We’re bringing you a three-part series where we review the portfolio. We want a reference where subscribers can quickly gain an understanding on:
- sectors where we have a bullish or bearish view,
- the reasoning behind our views,
- how to apply those views and,
- any changes to the trades in the alerts.
This is the first of a three-part series. We’ve produced a lot of material, and we realise that it can be overwhelming to keep on top of it all — hence the reason for breaking the review into three parts.
Alerts (sectors/themes) reviewed in this report:
We’ve tried to keep this review short and straight to the point.
Rather than repeating all of what we discussed in the initial Alerts we want to provide an update on fundamental developments since the alerts were published. We also want readers to come away with a clear concise understanding of our views. That way you can make better judgement calls with your own capital and how you manage it.
We want to reiterate to subscribers that these are long term views (5+ years). It is easily both the toughest thing to do as well as the most sensible we can think of.
There is no way we, you, or anyone without at the very minimum a few hundred million (though, realistically a couple billion) can compete with the algos who are extremely concentrated in multiple variations of technical analysis trading, down to split seconds.
This dynamic has led to the growth of what is referred to as “passive capital” and an entire fund management industry, which to this day steadfastly tries to compete, only to be forced to benchmark and trend follow. It’s not an area we have ANY competitive advantage in, nor is it one we’ve therefore ANY desire to even try.
As a consequence, we’re not concerned with shorter-term volatility, but this doesn’t mean we don’t recognise that there is likely to be a lot of volatility in some of these trades.
That is both a consequence of the nature of these deep, out-of-favour sectors and the collapse in volume that occurs in any sector left for dead, as well as the inevitable volatility that occurs when massive pools of capital moves from one area to another because algos’ technical levels have broken beginning a feedback loop, which itself brings on forced selling. If you’re unfamiliar with it, just go read my buddy Kuppy’s explanation on this topic here and the follow up here.
We are constantly asked, “What exposure should I take?” We can’t manage people’s portfolios for them but our “guidance” is that for individual stock trades a maximum of 1% exposure and to sectors up to 5%.
When to take profits? We haven’t any prescribed profit targets. However, in general, once the theme/sector starts to gain widespread acceptance amongst the investment community, we will be phasing out of the trade. In essence, we aim to buy in pessimism and sell in optimism.
Mongolian Mining (0975:HK)
Alert Published: 12 September 2016 at HK$0.12.
Action Today: Buy it now. If you were kicking yourself that you didn’t buy more at 0.12 when it got to 0.40, then now is you chance to acquire another parcel or two.
Exposure: 1-2% of risk capital
- Sentiment towards Mongolia and Mongolian mining is at rock bottom and likely to improve with growth in the Mongolian economy and rising cash flows at Mongolian mining.
- Fundamentally extremely cheap (trading at a forward P/E of 1x)
- Access to Chinese markets opening up with a new rail line linking the mines to Chinese rail heads on the border.
A company supplying coking coal to China from mines in Mongolia, trading on a P/book of 0.28x and 0.87x next year’s cash flow after tax. Darn cheap is what comes to mind, but realise this is Mongolia (Crazystan).
We’ve no idea how long we will have to wait on this one, which is another reason to temper your enthusiasm on your allocation. We like to have many lottery tickets sitting in the cupboard, and this fits the bill perfectly.
While this is Mongolia, it’s no Mickey Mouse operation. MMC is the second largest coal producer in Mongolia with a JORC-compliant resource of 1bn in coal reserves between its two mines.
One of the biggest issues that MMC has had to deal with is transporting of coal to the Chinese border — some 270km, and all by truck.
MMC’s all-in cost to deliver washed coal to the Chinese border is approximately US$55 per ton, which includes about US$15 for trucking. This means that MMC earns a net of US$60 per ton (based on US$115 ton) — still very profitable even with relatively high freight charges.
Earlier this year the Mongolian government approved the construction of a railway to link the Tavan Tolgoi basin mines with rail heads on the Chinese border. This will reduce the cost of transport by about US$10 per ton.
What do the numbers look like? Based on sales of 6m tonnes of coal p.a. (and without any benefits from transport cost reductions), MMC should earn about US$230m over the next 12 months. Its market cap is some US$200m — a forward P/E of some 0.87x.
So how much upside? Well, let’s say the upside far outweighs any downside risks. It doesn’t take much of an imagination to see at least a 5:1 return on this trade with MMC still trading at a discount to peers. Hey, the fact its in Mongolia means it’ll always trade at a discount. I think the hardest decision with this trade will be when to take profits. Yes, it will move materially higher within the next 5 years but don’t forget the risks — it is dirty old coal coal and it’s in Crazystan!
Our Alert came out on September 12th, 2016 at HK$0.12.
We are still ahead in the trade, but that means nothing because we could have easily bought the stock at HK$0.30 a few weeks later. We just got lucky with the timing. We figure we will need a good few years for value to be recognised, and for those who are patient, you will likely be well rewarded.
- 23 December 2016:
- Centrus Energy (LEU:NYSE)
- 22 November 2017:
- Bannerman Resources (BMN:ASX)
- Goviex (GXU:TSX)
- Fission Uranium (FCU:TSX)
- 20 February 2018
- Deep Yellow options (DYLO:ASX)
- 2 July 2018
- Boss Resources (BOS:ASX)
- Paladin Energy (PDN:ASX)
- Energy Fuels (UUUU:NYSE)
- Uranium Energy Corp (UEC:NYSE)
Action Today: We’re selling Centrus Energy (LEU) stock and Deep Yellow (DYL) options.
We believe that the other holdings listed above are definite buys — i.e. if you didn’t already have position or were “underexposed”, then if we were in those shoes, we’d be filling our Christmas stockings with these for sure.
- Demand for uranium will continue to increase. 11% of world electricity production is from nuclear power plants. Nuclear power plants in operation are at a record high in 2018 and will increase dramatically over the next 5 years as more plants come online.
- It is not profitable to mine uranium at current levels. Either the price of uranium goes up or more supply gets shut down, and if that doesn’t work, nuclear power plants eventually close down and 11% of the world’s electricity production grinds to a halt.
- The world is now consuming more uranium than it is producing. This accelerated in 2018 as Cameco began buying on the spot market to fulfill contracts.
I don’t have a “favourite” theme/sector but, if you believe that 5 years from now the world will be consuming as much uranium as it does today for nuclear power production purposes, then it is extremely hard to not overweight the uranium sector.
In my opinion the key to understanding the attractiveness of the uranium trade is to understand demand.
As you can see, it is mostly a story about China.
I don’t think it is a case of debating the demand for uranium.
The bigger debate is at what price will we see production of uranium come back online from the likes of Cameco, Paladin, and Kazatomprom? Given that Cameco have put their mines in care and maintenance (and others like Paladin), and it is costly and time consuming to bring mines out of C&M, we suspect that the contracting prices will have to be way higher than what folks are currently thinking.
The last thing you want as a miner is to bring your mine out of C&M only to have to put it back in to C&M 12 months later. So it is likely that miners will only bring mines back on line when they have some sense that there is longer-term sustainability of the uranium price.
What about Kazatomprom?
Kazatomprom (the world’s biggest producer of uranium) listed on the LSE mid-November. So what, you might ask?
Here is my thinking. Now that they are a listed company they are now far more accountable to stakeholders. Stakeholders who want to see profits. Profits don’t necessarily mean production. Indeed, often in the resource industry the opposite is true.
Well, now that they’re listed, the pressures on them will be far greater, and as such it’s less likely they will produce for less than the cost of production. Already they have cut production by about 30% over the last 18 months. Will we see more production cuts? I’m not the world’s leading authority on Kazatomprom but I suspect we will see more production cuts if the price of uranium doesn’t move higher.
Now, here are perhaps some important questions:
- What is Kazatomprom’s B/E price and how is its resource looking?
- Have they exploited cheaper ore bodies already and are now encountering a higher extraction cost base?
- Why did they sell a whack of their production to Yellow Cake PLC?
Again, I am no expert, but I suspect that all the aforementioned suggests that Kazatomprom’s resource quality is deteriorating and not as endless as the majority believes.
You might want to listen to John Borshoff talking about Kazatomprom (and the uranium industry in general). It’s a great interview!
Cutting a long story short, the price of uranium will have to go a helluva lot higher than current levels and trade at those levels for an extended period of time (months, not weeks) before we see any meaningful supply of uranium come to market from mines.
A few weeks ago the Taiwanese voted to maintain their nuclear reactors rather than phase them out by 2025. Nuclear energy currently accounts for about 10% of Taiwan’s electricity production.
The “brilliant” idea of phasing out nuclear energy came following the Fukushima disaster. But as time passes, folks begin to understand that it is hard (and messy/polluting ) to do without nuclear energy. And yes, time heals wounds. It certainly “heals” memories.
France backtracks on reducing its nuclear fleet. In 2015, the previous socialist-dominated parliament passed a law obliging the government to reduce the proportion of electricity generated from nuclear to 50 percent by 2025 compared with around 75 percent now.
France is now realizing that to reduce reliance on nuclear means increasing their reliance on coal (it took them all that time to work that out?). Geniuses!
Poland is going ahead with development of nuclear power plants to reduce its 80% dependence on coal fired power stations. The first plant will be operational by 2030. This is highly symbolic for European power production.
Despite some public backlash, nuclear energy’s use has not decreased across the continent in recent years.
Sweden reversed its no-nuclear commitment in 2010, and nuclear energy now generates a third of the country’s electricity. The UK, Finland, France, the Czech Republic, Hungary, and Romania are all looking to build new power plants and reactors. Talks are underway in Bulgaria to reopen its Belene nuclear power plant — a project that was cancelled in 2012.
And Germany? Well, they are now taking the heat for their political points-grabbing decision to cut its nuclear plants following Fukushima.
The Trades: We are happy with most of the trades we have on, namely:
- Energy Fuels
- Uranium Energy
- Fission Uranium
We are not happy with:
- Centrus Energy. It continues to bleed cash. Although we do take a loss on this trade we feel that we can make up the losses by investing in one of the trades listed above.
- Deep Yellow options. We haven’t got an issue with Deep Yellow at all. In fact, it probably makes for a good buy in itself (the stock). We concede that buying the options was a mistake because of the accelerator clause. The options have a strike of 0.50 and an expiry of June 2022. No problem with that. However, if DYL trades above 0.70 and remains above 0.70 for 20 consecutive trading days, then holders of the warrants will be forced to exercise the option on day 20. Accordingly, this accelerator clause puts a cap on what can be realistically be made on the option. It’s not a terrible deal, but the more we look at it and alternatives we have for out capital in this sector, the more we lean towards exiting this and redeploying. We can sell these options for pretty much what we bought them for so while we’ve not profited, we’re not out of pocket. We would suggest taking the capital in this trade and increasing your holdings in some (or all) of the holdings above. Obviously this depends on how much capital you have invested in DYL options.
Alert Published: 27 January 2017
Trades: Star Bulk Carriers (SBLK)
Action Today: Add to dry bulk shipping (Star Bulk Carriers). Hold the Invesco Shipping ETF (SEA).
- The fundamentals have improved dramatically over the last two years, particularly for dry bulk shippers. We are presented with an opportunity to buy dry bulk shippers at 30-50% less than where they were trading at just two months ago.
We’re perhaps even more bullish now than some 2 years ago because of these reasons:
- Dry bulk shippers are trading more or less at the same level now as they were at the start of 2017.
- Earnings and cash flows have been positive as a whole for the last 12 months.
- A supply deficit (an excess of demand vs supply) is opening up, which will be pronounced by 2020.
We feel this is a “gift” because fundamentals have only continued to improve over the last few years. But more on the fundamentals of Star Bulk later.
Let’s work through our bullish thinking and what has changed over the last two years namely from an industry perspective.
Up until 2016 virtually every dry bulk shipper had either gone through bankruptcy or they had to raise equity to avoid bankruptcy. Either which way, existing shareholders were essentially wiped out. Tragic but hey, that is capitalism, which, I dare say, is a heck of a lot better than the alternatives we bipeds have tried over the years we’ve been grubbing around on this ball of dirt.
The end result was that debt levels were bought wayyy down to manageable levels, companies were left with generous levels of cash on their books and they were probably in much better financial shape than at any time in the previous 20 years, though you wouldn’t know it looking at the share prices.
Since 2016 freight rates have improved across all vessel classes and dry bulkers have, as a whole, turned profitable for the last 4 quarters and free cash flow positive for the last 6 quarters. This has allowed them to increase liquidity and/or reduce debt levels even further.
It is important to note that dry bulkers have managed to generate a profit against a backdrop of freight rates that remain close to historical lows… or at least levels they were trading at some 18 years ago.
It’s a miracle that these shippers were able to show a net profit over the last 12 months given how low rates have been.
It’s quite incredible what can be achieved in what is a massively capital intensive business, when you wipe out all the debt originally used to get the entire operation up and going.
One wonders how much cash they will generate if rates get back to 2004-2006 levels let alone 2007-2008.
I’m not going to jump to too many conclusions based on the charts above because they are so noisy.
However, it does appear that the bottom was reached in early 2016, and we now have some 10 years of ultra low rates. If my experience is anything to go by, 10 years is long enough to work off any excesses that were built up previously.
What Are Valuations Implying?
Many dry bulk shippers:
- Still trade at substantial discounts to their book value
- Sit on actual P/Es below 10x and on forward P/Es 1-year out of some 5x and 2-years out of 3x
- Have forward EBITDA/interest expense ratios of some 4-6x
It seems to me that current valuations are implying that freight rates are about to collapse for an extended period of time, pushing dry bulkers back into bankruptcy (again).
And if the outcome isn’t as diabolical as that, then it isn’t far off.
That’s what the valuations are implying. Is that reasonable?
Let’s take a look.
The Growing Supply Deficit
By 2020 there will be a significant supply deficit open up and, given the downsizing and lack of capacity of shipbuilders, this deficit will persist for more than a few years.
The key to understanding the long-term outcome of shipping stocks is to understand freight rates which are more a function of shipping capacity rather than demand for shipping space. This is because the supply of shipping space is way more volatile than demand.
So here is the million dollar question, are we likely to see freight rates drop materially over the next 5 years as the valuations of dry bulk shippers imply?
We think not and this is to do with the widening supply deficit in shipping capacity relative to demand.
At the height of the commodity boom in 2011 the global shipping order book-to-fleet ratio stood at 36 percent.
The order book-to-fleet ratio is a key measure used by the shipping industry to determine the outlook for future supply of vessels. It’s a useful indicator of supply growth because a proportionately high ratio will lead to a fast-growing fleet and, if history is any guide, oversupply in the market as these ships are delivered.
A 36% order book-to-fleet ratio means there were enough existing new ship orders to increase the 8,600 total cargo fleet size as of 2011 by more than 3,000 new ships over the coming years.
This ratio peaked at 52 percent in 2009. That means that there were enough ships being built that year to grow the global fleet size by a whopping 52 percent — nearly 5 times higher than a decade earlier.
But if we zero in on the dry bulk sector (exclude tankers, containerships, cruisers, etc.), the ratio is even more pronounced on the upside and downside. Note that this was only up to 2017. Today the ratio is way lower.
Traditionally, a ratio of 15% is seen as what is required to replace aging vessels coupled with historic demand growth.
So even with a lot of order cancellations, from 2011 to 2016 an average of 400 new dry bulk cargo chips were still being delivered into the market each year — a nearly 5% annual increase for the past five years.
Meanwhile, less than half of that number of old ships were being sent to the scrap heap. That means global shipping capacity continued to expand by approximately a net 2.5% rate each and every year.
This increase in shipping capacity would have been OK if it was met with increased demand for shipping space but that wasn’t the case. Global trade of goods and services has declined by some 7% from 2011 to 2016 as commodity prices collapsed.
So for the better part of the last five years, the global shipping industry had been plagued by overcapacity, with many shipping firms operating their ships at a loss.
But it now seems that this oversupply has been worked off and capacity has swung the other way. Shipyards have gone very quiet and a few years from now there is virtually nothing on shipbuilder’s order books:
It’s not just a 14-year low:
As of the start of August 2018, the orderbook stood at 3,000 vessels of 76m compensated gross tonnage (CGT), its lowest level in CGT terms since April 2004, Clarksons said.This represented a 38% decline in the size of the global order book in CGT terms since March 2014, which marked the end of a year-long expansion.
The size of the global order book declined rapidly following this period, by 32% in CGT terms to April 2017, before falling at a steadier rate thereafter.
Furthermore, Clarksons says the orderbook has declined rapidly in comparison to the global fleet, with the volume of CGT on order as a percentage of the fleet reaching 9.9% as of start August, a historical low.This represented a 38% decline in the size of the global order book in CGT terms since March 2014, which marked the end of a year-long expansion.
The size of the global order book declined rapidly following this period, by 32% in CGT terms to April 2017, before falling at a steadier rate thereafter.
Furthermore, Clarksons says the orderbook has declined rapidly in comparison to the global fleet, with the volume of CGT on order as a percentage of the fleet reaching 9.9% as of start August, a historical low.
A graphical representation:
And from a slightly different perspective: fleet and demand growth.
This is hard to prove because obtaining data is extremely difficult. But for what it is worth, our thinking is that capacity of the world shipbuilding industry is significantly less than it was 5 and 10 years ago and looks due to contract even further.
Come 2020 shipowners might be in for a shock when they place orders for new ships. There will probably not be the capacity to build them which will result in long lead times. Excellent!
As a shipbuilder, would you be thinking of cutting back on staff, etc. when faced with an order book like this? Now, granted it is a few months old, but I don’t think anything material has changed in the last 6 months:
Over the last 5 years we have seen many shipbuilders go bankrupt and close down operations completely.
We have also seen many of the bigger shipbuilders scale back operations significantly as their order books continue to contract. What is happening at the world’s largest shipbuilder, Hyundai Heavy, is a classic example of what is going on in the wider shipbuilding industry:
Why Star Bulk Carriers (SBLK)?
Whether or not to invest in Star Bulk Carriers, Genco, Scorpio, or Golden Ocean (or all four) is probably a secondary consideration as to whether one should be increasing ones holding in dry bulk carriers as a whole.
We believe that if there was one trade to make which would cover the dry bulk sector it would be Star Bulk Carriers.
The stock is relatively cheap (not that any of the dry bulk shippers are expensive), well capitalized, profitable, and diversified across vessel classes. Furthermore, it has one of the youngest fleets of vessels.
Here are Star Bulk’s fundamental metrics:
- P/book: 0.43x (it was 0.35x a few days ago)
- Forward P/E: 4.5x
- ROE actual: 6%
- Debt/Equity: 1x
- Total debt/EBITDA: 6.51x
To give you an appreciation of the diversity of Star Bulk Carriers, I “borrowed” a graph from an Eagle Bulk Shipping presentation.
Yes, ideally we would like to have a dedicated dry bulk ETF to invest in, but there isn’t one.
In any event, many of these sector focused ETFs have high management fees, so one is probably best off creating their own basket rather than buying an ETF (if it is available).
- 16 December 2016 (Japan)
- 16 April 2017 (Japanese financials)
- 19 February 2018 (Japan update)
- WisdomTree Hedged Japan ETF (DXJ)
- Mitsubishi UFJ (MTU)
- Nomura Topix Bank ETF (1615)
- DXJ (call option, January 2020, 53 strike)
Action Today: No change. All the trades we have on are still buys, with the exception of the call option.
Japanese equities are extremely cheap and tightly held with a limited pool of marginal sellers.
We have produced two alerts on Japan. First a general bullish call on Japan and secondly a bullish call on Japanese banks.
The essence of our bullish call on Japan is twofold:
- The incredible JGB market, which has perplexed every macro fund manager I’ve ever known, now has nobody participating. None, and I mean it. I don’t know any that are involved. It is an outlier because well, we’ve never been here before and so there are no textbooks on this one. My thoughts, for what it’s worth, are that when (not if) the European bond markets blow out (I’ll have a dedicated report for you on the Eurozone discussing this), we’ll begin to see the problems in Japan coming to market. The best way we can think of playing this isn’t being short JGBs due to the carry costs involved and the fact that we don’t know what time horizon we’re really working with here. Being long the equity markets allows us to have massive longevity without any carrying costs.
- Valuation. The Japanese stock market now sits on a P/E of some 12x, P/Book of 1.2x, P/Sales of 0.75x. And it is trading at the same level now as it was in 1990.
Once upon a time the Japanese stock market accounted for some 50% of the world’s stock market capitalisation. Now, granted that was a bubble, and made about as much sense as German Bunds trading for less than a bip. The point is the Japanese stock market now accounts for some 9% of global market capitalisation.
The question that sometimes keeps me up at night is this, what happens if Japanese investors lose their affinity with the bond market and venture into the Japanese equity market? Not out of a desire for returns, but out of sheer frickin’ terror as the yen comes under increased selling pressure and the BoJ prints more and more to prop the JGB market.
They might be in for a shock because there is a lot less liquidity than there used to be due in no small part to the the BoJ becoming a top 10 shareholder in about 70 percent of shares in the Tokyo Stock Exchange first section and it now accounts for approx 3% of the Japanese stock market.
This amounts to a nationalisation of 3% of the Japanese stock market… or 3% less free float of shares on the Tokyo Stock Exchange. So will the BoJ sell this when it already owns the bond market? If history is any indication (of a country in this sort of trouble), they’ll just print. That is not bearish equities.
So in essence, the purchases of Japanese stocks by the BoJ have merely reduced liquidity in Japanese stocks. Japanese stocks are now more tightly held than they were 5 years ago, with a significantly smaller pool of marginal sellers (weak hands).
Our perspectives on Japanese banks is very similar to the general Japanese equity market.
A near 30-year bear market with prices down some 90% from their highs but a lot of evidence that they are hammering out a long-term bottom.
Valuations are “intriguing” to say the least for the sector (P/E of 7x, P/Book of 0.5x, dividend yield of 4.5%).
Over the last 30 years Japanese banks have had to contend with shrinking bond yields. Currently bond yields stand a few ticks above 0%. They have had to contend with a Japanese consumer who has only ever wanted to save and falling prices (deflation). Yet against this backdrop Japanese banks have been able to generate respectable profits.
I can’t think of another sector that has had to contend with what these guys have had to contend with and a small increase in interest rates would have a measurable impact on their profits. A larger one would have a “holy-mother-of-Mary” impact.
One wonders how Japanese banks will fare when all these headwinds become tails winds (i.e. bond yields start rising and/or Japanese consumers start consuming rather than saving)?
When I think of Taleb’s tail risk analysis where you’re betting on an event that absolutely nobody thinks possible and which, at the same time, has a much higher probability factor than commonly thought, then Japanese banks quite literally define this.
- 5th December 2016
- IEF puts (January 19, 105 strike; closed a few days ago)
- Bank of America stock (BAC)
- 1 March 2017
- Comstage inverse Bund ETF (5X62)
- 20 January 2018
- Credit Suisse Group (CSGN) calls (January 2022, 16 strike)
Action Today: Sell Comstage Inverse Bund ETF
The grand fight of inflation (rising bond yields) vs deflation (falling bond yields) continues to rage.
We still believe that a very long period of rising bond yields has already started. Let’s not forget that the world is coming off the back of a 30-year bull market in bonds (bear market in bond yields). Bond yields never went down in a straight line and they certainly won’t go up in a straight line either.
Our most perplexing issue isn’t whether or not bond yields will go up (we’re “certain” of that given time), rather how best to position to make money from rising bond yields. Is it to trade the bond market directly or via a second order effects?
We have been right on US rates moving higher, but have little to show for it, and we have less to show for European rates moving higher perhaps for obvious reasons (because they haven’t moved).
Our idea was that US rates would move higher and on the back of that so, too, would US Banks (using BAC as a proxy for US banks). Clearly that worked!
We have done ok out of being long BAC. We recently closed the puts on IEF (the US 7-10-Year Treasury ETF) at a loss. We placed the puts in December 2016 (105 strike) when IEF was trading at 105.5. We were doing ok until a few months ago. Two years may seem like a long time but, as it often turns out, it is way too short a time frame to express a long-term view.
European yields are way more perplexing, frustrating to put it conservatively. Shorter-term bond yields still remain negative — 3 years running.
To position for European bonds to move higher we bought the Comstage Inverse German Bund ETF. Since we put the trade on in March 2017 the bund has moved sideways but the Comstage Inverse Bund ETF has continued to move down. Herein lies the problem with these inverse ETFs — if markets move sideways, their value erodes. We know this, however, compared to alternatives such as trading the futures, this value decay is much, much slower — hence our choice.
To make money with these inverse bond ETFs one needs the underlying that the ETF is tracking to move in a reasonably linear direction.
While we genuinely believe that German bond yields will move higher, this is a trade we place knowing that when it moves, we’re likely to put the foot on the gas. We’re not there yet.
Our other idea was to buy long-term call options on Credit Suisse (5-year call options). The good news is that we were right. Credit Suisse has tracked the yield of the German 10-year reasonably well. Of course, the “slight” complication is that German bond yields have not gone up.
Our attraction to long-term calls on Credit Suisse was that they were so cheap (and they remain so). We will continue on with this trade. We have until December 2022 before this option (16 strike) expires.
Currently one can buy the December 2022 (4 years to expiry), 10 strike call for about 2. So breakeven at 12 (about 14% from current levels). That is where it was just a few days ago. I am still amazed at how cheap these options still are!
As we stated above trading bond markets is a difficult occupation.
The best way to trade them is via the futures markets. However, we are very mindful of the fact that many of our subscribers are not experienced in futures trading. Trading on margin is a whole different ball game, one where there is a constant battle with how much capital to hold against positions. It is absolutely NOT something that we’d ever recommend to anyone but very experienced professional traders.
What about long-term options?
If only things were that easy. Options on treasury futures only go out a couple of months and as such are completely useless.
The biggest opportunity is with options on eurodollars. We have talked about these trades before. You can get puts on eurodollars going out 4 years to expiry.
It does take a bit of knowledge about the eurodollar market, and yes, you can get 4-year options but they aren’t so liquid going out this far. This is definitely the way to go. However, going into the trade, it’s important to position size such that you can mentally let it go to expiry and reposition again if needs be.
Think about it like this. Recall the 2008 housing crash. Well, I’ve colleagues who were directly involved in this trade as featured in the movie The Big Short.
What wasn’t shown in the film was that many in this game began positioning themselves in 2004. Rolling those CDS positions meant going back in year after year after having lost 100% of “first capital”. I’ve been told about one gent who is a friend of a friend and basically ran out of capital in mid-2006 and threw in the towel. This is one reason why I hammer home position sizing and taking multiple bets where asymmetry presents itself.
When I look back on this trade and others in both my own past and those in historical context before I was around in this business I’m reminded how markets can easily “play” with you.
Consider that when we first positioned in this trade in 2016 our Euribor, short sterling, and eurodollar positions all went well for us. Rates bottomed (bonds topped) back in mid-2016. We can see this when looking at the charts now some 3 years later.
That said, while those positions ran higher for us much of that retraced again. We’ll only ever know in hindsight, but our belief is that we’re going through what all too often happens in any market going through a topping/bottoming phase, and that top in bonds was THE top. That means we’re now looking at an especially good time to re-enter that trade (especially in European sovereign bonds).
The other possibility we have to consider is that we’re completely wrong and the bond bull is alive and well and government bonds will continue higher well into negative territory once again and they’ll do so across the board. Because let’s face it, that’s the only way they can hold together in sync. And that’s where we part company with any bond bull thesis.
As you’re well aware, our belief here is that it’s not been the batshit crazy debt levels that make this a good trade (though, that certainly plays into it), but the fact that it ends when not ALL participants are playing from the same hymn book. And that most certainly is no longer happening. We could have made an argument to be short bonds and long rates for over a decade now, but we didn’t do that. It was only when we saw the shifts at a political level that we began taking our positions.
Again, and I don’t want to repeat too much of what I’ve written a lot about already, but that all changed with the upheaval in the political establishment beginning with Brexit, moving to Trump, and increasingly spreading across Western Europe as I write to you and as you read this.
Without political cohesion we’ll not see Central bank cohesion, and without coordinated central bank cohesion we have ourselves a situation of “relative divergence”.
And that has already caused problems in the bond markets, not to mention causing pressure at the political level (the two have a reflexive relationship). We anticipate that 2019 may well be a year where this not only accelerates at the political level but where those unavoidable differences of opinion, strategy, and beliefs will manifest themselves in the bond markets, beginning in the Eurozone.
In Part 2 of our Alert Review (due out in late January), we will discuss the following:
- offshore oil
- Greek equities
- solar energy
- rare earth metals
As always, thanks for reading and being part of Insider.
Founder & Editor In Chief, Capitalist Exploits Independent Investment Research
Founder & Managing Partner, Asymmetric Opportunities Fund
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