Next bubble and how to profit form it

[twacowfca]

Sanj, I think we're like the  blind men describing

the same elephant from different perspectives.

It's true that FFH's primary purpose for buying

CDS was to hedge, but they do point out , in their 2006 letter,

the enormous upside in an extreme market event.

 

This is the most astute form of value investing, something

that has intrinsic value plus a kicker that would be

pure speculation without the underlying value.

[SharperDingaan]

 

Keep in mind that riding a bubble up is momentum investing - as you're confident that there's a bigger fool than you out there. Yes you can do very well if you can catch it early, but you had better know your psychology! An entirely different mind-set from value investing.

 

We actually all know that we're in a massive financial bubble - as we speak. We can 'see' the globes Q4 & Q1 stimulus spending has now hit main street, we've heard the 'pull back' talk, .... and no-one wants to recognize that they can't 'see' what's taking up the slack as the stimilus wears off. Don't jinx it!

 

Value investing is not 'formula' investing, it's critical thinking - & the confidence to back your decisions with ongoing common sense. And it is because it's common sense, that it works in both bubbles & crashes.

 

SD

 

[Zorrofan]

If you wanted to protect your portfolio from a potential correction are you better off buying S & P LEAP Puts, a leveraged ETF that bets on the market correcting, or just out of the money puts? I ask as I am not familiar with options at all and I am more worried about protecting my portfolio than guessing what the next bubble is....

 

thanks

Zorro

[SharperDingaan]

 

For most folks it's sell 50% of the vulnerable positions (synthethic short).

 

If you're right you have the cash to buy it back, make a realized gain on the 50% short, & an unrealized loss on the 50% long. If you're wrong there's a realized loss on the 50% short, & an unrealized gain on the 50% long. Buy back the short at no more than your sell price & the cost of the 'hedge' is two commissions - a lot less than a put premium.

 

Most effective if the portfolio is also leveraged. The cash reduces the leverage through the uncertain period & the potential loss that you might otherwise have had.

 

Simple, but very unsexy.

 

SD

 

[netnet]

Remember availability bias.  Because we just went through an admitted huge bubble burst, we tend to look for another bubble right around the corner.  Are some markets over-bought, undoubtedly, but are they really in bubble territory--that's questionable.

 

Investors don't realize that speculating on things like bubbles often lead to frictional costs that will eat away at returns, since timing is a large part of getting a speculative bet correct. 

 

Sanjeev, you are absolutely right on this count, but if the odds are in your favor in whatever instrument you choose then it is NOT speculating, in the negative sense of the word.

 

 

Thus I would agree with twacowfca:

FFH's primary purpose for buying CDS was to hedge, but they do point out , in their 2006 letter,

the enormous upside in an extreme market event.This is the most astute form of value investing, something

that has intrinsic value plus a kicker that would be pure speculation without the underlying value.

 

But again remember folks that we are looking for bubbles  (mostly)  because of recent history.  Every overbought market does not a bubble make.

[vinod1]

Remember availability bias.  Because we just went through an admitted huge bubble burst, we tend to look for another bubble right around the corner.  Are some markets over-bought, undoubtedly, but are they really in bubble territory--that's questionable.

 

Investors don't realize that speculating on things like bubbles often lead to frictional costs that will eat away at returns, since timing is a large part of getting a speculative bet correct. 

 

Sanjeev, you are absolutely right on this count, but if the odds are in your favor in whatever instrument you choose then it is NOT speculating, in the negative sense of the word.

 

 

Thus I would agree with twacowfca:

FFH's primary purpose for buying CDS was to hedge, but they do point out , in their 2006 letter,

the enormous upside in an extreme market event.This is the most astute form of value investing, something

that has intrinsic value plus a kicker that would be pure speculation without the underlying value.

 

But again remember folks that we are looking for bubbles  (mostly)  because of recent history.  Every overbought market does not a bubble make.

 

Agree. From what I am reading in the financial press

 

S&P 500 at 1500 (in 2007) - Overvalued but not a bubble

S&P 500 at 1000 (late 2008) - bubble burst

S&P 500 at 666 (March 2009) - ???

S&P 500 at 1000 (Sept 2009) - Bubble

 

S&P 500 at current value is being called a bubble purely because of the path it took (666 -> 1000). I did not hear people saying it is in a bubble when it first fell to 1000. Except if you argue that the financial crisis altered the long term value of businesses, this does not make sense.

 

Vinod

 

 

[ERICOPOLY]

 

S&P 500 at current value is being called a bubble purely because of the path it took (666 -> 1000).

 

 

I think gold is currently becoming popular to discuss for the same reason.

 

Looking back 12 months, gold has been no better than AUD.  But people must look up the price of gold more frequently or something, because I hear a lot of talk about gold but not much chatter about AUD.  Maybe it's because we can't melt our jewelry into AUD.  I don't know.

 

http://finance.yahoo.com/q/bc?t=1y&s=AUDUSD%3DX&l=on&z=m&q=l&c=gld

 

[twacowfca]

Zorro, whatever you do, don't touch leveraged ETF's

even with a ten foot pole!  They are toxic and destroy value

for anything other than strict 24 hour day trading because

of the way they reset each day. They reset by rebalancing

in the last few minutes of each trading day.  This means that

traders can front run their anticipated buying or selling

when the market underlying their fund makes a move

up or down.  The result is an accurate reflection of that

day's change in the underlying values, but erosion in the

long term value of the leveraged ETF because of the

frictional costs of daily rebalancing compounded by

frontrunning on days when there is a substancial

move in the market value of the underlying equities.

[netnet]

Zorro, whatever you do, don't touch leveraged ETF's

even with a ten foot pole!  They are toxic and destroy value

for anything other than strict 24 hour day trading because

of the way they reset each day. They reset by rebalancing

in the last few minutes of each trading day.  This means that

traders can front run their anticipated buying or selling

when the market underlying their fund makes a move

up or down.  The result is an accurate reflection of that

day's change in the underlying values, but erosion in the

long term value of the leveraged ETF because of the

frictional costs of daily rebalancing compounded by

frontrunning on days when there is a substancial

move in the market value of the underlying equities.

 

To elaborate, on the above, the frictional costs are actually worse than twa describes. (I don't know about the front running part.  It is certainly a possibility.)  Particularly on the leveraged ETF's, say a 2x short fund. For example: if the underlying security or index rises 20% and then declines 16.666%, it will exactly break even. However, during that time the 2x ETF will NOT break even. As the security or index rises 20%, the ETF declines 40%. Then with a subsequent declines 16.666%, the ETF rises 33.33%. That's not enough of a recovery because that gain occurs over a lower capital base and the ETF ends up being 20% below where it started off. And because it seeks to mirror daily performance, it loses its capital base daily (or every second day, on average, if we want to be mathematical about it). Thus, volatility kills this sort of fund.

 

So a possibility would be to short a 2x.  now you would need a hedge to prevent ruin, so a call would be in order.  You probably construct a nice hedge that would make the trade work.  (It's not my cup of tea, so I haven't penciled it out to see if it really works.)

[twacowfca]

Netnet, what if the underlying security first falls 16.666% and

then rises 20%? would this not cut in the other direction

in relation to the capital base?  Or is there not some other

complication related to the constraints these funds are

under because of the swaps contracts they have with

banks?

[Uccmal]

When Oil ran up to above 120 I purchased some Horizons Betapro HOD units on the TSX.  These are inversely double leveraged to the price of Nymex Crude.  I ultimately made alot of money on the units as oil went up to 150 and then back down to 80 or 90 where I sold.

 

....But nowhere near what I should have made.  I was out probably 50% of my arithmatic gains due to the drag these units have by constantly readjusting the basket of holdings.  All of them behave the same.  Their daily tracking is quite close but long term you will ultimately end up with less than your investment. 

 

I use S&P puts - medium term to hedge any downward positions.

 

As Ericopoly mentions on another post, should they expire you take the tax loss and apply it against your gains.  It works in Canada tax wise, check for the US. 

 

 

Zorro,

I have hedged some of my holdings FFH/GE/HD leaps with June 2010 S&P puts that are at the money right now.  Should the market rise I will add more. 

[SharperDingaan]

 

Vinod

 

Keep in mind that 'bubble' is relative to where you measure from, & the sanity check is whether there is an obvious sustainable economic basis for what's going on. Choosing different measuring points changes the label, but not the sanity check.

 

Most folks recognize that without the one-time stimulus we would not have been at 1000, & that the stimilus (takes 4-6 months to work) was introduced well before the S&P was < 666 (Mar-09). The sanity check would suggest a pretty clear bubble.

 

SD

[twacowfca]

     Al, If you want to hedge/speculate in oil, a better

 Idea is Macro Oil Up (or Down) if still available.

 They had to liquidate that fund in June or July of 08

 because it had advanced beyond their preset limit.

 However, I believe they were planning to relaunch

 Those funds with new limits a few weeks later. (I haven't

 checked to see if they followed through on the relaunch)

 

    The advantage of their fund is that it's a pure derivative;  

 There are no frictional costs from constant rebalancing.  

 Even better they take the money they get from selling

 shares and buy T-Bills.  If the forward month contract

 rises, people who bought Oil Shares Up not only get

 a higher net asset value on their shares, but also

 a proportionally greater amount of interest on the

 T-Bills than those who bought the inverse mirror

 image fund, Oil Shares Down.

 

 The concept is investor friendly, unlike many funds.

[NumquamPerdo]

I deal with alot of retail investors so I have some exposure to lay-investor sentiment.  I would hazard a guess that gold still has a ways to go but I have noticed many of my less sophisticated clients inquiring about how to play gold.  But that's still a far cry from them lining up around the block to buy bullion and calling me stupid for not having exposure to it (which will happen, guaranteed).

 

It's hard for value-oriented investors to profit from bubbles.  You either have to ride something you suspect is overvalued or short the bubble, which is very difficult to time.

 

FWIW, my vote for the next bubble is carbon credits.  If someone creates a way for retail investors to access that market then God help us.

 

[ERICOPOLY]

 

Vinod

 

Keep in mind that 'bubble' is relative to where you measure from, & the sanity check is whether there is an obvious sustainable economic basis for what's going on. Choosing different measuring points changes the label, but not the sanity check.

 

Most folks recognize that without the one-time stimulus we would not have been at 1000, & that the stimilus (takes 4-6 months to work) was introduced well before the S&P was < 666 (Mar-09). The sanity check would suggest a pretty clear bubble.

 

SD

 

 

SD,

You are right, a bubble is something that cannot be sustained.  You are right, the stimulus cannot be sustained as it would eventually break the government.

 

But hold on there a minute...

 

A simple sanity check would suggest that we are building houses at an unsustainably low pace.  There is also an equilibrium level of automobile production, and without the stimulus we were producing cars at an unsustainably low rate.

 

There are unsustainably low levels of activity in the economy that are the very reason why some of this stimulus is necessary in the first place.

 

Are we, with the stimulus, now building cars and houses at an unsustainably high rate?  I'd say no.  

 

There was a bubble in house construction a few years ago, but today it's quite the opposite.  Rather than a downwards correction (what we were facing a few years ago), we now face the inevitable upwards correction... with a couple of years of waiting for the inventory overhang to clear.  

 

 

So I can't agree with you on a bubble being a no-brainer here.  The no-brainer to me is that production levels of major sectors of the economy (autos/housing) are operating at unsustainably low levels, not high levels.

 

- Eric

 

[hyten1]

personally i think when there is a bubble its pretty much a no brainer ... you should be able to spot it a mile away. its funny how i think this is true, but at the same time people involve don't see it only until afterwards... human psychic how fascinating.

 

i just want to be able to profit both from bubble and crashes... i read some people made a good deal of money from the recent Dubai trouble (selling/short their debt a few months ago)

 

maybe we can broaden the discussion... what are things that people see that is unsustainable, considerably outside then norm, few standard deviations outside the norm?

 

 

[twacowfca]

  Lets flip the interest in this topic upside down.

 

  Does this obsessive interest mean that............

 

  THERE ARE NO GOOD VALUES OUT THERE ?

[hyten1]

i am still mostly a bottom ups guy (looking for undervalue stocks) but its getting harder and harder to find extreme values.

 

its just interesting look for extremes (both bubble and crashes)

 

 

[Santayana]

 

 

So I can't agree with you on a bubble being a no-brainer here.  The no-brainer to me is that production levels of major sectors of the economy (autos/housing) are operating at unsustainably low levels, not high levels.

 

- Eric

 

 

Eric, why do you say the levels are unsustainable?    With autos, I don't see why we need to have any production in this country.   With housing, the current building rate may be unsustainable over the very long term, but I think we have years before the rate would need to increase in order to accomodate new household creation.

[ERICOPOLY]

 

 

So I can't agree with you on a bubble being a no-brainer here.  The no-brainer to me is that production levels of major sectors of the economy (autos/housing) are operating at unsustainably low levels, not high levels.

 

- Eric

 

 

Eric, why do you say the levels are unsustainable?    With autos, I don't see why we need to have any production in this country.   With housing, the current building rate may be unsustainable over the very long term, but I think we have years before the rate would need to increase in order to accomodate new household creation.

 

New cars are being purchased at a rate below replacement needs, that's why I said it.  Whatever the long term trend, production fell by 40% by Feb 2009 over a period of just a few months.  That's a sudden shock, more than twice the rate of decline in the 1982 recession.  Some people who could afford payments on cars could not buy them due to unavailablility of credit -- if the govt pumps money into the financial system so that these able borrowers can buy a car, it's not "unsustainable stimulus".  Unless one believes that the "new normal" will be an environment where banks refuse to lend to people who can afford to make the payments... I don't think so.  The stimulus buys time for the banks to earn themselves out of their losses, after which they will be able to lend without stimulus assistance.

 

Housing... I think a similar situation.  Just look at your brother... he couldn't find anyone to help him build a home even if he wanted to -- he had to set up an LLC to buy the house with a commercial loan.  That's not normal.

 

 

 

 

 

[SharperDingaan]

 

Eric. Agreed on the housing, but different logic.

 

Boomer demographics are increasingly moving into the downsizing stage; increasing demand for the more upscale, urban, one-floor bungalow/apartment - & the supply of suburban McMansion. And the suburban McMansions are allready oversupplied, as they were a prime benificary of the credit bubble.

 

Net result is an inventory overhang of obsolete McMansions, & a dearth of one-floors. Limited new-builds and a raft of 're-branded' developments. 

 

SD

[ERICOPOLY]

 

Eric. Agreed on the housing, but different logic.

 

Boomer demographics are increasingly moving into the downsizing stage; increasing demand for the more upscale, urban, one-floor bungalow/apartment - & the supply of suburban McMansion. And the suburban McMansions are allready oversupplied, as they were a prime benificary of the credit bubble.

 

Net result is an inventory overhang of obsolete McMansions, & a dearth of one-floors. Limited new-builds and a raft of 're-branded' developments.   

 

SD

 

Yes, I understand the empty nester problem and that they are a huge generation.

 

But how about the young people who are looking about for a nest?  Echo-boomer demographics are increasingly moving into the upsizing stage.  Perhaps they buy the McMansions at a discounted price, but either way there is a dam of pressure building for family-sized homes.

 

The Echo-boomers ("generation Y") are nearly as big as the boomers, yet were born in a tighter band of years.  They range from 18-30 yrs old, and they are 3x the size of generation "X".

 

 

[vinod1]

 

Vinod

 

Keep in mind that 'bubble' is relative to where you measure from, & the sanity check is whether there is an obvious sustainable economic basis for what's going on. Choosing different measuring points changes the label, but not the sanity check.

 

Most folks recognize that without the one-time stimulus we would not have been at 1000, & that the stimilus (takes 4-6 months to work) was introduced well before the S&P was < 666 (Mar-09). The sanity check would suggest a pretty clear bubble.

 

SD

 

SD,

 

Agree on the sanity check. I think we disagree due to differences in what is meant by a bubble. To me that means a near unambigous and demonstratable overvaluation. Take S&P 500 in 2000, at its peak of 1500 its dividend yield of 0.9% and normalized PE's in the 40's the expected real return on stocks in the long term is less than the return available on TIPS which at that time were having a real yield of 4.5%. This to me is a clear and demonstratable case of a bubble.

 

Take the present situation, using any of the most commonly used methods of estimating fair value for S&P 500, leads to a fair value range in the 850-1000. With nominal treasury yields in the 3-4% range and TIPS real yields around 2%, the expected returns on stocks over the very long term is much higher than bonds. It looks a little expensive but no where near the bubble range.

 

Vinod

 

[txlaw]

Most folks recognize that without the one-time stimulus we would not have been at 1000, & that the stimilus (takes 4-6 months to work) was introduced well before the S&P was < 666 (Mar-09). The sanity check would suggest a pretty clear bubble.

 

 

Perhaps we should distinguish between the spending and monetary policy aspects of the worldwide stimulus in trying to figure out their effect on the world equity markets.

 

I'm of the opinion that the one-time housing tax credit, the purchase of RMBS, and Cash for Clunkers were good for the real U.S. economy because they helped industries that employ a lot of people get through a really tough environment while the banks get on sounder footing.  Like Eric, I think that the main problem in these sectors is not necessarily with demand but rather with the extension of credit for purchases.  Mike Jackson of AutoNation has said as much with respect to new car sales -- he says that there is more demand out there than credit because the banking sector still has not fully recovered from last year's meltdown.  He expects car sales to get better starting in 2010 and normalize after 2012.  The housing sector might be similarly situated, but it's a little less clear than with autos because who knows how many people will downgrade to renting from owning going forward.

 

In any case, helping the housing and auto industries get rid of inventory through stimulus has allowed these firms to survive long enough to adjust to the business environment such that as many jobs <i>as possible</i> will be preserved.  Getting the banks healthy again will be the second part of making sure that firms in these industries survive and keep people employed.

 

I'm not sure about other spending measures such as the American Recovery and Reinvestment Act because I don't know the details of how money is being doled out (no doubt there's a lot of pork in that bill).  But note that there is still a lot of money left to be paid out under ARRA, so we will have ongoing stimulus from that policy measure.

 

What I'm trying to say is that I do not think that the spending part of the stimulus has caused equity markets to be overvalued.  Instead, I think it's the low interest/money printing aspect of the worldwide stimulus that is causing equity markets to be overvalued.  And this is exactly what policy makers want, as they need the banks' balance sheets to be propped up while loans get paid off and more cash comes into the banks' coffers.

[txlaw]

related to all of the above is the potential risk of a dollar-funded global carry trade.  see attached piece by frank veneroso, who used to work at omega...

 

Very interesting piece.  He raises some of the same questions I posed last month about the mechanics of the dollar carry trade.  It's hard to find the funding for such a carry trade on the balance sheet of the banks, as they appear to be reducing lending and hoarding cash.  And it seems odd at first that the banks, who are deleveraging, would lend money out to traders/arbitragers when they are refusing to lend out money for real economy activities. 

 

But the dollar carry trade definitely appears to be going on based on statements by all sorts of policymakers.  And Ben Hacker pointed out last month that there is anecdotal evidence to suggest that there is still lots of low interest securities lending capacity that is available to traders via the prime brokerages. 

 

On top of this, China has increased its money supply by a huge amount, and because the Yuan is pegged to the dollar, it is possible that there is a yuan carry trade going on, though Veneroso believes that the lending is primarily serving to inflate Chinese equities, Chinese real estate, and commodities located within China (which affects worldwide commodities prices due to China's buying power in the commodities market).

 

Given the above plus the the fact that Rex Tillerson (CEO of Exxon) has stated that between $20 and $25 of the price of oil is due to dollar depreciation, we should be very, very careful when it comes to all sorts of useful commodities, and especially oil and natural gas.  If the dollar carry trade reverses and the yuan remains pegged to the dollar, we could see a huge flight out of commodities that causes commodity prices to fall substantially. 

 

Rather than attempting to profit from any such fall, I'm opting to just stay away from oil, nat gas, and other non-ag commodities.