Sunday, November 16, 2008

Some Gurus Got it Right!

A friend sent me this article from Seeking Alpha, Watch Peter Schiff: it Pays to be Contrarian:

I have admired and followed Peter Schiff’s work over the years. Although contrarian at times, his market analysis is very solid and insightful and can be accessed through or directly at Peter’s website.

Being bearish is almost akin to high treason in America’s financial industry and media. Some of my money manager peers discredited me for having a 65% cash allocation from January 2008 and later increasing it to 90% on September 17th, 2008 and missing the two biggest moves of the market that followed the $700 billion bailout plan announced by Treasury Secretary Henry Paulson.

Despite the current bear market, I follow and analyze the U.S. markets daily in real time, i.e. monitoring for clues of change and continually building a solid watch list of companies that highly correlates with my investment thesis. Whenever the market trend and economic fundamentals turn around, a legitimate new business cycle will offer plenty of time to realize profits. Until then, I will research investment themes and stocks that offer compelling market growth and/or value opportunities and bring them to the attention of readers.

Back to Peter Schiff… In a nutshell, the emperor has no clothes and while openly discussing this violates investment finance etiquette, Peter’s penchant for the truth should be lauded and not taunted.

The above video should emphasize many of the "media’s market gurus" are too narrow minded and myopic in their focus on the capital markets to acknowledge the possibility of a flat world or black swan. Yet in extraordinary times such as these, they also seem to refute the phoenix-like principles of the business cycle.

However, the "real investment gurus" know much better and many of them are averse to sharing these secrets of the temple with the general public. In fact, whenever the media dismisses someone like Peter Schiff, it actually serves their cause. Never underestimate the power of the art of distraction. Their recent testimony before the House Committee on Oversight and Government makes it evident that these hedgies also shared Peter Schiff’s investment bias. Yet, no one from CNBC or other mainstream financial peep shows would discredit any of them (or Peter Schiff if he had a net-worth profile comparable to theirs).

Although I continue to emphasize in the Market Condition Summary that the primary trend for equities is downward and bearish, this is the perfect time to start preparing for a bottoming process. If the S&P 500 breaks support at the 840-850 level, then another down-leg testing the 2002 and 2003 lows between the 770 to 790 range could be experienced.

Understand that there will be no blaring of trumpets to usher in the new bull market and this is why it is more important than ever to monitor companies or securities with good fundamentals and price-volume relationships that confirm accumulation patterns to correctly identify their intermediate and long-term market direction.

Instead of being obsessed with the current situation, remember that, like Peter Schiff and some of the elite hedgies, it pays to be contrarian.

While I agree with Peter Schiff on most accounts, I strongly disagree with him on the final end game. He sees an era of hyper inflation coming back into the financial system whereas I agree with Nouriel Roubini and David Rosenberg that debt deflation will be the end game.

As mass layoffs are set to explode, cash strapped banks are raising their fees desperately trying to squeeze debt laden consumers, which is why you are seeing bankruptcies soar to unprecedented levels:

The sagging economy sparked 106,266 consumer bankruptcy filings in October, the first time monthly filings topped 100,000 since the bankruptcy law changed in 2005, the American Bankruptcy Institute said Tuesday.

During the first year after the new law took effect, personal bankruptcy filings plummeted dramatically, and since then, have risen gradually. In October, though, filings jumped 40% over the same month in 2007. For the year, bankruptcy filings are expected to exceed 1 million.

"This underscores that the underlying economic problems of consumers who are facing high debts, flat incomes and now declining home values are a very powerful force that pushes people over the edge," says Samuel Gerdano, ABI executive director.

While the risks were ignored, this crisis wasn't unexpected:

Most people describe the happy days before the crisis as a bull market, but not James Montier. Societe Generale's plain-speaking global head of strategy calls it the "dash to trash" – a period when the madness of crowds led market participants to ignore risk in almost every way.

The collapse that followed this orgy was not an example of one of Nassim Taleb's black swans – a massive and unpredictable event – but a clearly predictable consequence of what was going on in the markets. Indeed, plenty of economists and market watchers did see it coming. Bob Shiller, for example, a Yale economist who prodded Alan Greenspan into making his "irrational exuberance" comment in 1996, first warned of a housing bubble more than three years ago.

He made the following prediction in an interview with the New York Times in August 2005: "A very plausible scenario is that home-price increases continue for a couple more years, and then we might have a recession and they continue down into negative territory and languish for a decade." But Shiller and his fellow sceptics were in a minority.

Montier says there are several reasons why the market consensus was so wildly over-optimistic, despite the alarm bells. First, he argues, many modern risk management techniques helped give senior bankers a misplaced sense of confidence. "Things like value at risk give an illusion of being able to quantify risk," he says. "And yet we can neither quantify nor control risk in any meaningful sense."

To make matters worse, the financial industry also tends to have a self-serving bias towards happy thoughts, because most participants generally tend to do better when markets are rising – so it doesn't serve anyone's interests to draw attention to flaws in markets, accounting models or the banking system, which is why practices such as mark-to-model valuations didn't come under closer scrutiny. "It's like asking a school kid to mark his own homework," says Montier. "Don't be surprised if he gives himself 100%."

Finally, most of us are not good at spotting change. To illustrate, Montier gives the example of a popular study in which test subjects are asked to watch a clip of a basketball game and count the number of passes. Halfway through the video a gorilla walks on to the court and beats his chest, yet when asked about the clip 80% of subjects say they didn't notice anything unusual.

This is a phenomenon known as change blindness, and Montier says it can apply to markets too. "We're not inclined to look for what we don't expect to see," he says.

But some people were, in fact, expecting to see a collapse. Strategists like Montier, who are happy to work outside the consensus, were tracking the bubble as it moved through the stages described by economists Hyman Minsky and Charles Kindleberger. The key stage in the progression is commonly known as a Minsky moment; when financial distress flips into all-out revulsion, asset prices collapse and liquidity evaporates.

Back in June, Montier and the SocGen global strategy team had some particularly strong views that several markets were due to reach their Minsky moments, and his analysis prompted the bank's structurers to create a series of structured products aimed at hedge fund clients that would take advantage of the coming collapse.

At the time, crude oil was at $135 a barrel, the US dollar was at $1.56 to the euro and the S&P500 was at 1,350 points, but Montier was confident that all those values were toppish and the structurers, led by Stephane Mattatia in Paris, calculated the best way to express his views and were ready to go out and sell the products by early September.

Mattatia's so-called collapse-put was a straight forward one-year bet against 10 stock indices and crude oil. The pricing models put a very low probability on the bet coming off, based on the assumption that markets as diverse as Turkey, China and South Africa, as well as those in the developed world, are not likely to fall in tandem. With the odds apparently stacked against him, Mattatia was able to price the option cheaply with a strike of 110, meaning that investors have the right to sell the best performer in the basket at a 10% premium to the early September price.

Of course, as it turned out, the bet came off almost immediately. Right now, the best performer in the basket is South Korea's Kospi 200, down 21% since September 1, which means the option has an intrinsic value of 31% today. The option was priced at less than 3%, so investors are currently sitting on a return of more than 10 times their capital.

Even so, investors who bought the collapse-put may be worried that their bet came off too soon, but Montier is confident that equities are yet to hit rock bottom. Valuing stocks by looking at their price-to-earnings ratio is fine, he says, but only if you discount the effects of the business cycle. One way to do this is to use a 10-year moving average, and by this measure US stocks are not yet "super cheap", he says – they are at roughly 20-times right now, compared to a long-term average of about 15.

Current P/E ratios also support a gloomy outlook. Compared to average P/E levels, markets are signalling a 23% earnings decline in the US, 33% in Asia and 40% in Europe.

The second bet combined Montier's three main predictions: stock markets and crude prices would fall, and the dollar would rise. The triple European digit had a premium of roughly 20% and will pay back 100% after six months if the euro-dollar rate is down by more than 1%, the Euro Stoxx 50 is down by more than 2% and crude oil is down by more than 3%.

That looks like a safe bet today. The euro-dollar rate is down about 13% since early September, the Euro Stoxx 50 is down 28% and the price of a barrel of crude has fallen 47%.

Another of Montier's observations is that the bubble was biggest in the emerging markets, where over-optimistic investors overpaid for the hope of growth. His cyclically adjusted P/E for the emerging markets shows that valuations are still way above long-term averages and have considerably further to fall.

To capitalise on this view, Mattatia's team structured an outperformance trade that pits the two worst performers in a basket of developed market indices against the two best performers in an emerging indices basket. Investors bought a call on the spread between the two with a strike price of 110, and paid a premium of 3.5%.

At the moment the spread is zero, which means that the call is 10% in the money. The S&P500 and Nikkei 225 are down a combined 65%, which is exactly the same as the combined fall of the JSE Top 40 in South Africa and the National 30 in Turkey.

Ironically, the heart of Montier's investment philosophy is that nobody knows very much about what is going to happen in the short term – he describes his prescient call on the collapse as lucky timing – and that the only sensible way to invest is to have a longer time horizon.

By far the biggest contributor to returns during a one-year time horizon are changes in valuations, which, he says, are essentially random. But over a five-year horizon dividend yield and growth in real dividends account for as much as 80% of real returns – and these are things that fund managers should be able to analyse and understand.

Unfortunately, the market is biased against letting fund managers do that. "Good long-term performers underperform in the short-term," he says, which, in effect, means that people who get rewarded on the back of short-term performance are incentivised to underperform in the long term. Or as Montier puts it: "Doing what I say will generally get you fired."

Indeed, there is a disconnect between the tyranny of short-term performance and what is best for pension beneficiaries over the long run.

It isn't simply about setting long-term incentive compensation right, but also about having the fortitude and the wisdom to go against the grain and protect your beneficiaries from downside risks in spite of what your peers are doing.

No comments:

Post a Comment