This week we’ll dive straight in with the next episode of Alternative Investments for the Average Investor. A couple of weeks ago we discussed managed timber, a long time favorite of cautionary folks like GMO’s Jeremy Grantham and long-term commodity bulls alike. Seeking Alpha actually picked that article up for publication back on June 25th.
Seeking Alpha has picked today’s article up for publication as well, and even featured it on their front page yesterday. I feel kind of honored! Check it out and follow along if you’re a member over there.
Next week will be really exciting. We’re going to talk about The Trade of the Decade! We’ll give you our trade of the decade and also share with you some trades of the decade from the latest Agora investment symposium up in Vancouver. We’ll discuss specific trades from John Mauldin, Barry Ritholz, Doug Casey, and others from the folks at The Daily Reckoning. I’ll spoil some of the punchline: Uranium and Timber each were high on peoples’ lists.
Let’s get nuclear
It’s something of an afterthought today, but Uranium was a really trendy investment a couple of years ago as crude oil was getting up around $140/barrel.
That was the summer of 2007, and right around then Mike & I were visiting a very large, very successful, very famous New York-based hedge fund that will remain nameless. Trust me, though. You’ve heard of these guys. In every trader’s office was a gigantic white board. We have a white board in our office too and it’s where we sketch out all of our early-stage ideas. So I made a point to pay attention to the stuff on their white boards. It was sort of like being allowed to have a free peek at what goes on inside the mind of geniuses.
On nearly every single white board was “Uranium.” Sure, that was then and this is now and a lot has changed since the world was staring down the barrel of peak oil and stratospheric electricity bills. But investing in nuclear energy was one of their major long-term macro ideas.
If this idea was good enough for one of the best hedge funds in the history of hedge funds, might it be good enough for the rest of us? Our long-term macro thesis is that we are on the doorstep of a decade of hardship and investors are going to have to work a little harder than they did during the last few decades. Could Uranium and nuclear energy make life a little easier and more profitable for us all?
How nuclear works
Nuclear reactors are pretty cool. You guys know we like to talk about other things aside from the nuts and bolts of investing so I’ll give you a quick, non-technical explanation of how it works. Remember that it is all connected; you never know where knowledge will take you, however insignificant it may seem at first.
Uranium-235 is one of the few elements that can undergo a fancy process called “induced fission.” For the non-scientists, “fission” is just a fancy way of saying “division.” Anyway, if you put a chunk of Uranium into a reactor and throw some neutrons at it, one of those Uranium-235 atoms will split and in the process release a couple of extra neutrons. Those neutrons will then collide with other U-235 atoms and cause those little atoms to split and release some more neutrons. The chain reaction continues. Every time one of these atoms split, energy gets released. It releases quite a bit of energy too: one little uranium fuel pellet contains the same amount of energy as an entire ton of coal!
If you put these Uranium fuel rods in some water when you throw neutrons at them, the surrounding water will heat up as all this energy is released. When the water heats up it turns into steam. Then we use that rising steam to turn a big turbine which generates electricity the same way a windmill does.
It’s actually quite simple.
The good news about Uranium is that it’s naturally occurring in the Earths’ crust and there’s a whole bunch of it out there. According to the OECD, there’s enough uranium on the earth to last for at least a century at current consumption rates. It’s not the solution to the world’s energy demand woes, but it’s a part of it.
The future for Uranium
Here’s a chart of Uranium prices:
You guys have been hanging around long enough here at The Draconian to see what that chart’s all about. It’s a bubble!
As you can see, Uranium prices didn’t really go anywhere for a long time. A lot of that had to do with the fact that pretty much everybody in the world stopped building nuclear reactors after Three Mile Island and Chernobyl and so there wasn’t any new demand. Politics also played a big role too as politicians weren’t sure how to sell the issue of storing the nuclear waste. Now, nuclear power plants don’t pollute and there are plenty of ways to safely process the waste. But, whatever. The phrase “nuclear waste” carries certain connotations. Public perception and politics are the biggest hurdles for the industry and its future.
I doubt Homer Simpson has helped either.
But that perception is slowly changing as traditional forms of energy are getting more expensive and electricity demand continues to rise. The U.S. has indicated that it seems to favor coal since we have so much of it, but nuclear energy will play a role too. It was a big part of Obama’s and John McCain’s campaigns, but Obama hasn’t been as aggressive about pushing nuclear since he got elected. Hmm.
In any case, we’re all getting a little more open-minded about the idea again and according to Gallup, support for nuclear power is at an all time high of 62%. That’s good, but still nowhere near the support we show for other forms of energy. Ultimately, the only thing that will get the U.S. to really embrace large-scale nuclear development will be higher prices for coal, oil, and natural gas. The U.S. has a pretty good track record of compromising its moral values when it involves lower cost or higher profits.
On a cost-per-megawatt basis, nuclear is cheaper than wind and way cheaper than solar. But it’s still more expensive than coal and natural gas, which in this country is suuuper cheap. (C’mon people, get on board with the Pickens Plan!) The Department of Energy just published a fairly comprehensive report about the relative cost of various forms of energy. It’s worth a look. Watch these annual reports from the DoE and when you see nuclear becoming a relatively cheaper option I’d expect the U.S. to start to show legitimate excitement for it.
Other countries feel much differently about nuclear energy. France generates about 80% of its electricity from nuclear plants and they have the cleanest air of any industrialized country and the cheapest energy in all of Europe. South Korea is increasing its number of reactors by 50% and will eventually be generating over half of its electricity from nuclear sources. Would you believe that even the United Arab Emirates, the third largest oil exporter in the world, has proposed construction for 11 nuclear power plants? India currently has 6 plants under construction and another 23 on the way. China has a major energy need in the coming decade and nuclear power plants will play a major role over there. Last month, China made a big public announcement that they were going to buy a bunch of yellowcake this year and in the years to come. They’re planning to build at least 60 new nuclear reactors in the coming decade and have proposals to build 120 more.
It takes a while to get a new reactor built and fully operational. But that’s a lot of additional Uranium that the world is going to need. I think that the expectation of future demand has put in something of floor in prices over the last couple of years. The bubble euphoria has died out and the market is now starting to look ahead towards the future with some sense of rationality. Prices make sense again.
On the supply side there was about 50,000 tons of uranium mined last year around the world. All of that uranium already had demand from the current marketplace, from existing nuclear reactors. To put China’s plan into perspective, they alone may be demanding an additional 20,000 tons/year of uranium by the end of the decade. That new supply is going to have to come from somewhere or the price of the existing supply will need to increase to clear the market. It’s simple economics, and quite beneficial if you’re in the business of mining uranium.
That’s a good way to execute our investment thesis too, from the supply side.
How to play it
This is a long-term investment. If you’re looking for a short-term trade, check out one of our Draco Trade School newsletters. Uranium is for investors who are looking out a decade or two and want to add some interesting, alternative investments to their portfolio. But whatever you do, don’t fall victim to The Wormhole Fallacy! A lot can happen between now and then. You can’t just put on the trade and hop through the wormhole with profits waiting for you on the other side. You’ll have to take the long way around the space-time continuum which means you need to protect yourself from black holes and other dangers that lurk along the way.
We outlined a few strategies to deal with that back in this newsletter, so give it another read and make sure you understand how to avoid making crucial mistakes with a long-term investment like this.
Anyway, the easiest and most direct way to do it is through the stock of a company that mines it.
Cameco (Ticker: CCJ) is the first to look at. They’re the biggest. They’re a Canadian company which scores them points right off the bat. Canada has a better base currency and a government much less prone to monkeying around with the private sector. The regulation up there is not as onerous and inefficient as it is in this country, nor does it carry the same degree of political correctness, which matters with something like nuclear energy.
China has a contract with Cameco to buy a bunch of uranium over the next 10 years. There really aren’t that many companies in the world as engaged in mining Uranium, so barring any meltdowns in China (and I mean that literally) the demand will be there for Cameco’s product.
Cameco has an excellent balance sheet, too. They’ve got about $1.5 billion in cash, about $5 billion of Uranium reserves, and less than $1 billion of debt. They generate good free cash flow and their 34% profit margin is outstanding relative to their peers. If I’m going to make an investment in a company for the next decade or so, that’s the kind of corporate foundation I’d like them to have.
It trades over 20 times next year’s earnings. So the stock is a little pricey. But at least there’s some firmness in the foundation. There are far too many stocks out there that trade at high multiples based only the promise of an idea, with neither sales nor a balance sheet to back that up.
Generally speaking, I’m a fan of the perspective that the ubiquitous Dennis Gartman is always promoting. He wants to own stuff that hurts if you drop it on your foot, stuff like gold, copper, steel and coal. He also likes the stock of companies that dig this stuff up out of the ground and sell it to countries that need it. Cameco is squarely in that category.
Paladin Energy is another to take a look at (PALAF.PK). They’re based in Australia and they have a couple of mines working in Africa as well. They’re a much smaller miner — only about $115 million of revenue last year — but they seem to be on the rise, developing new mines. They’re not a bad bet if you want a little more spice.
Olympic Dam Uranium Mine
BHP Billiton (BHP) owns the world’s largest Uranium deposit, Olympic Dam in South Australia. But Uranium is a relatively small portion of all the stuff BHP Billiton mines. If you want a bigger, broader, more diversified mining company then check ‘em out. Their stock is somewhat expensive as well, trading a little over 20 times next year’s earnings on the back of a simply phenomenal decade. The next 10 years aren’t going to resemble their last, but relative to the rest of the market, you can do a whole lot worse than a company like BHP. They produce all the stuff that the developing world needs and they’re a direct play on resource-driven global growth. Even we market bears need a little bit of that in our portfolio.
I also just noticed a nice interview over at Seeking Alpha that covers a bunch of other different uranium-related companies. Check it out. Most of the names are small, but the article is a great supplement to this one.
From the demand side
You can also buy the stock of a power company that operates the plants. Exelon (EXC) is probably the best and certainly the biggest of breed. Over 90% of their power plants are nuclear and they operate the largest fleet in the nation and third largest in the world. It’s a pure play on the energy generation side, a way to take advantage of rising U.S. demand for nuclear power should that someday happen.
These guys get me a little more excited, if only because they’re a little more boring. I told you I was an odd bird. Exelon trades at only 10 times next year’s earnings, but hey, they’re a utility. Growing revenues isn’t exactly their gig, but that could happen if the U.S. gets more serious about nuclear plants. They pay a 5% dividend which is very cool. And they only have about $11 billion of long term debt against $25 billion worth of power plants and another $25 billion of cash, receivables, and other assets. Their operating margins are also fantastic, underscoring the efficiency of nuclear power in general and their plants in particular.
It’s interesting to see that trait on both sides of the uranium coin. Remember what we all learned in our college Econ classes? Firms with higher margins have better pricing power. That’s really important in the world of commodities — it’s profitable for shareholders when demand is strong, and should demand weaken there’s already a built-in cushion to absorb some of the slack.
Electricite de France (ECIFY) operates the biggest fleet of reactors in the world and they’ve been doing it for a long time. Despite their $75 billion market cap, their stock only trades on the Pink Sheets in the U.S. If your broker offers global trading and the ability to buy stuff on the French exchange (Euronext) you might be better off doing it that way. Be aware of the currency risk, too. Your stock will be denominated in Euros!
If you’d rather not deal with that hassle, another option is the Market Vectors Nuclear Energy ETF (ticker: NLR). Electricite de France is the single biggest position in that fund and Exelon is number two. Plus, you get exposure to a basket of other energy companies and uranium miners. This fund was launched almost exactly at the peak of the Uranium bubble, which probably shouldn’t come as a surprise. It was a sign of the times. The ETF hasn’t performed very well since then, which also is not a surprise since Uranium prices have collapsed. But now that prices have stabilized there is potential on the path from here forward.
PKN and NUCL are other exchanged traded funds you can buy to get a basket of nuclear names, but these funds are quite a bit smaller than NLR.
As with any stock, these companies will fluctuate with the market. My guess, though, is that these are much better bets to outperform the market over the next decade than a lot of other companies out there.
Inside the reactor
A final caveat
Ultimately, I’m of the belief that the best way to play alternative energy is through traditional energy companies. All these wind, solar, and nuclear companies may be great investments some day, but there doesn’t exist a world in which alternative energy does well and traditional energy does not do well. That’s a tricky concept, so I’ll repeat it a different way: a wind energy company is only a good investment if the price of coal or crude oil gets very high. Should that happen, then a coal miner or traditional oil & gas company has also been a very good investment. I think that traditional energy is a lower risk way to play alternative energy.
But when it comes to alternative energy, Uranium is clearly the way to go. The margins are much better than wind or solar, and it’s a much more practical way to generate electricity (on a cost-per-megawatt basis). I know Greenpeace still hates nuclear, but surely they have to understand that wind and solar can’t come anywhere close to satisfying the world’s energy needs, and certainly not at the price it would cost to do so. Nuclear energy is an interesting middle ground, a blend of practical efficiency and less environmental impact than coal or gas.
Odds are this kind of thing will probably be a pretty boring investment. There are a few risks — both general economic risks and uranium-specific risks — to consider, and make sure you consider them and size the trade appropriately. In aggregate, it boils down to an investment with:
- limited downside
- quantifiable and stable upside
- the chance for substantial appreciation if the cards fall a certain way
Most of the stocks in this sector are trading at relatively low levels, having been forsaken by investors for flashier opportunities. I don’t think that’s such a bad thing, though. I like out-of-favor investments where you buy a little bit and stash it away. I think the odds are high that the U.S. gets really excited about nuclear energy and uranium again at some point in the coming decade. I haven’t a clue when that could happen. But when it does these companies will get exciting again and the market will reward them with higher multiples.
We’re still in the first inning of a brand new game for nuclear energy.
Disclosure: No Positions
We’ve got a lot to cover today. It’s been a bumpy couple of weeks.
We’ll get right to it.
Market Recap
We had another mini-crash last Friday. The Dow fell about 260 points and the S&P lost nearly 3% on the day. We saw a similarly disturbing day yesterday. Things seemed to be going fine and then Bernanke started talking about banks that still had bad assets on their books and the Dow immediately fell 130 points. As I run through this for a final edit this morning, I see the futures are set to immediately reverse that loss. What really changed in the last 18 hours?
At this point, I’m not sure how many other ways I can say it. This market has been doing things like this on a disturbingly regular basis. I remember when 3% days were a really big deal but now they seem to happen every couple of weeks. ”Aww WTF,” we all say. ”Here we go again!”
I wish I knew exactly why this was happening, why general volatility is as high as any of us around here can remember. But it is. If you look at the market and think that there are attractive returns in buying it, you really need to ask yourself whether it’s worth the risk. As we discussed last week, be careful rationalizing a long-term buy with The Wormhole Fallacy. There are a lot of volatility-filled black holes lurking out there. Protect yourself against them.
I mentioned earlier that after the “flash crash” on May 6th we moved our entire proprietary trading fund to market neutral strategies. We took off every single directional trade. Initially I had some reservations. I mean, there are legitimate opportunities in certain directional strategies and I wasn’t sure if avoiding them altogether was a decision that would make us money. But now I’m absolutely confident that that was the right call. The market has declined about -8% since it’s recovery bounce after the flash crash and it’s currently in the middle of a -17% drawdown. The market neutral strategy we use has actually made a little bit of money since the middle of May. It’s nothing flashy but capital preservation is more important in these kinds of markets.
Every day like last Friday that goes by I get more convinced that now is not the time to play the market in any kind of directional manner. At least not over the next year or so. Any short- or medium-term investor needs to have some kind of hedges or insurance in place. This market is simply too dangerous for the average investor and laden with too many booby traps. Obviously, if you have a 10-year time horizon and can stomach crazy volatility you’re welcome and even encouraged to fish around. A couple of weeks ago we talked about managed timber in our series of alternative investments for the everyday investor. But if you have a 10-year time horizon, what difference does it really make if you buy today or next quarter? Why not chill out until early 2011 and see if these recession fears are warranted?
Something better may even come along. Patience is a really under-appreciated virtue in the world of finance.
It sounds like the Fed is finally on board with what we’ve been talking about forever. In their latest minutes they warned that they now believe it could be 5-6 years before the economy finally recovers. This means we’ll have cycles of slow and negative growth for some time to come, and it’ll be a long while before some of this slack finally leaves the labor market. These are the new realities that investors must come to terms with.
I understand that you guys out there are all starved for yield. I know how it goes. I want to make 10%/year too. But it’s just too difficult in the world of traditional investments right now and the risks totally outweigh the rewards. You have to really know what you’re doing. Yields on the less-risky stuff like government bonds or high quality corporate debt are very low. Too low to live off of. Those of you who have been reading since day 1 know that our solution to that problem is learn to live off of less. I think that’s a far better strategy than reaching out on the risk spectrum and getting burned in the process.
Then you might have to learn to live off nothing.
Melt Up, Melt Down… or Muddle Through?
The title for today’s newsletter was shamelessly stolen from a conversation I had with longtime friend, Joe Bradley. Joe has run Investor’s Hotline for 34 years and he’s interviewed some of the best minds in the financial industry. He’s talked with Jim Rogers, John Templeton, Peter Lynch, and even Ronald Reagan. We’ve been around for a little while too and we’ve been lucky enough to meet all sorts of interesting people in this industry. I always enjoy speaking with guys like Joe and swapping perspectives on the markets.
In any case, Joe asked me which one of those outcomes I thought was most likely to occur.
Would it be a gigantic melt up? Would hyperinflation produce the mother of all bubbles in risk assets?
Would everything melt down? Would we get a 2008-style deflationary panic where everybody sells anything that has value.
Or will we just muddle through? Will the economy take a slow, bumbling path, the kind that guys like John Mauldin and the folks at Pimco have talked about with their “New Normal” forecasts?
I said to Joe, “Why can’t we get all three?”
I’ll explain:
About the risk of inflation, let me be clear. Broad-based inflation is nowhere on the horizon. Near the end of last year when the US. Dollar was falling apart everybody started to get a little bit nervous about the prospects for inflation, we weren’t sure what all the fuss was about. Last fall I did a three-part mega-newsletter on The Inflation Chupacabra, a primer on how inflation works and a list of reasons why significant inflation would not materialize. Then, in our Predictions for 2010 we said, “everybody calm down. The Dollar is going to be just fine and we’re not going to see any inflation in 2010.” So you know where we stand on the issue.
“B-but…”
I know. I can hear you.
You’re all saying, “Mr. Draconian don’t you own a big pile of TIPS?”
You got me. Busted! I do own a big pile of TIPS (Treasury Inflation Protected Securities). TIPS are my hedge against the great melt up. I like TIPS because they’re a risk-free investment. I’m guaranteed to get my money back. They don’t give me much yield but they pay more than cash and I also get free bonus. Everybody likes free bonuses, right? Well, if inflation spirals out of control the value of my TIPS will be automatically marked higher in accordance with the Consumer Price Index. I’m not betting that’ll happen, but if it does my investment will be OK.
So: better yields than cash, zero downside, and bonus upside if inflation some day goes bananas. To me that’s a no-brainer. But I’m relatively young and I have a tremendously long-term view about things. I also don’t have to rely on my investments to generate cash flow to support my lifestyle. This is a crucial condition. Obviously, if you’re retired you’ll look at TIPS and say, “But I need more yield!!!” Yeah, welcome to the club. Everybody wants more yield.
In any case, I think we could get several melt ups in various pockets around the globe. Gold could be one. Jeremy Grantham thinks that emerging markets could be another. China’s probably got another melt up or two in its future, as does Brazil. We’ll probably see melt ups in domestic equities here and there as well. Some people like Jim Rogers say that government bonds are melting up; yields have been dropping for basically 30 straight years. It’s a hard to argue with the point that the bond space is a little surreal right now.
As for melt downs, I’ve written repeatedly that I don’t think we’ll see anything close to a repeat of 2008. That was a very unique confluence of events and I highly doubt the stars will align in that same constellation for a long time, perhaps for several generations. That being said, I think we’ll see plenty of mini-meltdowns here and there in the next decade. They won’t be as bad or as broad based as 2008 but we’re going to get more of them. Domestic stocks are obviously a prime candidate for melting down on pretty much any given day. We’re going to see sharper, faster drawdowns in the stock market in the coming decade than we all got used to during the long boom.
Banks stocks, specifically, will be prone to mini-meltdowns. The U.S. has stolen the Japanese playbook on how to manage a banking system, unleashing an army of undead Zombie Banks. Here is a chart of three of Japan’s largest banks, Nomura (blue), Daiwa Securities (brown), and Mizuho Bank (black):
That should serve as a road map for what to expect out of Bank of America, Citigroup, and friends. Like the Japanese banks, they’ll probably go up and down and ultimately nowhere for 20 years.
Lower-tier sovereign debt is another prime candidate for a melt down. Greece hasn’t defaulted on their debt yet, but they will at some point in this decade. It won’t be called “default”, of course. It will be called “restructuring” or it will happen after they get booted from the EU and start printing money like a Latin dictatorship. I read the Reinhart & Rogoff book. I know how that story ends.
It most definitely does not end with Greek bondholders having fun at the buffet in Santorini Bay.
When you add it all up, it’ll look like muddle through. It certainly won’t feel like muddle through. It’ll feel like a roller coaster at Six Flags, violently thrashing up and down and left and right and ending up right where you started. That’s fun if you’re at the park, but it’s not fun if it’s your investment portfolio. Investors are going to suffer a whole lot of heartburn in the coming decade and that’s sort of our informal purpose here at The Draconian, to help investors large and small reduce the heartburn on the horizon.
When you look at the numbers — a stock market that goes way up and way down, bubbles here and deflationary meltdowns there, and an economy that grows one year at 5% and the next year at 0.5% — it will to average out to “muddle through.” It makes for tough trading and even tougher investing. But I think that some of the things we’ve talked about in the last year will really help.
For all the new subscribers who have come aboard in the last few weeks, our story thus far can be boiled down into three main points:
- Diversification: get your investment portfolio super-diversified and carefully weigh the risk/reward of every opportunity.
- Prudence: save more, clean up your balance sheet, and get rid of all the debt you can.
- Diligence: work hard at your job; it’s probably your greatest asset.
Sounds really practical, right? Common sense, yeah? Three completely obvious principles to live by?
WHY IS IT THAT NEARLY EVERYBODY DOES EXACTLY THE OPPOSITE???
Whoah, easy there Mr. Caps Lock.
SORRY ABOUT THAT.
Just follow those three principles and someday the two of us will share a bottle of ouzo in Santorini Bay.
Recapping our bond strategy
Do you remember The Draconian’s Totally Thinkless Super-Low Risk Bond Strategy? We talked about this earlier in the year as an alternative for investors that needed a little bit of yield but didn’t want to take the risk in stocks or dodgy corporate debt.
I’ll recap:
- Buy VFSTX or SHY or something similar (short-term AAA rated or government debt).
- Go enjoy your life. Play some golf. Check back at the end of the year or next summer.
- If 10-year Treasuries are approaching 5%, pick ‘em up and lock that down. If they aren’t, I guarantee there will be opportunities abound that you will be glad you saved the cash for.
I got the call dead wrong (on rising rates) but that strategy has been a home run so far. When making trades, that’s actually a really important concept that we haven’t really discussed before. Investors should always consider what will happen to their investment if their call is wrong; the best investments are ones where you have contingencies in place that help you come out OK if your predictions don’t materialize. Or situations in which you are in better position to take advantages of the new opportunities now presented by your botched call.
SHY is up over 1% in the last three months. That’s almost 5% on an annualized basis. For a low-volatility fund full of risk-free stuff that yields 1-2%, that’s a gigantic move. A gigantically awesome move!
But seriously, this goes to show why that was such a great strategy and the key to why is in that third point up above.
With a yield currently at 2.94%, it doesn’t look like 10-year Treasuries are going to get to 5% any time soon. And guess what? In this new environment there are a whole bunch of other opportunities that you’re probably glad you saved your money for. If you wanted to buy some stocks, you got a chance to do so at a 20% discount. With these lower interest rates you can now get an even better deal on a house and mortgage. And with these deflationary fears all sorts of things are now on sale.
Anyway, there’s still plenty of time for that trade to play out. Who knows, maybe we will see yields on the 10-year up at 5%. If so, that’s a win. In the land of the muddle through 5% is a great rate of return, especially when it’s risk free. Nail that down if we get there. Don’t be greedy.
And if we don’t see rates at 5%, that’s also a win. In that event you will have made good money on something like SHY, protected your capital for even better opportunities, and saved yourself a whole bunch of heartburn in the meantime.
The Goldman settlement & Finreg
I’m surprised at how quickly this news came and went, especially considering all the fuss surrounding the original indictment. The SEC’s claim that Goldman fraudulently misled its investors eviscerated Goldman’s stock price and dragged many of the other investment banks’ stock down with it. This case is hugely important. I notice that the same Goldman advocates that were spinning the initial charges as baseless are now claiming this $550 million settlement as “no big deal.”
People. This is the biggest fine in the history of Wall Street. On top of that, Goldman admitted making the mistake. They knowingly sold garbage to their clients and marketed it otherwise. Perhaps our collective lack of concern is indicative of the level of cynicism the world has developed about Wall Street.
I’m still of the belief that this financial reform bill is weak sauce and an opportunity missed. Sure, it’s a step in the right direction. But there was a chance to really change things for the better (stronger regulation) and I think the Democrats blew it. They will almost certainly pay for this sin and so many others come November. Not that the currently-impotent Republican party had anything positive to contribute; most of those guys are living in some fantasy land right now, trapped in an echo chamber of right wing rhetoric and talking points. I understand strategy though, and the sad thing is that that’s the right way to play it while the party-in-power shoots themselves in the foot. Perhaps that’s indicative of my cynicism about Washington D.C.
But we all know why it’s so messed up. It’s the lobbyists, of course. The banking industry had a big hand in designing this finreg legislation and it’s no surprise that it wound up full of holes, ready for them to exploit and work around. Their business won’t be shaken up nearly as dramatically as it could have been, or should have been given the massive amount of mayhem they wreaked around the globe.
I love this recent Time cover. It’s symbolic of the growing frustration that so many of us feel with those we’ve sent to Washington D.C. to make decisions on our behalf.
The good news, and the best thing to come out of this Goldman case is seeing what the SEC has in Robert Khuzami, the recently appointed Director of Enforcement. This guy is, in fact, a badass. He has an exemplary, high-profile track record as a federal prosecutor in New York and he seems to be carrying that excellence over to the SEC, an organization with everything but excellence in its history. Khuzami has prosecuted all sorts of white collar crime, accounting fraud, and insider trading cases. He’s also done battle against the mafia. Appointing him might have been the best decision the SEC has made in a long time. I doubt he’ll kowtow to Wall Street CEOs the way his predecessors have.
If we really want to change things on Wall Street — and that is what the rest of the world wants, right? — then we’re going to need more fearless bastards like Khuzami in places of power.
Next stop: let’s get Elizabeth Warren in charge of this new Financial Oversight Committee. She’s not afraid of these bank CEOs either. Neither Democrats nor Republicans seem really thrilled about the idea of her appointment which means she’s probably the ideal person for the job.
And after that, we need 535 new congressmen and senators with backbones sturdy enough to challenge this legion of lobbyists, to stand up and make the hard choices on our behalf.
The fact that we currently don’t have a government like that could be one of the biggest reasons why this market always seems on edge.
Captain’s log. Stardate 17943; 18:50 UST.
The bridge is quiet today. The crew, hushed with anxiety. For days we have been drifting closer to the jump coordinates, all the while a sense of dread lurking just beyond the reach of our scanners. The vectors are clear and the calculations have been triple-checked; this is the path. But nobody at Command informed us that it would be like this, so ambiguous and fraught with doubt.
Command, ha! What do they know in their ivory space stations? They’ve never travelled beyond The Galactic Veil! How could they possibly understand the fear and uncertainty that eats away at us daily. They claim with their elegant mathematics that the wormhole will jump us immediately to Sector Whiskey/Zulu 6.6, but where would their faith be out here? Would they charge forth with such confidence? Would their chalkboard theories see them through to the other side?
“Captain…”
So many questions. The hour of action is drawing near. I – we, shall boldly go…
“Captain!”
Sigh. “What is it, Ensign?”
“Are we buying the stock market here or not?”
As you can tell, I read a lot of science fiction. You can probably also tell that I have zero future as a science fiction writer.
In the world of sci-fi, wormholes are a pretty big deal. Outer space is vast. So vast, in fact, that even when travelling at the speed of light, the cosmological speed limit, it can take a long, long time to journey from one alien galaxy to another. We’re talking hundreds of thousands of years. Enter the concept of wormholes or as they’re known in less-geeky circles “Einstein-Rosen Bridges”. Maybe that’s more geeky. I don’t know. I’m probably too big a geek in both circles to judge.
When Einstein put the finishing touches on his theory of general relativity in 1915, he had literally written the book on gravity. Isaac Newton’s centuries-old work on gravity was doing a good job describing most of the physical phenomena that we witness here on earth, but the Newtonian framework didn’t translate so well to the world of astrophysics.
Einstein came along at the right time, as we were becoming more and more curious about the world beyond the stars. General relativity is an immensely important part of modern physics, and helps us explain all sorts of things from black holes to the Big Bang, and other crazy stuff like the relation of space with time. Combining space and time into one continuum (3 dimensions + 1 time dimension) solved all sorts of problems in physics, and physicists were so excited by this they gave it an awesome and exciting name: space-time!
The neat thing about space-time in the framework of Einstein’s general relativity is that it’s curved by the presence of matter. Curved space-time has all sorts of interesting and technical applications, but for our purposes today, this curvature can imply shortcuts from one point on the space-time fabric to the other should certain conditions be met. If you thought economists used some bizarre, complicated math, you have no idea how bizarre and complicated some of the math in the world of physics can be. Physicist math is way beyond me, so let me explain it visually.
Think of space-time as a big sheet of graph paper or maybe a blanket that you can pull tight or wrap around other objects. If you fold it in half all the points on one half are now touching or very close to corresponding points on the other half.
Here’s a picture:
As captain of the USS Draconian, I could fly my starship from point A all the way around the space-time fabric to point B which will probably take a long time. Many lifetimes or more, even if I could travel at the speed of light. Alternatively, I could fly straight through the wormhole and immediately pop out on the other side of the universe. Pretty cool.
Nobody knows whether or not wormholes actually exist. They’re certainly not a joke, as major physicists from Einstein to Wheeler to Hawking have put forth serious work about how they might work and even how they might be traversed.
Wormholes were the greatest thing to hit science fiction since Swift opened up a world of possibility and imagination with Gulliver’s Travels and Mary Shelley’s Frankenstein definitively carved out the fledgling genre. There is no name more important in science fiction than Isaac Asimov, and he incorporated the idea of wormholes into his Foundation series over 60 years ago. Many of his stories feature characters that traverse great distances of space and time. Today the TV show Battlestar Galactica relies on the same act of “jumping” instantly from one point in the universe to another. The science fiction of tomorrow will continue to lean on this concept of instant, interstellar travel. Wormholes are a tidy fix to a tricky problem.
This has been fun, but this is an investment newsletter after all. What relevance could this possibly have? Well, I’ll tell you:
Investing doesn’t work like a wormhole
When you look at a market and study data both past and present, you might develop a thesis about where that market is ultimately heading. If you’re a trader or an investor, you might even actually establish a position or two around that thesis, perhaps buying stocks if you think they are cheap and will get more expensive or selling real estate because you think it’s too expensive and will get cheaper.
Investors, stationed in their starships at Point A, make the buy or sell focusing solely on where they’ll be at Point B. Since investing doesn’t work like a wormhole, they can’t just make the trade and pop out on the other side. Investors have to travel the long way around. And the problem with taking the long way around is that they fail to consider the things that can happen while they’re on that path.
It’s one of the biggest mistakes that novice traders make. Why do they do it?
Thinking of trading as a wormhole makes life vastly easier for traders – and especially investors, a broad galaxy with a diverse citizenship, all of whom are firmly fixated on the future and most of whom lack sufficient sophistication to understand where the black holes lie. It’s not their fault, as it has everything to do with how they’re wired. Humans can easily understand where they are at present, and where they expect to be in the future. They have a much harder time mapping out what all the paths between actually look like.
There can be a lot of volatility lurking between the time one puts on a trade and the time one plans to take it off. There are an infinite number of paths that the trade can take. Many of these paths are fraught with dangerous black holes. The bottom line is that trying to anticipate all these factors is tricky work. The potential frontiers a trade can take divide and multiply, complexity spiraling out of control.
Buy & Hold is a wormhole
This is also why buy and hold is a bad strategy. Does it work? Yeah, it does. There’s too much evidence to the contrary. About the only thing we can say conclusively about the stock market is that over the long, long run, it has a tendency to go up. So buying it and holding it sounds like a strategy that makes sense.
But you can’t just buy stocks, hop through a wormhole, and immediately emerge 50 years later with all of them being more valuable. All sorts of things can happen over that 50 years of space-time.
What happens if you come across a deadly asteroid field or a black hole? What if you have to abandon ship? What if the market crashes and you are forced to pull the plug, or what if you get a margin call on some of your real estate holdings and need to raise some cash? What sort of other factors aren’t you considering along the path between Points A and B?
For an actual wormhole example, imagine you bought stocks in 2001 thinking you were getting a great deal by buying on a big dip. Did you capitulate by 2003 after losing another 30%? Did you buy again during the enthusiasm of 2005 and 2006? Or did you really load up in 2007, afraid you’d missed the party only to be blindsided by the crash of 2008? How committed were you, really, to the “hold” portion of buy-and-hold? You made that buy back in 2001 with the expectation that you could pop through the wormhole and have it be 2025 with nice profits in your account. But a lot happened along the way.
Many trades and investments seem like no-brainers when you look at them as though they were wormholes. But don’t forget John Maynard Keynes’ famous quip “the market can stay irrational longer than you can stay solvent”. Make sure your investment starship is built to withstand the dangers of the long way around, a path fraught with irrationality.
The Black Hole of AIG
Wormhole thinking was what got AIG into trouble. AIG basically sold insurance (structured as derivatives, the infamous CDS’s) on all sorts of different types of debt obligations. They were fixated solely on the other side of the wormhole. They assumed that all this insurance they were writing would never be called on, and so they wrote as much of it as they could – way, way more insurance than they could ever possibly pay.
All of this seemed like a great idea at the time, because the more contracts they wrote the more revenue they collected. Their rationale was that over the long run they would never have to pay out on too many of these insurance policies and if they did have to, it would probably mean the end of their business anyway and would probably also mean that the financial apocalypse would be here. No big deal. Everybody else would be screwed too.
In 2008 you saw firsthand the danger of large firms employing this kind of logic.
The credit markets did fall apart. AIG did have to start marking the value of some of these derivatives to market, realizing mountains of losses in the process. It did put them out of business.
But instead of allowing them to die a violent, supernova death, we, the taxpayer, then bailed them out to the tune of over $180 billion. The rationale at the time was that we were doing it to prevent a chain reaction from spreading and sucking neighbor firms on Wall Street into the AIG black hole.
The AIG bailout shouldn’t be thought of as a strict bailout of AIG, but rather a bailout of its counterparties that were made whole at the taxpayer’s expense: Goldman Sachs, Societe Generale, Deutsche Bank, Bank of America, Barclay’s, Merrill Lynch, UBS, and sordid others including even a few states that will remain nameless *ahemCaliforniaAHEM*. AIG owed these firms billions and billions of dollars, and not getting paid back represented a serious threat to the already-shaky solvency of those firms.
Only time will tell if a bailout was the right call. In the meantime, AIG will go down in history as one of the greatest Wormhole disasters of all time.
The Wormhole Solution
How does one avoid the pitfalls of wormhole trading?
It’s a lot harder to do than it sounds, but try to live in the present with your investing. Continually reassess the validity of each investment every day, and do it rationally rather than emotionally. It’s a lot of work, but unless you use a perpetual continuum as your investment horizon, you won’t realize that the bad decisions you made were bad ones until it’s too late.
You’ll notice this has been a theme present in many of our newsletters. Investing is hard work. It’s no different than any other endeavor where the lazy person is punished for his sloth and the diligent one rewarded for his preparation. Sorry folks. Go watch Jim Cramer if you want cheap investing faith, but don’t come crying back here if you’re disappointed by the results. Investing is a harsh world, and The Draconian practices tough love. We are here to help you develop sane, prudent perspectives, however unpopular that may seem in certain environments. We think it will make you a stronger investor.
Here are some other tips for avoiding wormholes:
- Map out some possible paths the investment can take before putting it on. Map it out over different time horizons, not just to where you think the investment is ultimately going. In a three-year trade, think of where things could be one year from now and how you might respond to that. Attempt to forecast ways in which the trade could go wrong and ensure you have appropriate counterstrategies queued up if necessary.
- Recall the old chess adage and ask yourself two questions: “With this move, what is the opportunity? And what is threatened?“ The strategic goal might always be to move your pieces towards a checkmate, but make sure you don’t allow yourself to be mated along the way.
- Use diversification. If the risk of one investment is contained in a relatively small portion of your overall portfolio, you’ll be more likely to see that trade through to where it’s ultimately heading. When you keep black holes from swallowing your entire ship, it’s easier to get where you’re going in one piece. Low correlation should always be your guide when diversifying your portfolio.
Most investors fixate only on the opportunity and don’t realistically analyze the potential risk. They look at the stock market in a year like 2009 and are blinded by an 80% bounce – nevermind the fact that there is plenty of historical precedent for bounces like that in the middle of nasty bear markets that are followed by subsequent crashes. They rationalize a buy with the Wormhole Fallacy, reminding themselves that even if they lose money after making the investment, over the long run, it will probably go up. They ignore the risk of losing half their money like they did the year before and they fail again to consider how long it might take to recover those losses. Then they see something like 2010 outside their spaceship window and they panic. A flood of emotion and memory comes back to them at once.
Few investors give credit to their shifting needs and the emotions that accompany periods of severe loss and volatility. Trying to anticipate the risks along the way and making sure you have contingency plans in place will help you navigate safely from point A to B.
Your final destination may be a great place to be, but you can’t travel there instantly. Ask yourself: is it worth what lurks along the way? Is your investment spaceship equipped to handle it?
Beyond the Galactic Veil
Captain’s log. Stardate 17945; 01:02 UST.
This marks the 25th consecutive hour in our attempts to reestablish contact with Command. There has been no reply. Even still, would blame prove worthwhile at this point? Rightness and wrongness are now mere trivialities. Irrelevant concepts.
Our laser turrets have malfunctioned. The scanners crackle and hiss, worthless. Our fuel leaks slowly into the cold. We are blind and without defense, drifting towards…what? There is nothing but black silence. A yawning, indifferent void.
The crew looks to me, unblinking. I see it reflected in their eyes. Hope has abandoned us.
Out here, where we were going matters not.
[end communication]
Today we’re going to revisit some of things we discussed back in this newsletter around the beginning of the year. In that piece we outlined three major macroeconomic factors that would play a large role in the direction the markets chose to take in 2010. It was sort of a weather forecast for 2010.
Since we’re at the halfway point of the year, we’ll check in and see where we’re at. Keep in mind that this is all rather long-term stuff and these weather patterns are still evolving.
1. Cessation of Fed Purchase Program
Well, the Fed did finally stop purchasing those mortgage backed securities. The market rallied fiercely as the Fed was gobbling these things up last year and as soon as they stopped buying them on March 31st, the market stalled out.
Remember that during 2009, this purchase program established a virtuous cycle of epic proportions. The Fed gave banks and institutions and Fannie Mae real cash money for some of the questionable mortgage backed securities on their books, the mortgage backed securities that nobody else in the marketplace seemed to want. With this new cash money, these banks bought better assets. They bought bonds and stocks and all sorts of good stuff. It was the kindling for the rally of 2009. It was over a trillion dollars of buying demand.
Back then we warned that when the Fed stopped buying these things — or worse, started to sell them — it could have negative effects on the markets.
Well, this chart of the stock market should bring that point home:
You might be wondering what happened to all those stinky MBSes that nobody else wanted and the Fed gladly purchased. Well, they’re still on the Fed’s books:
The mortgage backed securities are the brown chunk. It’s pretty big, the brown chunk. About $1.2 trillion.
What happens now?
Apparently, the strategy is to just let these bonds run off. In all likelihood that will mean losses for the taxpayer — seriously, who thinks those MBS are worth what the Fed paid for them? It’s not like other investors were beating down the banks’ doors to buy those things. The Fed was the buyer of last resort.
The good news is that these losses will take place over the next 5, 10, 15 years as opposed to all at once. That’s likely what would happen if the Fed dumped these things back in the open market. But that’s not the only consequence to offloading those right away. Even if the Fed were to try and sell off pieces of that trillion dollar position, it would have the effect of increasing rates in the marketplace. That, of course, runs totally counter to everything that central banks around the world are trying to do.
This is yet another example of what has become our modern strategy for solving problems. We trade intense, short-term pain for prolonged suffering and sluggishness. We’re peeling the Band-Aid off slowly instead of ripping it off at once.
Psychologically speaking, that’s actually not such a bad strategy. We’re maximizing our short-term happiness (or minimizing our short-term unhappiness) and this is why most people are so quick to embrace this as a solution.
Independently of individual happiness, there are better ways to maximize the raw growth potential of an economy over the long-term. And we’re not doing any of that. We’re transferring wealth from the future to mitigate the pain of today. What this means is that, quite simply, the United States is done growing at the rate that most of us have grown accustomed to. You may have heard this described elsewhere, by people far more intelligent than I, as “The New Normal.”
I know you guys didn’t need another reason for why Buy-And-Hold is a dead strategy, but there you go. We’ve been banging this drum since day one. Successful investing through the next couple of decades will require different strategies and tactics than those that were employed in the last couple of decades.
2. Obama makes some difficult policy decisions
Remember this heavyweight title bout:
!!! Jobs vs. Deficits !!!
You don’t need me to tell you that we’ve got major problems in both areas. The reason why this is such an interesting conundrum right now is that it’s impossible to help both at the same time. Trying to force job creation through governmental stimulus means deficit spending. Addressing the deficits through government spending cuts will prolong any significant improvement in the unemployment rate.
Based on the rhetoric I’ve heard from Obama & his administration this year, it sounds like he’s going to focus on jobs, not the deficits. He’s been talking a lot about the importance of creating jobs and ways to stimulate that into happening. And he’s said relatively little about controlling deficit spending. That is, after all, the politically popular stance to take. People vote for politicians who promise them more jobs. By and large, they don’t vote for politicians who slash benefits and entitlements through spending cuts.
While there has been a lot of talk about jobs, little has actually been done to create them. The Census aside, there has been very little effort to create public jobs. Everywhere I turn I see teachers getting fired and police & fire departments getting scaled back. Not much seems to be happening at the federal level either as the total number of government jobs has also been decreasing. I see very little assistance in helping the private sector create jobs.
On the other hand, there might seem to be some action towards reducing the deficits. I almost fell out of my chair when I read about the most recent G20 summit. Might some of this neo-European austerity trickle over to our shores? Say what you will, but the government has really slowed down its spending and politicians are much more dismissive about additional stimulus measures than they were a year ago. There’s also no sign that they’ll reverse any of the tax increases scheduled to hit in 2011. All that stuff helps the deficits, or at the very least, doesn’t make them worse. Paul Krugman, the highest-profile and noisiest champion of the Keynesian cause, has thrown his arms up in defeat and thinks we may be heading into a Third Depression.
Could this be a case of the government saying one thing and doing another?
I know, you’re totally shocked, right?
As the year unfolds, I think our friends in Washington D.C. will continue to say one thing and do another. This will have interesting economic consequences. Actually, what I mean to say is that this will have negative economic consequences.
There are no easy choices for the U.S. On the one hand is the risk of another Depression. On the other hand is Japan, two decades (and counting) of “blah” and virtually no economic future to speak of.
I’m surprised that there isn’t more talk in the U.S. about Japan. I appreciate that Ben Bernanke is one of the foremost scholars in the world on the Great Depression and with a guy like him manning the printing presses, I feel pretty good that we won’t repeat the errors of the 1930′s. But where is the discussion of Japan? Where are the great scholars of turn-of-the-millennium Japan? Japan has had near-zero interest rates and major stimulus spending for twenty years now! Sure did them a lot of good, didn’t it?
3. Bernanke sets a course for interest rates
Man, did I get this one wrong.
In late 2009, I thought that after the market rally and legitimate economic improvement Bernanke would feel comfortable ratcheting rates back up to where they should be.
But then Europe happened. Bernanke changed course and amended some of the language he was using in his speeches early in the year. The tone of the recent Fed minutes have also expressed a great deal of concern about the economic recovery. It’s very clear that the Fed won’t be moving rates any time remotely soon. The short-term Fed funds rate will not get hiked until sometime in 2011. And that’s assuming the economy doesn’t double dip.
I may have been dead wrong on the timing, though I do think I’m still correct about this:
The low interest rate punch bowl is darn tasty to drink from, but the more one drinks, the nastier the hangover.
What are the consequences of holding interest rates at zero for a really long time?
It’s tough to say. A lot of it depends on the psychology on the nation involved. Independent of the net effects, there are always unintended consequences to zero-interest rate policy.
In the case of Japan, near-zero interest rates led to a trillion-dollar carry trade and played a big part of the 1997 Asian Financial Crisis. Everybody was borrowing Yen at zero percent and investing in higher-yielding currencies elsewhere in Asia. The reversal of that trade, when everyone got spooked and ran for the exits at once, wasn’t pretty. In the case of the U.S. and its recent experience with abnormally low rates, we inflated a gigantic bubble in home prices. Oops! The unwind of that wasn’t pretty either.
What unintended consequences will crazy-low rates bring this time?
I haven’t a clue. It will be something that few people expect and nobody intended. What scares me is that it might involve the bond market. The bond market is the biggest and most powerful beast the world has ever known. Some people out there claim that a bubble has been developing in the bond market, maybe the biggest bubble in history. Will another year of near-zero interest rates act as the pin?
The dot-com bubble was nasty and a lot of people lost a lot of money. The housing bubble was even nastier and a lot more people lost a lot more money. Not to get all apocalyptic on you, but a collapse in U.S. Treasuries would be… yikes… I can’t even wrap my mind around that catastrophe.
Honestly, I’d rather just take the blue pill.
The good news is that the odds of a collapse are very, very low. The Fed has established a policy of buying bonds when nobody else wants them and they’ll buy as much as it takes if they need to once again. Scroll back up to that chart of the Fed’s current holdings. I think they’re willing to expand the size of their balance sheet to $3 trillion or more to stave off any kind of trouble in the Treasury market.
And seriously, what other asset in the world are people going to buy? The yield on U.S. Treasuries certainly doesn’t excite me, but I have total faith and confidence that they will maintain their status as a risk-free investment.
I like cash and I like risk-free bonds. There are far worse things you can do with your money in deflationary bear markets.
Market Recap
We’ve had a nice bounce in the market this week. After 9 out of 10 straight down days it can get a little depressing, even for guys like us who have taken a completely market neutral approach to our in-house trading. We don’t really care whether the market goes up or goes down, but the world seems to be in a better mood when it’s going up. So it’s nice to see a relief rally. Environments where the market just goes down every single day make me think of late 2008.
There’s an awful lot of fear in the marketplace right now. We were a couple months early with our negative sentiment on the market, but now it seems like the consensus view has followed along. I always stop and question my methods and reasoning when my views match consensus. There seems to be an overwhelming amount of bearishness out there, so naturally, I’m wondering how one can play this over the short/medium-term on the bull side.
The consensus is always the easy path, and after over a decade in finance I’ve learned that there are no easy paths in this business. Sometimes the consensus is correct, but it always should be taken with at least a little bit of skepticism.
I think the upside in the stock market is capped, but there’s a possibility this rally could last a little while. I could see the market easily bouncing back to around the 1080 level at some point, which would bring it back in line with the current trend. A move through there could possibly set up another move to 1100 or 1120. If the market fails to get through any of those levels, the technicals and fundamentals are all pointing to somewhere down below. 890, maybe?
Allow me a to steal a line from the inimitable Dennis Gartman: if your horizon is longer than a couple of weeks, rallies should be sold into and dips should not be bought.
At the beginning of 2009, the consensus view in the trading community was that it would be a year for stock pickers. 2009 was supposed to be a year where those people who knew how to identify good companies and good valuations would excel. That was totally wrong. 2009 was a year where it didn’t matter what you bought. Everything went up. If you bought stocks in 2009, you made money. The irony is that relatively few people did that. At best, the average investor was still too scared to sell after the crash or too slow to react and started breathing easier when the market started going up again in March. The irony is that all these people still have gigantic losses in their portfolio from years prior. The market is a long way from its peak and won’t get back there for a long while.
This year, the consensus in the trading community is that investors should just be out of the markets altogether. We refer to it as “de-risking” in hedge fund land. I’m starting to think that the mindset that traders had last year is now the appropriate one for the second half of 2010. If you can identify good companies and good valuations, I think you can do all right in this kind of range-bound market. By employing some of the tactics from our Draco Trade School pieces and making use of attractive dividend yields and hedging strategies, I think it’s possible to get a little constructive in this environment.
How’s that for going against consensus?
We’ll try and keep it short this week. It’s the 4th of July and if you’re anything like me your mind has already drifted into the weekend, lost in daydreams of relaxing outside around the BBQ with a cool, tasty adult beverage in hand.
I’ve noticed a flurry of new subscribers come in on the e-mail list in the last couple of weeks. Welcome aboard! In case you haven’t read about who we are and what this site is about, all you really need to know is that each week we try and make you think or make you chuckle, and try and give you a few bits of actionable information. At best I’d say we’ve had “mixed” results at those objectives so far, but more people tune in each week so I guess we’re moving in the right direction.
Our little newsletter may not have the biggest circulation in the industry, but I think we might have one of the most diverse readerships. I’m proud of that. I know that this letter goes out to a lot of high income individuals who have boatloads of assets and huge investment portfolios. It also goes out to a lot of financial professionals, those that manage assets for others. I know many of these people personally through our real business, and I can attest that they are all very sophisticated investors.
I also know that this letter goes out to a lot of people that don’t make a lot of money and have modest or non-existent investment portfolios. Many of these folks aren’t even that interested in investing in the first place! But every month I get a handful of comments from different people telling me that even though they don’t know the first thing about finance they are still able to understand what’s going on. Honestly, that’s probably the best compliment I can imagine. That’s ten times more rewarding than hearing from people who applaud us for being right about this or chastise us for being wrong on that.
The fact that both groups of people and all those in between have stopped by is sort of mind-boggling to me. I guess we’re just lucky to know all kinds of different kinds of people. I’ve found that a broad perspective on life (and investing) is a wonderful (and profitable) thing.
Anyway, thanks again for reading.
I promise we’ll get to the meat of the markets in a minute, but first I want to talk a little bit about culture. Feel free to skip ahead if you can’t wait for the market recap.
Toxie the Toxic Asset
I cannot properly describe fascination with this story. I think it’ll bring a smile to your face too — or perhaps it’ll make you cry. Depends on how you feel about synthetic subprime collateralized debt obligations…
It’s a series of articles NPR has been running on their Planet Money blog. Two of the journalists over there spent $1,000 of their own money and bought a toxic asset just so they could watch it die. They’ve been writing about it along the way and so far they’ve received $449 of payments from the dodgy mortgages backing the bond. Doctors said that their toxic asset, affectionately dubbed “Toxie,” only has about two months to live and all the homeowners in their bond default. She is very sick and no payments have come through since April.
I was a young intellectual once too, so I’ve listened to my share of NPR. They perform a great service. My favorite thing about NPR is that it’s one of very few taxpayer-funded public programs that is overwhelmingly consumed by the wealthy and the educated. It’s sort of like a reverse welfare program. They’ve done a nice job with this.
It’s the human angle to this story that I find so wonderfully appealing. So many people have dissected this crisis in so many different ways. We’ve heard all about the CDS’s and the CDO’s and whatever it was Fannie & Freddie were doing. Most of it sounds rather sterile and removed. The details are important, sure, but there are many more dimensions to this issue. It’s nice to read a colorful take that puts this stuff into terms that everyone can understand.
This story really drives home the magnitude of how nasty these toxic assets were. A few years ago somebody actually paid $2.7 million for this bond which recently sold for $36,000. The $1,000 slice that Planet Money purchased used to be worth $75,000. It sounds like the real value will wind up closer to $400. Amazing. There is no hope for poor little Toxie and her brethren. Man, what were we all thinking back in 2005?
You’ll remember that a while back I wrote that we should look to popular culture for signposts displaying our progress through this crisis. Stories like Toxie’s are the sort of thing I’ve had my eye out for.
Signs, Signs
OK, so where are we in this whole cycle? Fewer people are talking about toxic assets now, with the EU debt crisis and the BP oil spill dominating the headlines. Are these things done wreaking havoc on the economy?
I’m honestly not sure. There are lots of Toxies still running around out there and a bunch of have taken up residence at the Fed via Fannie and Freddie. Meredith Whitney pointed out that plenty are still hanging out on the big banks’ books. Subprime has come and gone, but a tidal wave of Alt-A and Adjustable-ARM mortgages are about to start resetting this summer. Who knows what will happen to these loans.
Lately I’ve been asking myself a different question. Could this be a sign that it never really was about the things that did the damage, the stuff that everyone pointed their fingers at?
You know: the banks, the toxic assets, the financial WMDs, the bad balance sheets and the straight-up frauds, credit default swaps, AIG, the “previous administration,” Hank Paulson, House Democrats, the predatory lenders and dodgy mortgage brokers, the people who lied on their loans, golden parachutes and Goldman’s pay practices.
This crisis wasn’t about all that. Those were merely details and they could have varied dramatically, as could the period during which it transpired.
This crisis was about culture. It was about our greed and entitlement. It was about a lack of understanding. It was about all of us who wanted more and took shortcuts to get it.
Why do we do these things?
Whether it’s the banker who quickly packaged and sold a toxic asset to get a big bonus or the family who bought a McMansion with no money down and willfully ignored the consequences of a resetting interest rate, we all do it for a very human reason: the love, admiration, and respect of others.
It’s a noble goal. A very human goal.
We can design all the policies we want. We can re-regulate the banks. We can “protect consumers” with new legislation on credit finance. We can cap executive pay and get derivatives traded on an exchange. We can even promise that there will be no more bailouts. Ever!
None of that addresses the things that caused the crisis, the psychology of greed and all the crazy things we do to gain the love and respect of our peers. This is shared by every single one of us and it’s what binds Wall Street to Main Street. It’s probably one of the few things in the world that Lloyd Blankfein has in common with the guy collecting unemployment benefits. It’s the American Dream and much, much more. To make it in life, and for our peers to applaud us for it.
How do we fix that? How do we protect ourselves from that?
I suppose it starts with with nothing less dramatic than a sweeping re-assessment of modern Democracy. It involves intense study of how government and capitalistic markets integrate with and affect our collective psychology. It’s taking an entirely new look at 250 years of American history. I’m not gonna go there, though. That’s epic, manifesto type stuff. That’s for somebody else’s newsletter.
Perhaps the next best thing is for all of us to embark on a journey of self-discovery. We spend more time learning about our jobs and our hobbies than we do about our own selves; let’s change that. We need to understand and be aware of our innate deficiencies and recognize when they’re getting us into trouble. We need to be mindful of where love truly comes from and why it is this that truly drives us. We need to learn about human nature.
Once we’ve spent some time on this introspective journey, we should then branch out and seek greater understanding of our relationships with other people and with entities like our companies, communities, and government. If enough people do this it will change our culture for the better. There are real lessons to be learned here, the impact of which would far exceed this bill on financial reform. We can all move towards that libertarian utopia I’d fantasized about in my youth. Back when I listened to NPR.
Idealism vs. Reality
Look, I’m a realist to the core. I know that none of this going to happen. This is the quandary of the philosopher, I suppose. Those guys have been pondering the quirks of human nature for millenia and they’ll still be doing it a thousand years from now.
So at the very least, let’s all just understand and agree that this was every bit a crisis of culture as it was one of economics.
It’s easy to pass out blame for the economics of the crisis. We’re all doing that now. It’s the blame game phase. But accepting that culture was the real cause is going to be really hard. It means pointing the fingers at the rest of us, ourselves included.
In the meantime, we’ll all have to settle for new rules that save us from ourselves. New financial regulation that protects the banks from the duplicating the errors of their past even if it’s weaker than what those of us outside the banking industry wanted to see. For a little while, all of this will work.
But banks will find ways around this new regulation. They’ll find ways to pass costs on to consumers, ways to tilt their business towards ever-more-profitable lines, and ways to compensate their executives…fairly. That’s the nature of the financial industry. Sorry, Washington D.C., but they are smarter than you. They are quicker, more powerful, and don’t have to pander to their constituents to secure their re-election.
The rest of us will find ways too. We might not be able to buy a McMansion at 2% with zero money down anymore, but we’ll find new ways to get ahead of our neighbors. We’ll find a new assets to chase, new gold rushes somewhere in the world. New bubbles to inflate, pop, and then cry about how we got gum all over our face. Some of us will find new ways to flat-out cheat, while the rest will find corners that we’re comfortable cutting. And we’ll do it all without full understanding as to why.
Over time, I expect that this is the story that will endure. It will be a little window of history during which we allowed some of our base desires — some of our ugliest aspects — to run unchecked. The details will fade away.
OK, that’s enough touchy-feely ranting for today! Let’s get on with the recap and talk turkey.
Market Recap
It’s been an ugly couple of weeks with the market falling 7 days out of the last 8, climaxing with a one day drop of 3% on Tuesday. Booby trap! Hopefully you sold in May and went away, a strategy we advocate year-in and year-out for investors with short- to medium-term investment horizons.
In the last few newsletters I’ve been talking about several specific levels in this range-bound market. We thought that a rally up to around 1100 and the 200-day moving average was a likely possibility and it turned out that happened. A further rise toward and beyond 1220 would have been very bullish, but once again, the market bumped its head on that moving average and traded right back down. You don’t need to be a market technician to know that’s a bad sign.
What I’ve really had my eye since then on is this 1040ish level. The market has bounced off of that several times in the last few weeks. Most chart technicians will tell you that support can only hold for so long, and this week we finally got a decisive close below 1040. We’re trading even further below that this morning.
What does that mean?
Well, it means that if you didn’t sell in May you might reeeally want to think about it now.
From a technical analysis perspective, the market is now in what I call “no man’s land.” Having violated key support levels, it will fall to lower levels of support or will trend downward until it finds a fundamental reason to go up.
A year ago we started writing that the recession was officially over but that nobody was going to feel it because unemployment would stay high and growth would be modest, driven mostly by governmental stimulus. So far, that’s played out just about perfectly. The NBER hasn’t announced an end to the recession on June 30, 2009, but they typically wait a long time before making an official verdict and the consensus is that that’s where they’ll mark it. Whether they do or do not, our focus is about to shift on whether a new recession lurks ahead. That’s the “double dip” you’ve probably started to hear about.
Remember that the stock market is always one of the first things to react in anticipation of a recession. It usually takes a significant turn lower about 6 months before the recession officially begins. Unless we get some sort of a clear move back up in the stock market this summer, everybody needs to officially be on Recession Watch this fall and into the first quarter of next year. I don’t think we’ll get one the third or fourth quarters, but I think in 2011 it starts to become a legitimate possibility. Later this year we’ll take another look at our good friends, the Three Amigos, for predicting the beginning of that recession should it actually materialize.
Leading indicators
I’ve been following Lakshman Achuthan and the Economic Cycle Research Institute on my Bloomberg podcasts since the beginning of the year. You can listen to a snippet of a recent interview here; it’s definitely worth a listen. The ECRI really has their finger on the pulse of the near future with their Weekly Leading Index. It has garnered quite a bit of publicity lately now that the index has plunged into negative territory, though Mr. Achuthan has repeatedly stuck by his view that it’s forecasting a slowdown later this year, not an outright recession. He’s a data-driven guy, though, and if that WLI continues to drop, I can see him revising that forecast.
Another point he’s been making, along with The Mighty John Hussman, is that the last few decades have been a historical anomaly. It’s been a period of unnaturally low volatility and infrequent recessions. Folks in this camp are forecasting a future in which recessions occur more frequently as a variety of economic factors conspire to make strong, consistent economic growth a challenge. This fits very nicely with our decade-long view, one where the market goes up and down and up and down and at the end, investors look back and say, “Man, that wasn’t worth all the heartburn.”
I’ll admit, it’s tough to develop an investment strategy for that kind of environment. Job number one is protecting capital.
In our own hedge fund strategies we have moved entirely towards market neutral systems. They now make up 100% of our trading fund. We’ve done this because in uncertain, volatile, and slow-growth environments, stock prices fluctuate dramatically. That’s not opinion, it is historical fact. We’re not expressing any sort of market view here, we’re simply looking at the data and building an investment strategy to match. We don’t want to be exposed to any of that fluctuation and so we’ve totally neutralized it.
We recognize that not everybody out there is qualified to invest in hedge funds or has the knowhow to select the right ones. That’s why we’ve been preaching a gospel of caution in the last six months. We’ve talked about all sorts of things that the average investor can do to protect himself and squeak out a profit here and there. We’re not done with this conversation; we’ll continue to talk about these types of strategies until we get to the low point of the next mini-cycle. After that, it’ll get a little more fun because we can start looking at short/medium term growth strategies and also ways to efficiently scale into some fantastic longer term investments.
I wish the time for that was right now, but it is not. In the meantime I will wait patiently and with great anticipation. Patience is an under-appreciated virtue in the galaxy of finance, a universe driven by people who never stop moving and always need to be doing something, as though without all that activity their place in the cosmos would be quickly swallowed by the void.
Now is not the time to be greedy. Don’t worry, that time will come. The problem is that when those windows in history are finally opened few are in a position to take advantage. Fewer still are actually willing. So the strategy for right now is simply to get yourself ready, to ensure that you’ll be one of the few who can take action.
In the meantime, round up your friends and family this weekend and fire up the grill. You have far more important things to concern yourself with!
