Thursday, December 23, 2010

Thoughts from the Desk

Here is an email I just sent to my friend W (a former trading desk colleague who I still bounce ideas off every now and then). Not a particularly deep email or anything, but it may serve to give a flavor of the way I approach directional macro trading:
There seems to be a clear divergence in markets at the moment. On the one hand commodities especially ags are charging higher. JJS is up over 20% mtd. And soybeans are making their 2nd attempt at clearing resistance at 1350; if they break then the next target is around 1550. So that's bullish. On the other hand EM stocks are clearly weak. China, Brazil and India are all down 10% from their peaks in early Nov and the charts all look quite bearish to me (especially China). For whatever reason, commentators here are completely ignoring the EM swoon [1]. But it could be dangerous, especially if oil continues to rally (remember the rule: if oil use is above 6% of GDP, a recession is coming).

I am uncomfortably reminded of Jan 2008. Then too, oil was at 90ish. Then too, India and China had peaked a few weeks / months previously. Then too ags rallied phenomenally for a few more months before crashing. (This fits in well with my existing thesis that soybeans should rally till June 2011). Of course history never repeats itself exactly, but it does rhyme occasionally. At any rate, I am going to be watching very carefully for signs of a correction (possibly a major correction)...

[1] Everyone on TV is happy because US stocks are melting up into year end. My own theory is that people were convinced that QE2 was a "buy-the-rumor-sell-the-fact" trade and so they unwound their positions in Nov, happy to lock in their profits for the year. Without so many longs left in the game the market was free to rally, and so it did.

Thursday, December 2, 2010

Europa Endlos

One exercise that I used to do quite often, back in the days when I was a "professional" trader (that is to say, a trader with other people's money), was to make up improbable scenarios and justify / explain them.

Part of my motivation for this exercise was to be intentionally and deliberately contrarian. Saying No when the market says Yes is a long-term profitable strategy in itself, irrespective of the underlying fundamentals. (Some day I will write a longer post on why this should be the case).

Another part of my motivation was to have fun. There's nothing like donning a tin-foil hat to enliven a drab afternoon trading session.

But the most important part of my motivation was a serious one: to avoid confirmation bias. Quoting Wikipedia: "Confirmation bias is the tendency for people to favor information that confirms their preconceptions or hypotheses, regardless of whether the information is true."

This was something I had to constantly guard against in my career as a trader. Given the sheer volume of market data that I was constantly barraged by, and the necessity of somehow filtering that data, it was essential to make sure that my filters were unbiased. Considering alternative points of view not tainted by a priori estimates of "probability" was an excellent way of maintaining filter neutrality. Hence the contrarian game.

Here's an example of how to play. Right now the newspapers are full of the Irish bailout and the fear of contagion in other Eurozone economies ("PIIGS-hooey"). You might think that this somewhat fraught state of affairs would lead to a decline in the Euro, and indeed that is the consensus opinion. So your task is to be contrarian and invent a rationale for going long the Euro, despite (or perhaps because of) these macro currents.

And here's such a rationale. Assume the crisis gets worse. Assume contagion in the form of inexorably rising bond yields spreads to Portugal, then Spain, then Italy. The worse the crisis gets, the less possible it is for the centre to bail out the periphery. The only option left is default, and possibly exit. But what happens after that? As successive dominoes fall, the common currency zone shrinks until only healthy core countries (read: Germany) remain. The Euro ends up looking a lot like the old Deutsche Mark. Freed of all its baggage, it begins to rally. Voila!

Note that I don't actually believe this scenario will eventuate, at least not with a high probability and not in the near term. But at the very least, thinking through a scenario like this (replete with path-dependency and feedback effects) makes it difficult to simple say "Europe in crisis, Euro goes down" and use that as a guide to trading. Life is more complicated than that.

Month-End Recap, Nov 2010

The second installment of a new feature: a very quick summary of my investment positions, to be published monthly. This is not investment advice and should not be construed as such.

I am currently 90% invested, as follows:

57% Agricultural commodities
10% Other commodities
16% Emerging market equities
07% Miscellaneous equities
10% Cash

My largest position continues to be in soybeans, followed by sugar.

A rather boring month for my portfolio, to be honest. PL-wise I was down a very small amount, small enough to be considered mere noise in the context of my YTD returns. (Many a trader has said these words and lived to regret them, ha ha).

I usually try to be between 85% and 105% invested, so I am below my average exposure here. Indeed, as planned and previously advertised, I reduced my net exposure in November, from 93% last month to 90% today, by selling some commodities and some Indian stocks. It's not that I'm particularly bearish or anything; it's just that I have no strong convictions at the moment and so would like to wait and see what develops while keeping some powder dry.

Wednesday, December 1, 2010

Paragraphs Worth Reading

Why write long blog posts explicating your point of view, when others have done your work for you (and much more eloquently I might add)?

Here's the always-excellent Interfluidity on "hangover theory":

Proponents do claim that poverty in the sense of diminished consumption, painful financial losses, and “creative destruction” of cherished institutions usually attend the adjustment process, and they recognize all this is usually associated with unemployment. But hangover theorists argue that adjustment is worth doing despite the cost in employment, consumption, and disruption, not because those costs are good things. When they do argue that “pain is good”, it is along very conventional lines of moral hazard. It is not that the macroeconomy “deserves” to suffer, but that foolish lenders and borrowers, specific misallocators of capital and overconsumers, ought to suffer disproportionately pour encourager les autres. Hangover theorists, like smart Keynesians, promote policies intended to shorten depressions when they occur. Austrians ask that bad claims quickly be recognized and devalued, so that economic activity can go forward without a debt overhang. Keynesians urge government action that conjures financial income from thin air, risking devaluation of old claims by inflation. There are different tradeoffs between moral hazard, sharp incentives, and political feasibility among the two approaches, but both seek to repair balance sheets and create a clean slate going forward.

And here's commenter sardonic_sob on the same topic:

I understand completely, and furthermore agree completely, with the idea that if we wiped out all the bad debt etc tomorrow but everybody just got up and went to work and nobody panicked we would have no problem making enough food and housing and cars and big-screen TV’s and so forth for everybody. The problem is that we will not DO that. We will continue to issue massive amounts of real or implied debt to try to keep anybody from losing and the net result is that the malinvestments will not be purged until they grow so large that they just can’t keep the plates spinning anymore. Then everybody WILL panic and nobody will get up and go to work because that’s just how human beings are.

And lurking ahead is the spectre of Peak Commodities, which nobody is worried about because we can just tweak our economy like a big machine, and if prices get too high we can just pull on the pullem and push on the pushem and fix it, right? However, our system requires massive amounts of low-cost energy and materials to fuel growth. (Without growth debt service becomes impossible and see prior paragraph.) You can’t print oil, coal, rare earths, or potassium. Don’t get me wrong: while I find the Olduvai Theory eerily compelling I firmly believe that we have the technical capability to get ourselves out of this mess. But we aren’t using it because we are devoting so much energy to keeping everything the way it is. This will work until it doesn’t, and we don’t have a Plan B. (That last sentence is pretty much my entire objection to economic manipulation in a nutshell.)

Both posts are well worth reading in entirety.