Small-C October 2009 Letter

The portfolio returned 1.6% for the month of October, bringing our year-to-date return to 18.0%.*

* We report the percentage gain or loss during a month in an additive sense for ease of comparison, however the year-to-date returns are reported as a chained series.  As the total return become greater, and as inflows have an effect on the portfolio, the two will diverge.  Adding up the monthly returns for the year may not give the precise total return.

Small-C September 2009 Letter

The portfolio returned 4.9% for the month of September, bringing our year-to-date return to 16.4%.*

* We report the percentage gain or loss during a month in an additive sense for ease of comparison, however the year-to-date returns are reported as a chained series.  As the total return become greater, and as inflows have an effect on the portfolio, the two will diverge.  Adding up the monthly returns for the year may not give the precise total return.

Small-C July & August 2009 Letter

The portfolio lost 0.1% for the month of July, bringing our year-to date return to 16.1%.  The portfolio lost 4.7% for the month of August, bringing our year-to date return to 11.5%.*   We are disappointed to hand in two losing months in a row, especially one of the magnitude of our August loss.  It is perhaps overly simplistic to note that our shorts outperformed our longs - though fundamentally that's what happened.  The market rose, while China didn't.  Corporate bond spreads tightened, but yields fell as well.  Gold didn't do much of anything, while neither did oil.

In July, we took the step of adding two single-share relative value trades to the portfolio.  You may remember we swore off single stocks some time mid last year, and that in the early months of 2009 we had great confidence that this year’s returns would come from asset allocation.  As the market felt to be in a recovery mode, with shares bounding upward and bid/asks narrowing in many sectors, we thought it was a good time to get into relative value.  Certainly we had been surprised by the rapid recovery in equity prices, but couldn’t we at least capture some profits from laggards in the rally?  We invested in two stocks, which appeared quite reasonably valued and potentially able to benefit from continued stock market strength.  On that trade, we have experienced our fastest loss rate of any position so far this year.  We are considering increasing the size of our trade.

We are sad to report we have lost our confidence in the “science” of economics.  Until recently, we had an unwavering faith in a classical, Adam Smith-type economic model.  Then suddenly the penny dropped.  To be considered valid, a scientific theory must not only have explanatory power, but also predictive power.  Our classical model of economics appears to have great explanatory power, but outside the most facile cases is useless for predicting future effects.  What do we do now?  Become complete economic nihilists?  We're trying to get through Keynes as a bit of self-help, but he's not quite the entertainer Smith was. 


* We report the percentage gain or loss during a month in an additive sense for ease of comparison, however the year-to-date returns are reported as a chained series.  As the total return become greater, and as inflows have an effect on the portfolio, the two will diverge.  Adding up the monthly returns for the year may not give the precise total return.

From the Archive: Small-C June 2009 Letter

The portfolio returned 0.1% for the month, bringing our year-to date return to 16.2%.  We were within a rounding error of flat, which is slightly disappointing, but not greatly so. This note is so late because we had trouble coming up with good commentary for the month and now July is nearly over as well.  On present form, we are looking at a very similar month to June.  Clearly some of the momentum we had in the portfolio earlier this year has run out.

From the Archive: Small-C May 2009 Letter

The portfolio returned 5.3% for the month, bringing our year-to date return to 16.1%.There was little change in our positioning, as laid out previously.  The strength in the equity market, however, begs a few questions:

Why are we short equities?  This we had the opportunity to participate in an excellent exercise which forced us to think hard about the case for which direction to pick in equities.  Our main conclusion was that that many convincing arguments can be held up for either side.  Our personal view draws from the following:

• Unemployment is still rising and will continue to do so.  Entire sectors as yet untouched by layoffs must inevitably contract, and reduce the productive capacity well into next year.  However, we must recognize that unemployment has no predictive power to equity returns
• Barack Obama and his administration are increasing government interference in private life at a furious pace.  We want to like Obama.  His foreign policy holds out great promise, but in terms of expanding government he already looks worse than George Bush - which is saying a lot.  We have to admit, though, that equity markets reliably outperform during Democratic administrations.
• The Other January Effect, which we have written about before.  However, new study has shown that the dominant strategy is to be in cash after a down January, not short the market.
• Demographics.  There are some 80mn baby boomers on the verge of retirement.  We are led to believe they had a great deal of their retirement savings invested in stock.  They have been badly hurt by the last year’s equity declines.  They want to exit the equity market, either to protect what they still have left, or to have cash to spend in retirement.  The buyer for their equities is the less-numerous, cash-strapped younger generation.
  
• We just don’t see the value in owning equity.  There are endless arguments to be made around a correct valuation; the only thing we have to guide us is a feeling that equity just doesn’t offer the right ratio of pleasure to pain in the owning of it.  Sure, interest rates are low, but there are plenty of vehicles to earn an acceptable, contractually defined yield.  Sure, we could miss out on a 20% gain, but we don’t feel we desperately need that 20% gain when set against the very real possibility of losing 20%.  Incidentally, we think the world is moving into a sustainable "dividend yields greater than bond yields" environment of the type that existed prior to 1960.

Why are we long China?  We often hear analysts express a view that China is / will be an economic powerhouse because it lacks the constraints of a democratic political system.  When the communist party decides to, for example, build out highways or increase consumption of domestic cigarettes, it sends out a diktat and its will is done.  China has elevated 500 million people out of poverty in a generation - what can’t it do?  We think there is a naïve, pernicious idealism behind that view.  More Chinese may have risen out of poverty in the last generation than any other nation, but standards of living are well behind those in the Western world.  When Chairman Mao conceived his Great Leap Forward, the result of this government-ordered investment program was uncounted millions of deaths by starvation.  Most Westerners of our generation have no experience of even the slightest worry that there might not be food for a day and can not come close to imagining the horror of entire cities starving.  We’ll take our democratic process, thank you, which is precisely why we like China.  We believe that China does indeed have 50 years of strong growth ahead of it, that the gains of the last decade have been due precisely to a opening of the Chinese political system, and that increasing information, growing freedom, and economic success will tie up in a virtuous cycle.

Why are we long inflation?  We believe Adam Smith, who in 1776 wrote "for in every country of the world, I believe, the avarice and injustice of princes and sovereign states, abusing the confidence of their subjects, have by degrees diminished the real quantity of metal, which had been originally contained in their coin". And we believe Milton Friedman who in 1956 reminded us "Inflation is always and everywhere a monetary phenomenon".Major western governments have begun to print money, supposedly to "stimulate the economy", by increasing government expenditure programs using newly issued debt.  And if no one wants that debt, what do they do?  Well, becoming a fantastic Ouroboros, the government itself buys it.   What they are doing, and they surely realize this but can not state it explicitly, is using inflation to 1) reduce the real value of debts (and therefore redistribute wealth from lenders to borrowers) and 2) expropriate the hard-earned savings of the thrifty and older, to support the young and irresponsible.  Inflation is a more subtle way of doing this than explicit expropriation or rising taxation - though governments are doing that as well - a move which will serve to redistribute power to the politicians and bureaucrats, not, as stated, to redistribute wealth to those disadvantaged by the current downturn.  Does that sound outrageous?  It should.  If you played by the rules for last decade and were successful, your winnings are being stolen.

What are our investment goals?  What is our benchmark?  We have never set in writing either of these rather important concepts.  Our investment goal is to increase capital at a rate significantly greater than inflation over the long term.  How long?  The figure we have in our head is 60 years.  Being realistic, that implies we hope not to access this capital within our lifetime.  Our long-term benchmark is 0% or the S&P 500 return, whichever is greater.  We hope to preserve capital, but consider ourselves risk-tolerant - a 20% loss in year would not make us greatly uncomfortable.

A corollary to the "P-side Theory of GDP": Among market commentators, it is popular to say that the drop in wealth, across house prices, stocks, pensions, what have you, that we have experienced over the last year will lead people to adjust to more frugal standards of living, and because of that economic growth will be impaired for years to come.  Jeremy Grantham makes a representative summary:  "No longer as rich as we thought - under-saved, under-pensioned, and realizing it - we will enter a less indulgent world, if a more realistic one, in which life is to be lived more frugally."  Hmmm.  We don’t quite buy the argument.  Nowhere does he mention that we will work harder as well.  Imagine that over the last several years, people were in some measure living off of wealth they believed was stored in various assets.  We don’t dispute that - the popularity of home equity loans indicates they probably were.  Now, that source of consumption has disappeared.  True as well.  We dispute the conclusion that inevitably this leads to reduced consumption and therefore GDP.  Certainly, over some horizon, people will be more careful with money.  But aren’t they also spurred to produce income, where before they consumed assets?  We think this change in asset values brings the producer back online, and GDP can indeed start to grow again.  Isn’t that all a bit contradictory to our whole bearish stance?  Somewhat, we admit, but part of our argument is valuation as well, which we believe will remain lowered for long after economic grow restarts.

From the Archive: Small-C April 2009 Letter

The portfolio returned 4.1% for the month, bringing our year-to date return to 10.8%.  The big story from April was the 7.8% equity rally.  So, uh, great we managed to earn a bit more than half the market return for the month.  This was disturbing, not because we missed out on a larger gain, but because it was positive at all:  the portfolio was supposed to be short equity, and the performance leaves us wondering if our portfolio construction is really as clever as we think.  Have we been deceiving ourselves, thinking we are short the market while actually being long?  Probably.  After increasing our short early in the month, we were indeed very short true equity instruments.  However, when we add up the betas on gold, oil, and corporate bonds, we found the short is very small or even a net long.  We plan to increase the equity short again in May, and will continue until we lose money on days when the market is up.  The following chart helps us track exactly where the returns have come from so far this year.  Some of our smaller trades (like nuclear and Asia) have made meaningful contributions.  We take that as an indication that they are appropriately sized.  The percentages add up to 10.8%.

Why were the markets up in April?  One factor must be that many companies posted Q1 earnings that either met or exceeded analysts’ expectations, though those expectations represented a huge decline from a year ago and even from earlier in the quarter.  Also, many companies - especially in the financial sector - put large losses in the non-recurring category, which makes headline earnings look quite a bit better.  Stories from the financial sector were less panicky than they had been for much of the past year, possibly leading investors to believe the shocks are behind us.

A big theme during the month was the "stress tests" that the US government implemented to judge any potential capital requirements US financial institutions faced.  For the life of us, we can’t figure out why anyone is paying any attention to this.  Bank shareholders, boards, and management teams (who really had an interest in doing so) weren’t able to figure out the right level of capitalization for their institutions.  The ratings agencies and regulators (who are intelligent and well-meaning) couldn’t do it.  So why would anyone lend a penny of credence to a group of bureaucrats directed by politicians?  Possibly because the results might foreshadow how much more political interference the US is in for, though we didn’t hear that view expressed.  From what we’ve seen so far, the US is in for a lot more political intervention.  Witness President Obama’s public scolding of investment firms for having the audacity to argue for their contractual (constitutional) rights. 

The "P-side theory" of GDP and recessions: this is open to critique, ridicule even, but it is our simplified working model of the economic climate.  The focus of much economic discussion revolves are "the consumer" and whether or not this allegorical figure will spend or save.  Why is this?  It’s hard to measure production directly but mathematically, GDP = consumption + gross investment + government spending + (exports − imports).  Consumption is the largest, most variable quantity in the equation, so economists spend a lot of time trying to forecast consumption, which leads to focus on "the consumer".  But rarely is "the producer" ever mentioned - even though it is her activity which GDP actually measures.  "The producer" and "the consumer" are, of course, one and the same - but they have diametrically opposed motivations.  We think that over the last several years of expansion, the producer has been working hard.  She has increased productivity to the point where she does not have any obvious avenues to further gains.  She has grown satiated, complacent, and a little tired.  She feels she has built up the savings/borrowing capacity/social benefits to withstand some time off.  GDP won’t begin to recover until the producer feels motivated to go out and produce something.

Finally, a friend noted that had we just gone long at the beginning of the month, we would have made huge gains.  Actually, if we had applied leverage to that, we could have made even huger gains.  Very true indeed.  However, as we’re not comfortable predicting the short-term, or any-term for that matter, swings in the market, we are happy if we can make some gains out of positions which ex-ante make sense.  We value probability over prognostication, statistical significance over sophistry.  Our friend still owes us £100.

From the Archive: Small-C March 2009 Letter

The portfolio returned 3.5% for the month, bringing our year-to-date return to +6.7%.nbsp; Much of the action took place the week of March 16^th, when the US Federal Reserve announced its plan to begin buying treasuries.  It was a moment we had been salivating over all year.  Yields (though not spreads so much) on our corporate bonds squeezed lower, gold and crude moved up, and we were presented with precisely the moment we were waiting for to short treasuries.  Sterling corporate bonds, though, still didn’t perform much over the month which is starting to bother us.  The S&P trended upward, but more slowly than Asia-related equities, and failed to breach the boundaries of the wide strangle we sold, while implied volatilities moved down.  So nearly everything in the book was working.  And that meant that even the best moments were pretty boring - the natural result of our decision to pursue safe yield over the year.  It was one of those months where we wished we had made bigger bets.

We made three trades during the month.  We sold puts on the S&P at 600, we incrementally increased our S&P short at 830, and we went short long-dated treasuries.  We feel the book couldn’t be much better-positioned, which brings an interesting conundrum: if a book is well-positioned for likely future scenarios, it shouldn’t need adjustment.  But clearly the world changes every day, so shouldn’t that necessitate constant adjustment?  Whatever.nbsp; Frequent adjustment is costly enough from transaction and tax standpoints that we prefer to believe it’s not important.

Over the month of April, we will look to add to our equity short if the bear-market rally continues.  We’re not technicians, but the 830 S&P level is important to us because of the Other January Effect we have written about before.  We will also be thinking about how to add a bit of leverage to the book - the cash position is currently more conservative than we would wish.  With any luck, implied volatilities will increase to the point where we can sell options again; so far we have maintained a disciplined approach to selling volatility only when it looks expensive and it has paid off.

For those of you who are asking how big the bets are, we came up with the following representation of our positioning.  A traditional portfolio manager would tend to think of the book like the first column, at option delta.  However, since we do not hedge option positions dynamically and intend to hold them to maturity, we think about options as if we had the entire exposure invested, the second column.  This illustrates that our book is a bit short equities today (though long beta), but becomes long equities in the future if the price becomes more reasonable, while being long fixed income instruments and inflation - but roughly neutral rates (the duration of the net position should be low-ish).

We have no clueas to when to cut or increase our commodities exposures and so will probably hold them for a year to gain the tax benefit.

Mob rule continues.  The American Congress debated, though did not pass, a bill that would tax executive bonuses at 90%.  Congress also called on financial services companies to release names of individuals who had been granted bonuses in 2008, an act seemingly in violation of employees’ confidentiality, and one which could, quite literally, endanger those individuals to action by lynch mobs.  President Obama stated on television that he believes US citizens should pursue productive professions like engineering, not finance, though he refrained from endorsing Congress’ 90% bonus tax.  Do these facts make you feel inclined to invest in the US as a stable, democratic country, ruled by law?  Us neither.  Perhaps the reality will prove to be less biting than the rhetoric.  Some of what President Obama says, like a statement that "auto companies will not become wards of the state" is quite sensible, while other things like "from this day forward, your US car warranty is guaranteed by the US government" are just off the wall.  These are just small flotsam that we happened to pick out of the politico-financial maelstrom swirling through the media this month but much of it sounds similar.

One thing we are sure of is that as long as politicians continue to erode freedom in the markets and stand in the way of reconstruction, as long as the media focuses on finance, and as long as commentators pine for a return to "normality", there will be no durable rebound in asset valuations.