This Trade Works Like Clockwork

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The past few weeks we’ve been enjoying the sights and sounds of Colombia with our Seraph group, a country which has gradually been dragging itself out of a nightmarish civil war, constantly overshadowed and closely tied to drug cartel wars which pepper it’s history. Much of that seems a distant memory now and the rise of a middle class, the flip side of which is a fairly rapidly falling unemployment numbers and poverty levels, is evident all around. Colombia has benefited in the last decade from strong commodity prices and on the face of it is doing well.

In the short term I think there comes some serious dislocations in the market for a host of reasons which we discussed in earnest late into the nights. I like a bit of chaos as prices typically move accordingly and in emerging markets like Colombia they tend to move more violently than elsewhere. This is due to relative illiquidity amongst other things.

I’ll have more on this next week but due to what the broader markets, especially those in the US, are delivering us right now I felt it better to provide some thoughts from our colleague Mark Schumacher.

Enjoy!

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This past week the Dow Jones industrial average fell almost 900 points or 5.1% from 17,352 to 16,460. The index is now 10.1% below its 18,312 peak reached on 5/19/15 crossing the 10% mark which defines a technical correction.  For all of 2015 it is down 7.7% while our portfolios are still up this year. I’ll provide a thorough summary at the end of Q3.

The catalyst for the recent correction is renewed global growth fears which are centered on concerns about China having a hard landing as it attempts to become less dependent on exports by growing its service economy. The market is interpreting (correctly in my opinion) the recent nearly 2% devaluation of the yuan as evidence that China’s problems are worse than previously thought… why else would they need to make such a move on top of all the financial stimulus they have been pumping into their system. If trouble is indeed brewing in the 2nd largest economy and #1 exporter ($2.25T vs. 1.61T for the US), than there will be ripple effects across the globe.

There is no guarantee that US stocks prices will suffer a great deal especially for domestically oriented companies, plus some US businesses will benefit from a weaker China. However in case trouble spreads or the negative momentum simply feeds on itself for a while I purchased portfolio insurance in the form of three ETFs that will appreciate during a US stock market sell off.

Insurance: How Much and Which Products

I did not purchase enough insurance to cover our entire portfolio of investments as that would be overkill and too expensive. The products we own cover 26% – 30% of our entire portfolio including assets with limited risk. I am considering increasing it to cover up to 35% depending on how events develop but currently don’t see a need to go higher than that.  Should another step be necessary for greater safety, I would simply sell some shares and hold the cash for a while, but I much prefer sitting tight as our holdings offer very good value especially at today’s prices. I expect the businesses we own to flourish for years because they are either leaders in their respective fields while benefiting from strong trends, or they are super cheap turnaround candidates that we are generating income from. We are best served by sitting tight with these investments while having some insurance rather than exiting now then trying to time when to get back in again.

Gold may appreciate during a stock market sell off but it does not always work that way, therefore I do not think of gold as portfolio insurance.

The three ETFs we purchased were:

1. SDS – moves inversely 2-1 vs. the S&P 500 index which is a basket of 500 very large US stocks spanning many industries.
2. QID – moves inversely 2-1 vs. the NASDAQ 100 which is a basket of large US technology stocks. This nicely correlates with some of our technology holdings.
3. BIS – moves inversely 2-1 vs. the NASDAQ biotechnology and pharmaceutical index which has had a crazy run up.

FYI, because these are -2x products we can cover 30% of our portfolio by investing just 15% of our assets in these ETFs. These inverse products experience some daily rebalancing decay so they are not buy and hold investments. You don’t sit on them for years. Several months is more typical, and I only plan to hold them for as long as the current market weakness continues.

Historical Chart: Corrections and Recoveries

The two biggest things I take away from observing the 20-year stock market chart below (which is on a log scale) are:

  • Corrections happen quickly while recoveries happen more gradually but last longer. This is where the saying “stock investors ride escalators up but take the elevator down” comes from. The majority of the time you will be on the escalator. Right now we are in the elevator.
  • The stock market rarely moves sideways. It is nearly always either trending up or trending down. I believe this is purely due to investor psychology rather than fundamentals such as GDP and business profits which fairly often trend sideways. Best not to ignore investor psychology at least over the near term as it drives stock price trends, in my opinion.

I would say this historical chart puts the size of the recent decline from 2,100 to 1,970 for the S&P 500 index into proper perspective which is why it is not too late to buy some portfolio insurance.

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20-Year Chart: US Stock Market (SPX) 

The 15-year chart below is simply to demonstrate the crazy run up biotech stocks have had over just the past few years making that sector vulnerable to a price correction as many of these stocks sport multi-billion dollar valuations but don’t yet have any products on the market.

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15-Year Chart: US Biotech & Pharma Stocks (IBB) 

Bottom Line

The stock market correction that I have been worried about for a few years is finally here. I hope it will be shallow and short lived but hope is not a defensive technique so I thought it prudent to buy some protection in case the selling continues. Having a portion of our portfolios appreciate during a sell off is even better than holding extra cash.

Furthermore, I have a plan should volatility spike really high; I will execute our time-tested strategy of buying ZIV or XIV which I will reiterate should we put that plan into action.

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Members have just received an alert on this very trade.

Until next week…

- Chris

“A man who does not plan long ahead will find trouble at his door.” – Confucius

This Advice Has Cost Investors a Sh*tload of Money… and It Promises to Get Worse!

USDCLP Chart

Perhaps, like me, you’ve been hearing “the dollar is going to die” rhetoric nonstop for the last few years.

Our stance, well documented in these pages here, here, here and here, amongst many, many other posts, has been that for the last 12 months we’ve been long, and remain long – very, very long!

Last week I woke to 3 articles forwarded to me by some friends. I don’t typically pay any attention to these particular investment writers, as I categorize them in the “marketers,” not “professionals” basket.

The reason they were forwarded to me was to point out the duplicity. All three have been in the “dollar’s going to Hell” basket, and equally interesting, literally overnight all three have begun the spin process of changing their tune! The “unexpected” PBOC devaluation of the renminbi has been the catalyst.

Politicians could actually learn a few tricks from these guys! Here are a couple of the rules of their playbook:

Rule number 1: Never admit to being 100% wrong, and;

Rule number 2: Ensure you spin any market event to appear as if, “Why yes, of course we knew all along that the RMB was going to devalue.”

Quite frankly, the articles my friends forwarded me are a pig to read. They are filled with emotionally laden sound bytes, arrogance, inaccuracies, and logic which, like a cardboard cutout, simply goes soggy in the rain. It gives me a headache, and as I read through them, I found myself yelling obscenities at my computer.

It’s commendable in a morbid, psychologically imbalanced sort of way. A few simple Google searches reveal the deception, but no matter, press on we must, and revel in the fact that the vast majority of sheep will never do any meaningful due diligence.

When I see that sort of duplicity, then all credibility disappears for me. We have to be able to acknowledge our mistakes otherwise we’re bound to repeat them.

We’ve gotten things wrong before and we’ll certainly get them wrong again, but I always encourage a debate on the topics. Nothing can be more valuable than a rigorous debate in order to flesh out and better understand. After all, what if I’m wrong?

I have no particular ilk with any of these “investment experts,” aka “newsletter writers.” As a keen observer of market psychology and history I view them simply as another cog in the zeitgeist wheel which I find fascinating. Wolves will be wolves and sheep will be sheep.

Along the same lines, another tale that’s been as popular as a Kim Kardashian nipple slip video, has been this idea that investors should be long the RMB because really, no really, it’s going to replace the dollar soon, and possibly even while you sleep this evening. Yep, it’s gonna happen that fast. Never mind it’d be the first reserve currency in the history of the world to disappear overnight (and there are sound reasons why this is the case), but let’s not let rigorous analysis get in the way of sensationalism.

Before you send me any emails about the insolvency of the US government let me stop you right there. Yes, the US government is bankrupt (I know that “technically” that isn’t possible, but you get my drift). Yes, they have a pension nightmare and yes, the country is a police state. But, looking at the world in isolation, together with an oft agenda-driven myopic view, needs to be seen for what it is – marketing – nothing more and nothing less. No different to that “must have” shampoo that miraculously gets you a gorgeous, loving, nymphomaniac girlfriend.

Why?

I never fully understood why people would write such rubbish, and how they get away with it. It wasn’t until just the other day, during a conversation with a friend, that it all made perfect sense to me.

My friend, who I’ll leave anonymous so as to not get him into any trouble, is a true “professional investor” who authors an investment newsletter (or two). His niche is value investing, and year after year he’s soundly beaten the market. All he focuses on is finding great companies that have a high probability of success and capital appreciation. Novel idea.

Our discussion ran to the publishing business, and this is when it all made sense to me. Publishing houses test “copy,” and when they find “copy” that works well, they devise a product around it and sell it. Boom!

I remarked how bass-ackward this really is. Marketing hype sans rigorous intellectual and analytical thought. No matter… if the narrative works marketers push it and push it big.

My friend’s particular newsletter is less financially successful than many of its competitors, even though, like clockwork, it beats them all hands down on a pure return basis.

Shortly after this conversation I spoke with a long time reader who has become a friend. We discussed a purchase of land in Chile which he made some time ago. I pointed out that he’s lost over 50% on his investment in dollar terms since 2011, and over 40% since 2013. It wasn’t something he’d thought about, and thankfully he is un-leveraged.

To break even on this investment he now needs 100% appreciation. Think about that for a moment. What’s more is I think the Chilean peso goes even lower. In fact, it’s just broken a long-term trend line (as have some other LatAm currencies, including the Colombian Peso), and this is where we get big acceleration phases. We think you have to be short. We may be wrong, and of course we have been in the past. Our thinking, if interested, is laid out in our report entitled: USD Bull Report.

USDCLP Chart

Chilean Peso

My friend (now a bit more depressed than he was before our call) and I discussed what likely lies in store. He was (falsely?) comforted by the idea that this is temporary, a short-term setback for the Chilean economy and currency. I think this is a huge risk. Failing to understand why the USD is rallying in the first place means that the odds of understanding why and when it will end are vanishingly thin.

Part of the disconnect lies in failing to understand global capital flows, why the USD is rallying, and why on the balance of probability we’re still at the beginning of this run, not near the end.

Back to China and the RMB

I’ve heard the argument that China can sell their USD holdings to defend the RMB. Even if that were the case this fails to take into account the entire picture. There are many reasons for China to devalue, not the least of which is that it’s politically palatable. They are still an export driven economy who have seen their currency rise substantially against their competitors such as Japan.

Trying to quantify their FX reserves as a % of GDP is nuts. Their numbers are bollocks and can’t be trusted. Mark Hart has a more meaningful measure of reserve adequacy. This is FX reserves divided my M2.

This means that with a meaningful capital flight China will NOT have sufficient reserves to defend its currency.

The USD will be strong NOT because it’s the reserve currency, that has always been the case, but it’s NOT the answer now. The USD will be strong principally due to an unwinding of the carry trade. If you don’t understand this you’ll be lost.

If you have to pay back a loan to an individual who is insolvent it doesn’t matter a damn. You still have to pay that money back. That the US Government is insolvent is IRRELEVANT right now.

The low hanging fruit then?

USDTRY Chart

Turkish lira

Poster child of external debt.

USDZAR Chart

South African rand

Both of these two currencies are at major long term resistance levels. If they break from here it’s waterfall time.

USDCOP Chart

Colombian peso

USDKRW

Korean won

Bottom line? Don’t go walking into an investment without understanding its context.

When someone (newsletter writer or other “professional”) has a vested interest in telling you something, make sure you understand their bias and their agenda. One day, when I’m involved in a fund or funds (soon), please be sure to question me on my bias and my agenda. You’ll get the truth.

Until then (soon) I have no stake in the fight, other than to make money by being positioned correctly.

- Chris

“Fortunately for serious minds, a bias recognized is a bias sterilized.” – Benjamin Haydon

And the Bloodletting Begins…

Last week at my son’s football game, a fellow parent remarked to me that bald heads are cool. I actually thought the guy may be off his rocker a bit, but then I figured that maybe he was trying to be nice as I’ve got more hair on my big toe than on my shaved […]

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The Power of Shut Up!

Sitting with my lovely wife recently in a hospital waiting room (don’t ask) flicking through magazines, she showed me a picture of an elderly woman, a famous celebrity. Now, let me say that I care for celebrities and follow their movements in the same way I care for and follow the mating habits of the long-beaked […]

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9 Charts to Meditate On

As headlines flickered across a Bloomberg news feed this morning, I was struck by the plethora of slanted views. If it was anymore slanted it’d be vertical. A mishmash of sound bytes sans fact. I was reminded of days spent imbibing on University economics. It’s no wonder university students drink so much… Looking around for […]

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From the Mailbag: On Japan and the Yen

I’ve received a lot of responses to my thoughts on Japan from the post questioning Kyle Bass’ thesis on Japan earlier this week. I’ve taken two which I’d like to share with you today. One reader raised a good point on the Japanese “monetary perpetuum mobile” ever being questioned: Only missing one point: Spot on with your Japan […]

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