Sunday, April 5, 2015

Hanging on to leveraged instruments while it runs up

Read: March Madness Apr 2015

I have always felt that leveraged instruments are a double bet, similar to when a friend buys a number of bets from the local betting station be it lottery tickets with various numbers or, both a draw and win/lose result on a soccer match.

The only difference between the two, I find, is that for a leveraged instrument, it is on the results of 2 separate rolls of a dice whereby the results does not appear simultaneously.

Perhaps, more similar to wagering on a table, intending on using the winnings of a prior wager on a separate table.

Knowing how to maximize return versus risk in these new waters will be key. There are at least several approaches, anyone of which may be the correct one. 
  • Dalio/Prince from Bridgewater cautiously advance the theme that if borrowing costs center around 0% real, then assets can be cautiously levered, being cognizant at the same time of the fat tails inherent in our new world of leverage and extreme monetary policy. 
  • Jeremy Grantham and fellow professionals at GMO hint at waiting it out in low returning cash under the assumption of a 7 year reversion to the mean, instead of a 20 year cycle hinted at by Rogoff and others. Grantham expects a stock market deluge in the near term future and he may be right, but if not, GMO may underperform while waiting. 
  • Then there is Warren Buffett, who has the benefit of a near perpetual closed-end fund purchasing stocks when fundamentally cheap. 
  • For most investors who don’t have the benefit of a closed-end business structure, perhaps Jack Bogle is right. 
unconstrained portfolios at Janus mimic most closely the strategic philosophy at Bridgewater. Cheap leverage is an alpha generating strategy as long as short rates stay low and mimic the 0% real new neutral. Of course if an investor borrows short term to invest longer and riskier, the potential alpha necessarily demands choosing the correct assets to lever. That is not easy these days since almost all assets are artificially priced. The challenge is to purchase the ones that might remain artificially priced over one’s investment horizon. For me, credit spreads are too tight and therefore expensive. Duration is more neutral but there is little to be gained from it in the U.S., Euroland, and the UK unless the global economy inches towards recession. The most attractive opportunity to me rests with the notion that Draghi’s 18 month QE, which roughly purchases 200% of sovereign net new issuance during that time, will keep yields low in Germany and therefore anchor U.S. Treasuries and UK Gilts in the process. I would not buy these clearly overvalued assets but sell “volatility” around them, such that much higher returns can be captured if say the German 10 year Bund at 20 basis points doesn’t move to –.05% or up to .50% over three months’ time. Draghi’s QE should place a high probability on staying within that range 

It is lesser surprise to me, that Fed wants to increase interest rates. Now, it is more a curiosity to me: how? The components more interesting to me, of the current global arena, are the price of oil, USD value and the political/economic tightrope between a world accelerating toward bipolarity.

A more serious concern however, might be that low interest rates globally destroy financial business models that are critical to the functioning of modern day economies. Pension funds and insurance companies are perhaps the most important examples of financial sectors that are threatened by low to negative interest rates. Both sectors have always attempted to immunize their long term liabilities (retirement, health, morbidity) by investing at a similar duration with an attractive yield. Now that negative and in almost all cases low short term rates are expected to persist, long term bonds and similar duration assets do not offer the ability to pay claims 5, 10, 30 years into the future. With 10 year German Bonds at 30 basis points and the possibility of them going negative after the beginning of the ECB’s QE in March, what German, Dutch, or French insurance company would attempt to immunize liabilities at the zero bound or lower? Immunization makes no economic or business sense at these levels; similarly for pension funds. In fact even households are handcuffed by low/negative yields, who everyday must now address their inability to save enough money at a high enough rate to pay for education, healthcare, and retirement obligations. Negative/zero bound interest rates may exacerbate, instead of stimulate low growth rates in all of these instances, by raising savings and deferring consumption.
This possibility may be one reason why the Fed appears to be moving to raise interest rates gradually beginning in June this year. In an attempt to elevate returns, investors and savers do all the wrong things required of a stable capitalistic model. Savers save more, not less, and invest at higher risk levels in order to reach their long term liability expectations. Asset prices for stocks, high yield bonds and other supposed 5-10% returning investments, become stretched and bubble sensitive; Debt accumulates instead of being paid off because rates are too low to pass up – corporate bond sales leading to stock buybacks being the best example. The financial system has become increasingly vulnerable only six years after its last collapse in 2009.