Tuesday, May 09, 2006

The Sword of Damocles

The main orientation of my portfolio can be summed up succinctly as follows: long commodities, long foreign markets, especially emerging markets, short housing, and short the US dollar. So far things have worked out fabulously. The actively managed portfolio has returned 20+ % since inception. Year-to-date, the figure is closer to 25%. As much as I would like to believe this performance is sustainable, it cannot possibly be. In trying to find a way to depict my feelings about the stock market, the image most frequently comes to mind has been that of Damocles:

Damocles, it seems, was an excessively flattering courtier in the court of Dionysius II of Syracuse, a 4th Century BC tyrant of Syracuse, Italy. He exclaimed that, as a great man of power and authority, Dionysius was truly fortunate. Dionysius offered to switch places with him for a day, so he could taste first hand that fortune. In the evening a banquet was held, where Damocles very much enjoyed being waited upon like a king. Only at the end of the meal did he look up and notice a sharpened sword hanging by a single piece of horsehair directly above the throne. Immediately, he lost all taste for the fine foods and beautiful boys and asked leave of the tyrant, saying he no longer wanted to be so fortunate.

The Sword of Damocles is a frequently used allusion to this tale, epitomizing the insecurity of those with great power due to the possibility of that power being taken away suddenly, or, more generally, any feeling of impending doom. (Source: Wikipedia)

Although I stand by my the long term correctness of my bets on commodities and emerging markets, the counter trend moves may still be of such duration and magnitude that they cannot be ignored. I have always stated that I believe a housing-led slowdown in the US is a high probability. In this scenario, export oriented economies whose main customer is the US may suffer, or perceived to suffer, far worse than the US. Like wise, the commodity sector whose fortunes have been tied to growing demand from emerging markets may see the leverage turned against it just as quickly. I would like nothing more than to them both going up ad infinitum, but the parabolic moves of late are clear signs of speculative excess and just about guarantee a blood bath when the hot money exits.

Top calling is often a loser’s game. Accuracy and consistency is either a sign of genius or good luck, neither of which I can be said to possess. I recently dabbled in URPIX (2x inverse S&P bear fund) prematurely and had to bail out after the Fed indicated the possibility of a pause in raising rates. Although the losses was miniscule, it taught me an important lesson that to anticipate a crash, no matter how good the technical set-up, simply does not pay in this market environment. So for now my strategy remains to wait for a clean break of long term trend lines (e.g. 200 dma) before taking on any serious short positions in the general stock market. I’m keeping my BEARX (Prudent Bear fund) for now as it is actually in the green due to its gold component.

Precious metals
The ancient metal of kings occupies a special place in my heart. Long time readers know that I monitor the HUI (Amex gold bugs index) and the price of gold closely. As the HUI broke above the 350 level, I went above my usual 35% PM allocation and purchased TRE, NTO and SSRI. The first two stocks have since gained over 20%. The HUI had been stuck at the 385 level for more than two weeks while gold had gained about $40 in the same time span (see Ron Rosen). I have long maintained that the 390 level may be achievable on this leg (see the second chart in my first post on the HUI), notwithstanding some more optimistic souls have called for 420-460. The key question right now is do I consider the recent high of 387.62 a sufficient achievement of my objective, especially in view of the relative weakness of HUI vs. gold. I think the safer thing to do here is to start paring back weaker individual stocks such as EGO and put in some trailing stops in other stocks. Of course, if HUI:gold reverses and the HUI breaks through the 385-387 region, then 420 becomes a distinct possibility.

Risk factors
My current allocation to non-PM commodities is still under the 35% target, so I’m less inclined to make any changes there. I loath to hedge PMs or energy stocks directly as they could explode upwards at any moment in the present geopolitical setting. My plan is still to use bear funds or put options targeting the S&P (SPY) or the Russell (IWM). I’m also wary of shorting EEM in case the US dollar falls off a cliff. Even if the dollar only erodes gradually, the larger cap companies with multinational sales can be expected to weather the storm better than their smaller brethren. This could be the mechanism by which the “reversion to the mean” takes place.

I constantly ask myself what may be the pin prick that pops the bubble. I list some below:

  1. Housing led slow down in the US The home equity ATM may be finally turned off, causing the US consumer to finally slow down, the recent up tick in real income growth notwithstanding. Probably as much as 40% of the jobs created in this recovery were related to housing in one way or another. Believe it or not, I would consider this a (relatively) soft landing scenario. Much more serious, would be a blow-up in the loan portfolio of one of the retail banks. Or, heaven forbid, of Fannie of Freddie.
  2. Massive selling/loss of confidence in the US dollar/treasuries Even with the possibility of a retaliation for a myriad of things, out and out dumping of the US dollar/treasuries by Asian or Middle Eastern central banks is a low probability event, in my opinion. However, gradual shifting in the composition of global central bank reserves away from US dollar is definitely occurring, the most recent evidence being the announcement by the Riksbank of Sweden. The resulting upward pressure on the treasury yields will feedback to reinforce case #1.
  3. Commodity delivery failure Silver, copper (? Prices are in backwardation)
  4. Loss of significant oil producing capacity Iran, Nigeria, Venezuela, hurricanes, …
  5. An economic event in the emerging economies Both emerging market equity and debt have been on fire. Chinese investors came back from the weeklong May holidays in a buying mood. The Shanghai composite index was up 6% in two days, non-performing loans be damned. Left leaning Latin America and democratic-reform backtracking Russia have seen their stock markets leading the world (see the back page of the Economist magazine). How long is all this going to continue?
  6. Unexpected Fed raise Bartiromo-gate aside, there were always conflicting views on whether “helicopter” Ben would try to show some steely resolve as an inflation fighter. “Pause and raise” seems to be gaining some steam among forecasters. I do believe any future raises will be well televised to the market so sudden price dislocations are unlikely.
  7. Derivative implosion ContraryInvestor.com (subscription required but check out their free Monthly Market Observations) has a nice chart on the continuous growth of the derivatives market. Warren Buffet has called them “financial weapons of mass destruction”. On the other hand, Allen Greenspan has attributed to them market stability and resilience. No doubt they were designed to spread around risk, but were they the water that held up the sand castle for a greater fall? Only time will tell.
  8. Major terrorist attack After 9/11, the bombings in Spain and London, the response of the financial markets have been more and more muted. So unless there is a MAJOR attack resulting in lasting damage to key infrastructures, there won’t be much damage to the financial markets in my opinion.
  9. Global liquidity quench It may seem insane to talk about a liquidity quencyh when copper prices cut through first $3.00 than $3.50 like hot knife through butter, but many have observed the reduction in the rate of change in M2 in both US and Japan. Don Coxe mentioned that last year was the first where liquidity flew from emerging markets to the developed markets thanks again to the globalized economy we are in. But now that the Chinese are also tightening, what will come next?
  10. Democrats taking over the congress/failure to renew tax cuts/ US impose punitive tariffs on Chinese goods We can always count on the politicians to make things better, can’t we?!

If you actually bothered to read through all that you are probably wondering how I can sleep through the night. Well, the fact is that I sleep quite well knowing that the trend is on my side until it is broken. Though I do wish I knew which way the dominos will fall. I maintain that case #1 is of high probability. In cases 2-4, dollar will go down, commodities up. In cases 5 and 6, dollar up, commodities down. In cases 7-8, I don’t know what will happen. In past periods of instability, there was always a flight to safety benefiting the senior currency. This time, however, the senior currency is from an economy with negative savings and 7% current account deficits. Would the new safety be gold and other tangibles? That is the crux of the question.

Update 1
I started writing this over the weekend. On Monday I closed out my position in EGO (1200 sh @$5.30) for a gain of 9.6%. As of this moment, gold is up $19.50 and EGO is at $5.48. Ah, my wonderful sense of timing. Let this be a warning for those of you taking my ramblings too seriously.

Update 2
I’m having problems with Blogger. So this post probably won’t get posted till Tuesday night. The HUI has made a move above the 385-387 area. Here we go!

Update 3
I’m not at work today, so have plenty of time which is always dangerous. I couldn’t help but to picke up 10 Jan 80 puts on IWM@ $5.10. With such huge gains from my gold stocks I can splurge a little. Wish me luck!