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Middle of the Road

I stopped reading Hussman regularly about a year ago. His pieces are not conducive for a good night's sleep—a a statement which may come back to haunt me—but mostly, just because he has been wrong for so long that I simply lost interest [1]. His latest article, however, is worth reading in its entirety because it is one of the few pieces I have read in a while that excellently captures the frame of mind of investors at the moment. 

I will let John speak for himself; 

Several years of persistent yield-seeking speculation provoked by zero-interest rate monetary policies have created a fertile ground for cognitive dissonance. On one hand, any observer with historical perspective knows not only that the overvaluation from this kind of speculation inevitably ends in tears, but also that the heavy issuance of new speculative and low-quality securities during the bubble finances and enables unproductive malinvestment that leaves the economy far worse off in the end. We should recognize that this same narrative was observed in the late-1920’s bubble-crash, in the tech bubble-crash, in the housing bubble-crash, and will be remembered painfully, but in hindsight, as the QE bubble-crash. On the other hand, prices have been advancing.

Presumably, Mr. Hussman is talking about U.S. equities here since I can certainly come up with a number of markets where prices have not been advancing. And herein also lies the rub. In the current investment enviroment, there seems to be only two options. If you are in the upbeat corner, you believe in the trend and that Spoos will recover swiftly from every 5% correction and you act accordingly (probably with a nice dollop of leverage). The alternative is the seventh ring of hell, where a catastrophic 50-70% drawdown lurks just around the corner. The ability to say "I f*cking told you so" and the prospect of the warm fuzzy feeling of being able to deploy cash at firesale valuations outweigh the short-term pain of being short, in cash, or long vol since 2011 in what has, arguably, been one of the most steady and strong bull markets ever in U.S. equities.

My problem is that I don't like either, and I wonder whether both could be wrong. Consider for example a scenario in which the S&P 500 trades sideways this (with volatility), but equities in down-trodden Chile, Brazil, Eurozone bank sector, energy (etc) offer outperformance, or even, decent absolute returns. I think we have to, at least, entertain the notion that when it comes to the current investment environment, sector and country rotation represent the "X" that marks the destination for outperformance. Sometimes, the middle of the road is not such a bad place [2].

Portfolio notes: 

Not much to report. It has been an altogether volatile start to the year with the biggest position (KGF) seeing a rather unpleasant retracement after having some real legs into the end of last year. We remain convinced, however, that it can push higher in the first quarter. Elsewhere, the gold and US treasury position are providing a little bit of relief, and the upbeat earnings release from RSW was also a positive surprise. In the long-term part of the portfolio, we have exploited recent weakness to open up a position in Malaysian equities. We expect to do the same with Brazil and Chile towards the end of February. Cash balances remain about 20%, and the poor start to the year for risk assets is not enough for us to up this ratio ... for now! 


[1] - The flipside here is of course that Hussman is one of the few investors out there who sticks religiously to his framework, and for that he has my unwavering respect. But for the average investor (professional or retail) following his advice has been extremely costly (no matter what happens next). 

[2] - Polemic appears to have the same story; I agree completely with this narrative. If you haven't bookmarked this blog, by the way go do it. 


Did a Butterfly Just Flap its Wings in Denmark? 

I am not entirely sure, but the decision by a number of plain vanilla investment managers in my home country to increase redemption fees on their high yield funds does raise my eyebrows quite substantially. Last week Sydinvest thus followed Sparinvest in increasing the exit-fees on a number of their high yield bonds, and you don't get a clearer signs of illiquidity. I doesn't, yet, violate my view as expressed in my two previous posts that sector rotation in the latter part of the cycle can still garner significant excess returns, but if this becomes a general tendency, I would run for the hills.

Consider a big diversified HY fund, and the following sequence of events.

1) They try to sell a bond from Energy Turd 1, marked to market at 95, but get it off at 75.

2) The get scared as they begin to sense that liquidity is drying up, and if redemptions continue/accelerate they might not be able to meet cash demands.

3) They impose Hotel California type exit costs in order to share the burden of the illiquidity costs with the investor.

We have heard talk about the Fed, and the regulator, considering exit fees on bond funds, and I am very curious to investigate whether this is actually happening on a larger scale. The Danish example above indicate that it might be, and we should look for this trend, if it is indeed one, to migrate into ETF space as well. If large buy-and-hold investors are still not getting worried, I think we are ok at the margin, but if the likes of Templeton et al. suddenly decided to do a little spring-cleaning in their bond portfolio the liquidity of the market could be stretched to a breaking point. 

During the sell-off in October, the big guns were quick to express their desire to buy the dip, but the hole is just getting smaller. The chart in this post by Dealbook on just how concentrated the holdings of some of these issues are is a huge warning sign for me. This also leads me to adjust my strategy (in preparation) for how to ultimately play this. Shorting the equity and debt of the underlying companies and sectors, energy for example, has been a lucrative punt, but the big one has to be heart of the carousel. When the largest bond funds of the world start slugging it out to reduce their bond portfolio sizes, the equity of the likes of BLK, BEN and ALZ could be real juicy plays on the probability of the non-financial corporate debt binge going systemic. Central banks will come to the rescue, eventually, and the next big rounds of QE in the US will likely include corporate bonds, but we are far from such a point. First comes the panic, and it might not come next year, but when the Fed shakes the tree (and I think it will), apples rottening on the vine will be the first to hit the ground. 

If the notes above represent a working hypothesis for the sources of the next global financial panic, the portfolio remains broadly constructive. It has benefited nicely from the Santa rally, which arrived right on cue, and to boot, the biggest positions has had some real legs in the past week. Unless the world ends in Greece, this year should be very good indeed. Specifically, the position in Eurozone banks is holding up, just, but is trading poorly, and is starting to represent dead money given the uncertainty (and rising bullishness) for the first quarter. Elsewhere, it is all very much steady as she goes except for the performance of CNA which has been atrocious. Overall, in the next few months, I still think the market is about to show the bears just how effective divergent sector leadership can be in forcing a steady grind higher in global equity indices.