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!

Mid-Month Update: Waiting for Godot…

Our Man, being of a more laconic nature, has never been accused of being “communicative” but he had hoped to stumble upon such a talent upon starting this blog. Sadly old habits die hard, especially when aided by distractions of birthday and holiday season. Nonetheless, after an impressively dismal run of performance to start December there is surely no better time for update!

So far, December has proved to be a microcosm of the scenario that Our Man fears most; a drifting market. It means, that in the absence of good news, the portfolio quietly bleeds a small amount as Our Man’ negative bets (through puts) quietly burn their theta (time decay), which his equity holdings barely offset this as they drift sideways. As such, the book’s performance is buffeted by the sparring forces of his (overly?) popular position in GLD (Gold) and his (overly?) unpopular position at the long-end of the Treasury curve (TLT). The two positions have combined fairly evenly for almost the entirety of the month-to-date losses and as the numbers below show, death by a thousand cuts never looks pretty…

Our Man’s Current Thoughts:

- TLT: Despite being the largest position in the book, the Treasuries position remains a comfortable one that Our Man would consider adding to in the future. The position reflects the underlying belief that we’re in a deleveraging cycle, as evidenced by the FED’s Commercial/Industrial and Consumer lending data, which will likely prove deflationary despite the FED’s attempts. Additionally, the position would also benefit from any flight to safety away from risky assets (in particular equities).

- GLD: As mentioned when the Gold position was cut-back, it is now a far more popular position than when it was originally put on. As such, Gold has also generated an array of articles from market commentators which run the gamut from “bubble” to “fair value of $6,000+”. Our Man’s thought process remains unchanged; Gold continues to be held firstly as a hedge against bad governance (by the Fed/Treasury), and secondly as a shorter-term momentum/trend play. In November, Our Man noted that he intended to place the equivalent of a rolling stop under 50-67% of the position once gold reached $1,250. While Gold never quite got there, it has retreated to the level where Our Man exited his first slug of his position and currently sits just above its 50-day & 65-day moving averages. Should it break these levels (c$1,080) then Our Man will be exiting at least 50% of the existing position.

On a more general basis, December has shown many of the potential risks that this portfolio could suffer from in 2010:

- How sideways markets will likely lead to small and steady theta burn that goes uncompensated by the equity positions
- How uncertainty over US government debt levels, increased supply of long-term bonds, and a lack of short-medium term clarity on inflation/deflationary trend, and no catalyst for a flight to safety will likely cause bond prices to drift.
- That whether or not Gold is in a bubble, its ride from here is likely to be more volatile…especially as the US-Dollar shows signs of strengthening.

Portfolio Update

This is an unexpected update and due to a sore neck that Our Man claims is from looking at the soaring markets, it shall be a brief one. Somewhat to OM’s surprise, Mrs. OM has decided that he should be in charge of a more substantial part of their LNW and as such has suggested he take over the rest of their assets in the market. Thankfully, such generosity of spirit does not come with a ban on the words such as Japan, bubble, Minsky, credit contraction, deflation and Treasuries that Our Man has a tendency to throw around, and so unfortunately you will not be spared his ludicrous ideas.

As with all things in life, while the move almost doubles the size of the portfolio it also comes with some downside; in this case, it’s that these assets while predominantly in cash also contain a number of securities, some of which cannot be sold at the current time (due to the constraints that Our Man operates under). However, this is but a minor detail and the assets are expected to be co-mingled and the portfolio reshaped to reflect Our Man’s views immediately.

The timing also allows Our Man to use the moment to introduce some of the new ideas that he’s been considering. The most notable of these is by adding some medium-term high quality bond exposure to the portfolio, by adding some risk exposure to the book but by limiting the directionality of the portfolio by adding a substantial exposure to medium-term downside equity protection (through puts).

It goes without saying that the performance and exposures will include these assets, the moment they are co-mingled within the portfolio. As noted, the incoming assets are primarily in cash but also include the following:

- 1 TIPS Bond

As someone who prattles on about deflation, it’s unsurprising that OM will sell it immediately.

- 2 Intermediate Term Bond funds

Our Man expects to sell one (which holds 40% in pass through mortgage securities!), and substantially increase the size of the other Fund (VBIIX), which holds both Treasuries and Corporate bonds and (ironically) was amongst the list of potential bond funds that OM had been looking at.

- 4 Equity positions

These are positions that OM expects to be restricted from adding/removing from the portfolio (or in 1 case the commission would make it pointless to do so). While none of these names fall into the ideas that OM was considering investing, and add directionality to the book, they also make up a relatively small part of the book (OM estimates <4% style="">

- L THRX (OM doesn’t believe that it will be restricted)

However, it is a position that Our Man knows reasonably well, having done a stock pitch on the name just under a year ago while he was a loafing student, and having encouraged Mrs. OM to purchase it when she was considering adding exposure. Ironically, the stock trades today at almost the exact price that Mrs. OM entered the name (read what you will into that, about OM’s stock-picking ability!) and Our Man is secretly quite pleased to be inheriting this name. The sizing is a little large (6.5% of total assets, estimated), but OM is comfortable with the downside given the heavy equity put-hedge that he intends to apply.

Other portfolio moves that will be made, concurrently:

- TLT

So far Our Man’s exposure to long-end Treasuries has been through a specific bond; with the need to add to the Treasuries position in order to take long-end Treasuries back up towards 40% of the book, TLT will be added to the portfolio.

- Put Options (SPY and Financial Firm/ETF)

Our Man is largely constrained in expressing his negative views on things except via options (especially since he has no understanding why people with time horizon >1week would invest in Short/Ultrashort ETFs, and have the magic of simple mathematics working against them)

During December, we’ll look a little more closely at what Our Man suspects and fears could happen in 2010. Suffice to say, that it’s not likely the most bullish of views and this is reflected by a heavy put hedge on the portfolio. Our Man intends to buy Dec-10 options on the SPY, with a couple of different strikes (one close to at the money, one out of the money) and to do so now (rather than later/in the New Year) as he’s somewhat more skeptical of a strong run into year-end (potentially in the face of weakening data) than most.

In addition, there will also be a longer-dated option on a Financial Institution/ETF reflecting the belief that the “Credit Crisis” is in hibernation rather than over, and spread to prime mortgages, Option-ARM recasts (rather than resets) and CRE weakness will raise further issues for financial firms in 2010.

The premium is likely to be 2-3% of the total assets.

- GLD

The Gold position has proved the hardest to decide what to do with; while Our Man would like to add to it (to retain its % of NAV in the book), it seems like it will be somewhat impractical to do so. This a function of the gold price (now $1,170-ish), OM’s desire to run a ‘mental’ stop under the 50%+ of the existing position once it goes through the $1,200-$1,250 barrier, and given the constraints imposed (OM would not be able to trade in it again for at least 1-month). If the last issue wasn’t applicable, Our Man would double the position and continue with his original plan, but given its presence (and the pace at which Gold is moving!) OM is currently leaning (very frustratedly) to forsaking on adding to the GLD position and instead running that mental stop underneath a far smaller part of the resultant position.

The Plight of the Consumer

While we’re suffering through it, every recession is “special” with unique characteristics; however, as mentioned before the type of recession that Our Man fears is a ‘balance sheet’ recession as he’s not convinced that the power that be (let alone simpleton’s like himself) have figured out a way to get out of such a recession (see Japan). Thus, as we’ve also discussed before, he makes it a point to mosey on over to the FED’s website and take advantage of the voluminous information that they provide. Last week, we saw on how Commercial Bank’s lending to real companies (as defined by their Commercial and Industrial loans) provided unpleasant viewing and the pain has yet to show signs of abating. Today, Our Man thought he’d stop in and see how consumers are doing…

As you know, Our Man is a Brit and as such has great respect for the American consumer. In fact, when he was knee-high to a grasshopper his first ever money making scheme was an arbitrage involving American consumers; where he would purchase cans of Coke from his subsidized school shop, before strolling down Church Road to sell them at a hefty premium to the tourists (mainly American) queuing to get into the Wimbledon tennis tournament! As such, he learned at an early age never to underestimate the buying power of the American consumer!

So Our Man fully expected to see credit growth over the last few years but what he hadn’t expected was to see how consistently positive it was. Some random things he discovered by looking at the statistics:

- From 2002 to July 2008 (peak of consumer credit) consumer credit grew at an amazingly steady rate of c5% per annum (with each calendar year falling in between 4.0% to 5.6%). This was positively tepid compared to the previous few years (where it threatened double digit annual growth)
- In the 10-years leading up to July 2008, credit never contracted in any single month. Not one….in 10 years!
- In the 15-years leading up to July 2008 credit contracted in 1 (yes, one) month. October 1998, in case you were curious.
- The longest contraction in consumer credit lasted 20months (Nov-90 to Jun-92) and consumer credit contracted a whopping 2.01% in that time. (It recovered the loss in 9months)
- That 2.01% contraction was the largest contraction since the end of World War 2 (until the 2008 peak).
- The current contract has lasted 14months, and credit has contracted by 4.87% in that time and hasn’t showed much sign of slowing (3.92% annualized over the last quarter, including August’s C4C impact, and almost 7% annualized last month).

And here are some self-explanatory charts and graphs:


Consumer Credit



So how does this fit in with Our Man’s thinking?
Well, he assumes that the last few years have seen a negative wealth effect for Mr. & Mrs. Consumer given the likely impact on their home price and investments. Now, as well as the increased prospect of unemployment, they are also seeing their access to credit financing is being diminished not to mention higher credit card rates (per Rasmussen, 50% have seen increased rates in the last 6months). What are Mr. & Mrs. Consumer to do? Well, Our Man’s thinking is if…and it’s a big if...they are rational, we should see Mr. & Mrs. Consumer choose to pay down their credit balances (and its 20% interest rate) and start to save a little for their impending retirement, rather than splurge it on a (final?) Christmas shopping binge. This broad thesis is, amongst a number of other reasons, why Our Man is quite comfortable with his large Long TLT/Long-end Treasuries position. That slowly, despite the government’s best efforts and bribes, saving will become the new consumption and (given Mr. & Mrs. Consumer’s age) income will become the new capital gain. However, Our Man is wary of the American consumer…and as such, you will find him each month checking in with the FED to see that Mr. & Mrs. Consumer’s credit is declining (and quarterly to check-in on their savings).

Portfolio Thoughts

Frankly, Our Man is somewhat surprised by the slide over recent days having expected to hear a number of companies talk about how 2010 (or 2011!) is going to be the best year…ever! However, slide the market has, and thankfully OM’s portfolio has largely managed to resist the urge to join in.

So firstly, it’s important to note, that if the recent weakness is just a head-fake or a buy on the dips opportunity for others, then OM is comfortable with his book.

However, today the market has started to reach the technical levels that Our Man had jotted down as interesting in the…”this might not just be another opportunity for (the ubiquitous) them to buy on the dips” kinda way. While he’s relatively comfortable with the portfolio and not planning on doing anything, yet, Our Man has begun pondering the following:

- L GLD: Is it time to trim the GLD from its oversized position?
The position was oversized as OM felt that as the trade became more popular Gold would break through its March highs (turning the resistance to support) and possibly head up towards $1,200. With Gold now back around the level of those March highs, Our Man is watching carefully to see if they hold. Should gold be unable to hold it, OM will likely reluctantly part with some of his loot.

- L TLT: Is it time to roll some of the TLT position into SPY puts?
Our Man had circled the 1060, 1050 and 1020 levels on the S&P Index as his numbers to watch, after taking it as a positive sign that his simplistic technical analysis and Elliot Wave Theory seemed to settle on similar numbers for the first time. 1060 as a level at which to start pondering, 1050 as one to see whether there were any buyers on these dips and 1020 as a sign that there weren’t enough of those buyers.

Our Man’s view of market structure is pretty simplistic, as there are only 3 investors Momentum guys, Fundamental guys and Others (Who? Well our man looks at them as the wild cards…a mixture of I-need-to-keep-my-job people and retail investors).
- Momentum guys have been buyers on the way up, Fundamental guys have been holders on the way up, and Others have been neutral to net buyers on the way up.
The market has now fallen 5% from peak -- will people call it a dip and still be buyers (like every pullback in this rally)?
Or will the plethora of negative data give a pause as people wait to see what happens (hello, to OM's boss)? If it does give a pause, does that mean Fundamental guys start/continue to bail (they know they're beyond fair value, and were likely running winners) and do Others (especially those that lost a ton last year, made a good chunk this year and can see year-end redemption so close at hand) join them getting out to protect themselves? If so, given retail has shown little interest in playing this rally and there's no natural buyers -- does that cause momentum guys to want to move from L to S? Especially if the move downwards stretches from 5-8% and the peak drifts further into the past?

Thus, if the market eases through 1050, is that the time to find some puts…with the intent of adding more if it ever goes through 1020? Or should he stick with his flight to quality play? Or is there a more creative way to use his mix of TLT, GLD and SPY put assets to profit from a falling market?