2008 and Beyond… (What To Do in a Bearish Market)

Hedging Is Past Its Prime

I think in 2008 and beyond the concept of hedging will fall apart. Hedging was a construct that quants dreamed up to make products have no risk, or at least managed risk. The thing is that hedging works, but you will still loose money due to the premium of setting up the hedge. At Wikipedia a hedge is defined as:

In finance, a hedge is an investment that is taken out specifically to reduce or cancel out the risk in another investment. Hedging is a strategy designed to minimize exposure to an unwanted business risk, while still allowing the business to profit from an investment activity.

People misconstrue a hedge with some type of fact as illustrated in Wikipedia:

Since the trader is interested in the company, rather than the industry, he wants to hedge out the industry risk by short selling an equal value (number of shares × price) of the shares of Company A’s direct competitor, Company B. If the trader were able to short sell an asset whose price had a mathematically defined relation with Company A’s stock price (for example a call option on Company A shares) the trade might be essentially riskless and be called an arbitrage. But since some risk remains in the trade, it is said to be "hedged."

How is there a relationship between Company A, and B? It is assumed because implied is that if the company A’s shares went down, so will Company B, thus the hedge of shorting B will become profitable. But what if Company B goes up, and Company A goes up? You cannot deny that possibility. The real problem and this is where hedging becomes a problem is how well can you determine that "fact?" Answer is that you can’t.

About a year ago I posed a question on CNBC European Power Lunch and asked, "What books do I read to learn about the market and hedging?" The gentleman was an older gentleman and paraphrasing he replied, "you know hedging is overrated and not as profitable as actually taking on the direction." He also gave me some good books to read, which I have. When he said hedging was overrated I was wondering why, but now I understand what he is said.

Whenever you establish a hedge you are defined a certain behavior, and then you have to ask the question why not take on that risk in the first place?

What is being implied is that at the end of the day every hedge involves opening yourself to some type of risk. Thus if you can measure the risk, why not take on the risk and manage it properly? For example, why are we so bent on hedging stocks? Why not just sell the stocks, and buy some bonds or treasuries and collect the interest on that? I know why we don’t want to. We want to have our cake and eat it too. We don’t want to miss on any upswing, but don’t want to take part in a down swing.

One thing that came to my mind, does Warren Buffett hedge (by way of link)? The text is at the end of this blog and I urge you to read it. It is long, but very interesting and vividly points out the problem of hedge funds and their constructs. So if Warren Buffett is skeptical, and is holding oodles of cash (in contrast most funds don’t) should you not be concerned as well?

So what do you? You don’t hedge anymore! You stay aware, and look at all of the risks! You look at what Warren has to say and do and follow his advice. I feel we are entering a market where growth will not be a part of the story, but keeping value will be. And who is the best at that? Warren Buffett!

As We All Grow We All Shall Bust

Warren Buffett has critiqued derivatives and many have shot back at how he is saying, "good for me, but not you."  The blog entry is an example of missing what Warren Buffett is really saying. What he was saying is, and this needs highlighting.

Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one another. The troubles of one could quickly infect the others. On top of that, these dealers are owed huge amounts by nondealer counterparties. Some of these counterparties, as I’ve mentioned, are linked in ways that could cause them to contemporaneously run into a problem because of a single event (such as the implosion of the telecom industry or the precipitous decline in the value of merchant power projects). Linkage, when it suddenly surfaces, can trigger serious systemic problems

You may say, well gee Warren tell us something that something we don’t know. Take a good look at the date of the blog entry… Did you see it… March 2003! The height of this centralization of problems was not even starting to show. Yet in 2003 Warren pin referenced it to a T! Hmm, who did I say was holding oodles of cash right? Oh yeah, some old fart called Warren Buffett.

I blogged about how recently somebody told me of the problems regarding bond ratings, and these days you probably have heard about MBIA, and their problems.

One day after its ratings outlook was cut to negative by Standard & Poor’s, bond insurer MBIA (MBI) took another hit after it presented details of its exposure to the troubled credit markets.

MBIA said Dec. 20 that its total exposure to bonds backed by mortgages and collateralized debt obligations is about $30.61 billion. Included in that exposure is a pool of about $8.14 billion in CDOs backed by a combination of other CDOs and mortgages, which some analysts consider the riskiest part of an investment portfolio.

Thus the problem will be that there will be a global slow down, and it will be the reason why the overall slow down will be more marked than usual. People have always said that there was a coupled market, but I would argue counter to that. Remember the Japan crisis? Russian crisis? How much did those events affect the rest of the world? Not really! I present a opposing view that until recently the world has actually been growing and busting independent of each other. My Wife and I came to Europe to escape the 91-92 recession that occurred in North America. And in 2003 Germany entered a short recession. Did any of you catch that?

Germany’s recession continued in 2003: for the previous three years, Europe’s biggest economy had the lowest growth rate among EU countries. In Aug. 2003, Schröder unfurled an ambitious fiscal-reform package and called his proposal “the most significant set of structural reforms in the social history of Germany.” Schröder’s reforms, however, did little to rejuvenate the economy and angered many Germans, accustomed to their country’s generous social welfare programs. His reforms reduced national health insurance and cut unemployment benefits at a time when unemployment had reached an alarming 12%.

How was the American economy doing when the Russian ruble fell apart?  Oh yeah it was 1998 and the American economy was in the middle of the dot com bubble. My point is that while some economies slowed down, they never stalled or synchronized up with each other. Each of these economies acted as if they were connected with rubber bands allowing independent moves from each other.

Now the world economies will be coupled, and when the bubble bursts it will be a global bubble burst. I believe the synchronization of the economies is a real problem because each of the economies will have to be start up in sync. This synchronization up and down takes time, thus delaying and prolonging the downturn and upturn of the economies.

I am seeing this slowdown and upturn lasting 6 to 10 years.

How would you invest in this market? Protect yourself using Warren Buffetts investing techniques. Yes I am repeating Buffetts name again. But I have been writing this blog entry for a solid week and I keep coming back to Warren Buffett as advice. I think he will be, and has been the investor that has shown time and time again how to get through the good times and bad times.

Investing Through Basketing

Basketing is the process of creating your own index. It means that you stop thinking in big single concepts like BRIC, NASDAQ, Gold, USD, or EUR. You think in terms of building your own products. This is not pairs trading, or relative trading, or diversification. I am not talking about hedging, I am talking about specializing in fields and then building your own portfolio. This is not about diversification because in my mind diversification is about reducing risk, thus like hedging. I am not talking about Jim Cramers am I diversified (2).

Jim Cramer in his am I diversified show said that the guy from Indiana was not diversified because he had three financial’s (Country Wide, Morgan Stanley, and Fannie Mae). I would actually call those three as an example of basketing and how it actually is a good idea. Ok I might not agree with the guy’s selection of stocks, but those stocks do represent a basket in my eyes.

Basketing is about learning a few domains and specializing in them. As one of my earlier stock investment books said, you can’t compete against those people who eat, live, and breath the markets. You need to create your own niche, your own forte. If you can’t do that, then get yourself a fund manager who will spend that time for you. By building a niche you have the ability to execute in a consistent and robust manner.

The real problem with investing is that technical analysis whether it be PE, PEG, and moving average only gets you so far. They are complements to other pieces of intangible information such as market potential, corporate execution, etc. By building a niche you have the ability to execute on those intangible pieces of information. You don’t want to focus on a few stocks, but focus on sectors and then a few stocks within those sectors. This is what I call building a portfolio through basketing.

Here is how I basket:

1. Pick a sector that is a cash cow. For example you could pick a bunch of dividend stocks that are large American corporations.
2. Pick a domain that is growth. This could be tech, or financial’s, or retailers. This could include sectors like financial’s in South America. Please stay away from sectors like BRIC because that is not a sector. That is like saying, I will invest in half the world and see where things take me.
3. Pick a pot luck domain. This could be green stocks, genetic engineering stocks, what have you. These stocks are your high risk high payoff sectors.
4. In each of these domains learn everything there is. Learn who the players are, learn the magazines, books, and things those players are doing.
5. Pick a basket of stocks in each of the domains and follow them like hawk. Follow their P/E, follow their potentials.
6. Then invest in each appropriate to the amount of risk that you deem is right. Ok this one comment is vague, but this is where you apply standard risk management techniques.

Daytrade:

When sentiment is bearish or the market is not knowing what to do it is actually a good time for traders. I have talked to some of my friends who are traders and they are making money hands over fists. We have market swings in the 1-5% range per day, which is prime territory for experienced traders is a boon for making money. The problem with day trading is that it is yet another skill to learn. Day trading is not investing, and thus don’t think it is easy to get into and make money. Though it is something that you can do in a market like this.

Bonds:

Yes bonds are not sexy nor do they pay high dividends, but they do for the most part keep your value. There are many corporate or municipal bonds that pay ok and they are triple A rated. One problem with bonds is that you might be subject to currency fluctuations. Invest in bonds in your primary currency.While many argue that the dollar is being deflated and becoming worthless, the real question you have to ask is "do you actually care?" You only care if there is inflation, and if there is inflation you need to invest in something that beats inflation. Generally speaking right now bonds do an ok job of beating inflation. Assuming that you are in this for the long run (eg a couple of years) there are two bonds that come to mind (General Electric ISIN XS0276027389, or Shell Oil ISIN XS0235456752) Both of these bonds are yielding around 4.5%. Not great, but not that bad. The coupon rate is higher on both bonds, but due to the fact that the Fed dropped the interest rates the prices of the bonds have gone up thus generating less yield.

Commodities:

I would be careful about this one because the commodities market is jigged and you can very easily get caught with your pants down. I would stay away from gold, but maybe move into silver or platinum. These are valuable metals that have a purpose other than being buried in the ground. Though the main issue with these plays is that you are going to run the risk that prices do drop. In the long run I don’t see a decline in need of commodities. The reality is that the developing countries have needs and wants. The question is how much are they willing to pay. I could envisage a pullback. Though if there is a pullback it might present itself as a great moment to step in. My point is that commodities is a growth play, but one with risks.

Productive Land:

Ok, this one will probably sound flaky, but get a property (without a house on it). If you have the ability to manage it, get a property that has hardwood trees, or is attractive for hunters, or has Christmas trees, or some type of fruit. Stay away from softwood lumber since that is being dragged down by the housing market. If you get an empty lot for building houses you need to do quite a bit of due diligence because you want a property that you can sell in say 5 to 10 years from now. This is where demographics comes in. Where are people moving to? What are they going to be doing 5 to 10 years from now? As one person said to me, "land they are not growing it on trees."

The problem here is that you might overpay and not get the returns you want. If you are going to buy a productive piece of property you are going to have to do some hands on work. One person told me that a client of his bought a hardwood forest to make flooring destined for Europe. Everyday he is sending a container of hardwood (50,000USD profit) to Europe. Another suggestion is to buy property that takes advantage of global warming. Twenty years ago Quebec could not produce wine. Now Quebec is one of the top ice wine producers and is starting to produce red (REALLY bad red, but red none-the-less). Another idea is niche food (eg speciality forest mushrooms) or speciality organic herbs and vegetables. All of these ideas require a hands on approach, but don’t require huge amounts of capital.

There you have it my thoughts on how to invest for 2008 and beyond. Overall I am bearish and becoming defensive. I am trying to keep value, and organizing my ducks such that I keep what I know and discard what I don’t know. I don’t think its time for risky bets in sectors that you don’t know or don’t understand.

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Warren Buffer:

The explanation of how this is happening begins with a fundamental truth: With unimportant exceptions, such as bankruptcies in which some of a company’s losses are borne by creditors, the most that owners in aggregate can earn between now and Judgment Day is what their businesses in aggregate earn. True, by buying and selling that is clever or lucky, investor A may take more than his share of the pie at the expense of investor B. And, yes, all investors feel richer when stocks soar. But an owner can exit only by
having someone take his place. If one investor sells high, another must buy high. For owners as a whole, there is simply no magic – no shower of money from outer space – that will enable them to extract wealth from their companies beyond that created by the companies themselves. Indeed, owners must earn less than their businesses earn because of “frictional” costs. And that’s my point: These costs are now being incurred in amounts that will cause shareholders to earn far less than they historically have.

To understand how this toll has ballooned, imagine for a moment that all American corporations are, and always will be, owned by a single family. We’ll call them the Gotrocks. After paying taxes on dividends, this family – generation after generation – becomes richer by the aggregate amount earned by its companies. Today that amount is about $700 billion annually. Naturally, the family spends some of these dollars. But the portion it saves steadily compounds for its benefit. In the Gotrocks household everyone
grows wealthier at the same pace, and all is harmonious.

But let’s now assume that a few fast-talking Helpers approach the family and persuade each of its members to try to outsmart his relatives by buying certain of their holdings and selling them certain others. The Helpers – for a fee, of course – obligingly agree to handle these transactions. The Gotrocks still own all of corporate America; the trades just rearrange who owns what. So the family’s annual gain in wealth diminishes, equaling the earnings of American business minus commissions paid. The more that family members trade, the smaller their share of the pie and the larger the slice received by the Helpers. This fact is not lost upon these broker-Helpers: Activity is their friend and, in a wide variety of ways, they urge it on. After a while, most of the family members realize that they are not doing so well at this new “beatmy-brother” game. Enter another set of Helpers. These newcomers explain to each member of the Gotrocks clan that by himself he’ll never outsmart the rest of the family. The suggested cure: “Hire a manager – yes, us – and get the job done professionally.” These manager-Helpers continue to use the broker-Helpers to execute trades; the managers may even increase their activity so as to permit the brokers to prosper still more.

Overall, a bigger slice of the pie now goes to the two classes of Helpers. The family’s disappointment grows. Each of its members is now employing professionals. Yet overall, the group’s finances have taken a turn for the worse. The solution? More help, of course. It arrives in the form of financial planners and institutional consultants, who weigh in to advise the Gotrocks on selecting manager-Helpers. The befuddled family welcomes this assistance. By now its members know they can pick neither the right stocks nor the right stock-pickers. Why, one might ask, should they expect success in picking the right consultant? But this question does not occur to the Gotrocks, and the consultant-Helpers certainly don’t suggest it to them.

The Gotrocks, now supporting three classes of expensive Helpers, find that their results get worse, and they sink into despair. But just as hope seems lost, a fourth group – we’ll call them the hyper-Helpers– appears. These friendly folk explain to the Gotrocks that their unsatisfactory results are occurring because the existing Helpers – brokers, managers, consultants – are not sufficiently motivated and are simply going through the motions. “What,” the new Helpers ask, “can you expect from such a bunch of zombies?”

The new arrivals offer a breathtakingly simple solution: Pay more money. Brimming with selfconfidence, the hyper-Helpers assert that huge contingent payments – in addition to stiff fixed fees – are what each family member must fork over in order to really outmaneuver his relatives. The more observant members of the family see that some of the hyper-Helpers are really just manager-Helpers wearing new uniforms, bearing sewn-on sexy names like HEDGE FUND or PRIVATE EQUITY. The new Helpers, however, assure the Gotrocks that this change of clothing is all-important, bestowing on its wearers magical powers similar to those acquired by mild-mannered Clark Kent when he changed into his Superman costume. Calmed by this explanation, the family decides to pay up.

And that’s where we are today: A record portion of the earnings that would go in their entirety to owners – if they all just stayed in their rocking chairs – is now going to a swelling army of Helpers. Particularly expensive is the recent pandemic of profit arrangements under which Helpers receive large portions of the winnings when they are smart or lucky, and leave family members with all of the losses – and large fixed fees to boot – when the Helpers are dumb or unlucky (or occasionally crooked).

A sufficient number of arrangements like this – heads, the Helper takes much of the winnings; tails, the Gotrocks lose and pay dearly for the privilege of doing so – may make it more accurate to call the family the Hadrocks. Today, in fact, the family’s frictional costs of all sorts may well amount to 20% of the earnings of American business. In other words, the burden of paying Helpers may cause American equity investors, overall, to earn only 80% or so of what they would earn if they just sat still and listened to no one.

Long ago, Sir Isaac Newton gave us three laws of motion, which were the work of genius. But Sir Isaac’s talents didn’t extend to investing: He lost a bundle in the South Sea Bubble, explaining later, “I can calculate the movement of the stars, but not the madness of men.” If he had not been traumatized by this loss, Sir Isaac might well have gone on to discover the Fourth Law of Motion: For investors as a whole, returns decrease as motion increases.