Ask And Ye Shall Receive

Questions require answers and lots of questions require lots of answers.

You’d be wrong in thinking that you’ll get either since the missing ingredient to both is lots of time. Someone invent me a time machine and I’ll answer more questions. Until then I have a select few to share.

I do read all emails and questions sent but obviously can’t answer them all. Sorry about that…

It’s been a while since I did a Q&A on the blog so here goes the first one:

Quick note to let you know I really enjoy the podcast. I discovered it through a republication on the Zerohedge blog.

I greatly appreciate the focused, intelligent, macro-economic discussions without the spin and sensationalism. I work for a hedge fund, and have (like many others) been struggling to make sense of these QE fueled, Central Bank driven markets. Retail investors (friends & family, not clients) ask me all the time where to put their money, which is a tough one because where do you go if both stocks & bonds are at historic highs?

There is also not a ton of value for real estate buyers & investors, and nothing to be had for money in the bank (except for fees). Not a good sign when guys I play pickup basketball with are talking about buying vacation properties as an investment since rates are cheap. I suppose I should tell them to lever up to the hilt, and wait for the next bailout?

Keep up the good work!

Thanks for the kind words! I don’t know where you’re based as we’ve readers from all over the world but I’ll assume you’re US based. The US is almost certainly heading into a recession so even if you’re prepared to play the momentum game you’re not really being paid to take the risk.

Buying real estate at the tail end of the long term debt super cycle takes cojones I don’t have. What’s your compensation?

What does make sense – if you can find it – is cashflow real estate, based on a 30-year fixed rate mortgage. Even at breakeven on cashflow this can make sense (location dependent) since you’re synthetically short the bond market with other people’s money. I’d be OK doing that.

To more specifically answer your question: standard portfolio theory works in a world where every single asset price on the planet is not manipulated. That’s not a world we enjoy to any degree at all.

And yet, these asset allocation models persist because they’re taught at most business schools by men with moustaches and pointy shoes who don’t have to deal with the real world.

Going to cash, cash equivalents, and liquidity with the majority of your capital, while placing bets on convexity, makes a lot of sense to us. Look for where convexity lies because your cost of entry is so stupidly low and your return potential so high that even when you get it wrong you’re not penalised much for it. This makes even more sense in a world where you’re now penalised for holding cash in a bank.

Thanks for an excellent site. I’ve been a reader since 2012 but this is the first time I’ve reached out. I can’t tell you how many times your sound reasoning has saved my butt. Thank you.

With all the advances in technology I’m curious as to why you are not investing in Venture deals which you were doing previously? Also I read your article on Tesla and wondered if you had any thoughts on Amazon as a tech play since I’ve been buying them over the last year, as I see so much going online and they are the 100lb gorilla in this market. Any thoughts on them?

Sincerely appreciative F.E

As you may already know, I ran an early stage VC business from 2012 through early 2016 so I know a thing or two about it.

To answer your question, I’ll tell you about a previous life. In the early 2000’s I built a real estate investment holding business. Super simple business model which a trained monkey could execute. Buy middle to lower middle class homes at double digit yields (they were available then), leverage them up, and buy more.

It was simple interest rate arbitrage with leverage, where you could constantly examine and understand risk by managing your spread.

Fast forward 2006, and I was struggling to find anything worth adding to the portfolio. Credit was still available but yields had collapsed to 4% or less. Great for asset values (I’d made 60x on my capital) but nothing to buy without going further down the risk curve. I sold up and got out.

Increasingly, I found the same set of problems in VC. It’s hard to compete with excited 30-year olds, flush with cash who will blindly throw money at deals. It’s eerily similar to the situation I found myself in when I liquidated real estate in late 2006. Also equally importantly, the risk to being illiquid ahead of what I am looking at now is just too great for me to ignore.

My friend Raoul Pal mentions private equity is in a “terrifying situation”. I’m no expert on the subject and Raoul certainly knows more about it than I do but early stage VC has increasingly become a lottery ticket investing market right at the point where global liquidity is drying up. It’s a function of easy money distorting asset prices globally.

There are a couple of really interesting private deals that I’m working on with partners but as a whole I’m not spending time on the sector.

Regarding Amazon: remember that Elon Musk, Jeff Bezos, etc. are using available capital to build their dreams. But if you look at the cap tables they are certainly not “all in” backing these companies with their own personal balance sheets. Not even close. But hey – you and I’d do the same thing if we could get away with it…

In an environment of zero interest rates and cheap capital, companies with great stories, accompanied by media buzz, benefit from herding and crowd behaviour. This is where both Tesla and Amazon shine.

Now, I’m not suggesting Amazon is a fraud which I think Tesla probably is. As far as I can tell it’s just another overvalued company which has grown on the back of very accommodative monetary policy and bullish equity markets. Part of the reason is that it’s valued like a tech company, but if you look at their operations, aside from cloud, it’s a retailer.

They have a market capitalization of $360 billion dollars and their listed P/E (TTM) is 191. EPS is a paltry buck and change and operating margins are 2.7%. For this to somehow work out, Amazon has to take over virtually all online commerce and run IT for most corporations in the US and maybe even the rest of the world. That’s just for it to live up to its current market cap.

All I’d say is to make sure you make the distinction between fascinating exciting ideas and what you’re prepared to pay for them. Full disclosure: I’m not interested in Amazon, either long or short.

The ‘dollar’ is the single most interesting and important issue for the global financial system right now — at least, that is my instinct (and Raoul has banged this drum for quite a while) but I still haven’t come across anyone who can articulate (in layman’s terms) why this structural short exists. Jeff Snider at Alhambra Capital Partners is all over this — he knows his stuff but he is difficult to follow. And Raoul had a go on this podcast but his description is still fairly vague. We know that the Eurodollar system is unwinding (via the mountain of derivatives the banks created in the decade leading up to the GFC) but who exactly is left ‘short’ after these derivatives are unwound? The unwind itself doesn’t involve a cancellation of one leg — both parties to the transactions are matched off. I assume it has to do with foreign banks’ ability to lend dollars to their customers who themselves have $ liabilities. Any explanation from anyone would be gratefully received 🙂

Ignoring, for now, the challenge of explaining precisely why this dollar short exists, the dollar short is key IMHO to the endgame, as this short will pressure the dollar much higher at some point (when the next crisis erupts) and that will create all manner of problems across the globe — other than $ longs and the American public, the effects would be hugely negative for most. That says to me that the Fed will have no choice but to step in to counteract $ strength (via the printing press, swaps etc) and they will need to do so in a massive way as the gap left by the collapsing Eurodollar system is colossal ….. and this intervention will inevitably lead to the destruction of the dollar (and the global currency system as a whole).

The core thing is that dollars were borrowed globally due in part to QE which followed the GFC. QE created a wonderful carry as investors could borrow dollars and invest them into higher yielding foreign currency investments (I discussed the anatomy of a carry trade here if you’re interested). On a macro scale foreign countries actually receive less dollars because assets are priced in dollars. Take oil as a prime example: oil priced in dollars goes down when the dollar goes up.

DXY vs oil

I grabbed the above chart from my trading platform. Oil in blue and dollar index in red and green. You can see how correlated they are.

So when oil countries receive dollars they’re earning far less. So now there is an additional shortage of dollars. This affects world trade since profits are lower for anyone selling anything priced in dollars, which is a lot since world trade is still done mostly in dollars. As a result, world trade shrinks and this is without getting into dollar funding liabilities.

Your question is about the eurodollar market which provides us with a window into the risk in the European banking system (or at least in theory it should do so). There are no signs of stress right now, though there are mitigating reasons why I think this is the case (backstopping by ECB is being priced into the market).

There is no way eurodollar futures should be trading at current levels given the market risks. This is more a function of the market pricing in central bank intervention. Very dangerous!

Remember, foreign banks’ ability and confidence to lend dollars will likely show up in Euribor rates moving. Those are still ridiculously low. I think if there are any problems, the Fed wouldn’t hesitate to open swap lines.

The second part of your question is around how the strength of the dollar impacts global capital flows. As I mentioned, a strong dollar is bad for global growth. The Fed know this and have indicated it in their minutes.

Right now there is an interest rate differential the other way: US rates are still positive, while European and Japanese are negative, and the UK is at zero so this attracts capital to the US.

It’s why – as insane as it may seem – when looking at it in isolation, the US bond market is likely to go higher (i.e rates lower). Ultimately there is a reset coming and we don’t know when or even how it will play out. We can only look for clues and position accordingly.

Your article on 7 steps to shorting the Euro was fu**ing exceptional. I sent it to everyone I know and have printed it and stuck it on our conference room whiteboard as a talking point. I am a partner at a fixed income fund in London and both internally, and with colleagues we talk a lot about this. Until today I’d not come across such a cogent explanation of how the social interacts with the financial. If I am correct your thesis is largely on rising intolerance towards migrants. You don’t need to convince me of this. I’m seeing it in trips to the continent. I’ve not seen much of it in the mainstream media though. Have you seen any indication in the mainstream media yet?

Thanks for the excellent work. P.T

It’s been fascinating to watch.

Remember, when we first heard about these people from Middle Eastern and North African trouble spots they were referred to as displaced people. Remember that?

Then a few years later they where called refugees, and now increasingly they’re referred to as migrants. The language itself is informative.

If we pay careful attention to the language used, we can pick up the underlying tone. Let’s use you as an example. So you’re a fund manager. I can refer to you as a “fund manager”, or as “one of the 1%”. Both statements are strictly speaking true but the underlying tone is quite different.

My researcher just sent me an article about a study that was conducted on the topic of refugees and sentiment towards them. It’s profoundly negative and will only keep rising.

The lid can come off the kettle when the media feel at ease with stating things currently politically incorrect. This lifting of the veil can come with election of leaders who are already using this language.

This is why Trump’s snake story and pig’s blood story resonates. It is tapping into this underlying tone. By the way, I’m not for or against any of these crooks – just pointing out the consequences.

I’m interested in the knock on effects and how to position accordingly.

Have a great weekend, wherever you are.

– Chris

“The essence of the independent mind lies not in what it thinks, but in how it thinks.” — Christopher Hitchens

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