Cult of the Guru and Independent Thought

You wont believe who said this….but more on that later.

Depression Not Recession

Depression Not Recession

To say that I read a lot of outside research from the sell side, buy side, independent shops, blogs, tweets, and whatever else I can find would be an understatement. I read about one actual book a week along with a gazillion pages and articles of research. I basically get paid to think, read, look at and model data, and……think some more.

That last part is of course key because it is what brings together everything else I do. Sadly I have found that far too many people, and in this case investors/traders, fail to do this. Too many people find a guru or two or three and then attempt to just follow what the guru does, or at least what the investor thinks the guru does. If you actually get to sit in the office with Buffett or Soros or someone similar day after day then maybe this strategy would work–although it probably won’t–but barring that it definitely will not.

We, and by we I hope I mean me and anyone reading this, study great investors to learn the how of what they do and not just what they are doing. I scour 13F’s as much as the next guy…..OK maybe a lot more, but the point remains that if you are not also thinking about both what the famed investor is thinking and whether any of this is applicable to your portfolio. then it is all for naught.

For example look at Warren B. Most people who claim to be following his methodology buy and hold stocks and claim that they are never going to sell. While this may or may not be a successful strategy–for most it ends up being mediocre–it is NOT where Warren B has actually generated most of his outperformance. It is also NOT what he has said to do.

We could go on for a few days on this topic, but the short version is that Warren B says that the ideal stock–sorry, in B terms, it is a company–is one that he never has to sell. Living in reality however WB has regularly bought and sold stocks. In addition he has done more than his share of workouts–in Graham/Dodd speak a workout is what most now refer to as Merger Arbitrage–not exactly a buy and hold forever deal. On top of all this he trades derivatives in massive size, has traded commodities more than once, and finally, at least for now, he gets investment deals that no regular person has a chance of getting into. How many of you did Goldman call up in the 2008 crisis? I was sitting by my phone, but it never rang.

All of this is not to rail on an aspiring Baby Buffett, in fact everyone should read all the Berkshire letters, the Buffett Partnership letters (his Hedge Fund), “How to Trade Like Warren B” by Altucher, “Buffett” by Lowenstein, and all of the academic studies and other books written on the guy. You will learn many things but two stand out. 1-Warren B is a great businessman but a lot of your beliefs about him are probably wrong and 2-You should now have learned enough to adapt parts of his philosophy to your own personality and become your own investor. Notice that I did not say “you can now follow Warren B’s every word and outperform.” The reality is that you can’t. You have to learn from but not worship the great investors.

In the end after you read or listen to anything from anyone but especially supposed “experts” you need to think for yourself.  Failing to do so not only guarantees that over time you underperform but likely makes you drastically underperform.

I love writing this letter and putting my thoughts down on paper. I run a model portfolio to keep me accountable for my official “trade ideas,” but I would hope that anyone reading it would think, read, think some more, and then make a decision about whether what I am saying makes sense to them as well as their portfolios before possibly doing anything.

Why am I all anti-guru all of the sudden? First of all, I have always been anti-guru worship. Second of all, I have had 4 conversations in the past few days regarding the comments of one of my guru heroes. Being unsolicited conversations I thought now a good time to explain my anti-hero worship and blind following.

Professionally my two gurus are undoubtedly Stanley Druckenmiller and Ray Dalio. They are amazing at what they do based on any measure. They make money in most up and down markets, have made more than just about anyone, are both macro, both wicked smart, etc. etc. Basically my goal is to emulate them……but in my own way.

If you are familiar with them, you have already recognized that while they are both macro, they go about things very differently and seem to have different strengths. Where Dalio is king of detailed economic research, Druckenmiller is king of risk taking and risk management.

Both are very much worth studying but guess what?…….They have both been wrong before and will be wrong again.  This is why it is critical that you think for yourself. Everyone, even the best, are wrong on a regular basis.

All this brings us to the next point: A few days ago Dalio came out saying that he expects more QE sooner rather than later. He then clarified what the news reported by writing on LinkedIn his views. Here is the link and it is worth reading for yourself.

The Dangerous Long Bias and the End of the Supercycle

He could be right, and he brings a well thought out case for why he thinks that more QE is on the way. However, I have read it a few times now and disagree with him. I went into why I disagree in the letter this week but let me show you how a guru cannot only be wrong but drastically so.

In my visits to the library in order to read old Barrons (it is both very enjoyable and very enlightening) I came across this article a few months ago (see graphic below). It was published October 12th 1992 by a young Ray Dalio who was then managing $1.5 billion instead of the $150+ billion he is now managing. If you look at the title and then at the date you might be literally laughing out loud. The 1990’s were a lot of things but a depression is not one of them.

Ray Dalio Depression Not Recession

Ray Dalio Depression Not Recession-Barrons October 12, 1992

In the article Dalio goes into why he thought that we were in the early stages of a new depression. Among other things he pointed to was that the Fed had already drastically cut rates and yet the overall economy remained weak.

As you can see in the chart below of the 10-2 yield spread, this piece, and Dalio’s view, came out right at peak Fed ineffectiveness. What I mean by this is basically right around the time that this piece was published, the Fed stimulus started to work, and we left the recession which means that not only was he wrong but he was wrong at exactly the wrong time.

10-2 Yield Spread 1988-1995

10-2 Treasury Yield Spread 1988-1995

As we now know the economy not only did not go into a depression but was actually in the middle of the best 20 year period in the US stock market history. Of course Dalio being a master of the craft must have figured this out since as you can see in the performance table below he proceeded to make a little bit in 1992 and kill it in 1993 (see table in the graphic below).

Bridgewater Pure Alpha Fund Returns

Bridgewater Pure Alpha Fund Returns-Source ValueWalk

Hopefully you see the value in independent thought. Here is a true master, or wizard if you prefer, calling for a depression in something as public as Barrons. He was not only wrong but drastically wrong. If you had blindly followed it, you would have missed some of the best years in market history.

Blindly following a guru, even a guru as good as Dalio, is a sure way to the poor house.  Please think for yourself in all things. Read research (shameless plug: this letter is a great place to find some) but in the end make sure that you agree with any trade idea you find here or anywhere else and that it fits with your current portfolio. Doing anything else is just a way to lose money in the long term.

As a not so side note you should always be thinking things through and making your own decisions. Doing anything else deprives you of learning…..and that sounds like something out of “Principles” by Dalio.

Happy Trading,

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Does This Feel Like Mid-2007?

We track volatility across asset classes and throughout this year, especially the second half, have been amazed and the consistent volatility compression across assets. Here is our Average VIX where we take a simple average of several different volatility indices. Right now we are sitting at levels last seen in mid-2007 and we are struck with the complacency in the marketplace.(Click on chart to enlarge)

Are the potential risks really so small that no one finds it worthwhile to buy protection? A short list of potential risks would be the sovereign debt issues, fiscal cliff, Europe, Japan, China, Italy, Middle East, etc.,we can almost literally go on forever. Our current list of risks is as high as it has ever been and yet volatility is getting lower and lower from already low levels. While the Bernanke put has some power we question whether it is really the holy grail of safety nets. Just something to think about as we watch European stocks breaking out and US equities moving higher while at the same time Treasuries continue to catch a bid.

Happy Trading,

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The Most Overvalued Currency In The World*

While not quite as cool sounding as “the most interesting man in the world” the most overvalued currency could actually help you make money, as many other alternatives online like the use of investment solutions such you can learn from resources as this candlestick patterns pdf that teach people to make money online. Interesting doesn’t pay like over/under valuation. So what is the most overvalued currency in the G-10? If you guessed the Australian Dollar you win. Across pairs the AUD is consistently the most expensive currency and has been for a while.

Why is the AUD so overvalued? They never had a housing crash like in the US and southern Europe, they have strong natural resources, up until this year investors kept believing that China can save all, and last but not least they had the highest short term interest rates in the G-10. With high relative interest rates the AUD has been the carry trade of choice and consequently has been one of the go to “Risk On” trades since the 2008 crash. How high have rates been relative to the rest of the G-10? Below is a chart of G-10 90-day rates. (Click on chart to enlarge)

G-10 90-Day Interest Rates

Combined with the ZIRP or near ZIRP policies in most of the world the AUD has attracted a lot of money looking for yield. Of course you then have to ask is this yield safe? Judging from the slowdown in China and the drop in Australian interest rates we question the safety of this trade, of course we question anything that is considered safe.

So how overvalued is the AUD? Well using PPP-purchasing price parity as our valuation gauge here are a few charts showing how extended it really is. Our first chart is of the EUR/AUD. Here the AUD is “only” 20% overvalued.(Click on chart to enlarge)


Next up is the AUD/CAD. Here you would think the relationship would be closer since the makeup of their economies is similar with commodities making up such a large part. Of course Canada is tied to the US and Australia is tied to China. Either way the AUD/CAD is overvalued to the tune of 27%.(Click on chart to enlarge)


Looking at the AUD/JPY things continue to get worse as the Australian Dollar is overvalued against the Yen by 40%.(Click on chart to enlarge)


Up last we have the worst case of overvaluation of the group. The AUD/USD is ridiculous for several reasons but the one we are looking at today is that it is overvalued by over 50%.(Click on chart to enlarge)


As you can see by the charts currencies have their share of value fluctuations but like most of finance things are rarely different and it is hard to fight reality forever. Trading currencies based on valuations is not for the impatient as it can take months and even years for things to come back in line but as evidenced by the above charts once the pendulum starts to swing the other direction it tends to carry it for some time. With China slowing down and the RBA in a rate easing cycle we think that the pendulum is ready to swing the other way.

*-We deal primarily in G-10 currencies. AUD is not the most overvalued currency on the planet, but is the most overvalued currency in the industrialized world.

Happy Trading,

Disclaimer-In our model portfolio we are short the AUD

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The Futility of Buzz Lightyear and QE to Infinity and Beyond

We have all seen a chart similar to the one below of the effects of QE on the stock market.  When the Fed is buying the market moves higher and when it sells it helps the market move lower.  Of course what we have all noticed, well everyone except for Buzz Lightyear at the Fed, is that each successive buy program has led to a smaller and smaller rise in the market.  So the question is with a zero interest rate policy and with an additional and infinite buy program in place, at what point do we decide that maybe it is alright to fight the Fed?  The more we look at it the more we think that their stance is sufficiently weakened that shorting may soon be, and indeed may already be, a viable option.

Looking at the situation from a smaller time frame the results are basically the same.  Here is a table showing how Fed buy days compare against sell days as well as all days for the SP500.  As you can see the out performance was fairly consistent since the end of August 2005.  If you bought the market at the open on the day of a POMO buy and sold at the close you outperformed by a wide margin.  If you held for 10 days you still were winning.

When we go to the latest finished action of operation twist however we can see that, like the large chart above shows, the effects of Fed buying have been drastically diminished.  Buy days still outperform the SP500 by a small margin but does not fare so well against the sell days.  Wen you take it out to 10 days the out performance is almost non-existent showing that Fed buying is not what it used to be.

All of this combined with out slowdown/recession forecast gives us more and more reason to look for shorting opportunities.  If we are entering an earnings led recession and the Fed’s efforts are falling on investors with less and less force than it is getting closer and closer to being safe to fight Buzz Lightyear Bernanke and the Fed.

Happy Trading,

Disclaimer-In our model portfolio we are long TLT.

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A Case For Buying Treasuries

The majority of investors seem to hate them and the rest are shorting them. While at some point shorting bonds will be a huge trade we think that the timing is still a ways off for the end of the 31-Year bond bull. So what do bonds have going for them? Well the most obvious and yet what seems to be the most overlooked is the simple trend. Looking at the chart below you should ask yourself how many times have investors been convinced that rates were too low? (click on chart below to enlarge)

30-Year Treasury Yield

Aside from the trend we have the current situation with GDP growth of only 1.7% which is very slow for a so-called recovery, especially one that is five years along. In addition we have very slow growth globally as Europe continues to blow up and we keep seeing estimates for China drop every month or two. We have very slow global growth and this is showing in very low inflation data. Yes, the central banks led by Helicopter Ben are juicing the system, hell I hear Ben is dressing up as Buzz Lightyear for Halloween so he can say “QE to infinity and beyond” but the fact is that despite their best efforts inflation remains muted.

In a world of extremely slow growth and chronically low inflation we would expect Treasuries to do well and lo and behold they have. Since QE1 was announced November 25th 2008 we have seen 30-Yr yields drop from 3.632% to 2.988% and the 10-Yr dropped from 3.092% all the way to 1.811%. If this does not make it obvious that QE alone does not cause the bond market to crash then nothing will. No, until we see stronger growth and a large pick up with inflation we expect fundamental picture to remain decent to strong for Treasuries.

Now of course we are going to get some people saying “but bonds are up too much” our natural response would be something like WTF? but our more reasoned response would be compared to what? Bonds have been up “too much” for the last 20 years. Who would have ever thought that 5% 30-Yr interest rates would sound high? Rates are low but they are a long ways from 0% which would indicate that they have room to go lower. That said what does the technical picture look for bonds? In the chart below we have our intermediate term 30-Yr Reversion to the Mean (RTM) chart. While the RTM chart isn’t saying load the boat it is also not saying run for the hills as it is instead giving us an almost perfectly neutral reading which indicates that bonds have plenty of room to go up or down before reaching anything near an oversold/overbought point. (click on chart to enlarge)

30-Yr Treasury RTM

Finally, at least for now, is the sentiment picture. We all know that volatility is one of the most mean reverting series in all of finance. In the chart below we have the Treasury MOVE index vs the 30-Yr yield and then we have overlaid the 30-Yr yield with an inverse scale. We inverted it so it is a better visual as to what happens to bond prices when the MOVE index is so low. As you can see when Treasury volatility is really low it is usually a time to be buying bonds and when it is high is when you should be selling. Well right now we are hovering close to the lows of the past five years indicating that bonds could take off at any time. (click on chart to enlarge)

So is going long bonds the new trade of the century? Nope not by a long shot. Still that doesn’t meant that there isn’t a case to be made for being long. The economic fundamentals are in place, unless you think we are the cusp of a huge growth spree. The technical picture is saying that while its not a perfect buy there is plenty of room to run. Finally sentiment/volatility are saying that the time in at hand for a renewed move higher in Treasury bonds. Obviously we could be wrong but the risk reward is there.

Happy Trading,

Disclaimer-In our model portfolio we are long TLT, AGG, and FLAT.

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