhaps fortune will smile on us and the Fed will buy long-end Treasury bonds…

DragonWave Update

Results
As noted in the original write-up the major risk for DRWI is its current dependence on 1 customer (Clearwire, 80%+ of revenues) and its need to increase its customer base.  As such, until it has a broader customer base, the potential for DRWI to be volatile, especially around earnings, is very high.  This is what we have seen over the last week around Q1-11 earnings. 

- The earnings numbers were adequate ($48mn revenue, $9.7mn profit, $0.27 EPS)
- However Q2 guidance spooked the market; with Clearwire only expected to contribute $6.25mn (vs. $38mn in Q1) and other customers expected to contribute $18.8mn (vs. $10.7 in Q1) to revenues.  The Clearwire drop being larger than the market expected, while other customers is growing quicker than the market expected.   
- This obviously leads to questions:
While a drop in Clearwire sales was expected (they are approaching the end of phase I of their 4G rollout), is the Clearwire drop a one-off (inventory digestion), a result of competition, or what?
Is the increase in other customers a one-off, one big customer, lots of little ones, etc?

Other Information
Here’s some of the other information that I’ve gathered (from reading the release and presentation, listening to the conference call, digging around a bit, etc)
- DRWI was surprised by CLWR’s Q2 demand, but the guidance is conservative so a new surprise is unlikely.  They’ve shipped 90-95% of the equipment for Phase I of CLWR’s buildout (where competitors won <10% market share), and Q2 represents c1/3 of what’s left.
- CLWR has been silent (so far) on the details of the Phase II rollout (150mn households vs. 120mn in phase I) though given they’ve not been shy of touting the speed of their 4G network, amongst other things, all indications are that it’s almost certainly going to go ahead.  Based on my assumptions on market share, number of towers involved, etc, this would represent c$175-200mn for DRWI spread over a number of quarters.
- Other Customers: Plans have accelerated and DRWI claims the pipeline is stronger than at any point historically.  It also should be noted that the Q2 revenue projection would be the highest non-CLWR quarterly revenue.
- OEMs: DRWI indicated it expects to sign a deal with a 2nd OEM in the next quarter.  DRWI aren’t giving much more details, except it’s a Tier-1 player and they’re expecting the demand to help in LatAm/Asia (good as only 17 of 88 customers, and <$0.5mn of revenue, are from those regions) and it’s likely to represent 10% of revenue within 1 year.

Other Thoughts
- Balance Sheet Value:  After Q1-11, DRWI has $3.15.share of Cash/ST Investments, a $3.49/share liquidation value and a Book Value of c$4/share.   In short, while the business is clearly risky, will be volatile and my thesis remains based on potential growth, you’re not paying a lot for the growth given the company is currently break-even (in Q2)/profitable (historically, and with any increase from Q2 revenues) and the  value of the balance sheet supporting it.
- Management:  The sense that I get is that they believe this is a soft patch, a gap between the first CLWR roll-out ending and new customers buying in size/CLWR Phase II kicking in.  However, from my conversations, they seem to be willing to cut costs appropriately should the soft patch be more prolonged. 
- Final Thought:  Given all the information, and the positive long-term thesis coupled with the balance sheet value, I’m comfortable with the DRWI position.  The major question that’s unresolved is how large this soft patch between CLWR Phase I and the take-up by new clients (and/or CLWR Phase II) is.  Should that extend into the 2nd half of the year, there may be the chance to pick-up some DRWI at close to its liquidation value (i.e. really get the business for free) but if it ends sooner, then yesterday’s $4.60’s prices will be the best we’ll see.  At this point, I’m comfortable with the current size of the position (1.4%), though could be looking to add to it if we see any prints in the $4 or below range.