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Watsa from his 2014 annual letter


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We continue to worry about the unintended consequences, and continue to hedge our common stock portfolio for the reasons discussed in our last few Annual Reports. Just to highlight a few of them:

1. The U.S. total debt/GDP ratio is at a very high level and significant deleveraging is yet to come. This applies to Europe and the U.K. also.

2. Economic growth in the Western world is still very weak in spite of huge monetary and fiscal stimulus by the Fed and the ECB. In nominal and real terms, annually since 2009 the U.S. only grew by 3.9% and 2.3% respectively (while Europe grew by 1.6% and 0.5% respectively). In spite of this anemic growth, after-tax profit as a percentage of GDP in the U.S. is at the highest level of the last 60 years.

3. Inflation in the U.S. and Europe, after five years of huge fiscal stimulus, is still in the 1% area – and falling. We remind you that it took five years after the stock market crash in 1990 before Japan saw deflation – and this deflation continued for most of the following 19 years.

4. QE1, QE2 and QE3 have helped the financial markets but have not worked in the real economy. What happens when everyone realizes that the Fed and the ECB have no more bullets?!

5. There is a monstrous real estate and construction bubble in China, which could burst anytime. It almost did in 2011 but China increased its credit growth significantly since then.

6. Reaching for yield continues everywhere, with junk debt at record low yields, emerging market debt in U.S. dollars at very low yields and corporate bonds at very low spreads. Many emerging market countries also have significant external debt in foreign currencies. All vulnerable to a ‘‘risk off’’ run on the bank!

 

 

 

In the last few years we have discussed the huge real estate bubble in China. In case you continue to be a skeptic, here are a few observations from Anne Stevenson Yang, an American who has been in China for over 20 years and is the founder of JCapital Research in Beijing:

1. China added 5.9 billion square metres of commercial buildings between 2008 and 2012 – the equivalent of more than 50 Manhattans – in just five years!

2. In 2012, China completed about 2 billion square metres of residential floor space – approximately 20 million units. For perspective, the U.S. at its peak built 2 million homes in a year.

3. At the end of 2013, China had about 6.6 billion square metres of new residential space under construction, around 60 million units.

4. Yinchuan, a city of 1.2 million people including the suburbs, has 30 million square metres of available apartments – roughly 300,000 units that could house 900,000 people. This is in addition to the delivered but unoccupied units. The city of Guiyang, capital of Guizhou Province, has roughly 5.5 million extra units for a city of 5 million.

5. In almost every city Anne has visited, pretty much the whole existing housing stock has been replicated and is empty.

6. Home ownership rates in China are estimated to be over 100% versus 65% in the U.S. Many cities report ownership over 200%. Tangshan, near Beijing, is one.

7. This real estate boom could only be financed through unrestrained credit growth. Since 2009, the Chinese banks have grown by the equivalent of the entire U.S. banking system or 15% of world GDP.

8. The real estate bubble has resulted in companies extensively borrowing and investing in real estate or lending on real estate in the shadow banking system. This is exactly what happened in Japan in the late 1980s.

9. And one observation of our own: Since 2009, the easing by the Federal Reserve combined with the explosive growth in China, backed by higher interest rates, has resulted in huge inflows (‘‘hot money’’) into China. The near unanimous view that the renminbi would strengthen has resulted in a massive carry trade where speculators have borrowed at low rates across the world and invested in China, almost always backed by real estate. The shadow banking system in China – i.e., assets not on the books of the major Chinese banks – is estimated by Bank of America Merrill Lynch to be approximately $4.7 trillion or 51% of Chinese GDP. Oddly enough, prior to the credit crisis, the U.S. had $4.5 trillion in asset-backed securities outstanding or approximately 31% of U.S. GDP. You know what happened then. When the flows reverse in China, watch out!

 

These observations remind me again of the following quote from Michael Lewis’ essay in Vanity Fair, ‘‘When Irish Eyes are Crying’’, which I wrote to you about in our 2010 Annual Report: ‘‘Real estate bubbles never end with soft landings. A bubble is inflated by nothing firmer than expectations. The moment people cease to believe that house prices will rise forever, they will notice what a terrible long term investment real estate has become and flee the market, and the market will crash.’’ Amen!

As they say, it is better to be wrong, wrong, wrong and then right than the other way around!

For those of you who believe a picture is worth a thousand words, please watch the recent BBC documentary ‘‘How China Fooled the World’’.

Finally, in our 2007 Annual Report, we quoted Hyman Minsky, the father of the Financial Instability Hypothesis, who said that history shows that ‘‘stability causes instability’’. Prolonged periods of prosperity lead to leveraged financial structures that cause instability. This quote was in relation to the U.S. in 2007. It applies in spades to China in 2013!

Any credit event in China will have very significant ramifications for the world economy, as China is the world’s second largest economy and consumes 40% to 50% of most commodities

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Seems to be pretty prescient on China. Other than that, I held all the same views/points - but China is proving to be a key trigger/risk right now. Let us see what happens over the next few weeks/months.

 

As I explained in an earlier post on another thread with Dazel, my view/guess is: The market basically continues to correct (with violent upward spikes - including when the Fed says they were just kidding about raising rates) until the Fed reverses course - meaning not just making it clear it will NOT raise rates, but making clear it is flirting with QE4 (or alternatively, we get something equivalent from Chinese authorities which would have to be huge).

 

The Fed can not rescue the market near-term - until more of a sell-off - because they are looking the other way (ie thinking about raising or waiting). Pain needs to be felt first for the Fed to do a complete about-face at this point. So, if you believe like me that the markets (Equities, junk debt, etc) have risen because the Fed always had everyone's back - and they don't/can't at this point - you are at least fully hedged at this point.

 

But don't worry, if you are unhedged, they will probably attempt another reinflation of assets, so this could be a material and abrupt correction followed by a policy response. My concern is that if that is not as effective this time around, the investment landscape will materially change (ie a seminal event that happens once every 30-40 years).

 

In any case, that is my market prognostication for what it is worth.

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I just read on Bloomberg some guy starting to talk about the Fed saying they won't raise at all...and they may have to do QE4!!!

 

Wow, a week ago, only lunatics had that perspective.

 

Having said this, there should be very strong counter-rallies. One will come when the Fed decides its not raising rates this year...I think that will be very painful for me, but I just don't know if that will stop the decline or not...

 

When the market starts talking QE4, that'll probably stop it and between massive chatter and the Fed starting to debate that is probably the time to exit the shorts.

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Dazel,

 

By the way, how are you trading this? I have way too much short exposure at this point. I will exit the 100% notional in the money puts on Monday (we were down 5% last week, and if down another 2% Monday, that'll be good for 7% down).

 

This way, I will only be holding the cheaper short-term just out of the money options I am holding representing roughly 300% notional. I will take 100% off of that as significantly more pain is felt, then the final 200% later (when QE4 chatter really heats up, assuming it does).

 

 

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hahaha OM correct!Lucky timing...it certainly has not been my strength in the past!

 

That is a sweet return for you last week!!! Good for you! I certainly am not making out as well as you are on the downturn..yet! However, I sold out a massive position in U.S financials that I have been able to do twice this year at the top so my liquidity-cash level is at an all time high. I "am" buying Fairfax in a big way and I will continue to do so...like you they had a stellar week last week! As you know i do not use short term language very often..but what is happening has been coming for a long time. I am more excited about the buying opportunity ahead but missing-profiting on the correction would be so fun!

 

note China opened down 5%...I think we could get a 20% plus correction here (the Fed will step in at that point) but I do agree there will be big bounce trading opportunities which I will be ready for....Volatility is our friend.

 

Best of luck!

Dazel

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make that 7% down in China now...OM you will be a happy camper tomorrow! You will have a tough decision to make on your hedges...

I am pretty sure we will see a 10% plus up day in Fairfax in this environment when the market figures out where they are positioned. It is very tough to buy shares and when the institutions figure out that they can tell their clients they bought Fairfax for protection against this blood bath their will be a buying stampede.

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now 8% down...wow.

 

feels like 2008....read the comments from Prem at the top of this thread again...it is like he had a play book for what is happening now globally!

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I was 200% long Valeant though which had a very bad week last week. But at this point, the stock price is so close to the strike on the call LEAPS I bought, there is not much more downside on that long - so even though my only stock position was down dramatically, last week my portfolio edged up a bit. From here on in however, any further declines in the S&P are all gravy from the 400% notional short of which I am taking off 100% Monday leaving 300% (against a 200% notional Valeant position that can not go that much lower given the dynamics of the options pricing on that).

 

I do expect precious metals to do well in this environment as well.

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hahaha OM correct!Lucky timing...it certainly has not been my strength in the past!

 

That is a sweet return for you last week!!! Good for you! I certainly am not making out as well as you are on the downturn..yet! However, I sold out a massive position in U.S financials that I have been able to do twice this year at the top so my liquidity-cash level is at an all time high. I "am" buying Fairfax in a big way and I will continue to do so...like you they had a stellar week last week! As you know i do not use short term language very often..but what is happening has been coming for a long time. I am more excited about the buying opportunity ahead but missing-profiting on the correction would be so fun!

 

note China opened down 5%...I think we could get a 20% plus correction here (the Fed will step in at that point) but I do agree there will be big bounce trading opportunities which I will be ready for....Volatility is our friend.

 

Best of luck!

Dazel

 

I'm also thinking 20% correction - possibly relatively fast - before the Fed steps in.  I wouldn't be surprised if they start talking about changing course even before that. So this shorting thing, while a nice position to be in, is very tricky to execute. Take out the Fed, and it would be easy to hold the shorts... my plan is therefore to do tranches, with the first tranche likely starting Monday at some point.

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pre market dow futures down 322....30 points on the S&P 500...

 

how good do you feel OM!

 

I  am hoping to be able to increase my Fairfax position substantially here as their bonds (1.99% 10 year and 2.69% 30 year treasuries tonight), individual and index shorts and deflation hedges will explode higher in a full fledged correction. I looked at Gold but Prem and his team are positioned for this...Gold is not reacting well as it did not in 2008 when Fairfax took off higher. Only when the fed jumps on board to stop the correction will Gold move and I think there is time for that...so I will look to buy during the correction.

 

 

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pre market dow futures down 322....30 points on the S&P 500...

 

how good do you feel OM!

 

I  am hoping to be able to increase my Fairfax position substantially here as their bonds (1.99% 10 year and 2.69% 30 year treasuries tonight), individual and index shorts and deflation hedges will explode higher in a full fledged correction. I looked at Gold but Prem and his team are positioned for this...Gold is not reacting well as it did not in 2008 when Fairfax took off higher. Only when the fed jumps on board to stop the correction will Gold move and I think there is time for that...so I will look to buy during the correction.

 

I'm feeling OK, but I'll feel good only when the trade is unwound (tranche by tranche) and the portfolio gains are in. I agree on Gold, but remember the market is forward-looking. If you and me - the couple of idiots getting lucky here - could figure this out a few weeks/months ago (ie stocks exposed as internals breaking down big time, Apple and other high-flyers also start breaking down with S&P crossing 200-day moving average, Fed is going to be trapped therefore no Fed until significant drop, the Fed probably comes back in with a u-turn into QE4) it won't be long before the macro guys realize Gold is going higher. Hell, even the Fed wants it higher given the deflationary pressures we are seeing now. Its not exactly a coincidence that Stan Druckenmiller - probably one of the foremost experts on currencies/macro - just went long 20% of this portfolio with GLD.

 

Actually, would you not agree that the more the stock market sells off, the closer we get to Gold going materially higher - I just don't think its wise to compare what we have now to 2008. We may be going into full-on currency debasement mode now. It shouldn't take more that a few days or week or two to start seeing big time upward pressure on Gold if this continues. The miners are in the shitter, they would make a great hedge (ie cheap/asymmetric) , in my view, to your deflationary FFH bet. You know the Fed is going to try to take out your deflationary bet - and the rest of the market will think that also.

 

I don't know, you may have a bit of time... my feeling though is it might not be much time.

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now 8% down...wow.

 

feels like 2008....read the comments from Prem at the top of this thread again...it is like he had a play book for what is happening now globally!

 

Another 8%? Wow, if that keeps up, it'll drag down North American markets on Monday morning big time.

 

Make that 9% now at 11:00.

 

just a hair under 10% at 12:15 - I'm going to bed now; in China, they are going lunch now!

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Ok, they're rebounding a bit but it's still a bloodbath in Asia. The US futures do not reflect such a dire situation  for the open in the states.

 

I'm not as fancy with you guys with so many derivatives, just waiting for stuff to get cheap to buy. All I can say is that stuff still needs to drop a bit from where it is to get really interesting. Some names like BRK, ROST, DE, and WMT are closing in on that number.

 

My problem is that I'm running into position limits for BRK.

 

I may buy FFH. Btw, Dazel I think you're wrong. I think FFH will sell off, I got this feeling that FFH's equity hedges are not well known outside this board. But the one issue I have with the hedges ( and I know you'll disagree with me here) is that the only way they're of any value is if they're closed and collect some funds. If we stay on them and the market rebounds (eventually it will) and we're still holding them the gains will be gone.

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I agree with rb. Unlike deflation derivatives that might be for sale at the right price, I doubt that Prem will exit equity hedges if market drops even 20%. I hold FFH, but not because of their equity hedges.

 

I am buying BRK. Most of the other stocks are still too expensive for my taste, including the ones mentioned by rb. There are pockets of cheapness, though some of them might be illusionary (oil cos for example).

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What will happen tomorrow in US stock market.

 

Watsa from his 2013 annual letter. Quoting Gary Schilling

 

the grand disconnect”. This “disconnect” or gap will be closed by either eco- nomic fundamentals rising to meet the financial markets or the markets coming down to meet the fundamentals. We think that the latter is likely and that the Fed has simply postponed the inevitable by its QE1, QE2 and QE3 actions.

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I hope you guys are right about Fairfax price action but I think you are forgetting the global attention that Fairfax received for their 2008 drubbing  of the markets! Remember that they will have their market cap in cash to buy the cheap quality stocks like they did in 2008! The win is two fold a huge win (to break even Fairfax would need to make over $5 billion from their hedges!!!) but what they do with the win is the key...if you did read Prem's 2008 annual letter you would know that they were giddy at the opportunity to buy cheap stocks with their hedge winnings.

 

we will see!

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Jumping the gun a little Dazel, China is still only at the level it was at the start of this year and we haven't seen anything implode yet in the US aside from commodities etc. We can also just have a normal correction without any fundamental economic change.

 

But to be fair, I sure miss my puts from last year (many went to zero or were sold after I figured I really couldn't time any of it). All I hold is 40% cash and some CRM puts (the only frikkin' stock that keeps going up).

 

Dazel do you expect this to be a prolonged correction/economic downturn? Because why would you rather buy Fairfax instead of other high quality stuff that gets cheap? Or do you hold and buy now to sell in a few months?

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Tombgrt,

 

today was officially called black monday in China and although the market just turned negative for the year it is the reasoning for the quick crash that is scaring everyone. I have not seen anyone do what fairfax has to profit-hedge to cash in from the fallout that they have called almost precisely.

In "my" opinion there is no one with a higher quality company than Fairfax in this environment...if you find one let me know.  We are going to have a deflation scare as the numbers come in this fall and the Fed is gone for now so the nose bleed valuations in companies like CRM are going to get crushed. To be sure the baby will get thrown out with the bath water...but there are companies that could lose 90% of their value and still be over valued.

 

Fairfax added to their shorts, deflation hedges and bond portfolio significantly this year...if you add their $6.5 billion in cash you see a company that will benefit more than any other in this market environment. why would you sell that in couple of months when you know they will deploy that dry powder to any cheap stocks that they see that will set them up for growth for years? I do not have access to deflation hedges...and the massive size of hedge bet for Fairfax  is a game changer.

 

 

I think we are just getting started...but that makes more sense now to you and others who questioned it two weeks ago...a 30% correction is warranted by high valuations and declining growth...this in turn will cause a worldwide deflation scare not seen since 2009. The US was in deflation last year....Gold is not reacting because no one knows what to do with deflation.

Fairfax looked silly for 5 years with unrealized hedge losses they are going to reverse taking book value up sharply.They will look very very smart in hindsight...but that is nothing new for them as they have done it before.

 

 

 

 

 

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It would be a good idea for Fairfax to release an update on their hedging portfolio with the vote for the Watsa family voting structure results today to let their investors know how the hedges are performing. They have taken a lot of criticism for these hedges in the past so it is likely they will let us know how smart they are and let the market know they are a safe haven.

 

As has been stated here the public outside this board does not know about their hedge program as it took awhile for the market  to understand their hedge program in 2007-2008 (for those not following the other threads...they realized of $4 billion in profit from that hedge program).

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As has been stated here the public outside this board does not know about their hedge program as it took awhile for the market  to understand their hedge program in 2007-2008 (for those not following the other threads...they realized of $4 billion in profit from that hedge program).

 

Which is exactly why I figured buying FFH now (or earlier) is maybe too early. On the other hand, if they do make outsized returns from here and the market figures it out, you could miss the boat.

 

 

As a side note: It will be interesting to see who will be buying if sh*t hits the van. Early october 2011 many seemed to have missed the boat even though VXO was very close to 50, indicating some serious fear in the market.

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