December Review

Performance Review
December provided Our Man’s first dose of reality, with the portfolio bleeding steadily during the month resulting in a loss of 4.24% for the month.  As indicated during the mid-month update (Waiting for Godot), substantially all of the loss came from the Long positions in Gold and in Long-term Treasuries.  The L GLD position cost 160bips and risk management triumphed over patience, with the position substantially cut-back.  The Long positions in Long-term Treasuries (L TLT and L Aug-29 Treasury Bond) cost 258bips, however no action was taken and this remains the portfolio’s largest positions. 

Why the difference in reaction?
Well, without going into substantial depth, the underlying reasons are based on Our Man’s conviction (the underlying thesis being debt deflation and the key information being the lending data to consumers/commercial industries), maximum loss of capital (which Our Man believes to be substantially lower for Treasuries than for Gold), expected return (similar over a 12-month period) and time horizon (Our Man’s thesis behind his Treasury position is strategic and secular, and thus long-term in nature, whereas as discussed previously part of his Gold position was tactical).  As such, Our Man has far more patience with his Treasury position (note the short-term volatility is also substantially smaller, which in conjunction to the above is why Our Man is comfortable with its size in the book).

Portfolio
40.08% -- Long Long-term Treasuries (via L TLT and L Aug-29 Treasury Bond)
9.11% -- Long GLD
7.49% -- Long Intermediate Bond Fund (via L VBIIX)
6.57% -- Long THRX equity
4.79% -- Long Restricted equity positions (via L NWS, L CMTL, L CRDN, L SOAP)

(4.01%) – Delta-Adjusted Short position in the SPY (via L Dec-10 puts, with strikes at 100 & 85; 0.88% premium at risk)
(2.04%) – Delta-Adjusted Short position in GS (via L Dec-10 puts, strike 120; 0.49% premium at risk)

29.58% -- Cash

Performance

2010: Fingers of Instability

The first few fingers relate to the possibility of Banks suffering from “rolling waves of defaults” (Our Man thinks Mike Mayo, of Calyon Securities and formerly Deutsche Bank coined the term a couple of years ago).  Our Man suspects that most of the cases below bear conceptual similarities to sub-prime in that the risks are well understood by the market but that the consequences (especially the secondary and tertiary impacts; as a result of parceling out of risk from the banks to other investors) are not fully appreciated.

- Commercial Real Estate
The weakness of CRE is well-known, with the Moods/REAL Commercial Property Price Index down 44% from its October 2007 peak and reaching levels last seen in August 2002.  Given how well-known the decline is, the general assumption is that defaults will have limited impact on the markets.  With only a limited number of defaults so far, an estimated $1.4trn of CRE debt scheduled to mature over the next 5-years and 50%+ of it underwater (per Foresight Analytics), Our Man thinks we’ve yet to see how this one plays out.

- Residential Real Estate:
While Our Man thinks it is fair to say that most believe that the residential estate issues are behind us, his opinion is that we’re sitting in the midst of a lull period between the first wave of issues and a second wave.  Unfortunately, while the FED/Treasury has done a fine job in delaying (or ‘extending and pretending’, if you’re feeling less generously inclined) defaults and trying to maintain home prices (think HAMP, first-time tax buyer’s credit and it’s extension and expansion, FED buying mortgages, Treasury backstopping Fannie & Freddie, etc), Our Man is of the opinion that this is all it is…delaying.  Things he worries about in Residential Real Estate world are:
 a). The recast schedule for Option ARMs (which is when the payment changes, to reflect full amortization as well as interest payments). 
Given the predominance of homeowners (analysis from S&P, Moodys, etc suggests they are in the 80%+ range) who’ve been paying only the minimum payment (i.e. interest-only), the jump in payment (to include amortization over the remaining term of the mortgage) is far more important than the impact of a change in rates (known as a “reset”).  The difficulty is knowing when the recast will happen, as it will happen at either at the time of the reset (generally 5-years after the mortgage was taken out) or when the negative amortization cap (normally 125% of the original principal balance) is reached.  Given the level of minimum payments being made, it is likely that recasts will happen before the reset schedule.

b) Prime Mortgages default rates well above historic norms.
Our Man can hear you snickering in the background at this one, after all Prime Mortgages are the good stuff and have been around long-before all this financial shenanigans began so we can data-mine and know how they’ve defaulted historically.  However, Our Man notes that the standard (pre-2003) DTI (Debt-To-Income) ratios were 28% (for housing, 33% for Jumbo loans) and 36% (for total debt) and were based (largely) on documented income.  Post-2003, they could be anything up to 50% and in many cases (data varies from 35-50%+of Prime/Jumbo Prime loans) were based upon limited documentation (which Our Man is willing to bet is because the borrowers didn’t have their stated income).   Given these 2 changes; Our Man isn’t certain that the historical data will be an accurate guide to future problems.

 - Bank Lending (general) and Consumer Deleveraging
Our Man has already mentioned that he thinks Bank Lending & Consumer Deleveraging will prove to be the key factors in the coming months (perhaps years).  The reason is simply that they stand at the hub of the primary debate, will the FED's 'quantitative easing' cause inflation or will we see continued deleveraging from an over-levered consumer causing deflation.

- Sovereign Risk
Dubai & Greece have hit the headlines recently, there have been additional worries over Spain and Ireland during the year, Short Japanese Government Bond trades are being put back on (again!) as their Debt/GDP goes through 200% and there’s been a lot of muttering over the last couple of months about how US rates will have to rise substantially (though Our Man's L Treasury position is clearly a wager that this will not be the case), will there be more tumult (especially across Eastern Europe, Italy and Our Man's homeland) to follow.

- Monetary Tightening
While Our Man would be surprised if the FED Funds rate went up any time soon (in part since many blame the FED for raising too early during the Great Depression causing the relapse; though Our Man's view this is that it's a tad hopeful to try and solve a major solvency crisis by injecting liquidity, and then being shocked that the underlying solvency issues remain when the liquidity is removed).

- China
“The Chinese government…are executing their eleventh ‘five year plan.’ They do exactly what they say they will do. They will likely be the biggest economy in the world someday. Man, these guys are good.” - Jeffrey Immelt, CEO of GE, following a speech at WestPoint earlier this month. 
The point of the quote isn't mean to disparage Jeff Immelt (who in OM’s opinion has done a fine job, given the abysmal quality of the hand dealt to him by Jack Welch) but more to display what's the prevailing conventional wisdom China be it from business folk or finance experts (like Nomura's Richard Koo, an expert on Japan) -- China can do no wrong & will grow at 10%+ forever (ok, maybe that’s a touch of hyperbole).  Sadly, Our Man fears reality is never like that...and notes that in addition to  mass certainty in an outcome (house prices never go down & Tech is the new paradigm (and so deserves a new valuation model where profitability doesn't matter) the other 'best' indicator of an asset bubbles is loose credit conditions (and he'd certainly call China's loose). 

- Terrorism
Enough said.

- Global Trade, Protectionism & Emerging Asian Economies
For those who are historically minded, the steady decline of Global Trade and the rise of Protectionism, was one of the noticeable features of the 1930's depression in the US.  That threat is clearly present today (see this week's decision by the US ITC) and will only become more tempting for US firms/ politicians/ people to demand should the recovery prove sluggish.  With so many Asian economies relying on export driven demand (to Japan, Western Europe, and the US), and gearing their industrial production to a pick-up in this demand, the rise (or not) of protectionism home & abroad could be a vital factor.

- Valuation
 From Our Man’s perspective, the market is not cheap; currently, based on the Shiller 10yr P/E ratio, the S&P trades around 20x, which is above the historical average (c16.5x).  Furthermore, Our Man notes the persistent overvaluation of the S&P over the last 20years and despite expectation of a V-shaped recovery, his simple model (using the very generous assumption of $75+ Earnings for the S&P 500 in 2010) the S&P’s multiple looks set to climb next year (towards 22x) even without an increase from the present S&P level.

Fingers of Instability & Glimmers of Hope -- An Explanation

This is Our Man’s way of (exceptionally broadly) applying the concepts of Bak-Tang-Wisenfeld’s sandpile model to how he thinks about investing. While Our Man has no physics background, he’s stumbled across various descriptions of the game (most clearly in “Ubiquity” by Mark Buchanan, which he recently re-read), and found the idea fascinating and most helpful as a discipline in thinking about the world.

So what’s the idea and what does this have to do with investing?
Bak, Teng & Wisenfeld model stems from their investigations into the instability of complex systems, and their discovery was that these systems tended to naturally arrive at a “critical state”, after which any sand grain landing in the wrong spot can start an avalanche. Furthermore, the size of the avalanche is the result of a domino effect – how unstable was where the grain landed, and did the resulting slide cause grains to move over other unstable spots thereby creating more slippages, etc. Clearly the number and size of the “fingers of instability” that are impacted (primarily, and as an after-effect) by that falling grain of sand will play a key role in determining how large the eventual avalanche will be.

Fascinatingly, Bak-Teng-Wisenfeld discovered a mathematical property connecting the number of grains involved in an avalanche and the frequency of an avalanche of that size. Simply put, if you doubled the number of grains involved in an avalanche it becomes about 2.14x as rare. Moreover, the presence of a power law, critical state, and fingers of instability appears to be more widespread; for example, in Ubiquity, Buchanan talks about how similar properties are found in the size of earthquakes, forest fires, scientific paper citations (as a proxy for “new” scientific ideas), deaths in wars & last (but not leastly) stock price fluctuations (though Benoit Mandelbrot deserves a big nod for his works on that specific topic, but Our Man shall leave that for another time).

As such, in an attempt to impose some discipline over his thought process, Our Man hopes to jot down some of the Fingers of Instability (that could drag stock markets downwards) and Glimmers of Hope (that could drag it upwards) to: help him remind himself what he was worried about at the start of each year, to provide a guide of things to keep an eye on during the year, and to look back on in futures and see what he missed & why. It should be noted that these lists are absolutely 100% NOT predictions (it’s a mug’s game) but are things that Our Man is watching out for, worried about, or hoping for – if other people call something a “Black Swan” (something, along with 20-standard deviation events, that Our Man doesn’t believe in) and it’s not on Our Man’s list, he just missed it…

Portfolio Update

You may have noticed, over the last few of days that Gold fell back into Our Man's stop loss range. Now given that Our Man is a fairly simple kind of chap and is unable to short-term trade his positions (given the investing constraints imposed upon him, not to mention the commission involved!), he's a big fan of having a Stop Loss range rather than a specific Stop Loss point. After all, how do you pick that specific point, without it being somewhat arbitrary?

A range also makes more sense to Our Man as it can help balance the two conflicting emotions; a desire to be patient with positions and to give them an opportunity to work, and the ex-post need* to be disciplined in managing risk. Thus by having a range Our Man is able to encapsulate a number of things into his decision such as key support levels (be they moving average related or just psychological round numbers like $1,100) and normal intra-day volatility.

Anyways, in this instance…Gold fell through $1,100 (a psychological round number) and the moving averages (support levels, in the $1,080-$1,090 range), touching and intraday an intra-day low of $1,074. Thus discipline trumps patience and Our Man exited just over half the Gold position at the equivalent of $1,085. The Gold position now represents 8.8% NAV, with the Cash position increasing to 29.5% NAV.

*Note that by "ex-post..." Our Man means the need to be disciplined in managing risk, after the decision to invest has been made. The ex-ante discipline in managing risk should (obviously) be done before making the investment and Our Man's consideration of risk is an important factor in both making the investment AND how the investment is sized.

2010 - Year of the Relapse?

While Our Man has stated his central belief is that this is a credit crisis caused by an over-leveraging of the consumer, he hasn’t really explained why. As everybody knows, a major driver of the US economy is the consumer…and the US consumer (including Mrs. OM!) loves to shop, can’t get enough of it in fact! Some might even say that the US consumer over-consumes! And we’re not talking too many Happy Meals here; we’re talking the kind of consumption that bears little resemblance to future income (wages, etc) but instead comes from spending the kids’ college fund (or your retirement fund, or taking the equity out of your home to spend it now, or just not bothering to save) and then relying on ever-increasing amounts of debt to support it!

They say a picture’s worth a thousand words, so here’s a picture illustrating what I’m talking about:

Now there are a number of reasons why this debt problem has come around (hello ‘free-market’ neo-classical economic theory that doesn’t really consider the level of debt, bank lending policies & financial engineering, and irresponsible US consumers, to name a few) but that’s not our concern today. Our concern is what does it all mean! Well, Our Man’s firmly in the camp that it means we’re in a credit crisis…that the US consumer instead of over-consuming is going to have try and deleverage and do some of that 'saving', which was popular back in the old days! He also suspects that it also means that this recession (dare he mention the ‘d’ word) is going to end up in 1 of 2 ways; a Great Depression style collapse (quick deleveraging, increased savings but reduced consumption) or a Japanese (sorry Mrs OM!)-style stagnation and lots of w’s (where uneven growth, often driven by government, gives way to another recession as the government steps away…leading to the government throwing $$ at the problem, ad nauseum while delivering takes a longer slower trajectory).

The government’s response has been simple; keep asset prices up (TARP, liquidity to banks, get rid of mark-to-market, etc), try to get the consumer to spend (and taken on more debt, cash-for-clunkers, first-time high buyers credit, etc) and throw money at the problem (Stimulus). Though you’ll notice very little on debt forgiveness and credit write-downs (though, Our Man supposes HAMP was an attempt at this!), it’s also fair to say that they’ve been very successful so far in producing GDP growth. The questions will come when the support is removed and the baton is passed to the private sector.

For the baton to be passed over smoothly it will almost certainly require the consumer to be willing to take on debt (or at least not reduce debt, and take advantage of lower interest rates to refinance/roll-over debt) and resume over-consuming. However, Our Man’s wager is that the hand-off will not go smoothly, and the Japanese W’s will raise their ugly heads. We may see the first signs of this in asset prices, after February when the FED’s move to single-handedly support the toxic assets is scheduled to be withdrawn.

So either way, Our Man looks at 2010 as the year of the relapse…it’s just a question of whether it’s the economy or the consumer who’s relapsing!

What does this mean for the portfolio; well this core view helps create a starting point and from there Our Man tries to consider the “Glimmers of Hope” and the “Slivers of Instability” that could impact the markets and his book. More on that, next time…

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.

November Review

Performance Review
November proved to be the strongest month in the portfolio’s short history, with the portfolio rising 6.43%. The portfolio was profitable throughout the month making money in every 5-day rolling period, and during both the strong 1st half of the month for the markets, and the more uncertain 2nd half.

The performance was again driven by the position in GLD (Gold ETF) which contributed over 500bips to the month’s profit following the barbarous metal’s almost 20% rise during the month. The position in L-end Treasuries (through L TLT, and an individual bond) contributed over 150bips as yields continued to tighten. As noted during the mid-month updates, the portfolio’s positioning changed significantly during the month and the new positions proved a small drag on performance.

Portfolio
The portfolio’s positioning is unchanged from the update a couple of days ago.

During December, Our Man hopes to discuss the following issues:
- 2010 Outlook and Positioning
- 2010 Alternative Scenarios
- China, and Our Man’s skepticism of its economic miracle
- Potential Investments that Our Man hopes to build during 2010