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Next bubble and how to profit form it


hyten1

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even people realising that it is a bubble and who choose not to participate, might refrain from taking the opposite side of the trade because they know that the irrationality might persist for longer than their bank accounts. And when people refrain from taking the other side of the trade - then this also helps forming the bubble.

 

I think this is incorrect.  Bubbles don't burst because there are investors with opposite positions.  They burst usually because at some point, they are no longer sustainable.  As one triggering event occurs, a cascading effect usually leads to the unwinding and deleveraging of the entire system.  Now investors with the opposite position can speed the process of the unwinding, but they are never the underlying trigger.

 

By the same token, I don't believe Prem et al. just got lucky with their CDS "hedge", just randomly buying a cheap hedge that happened to pay off during a random panic.  I think they identified something that was likely to be a bubble, and figured out a way to profit from it.

 

I don't think Prem and the team really were as concerned about profiting from the hedge as simply protecting their behinds from a one in fifty year storm.  They held those hedges for over three years before they enjoyed the full benefit...and that was just icing on the cake.  For an insurance business, it is often necessary to hedge against certain macroeconomic risks, because it means the difference between being able to write business and being out of business.  For the average investor, hedging provides little value as the frictional costs over time will actually hurt their results.  Cheers!   

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Guest Broxburnboy

Re: Gold bubble

 

I think the point has been made many times that an ounce of gold purchases roughly the same amount of hard and soft commodities it has historically, as far back as you care to take it. The same can not be said of fiat currencies like the US dollar. By any roughly equitable measure it is the buck and other financial instruments whose purchasing power has diminished as its supply has increased and is further expected to continue to do so, possibly to the point of worthlessness.

The purchasing power of gold has remained stable (though a bit lumpy) mainly because its supply can not be inflated. During times of currency instability, gold becomes more desirable as a store of value and its price reflects this increased demand. Look for the price of gold to continue to rise if the dillution of the purchasing power of currencies continues, look for it to stabilize if Western economies show real GDP growth and balance their spending/taxation dynamics. Look for the gold price to skyrocket in US dollar terms if the economic fundamentals of the US economy continue to deteriorate even with increased "stimulus".

 

This article says it far better than me:

 

http://www.atimes.com/atimes/Global_Economy/KK14Dj01.html

 

On a completely different (but related) subject, a diary entry by the Madge Hedge Fund Trader, which is relevant to today's

bubble in equity markets:

 

http://www.madhedgefundtrader.com/November_12__2009.html

 

Cheers

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To be clear on my comments from an earlier post...I don't think gold is in a bubble, I believe that gold is entering a bubble. 

 

It is ironic to me though...people are flocking to gold b/c the U.S. currency is being devalued.  U.S. currency is useful only because people accept it as a valid currency and are willing to trade with it.  Gold has a similar pyschological effect - it is only a hedge because people accept it as a hedge. 

 

I am the world's worst trader when it comes to gold, but I do believe it is entering a bubble which may continue for a year or two.  We'll see.

 

I also think that bubble will pop.  But I would rather play the market by buying companies involved with oil, pipelines, real estate, etc...stuff that gets used vs. stuff that is an "accepted" store of value.

 

Just my 2 cents.

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  • 2 weeks later...

Commodities and resources.

The market is looking for a place to park their money.

In 2004 after the tech wreck it was housing.

This time around with rates at the same low rates of 0-1%, my gut feel is that it will head into commodities (again).

Front page news is always BRIC.

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You can buy cheap out of the money puts that have no margin requirements and capped downside.

 

Oldye,  please explain how one can do this.  Is there a

point where margin requirements are waived for out of

the money puts and calls?  How can a put be caped on

the downside?

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The supposed equities bubble is confounding me because a rising tide should lift all boats.

 

YTD performance:

Berkshire +6.6%

JNJ  +3.9%

WFC -4%

 

Eric, it's only in the latter stages of a bubble that

this happens.  Ergo we' re not in a general equities

bubble yet.  This is not to say that the current

market is over or undervalued.

 

 

 

 

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even people realising that it is a bubble and who choose not to participate, might refrain from taking the opposite side of the trade because they know that the irrationality might persist for longer than their bank accounts. And when people refrain from taking the other side of the trade - then this also helps forming the bubble.

 

I think this is incorrect.  Bubbles don't burst because there are investors with opposite positions.  They burst usually because at some point, they are no longer sustainable.  As one triggering event occurs, a cascading effect usually leads to the unwinding and deleveraging of the entire system.  Now investors with the opposite position can speed the process of the unwinding, but they are never the underlying trigger.

 

By the same token, I don't believe Prem et al. just got lucky with their CDS "hedge", just randomly buying a cheap hedge that happened to pay off during a random panic.  I think they identified something that was likely to be a bubble, and figured out a way to profit from it.

 

I don't think Prem and the team really were as concerned about profiting from the hedge as simply protecting their behinds from a one in fifty year storm.  They held those hedges for over three years before they enjoyed the full benefit...and that was just icing on the cake.  For an insurance business, it is often necessary to hedge against certain macroeconomic risks, because it means the difference between being able to write business and being out of business.  For the average investor, hedging provides little value as the frictional costs over time will actually hurt their results.  Cheers!   

[/quote\]

 

The amazingly astute insight that Prem, Brian et al had

was much more than downside protection.  Their earlier

hedging strategy had been merely to buy S&P 500 puts.

If that was all they had done before the recent crash,

they would merely have bought protection against a

decline in the value of their equity portfolio.  However,

they realized that CDS could be bought for an annualized

cost not much different than S&P 500 puts, and that

these would pay off with a much larger gain once the

credit bubble popped, than the usual hedge.

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Buying a Put(going short) gives you the right to put the gold to the seller at a set price...its insurance if you buy the right for 200$ you can't lose more than the 200$. 

Here is an example:

http://finance.yahoo.com/q/op?s=GLD&m=2012-01...you can purchase the 90 put for 560$...you'd need gold to trade below 850$ sometime between now and Jan 2012 , if gold goes up you can't lose more than the 560$ you purchased the put for.  That said I haven't done it yet and won't unless I buy something I want to hedge. 

 

I'd be far more interested in a poorly run, high cost, leveraged gold mining co. than the actual metal but I don't follow any mining co's so if anyone see's something interest I'd be all ears. 

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Since we have some consensus that gold is going up from here into bubble territory why not buy gold, ride it up, and sell.  With the situation in Dubia and possible spinoffs gold's rise may be meteoric from here.  Notice the words: consensus, may be, etc.  I wont be trying this. 

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Guest Broxburnboy

Since we have some consensus that gold is going up from here into bubble territory why not buy gold, ride it up, and sell.  With the situation in Dubia and possible spinoffs gold's rise may be meteoric from here.  Notice the words: consensus, may be, etc.  I wont be trying this. 

 

I don't see any such consensus.. the bubble story is the devaluation of the US Buck and competitive devaluation of other currencies. Those who expect the price of gold to crash are playing the opposite trade... a sustainably stronger US dollar. This is quite unlikely as each day other countries seek to diversify their foreign exchange holdings. Russia just announced its intention to diversify to the Loonie (of all things) and continues to buy its own gold production. India made another purchase of gold from the IMF and Vietnam has added to its gold stash in order to prop up the Dong (no Viagra sold there). Central banks, ETFs and hedge funds throughout the world are now net buyers of gold..if this is a bubble, it is in its very early stages, as is the collapse of the US buck.

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I think the last time I commented on Gold, it was on the old message board, I purchased gold at $394 (physical) various coins graded MS-11 , MS-13 and Silver at $7.  At the time (2004), Kudlow and Cramer (when they were on together) stated, "shorting gold below $400 is a no-brainer." 

 

With that said, the people on this board are scary smart, with an uncanny ability to spot bubbles short term and long term, when oil was $100+ and approaching $150 level, a lot of smart people here rightly placed trades that were subsequently in-the-money. 

 

For me, gold is an ideology passed down from my father (jeweler in Iran) and his father.  I know gold is considered money, I've seen it first hand in the Mid. East.  It's also one of the few assets that has no liabilities in it's physical form (but not in equity). 

 

At Grant's conference, John Paulson put it best, "What I'm looking at is not where gold is going to be tomorrow, one week from now, one month from now, three months from now. What I'm looking at is where is gold going to be vis-a-vis the dollar one year from now, three years from now, five years from now. And I think, with a high probability at each of those points, gold will be higher than it is relative to the dollar today. That probability increases the further out you go. So when I look at what the risk is, the risk to me is far more staying in dollars than it is in gold at this point."

 

Paul Tudor Jones in his most recent letter stated, ""I have never been a gold bug. It is just an asset that, like everything else in life, has its time and place. And now is that time. The economic and political comparisons to the late 1970s are too numerous to ignore. And as such, gold is at the center of our thinking as a store of value during a period of potentially large and persistent global portfolio shifts. The temptation to directly, or indirectly, monetize rising fiscal deficits globally means gold could have a bid for the foreseeable future."

 

I didn't buy based on Paulson or Jones and I don't know where gold is headed tomorrow or next year.  I do think that in a World that is increasing debt to pay off debt, asset classes with the lowest relative debt can and should thrive.  Overall, I do think value investors have a lot of problems with gold, and correct me if I'm wrong, but the basis for that problem is Mr. Buffett's view. 

 

S.K.

 

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It's viewed at useless in the States, but trust me, some of the rest of the world considers it money and vs. the dollar and other currencies with no control at the printing press, it has not been a poor use of my capital.  I do plan on selling some at some point and purchasing my dream home (one physical asset to another physical asset). 

 

S.K.

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Since we have some consensus that gold is going up from here into bubble territory why not buy gold, ride it up, and sell.  With the situation in Dubia and possible spinoffs gold's rise may be meteoric from here.  Notice the words: consensus, may be, etc.  I wont be trying this. 

 

I don't see any such consensus.. the bubble story is the devaluation of the US Buck and competitive devaluation of other currencies. Those who expect the price of gold to crash are playing the opposite trade... a sustainably stronger US dollar. This is quite unlikely as each day other countries seek to diversify their foreign exchange holdings. Russia just announced its intention to diversify to the Loonie (of all things) and continues to buy its own gold production. India made another purchase of gold from the IMF and Vietnam has added to its gold stash in order to prop up the Dong (no Viagra sold there). Central banks, ETFs and hedge funds throughout the world are now net buyers of gold..if this is a bubble, it is in its very early stages, as is the collapse of the US buck.

 

Brox, you just agreed with me.  On this board we, including you, seem to have some consensus that gold is going up.  For what its worth.  It's going up relative to something else same as anything else does.  Still not an investor.  I will find it easier to short it when its gets scary high in a year or two.

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Shah, some interesting comments.  Buffett has never liked gold but then Buffett can run a business like no one else on earth so why would he buy gold.  He bought Sees, Buffalo News, and WPO instead of gold during the last run up.  This time he is buying railroads and preferred shares.       

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Shah, some interesting comments.  Buffett has never liked gold but then Buffett can run a business like no one else on earth so why would he buy gold.  He bought Sees, Buffalo News, and WPO instead of gold during the last run up.  This time he is buying railroads and preferred shares.       

 

Yup, and at this stage, for him to move the needle, he would have to take a 2x Paulson position.  It wouldn't make sense.  However, I think most value investors, in the most simple way of categorizing the group, are ROIC and FCF screeners.  Before I get responses begging to differ, I understand I'm making a very generalized blanket statement.  The point I'm trying to get across, is simply Gold is senseless and downright foolish based on ROIC and FCF metrics.  You have to be breaking value investing commandment rules to invest in gold if you're a value investor; hence the reason I rarely talk about it.  Also, in my experience, owning gold is equivalent to being a gold bug, clearly I am not. 

 

 

Given the choice, Gold at $1,200 vs. JNJ, WMT, and some of the world-class franchises out there, I wouldn't put a dime in gold.  Trust me.

 

S.K.

 

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Shah, gold was probably the ideal investment for

your family when they were in Iran.  Your dad would have

been able to add value to it as a jeweler, and it was

certainly ideal that it would very likely appreciate in value

and be easily moved to a place of safekeeping in time

of trouble.  We are very blessed in North America that

we have not experienced such trouble in recent history.

I think I'll buy a few Maple Leafs, just in case...

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Chou had some words on a bubble that he sees...

  • However, when compared to corporate bonds, U.S. treasuries are in bubble territory. In our
    opinion, this is the worst time to hold cash and short-term treasuries unless you believe we are
    headed into a 1930s style depression. And if you believe that you should redeem all your Fund
    units.

...and the counter move that he sees...

  • CONSTANT MATURITY SWAPS: With world governments flooding the system with liquidity
    and keeping interest rates unduly low, we wonder what financial instruments we can use that will
    protect us if inflation takes hold. We want an instrument similar to an insurance policy whereby
    the most we could lose is the amount of premium we pay upfront but get all the upside if the
    interest rate rises. We have identified two such instruments: Constant Maturity Swap Rate Caps
    (CMS RC) and Constant Maturity Swap Curve Caps (CMS CC).
     

http://choufunds.com/pdf/SeAR%2009%20printing.pdf

 

 

I like to run and hide from stuff that is in a bubble. Rather, I like to find stuff that is in a bear market and unloved. Other than perhaps the US$, not alot to chose from...

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At this point, I'll take gold and silver over those constant maturity swaps.  There will be a time to move into those but that is tougher bet than gold/silver at this point.  My view is in line with Paulson's - gold is the easier bet.

 

To execute that view I bought out-of-the-money LEAP calls on silver (SLV) and shorter-term out-of-the-money puts as a hedge.  Those calls are within 5-10% now of being in the money now.  That is for notional of about 80% of my portfolio.

 

Ericopoly has identified the best values out there: large cap quality stocks such as JNJ, KO, BRK.  I am in those but hedged against the Russel 2000.

 

I also have puts out-of-the-money on the Russell 2000.  I am expecting another recession in 2010 or 11.

 

With all that, I am comfortable adding bread and butter small/mid cap values if I find them but will remain hedged. 

 

 

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The amazingly astute insight that Prem, Brian et al had was much more than downside protection.  Their earlier hedging strategy had been merely to buy S&P 500 puts.  If that was all they had done before the recent crash, they would merely have bought protection against a decline in the value of their equity portfolio.  However, they realized that CDS could be bought for an annualized cost not much different than S&P 500 puts, and that these would pay off with a much larger gain once the credit bubble popped, than the usual hedge.

 

They may have noticed that opportunity as credit spreads continued to narrow and added to their stake, but their original investments were made purely on the premise to protect their portfolio and reinsurance recoverables.  Virtually all of the swaps they purchased in the first couple of years were done solely for that purpose as Prem indicated in the 2006 Letter to Shareholders excerpt below:

 

Just a brief overview for you on our credit default swaps, which are 5-year to 10-year fixed income derivatives, which fluctuate with credit spreads, that we have purchased from major banks. Here is an example. To purchase a 5-year $100 million credit default swap on a company that sells at a 30 basis point spread over treasuries, one has to invest 150 basis points (30 basis points/year 5 years), so $1.5 million purchases protection on an underlying $100 million of credit exposure of the chosen company over the next five years.  The maximum loss to the purchaser in 5 years is $1.5 million if the credit spread stays at 30 basis points or tightens even further. On the other hand, if the credit spread on this company doubles to 60 basis points, the credit default swap can be worth as much as $3 million, and if the company goes bankrupt, that swap can be worth up to $100 million. We have a diversified list of companies, mainly financial institutions, with respect to which we have paid approximately $250 million to purchase protection on underlying credit exposures.

 

Prem does not like to speculate, but he's happy to accept a wager if it is already included in the cost of a hedge.  Thus any large profits they would make on the swaps when they initially invested, were just icing on the cake from buying protection at such extraordinarily low prices. 

 

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.  The mortgage bubble could have gone on for several more years.  And Fairfax's $500M investment could have easily become a $1.5B investment as the five-year swaps expired and they had to double down on the protection.  It's just fortunate (for Fairfax anyway) that the bubble collapsed when it did.  Cheers! 

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