ni-co

Gary Shilling thinks $10 could be the worldwide marginal cost of production: http://www.bloombergview.com/articles/2015-02-16/oil-prices-likely-to-fall-as-supplies-rise-demand-falls As I said in in other threads as well: I'd think carefully about controlling my value investing reflexes here and control the risks. This could be a very long price slump – and then what? LEAPs are the only way I'd even consider to invest into the oil sector right now. But actually I bought puts back in December because I think they have the better risk/reward ratio. This could be a real value trap that catches many of the investors who've been so successful in buying the dip in recent years. Buffett was absolutely right to exit this awful risk/reward investment.

Have you seen what happened to Swiss equities on the day the peg broke? You have to be very confident that your productive assets remain productive when export prices shoot up by, say, 30%.

That's exactly what I did. Hedging my positions denominated in USD partly with a short USD/HKD position. Though I have to say I'm afraid to be a bit too clever by half there. I don't know whether I'm going to keep that hedge.

I agree 100%. Cheers, Gio Yes. The problem with this is simply that with all these efforts to debase the world's currencies we may get a proper inflation instead. Either way I suspect most asset prices come down initially. I think everything is currently priced for perfection: continued CPI stability in a world of unprecedentedly easy money, high debt, trade imbalances, wealth inequality, record margins, etc etc. Good luck sustaining all that. I've also been thinking about that. The critical issue here is timing. Dalio talked about this, too. I can't remember where I heard him saying it but he said something along the lines you'd get deflation first and inflation later. So, it's definitely something to be aware of but right now I also think of Howard Marks' quote that being far to early with something is indistinguishable from being wrong. I have to add though, that I always have a small fracture of my portfolio in gold LEAPs. I'm fine with losing 1% of my portfolio per year on them but I can't bring myself to buy a significant position. Maybe this will change some day but I find it too volatile to regard it as a "real" currency – the way so many hedge fund managers look at it. Dalio, and also Sam Mitchell at Fairfax, who said the key will be identifying the inflection point from deflation to inflation. I recall Klarman has very long dated, way out of the money calls on gold. Sounds good to me. How long dated can you get leaps? Also just finished reading Ned Goodman's Dundee annual letter which comes across to me at least as a rather poorly written and egotistical rant with some quite wooly thinking - but there's also some good stuff and I'm intrigued by his notion that the Chinese will eventually move the world away from the dollar as the reserve currency by backing the RMB with gold. I don't think that'll happen for various reasons, but it just opened a door in my mind to thinking about how the world might go about dumping the dollar as the reserve currency, and who might want to make that happen. I roll 2 year out of the money calls on GLD. I think there are far better ways for institutional money managers like Klarman doing this with OTC options. Michael Pettis suggests to use special drawing rights as a global currency.

I agree 100%. Cheers, Gio Yes. The problem with this is simply that with all these efforts to debase the world's currencies we may get a proper inflation instead. Either way I suspect most asset prices come down initially. I think everything is currently priced for perfection: continued CPI stability in a world of unprecedentedly easy money, high debt, trade imbalances, wealth inequality, record margins, etc etc. Good luck sustaining all that. I've also been thinking about that. The critical issue here is timing. Dalio talked about this, too. I can't remember where I heard him saying it but he said something along the lines you'd get deflation first and inflation later. So, it's definitely something to be aware of but, as of right now, I'm also thinking of Howard Marks' quote that being far to early on something is indistinguishable from being wrong. I have to add though, that I always have a small fracture of my portfolio in gold LEAPs. I'm fine with losing 1% of my portfolio per year on them but I can't bring myself to buy a significant position. This might change someday but I find gold too volatile to regard it as a "real" currency the way so many hedge fund managers look at it. And even then I'd probably prefer to look at TIPS first. Preferring gold over TIPS practically means predicting the end of the world – I don't think "my" gold would be secure in such a scenario and I'm a bit too peace loving to buy the complementary guns ;D

Thanks ni-co. I find Pettis' work excellent but as you say it can be counter-intuitive, so I find I have to think it through every time. Not helped by the fact that although I have read the China book, I got TGR on Audible and I have discovered my concentration as a listener is no match for my concentration as a reader! P I've also bought it on Audible. What works for me is taking it with me when I go for a walk. And I've listened to it twice and I'm going to listen to it at least a third time :D

Thank you, too, Gio. Yes, you are right. The problem is that QE and ZIRP worldwide brought us into a currency war – in hindsight this seems to have been unavoidable. No country wants to be the one with the high currency – including the US! A high USD is the one thing that keeps the FED from raising rates. Consensus view in the US is that lower prices will make consumers consume more. I'm very skeptical about that, to say the least. Not only is there no indicator showing that to be true (be aware that oil prices have been falling drastically since September 2014 – no positive effect on Christmas retail sales!), but baby boomers are in the process of going into retirement and they haven't been saving enough for that! They are happy over every dollar they don't have to spend right now. So, if products become cheaper because of the rising USD and consumers don't want to consume more there almost has to be a deflationary spiral. This is what the FED is afraid about and what keeps them from raising rates in spite of the good unemployment figures. I think for the time being there might remain some upward pressure on the USD but the US don't want to let this escalate because it could kill their recovery. The problem is that any counter measure the US is going to take would likely kill any hope for a recovery in the rest of the world. As long as we're in this deflationary environment and the deleveraging process is going on there has to be downward pressure on asset prices – this is just a question of time. Because my most important goal is avoiding the risk of permanent loss of capital I'm only hedged and not outright short – I bought a few put options, though. I think sometimes it's almost easier to take the birds-eye view. Think about it this way: Deflation means that the value of money rises in relation to the things you can buy with it. You can see this in commodity prices but what is true for commodities should be true for (most) productive assets, too. The products those assets produce are going to fall in price and this should bring asset prices down sooner or later. There seems to be broad consensus that inflation lifts asset prices I wonder why there is so much resistance to the thought that the reverse should also hold true: Real deflation has to bring asset prices down. The only assets that won't get hurt are those that are assured to keep their cash generation levels at least where they are – especially US Treasuries.

I'd recommend "The Great Rebalancing" as a primer. It explains the whole mechanics. It's also available on Audible. In his China book he goes more into debth with regard to, well, the Chinese economy but it's the same theoretical basis. Both books are excellent.

Trying to work this through in my head - can you elaborate? The main effect of and reasoning behind QE is keeping interest rates down and, thereby, devaluing the euro. The effect is twofold: you're making exports cheaper/imports more expensive and you pay people less money on their savings. Both depresses household consumption in the eurozone (traveling, foreign products become more expensive), forces up the savings rate (you have to save more to buy a house or for your retirement because you receive lousy returns) and, at the same time, makes the industrial sector much more competitive internationally, not only by making their products cheaper but also by providing them with cheap financing. That's what China's been doing for years now and what Germany's been doing within the euro zone. The euro zone, Japan, China, GB and even countries like Australia do the same thing now, albeit with different tools. On the other side of this trade there is more or less the US only (and smaller countries like Switzerland). Their consumers can buy products on the cheap, this increases their consumption and decreases their savings rate. Alternatively, the US could keep their savings rate constant by forcing people into higher unemployment – this forces consumption upwards in relation to savings as unemployed people still consume but don't save – or they would have to intervene in trade. They can intervene with tariffs (making imports more expensive), with higher consumption taxes or with monetary policy, essentially doing what the rest of the world is doing and, thereby, forcing the USD downwards. Momentarily, they do none of the above and this is going to either hurt their economy or let the US (private and/or public) debt grow. It has been this way until 2008 but you can only raise your level of debt so much and it became unsustainable. Since 2008 we are therefore in a worldwide deleveraging (the US had to delever and the rest of the world has to follow sooner or later). That's pretty much what we are witnessing in my opinion. By the way, I'm stealing all this from Michael Pettis' book "The Great Rebalancing" but his explanation just made complete sense to me. I think a good part of it is "classic" Keynes, though I haven't read the original. Some of it is a bit counterintuitive at first but it will become completely logical if you think it through. It also fits perfectly into Ray Dalio's explanation of what's happening right now. Yesterday, Martin Wolf wrote a very good article for the FT basically explaining the same mechanics (http://www.ft.com/intl/cms/s/0/4c7dfcb8-b5d5-11e4-b58d-00144feab7de.html – paywall – maybe googling "Unbalanced hopes for the world economy" works?). And there is a good interview with Pettis from 2013:

That’s why I said the situation is scary… Think about it: the best solution you see is for the 3rd largest bond market in the world to leave the Euro… Wow! We better expect a lot of turbulence…!! ::) Gio Do you see any other long term solution? I think the problem is that politicians don't speak out the only two logical solutions to the euro zone problem: 1. United States of Europe (my personal favorite but not (yet) politically feasible I'm afraid), 2. Euro zone break up. Every other "solution" is no solution but kicking the can down the road – the can thereby getting bigger and bigger. You might say "well, there's been a lot of can kicking down the road for quite a few years" and you'd be right but I think the state of the world economy is a catalyst this time.

Well, I just don’t see how… If the US say to the EU: stop printing, because the Euro has been devalued too much! And as a consequence Draghi stops buying Italian government bonds, and the creditworthiness of Italy then starts to matter once again… well, Italian government bonds yields will spike up like they did in 2011… but this time what’s going to bring them down? And, given the shape it finds itself in, Italy simply cannot afford paying high interests on its debt… Gio Yes, you're right, I thought more about the long term. I think leaving the euro and inflating the debt away could actually be a net positive for Italy. The status quo is simply awful for countries like Italy. The only other option would be debt restructurings every few years within the euro zone – I can't see this working out politically (in creditor countries) and I can't see why this should be any better for Italy than simply leaving the euro.

Or he needed a cool 4b for the big elephant. ;D With debt cost this low? Berkshire would essentially be paid if it took a loan to buy an elephant. I think it's highly improbable that "he was young and he needed the cash" is the explanation for this.

This makes a lot of sense... though its consequences are a little scary... Gio We're going to get through it, I guess. It might actually be good for Italy :) I'm a bit scared of asset price levels and how they're going to react under such a scenario. That's why I turned so bearish last year.

There are only two logical answers: Either Buffett decided to put oil stocks on the "too hard pile" or he regarded the long term risk reward ratio for oil stocks as too bad.

I don’t think I agree 100% here… What I wanted to say is that imo it is no longer a matter of creditworthiness… Imo interests rates are clearly being manipulated, in order to relieve highly indebted governments from the burden of interests that otherwise would be unsustainable. Do you think anyone truly believe Japan would ever be able to repay its debt?! I don’t… Do you think anyone truly believe Italy would ever be able to repay its debt?! I don’t… Most observers by now think that France is in big trouble too... Things in Europe just get messed up by the fact we pretend we are a nation, but we are not, and probably will never be… So interest rates get manipulated also as a mean to reproach those countries which don’t conform diligently to what Germany dictates… Sorry to say this, I know you are from Germany, but I simply don’t see how else to read the EU situation right now… I repeat: it is no more a matter a creditworthiness: as long as inflation or deflation permit government and central banks to keep interests rates suppressed, they will stay very low and even get lower. Gio I think I mostly agree with you. Yet, I think in Europe the two aspects intermingle. Yes, I am from Germany, but I regard the German economic/euro policy as stupid and dangerous. German politicians and the political consensus don't realize that they caused this debt problem for debtor countries. It was very beneficial for our economy to force our savings onto Italy, Spain etc. However, it has created huge imbalances for which we now try to blame other countries. And our solution is to force those countries to save more? This is just ridiculous. The point where I might differ, I guess, is that you seem to imply that central banks can play this game forever. This asset purchasing/devaluing your currency policy only works as long as other countries are willing to take the other side of the trade – effectively taking on either additional debt or higher unemployment. I don't think the US are prepared to do it any longer. This is only a question of how much they are willing to let the dollar rise. As soon as the US pull the brakes the whole world economy is going to collapse under the global lack of demand.

Insane?!… Maybe!… Until you realize that governments, so much into debt as they are, will do anything to keep rates as low as possible for as much time as possible. Imo it all revolves around inflation: if it keeps going down, rates will follow suit. And if we finally experience deflation, rates might get near zero like Japan (and Germany already!). Gio Yes, Gio, I realize this. Yet it only works as long as the market consensus is that a country is able to serve its debt. Greece doesn't have an inflationary problem, yet. And look what rates did. It's even worse: as soon as the market consensus shifts rates will rise and the country, therefore (!), won't be able to serve them. If or better when this happens it will be a self-fulfilling prophecy. If Germany signals markets that it's not willing to stem the southern countries' debt (which it very much helped to accumulate), the euro zone will break apart just by those countries' rates going up. In other words: deflationary pressures are a structural problem for the creditor countries. The only reason debtor countries suffer from it is that creditors "export" their structural problems via the euro and its rules. If the euro zone broke apart there would be huge inflationary pressures in countries like Italy and even more deflationary pressures in Germany.

Is this insane or not? That's the 5 year chart of the 10Y US treasury (orange) vs. the 10Y Italian government bond (green). I have to tell myself over and over again "Markets can remain irrational a lot longer than you can remain solvent" but that's a spread position I'm willing to take.

http://www.advisorperspectives.com/newsletters15/Why_You_Should_Own_Bonds.php This is almost exactly what I'm thinking right now. I'm a bit sceptical with regard to the USD/EUR. If the euro breaks apart we will see a massive revaluation move in Germany – a tail risk I'm trying to hedge as good as I can because it matters to me personally. Otherwise I think Shilling has it exactly right. All value investors jumping into oil right now should carefully think about the implications and risks of the above scenario vs the rewards of a scenario in which oil goes back to +$100. This is an awful risk/reward bet in my opinion. You have 10-20% upside in big oil and a really huge downside – thanks to the yield chasers. Buying XOM for its 3% yield is a really dangerous game to play (honestly, I think it's much safer to buy the 10 year treasury at 2.1% if you need the yield). Buffett, as always, smells a rat. There's really no margin of safety in big oil right now.

Out of XOM doesn't surprise me at all. You're going to see rapid cash flow declines. And they are overly committed to their capital return policy.

Very interesting! Thank you! :) Gio Just as a background: HKD instead of USD is the Bill Ackmann bet, short JPY is Kyle Bass' hypothesis and for short AUD I cloned Crispin Odey's idea of the repurcussions of China's slowdown. I'm also planning to short the Australian stock market, especially the banks, but I want to wait until they are through their monetary firepower (they are on their way to ZIRP right now). You see, I'm a friend of eclectic cloning. ;)

I agree with your assessment. For me, capital allocation is part of the fun. I want to try to do better than Marks, Watsa etc. but this is more a kind of game for me. I think it's very reasonable to simply invest with them. I have about equal exposure to EUR and HKD (which is pegged to the USD, technically I'm short USD/HKD). I'm short JPY and AUD both to HKD and EUR.

ni-co, I don’t understand: if no great business might work in the future, how is Bridgewater supposed to work?… Bridgewater is a business itself! What I am saying is very simple: if you think Bridgewater might work in the future, very well then: invest in Bridgewater! Or in anything which share with Bridgewater similar characteristics! Do you envision instead a world in which no business might work in the future? Well, if that is the world that awaits us, I am sure Bridgewater will go bust. Gio I'm only saying: be prepared. I only envision a long time slow growth environment – not the end of the world. In other words: the great businesses still may work but they might not be as great. And this has a huge effect on their valuations. Markets usually try to anticipate those things. So, if I'm right you'll see a large and lasting correction in asset prices as soon as the consensus changes towards this view. Now, if I'm wrong I will sit on a "cash" pile (i.e. I will have hedged my equities against market risk) and underperform the markets for a few years. Yet, there is no inflation in sight, so I really don't care all that much about it. I won't stop investing. But I want the markets to have at least some part of this priced in. I'm quite sure that this is not the case at the moment. And as long as I don't change my view I try to be hedged. There are always a few businesses that are going to prosper in one scenario or the other. But I'm not sure whether I can pick them in advance. I try my best. And believe me I'm trying very hard to get the 5bn I need to be allowed to invest into one of Bridgewater's funds ;-)

This is the usual macro bear argument that people have been repeating from 1980s and possibly before (I have not been around before that). There are couple issues with that: - By being in cash/etc. you are horrendously underperforming for couple years now. So it might not matter that your portfolio will drop only 30% in a crash compared to 50% of someone who is 100% in equities. Your long term result will be worse. - You are assuming that Dalio will perform better in a crash. So far a lot of algorithmic shops collapsed during the crashes because their models were not crash proof. Pretty much no value investor every collapsed during a crash. Or they recovered. - You have a mental model of what will happen. This is very dangerous. I can almost guarantee that you don't know what will happen and pretty much nobody else does. Hey, Buffett has been wrong about inflation for 20+ years. That being said, I am fine with people holding Graham-like portfolio of having 20-50% money in bonds as long as this is not a market call, not a macro call, but forever philosophy independent of the market/macro etc. Just don't expect the 100% equity returns. Two things I wanted to add here: 1. Dalio uses computer models but they are wholly fundamentally based. This is very different from your regular quant shop. I'd recommend the Dalio Interview in Jack Schwager's Hedge Fund Market Wizards book. You can get a very good idea from it how Bridgewater roughly works. 2. I think that the "stocks and bonds" mindset is exactly the problem. We've had 30 great years for stocks and bonds. Why shouldn't there be a large time period where both asset classes perform badly (assuming you take a buy and hold approach)? 3. I'm not really assuming what will happen. I realize that it's always a matter of probabilities. However, I don't think they look good for either stocks or bonds. Most value investors assume that they can't go wrong being 100% invested in stocks and bonds. Isn't this dangerous as well? I think they should expand their time horizon and realize that we are in a very special environment today. I think one thing we can say for certain is that there were several generations of investors who didn't live through comparable circumstances. Even Buffett, who's been investing longer than almost anybody, didn't experience the Great Depression as an investor. Graham did – there's a reason why he was much more cautious. 4. Assume for a second the world economy would really collapse and it would take one or two decades to fully recover. What would happen to treasuries if this period matched the time when the working population shrank significantly? Which, by the way, is a worldwide phenomenon, it concerns every developed country and China. Do you think treasuries would remain at the levels they are today? I'm not saying that you should stop investing. But I decided for myself that I'm going to think much more about these questions and that I – as Dalio puts it – invest a bit "scared".

Keep in mind that Germany's unemployment rate in the 1990s was constantly above 10%. Did we change our work ethics within just one decade? Improbable, to say the least. Spanish workers work more hours than Germans. This has much more to do with politics. Of course corruption etc. play important roles. But it's not about work ethics. I'm no economist, but I strongly suppose that in the case of a central bank keeping money in the local currency this doesn't count as savings. It's simply a reduction of money supply. Bank reserves, too, get invested. They might not lend them out as credit but that doesn't mean there's no effect on investments. Tell me why this doesn't make complete sense to you: http://blog.mpettis.com/2014/05/why-a-savings-glut-does-not-increase-savings/

Savings has nothing to do with investment? If you have a closed economy, they are complementary. Savings go up, investments go up and vice versa. That means savings and investment have to balance globally. The reason the investments exploded in China in 2010-2013 is that the U.S. and Europe reduced their demand because of the financial crisis, therefore China's trade surplus shrank and they had to balance it with higher investments.