WHEN IS “ENOUGH” LIQUIDITY NOT REALLY ENOUGH?
In our last investor letter, we postulated that the deflationary cycle was broken by
the massive liquidity efforts of the central banks. We had shifted from bearish to
market neutral in June 2009 when the Dow Jones Industrial Average was about
8400. The question is now whether or not the liquidity provided to stabilize the
system was enough to generate growth, and more importantly, enough growth to
satisfy the expectations of the market. We think not. However caution is still
warranted as it will likely take some time for bullish momentum to dissipate.
So while liquidity is king, at this point we believe that not enough was done, and
that the economy is going to sink from its own weight; the weight of debt, the
weight of persistently low velocity, the weight of a bailout that preserved large
zombie institutions at the expense of the small business entrepreneurial
backbone of job creation in the US and the weight of a president whose frenetic
policy mix has (on top of all the other problems) served to confuse and paralyze
business investment.
As the disconnect between the stock market and the real economy widens, we
are again becoming bearish. Very bearish. As for how we might play this, we are
looking for a test of the 10300 level of the Dow Jones Industrial Average. How do
we get to that number? The 10300 level represents the 50% retracement of the
entire bear move from 14000+ to 6600. Very often major moves are followed by
large retracements. At this point, heading into the third quarter earnings season
we find as of last week that there were an inordinate number of parties in the
short or correction camp for the market, and the bearishness was building as it
often does as the market falls. However, we suspect that this bearishness will be
wiped out by another upsurge in the market, taking it toward the 50% retrace
level mentioned above. We have started to deploy some short positions, but our
short is relatively modest at this stage. We will short more if/when the market
rallies and we see sentiment turn more bullish.
Speaking of bullish sentiment we find the bond market sentiment to be extremely
conducive to shorting. The government has been buying more and more
Treasury and related debt securities in an attempt to keep rates down, and this
has created a bull market that is now sucking in the public into bond mutual funds
at a rate almost equivalent to tech buying in the late 1990’s. No doubt this bond
market bubble will end badly for the public, as they are typically last in and end
up holding way too long. The only question about shorting bonds is when and
how much?
Regarding gold, we find the market action to be extremely bullish, as the
gradually but inexorably falling dollar is driving gold higher. Interestingly, gold is
making new highs in almost all currencies which shows that paper money
creation is eroding purchasing power around the world, not just in the US, though
we are the worst culprits.
By the time you read this you should have received your September
performance. You will see that we have recovered all of our losses and that our
fund is now positive. Part of this performance is due to the rise of gold and
precious metals stocks in which we have a core investment, but a good portion of
the performance is also due to two special situations we have invested in:
Vermillion (VRMLQ) and Design Within Reach (DWRI).
Vermillion is a small medical diagnostics company that was sitting in bankruptcy
expecting a protracting approval process for their Ovarian cancer blood test,
when they unexpectedly received FDA approval. We were fortunate enough to
learn of the situation relatively early after the approval through our network of
health care contacts, and we accumulated a decent sized position at an initial
price under $5. At this time we have in excess of 10% of the portfolio in this
security, and it is trading in excess of $15. We believe that the potential news
flow and earnings potential for this company is dramatic and that the stock has
limited downside and significantly more upside. We continue to hold this position,
but are not adding because we do not want too much concentration in any one
name.
Design Within Reach is a promising furniture retail brand that suffered a
deterioration in their business as a result of the recession. Through a
combination of circumstances we were able to purchase a significant position in
the company at a price that we believe to be 50% below the liquidating value of
the business. We believe that the downside is limited from these levels (our cost
is $0.20/share) but that there are numerous positive scenarios that would cause
the stock to move higher in both the short and intermediate term. This position
has appreciated about 20% for us so far, and currently constitutes a little more
than 10% of our portfolio.
At present we maintain a slight short on the equity market (that we plan to
increase) and a sizable long position in gold. We continue to look for
disappointing growth and greater money creation by the government. We
believe that stocks are overpriced and gold is underpriced and have structured
our portfolio accordingly. We are short the dollar by virtue of our gold position.
We believe that bonds are in the later stages of a generational bubble and we
are bearish over time, but we do not have a short position at this time.
As always, please feel free to call us with any questions or updates. We always
like hearing from our partners.
Wednesday, January 6, 2010
Investment Letter: September 2, 2009
WHAT HAPPENED TO THE DEFLATIONARY SPIRAL?
In the late 1970’s, leading up to the market bottom in 1980-81, there was a
period of time where in order to choke off inflation, the Federal Reserve drove
short term interest rates up to levels that exceeded long dated Treasuries. This is
called an inverted yield curve, and it was our first experience with this
phenomenon. What it does is basically eliminate the ability for anybody to get
any kind of short term financing in the credit markets and wipes out anybody in
the business of borrowing short to lend long. We will never forget an article that
we read about it entitled: “Inverted Yield Curve, A Warning to the Money
Markets”.
Regardless of the relative level of interest rates, an inverted yield curve is also
very bad for equity prices, since the high risk-free Treasury bill rate tends to pull
money out of riskier asset classes. The inverted yield curve represents an
extreme stage of tightening by the central bank, and is the opposite of the
extreme accommodation we have now.
Regarding our current ongoing and evolving “crisis”, the timeline is more or less
that the western banking system imploded and created a credit crisis where
nobody trusted anybody else’s balance sheet. This caused the entire system to
panic; inter-bank rates soared and credit markets “froze up”, leading the financial
system to desperately attempt to de-leverage as fast as possible. This initiated
and then fueled a downward spiral in asset prices that resulted in the massive
liquidation pressures that drove the markets to their early-2009 lows.
Step in the central banks of the world with unprecedented liquidity and support –
essentially backstopping the entire banking system. It took the market some time
to accept that this government support of the counter party system would work to
slow or stop the liquidation, but once the market realized that the central banks
were more or less guaranteeing the other side of any trade involving a significant
financial institution, the credit tightness eased. As the credit tightness eased, the
market began to take a deflationary death spiral off the table and began to
assess the future.
The bottom line is with the central banks providing virtually unlimited liquidity they
have succeeded in slowing the normal asset liquidation process. There is no
pressure to liquidate bad loans, and short-term financing is being made available
by the Fed through all kinds of credit facilities. This process is assisted by what
has amounted to a changing of the rules to accommodate bank balance sheets,
and a generally well coordinated effort by official parties and the financial media to paper the crisis over with liquidity and positive news flow. Many companies
that are highly leveraged and dependent on short term financing have been
rescued from the clutches of their own balance sheet indiscretions by the
accommodative central bank policy. However, this government rescue can only
work while the central banks are able to produce unlimited amounts of money
without any negative consequences.
Logically, if the central banks are on a coordinated reflation mission, sooner or
later they are going to succeed (who wants to be against the printing press),
which means eventually we will have growth but in order to overcome the
structural weaknesses in the economy, the growth will be slow and will cost a lot
of money relative to prior recoveries. Eventually, the logical conclusion of this
process is that we will get a lot of nominal growth, but it will come with inflation,
and regardless of the chatter about an exit strategy, we find it extremely unlikely
that the central banks will exit the reflation mission before there is an actual
inflation problem.
Once that occurs, and once the central banks shift from an accommodative to
restrictive policy, then they will be unable to protect the market from deflating
asset prices. So, during this period of government created buoyancy in the
markets, we expect to see huge amounts of equity offerings and debt/equity
conversions as overleveraged balance sheets attempt to take advantage of what
is essentially a government sponsored second chance to bring themselves in
line. The smart balance sheets will try to de-leverage in this extended “eye of the
hurricane” period.
Our view is that a continued central bank reflation effort will eventually work, and
that we are at the beginning of the next wave of inflation, with each bout of less-
than-robust real economic growth (read “jobs”) met with greater central bank
stimulation efforts. This will lead to growth, along with a weaker dollar and higher
inflation, which is how the market is handicapping the future as it moves cash out
of low yielding Treasury securities. Eventually we see the central banks
withdrawing the liquidity, but only after inflation rears its head, and then we will
be on our way towards an inverted yield curve. This will create the final leg down
in the bear market, as the inverted yield curve needed to cure inflation will
decimate leveraged balance sheets and finish the deflationary liquidation that
was interrupted in 2008-2009 by massive government intervention and
accommodation. Once inflation returns, this level of accommodation will simply
not be possible, as each effort to stimulate will be met by rising rates (bond
vigilante phenomenon) and essentially be self defeating.
The real question is how long will it take to reflate the economy, and how far will
it go until the situation reverses. We think it may take some time because the
real economy has a very long way to go, and until there is another crisis, we
don’t see any end to the liquidity and stimulus frenzy of central bank super
accommodation. Right now the central banks are in a sweet spot as the deflationary pressures on prices have created low levels of inflation which allow
for almost unlimited injections of money. At this stage the dollar decline is well
managed and we expect government support in the form of liquidity to continue
unabated. After all, we know that a slow economy and high unemployment rate
are politically untenable in the United States, especially when we are using a well
oiled printing press without any repercussions and everybody agrees inflation is
not a problem. That, my friends, is a recipe for a lot of inflation.
Our take on what is happening is essentially that the market, being a discounting
mechanism more than anything else, has determined that sooner or later the
central banks will create enough money to reflate the global economy. Therefore
it doesn’t make sense to hold capital in zero percent or low yielding Treasury
securities when there is probable future inflation in addition to a depreciating
currency. Periodic market corrections notwithstanding, this money is going to
work rather than sit and deteriorate, and the rally from the March lows reflects
relatively positive news flow regarding GDP and corporate earnings, and the
market’s belief that the central bank will get it right. This is, of course, overlapping
with the apparent fiscal irresponsibility of our left leaning administration, and you
get the recipe for a market that believes growth is coming, and with it a probably
weaker currency and some inflation. In addition, with the market caught short in
March, there was (after the initial short covering rally) a kind of low volume
tyranny of the most bullish as they drove prices up and started a cycle of
performance chasing by the rest of the benchmarking underinvested world. This
explains the cyclical bull and its enormous strength. Remember, there is no
liquidation pressure and now the underperformance situation is becoming
catastrophic for all the money benchmarked to the S&P 500.
But the big macro cycle has not changed. This is the eye of the hurricane. We
are reminded of the 1973-1981 period when the market suffered from a severe
bear market in 1973-74, bottoming at about 550 before it rallied to over 1000 in
1976 on the back of significant government support before falling back under 750
twice in the 1980-81 bear market before finally breaking out over the 1000 level
in 1982. The point is that when the government throws everything at the market it
can impact it and the duration can be years rather than months.
In this cycle, government intervention has clearly obscured and slowed the de-
leveraging process, but not eradicated it. Money velocity remains low because of
depressed incomes and housing prices. Global balance sheets are still highly
leveraged. We are still in a longer term global de-leveraging cycle in which
current and future incomes are not likely to be able to both service existing debt
requirements and generate any significant growth. The central banks and
government leadership had a chance to wipe the slate clean and guide the global
economy through a de-leveraging that would have set the foundations for
sustainable longer term growth, but they opted to try and reflate instead. And
since the patient is sicker than before there is going to be a lot more government
accommodation needed, and eventually the money created will find its way into asset prices. Once the inflation comes it will bring with it higher rates and
eventually central bank tightening, and it will be at this point that global leverage
cannot be eased by central bank accommodation, and only then will we see the
completion of the global de-leveraging process.
Summary and Conclusions:
Based on the global central bank reflation mission, we have changed our stance
to neutral from bearish on equity and asset prices as we anticipate the beginning
of a new inflationary wave. We remain bearish on the dollar, bullish on gold, and
continue to believe that interest rates will tend to move much higher over time,
though they may have room to decline in the short term. We would be inclined to
become bullish if the market corrected and made a higher low, but at these levels
we are neutral.
Our investment thesis is best represented by our commitment to owning gold as
a core holding. In addition, we like exposure to commodities as a play on the
falling dollar, and we will selectively invest in individual equity names, particularly in the health care area where we have substantial knowledge capital.
To date our portfolio performance has suffered from our too bearish outlook up to
and into mid-July, but we covered most of our net short position and turned
neutral on the market in mid-July when the Dow Jones Industrial Average was
roughly 8600. The unwinding of these positions in July and August has resulted
in some additional small losses in our portfolio. At this time we are maintaining
our market neutral position on equity, as we believe the chances of a further rally
are equally balanced by the chances of a 10% correction (more or less). We are
selectively adding long exposure but hedging it to stay market neutral, and will
consider getting net long into any significant weakness. We are taking
substantially less risk with our positions at the moment, as we seek to gradually
recover our losses and carefully work our way back to profitability for our
investors.
In the late 1970’s, leading up to the market bottom in 1980-81, there was a
period of time where in order to choke off inflation, the Federal Reserve drove
short term interest rates up to levels that exceeded long dated Treasuries. This is
called an inverted yield curve, and it was our first experience with this
phenomenon. What it does is basically eliminate the ability for anybody to get
any kind of short term financing in the credit markets and wipes out anybody in
the business of borrowing short to lend long. We will never forget an article that
we read about it entitled: “Inverted Yield Curve, A Warning to the Money
Markets”.
Regardless of the relative level of interest rates, an inverted yield curve is also
very bad for equity prices, since the high risk-free Treasury bill rate tends to pull
money out of riskier asset classes. The inverted yield curve represents an
extreme stage of tightening by the central bank, and is the opposite of the
extreme accommodation we have now.
Regarding our current ongoing and evolving “crisis”, the timeline is more or less
that the western banking system imploded and created a credit crisis where
nobody trusted anybody else’s balance sheet. This caused the entire system to
panic; inter-bank rates soared and credit markets “froze up”, leading the financial
system to desperately attempt to de-leverage as fast as possible. This initiated
and then fueled a downward spiral in asset prices that resulted in the massive
liquidation pressures that drove the markets to their early-2009 lows.
Step in the central banks of the world with unprecedented liquidity and support –
essentially backstopping the entire banking system. It took the market some time
to accept that this government support of the counter party system would work to
slow or stop the liquidation, but once the market realized that the central banks
were more or less guaranteeing the other side of any trade involving a significant
financial institution, the credit tightness eased. As the credit tightness eased, the
market began to take a deflationary death spiral off the table and began to
assess the future.
The bottom line is with the central banks providing virtually unlimited liquidity they
have succeeded in slowing the normal asset liquidation process. There is no
pressure to liquidate bad loans, and short-term financing is being made available
by the Fed through all kinds of credit facilities. This process is assisted by what
has amounted to a changing of the rules to accommodate bank balance sheets,
and a generally well coordinated effort by official parties and the financial media to paper the crisis over with liquidity and positive news flow. Many companies
that are highly leveraged and dependent on short term financing have been
rescued from the clutches of their own balance sheet indiscretions by the
accommodative central bank policy. However, this government rescue can only
work while the central banks are able to produce unlimited amounts of money
without any negative consequences.
Logically, if the central banks are on a coordinated reflation mission, sooner or
later they are going to succeed (who wants to be against the printing press),
which means eventually we will have growth but in order to overcome the
structural weaknesses in the economy, the growth will be slow and will cost a lot
of money relative to prior recoveries. Eventually, the logical conclusion of this
process is that we will get a lot of nominal growth, but it will come with inflation,
and regardless of the chatter about an exit strategy, we find it extremely unlikely
that the central banks will exit the reflation mission before there is an actual
inflation problem.
Once that occurs, and once the central banks shift from an accommodative to
restrictive policy, then they will be unable to protect the market from deflating
asset prices. So, during this period of government created buoyancy in the
markets, we expect to see huge amounts of equity offerings and debt/equity
conversions as overleveraged balance sheets attempt to take advantage of what
is essentially a government sponsored second chance to bring themselves in
line. The smart balance sheets will try to de-leverage in this extended “eye of the
hurricane” period.
Our view is that a continued central bank reflation effort will eventually work, and
that we are at the beginning of the next wave of inflation, with each bout of less-
than-robust real economic growth (read “jobs”) met with greater central bank
stimulation efforts. This will lead to growth, along with a weaker dollar and higher
inflation, which is how the market is handicapping the future as it moves cash out
of low yielding Treasury securities. Eventually we see the central banks
withdrawing the liquidity, but only after inflation rears its head, and then we will
be on our way towards an inverted yield curve. This will create the final leg down
in the bear market, as the inverted yield curve needed to cure inflation will
decimate leveraged balance sheets and finish the deflationary liquidation that
was interrupted in 2008-2009 by massive government intervention and
accommodation. Once inflation returns, this level of accommodation will simply
not be possible, as each effort to stimulate will be met by rising rates (bond
vigilante phenomenon) and essentially be self defeating.
The real question is how long will it take to reflate the economy, and how far will
it go until the situation reverses. We think it may take some time because the
real economy has a very long way to go, and until there is another crisis, we
don’t see any end to the liquidity and stimulus frenzy of central bank super
accommodation. Right now the central banks are in a sweet spot as the deflationary pressures on prices have created low levels of inflation which allow
for almost unlimited injections of money. At this stage the dollar decline is well
managed and we expect government support in the form of liquidity to continue
unabated. After all, we know that a slow economy and high unemployment rate
are politically untenable in the United States, especially when we are using a well
oiled printing press without any repercussions and everybody agrees inflation is
not a problem. That, my friends, is a recipe for a lot of inflation.
Our take on what is happening is essentially that the market, being a discounting
mechanism more than anything else, has determined that sooner or later the
central banks will create enough money to reflate the global economy. Therefore
it doesn’t make sense to hold capital in zero percent or low yielding Treasury
securities when there is probable future inflation in addition to a depreciating
currency. Periodic market corrections notwithstanding, this money is going to
work rather than sit and deteriorate, and the rally from the March lows reflects
relatively positive news flow regarding GDP and corporate earnings, and the
market’s belief that the central bank will get it right. This is, of course, overlapping
with the apparent fiscal irresponsibility of our left leaning administration, and you
get the recipe for a market that believes growth is coming, and with it a probably
weaker currency and some inflation. In addition, with the market caught short in
March, there was (after the initial short covering rally) a kind of low volume
tyranny of the most bullish as they drove prices up and started a cycle of
performance chasing by the rest of the benchmarking underinvested world. This
explains the cyclical bull and its enormous strength. Remember, there is no
liquidation pressure and now the underperformance situation is becoming
catastrophic for all the money benchmarked to the S&P 500.
But the big macro cycle has not changed. This is the eye of the hurricane. We
are reminded of the 1973-1981 period when the market suffered from a severe
bear market in 1973-74, bottoming at about 550 before it rallied to over 1000 in
1976 on the back of significant government support before falling back under 750
twice in the 1980-81 bear market before finally breaking out over the 1000 level
in 1982. The point is that when the government throws everything at the market it
can impact it and the duration can be years rather than months.
In this cycle, government intervention has clearly obscured and slowed the de-
leveraging process, but not eradicated it. Money velocity remains low because of
depressed incomes and housing prices. Global balance sheets are still highly
leveraged. We are still in a longer term global de-leveraging cycle in which
current and future incomes are not likely to be able to both service existing debt
requirements and generate any significant growth. The central banks and
government leadership had a chance to wipe the slate clean and guide the global
economy through a de-leveraging that would have set the foundations for
sustainable longer term growth, but they opted to try and reflate instead. And
since the patient is sicker than before there is going to be a lot more government
accommodation needed, and eventually the money created will find its way into asset prices. Once the inflation comes it will bring with it higher rates and
eventually central bank tightening, and it will be at this point that global leverage
cannot be eased by central bank accommodation, and only then will we see the
completion of the global de-leveraging process.
Summary and Conclusions:
Based on the global central bank reflation mission, we have changed our stance
to neutral from bearish on equity and asset prices as we anticipate the beginning
of a new inflationary wave. We remain bearish on the dollar, bullish on gold, and
continue to believe that interest rates will tend to move much higher over time,
though they may have room to decline in the short term. We would be inclined to
become bullish if the market corrected and made a higher low, but at these levels
we are neutral.
Our investment thesis is best represented by our commitment to owning gold as
a core holding. In addition, we like exposure to commodities as a play on the
falling dollar, and we will selectively invest in individual equity names, particularly in the health care area where we have substantial knowledge capital.
To date our portfolio performance has suffered from our too bearish outlook up to
and into mid-July, but we covered most of our net short position and turned
neutral on the market in mid-July when the Dow Jones Industrial Average was
roughly 8600. The unwinding of these positions in July and August has resulted
in some additional small losses in our portfolio. At this time we are maintaining
our market neutral position on equity, as we believe the chances of a further rally
are equally balanced by the chances of a 10% correction (more or less). We are
selectively adding long exposure but hedging it to stay market neutral, and will
consider getting net long into any significant weakness. We are taking
substantially less risk with our positions at the moment, as we seek to gradually
recover our losses and carefully work our way back to profitability for our
investors.
Investment Letter: July 23, 2009
In our May 12th, 2009 investor update we said:
“...we do not believe this is a new bull market; we think it is a
countertrend rally in a primary bear market. The rally could go
further, but is likely closer to the end than the beginning. Sharp
rallies of this character in bear markets are... the rule rather than
the exception. The sentiment and valuations have been all wrong
for a bottom. There has never been an ultimate market bottom
when you have so much optimism and constant attempts to make
every new low into “the bottom”, volatility is way too high
historically, and multiples are too high. Prior bear market bottoms
have been characterized by a loss of interest in equity and very low
multiples...”
Nothing has happened in the past 70 days to change that fundamental longer-
term overview; however, the near term market rally is proving to be much
stronger than we anticipated. We have clearly underestimated the potential of
the cyclical bull market to rally within what we still think is a secular bear market.
Consistent with our very bearish view of the economy and market, we
significantly increased our short positions in early July, just in time to have the
market commence a 10+% rally beginning early on the morning of July 13th. We
took the brunt of a couple big rally days early in the move and realized that the
market was not behaving as we expected. As a result, we covered our excess
short position, returning the fund to a market neutral position and leaving the
partnership down roughly 6.5% year-to-date, according to our internal
calculations (based on assets under management). This is not a happy
circumstance, but neither is it fatal, as losers are part of the business, and we
anticipate losing 5-10% on our bad trades, expecting our good trades to yield
substantially higher gains than our losses.
While we believe that the market will trade lower at some point, given the recent
uptrend, we were not prepared to suffer any more losses and so we stepped to
the sidelines. In particular, the market’s ability to shake off bad news of some
magnitude (such as California going bankrupt or CIT Group failing) underscored
the robustness of the current rally. The reigning in of our excess short proved a
wise decision as the market has continued to rally every day since, and is up
strongly again today.
BULL VS BEAR
The Bull Case is championed by the financial industry, including the financial
media, which functions as an arm of the Wall Street distribution system. The bull
case is based on the following factors:
1) The Fed is easing aggressively as are other central banks. How many
times have we heard them say: “don’t fight the Fed”
2) This is just another recession, not something fundamentally different.
3) The positively sloped yield curve (lower short term rates, higher long term
rates) is good for banking and business
4) Sooner or later, all of the Fed and Government activity in the market “has
to” produce a recovery.
5) Things are getting better by some definitions, including “not as bad”
6) There is almost no return in risk free assets (0% T Bill and 3+% 10
Treasury Note rates)
7) There was and continues to be a lot of “cash on the sidelines” getting no
return, and as the market moves up these participants (mutual funds, pensions,
brokered public) must put money to work. This becomes a more important factor
as the market rallies more.
8) Valuations are “reasonable by long term standards”. SP500 trading at 18X
forward earnings, which is only slightly above the long-term trend.
These are the primary elements of a cyclical bull market. They’re cyclical
because they’re based on the cycle of business slowdown, inventory liquidation,
Fed accommodation as a response to the downturn, subsequent inventory
rebuild and expected employment recovery, against a backdrop of lower equity
prices following a bear market. The financial industry is absolutely expert at
generating optimism and systematically building it by beating earning estimates
to nurture more positive news flow, which then pulls more cash into the market.
The recent rally has been on light volume and acts more like a short squeeze
than a breakout. In a short squeeze, the desperate buyers push prices up a little
bit each day. This is what buying the market has become for a lot of investors on
the sidelines who are now suddenly underperforming their benchmark and must
put money to work.
Overall, we must admit that given the market action, it is hard to argue with the
bull case in the short term.
The Bear Case is very lonely and out of favor at the moment, but we believe it
still has merit. It is more secular in nature, and based on the following factors:
1) The 2007-2008 credit crisis and subsequent economic downturn is
fundamentally different from prior post war recessions. It is the result of an
exhaustion of a long-term credit cycle and not simply a normal business cycle
downturn. It is structurally the same phenomenon that precipitated the Great
Depression. This limits the expected benefits of central bank easing.
2) The amount of global wealth that was destroyed has fundamentally
changed the robustness and output potential of the economy, especially
considering that 70% of the world’s largest market (USA) is dependent upon its
consumer.
3) The amount of debt remaining from the pre crisis economy is much too
high for the reduced level of incomes. Global de-leveraging will be a continuing
theme.
4) The banking system is in very weak shape, and not willing to loan
aggressively because their balance sheets are weak and there is also a dearth of
credit worthy borrowers and viable projects.
5) Consumer demand is likely to remain muted compared to prior cycles,
primarily due to the devastating effects of high and rising unemployment
combined with still depressed housing and stock prices. People are saving more.
6) The consumer is structurally weakened in a way that will not repair itself
easily or quickly.
7) The financial industry is overly optimistic about the strength of the
recovery.
8) Sentiment is much too bullish, with the vast majority of market participants
believing that “the bottom” is in and the worst is over.
9) The disconnect between market optimism and the weak consumer/real
economy create an opportunity to wait for lower equity prices. Valuations are
relatively high with stocks trading at close to 20X forward earnings, thus making
the risk reward for shorting the market more compelling. At some point anyway.
What makes the bear case secular is that there are trends at work which are
beyond the scope of the cycle, which are not accounted for by the cycle, such as
the de-leveraging of global balance sheets.
The lynchpin of the bear case is that “this time things are different”; that the
consumer is irreparably damaged; and, output/income/earnings are going to be
disappointing going forward. The government will have to spend much more
money to generate economic activity, and this will make real growth difficult and
come at the expense of the currency and inflation rate.
From our perspective, stock prices are discounting a big recovery. With all of the
money creation by central banks, any serious recovery would come with inflation,
which is not good for stock prices, and if the economy doesn’t snap back
earnings will likely be very disappointing. Either way, we see stock prices having
trouble going forward.
The recent earnings season has been celebrated as companies have beaten
their estimates; however, most companies reported lower top line, and only
bettered the Wall Street earnings estimate because of cost cutting. Cost cutting
is not going to generate enough earnings growth to support this rally much
longer. The question is how much longer, and how much higher.
GOLD
Gold has been one of the best performing assets in the past ten years. We
believe that it will continue to be a top-performing asset. In an environment like
we have today, where central banks are creating massive liquidity, any upside
momentum generated by the global economy is likely to bring inflation, or at least
the fear of it. So, on the upside, we believe that gold will perform well if the
economy rebounds sufficiently to maintain or increase stock prices.
In addition, we believe that the US will need to systematically weaken the dollar
in order to improve the economy, and since gold is denominated in dollars, any
sustained dollar weakness will result in higher gold prices.
On the downside, we believe that any further weakness in the economy will see
other assets fall more than gold; hence, it is the safest store of value on the
downside.
Therefore, we maintain a substantial core position in gold, against which we can
short more or less equity depending on market conditions. We believe that gold
should be at the core of any investment portfolio in the near future.
US DOLLAR
We continue to believe that the dollar is key to any resolution of the deflation v
inflation debate. We continue to believe that in spite of all the “strong dollar”
rhetoric, the true US policy is to systematically weaken the currency, but to do so
in an orderly manner. This makes sense for several key reasons: 1) improved
export competitiveness which translates into JOBS, 2) put the wind behind
consumer/business balance sheets, 3) making it easier for us to repay our
national debt, 4) making our assets more attractive to foreign buyers/investors.
In addition, we believe that President Obama’s pursuit of a populist agenda of
change is extremely negative for the dollar, as government spending soars in the
face of falling revenues, and our nation takes on the feel of a chicken with its
head cut off. There has never been a shift to the left of this nature that did not
result in a sharply lower native currency.
We believe that there is a large amount of capital in the market being allocated
with a strategy of looking through the inflation trough towards the expected peak
that will result from what is perceived to be an inevitable decline in the US Dollar.
These pools of capital are betting that sooner or later the current global reflation
effort will work, and that it is best to get positioned now. While we have been and
continue to be in the deflationist camp, we certainly see the merit of this
approach, and are considering how best to position ourselves. At the moment,
our substantial gold position will provide us some protection if this inflation trade
proves to be the correct approach.
We expect to see a decoupling at some point between the dollar and the growth
trade, as continued declines in the currency eventually diminish the global
appetite for dollar denominated assets. This is a long process that is slowly
unfolding. We wonder about a future world in which the falling dollar moves hand
in hand with a falling equity market and low growth. This would be the stagflation
scenario, and we think it is coming. Again, our position in gold as the “anti dollar”
covers us against this eventuality, which is one of the main reasons we hold a
large gold position as a core in our portfolio.
ASSET ALLOCATION
As we make this final edit the morning of Thursday, July 23rd, here is our asset
allocation:
75% invested, 25% cash in US Dollars
Of the funds invested, the allocation is as follows:
55% Long Gold and related securities
46% Short Equity
“...we do not believe this is a new bull market; we think it is a
countertrend rally in a primary bear market. The rally could go
further, but is likely closer to the end than the beginning. Sharp
rallies of this character in bear markets are... the rule rather than
the exception. The sentiment and valuations have been all wrong
for a bottom. There has never been an ultimate market bottom
when you have so much optimism and constant attempts to make
every new low into “the bottom”, volatility is way too high
historically, and multiples are too high. Prior bear market bottoms
have been characterized by a loss of interest in equity and very low
multiples...”
Nothing has happened in the past 70 days to change that fundamental longer-
term overview; however, the near term market rally is proving to be much
stronger than we anticipated. We have clearly underestimated the potential of
the cyclical bull market to rally within what we still think is a secular bear market.
Consistent with our very bearish view of the economy and market, we
significantly increased our short positions in early July, just in time to have the
market commence a 10+% rally beginning early on the morning of July 13th. We
took the brunt of a couple big rally days early in the move and realized that the
market was not behaving as we expected. As a result, we covered our excess
short position, returning the fund to a market neutral position and leaving the
partnership down roughly 6.5% year-to-date, according to our internal
calculations (based on assets under management). This is not a happy
circumstance, but neither is it fatal, as losers are part of the business, and we
anticipate losing 5-10% on our bad trades, expecting our good trades to yield
substantially higher gains than our losses.
While we believe that the market will trade lower at some point, given the recent
uptrend, we were not prepared to suffer any more losses and so we stepped to
the sidelines. In particular, the market’s ability to shake off bad news of some
magnitude (such as California going bankrupt or CIT Group failing) underscored
the robustness of the current rally. The reigning in of our excess short proved a
wise decision as the market has continued to rally every day since, and is up
strongly again today.
BULL VS BEAR
The Bull Case is championed by the financial industry, including the financial
media, which functions as an arm of the Wall Street distribution system. The bull
case is based on the following factors:
1) The Fed is easing aggressively as are other central banks. How many
times have we heard them say: “don’t fight the Fed”
2) This is just another recession, not something fundamentally different.
3) The positively sloped yield curve (lower short term rates, higher long term
rates) is good for banking and business
4) Sooner or later, all of the Fed and Government activity in the market “has
to” produce a recovery.
5) Things are getting better by some definitions, including “not as bad”
6) There is almost no return in risk free assets (0% T Bill and 3+% 10
Treasury Note rates)
7) There was and continues to be a lot of “cash on the sidelines” getting no
return, and as the market moves up these participants (mutual funds, pensions,
brokered public) must put money to work. This becomes a more important factor
as the market rallies more.
8) Valuations are “reasonable by long term standards”. SP500 trading at 18X
forward earnings, which is only slightly above the long-term trend.
These are the primary elements of a cyclical bull market. They’re cyclical
because they’re based on the cycle of business slowdown, inventory liquidation,
Fed accommodation as a response to the downturn, subsequent inventory
rebuild and expected employment recovery, against a backdrop of lower equity
prices following a bear market. The financial industry is absolutely expert at
generating optimism and systematically building it by beating earning estimates
to nurture more positive news flow, which then pulls more cash into the market.
The recent rally has been on light volume and acts more like a short squeeze
than a breakout. In a short squeeze, the desperate buyers push prices up a little
bit each day. This is what buying the market has become for a lot of investors on
the sidelines who are now suddenly underperforming their benchmark and must
put money to work.
Overall, we must admit that given the market action, it is hard to argue with the
bull case in the short term.
The Bear Case is very lonely and out of favor at the moment, but we believe it
still has merit. It is more secular in nature, and based on the following factors:
1) The 2007-2008 credit crisis and subsequent economic downturn is
fundamentally different from prior post war recessions. It is the result of an
exhaustion of a long-term credit cycle and not simply a normal business cycle
downturn. It is structurally the same phenomenon that precipitated the Great
Depression. This limits the expected benefits of central bank easing.
2) The amount of global wealth that was destroyed has fundamentally
changed the robustness and output potential of the economy, especially
considering that 70% of the world’s largest market (USA) is dependent upon its
consumer.
3) The amount of debt remaining from the pre crisis economy is much too
high for the reduced level of incomes. Global de-leveraging will be a continuing
theme.
4) The banking system is in very weak shape, and not willing to loan
aggressively because their balance sheets are weak and there is also a dearth of
credit worthy borrowers and viable projects.
5) Consumer demand is likely to remain muted compared to prior cycles,
primarily due to the devastating effects of high and rising unemployment
combined with still depressed housing and stock prices. People are saving more.
6) The consumer is structurally weakened in a way that will not repair itself
easily or quickly.
7) The financial industry is overly optimistic about the strength of the
recovery.
8) Sentiment is much too bullish, with the vast majority of market participants
believing that “the bottom” is in and the worst is over.
9) The disconnect between market optimism and the weak consumer/real
economy create an opportunity to wait for lower equity prices. Valuations are
relatively high with stocks trading at close to 20X forward earnings, thus making
the risk reward for shorting the market more compelling. At some point anyway.
What makes the bear case secular is that there are trends at work which are
beyond the scope of the cycle, which are not accounted for by the cycle, such as
the de-leveraging of global balance sheets.
The lynchpin of the bear case is that “this time things are different”; that the
consumer is irreparably damaged; and, output/income/earnings are going to be
disappointing going forward. The government will have to spend much more
money to generate economic activity, and this will make real growth difficult and
come at the expense of the currency and inflation rate.
From our perspective, stock prices are discounting a big recovery. With all of the
money creation by central banks, any serious recovery would come with inflation,
which is not good for stock prices, and if the economy doesn’t snap back
earnings will likely be very disappointing. Either way, we see stock prices having
trouble going forward.
The recent earnings season has been celebrated as companies have beaten
their estimates; however, most companies reported lower top line, and only
bettered the Wall Street earnings estimate because of cost cutting. Cost cutting
is not going to generate enough earnings growth to support this rally much
longer. The question is how much longer, and how much higher.
GOLD
Gold has been one of the best performing assets in the past ten years. We
believe that it will continue to be a top-performing asset. In an environment like
we have today, where central banks are creating massive liquidity, any upside
momentum generated by the global economy is likely to bring inflation, or at least
the fear of it. So, on the upside, we believe that gold will perform well if the
economy rebounds sufficiently to maintain or increase stock prices.
In addition, we believe that the US will need to systematically weaken the dollar
in order to improve the economy, and since gold is denominated in dollars, any
sustained dollar weakness will result in higher gold prices.
On the downside, we believe that any further weakness in the economy will see
other assets fall more than gold; hence, it is the safest store of value on the
downside.
Therefore, we maintain a substantial core position in gold, against which we can
short more or less equity depending on market conditions. We believe that gold
should be at the core of any investment portfolio in the near future.
US DOLLAR
We continue to believe that the dollar is key to any resolution of the deflation v
inflation debate. We continue to believe that in spite of all the “strong dollar”
rhetoric, the true US policy is to systematically weaken the currency, but to do so
in an orderly manner. This makes sense for several key reasons: 1) improved
export competitiveness which translates into JOBS, 2) put the wind behind
consumer/business balance sheets, 3) making it easier for us to repay our
national debt, 4) making our assets more attractive to foreign buyers/investors.
In addition, we believe that President Obama’s pursuit of a populist agenda of
change is extremely negative for the dollar, as government spending soars in the
face of falling revenues, and our nation takes on the feel of a chicken with its
head cut off. There has never been a shift to the left of this nature that did not
result in a sharply lower native currency.
We believe that there is a large amount of capital in the market being allocated
with a strategy of looking through the inflation trough towards the expected peak
that will result from what is perceived to be an inevitable decline in the US Dollar.
These pools of capital are betting that sooner or later the current global reflation
effort will work, and that it is best to get positioned now. While we have been and
continue to be in the deflationist camp, we certainly see the merit of this
approach, and are considering how best to position ourselves. At the moment,
our substantial gold position will provide us some protection if this inflation trade
proves to be the correct approach.
We expect to see a decoupling at some point between the dollar and the growth
trade, as continued declines in the currency eventually diminish the global
appetite for dollar denominated assets. This is a long process that is slowly
unfolding. We wonder about a future world in which the falling dollar moves hand
in hand with a falling equity market and low growth. This would be the stagflation
scenario, and we think it is coming. Again, our position in gold as the “anti dollar”
covers us against this eventuality, which is one of the main reasons we hold a
large gold position as a core in our portfolio.
ASSET ALLOCATION
As we make this final edit the morning of Thursday, July 23rd, here is our asset
allocation:
75% invested, 25% cash in US Dollars
Of the funds invested, the allocation is as follows:
55% Long Gold and related securities
46% Short Equity
Investment Letter June 21, 2009
To Our Friends and Investors,
At Saddle Point Capital Partners, LP, we focus on market trends and very
importantly, on the correlations between asset classes. Trends matter because
that is where one gets the biggest edge against the market. Correlations matter
because they validate one’s fundamental theses about the markets and also
provide clues about important inflection points and shifts in themes.
At this time, we are very watchful of the relationship between the US Dollar and
the global equity markets. The US dollar was strongly negatively correlated to the
stock market during the earlier stages of the financial crisis and economic
downturn because the earlier stages of this crisis were focused on liquidity and
solvency issues. As such, the dollar repatriation/strength was the mirror of equity
weakness (dollar up 20%, stocks down 45% from July 08 to March 09).
This negative correlation maintained through the stock market rally beginning in
March, with the dollar weakening almost 15% while stocks rose almost 40%.
We believe the US Dollar is in a major bear market primarily because on the
margin, we are creating dollars and debt (relative to income) at a much faster
rate than any other country in the world. We also believe that there may be
political reasons as to why capital does not feel as welcome in the United States
currently as it has historically.
We also believe that it will be a shadow policy of our administration to weaken
the dollar as much and as fast as possible in an orderly manner - a falling
currency will sooner or later put a wind at the back of asset prices at the expense
of creditors. This is essentially the process that people are referencing when they
talk about “inflating away the debt”. We should also remember our history, and
the fact that FDR didn’t get the economy moving after the Depression until he
devalued the dollar by 40% in late1933. While devaluation would not seem to be
an option for the US, conceptually, such a devaluation (40%) would overnight go
a long way to solving our consumer and bank balance sheet problems.
Therefore, we believe it is likely that the dollar will be devalued systematically
over time to achieve some of the equivalent balance sheet and asset benefits
that would be associated with one time devaluation.
That stated; what we are watching for is a change in the recent negatively
correlated relationship between the dollar and the equity market, because this
will signal a likely new period of decoupling between hard assets and financial assets. We believe that this is going to happen, and once the dollar begins to
decline in concert with a declining equity market, there will be an environment in
which commodities and other hard assets outperform financial assets.
The Equity Market
We want to be bullish, but since the tendency is to underestimate how long
things take to play out, and because our work leaves us tepid at best about the
economy and markets, our concern is that we are early, possibly way early, in
the bottoming process. As such, we are becoming increasingly bearish as equity
prices rise in the face of a sluggish real economy and still battered consumer
sector. Note the DOW:GOLD ratio below which has increased with the market
rally since March from slightly under 7 to a mid 9 handle. It is interesting to note
that this ratio has widened about 37%, which is equivalent to the move in the
equity market.
At the last two major market and asset bottoms (after 1929 and 1980-81), this
ratio was well under 5, and close to 1:1, and we expect that before this cycle is fully played out, that the ratio will return to those levels that mark generational
bottoms for equity prices.
At present, people observe what seems to be a “disconnect” between the real
economy and the markets. We believe the real economy has it right and it’s only
a question of time. We still think it is a bear market rally, not a bottom.
A couple of key data points from late last week:
a) Last week there was a sharp drop in mortgage applications. With
income down, credit tighter and interest rates not going down, we don’t believe
that there is much help coming from the housing sector. Maybe the Fed can keep
rates down, maybe they can’t. More on that later. Anyway, so far interest rates
have been trending up and mortgage applications are down. And any recovery
without a strong real estate market seems unlikely given the structure of
consumer balance sheets and our dependence on consumer spending.
b) In addition, Federal Express reported very disappointing earnings and
guidance last week. This is not a good sign. This is a red flag if ever we saw one.
FDX is a leading transportation company, and we believe that their results are a
foreshadow of an economy that is doing much less recovering than the “green
shoots” crowd is discounting into equity valuations.
We still believe the “inflationists” are a bit ahead of themselves; that powerful
deflationary forces are at work; that income and velocity are way down; and, that
the financial markets are overly optimistic about both the real economy and
corporate earnings.
Examining some key considerations, we make the following observations:
a) the major stock indexes have rallied 40% off the March lows
b) the major indexes have reached their 200 day moving average
c) sentiment has been squarely balanced, the market is for sure long again
now,
d) valuations are very high historically,
e) there is a large disconnect between the market and the real economy.
f) the primary trend is down
In conclusion, we see the slowing of deterioration in the economy akin to a
sharply declining line hitting bottom and then bouncing modestly before drifting
gently sideways in a flatline, without any significant upslope. The market has
priced in a much more robust bounce, and only time will tell if this has been a
sucker rally like the one that followed the market decline in 1929, or if this is
really the generational buying opportunity that many hope it is.
ASSET ALLOCATION:
For a fund that is positioned to give investors with correlated net worth a chance
to earn a positive non-correlated return, this is where we have to step up to the
plate a little bit. We currently have 50% of the fund assets in short directional
positions in the US equity market.
As we make this final edit the evening of Sunday, June 21, here is our asset
allocation:
50% short US equity
10% long “commodity currencies” -- Australian and Canadian $
15% long gold and silver and the GDX (Blue Chip Gold/Silver Mining Index)
2% short US Treasury bonds via long TBT (double short bond ETF)
1% long options on USO (crude oil proxy ETF)
32% in highly liquid US $ money market funds
Regarding our currency and gold positions (we consider gold basically to be the
ultimate non dollar correlated currency), at the present moment, we believe these
positions to be correlated with the equity market and inflation trade in the near
term, and if we believe the equity market is going to decline, and therefore the
dollar will rally in the short term, then we would have risk associated with gold
and commodity currencies because these commodity prices would tend to fall
with a rising dollar. Thus we have a relatively lower allocation to these assets at
the moment. In addition, we are very wary of these commodity markets, such as
oil and copper, that are currently so long and vulnerable. A little dollar rally and
these markets could have a mini crash.
At Saddle Point Capital Partners, LP, we focus on market trends and very
importantly, on the correlations between asset classes. Trends matter because
that is where one gets the biggest edge against the market. Correlations matter
because they validate one’s fundamental theses about the markets and also
provide clues about important inflection points and shifts in themes.
At this time, we are very watchful of the relationship between the US Dollar and
the global equity markets. The US dollar was strongly negatively correlated to the
stock market during the earlier stages of the financial crisis and economic
downturn because the earlier stages of this crisis were focused on liquidity and
solvency issues. As such, the dollar repatriation/strength was the mirror of equity
weakness (dollar up 20%, stocks down 45% from July 08 to March 09).
This negative correlation maintained through the stock market rally beginning in
March, with the dollar weakening almost 15% while stocks rose almost 40%.
We believe the US Dollar is in a major bear market primarily because on the
margin, we are creating dollars and debt (relative to income) at a much faster
rate than any other country in the world. We also believe that there may be
political reasons as to why capital does not feel as welcome in the United States
currently as it has historically.
We also believe that it will be a shadow policy of our administration to weaken
the dollar as much and as fast as possible in an orderly manner - a falling
currency will sooner or later put a wind at the back of asset prices at the expense
of creditors. This is essentially the process that people are referencing when they
talk about “inflating away the debt”. We should also remember our history, and
the fact that FDR didn’t get the economy moving after the Depression until he
devalued the dollar by 40% in late1933. While devaluation would not seem to be
an option for the US, conceptually, such a devaluation (40%) would overnight go
a long way to solving our consumer and bank balance sheet problems.
Therefore, we believe it is likely that the dollar will be devalued systematically
over time to achieve some of the equivalent balance sheet and asset benefits
that would be associated with one time devaluation.
That stated; what we are watching for is a change in the recent negatively
correlated relationship between the dollar and the equity market, because this
will signal a likely new period of decoupling between hard assets and financial assets. We believe that this is going to happen, and once the dollar begins to
decline in concert with a declining equity market, there will be an environment in
which commodities and other hard assets outperform financial assets.
The Equity Market
We want to be bullish, but since the tendency is to underestimate how long
things take to play out, and because our work leaves us tepid at best about the
economy and markets, our concern is that we are early, possibly way early, in
the bottoming process. As such, we are becoming increasingly bearish as equity
prices rise in the face of a sluggish real economy and still battered consumer
sector. Note the DOW:GOLD ratio below which has increased with the market
rally since March from slightly under 7 to a mid 9 handle. It is interesting to note
that this ratio has widened about 37%, which is equivalent to the move in the
equity market.
At the last two major market and asset bottoms (after 1929 and 1980-81), this
ratio was well under 5, and close to 1:1, and we expect that before this cycle is fully played out, that the ratio will return to those levels that mark generational
bottoms for equity prices.
At present, people observe what seems to be a “disconnect” between the real
economy and the markets. We believe the real economy has it right and it’s only
a question of time. We still think it is a bear market rally, not a bottom.
A couple of key data points from late last week:
a) Last week there was a sharp drop in mortgage applications. With
income down, credit tighter and interest rates not going down, we don’t believe
that there is much help coming from the housing sector. Maybe the Fed can keep
rates down, maybe they can’t. More on that later. Anyway, so far interest rates
have been trending up and mortgage applications are down. And any recovery
without a strong real estate market seems unlikely given the structure of
consumer balance sheets and our dependence on consumer spending.
b) In addition, Federal Express reported very disappointing earnings and
guidance last week. This is not a good sign. This is a red flag if ever we saw one.
FDX is a leading transportation company, and we believe that their results are a
foreshadow of an economy that is doing much less recovering than the “green
shoots” crowd is discounting into equity valuations.
We still believe the “inflationists” are a bit ahead of themselves; that powerful
deflationary forces are at work; that income and velocity are way down; and, that
the financial markets are overly optimistic about both the real economy and
corporate earnings.
Examining some key considerations, we make the following observations:
a) the major stock indexes have rallied 40% off the March lows
b) the major indexes have reached their 200 day moving average
c) sentiment has been squarely balanced, the market is for sure long again
now,
d) valuations are very high historically,
e) there is a large disconnect between the market and the real economy.
f) the primary trend is down
In conclusion, we see the slowing of deterioration in the economy akin to a
sharply declining line hitting bottom and then bouncing modestly before drifting
gently sideways in a flatline, without any significant upslope. The market has
priced in a much more robust bounce, and only time will tell if this has been a
sucker rally like the one that followed the market decline in 1929, or if this is
really the generational buying opportunity that many hope it is.
ASSET ALLOCATION:
For a fund that is positioned to give investors with correlated net worth a chance
to earn a positive non-correlated return, this is where we have to step up to the
plate a little bit. We currently have 50% of the fund assets in short directional
positions in the US equity market.
As we make this final edit the evening of Sunday, June 21, here is our asset
allocation:
50% short US equity
10% long “commodity currencies” -- Australian and Canadian $
15% long gold and silver and the GDX (Blue Chip Gold/Silver Mining Index)
2% short US Treasury bonds via long TBT (double short bond ETF)
1% long options on USO (crude oil proxy ETF)
32% in highly liquid US $ money market funds
Regarding our currency and gold positions (we consider gold basically to be the
ultimate non dollar correlated currency), at the present moment, we believe these
positions to be correlated with the equity market and inflation trade in the near
term, and if we believe the equity market is going to decline, and therefore the
dollar will rally in the short term, then we would have risk associated with gold
and commodity currencies because these commodity prices would tend to fall
with a rising dollar. Thus we have a relatively lower allocation to these assets at
the moment. In addition, we are very wary of these commodity markets, such as
oil and copper, that are currently so long and vulnerable. A little dollar rally and
these markets could have a mini crash.
Investment Letter June 3, 2009
To Our Friends and Investors,
This is an update from Saddle Point Capital Partners, LP.
We acted on our comment mentioned at the end of the May update (see “SPCP I
Update 5-12-2009”), and invested 40% of the fund’s assets in a combination of
mostly Canadian and some Australian dollars. We also added a little bit to our
GLD and GDX positions. Shorted equity modestly -- little worried about the
market going higher. Covered a good portion of our equity shorts on June 1st.
Everybody wants to know about the stock market because it’s seen as the
barometer of how things are. At the moment the bulls clearly have the upper
hand. As we wrote last month, “currently the markets and growth trade is
enjoying a nice cyclical bull market within a larger secular bear trend”, and overall
nothing has changed that view, except that the market rally seems to be
extending itself. As the Saddle Point “way” is one of skepticism, we would state
that all is not as well as it appears for the bulls; however, we have enough
respect for them that we have fairly modest equity short holdings, compared to
our holdings of gold (20+ %) and Canadian / Australian dollars.
Notwithstanding that the market may ride the liquidity train to new highs, in
general, we believe that the market is seriously overoptimistic about things; that
“green shoots” are more a phenomenon of spin and hype than real resurgence;
that the consumer is irreparably damaged; and, that the market is very vulnerable
to numerous unintended consequences of the very policies that have floated this
latest mini bubble. For example, we’ve seen that Treasury bond yields have
started to rise sharply and that the dollar is declining sharply at the same time -
this is not a good combination if you think in terms of getting people to buy our
Treasury Debt. We believe that these are powerful trends (rising rates and
depreciating dollar) and that they will stress the system in unforeseen ways.
To keep the recent equity market activity in perspective, see the two charts
below. The top chart depicts inflation-adjusted earnings for the S&P 500; the
bottom chart represents the P/E multiple that is applied to the earnings to arrive
at the S&P 500 value. These two charts illustrate how market optimism has
driven up equity market valuations in the face of falling earnings. In the event
that “green shoots” do not manifest in a sharp rebound in economic activity and
earnings, one can only conclude the market is very vulnerable. Technically there are a couple of major red flags: volatility is still extremely high
by historic standards and characteristic of an early phase bear market rally. The
volatility comes from the fact that the primary trend is really down, but the public
doesn’t believe it and, as a result, when the market starts to rally it brings out
residual bullish behavior (ie. appetite for risk) and the market regains that “old
time” feel in spurts. Unfortunately, it is swimming an upstream battle against an
overleveraged global capital structure and equity prices are not likely to win. If
one studies the sentiment of past market bottoms, there is very low volatility and
nothing of this residual bullishness left when the real bottom comes along
because at the real bottom, everybody has been demoralized and nobody is
interested in stocks (opposite of a mania). Ironically, it is that very lack of interest
that creates the values from which a bull market can take root.
Another red flag for the market is the fact that volume has been much lighter on
the rally than it was during the decline. So, while the market feels and acts great,
and we are sad to be missing out, we are still pretty bearish and expect that the
market will make new lows, and would not be shocked to see this happen by the
end of the year. We believe that the next couple of weeks will be important as
the market is very volatile and stuck in a trading range (8200-8500 on the Dow
Jones) where a break either way would probably cause a pretty good move in the
market. Keep in mind that a breakout either way (to the upside or downside)
without follow-through (a.k.a. a “false” break) would also be a significant data
point.
In addition, there are some very interesting divergences in the markets, which
may be indicative of some future trends/themes. A good information source of
ours, floated the idea that there is an ongoing early-stage bifurcation occurring
between asset classes, with those that are oversupplied and typically
overleveraged (like commercial real estate) plunging (we recently took a short
position in IYR a real estate ETF), and those that are not leveraged and not
oversupplied, like oil and wheat...oh, and gold...going up. This concept is
supported by the charts of major global markets, and it could be explained by the
fact that even though there is not enough money yet created relative to what was
destroyed to cause leveraged assets to rise, people are still willing to make
advance bets against the future point at which enough, and then naturally... too
much, money would be created. So, people flee the dollar for inflation hedges as
they watch the USA shift hard left with an associated monetary/fiscal package
sure to damn the native currency...In the meantime, cash starved over-levered
real estate and corporate and personal assets will continue to deflate for the
foreseeable future. And of course, rising interest rates won’t help either. Many
talk of deflation, but most talk about the coming inflation and that is more or less
a foregone conclusion. It is as if deflation doesn’t have a chance, and in the
“black swan” school, this is interesting in and of itself.
As of this writing, we are looking to add to our dollar short exposure, either
through continued purchasing of select foreign currencies, and/or gold related
assets. In addition, we remain watchful of the bond market and continue to see
the short side in Treasury bonds as one of great opportunity. We will watch the
market the next few weeks to see if we will be standing pat or shorting more, or
possibly covering to minimize potential future losses, and we will be watching the bifurcation theme to identify outperforming sectors such as commodities and selected currencies.
This is an update from Saddle Point Capital Partners, LP.
We acted on our comment mentioned at the end of the May update (see “SPCP I
Update 5-12-2009”), and invested 40% of the fund’s assets in a combination of
mostly Canadian and some Australian dollars. We also added a little bit to our
GLD and GDX positions. Shorted equity modestly -- little worried about the
market going higher. Covered a good portion of our equity shorts on June 1st.
Everybody wants to know about the stock market because it’s seen as the
barometer of how things are. At the moment the bulls clearly have the upper
hand. As we wrote last month, “currently the markets and growth trade is
enjoying a nice cyclical bull market within a larger secular bear trend”, and overall
nothing has changed that view, except that the market rally seems to be
extending itself. As the Saddle Point “way” is one of skepticism, we would state
that all is not as well as it appears for the bulls; however, we have enough
respect for them that we have fairly modest equity short holdings, compared to
our holdings of gold (20+ %) and Canadian / Australian dollars.
Notwithstanding that the market may ride the liquidity train to new highs, in
general, we believe that the market is seriously overoptimistic about things; that
“green shoots” are more a phenomenon of spin and hype than real resurgence;
that the consumer is irreparably damaged; and, that the market is very vulnerable
to numerous unintended consequences of the very policies that have floated this
latest mini bubble. For example, we’ve seen that Treasury bond yields have
started to rise sharply and that the dollar is declining sharply at the same time -
this is not a good combination if you think in terms of getting people to buy our
Treasury Debt. We believe that these are powerful trends (rising rates and
depreciating dollar) and that they will stress the system in unforeseen ways.
To keep the recent equity market activity in perspective, see the two charts
below. The top chart depicts inflation-adjusted earnings for the S&P 500; the
bottom chart represents the P/E multiple that is applied to the earnings to arrive
at the S&P 500 value. These two charts illustrate how market optimism has
driven up equity market valuations in the face of falling earnings. In the event
that “green shoots” do not manifest in a sharp rebound in economic activity and
earnings, one can only conclude the market is very vulnerable. Technically there are a couple of major red flags: volatility is still extremely high
by historic standards and characteristic of an early phase bear market rally. The
volatility comes from the fact that the primary trend is really down, but the public
doesn’t believe it and, as a result, when the market starts to rally it brings out
residual bullish behavior (ie. appetite for risk) and the market regains that “old
time” feel in spurts. Unfortunately, it is swimming an upstream battle against an
overleveraged global capital structure and equity prices are not likely to win. If
one studies the sentiment of past market bottoms, there is very low volatility and
nothing of this residual bullishness left when the real bottom comes along
because at the real bottom, everybody has been demoralized and nobody is
interested in stocks (opposite of a mania). Ironically, it is that very lack of interest
that creates the values from which a bull market can take root.
Another red flag for the market is the fact that volume has been much lighter on
the rally than it was during the decline. So, while the market feels and acts great,
and we are sad to be missing out, we are still pretty bearish and expect that the
market will make new lows, and would not be shocked to see this happen by the
end of the year. We believe that the next couple of weeks will be important as
the market is very volatile and stuck in a trading range (8200-8500 on the Dow
Jones) where a break either way would probably cause a pretty good move in the
market. Keep in mind that a breakout either way (to the upside or downside)
without follow-through (a.k.a. a “false” break) would also be a significant data
point.
In addition, there are some very interesting divergences in the markets, which
may be indicative of some future trends/themes. A good information source of
ours, floated the idea that there is an ongoing early-stage bifurcation occurring
between asset classes, with those that are oversupplied and typically
overleveraged (like commercial real estate) plunging (we recently took a short
position in IYR a real estate ETF), and those that are not leveraged and not
oversupplied, like oil and wheat...oh, and gold...going up. This concept is
supported by the charts of major global markets, and it could be explained by the
fact that even though there is not enough money yet created relative to what was
destroyed to cause leveraged assets to rise, people are still willing to make
advance bets against the future point at which enough, and then naturally... too
much, money would be created. So, people flee the dollar for inflation hedges as
they watch the USA shift hard left with an associated monetary/fiscal package
sure to damn the native currency...In the meantime, cash starved over-levered
real estate and corporate and personal assets will continue to deflate for the
foreseeable future. And of course, rising interest rates won’t help either. Many
talk of deflation, but most talk about the coming inflation and that is more or less
a foregone conclusion. It is as if deflation doesn’t have a chance, and in the
“black swan” school, this is interesting in and of itself.
As of this writing, we are looking to add to our dollar short exposure, either
through continued purchasing of select foreign currencies, and/or gold related
assets. In addition, we remain watchful of the bond market and continue to see
the short side in Treasury bonds as one of great opportunity. We will watch the
market the next few weeks to see if we will be standing pat or shorting more, or
possibly covering to minimize potential future losses, and we will be watching the bifurcation theme to identify outperforming sectors such as commodities and selected currencies.
Investment Letter: November 6, 2009
Inflation v Deflation – The Binary Dilemma
In our last investor letter, we made the observations, some of which are
reiterated below for further discussion:
1) Considering the amount of money that the government has provided it is
remarkable how little benefit the real economy has experienced, in terms
of income or employment, financial market rallies notwithstanding.
2) The basic bull/bear debate is now focused on whether the financial market
rallies are forecasting a better economy or are simply a liquidity bubble
fostered by an extremely low interest rate environment. We suspect that it
is more the latter than the former, and we are structuring our portfolio
accordingly.
3) We suspect that there is some kind of tail event lurking, and that the
markets have become complacent and are vulnerable to any kind of tail
event shock.
4) We believe that there are going to be some paradigm and correlation
shifts in the near future, and that these will mainly be focused around the
dollar, as the continued bear market in the greenback begins to bleed over
into equity and fixed income markets in addition to the commodity markets
(where it is already being felt as investors worldwide seek to diversify out
of dollars into other assets like gold, copper and crude oil).
Regarding the correlation shifts, it is noteworthy that in the past week we have
had some brief bouts of equity market declines in which gold actually firmed up
and rallied. This is a harbinger of our future.
The market as defined by the Dow Industrials has not quite hit our 50%
retracement target of 10330, having put in a high so far of 10,119. We will note
that our experience is that the markets usually don’t reach the targets when you
are right and when you are wrong they blow right through them, but that said, the
fact remains that we appear to be in a dynamic binary situation in the global
macro market environment.
The binary options we face are basically inflationary growth vs deflationary
contraction. At this stage the equity market is the battleground since it is the
floppy tail of still overleveraged global balance sheets. It is critical to note that the
hyperinflation scenario while almost inconceivable becomes more possible as a
chapter following a deflationary contraction due to the inevitable response of the
current US political leadership.
Saddle Point Capital Partners, LP
9601 Wilshire Boulevard, Suite 736, Beverly Hills, CA 90210
The Dow is a good benchmark (or the SP 500) and right now, this market is
consolidating and will likely break out to the upside or reverse and test the
downside. The likelihood of going sideways for an extended period at these
levels is fairly remote. We believe that a recent pick up in volatility is a harbinger
of even more volatility; increasing volatility is not healthy for markets as we have
discussed before. We believe that this period since the March lows will
historically be viewed as the eye of the hurricane, where there was a calm that
engendered a false sense of security.
It is really impossible to know what will happen because it is impossible to predict
money velocity, however, the two alternatives and scenarios seem fairly clear: a)
the asset markets continue to rally off of the central bank accommodation and
this will eventually lead to higher growth and higher inflation, or b) the asset
markets will roll over and do so sharply because they are complacently bullish
and very long, and this rolling over will lead inevitably to more desperate
government attempts to revive it, which will increase the chances of even higher
(ie. hyper) inflation.
What is knowable is that given the level of money creation, and the fact that any
weakness in the economy and/or markets is going to be met by more money
creation, we do know that equity prices must decline relative to the price of gold
and hard assets.
Our portfolio is structured to benefit from a decline in the price of equity relative
to gold, and we believe this narrowing will occur regardless of whether we have
an inflationary or deflationary resolution to the current situation. We are also
structured to benefit from increased volatility, whether it comes from an up equity
market or a down equity market.
Our opinion is that it is hard to keep focused on the big picture but we are
reminded of the old French saying: “Plus c’est change, plus c’est meme chose”...
which translates into “ the more things change the more they stay the same.”
This seems like a modern version of the early 1930’s and the resolution is not
going to be tame. We believe it is still possible that this rally since March will
prove to be just a great bear market rally, just like what followed the stock market
crash of 1929.
We discussed “tail events” last month, and so in keeping with that theme we will
postulate that the market is absurdly complacent and that the resolution will find
itself in the tail of expectations rather than in the belly of the curve. What does
this mean, obviously it is impossible to know, but expect the unexpected. That is
how our portfolio is structured, to expect the unexpected. We think there is a
chance the market is set up for a vicious downside reversal that will take it much
lower than imaginable as the financial world sits complacently in the eye of the
hurricane, but at the same time, if we are wrong and the resolution is to the
Saddle Point Capital Partners, LP
upside it will come with much higher inflation, possibly hyperinflation, sharply
higher interest rates and a set of problems not seen since the late 1970’s.
Building on our initial small position from last month we have added to our short
in US government bonds, as we believe over the next four to six months there
will be upward pressure on the long end of the global yield curve, especially with
regards to 30 year US Treasuries. This pressure will be greatest if the resolution
of things is to the upside, due to inflation expectations rising, however, even if the
economy doesn’t take off as the bulls hope, there will still be upward pressure on
rates as the US issues more and more bonds with the Fed running out of money
designated to support this market. If the markets resolve strongly to the
downside, this would likely create conditions for a final attempted bond market
rally, and so our short bond position is in the form of put options that allow us to
quantify our risk as a small fraction of our potential upside.
In a world where we anticipate increased volatility and potential binary outcomes,
we have structure our portfolio accordingly.
In our last investor letter, we made the observations, some of which are
reiterated below for further discussion:
1) Considering the amount of money that the government has provided it is
remarkable how little benefit the real economy has experienced, in terms
of income or employment, financial market rallies notwithstanding.
2) The basic bull/bear debate is now focused on whether the financial market
rallies are forecasting a better economy or are simply a liquidity bubble
fostered by an extremely low interest rate environment. We suspect that it
is more the latter than the former, and we are structuring our portfolio
accordingly.
3) We suspect that there is some kind of tail event lurking, and that the
markets have become complacent and are vulnerable to any kind of tail
event shock.
4) We believe that there are going to be some paradigm and correlation
shifts in the near future, and that these will mainly be focused around the
dollar, as the continued bear market in the greenback begins to bleed over
into equity and fixed income markets in addition to the commodity markets
(where it is already being felt as investors worldwide seek to diversify out
of dollars into other assets like gold, copper and crude oil).
Regarding the correlation shifts, it is noteworthy that in the past week we have
had some brief bouts of equity market declines in which gold actually firmed up
and rallied. This is a harbinger of our future.
The market as defined by the Dow Industrials has not quite hit our 50%
retracement target of 10330, having put in a high so far of 10,119. We will note
that our experience is that the markets usually don’t reach the targets when you
are right and when you are wrong they blow right through them, but that said, the
fact remains that we appear to be in a dynamic binary situation in the global
macro market environment.
The binary options we face are basically inflationary growth vs deflationary
contraction. At this stage the equity market is the battleground since it is the
floppy tail of still overleveraged global balance sheets. It is critical to note that the
hyperinflation scenario while almost inconceivable becomes more possible as a
chapter following a deflationary contraction due to the inevitable response of the
current US political leadership.
Saddle Point Capital Partners, LP
9601 Wilshire Boulevard, Suite 736, Beverly Hills, CA 90210
The Dow is a good benchmark (or the SP 500) and right now, this market is
consolidating and will likely break out to the upside or reverse and test the
downside. The likelihood of going sideways for an extended period at these
levels is fairly remote. We believe that a recent pick up in volatility is a harbinger
of even more volatility; increasing volatility is not healthy for markets as we have
discussed before. We believe that this period since the March lows will
historically be viewed as the eye of the hurricane, where there was a calm that
engendered a false sense of security.
It is really impossible to know what will happen because it is impossible to predict
money velocity, however, the two alternatives and scenarios seem fairly clear: a)
the asset markets continue to rally off of the central bank accommodation and
this will eventually lead to higher growth and higher inflation, or b) the asset
markets will roll over and do so sharply because they are complacently bullish
and very long, and this rolling over will lead inevitably to more desperate
government attempts to revive it, which will increase the chances of even higher
(ie. hyper) inflation.
What is knowable is that given the level of money creation, and the fact that any
weakness in the economy and/or markets is going to be met by more money
creation, we do know that equity prices must decline relative to the price of gold
and hard assets.
Our portfolio is structured to benefit from a decline in the price of equity relative
to gold, and we believe this narrowing will occur regardless of whether we have
an inflationary or deflationary resolution to the current situation. We are also
structured to benefit from increased volatility, whether it comes from an up equity
market or a down equity market.
Our opinion is that it is hard to keep focused on the big picture but we are
reminded of the old French saying: “Plus c’est change, plus c’est meme chose”...
which translates into “ the more things change the more they stay the same.”
This seems like a modern version of the early 1930’s and the resolution is not
going to be tame. We believe it is still possible that this rally since March will
prove to be just a great bear market rally, just like what followed the stock market
crash of 1929.
We discussed “tail events” last month, and so in keeping with that theme we will
postulate that the market is absurdly complacent and that the resolution will find
itself in the tail of expectations rather than in the belly of the curve. What does
this mean, obviously it is impossible to know, but expect the unexpected. That is
how our portfolio is structured, to expect the unexpected. We think there is a
chance the market is set up for a vicious downside reversal that will take it much
lower than imaginable as the financial world sits complacently in the eye of the
hurricane, but at the same time, if we are wrong and the resolution is to the
Saddle Point Capital Partners, LP
upside it will come with much higher inflation, possibly hyperinflation, sharply
higher interest rates and a set of problems not seen since the late 1970’s.
Building on our initial small position from last month we have added to our short
in US government bonds, as we believe over the next four to six months there
will be upward pressure on the long end of the global yield curve, especially with
regards to 30 year US Treasuries. This pressure will be greatest if the resolution
of things is to the upside, due to inflation expectations rising, however, even if the
economy doesn’t take off as the bulls hope, there will still be upward pressure on
rates as the US issues more and more bonds with the Fed running out of money
designated to support this market. If the markets resolve strongly to the
downside, this would likely create conditions for a final attempted bond market
rally, and so our short bond position is in the form of put options that allow us to
quantify our risk as a small fraction of our potential upside.
In a world where we anticipate increased volatility and potential binary outcomes,
we have structure our portfolio accordingly.
Investment Letter May 10, 2009
This is a monthly update from Saddle Point Capital Partners, LP.
Currently the markets and growth trade is enjoying a nice cyclical bull market within a
larger secular bear trend. The current growth rally is clearly confirmed by the majority of
the key markets that we watch. The Canadian $, Euro, Crude Oil, Copper, Precious
Metals and the critical growth barometer, Global Equity, are all trading near multi month
highs, while the deflation beneficiaries are all trading near multi month lows: Treasury
Bonds, the US Dollar and to a lesser extent the Japanese Yen.
Some key points:
1) We do not believe this is a new bull market; we think it is a countertrend rally in
a primary bear market.
2) The rally could go further, but is likely closer to the end than the beginning.
3) Sharp rallies of this character in bear markets are common and are the rule rather
than the exception. Note the extent of the bear market rallies below:
4) What is much more unlikely is that a bear of this scope would be over after such a
short duration. Note the table below which shows the duration from peak to
trough of the primary bear markets in the Dow Jones from 1885 to 2008. Since
this table was created, the bear that commenced Oct 07 reached a new low at
about the 75 week mark, in early March, before this current rally started.
5) The sentiment and valuations have been all wrong for a bottom. There has never
been an ultimate market bottom when you have so much optimism and constant
attempts to make every new low into “the bottom”, volatility is way too high
historically, and multiples are too high. Prior bear market bottoms have been
characterized by a loss of interest in equity and very low multiples, well under 10.
Currently the market is trading at about 14x 2009 earnings.
Regarding credit spreads tightening, the fact is that the central banks are on both sides of
the trade helping tighten, by providing low cost funding and then essentially becoming
the guarantor of all counter parties. So it really makes sense that inter bank spreads would
be tight, the real issue is what is going to happen to the US Dollar, Treasury market and
interest rates as a result of this massive liquidity support.
We believe that the government is going to find it increasingly difficult to issue volumes
of Treasury Notes to pay for all of the deficit spending, and that this is going to have
negative consequences for the markets.
At this time, we have established a position in Gold and a smaller position in the GDX
diversified major gold/silver producers index. We are looking to establish short positions
in the equity market through put option positions on indexes or selected names with
expirations later in the year or early next year, and we are waiting for opportunities to
short the 30 year US Treasury Bond.
We are holding a substantial position in Money Market funds, but are looking at
diversifying into some of the raw material producing currencies, such as the Canadian $,
Australian $ and Brazilian Real.
Please feel free to contact Mike Terner or myself with any questions you may have, or for
a more detailed explanation of the topics discussed in this communication.
Currently the markets and growth trade is enjoying a nice cyclical bull market within a
larger secular bear trend. The current growth rally is clearly confirmed by the majority of
the key markets that we watch. The Canadian $, Euro, Crude Oil, Copper, Precious
Metals and the critical growth barometer, Global Equity, are all trading near multi month
highs, while the deflation beneficiaries are all trading near multi month lows: Treasury
Bonds, the US Dollar and to a lesser extent the Japanese Yen.
Some key points:
1) We do not believe this is a new bull market; we think it is a countertrend rally in
a primary bear market.
2) The rally could go further, but is likely closer to the end than the beginning.
3) Sharp rallies of this character in bear markets are common and are the rule rather
than the exception. Note the extent of the bear market rallies below:
4) What is much more unlikely is that a bear of this scope would be over after such a
short duration. Note the table below which shows the duration from peak to
trough of the primary bear markets in the Dow Jones from 1885 to 2008. Since
this table was created, the bear that commenced Oct 07 reached a new low at
about the 75 week mark, in early March, before this current rally started.
5) The sentiment and valuations have been all wrong for a bottom. There has never
been an ultimate market bottom when you have so much optimism and constant
attempts to make every new low into “the bottom”, volatility is way too high
historically, and multiples are too high. Prior bear market bottoms have been
characterized by a loss of interest in equity and very low multiples, well under 10.
Currently the market is trading at about 14x 2009 earnings.
Regarding credit spreads tightening, the fact is that the central banks are on both sides of
the trade helping tighten, by providing low cost funding and then essentially becoming
the guarantor of all counter parties. So it really makes sense that inter bank spreads would
be tight, the real issue is what is going to happen to the US Dollar, Treasury market and
interest rates as a result of this massive liquidity support.
We believe that the government is going to find it increasingly difficult to issue volumes
of Treasury Notes to pay for all of the deficit spending, and that this is going to have
negative consequences for the markets.
At this time, we have established a position in Gold and a smaller position in the GDX
diversified major gold/silver producers index. We are looking to establish short positions
in the equity market through put option positions on indexes or selected names with
expirations later in the year or early next year, and we are waiting for opportunities to
short the 30 year US Treasury Bond.
We are holding a substantial position in Money Market funds, but are looking at
diversifying into some of the raw material producing currencies, such as the Canadian $,
Australian $ and Brazilian Real.
Please feel free to contact Mike Terner or myself with any questions you may have, or for
a more detailed explanation of the topics discussed in this communication.
Subscribe to:
Posts (Atom)
