Our Man hasn’t really written a post of substance in a while, for a mixture of good and bad reasons. On one-hand, Our Man doesn’t really like to write when he has little of note or new to say, and on the other he spent most of the last 6 weeks obsessing over the Giant’s unlikely Super Bowl run! However, with the Super Bowl clinched and the market partying like it is 1999…what better time to put down on paper some of the things that Our Man is pondering.
First, let’s take a step back and start on a philosophical note, and discuss the difference between risk and uncertainty as the two often become conflated when people talk about the markets. To my mind, risk refers to an event (or series of events) that can cause a significant loss to the markets (market risk), or to one’s portfolio (portfolio risk). Uncertainty is something different; it refers to a greater number of potential and viable pathways or routes for the market, some of which may entail great risk and others very limited risk. What is important though is that because there are a greater number of viable pathways, the certainty that any particular one will be taken is low. This means that the impact from small changes in information is magnified, because each change can be can easily extrapolated forwards as they new reality and thus change the markets potential route. Of course, if the next piece of information contradicts the existing set, the probabilities change once more resulting in new potential routes. While it’s tempting to assume that risk increases as things become more uncertain, that isn’t necessarily the case.
Secondly, in investing as with many other pursuits, it’s vitally important to separate out opinion from execution, and understand their relative importance. While this sounds simple, in practice it’s somewhat more difficult – opinions are the most interesting part of being engaged on a subject, everyone has one and most aren’t shy about sharing them (irrespective of how well-formed they are)! In short, people want to talk about (and listen to other peoples thoughts on) whether the market is going up, if Greece is going to exit the euro, will China have a hard landing, or are Eli Manning and Tom Coughlin certainties to make the Hall of Fame! However, while opinion is interesting and fascinating, it’s what you do with those opinions (i.e. execution) that really matters. Let’s imagine China were to have a hard landing; if you held this opinion in advance, that’s great but it’s not necessarily what makes you money – that’s driven by how you choose to express China hard landing (what companies/countries/etc, and what instruments), the resultant risk/reward of those choices, along with when you choose to put the trade on (is the hard landing coming in 2012, or 2013, or later…or should it have already come) and how you size it (if you’re too big too early, you may not be able to hold your position until the day it works, but too small or too late and you don’t make any money). Unfortunately, while the sizing, timing and expression of a trade (i.e. the execution of an opinion) is what will drive returns, its importance is undervalued and largely ignored in the swirl of opinions.
So, why talk about this today? Well, it’s a subject Our Man has touched on before and ponders a lot about, but it’s also one that has greater resonance today given Our Man’s skepticism and the market’s strong start to the year. Opinion-wise, Our Man’s main skepticisms surround whether Europe is heading towards a long-term solution towards the sovereign debt issues, if the China-story is real or just another credit & investment-driven bubble, whether corporate margins are unsustainably high and if the US economy can continue to muddle-through. Of these, the strength of the US economy is the one that the market has largely dismissed (though it’s doing its best to dismiss them all), as a result of the improving macro economic data that has come out with the consensus being that the US economy has hit escape velocity (again!). Our Man would point out that while the leading data has been muted, most of the improving data has been coincident and lagging and thus extrapolating where we are now (or were yesterday) to project where we will be tomorrow is fraught with error, far smarter people have gone into far greater depth on this so he will leave you to read their words of wisdom.
See, Our Man fell into the trap of wanting to talk about opinions, even after commenting on the frequency of such discussion. So, enough about opinions, what about execution! When talking about execution, Our Man will focus on the broad Equity books, the China thesis, and the Puts/Hedges books. This is simply because the majority of the risk, and prospective returns, lie in these books - the Treasury Bonds and Bond Funds, which make up most of the exposure are unlikely to be a major driver of returns (either positively or negatively) except in extreme scenarios, and neither is the NCAV book or the position in the Euro*. There is some other Equity risk in the portfolio, split largely between the Value Equities and Energy Efficiency books; in both cases it's relatively idiosyncratic, and invested in smaller more speculative names, hence the small position sizes to limit the potential losses.
So where does the main risk lie? Well, as you know, Our Man's strongest opinions are his skepticism of China's growth and of the strength of both corporate earnings and the US economy. Thus, unsurprisingly, the largest risks (and potential returns) are likely to be found in the Put/Hedge and the China Thesis books. In both cases, Our Man's skepticism is expressed through out-of-the money put options; on Brazil (China Thesis) and on Market Indices and Consumer Stocks (Put/Hedge book). Given the use of put options, the risk is easy to measure - the most the portfolio can lose over 2012 is the premium that Our Man has spent to buy these options (as they expire in Jan-13). So far, Our Man has spent a total of 80bps on his China Thesis and 175bps in the Put/Hedge book, for a total of c250bps maximum loss (put premium) in 2012. Again, impactful but not disastrously large amount should Our Man be wrong...however, I hope you noticed the "so far". It matters because Our Man has mentally budgeted spending up to 500bps of put premium (i.e. a 5% maximum loss) in these two buckets, over the course of 2012. To get there, it will require time, greater opportunity (or put another way, greater prospective return from each unit of risk) and higher conviction. In practice, this is likely to come from a combination of higher stock prices (so that out-of-the money puts, struck at the same level as existing ones, become cheaper) and the underlying coincident data (on China, and/or the US economy/consumer) to hold steady or weaken. This means, for example of the US-centric positions, the ideal scenario for Our Man is a market that rallies to 1,500 (S&P 500) while coincident economic/consumer/earnings data weakens, which would cause short-term loss on existing positions but the opportunity to add aggressively to them. The main risks of course are that the coincident data continues to remain strong, the leading data improves and that the consumer and corporations prove resilient. This is what Our Man has and will be watching in the coming weeks and months, to help him better execute on his bearish opinions.
* While the size of the Euro position looks relatively large (after adjusting for leverage), it would take an extreme scenario for it to be the major driver of performance. For example, if we woke up tomorrow & the Euro was trading at its best point in 2011 (a move of 13% overnight), the loss would be c125bps…painful but not something that would ruin the portfolio. By the same token, if it traded at its 2010 lows (a move of 10% overnight), the profit would be c100bps – once more, not something that would make a successful year.
