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Friday, August 04, 2006

We are on Digg!

Check out digg.com. The link is on our sidebar. Cool stuff.

Our blog's article Nearing the Peak is currently waiting to be digged at.

My New Job and My New Hairstyle

It's quite difficult adjusting to the life of a fund manager... you have to learn to take a bigger picture of things, at the same time balance it out with trying to limit losses and managing risk. It's also hard coming in at this stage of the market, nearing the Fed meeting, when the market has climbed a lot that its quite volatile (though it continues to move up). By the way I have a new hairstyle and people in the office are already giving me crap about it...it's the stressed out look, which is how I'll probably be the rest of my life as a fund manager.

After 3 days of trading, I've shown some modest gains of 0.44%, net of some minor losses. My holding primarily consist of stocks representing my top down view. I favor Rmb revaluation plays in HK, such as HK properties and China consumer plays. HK properties will also benefit from a potential pause in US rate hikes next week or at worst in Semptember. I already took half of my profits in 683, a nice gain. China consumer plays gives us a defensive attitude, as these are more of volume plays rather than asset appreciation plays (like commodities and China properties) which the Chinese government is trying to clamp down on.

In the US I like utilities and other high-yielding stocks, which is why i took positions in HIH and FCH, yielding 5% and 3.8% respectively. I also took a position in RTN... I believe the world is increasingly at risk of war everyday, especially with the US's hidden agendas. RTN also has good export exposure at about 20% of sales, which should make it a weak dollar play. Being an industrial exporter it is also immune from the US consumer slowdown. Along with NEM, I consider it as my core holding. Volatility has hit NEM's share price as the price of gold commodity has been climbing for the past few days, I have hedged it by shorting 7 call contracts with exercise price of $55 at $0.60. If there is no assignment on the calls I get to keep my $420:) I also have a current short position in LEND. The stupid stock got pummelled to $42.50 to my excitement, only to get short-squeezed back to $45.50. It's gapped down $1 or so after-hours... hurray...

As for my next moves, I am looking at 694 in HK, another Rmb and China domestic consumption play from another angle. In the US I'm looking to add on the RTN when it breaks out. Meanwhile, I've yet to put some 40% of the fund, allocated to the Philippine and bond markets respectively to good use.


Increasing or Decreasing Probabilities

People think in two ways to reach a conclusion: inductive and deductive reasoning. An example of inductive reasoning is "seeing" the sun rtise in the east everyday thus concluding that the sun always rises in the east. An example of dedcutive reasoning would be knowing the fact that the earth rotates on its axis from west to east therefore concluding that the sun rises from east to west.

Let's say you are put blindfolded on a train running at 120 kph with no working breaks.

As you sit there you begin to think of what will happen. If you use inductive reasoning, the longer you sit there the more you are convinced that the train will not crash because it hasn't yet. You think the probabilities are decreasing that the train will crash.

How about using the deductive approach? The train is moving fast. The track is not infinite. Since you know the only thing that will stop the train is a crash, you conclude that the probabilities of the train crashing soon are increasing.

The two methods come to exact opposite conclusions.

I think too many traders/investors use inductive reasoning when approaching the markets. They are fooled into wrong conclusions because they are conditiioned to. Behavior is re-enforced even though that reinforcement is actually changing the odds in exactly the opposite way.

We can use this argument on the effect of growing debt on the US economy and its effect on asset prices. Total debt in the U.S. is now over three times GDP. Inductive reasoning tells many people that since nothing bad has happened to asset prices, the probabilities are decreasing that they ever will.

Deductive reasoning tells us that, by definition, there has to be a level of debt that will eventually curtail consumption and that since debt is growing, the US is getting closer to the point that high debt will curtail consumption.

Scientific evidence and history have shown people are more prone to being inductive than deductive. This is the root cause of herd mentality.

Choo choo choo...

Thanks to John Succo for the idea.


Thursday, August 03, 2006

Can You Feel the Heat?

Ah yes. Nothing beats a thirst quenching drink of Kool Aid nowadays. I guess with that sizzling temperature, ANY POSITION IS DEFINITELY UNCOMFORTABLE!

Sounds like the market where we're at right now. You go long and the other side of the trade is not really a seller but a shorter ( take note there is a difference). Go short and the other side is covering his short. Synthetic buying and selling bodes for a dazzling array of volatilty.

As The Great Trader would say, having no position is still a position. Unless you are playing for the Blazers, it is probably the best position to have right now.

'Til the smoke clears.


Tuesday, August 01, 2006

Nearing the Peak

Very good guide to economic and market cyles provided by Absolute Return Partners President Niels Jensen. He provides a chart which shows the economic cycle in terms of the curved lines, and the performance of the three asset classes (stocks, bonds and commodities) during those periods. The point of debate is whether we are just approaching the peak (green dot) or past the peak (red dot) of the economic cycle. If we are still at the green dot, then we might see another last gasp push for both stocks and commodities, maybe a short-lived new high or a double top? We agree that this is the most likely scenario right now. A pause in the August 8 Fed meeting may push both stocks and commodities higher, but when the economy slows down much faster than expected (i.e. the pause came too late) this may be a temporary reprieve and the May/June hiccup may not be just a hiccup at all... CLICK THE IMAGE TO ENLARGE


So Much Nonsense

So much nonsense has been written recently, following the dramatic sell-off in equities that we thought we would take a quick look in the rear mirror and see what history may be able to teach us in terms of what to expect of both stock, bond and commodity prices over the next year or so.

Let's begin by putting a marker down. We are great believers in the value of past experience. So often we hear the dreaded words - this time things are different - and every time those words make us cringe. As students of economic history we believe we can learn a great deal from the past. In the world we observe, things are rarely that different.

Back in 2004, Gary Gorton and K. Geert Rouwenhorst wrote a paper called Facts and Fantasies about Commodity Futures1. The paper has been updated recently and offers some revealing insight into the interaction between stocks, bonds and commodities.

Let's begin with a table which may surprise you a bit. It certainly surprised us. The National Bureau of Economic Research in the United States (NBER) divides every business cycle into periods of economic expansion and recession respectively. Since they started doing so in 1959, the U.S. economy has undergone seven full business cycles, each consisting of one expansion and one recession.

As you can see from table 1 below, it is very tempting to conclude that there is no real reason to add commodities to your portfolio, as the returns you have achieved during both expansions and recessions are broadly similar to those of the equity market. During periods of economic expansion, equities modestly outperform commodities whereas, during recessions, commodities do marginally better than equities. However, the difference in performance does not really get the adrenalin going.

Table 1:
Average Returns during Expansions and Recessions
Stocks Bonds Commodities
Expansion +13.29% +6.74% +11.84%
Recession +0.51% +12.59% +1.05%

Source: NBER, Working Paper 10595

Also, bear in mind that the returns in table 1 are not annual returns. They are returns from economic cycle peak to trough (or trough to peak). Since the periods of economic expansion tend to run considerably longer than the recessionary periods, average bond returns are not quite as attractive as they appear in table 1.

However, what Gorton and Rouwenhorst did next, changed everything. Following NBER's methodology, they divided each period of economic expansion into early stage expansions and late stage expansions. The results are summarised in chart 1 and are really fascinating. We make the following observations:
As we already pointed out, over an entire economic cycle, stocks and commodities behave quite similarly, at least as far as the total return pattern is concerned.

Stocks (and bonds) do much better than commodities in late recessions and early expansions. Late recessions are, in fact, the worst environment for commodities where the average return has been negative.

The best environment for commodities is late expansions where the average return both in absolute and relative terms is very attractive.

In early recessions, where stock and bond returns really suffer, commodity returns are still quite attractive, at least in relative terms.
All this leads to the $1 million question: Where in the cycle is the global economy today? Knowing the answer to that may explain the difference between poor and good performance in your portfolio over the next 12-18 months. Before we go there, an important disclaimer:

Absolutely no assurances can be made that history will repeat itself. Furthermore, the performance numbers in chart 1 are average performance numbers over seven economic cycles. The performance from cycle to cycle may in fact vary considerably.
Having said all of that, chart 1 contains important information unless you believe that globalisation and cheap money has changed the way stocks and commodities correlate with each other. This argument was put forward by Merrill Lynch in a report earlier this year2 and reiterated in a Wall Street Journal article only a few weeks ago.

The cheap money argument may carry some validity in the sense that low interest rates globally have contributed to the rolling asset inflation phenomenon, which started with the equity boom in the late 1990s only to move on to property markets and recently also to commodities. However, cheap money is becoming more expensive by the day, so that explanation may not hold water for much longer.

The globalisation argument simply does not stand up to closer scrutiny. It implies that either globalisation has changed the way we cover our commodity needs or that globalisation has fundamentally changed the nature of economic cycles or possibly even both. Neither, in our opinion, is true.

So, back to the $1 million question: Where in the cycle are we? Well, the world's largest economies are not synchronised at the moment, so the philosophical answer to the question is that it depends. The Anglo-Saxon economies are clearly at a more mature stage in the cycle than most continental European economies and certainly more advanced in the cycle than Japan.

So, in order not to confuse matters, let's keep our eyes on the U.S. economy which, whether we like it or not, drives everything else anyway.

The yield curve tells you that the U.S. economy is past the peak and is rapidly approaching the next recession. On chart 1, this point is represented by the red dot. If this is the point where the U.S. economy finds itself at the moment, the May/June stock market correction is probably only the beginning of something worse to come. However, in such a scenario, history suggests that commodities may do relatively well for a fair bit longer.

The problem with the yield curve approach, as we pointed out in our March 2005 Absolute Return Letter, is that the yield curve may not be as good at predicting recessions as it once was. Structural changes in the bond market have changed the shape of the yield curve. We concluded back then (and we stand by that conclusion) that a mildly inverted yield curve should be interpreted with care. A strongly inverted curve, on the other hand, is probably still a pretty good indication of recession knocking on the door. As these lines are written, the yield curve is only marginally inverted.

Meanwhile, virtually all other indicators suggest that the U.S. economy has not yet peaked. It may be prudent to expect a modest slowdown from the rampant growth in the first quarter of this year but, overall, Uncle Sam is still firing on most cylinders. This scenario is represented by the green dot on chart 1. Importantly, the behaviour of both stocks, bonds and commodities over the past 12 months supports this line of thinking, i.e. that we are in the latter stages of economic expansion but that we have not yet passed the peak. We prefer to listen to the markets. They usually don't lie.

As an aside, we actually think something completely different caused the hiccup in May and June. We often disagree with Stephen Roach of Morgan Stanley but believe that he nailed the issue when suggesting that the correction was a result of the world's leading central banks once and for all closing the book on the Greenspan era of cheap money and bail outs.

The so-called Greenspan put (the Fed's apparent limitless willingness to flood the system with liquidity and bail out markets every time someone caught the flu) has been ruthlessly removed and the change in policy has radically altered investors' appetite for risk. Don't expect it to be reinstalled anytime soon.

If our read is proven correct, then global equity markets will enjoy a decent spell over the next several months before markets start to discount the point at which the U.S. economy finally tips over and lands in the next recession. At that point in time, you do not want equities in your portfolio.

If, on the other hand, our analysis is wrong and the U.S. economy has already passed the peak, you can draw your own conclusions from chart 1. The picture isn't pretty. And that goes for European and Asian stock markets as well. However, wherever we are in the cycle, do not expect stocks and commodities to continue to move more or less in parallel. History suggests that this is a highly unlikely outcome. The sooner you decide whether to put your chips on green or red, the better.